The Advisors' Blog

– Gregory Schick, Sheppard Mullin Richter & Hampton LLP

The last two years of tumult in the financial markets has generated even greater scrutiny of executive compensation practices in part because of the view that such practices contributed to the on-going global financial crisis. Much has been discussed and written on this topic and the federal government has openly called for market reform and has adopted/proposed various regulations to curb excessive executive compensation.

As a result, equity compensation awards have also garnered much attention. In particular, what to do with outstanding underwater stock options and how to avoid providing a windfall to executives by granting options in a depressed market such that grantees will end up being unjustly enriched simply because stock market prices return to their former higher levels without any underlying superior performance achieved by the grantee or his/her company. Indeed, a quick look at the S&P 500 Index shows its significant volatility over the last couple of years.

Until earlier this Spring, the S&P 500 Index has generally been on a precipitous decline and approximated 1,500 two years ago in October 2007, 950 in October 2008 and 700 in March 2009. However, the index has since strongly rebounded and is currently approximating 1,100 in October 2009.

Broc’s reference to Bud Crystal’s recent article, “Stock Options Winners and Losers”, touched upon the unjust enrichment concern with granting option awards in a down market. Mr. Crystal’s article states that there are stock option “winners” which are options granted at a time when the stock price is materially lower than the average price during the calendar year of grant and “losers” which are options that are granted with exercise prices that are materially higher than the year’s average price. Mr. Crystal also suggests that an option’s exercise price could be based on an average of the issuer’s stock price for the year preceding the date of grant in order to eliminate such stock option winners and losers.

In another very interesting blog, Ed Burmeister proposes the intriguing idea of underwater stock option grants automatically being canceled without consideration if their degree of being underwater reaches some prescribed depth. Granting such self-canceling stock options could benefit the issuer since it would not have to go through the typical hand-wringing ordeal of what to do with deeply underwater options and potentially going through with a costly tender offer stock option exchange program.

Mr. Burmeister’s proposal to prematurely terminate a stock option based on the relationship between stock price and option exercise price represents the flip side of my blog from last year (“Mandatory Stock Option Exercises – A Benefit for Both Employer and Executive?”) in which I commented on the potential benefits of mandating automatic exercises of a nonqualified stock option upon attaining a prescribed threshold increase in the issuer’s stock price relative to the option’s exercise price.

As noted in my earlier blog, among other things, one benefit of an automatic exercise provision is that the option holder is converted into a shareholder with respect to the exercised shares and this feature can potentially mitigate an executive’s interest in taking excessive risks that a stock option could otherwise possibly promote.

With respect to the issues regarding the timing of equity compensation grants, it is important to recognize that it is not easy to accurately predict the future of the stock market in general (or of any particular company’s stock price) absent inside information. In fact, proponents of the Efficient Markets Hypothesis (EMH) or Random Walk Theory would generally say it is not possible.

Even critics of the EMH who advocate alternative views based on Behavioral Economics/Finance or the Adaptive Markets Hypothesis would presumably acknowledge that it is difficult to routinely and consistently outperform the market over time. This should not be a terribly difficult proposition to accept as forecasting the future with precision is something that is generally not achievable on a recurring basis. This means that at the time of any equity compensation grant, one cannot know with certainty whether the grant is occurring in a down or up market or whether the underlying stock price will appreciate or depreciate after grant. What we do know, based on market and stock price history, is that there will be fluctuation of prices in the future and that in hindsight one may contend that a particular equity award potentially was a beneficiary or victim based on the timing of its grant.

Therefore, it could be beneficial to try and smooth out the effects and consequences of the timing of equity compensation grants. Along the lines suggested by Mr. Crystal, a company may want to consider using an average of stock prices for establishing an option’s exercise price. Moreover, applying the self-cancellation and self-exercising features discussed above could address some of the adverse consequences that could be created in part simply because of when the options were granted.

It is important to note though that an issuer will want to be mindful of the regulations under Internal Revenue Code Section 409A that impose certain requirements when using average prices for establishing the fair market value that underlies an option award. That is, if an option’s exercise price is going to be based on an average of stock prices, a company would likely want to structure such a grant in accordance with the 409A regulations to ensure that the option is not treated as nonqualified deferred compensation. And, option grants to named executive officers that do not simply equate the exercise price to the closing price on the date of grant would require fuller disclosure under the SEC’s executive compensation disclosure rules.

In addition, companies may want to consider having grants issued more frequently than the typical one grant per year. For example, smaller magnitude grants, incorporating some or all of the features discussed above, could be awarded on a quarterly basis during a company’s open trading window period. More frequent grants, while probably more administratively burdensome, could produce a greater smoothing out of the effects of stock price fluctuations. Furthermore, particularly when a company’s stock price and/or the market is generally rising, using smaller but more frequent option grants as compared to one larger annual grant could provide less of a conflict of interest for executives with respect to their company’s stock price.

Similar to those nutritionists who recommend “grazing” which is the consumption of more frequent smaller meals rather than fewer larger meals, smaller but more frequent equity grants (“Equity Grant Grazing”) with fenced high/low stock price boundaries on exercisability and/or averaged exercise prices could become more easy to digest by both executives and shareholders than the current typical annual grant cycle.