The Advisors' Blog

– Ira Kay and Steve Seelig, Watson Wyatt Worldwide

We understand that at least some companies are discussing or considering special off-cycle equity grants for top executives in response to the recent decline in share prices. Such grants may pre-emptively address concerns that executives will “self re-price” by forfeiting options at their current employer in exchange for large new hire option grants with a relatively low exercise price at another company. While off-cycle grants were made by some companies during the last broad-based market decline in 2001, we believe that fewer companies will do this in today’s environment.

Our colleague Tom Kelly pointed out the reasons why this market is different:

1. Several companies who did this in 2001 found they made the special grants too early, and continued declines in share prices meant that the additional grants simply compounded the retention problem of underwater options.

2. Off-cycle equity grants are criticized by many investors as a form of “spring loading” or “market timing.”

3. With the new accounting rules, more companies have transitioned to viewing annual equity grants in terms of grant date value and as part of “total compensation.” Making off-cycle equity grants in response to a share price decline weakens the argument that equity grants are a key element of regular direct compensation.

4. The new proxy disclosure rules require companies to discuss in more detail their methodologies and processes for awarding equity-based compensation. This includes timing of awards as well as how the size of grants is determined.

5. Making an additional round of option grants just because the share price is considered to be at a low is not something most companies want to put into their proxy statement.

6. Companies are more judicious about managing their authorized pool for equity awards and Compensation Committees have become more diligent in managing things like overhang and total annual grant size. Accelerating 2009 grants into late 2008, which some companies did in 2001 and others did in 2005 (in advance of the change to FAS 123R), is similar to taking an advance on a line of credit. Using too much in one year can result in constraints on grant capacity in future years.

7. Fears about executives “self-repricing” by leaving their job and underwater options at one company for a large new hire grant at another company do not seem to be holding up in 2008 as compared to 2001. This time, the decline in share prices is more broad-based and the outlook for recovery is more uncertain.

8. Option grants are only one part of most companies’ long-term incentive program. Although other vehicles could be impacted by declining share prices, a primary reason why many companies shifted to restricted stock after 2001 was to provide a retention cushion in the event of share price declines.

While outstanding restricted shares have also declined in value since the time of grant, they still have some higher perceived value as compared to underwater stock options. Companies that have unvested restricted shares are less likely to feel the need to restore retention hooks through special grants of options.