– Ed Hauder, Senior Attorney and Consultant, Exequity, LLP
With all the gyrations in the market lately, I couldn’t help but wonder what this might mean for stock options. Yes, stock options have already experienced a bit of a decline in popularity in recent years thanks to FAS 123(R), but will the flight from options increase? (To read a better version of this blog, see this document with four charts added.)
Not being able to let this go, I ran some quick calculations of volatility for the Dow 30 stocks. The results confirmed that volatility had increased dramatically in 2008 (through October 17th) compared to 2007, 38.99% vs. 21.80% (based on a daily volatility calculation using adjusted closing stock prices), an increase of approximately 80%.
To see how this dramatic increase in volatility might impact stock options, I then looked at volatility for the same group of companies over two three-year periods (i) 1/1/2006 to 10/17/2008, and (ii) 1/1/2006 to 12/31/2007. Not surprisingly, the rise in volatility that showed in the year-over-year comparison also echoed in the three-year volatilities, 24.11% vs. 19.84%, an increase of approximately 22%.
So, how might this impact the future use of stock options? Options are going to become more expensive to use and, if the market is in a prolonged bear market (such as that between 1966 and 1982), there may not even be much upside potential. Additionally, the new bailout-related mandates, including admonitions against incentives that encourage “excessive risk,” are also likely to have an adverse impact on the use of stock options.
However, the stock prices themselves will be depressed compared to prior periods, so wouldn’t the impact of increased volatility be offset by the decrease in the stock price? To test that I took the closing median stock price of the Dow 30 companies for each of the 3 year periods, $33.33 for 1/1/2006 to 10/17/2008 and $46.99 for 1/1/2005 to 12/31/2007, and then used the medians of the most recent FAS 123(R) assumptions disclosed by the Dow 30: risk free interest rate of 4.80%, dividend yield of 2.33% and an expected life of 6.0 years, and ran a Black-Scholes model of a “median” stock option for the Dow 30 in each three-year period.
The results confirm that the relative cost of a stock option will increase as a result of the increase in volatility for 2008. The Black-Scholes values were $8.45 (25.36% of face value/median stock price) for the 1/1/2006 to 10/17/2008 period and $10.45 (22.23% of face value/median stock price) for the 2005-2007 period, representing a 14% increase in the percent of face value/median stock price. So, even though the stock price has dropped as has the Black-Scholes value, the FAS 123(R) cost for stock options will represent a larger percent of the stock price.
Is this the death of stock options? Probably not. But, their increased cost, possible limited upside and the new mandate to avoid excessive risk in compensation programs (at least for those companies participating in the financial bailout) will cause a good number of companies to reconsider their use of stock options, and, most likely, many of them will veer further away from stock options and towards full value awards like restricted stock units and performance shares/units. In these challenging times it will be harder to justify leveraged incentives that can result in greater upside potential than is the case for shareholders whose equity participation has come the old fashioned way – by buying full value shares.
A short while ago, Corp Fin Director John White announced he will be leaving the SEC at the end of the year after working at the SEC for nearly three years. I understand that John will return to the law firm for which he spent over 30 years, Cravath Swaine & Moore. Like his predecessor, John has overseen an enormous amount of regulatory change on his watch – and we thank John for all he has done for the corporate community (and for us by speaking out about responsible executive compensation disclosures).
Last Friday, the WSJ ran this front page, top article – entitled “Banks Owe Billions to Executives” – reporting that the big financial institutions getting capital infusions from the Treasury Department owed their senior executives more than $40 billion for past years’ pay and pensions as of the end of 2007.
The article notes that “Few firms report the size of these debts to their executives. (Goldman is an exception.) In most cases, the Journal calculated them by extrapolating from figures that the firms do have to disclose.”
What the WSJ would be surprised to hear is that many companies don’t even report the size of these debts to their own compensation committees and boards – because they don’t conduct a wealth accumulation analysis! In our “Wealth Accumulation Analysis” Practice Area, we have a number of sample tables to help you get started, including this new “Wealth Accumulation/Full Walk Away Amounts Chart” courtesy of Watson Wyatt and Deloitte Consulting.
In his “Icahn Report” Blog, Carl Icahn recently threw down the gauntlet and blamed compensation consultants for excessive CEO pay. Here is an excerpt from his blog:
A major reason executive pay packages are ballooning is because of the incestuous relationships between boards and CEOs who conspire to give lucrative pay-and-perk packages to each other. But it is also due to the egregious use of “compensation consultants” that soak up multi-million dollar fees to provide strategic counsel to boards and in addition advise ever higher pay packages to top managers they presume to oversee – whether they perform well or not.
We’re ready to see some responses from those toiling in the fields. I know Carl has missed the mark, how about you?
Recently, Equilar released its latest trend reports regarding stock ownership policies. Below is a summary of the full reports (which can be purchased from Equilar here):
1. Executive Stock Ownership Policies
– The prevalence of Fortune 250 companies with publicly disclosed executive stock ownership policies, including ownership guidelines and/or holding requirements, increased from 80.9% in 2006 to 82.6% in 2007.
– Ownership guidelines remain the most prevalent form of ownership policy, appearing at 78.0% of Fortune 250 companies in 2007. In 2006, 75.5% of companies disclosed guidelines.
– For Fortune 250 companies with ownership guidelines, most choose to define ownership targets as a multiple of base salary. In 2007, 79.8% set their targets in this fashion.
2. Director Stock Ownership Policies
– The prevalence of Fortune 250 companies with publicly disclosed non-employee director stock ownership policies, including ownership guidelines and/or holding requirements, increased from 77.6% in 2006 to 78.9% in 2007.
– Often, ownership guidelines and holding requirements can be used in tandem to promote equity ownership. Among the Fortune 250, the prevalence of companies with both types of policies for non-employee directors increased from 12.8% in 2006 to 16.2% in 2007.
With November just around the corner and, for many companies, perhaps the last compensation committee meeting of the year scheduled in the next two months, it is now critically important to start thinking about your Compensation Discussion & Analysis for the 2009 proxy statement. There is still time for companies and compensation committees to take appropriate actions that can serve as the foundation for the analytical disclosure in the CD&A that the SEC and others expect. Many of these actions were discussed in detail last week at our two conferences, “Tackling Your 2009 Compensation Disclosures: The 3rd Annual Proxy Disclosure Conference” and the “5th Annual Executive Compensation Conference,” as well as at the “16th Annual NASPP Conference.”
To kick off the CD&A panels at the 3rd Annual Proxy Disclosure Conference, I noted my view that CD&A is really at a crossroads this coming proxy season. In many ways, the 2009 proxy season will likely determine whether CD&A slides into irrelevance like its predecessor, the old Board Compensation Committee Report, or whether it will finally provide the crucial analytical background to the compensation numbers that was intended all along. I don’t think that the possibility for irrelevance is overblown – complaints are surfacing that institutional investors are skipping over CD&A and going straight to the compensation tables, because they are not finding useful information presented in the CD&A. This trend was confirmed by Pat McGurn and others on “The Investors and Proxy Advisors Speak” panel at the 3rd Annual Proxy Disclosure Conference. This trend, in my view, can only lead to trouble, because investors are only getting part of the story if they skip the explanation and rationale that is supposed to be included in the CD&A.
Several factors will certainly contribute to the focus on CD&A in 2009 and beyond. If some form of say-on-pay is enacted and investors are given the opportunity to cast an advisory vote on the CD&A and the other compensation disclosures, then what is said this next proxy season will be an important backdrop for voting decisions, even if mandatory say-on-pay votes don’t occur until 2010. Further, while the recent Emergency Economic Stabilization Act and the TARP program implementing that legislation included executive compensation provisions that are only applicable to participating financial institutions, the existence of these provisions in the federal legislation are reason enough to compel companies to consider taking action now on executive pay concerns – whether analogous to the Act’s provisions or in other areas that remain a significant focus of investor criticism.
As Broc noted in the blog last week, John White’s speech at our 3rd Annual Proxy Disclosure Conference included White’s views on how the executive compensation provisions of the TARP may be instructive for other companies on how they should approach their executive compensation programs. Finally, with 2008 being a year when many companies faced significant challenges given the markets and the economy, all eyes will be on the CD&A in the 2009 proxy to see what compensation committees did do – or did not do – to address executive pay in the face of difficult conditions.
It may be that we now find ourselves at a broader tipping point on executive pay, marked by the recognition of some pay excesses in recent federal legislation and a clearly rising level of anger among investors over how compensation decisions may have contributed to the current situation.
Now it is up to all boards and their advisors to take the public and shareholder anger to heart when making compensation decisions. These developments make this year very different from what we have been dealing with in the past. As a result, disclosures must be different, and the company and compensation committee actions described in those disclosures need to be different. I don’t think that this is a situation where you can just look at the disclosure in a vacuum and try to tweak it here are there – there needs to be some deep consideration in the next two months as to how the compensation policies and decisions are going to be explained to investors in 2009.
For more on John White’s speech and how executive compensation disclosure should be changing in 2009, take a look at Mark Borges’ initial blog and follow-up blog on the 3rd Annual Proxy Disclosure Conference.
Yesterday, House Oversight and Investigations Committee Chairman Henry Waxman sent letters to nine Wall Street firms requesting compensation and bonus information (here are the letters). The concern is that government bailout money will be used to pay bonuses. In addition, Senator Carl Levin has sent a letter to Treasury Secretary Paulson inquiring into these bonuses.
Here is a disturbing excerpt from an article in today’s Washington Post:
But a new study suggests that financiers are still bullish about their bonuses. More than two-thirds of Wall Street professionals are expecting a bonus this year, and 36 percent are anticipating a larger bonus than last year, according to a survey by eFinancialCareers, a career networking company.
The idea of taxpayers funding the bonus pools of Wall Street won’t play well across the land – and likely will bolster the chances of new legislation being adopted to curb excessive pay packages early in the new Administration. I would say it’s hard to believe that Wall Street could be so ignorant to not expect a backlash – but then again, it’s Wall Street that got us into the mess we are in to begin with. Here is a related Bloomberg article (and this older article) and an Associated Press article.
A combined threat of increased regulation, higher taxes and an economic downturn provide the context for executive pay decisions in the near term, and potentially longer term. Companies that have successfully focused on aligning executive pay and performance when financial results and stock price were improving now face the more difficult task of paying appropriately in a turbulent market and avoiding excessive pay for nonperformance.
As discussed in a recent Towers Perrin white paper, companies across all industries need to proactively review their existing executive pay practices in light of recent developments and the new world we find ourselves in. Executive pay programs developed in a different climate and under different business circumstances need to be assessed to ensure there is continued alignment with business strategy, financial results and shareholder returns in the environment ahead.
1. Accelerating Grants – We’re finding ourselves working w/ a lot of companies on taking advantage of the low prices we have out there and, in essence, “accelerating” next year’s grant to today. This was something that I actually did in 1987 after Black Monday while a partner at KPMG.
In addition, Microsoft did this immediately after the Justice Department handed down that negative ruling years ago, so there is good precedent—the trouble today is in the execution as well as the optics..like who should get it and who should not; how do you value the equity if one believes that the panic and hedge fund selling has created unrealistically low prices; and what type of long-term incentive vehicles do you grant? Again, where we find a strong argument that this will help significantly in the ability to retain and motivate, then it’s an idea worth pursuing;
2. This Year’s Grants—How should they be valued if 4 months ago you were at $70 and today you are at $10? And last years’ grant was at $60 and you have presentations saying that your enterprise value is $80? Is one LTI vehicle better than another for a time like this? Plus, whatever we do for the executives, we probably need to do for the directors as well, are all common issues that we are also working on and, in many cases, w/ no easy answers.
3. Change-in-Control—We have several projects as well dealing w/ CIC and how they are effected in an environment like this and again with multiple dynamics that need to be factored in…especially when these are front and center in DC.
4. Severance—And even in some cases, we’re having to work on employee severance packages while companies brace for the worst. Usually we find ourselves agreeing that standard norms don’t apply right now for the rank and file and that every bit of grace and consideration be given to those being put out into this market.
5. Ownership Guideline Issues—Again, as one can imagine, the low prices have impacted OGs significantly. The same was true in 1987, but there weren’t nearly as many companies w/ these back then as there are today. Again, care and consideration of all the factors are needed here like all the above.
I recently co-authored this article – along with Ethan Lipsig, Steve Harris, and Eric Keller of my firm – in which we addressed the following seven questions:
1. What are your most critical workforce challenges – e.g., retention, relocation, growth, reduction, or restructuring?
2. Who do you need to retain and motivate?
3. Are there opportunities to better deploy under-utilized personnel? If not, when and how will you contemplate layoffs, exit incentives, furloughs, forced vacations, reduced hours, or other temporary or permanent work force reductions?
4. Is your company perceived as being at risk of being sold, taken over, or going bankrupt?
5. Do your incentive bonuses or stock-based awards need recalibration?
6. Do you want to better discourage employees from pursuing competitive employment or improper behavior (such as unduly aggressive financial statement accounting practices that ultimately may require a financial restatement)?
7. How will you effectively communicate the actions taken to advance your workforce goals?