The Advisors' Blog

– Fred Whittlesey, Principal, Buck Consultants

The rapidly escalating activity in, and debate about, “fixing” underwater equity has resulted in some public rifts. Much of the discussion centers on the technical complexity of option exchanges and performance plan resetting. Others, like our firm’s position, focuses more on Equity EffectivenessTM and the opportunity that the current market chaos presents for re-evaluating the role of equity compensation in total pay strategy.

Frankly, I think some are more interested in selling option exchange programs, and the time-intensive valuation, design, and disclosure processes that they require, though I would hope that the lucrative fee opportunities in these would not cause anyone to recommend these programs over simpler and more cost-effective strategies.

The phrase coined by our Firm – which is the name of this memo, “Stop Before You Swap” – is intended to encourage companies to step back and re-assess why they use equity compensation and, more importantly, the total financial return they are realizing from the related expenditures. While there are numerous obvious responses to this question – market practice, industry norms, financial efficiency – we believe all of these are called into a new light in this unprecedented environment.

Remember, the “cost” of equity compensation is not just FAS123R or IFRS2 accounting expense. The all-in cost of plan evaluation, design, valuation, implementation, and administration is rarely tracked but typically quite high. We believe that these cumulative costs sometimes exceed the pay delivered to plan participants, even before the recent market downturn. Equity compensation may be the sole business practice that is exempt from ROI calculations.

To suggest that underwater equity – inclusive of underwater options, RSUs with minimal value compared to values at grant date, and performance plans with little or no hope of payout – should only be dealt with through direct action on those awards is simplistic.

Similarly, in this era of heightened scrutiny to executive pay practices and the spillover to equity programs, it is irresponsible to suggest that conforming to a single proxy advisor’s arbitrary criteria as guidance for such actions is de facto “good governance.” We already have examples of companies that conformed to “the rules’ but whose programs failed as well as those who ignored the rules and proceeded with successful programs that made good business sense.

We are not in a time where programs and checklists can be the basis for good governance and good business decisions. We are in a time that requires comprehensive analysis about governance and financial issues, and not just how to optimize option exchange rates through manipulation of expected life assumptions.

Corporate governance advisors expect more and shareholders deserve more. When millions of Americans have lost one-third or more of their life savings, and some have lost their jobs and their homes too, a focus on restoring equity compensation value to “incent and retain” employees deserves critical thinking.