The Options War

In a soaring market, building an executive compensation plan around stock options seems to make the most sense. So how does the awarding of CEO options become such a sore point between the board, the executive, and, more than ever before, the shareholders?

Shareholders who attended BankBoston Corp.’s annual meeting on April 22 were greeted with wheelbarrows full of fortune cookies on their way in.

The individually wrapped goodies weren’t part of a buffet served up by BankBoston; they were part of a demonstration by shareholder activist group Responsible Wealth. Members of the group carried signs that read “How Much is Enough?” and “Economic Boomu00e2u20ac”For Whom?” Two wheelbarrows, heaped to overflowing with fortune cookies, were labeled “BankBoston CEO Chad Gifford’s Fortune” and “Fleet CEO Terry Murray’s Fortune.” A third wheelbarrow, empty save for a lone fortune cookie sitting forlornly in the bottom, bore the label “Minimum Wage Worker’s Fortune.”

At the meeting, Responsible Wealth member and BankBoston shareholder Jennifer Ladd presented a proposal to cap CEO compensation at a multiple of the lowest-paid company employee’s pay. The fortune cookies provided a visual metaphor for Responsible Wealth’s keystone issue: the wage gap between a company’s employees and its leaders.

While the shareholder group’s concern is the overall level of CEO compensation, the largestu00e2u20ac”and fastest-growingu00e2u20ac”component of the total pay package for many bank CEOs is stock options. Gigantic payouts at companies like Citigroup, where co-CEO Sanford I. Weill took home an extra $156.6 million in 1998 simply by exercising options, are certainly raising eyebrows.

“It is time to look at the large option grants offered to our leaders who already have options worth millions of dollars, and ask ‘how much incentive is enough?’” stated Ladd.

For good reason, options are a popular form of compensation. “Pay for performance” has become the mantra of many consultants and shareholders alike. Granting options, which have no value unless the company’s stock price increases, links the executive’s performance to his or her payout, while aligning his or her interest with that of shareholders. Options are also the only form of compensation that does not result in a financial expense for the company, although certain specialized types of options do have an accounting cost.

However, when option-related payouts get big enough, some say the excesses should be curbed. Incentive pay is supposed to reward excellent performance, not the mere ability to show up at the office each day. “If CEOs have $10 million in unexercised options, do they really need another $200,000 in stock options to motivate them to get up and go to work in the morning?” asks Responsible Wealth spokesperson Scott Klinger. “I think the answer is no.”

“Even mediocre increases in stock price can lead to a million dollar payout, because the number of shares covered by a typical option grant can be so large,” says Kathy Ruxton, an attorney specializing in compensation issues at the Investor Responsibility Research Center.

“Seventy percent of option gains are not attributable to the individual, but rather to the market as a whole,” notes Nell Minow, a principal of the LENS Fund, which takes a strong stand on corporate governance issues with companies in its portfolio.

“A lot of companies have argued that this is what the market demands,” says Klinger. “I’ve read through hundreds of proxy statements, and the vast majority of them say ‘we strive to pay our CEO above-average wages,’ which makes it sound kind of like Garrison Keillor’s Lake Wobegon, where all the children are above average.”

When a company’s peers increase option grants for their CEOs year after year, the average that companies use to determine “competitive” levels of compensation continues to rise, resulting in a seemingly unstoppable upward spiral in option awards.

It’s not merely moral outrage that prompts shareholder agitation at huge option grants. Options may cost a company little or nothing to issue, but some argue that the burden of cost is effectively shifted to shareholders, because their purchasing activity drives the stock up.

Another cost borne by shareholders was summed up by Richard Wagner, president of Strategic Compensation Research Associates, an independent corporate research and consulting group that tracks shareholder voting across a broad base of companies. Says Wagner, “Everybody thinks that more and more options for executives is a great thing, except for the shareholders, who hate dilution.”

The big leagues

Responsible Wealth presented proposals aiming to cap CEO pay during eight other companies’ annual meetings, including two banks: BankAmerica Corp. and Citigroup. These two companies, products of megamergers, also made megagrants of options (a megagrant is defined as a grant that has a face value of more than five times the executive’s base salary).

Citigroup’s co-CEOs, Sanford I. Weill and John S. Reed, each made out well in 1998. They were each granted 1,750,000 options with a face value of $16.9 million. BankAmerica CEO Hugh McColl did not receive an option grant in 1998, nor did he as CEO of NationsBank Corp. in 1997. However, at the 1997 pre-merger version of BankAmerica, then-CEO David A. Coulter received 1,941,500 options worth an astounding $112.4 million as part of a severance package when he resigned after leading the new company for only a month.

As for BankBoston, CEO Chad Gifford was granted 255,000 options with a face value of $11.4 million in 1998, up significantly from 1997’s grant of 73,100 options with a face value of $5.1 million. And although BankBoston plans to merge with Fleet Financial Group. Gifford’s compensation is not likely to decrease: He will hold the second-in-command position at the new bank, under Fleet CEO Terrence Murray. Murray has said he will retire at the end of 2001, at which time Gifford will become CEO of the combined entity.

Gifford’s grant of $11.4 million may seem high, but it represents the 1998 median face value for option grants among CEOs of a selected group of 21 large commercial banks examined by compensation consulting firm William M. Mercer. That’s up from the 1997 median face value of $7.3 million for a similar group of 25 companies.

While the median rose, the number of option grants actually decreased: 21 of the 25 companies surveyed in 1998 made option grants, while in 1999, only 13 of 21 did so. The trend of fewer, but larger, option grants is to be expected in a booming market, according to Mercer principal Yale Tauber: “Granting a smaller number of shares, but making a grant each year, would dollar-average down the grant price in a falling market. But this trend makes a substantial grant and sticks with it as the base point for measuring increased shareholder value.”

“Substantial” may be a bit of an understatement when the typical CEO’s option grant is compared to his or her base salary. All 13 surveyed companies making option grants in 1998 made megagrants to their CEOs, with a median multiple of 12.16 times base salary. The highest multiple went to J.P. Morgan CEO Douglas A. “Sandy” Warner, whose options represented a multiple of 23.38 times his base salary. The lowest multiple went to MBNA Corp. chief Alfred Lerner, whose options represented only 8.93 times his base salary.

The single most valuable 1998 option grant in the group, as disclosed in 1999 proxy statements, was awarded to First Union CEO Edward Crutchfield, who received 400,000 options with a face value of $24.9 million. However, Crutchfield did not receive an option grant in 1997. In second place for 1998 was J.P. Morgan’s Warner, who received 125,000 options with a face value of $16.4 million. In 1997, Warner received 80,000 options worth $8.6 million.

A recent survey of proxy statements at 350 of the largest U.S. companies conducted by Mercer for the Wall Street Journal indicates that while 1998 salaries and bonuses for CEOs increased by 5.2% over 1997 levels, option gains for the same group of CEOs jumped by 85.3% in the same period. Business Week recently reported that total CEO pay at large companies grew by 36% from 1997 to 1998. Such astonishing growth has naturally led compensation committees, as well as activist shareholders, to wonder, “how much is enough?”

The right recipe

Determining the appropriate number of options to grant to a bank CEO is a little bit like inventing a recipe for, say, an ice-cream sundae. Each ingredient in the pay package, as well as the proportion, is importantu00e2u20ac”even the cherry on top. And the shareholders will be the ultimate taste-testers when the final product is delivered in their proxy statements.

“The key thing that gets companies in trouble [with shareholders] is to assume that no one’s going to notice or question. You have to assume that you’re going to get criticized, and you have to have a good answer,” says Alan Johnson, managing director of compensation consulting firm Johnson & Associates. That’s why he and other consultants recommend keeping institutional shareholders in the loop during the entire process of structuring an option plan. Continues Johnson, “On a lot of executive pay issues, getting your large shareholders involved and getting them to hear your rationale before the fact is usually much better than them hearing your spin on it after the fact.”

“Institutional investors are not illogical or irrational or inflexible, but you need to talk to them about why you’re doing what you’re doing. If you have a good reason, they’re going to understand in most cases,” says Rich Semler, worldwide practice director for executive performance and pay at compensation consulting firm Sibson & Co.

So, how should a compensation committee go about designing an effective CEO option plan, and keep their shareholders happy at the same time?

“What’s the right way to design an option plan? That’s tricky,” says Mark Poerio, a partner at the law firm of Kutack Rock. He continued, “What I can tell you is the wrong way to do it, and that’s in a vacuum. All the parts of the packageu00e2u20ac”cash compensation, bonuses, etc.u00e2u20ac”should be factored in.”

Since options can represent the largest economic gain to executives, some observers think that salary and bonus should decrease in proportion. As Nell Minow, of the LENS Fund, puts it, “You don’t want options to be the cherry on the sundae, you want them to be the ice cream.”

In dollar volume, that already seems to be the case. According to Drew Hambly, a research analyst at the Investor Responsibility Research Center, the median 1997 pay for an executive (not just the CEO) at a company in the S&P 500 was $800,000, the median bonus was $877,000, and the median option grant was $2.1 million (in future potential value, assuming a 10% appreciation rate). The median value of exercisable options held by these executives was $7.5 million, and they also held a median $3.2 million in unexercisable options.

In addition to balancing a pay package between stock and cash, a company should carefully consider what percentage of its shares outstanding it will keep available for option grants. That calculation plays out in two important ways: it determines how much dilution shareholders will have to take as a result of new option plans, and it determines how much of the company’s value could potentially be given to option recipients. The actual amount that is awarded each year, or the run rate, can be used to see how quickly a company has burned through its available store of options.

Some institutional shareholders use a simple dilution-based metholology, in which potential share dilution of over 10% will trigger a “no” vote on any proposed option plan. Others use a cost calculation similar to that performed by Institutional Shareholder Services, which figures out how much of the value of the company, measured as a percentage of market capitalization, would be transferred from the shareholders to the option recipients under a proposed plan. If the percentage is above a company-specific cap, ISS recommends voting against the plan.

Finally, many investors look at run-rate calculations to see how quickly companies use up their store of available options. For the 200 largest companies in the United States, the average run rate is 2%. Semler cautioned, “Once you start giving out more thanu00e2u20ac”in really round numbersu00e2u20ac”2% of the shares per year, you’re getting into potentially troubled waters.”

Plain vanilla or exotic?

In addition to all the calculations involved in determining the number of options to grant, directors face decisions about the type of options to use, and the vesting schedule.

Plain vanilla options simply reward length of service. If a CEO stays for the entire vesting period, the options belong to him or her regardless of individual or corporate performance. While tenure may indicate a CEO’s commitment to a company, other measures may be more appropriate when attempting to truly link pay with performance.

“Pay for performance does work, provided that credible peers are chosen for the purpose of determining competitive pay and that the CEO’s compensation is calibrated appropriately,” comments Denis Lyons, a senior director at executive search firm Spencer Stuart. “If you’re better than your peers by 1%, does that justify a $500 million stock option grant? Directors need to think carefully about these issues.”

“The mantra for institutional investors is that when it comes to individual CEO pay, they want to see real pay for performance,” said McGurn. “They tend to get upset when they don’t see a linkage in the pay package between company performance and the rise or decrease in executive compensation levels.”

The most direct way to align option grants with performance is to grant incentive stock options (ISOs), which have tax-favored treatment. However, the SEC limits ISO grants to no more than $100,000 worth of stock per year. In today’s world of multimillion-dollar payouts, that’s not much, so companies are turning to other ways to tie pay to performance, not merely to tenure. Three increasingly popular methods are indexed options, premium-priced options, and vesting-accelerated (also called performance-accelerated) options.

Indexed options, championed by Fed chief Alan Greenspan in recent testimony before Congress, link the exercise price of the option to the price of an industry index or a group of company peers. Indexed options keep the motivational value of stock options, because the recipient continues to share in the gain as the price rises, but since the exercise price rises proportionally, the payout is limited.

The only real hitch to indexed options is that companies that use them must take a charge to earnings, which is one reason why so few companies currently employ them. However, explains McGurn, “The overall cost of the charges that would have to be taken for a top executive indexed option plan is not that significant, unless, of course, the company has very marginal earnings, and then it’s got bigger problems than its executive compensation.”

Premium-priced options also reduce the possible initial payout while retaining motivational value, but they carry no accounting cost. The methodology is simple: Instead of issuing an option with an exercise price fixed at today’s stock price, the option is issued underwater, making it essentially worthless until the stock price reaches a preset level. While these are riskier than indexed options, the potential gain is unlimited after the stock reaches that level. (The opposite approach to premium-priced options, discount options, amounts to issuing already in-the-money options. In this scheme, the recipient gets an automatic gain the day the options are issued, which is why they draw fire from some critics. However, these options also carry a significant accounting cost.)

Vesting-accelerated options combine some features of incentive stock options with some features of premium-priced options. The exercise price is fixed at the day-of-issue, but the options do not vest until the earlier of two events: either a performance or price hurdle, or a time limit.

If a company issues vesting-accelerated options at $10, the options could vest either in five years, or when the stock price reaches $15. Executives have an incentive to perform, and the time-linked vesting provision prevents these options from carrying an accounting charge.

As for the vesting schedule for other types of options, including plain-vanilla, premium-priced, and indexed, industry observers agree that a typical vesting period of three to five years is reasonable. Although the idea behind longer vesting schedules is retention of the executive, “when you start talking about vesting longer than five years, you’re not going to accomplish much,” according to Semler.

By the same token, vesting should happen over a reasonable period. Johnson says, “Shareholders, in a perfect world, would like vesting to be four or five years.”

One topic that brings a unanimous reaction is that of repricing, the practice whereby the exercise price of an option is adjusted downward after the company’s stock price drops. McGurn calls it “extremely politically incorrect” and says “it’s a very serious thing to do.” Semler agrees, saying, “Repricing flies in the face of the philosophical justification for having issued the options in the first place.” Companies that still have provisions allowing repricing of their option plans draw heavy criticism from shareholders, and now that FASB has instituted an accounting cost for the practice, it’s even less likely that companies will use it.

The buck stops with shareholders

For a look at how dilution, run rate, and shareholder-value-transfer calculations affect shareholder reaction, consider the case of Riggs National Corp.

Riggs proposed amendments to its option plan at its last two company meetings (1998 and 1999). The 1998 amendment increased the number of shares available for stock option awards from two million to four million. Based on its shareholder value transfer methodology, ISS recommended voting “no” on the proposal. In fact, 19.9% of the votes cast were “no” votes in a year when, according to Hambly, the average vote against stock option-related proposals was 17.8% at the IRRC’s universe of approximately 2,000 companies.

The proposal passed, as management proposals usually do. “It’s very difficult as a practical matter to get a majority of shareholders to defy management’s interests,” observes Dennis Carey, a vice chairman at executive search firm Spencer Stuart. “In most cases, what management wants, management gets, with shareholder votes. It’s pretty rare that shareholders step up to the plate and vigorously oppose those proposals.”

Even so, when a significant minority of shareholders votes against a company proposal, management may take steps to ameliorate the plan, offer a more carefully thought-out plan next time, or at least communicate with shareholders. That doesn’t appear to be the case with Riggs, which proposed at its 1999 annual meeting that the number of shares available for option awards be more than doubled, from four million to nine million shares.

ISS again recommended voting against the amendment. Riggs’ shareholder-value-transfer cap was 9.4%, and the total cost of all compensation plans, assuming the 1999 proposal passed, was fully 21.3% of the company’s market capitalization. That meant that a full one-fifth of the company’s value could potentially be transferred from shareholders to option recipients.

And Riggs hasn’t been stingy with option awards to its CEO. After the 1998 amendment doubled the option pool, the bank granted 1.3 million options, of which Riggs CEO Joe L. Albritton received 87.8%. Albritton was granted 1,150,000 options in 1998, with a face value of $34.9 million; no other officer received more than 50,000 options. ISS’s McGurn points out that Riggs had a run rate of more than 6% in 1998 and a run rate of 15.3% for the past three years combined.

Investors who look only at share dilution also had reason to complain: Riggs’ total potential dilution for all compensation, assuming the 1999 amendment passed, was 36.7%, nearly quadruple the 10% rule of thumb many dilution watchers use. For comparison, consider that the IRRC reported that in 1998, the 25 regional banks in its universe had an average total potential dilution of 7.9%.

Shareholders apparently didn’t take these objections lightly. A Riggs spokesperson confirmed that 6.8 million shares were voted against the proposal at the April 1999 meeting. The bank has 28 million shares outstanding, but the spokesperson would not confirm the total number of shares cast. Out of 28 million, 6.8 million represents nearly 25%, but since the number of shares cast is nearly always somewhat less than the total number of shares outstanding, it is likely that the percentage voting against the proposal was higher than 25%, perhaps as much as 30% to 35%.

The Riggs spokesperson would not comment for Bank Director on the proposal, the shareholder vote, or management’s response to the vote.

And what about Responsible Wealth, the group trying to cap executive pay at the nation’s largest banks? All three of the activist group’s bank proposals were voted down, as shareholder proposals normally are. The group will present similar proposals to companies in next year’s proxy season, but it has not decided whether the three banks it challenged this year will be singled out again.

In a preliminary count, the BankBoston proposal only received 4.8% of the votes cast, and the BankAmerica proposal won 6.7% of the shareholders’ support. However, the Citigroup proposal garnered a respectable 10.8% of the shareholder vote. Responsible Wealth’s Klinger said, “We’re gratified by it. We think we’ve opened the door to some dialogue.”