The Employee Stock Option – An Endangered Species?

Amid the fallout from the scandals at Enron, Worldcom and numerous other companies has been a renewed focus on corporate compensation practices. Stock options have become a particular subject of scrutiny due to their widespread use, the increasingly large size of grants to executives and the enormous gains realized by some executives on sales of stock option shares at artificially inflated prices resulting from deceptive (and, in some cases, fraudulent) accounting practices.

In response to these and other concerns, corporations, shareholders, regulators and oversight groups have all taken or proposed various actions that are likely to change profoundly the stock option practices of recent years. Although executive stock options have been the primary focus of reform efforts, options granted to lower-level employees under broad-based option plans will also be affected, with some reform proposals being termed the “death knell” of broad-based option grants. When coupled with the recent market decline that has reduced the size of the stock option component demanded in executive compensation packages and the current labor situation in which large option grants are less necessary to attract workers, the continuing role of the compensatory stock option has come into question.

Background. The growth of stock options as a component of compensation has been dramatic, commencing in the case of executive compensation with the general acceptance of the concept that an equity stake in the company is necessary in order to “align the interests of the executive with those of the shareholders.” A somewhat comparable view that an equity stake in the company increases the productivity and loyalty of lower-level workers has also contributed to the adoption of broad-based equity incentive plans by many companies. The disparity in the financial accounting treatment of a stock grant versus an option grant has made options the preferred method for creating that equity stake and the hoped-for alignment of interests and incentive for productivity and loyalty; a stock grant results in an accounting charge to earnings, while an option grant generally does not result in such a charge, even though the grant of a stock option is not actually free of economic cost to the corporation. When faced with a choice between stock grants that reduce earnings and option grants with no earnings reduction, companies generally have chosen the “free money” approach and granted stock options. As an added bonus, despite there being no reduction in earnings for financial accounting purposes, the exercise of compensatory stock options generally results in a compensation deduction that reduces the company’s taxable income. The use of options instead of stock grants in executive compensation arrangements was further encouraged by the tax laws in that, unlike service-vested restricted stock, options could qualify for an exception to the $1 million cap on deductible executive compensation imposed by the Internal Revenue Code.

Reliance on options increased during the technology boom of the 1990s when start-up dot-coms with little cash for salaries began using large stock option grants to attract workers. The size of those grants and the spectacular rewards they produced in turn led to a perceived need by more traditional businesses to increase the size of their own option grants in order to attract or retain executives and other workers. In the process, stock options became an ever-larger part of the average executive’s total compensation package, increasing from about 27 percent of median CEO compensation in 1992 to about 60 percent in 2000.

The effectiveness of stock options to “align the interests of the executive with those of the shareholders” has generally been accepted without question. Unfortunately, that acceptance may not be warranted. A leading executive compensation consulting firm recently examined data from more than 100 companies in 10 different industry groups and found that, while there was a positive correlation between corporate performance (compared to the industry group) and the level of executive ownership of company stock, there was actually an inverse correlation between corporate performance (compared to the industry group) and the ratio of stock options held to company shares owned; i.e., company performance actually declined as the ratio of options held to stock owned by executives increased. Although stock option grants to executives undeniably create a performance incentive, the absence of any downside risk that accompanies actual stock ownership may create a management focus on short-term stock price increases (sometimes achieved by cooking the books) rather than longer-term fundamental performance. The recent stories of executives cashing out large stock option holdings before shareholder values plummeted clearly indicate that the interests of those executives and the shareholders of those companies were not aligned.

The effectiveness of stock options as an incentive for rank-and-file employees has been questioned much more than the effectiveness of executive options due to doubts that workers at that level can affect company performance and, therefore, the price of the stock. However, there is some evidence that companies with broad-based stock option plans perform better than companies without such plans. While the precise reasons behind that performance differential are not known, the grant of broad-based options may engender a spirit of common ownership and participation that fosters a higher standard of care and efficiency in carrying out job tasks. Companies such as Starbucks and Home Depot have done well using that approach.

The winds of change. The renewed focus on compensation practices and stock options has prompted suggestions for changes from a variety of sources, including Congress, the New York Stock Exchange (NYSE), Nasdaq and the Financial Accounting Standards Board (FASB).

A number of pieces of legislation have been introduced in the 108th Congress, which, if enacted, would significantly affect the benefits of stock options to both grantors and some recipients. For example, the “Ending the Double Standard for Stock Options Act,” which has been introduced this year in both the Senate (S. 182) and the House of Representatives (H.R. 626), would limit a corporation’s tax deduction on the exercise of a compensatory stock option to the amount reflected by the corporation as an expense for financial accounting and reporting purposes. In addition, the “Prevention of Stock Option Abuse Act of 2003” introduced in the Senate (S. 690) would impose significant vesting and holding period requirements with respect to options granted to directors and executive officers of public companies.

The NYSE and Nasdaq proposals (expected to be approved by the Securities and Exchange Commission in the near future) would require, at least for listed companies, that shareholders approve any newly adopted stock option plan and, in the case of the NYSE proposal, any material modification to an option plan (with a bright-line test for determining whether a modification is material). The NYSE and Nasdaq proposals will increase the opportunity for shareholder input on stock option issues. While institutional investors have been concerned for some time about the dilutive effect and economic, if not accounting, cost of large option grants (particularly grants to top executives), the attention on options brought about by recent events has broadened that concern. As a result, shareholder opposition to stock option plans has increased, and stock option issues are expected to be a major subject of shareholder proposals during the 2003 proxy season. For example, the California Public Employees’ Retirement System, the owner of 47 million General Electric shares, is pressing GE to stop using regular options in its compensation programs and to use performance-based options instead (i.e., options that vest only if a specific performance target is met or that have an exercise price linked to an industry index so that a reward is provided only for superior performance compared to industry peers and not for stock price increases attributable to a generally rising market).

Of even greater potential significance is the move toward the mandatory expensing of options for financial accounting purposes. The International Accounting Standards Board has already proposed that stock options be accounted for as an expense, and the FASB has recently added to its agenda a new project to consider the required expensing of options. Should that accounting rule change take effect as expected, although some tax incentive for the use of options would remain (unless the tax laws are also changed), the financial statement bias favoring options over other forms of equity compensation would be eliminated.

However, a similar proposal by the FASB in the mid-1990s was unsuccessful due to loud protests from business and Congress. Although it is widely expected that the FASB proposal will become effective this time due to the post-Enron environment, heated opposition is again coming from the same sources. Strong objections have been voiced by the International Employee Stock Option Coalition, a lobbying group comprised of trade associations and companies that oppose mandatory option expensing. High-tech companies (which have traditionally relied heavily on stock options in their compensation programs) have been especially vocal in their opposition. The CEO of Cisco Systems has stated that mandatory expensing of options could result in the shift of technology jobs overseas, and the CEO of Intel has suggested that, because of the difficulty in valuing compensatory options, mandatory option expensing could result in the refusal by corporate executives to certify their company’s financial statements as required by the Sarbanes-Oxley Act. A group of 15 U.S. Senators recently sent a letter to the FASB labeling the mandatory expensing of options a “fatal blow” that will “effectively end the use of broad-based stock option plans and their ability to contribute to increases in productivity, the expansion of employee ownership, and to growing the economy.” Legislation has also been introduced in both the House and the Senate that would prevent the SEC from recognizing as generally accepted accounting principles any new “accounting standards related to the treatment of stock options” (a euphemism for mandatory option expensing) for at least a three-year period in which new option disclosure requirements would be monitored (the “Broad-Based Stock Option Plan Transparency Act of 2003,” H.R. 1372, S. 979).

Whether these protests will again be sufficient to stem the tide in favor of option expensing remains to be seen. A number of companies (including GE, Coca-Cola and Wachovia) have announced their intention to begin treating option grants as a compensation expense even before that treatment becomes mandatory. Shareholders of Apple Computer, NCR and Delta Air Lines have recently approved, despite opposition by the companies, non-binding resolutions calling on those companies to begin treating options as an expense, and a similar proposal was only narrowly rejected by the shareholders of IBM. In addition, many of the leading accounting firms (including KPMG, Ernst & Young, PricewaterhouseCoopers, Deloitte & Touche, BDO Seidman and Grant Thornton) have, to varying degrees, advocated the expensing of options.

The future of the option. So what do these developments mean for the future of the compensatory stock option? Increased accountability to shareholders would likely be enough by itself to reduce the rate and size of option grants, especially to executive officers. In addition, the adverse effect on the bottom line resulting from option expensing may make it more difficult for a company to justify (or perhaps more accurately, may require a company to justify) the mega-grants to senior executives that had become rather commonplace. A reduction in the number of options granted would also result if compensation committees took to heart the recent research indicating that an over-reliance on stock options as an executive incentive may actually result in lower corporate performance. In fact, recent executive compensation surveys indicate that, for calendar year 2002, both the number of option shares granted to executives and the value of those grants declined significantly when compared to grants in 2001. At the very least, these factors put in jeopardy the recent role of the stock option as the undisputed king of equity incentives.

However, none of the factors discussed above should spell the demise of the stock option as an incentive for executives or, despite protestations to the contrary, result in the end of broad-based option grants for rank-and-file workers. Companies will continue to need incentive mechanisms for their executives and employees, and those incentive mechanisms presumably will continue to involve some type of equity component. Although option expensing and the other proposed changes (other than the proposed moratorium on required option expensing) would make stock options less attractive than at present, the real effect of those changes is to eliminate a collective bias in favor of stock options and to create a more level playing field in the competition to determine which type of incentive is the most suitable (a determination that should vary from company to company). Even if all those proposed changes were to become effective, stock options would not be inherently less attractive than the available alternatives, such as cash bonuses, stock grants and stock appreciation rights. Each of those alternatives generally would produce the same, or even less favorable, accounting and tax consequences as options, and they may have other disadvantages as well (such as reduced flexibility in the timing of income recognition or the reduction in cash available for other purposes). As a result, stock options, perhaps with performance-based features, can still play a significant and effective role both in a balanced executive compensation policy that also includes actual and continuing equity ownership and in a broad-based compensation program for rank-and-file workers.

When you consider all the pros and cons, it looks like stock options will continue to be a part of most compensation programs for a while, both for executives and rank-and-file workers. While its role may be evolving, the option isn’t on the verge of extinction just yet.

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