Corporate America took advantage of the stock market meltdown 18 months ago to shower executives with new and often larger grants of stock options, which now has led to multiple CEOs sitting on huge “mega-grants” worth tens of millions thanks to the ensuing stock market recovery.
A new study from the Corporate Library finds that during the depths of the crash in late 2008 and early 2009, companies started handing out equity-based compensation in greater numbers than previous years. More companies also awarded mega-grants, which the Corporate Library defines as grants of 500,000 options or more.
A frequent critic of Corporate America’s governance practices, the Corporate Library singled out 10 companies as particularly galling examples: Sirius XM, MoneyGram, Oracle Corp., Tenet Healthcare, Ford Motor Co., Standard Pacific, Nabors, Move Inc., Sprint Nextel, and Starbucks. All 10 granted mega-options to their CEOs during the market crash, who then reaped an average profit of nearly $23 million as of May 24, 2010.
The authors of the report, Michelle Lamb and Greg Ruel, say such large grants contradict the idea that executives should work hard for their compensation. “By granting options at such depressed stock prices, those companies are setting up their CEOs to make huge gains … without any effort,” Lamb says.
Fried
Harvard law professor Jesse Fried agrees. Equity compensation is supposed “to reward the CEO for taking steps that boost the stock price,” he says. “If the stock price rises simply because the market is going up, and the CEO’s pay is tied to the stock price, even a poorly performing CEO can get quite rich.”
Stock options enjoyed a long reign as the most popular form of equity compensation, until accounting rules were changed in 2005 to require companies to expense them like other forms of equity pay. The percentage of corporations awarding options fell from 55 percent in 2007 to 32 percent in 2008—and then jumped back above 50 percent amid the market crash of 2009, according to the Corporate Library report.
The percentage of companies giving mega-grants also rose, from less than 7 percent in 2007 (when the Dow Jones Industrial average hit its all-time high), to 10.6 percent in 2009. The portion of all awards that qualified as “mega” also rose, from 5.8 percent in 2007 to more than 9 percent in 2009. The average number of options in a mega-grant last year rose to 1.85 million.
The option grant with the single largest value went to Oracle Corp., which gave CEO Larry Ellison an award valued at $78 million. In fact, Oracle has given Ellison a mega-grant of 7 million options in each of the last three years, for a total paper profit of $850 million, according to the report.
The headline-grabbing Ellison is no stranger to large amounts of compensation. Just last week, the Wall Street Journal christened him the highest-paid CEO of the 2000s, collecting a total of $1.84 billion in compensation; $1.78 billion of that came through exercising options. (In that same period, Oracle investors saw $100 in shares increase to $316.64 by the end of 2009.)
Ruel
‘Most directors’ views are that options are performance based and align the interests of shareholders and management. That’s not going to change overnight.’
—James Reda,
Managing Director,
James F. Reda & Associates
Ruel says one of the worst offenses was the “golden hello” Anthony Ryan received when MoneyGram promoted him from chief operating officer to interim CEO last year. Ryan already had 116,575 outstanding options (with exercise prices from $15.62 to $29.26) when he took the top job in January 2009. In May of that year, he received another 8 million options with an exercise price of $1.74. The grant-date value of the award was more than $9 million.
Ryan resigned as MoneyGram’s CEO and from its board the previous September, forfeiting 7.4 million of his options that were still unvested. MoneyGram replaced him with Pamela Patsley, who had been the company’s part-time executive chairman. She received a grant of 6.3 million options, on top of two previous mega-grants awarded earlier that year. In total, Patsley received 12 million options with a grant-date value of more than $16.6 million in her first partial year as CEO, according to the report.
Lamb
Lamb, meanwhile, faults what she calls “business as usual grants,” where the board awards equity pay at the same time every year regardless of the company’s stock price. Starbucks CEO Howard Schultz, for example, has received equity awards in the middle of November every year since 2003, with the exact number of options calculated based on a target value of the grant. In fiscal 2009, he received a grant of more than 2.7 million options as the company’s stock price hit a five-year low of $8.64. The paper profit on those options as of May 24 was more than $44.6 million.
During down markets, Lamb says, compensation committees should consider market conditions and the CEO’s existing holdings and cut the number of options awarded.
Bigger Picture on Big Paydays
Not everyone sees the same impropriety that the Corporate Library raises in its report. James Reda, managing director of compensation consulting firm Reda & Associates, says the resurgence in options is “only momentary” since the market lows of 2009 were a temporary phase. Most companies are still moving away from options, he says, and “as options become more expensive, it won’t last.”
SURVEY SAYS
Below is the conclusion from the Corporate Library’s Mega-Grants Survey:
As the details of these option grants show, the reasons companies give for granting these mega-grants can vary and so can the terms of the options. What should be constant is a proper alignment of the grants with the interests of shareholders. Replacing outstanding underwater options with grants of stock at basement-level strike prices is only in the interest of the executive. This is compounded by the fact that most often the executive will get to keep this award if he is terminated for anything other than cause. In many cases, he can also keep it when he decides to retire, leaving him with valuable options at cheap strike prices on which he can profit while someone else runs the company.
Sometimes, given circumstances of a CEO’s pay structure and past grants, there is simply no rationale for additional grants. If a CEO is already a large shareholder, the purpose of another option grant (to tie management interests to shareholders’) is made moot. However, if this is not the case, there are better ways to structure a stock option grant so that it remains an effective incentive, even in a depressed market.
While we do see some examples of such best practices even amidst the highest of these option grants, they are rare and insufficient. One example was the reduction of historic grant date values. Lowering the grant date value of the awards makes sense when the share price has taken a big hit, since giving a CEO more options to meet a previously established grant date value only rewards him for a job not well done, or simply an overall market rebound. Another option is premium pricing. Premium pricing the options in order for them to vest in tranches at increasingly challenging targets is a simple and effective means of marrying executive and shareholder interests—the rise in stock price needed to profit from the options benefits both the CEO and company shareholders. However, it must be done to a degree that it has a true motivating impact. Premiums of 120 percent or 140 percent are not adequate when the stock is at a five-year low. As we saw at Sprint/Nextel, such premiums still result in an undeservedly large payday due to a gain in stock price that overshadows the premium-priced targets.
Another option for compensation committees is to set the exercise price at the company’s 12-month trailing stock price, or even the 12-month average stock price, when it is clear that the company’s stock price is currently depressed due to overall market conditions. And finally, as a last resort, the number of options granted should at least be held to the level of the prior year, when the stock had some value.
Source
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Reda also questions about whether mega-grants should be defined based solely on the number of options since in a depressed market even companies that cut options substantially could fall into that category.
Reda
That being said, Reda also admits that “there’s a lot of inertia” in corporate boardrooms, with directors not eager to draw up new equity plans amid every market swing. “Most directors’ views are that options are performance-based and align the interests of shareholders and management,” he says. “That’s not going to change overnight.”
Anthony Eppert, of counsel in the law firm Winstead, says mega-grants may also “fall by the wayside” in coming years, thanks to new proxy disclosure rules the Securities and Exchange Commission adopted in February. Companies now will be required to disclose the grant-date value of equity awards in the summary compensation table, rather than burying it as an accounting expense recognized during the year.
That change may lead to “some huge numbers in the total compensation column, that could embarrass companies into changing their grant practices,” Eppert says.
The Corporate Library report offers several ideas for how compensation committees can restructure option grants so they are better incentives, even in a bad stock market. One suggestion: lowering the grant-date value of the award when the share price drops.
Tenet Healthcare did just that, reducing the value of a grant made to CEO Trevor Fetter by 34 percent because the exercise price was $1.14. Ruel and Lamb, however, say the adjustment wasn’t adequate. Fetter got 5.5 million options in 2009, worth a profit of more than $24 million as of May 24, when the stock was trading at $5.54.
Other suggestions include premium-pricing the options to vest in tranches at increasingly tougher targets; setting the exercise price at the company’s 12-month trailing stock price or the 12-month average stock price; and holding the number options granted to at least the prior year’s level.
Fried says boards can give smaller grants on a regular schedule, fixed in advance, to avoid spring-loading—that is, awarding grants when insiders know the stock is depressed, and the actual value of the award promises to be much larger than the reported value on the grant date.
To avoid rewarding CEOs when market fluctuations boost grant values, Fried says companies can index the exercise price to the S&P 500 or an industry index, or condition vesting on the stock price out-performing an appropriate index.
When mega-grants vest, Fried warns, the CEO has the ability to unload a huge amount of equity at once. That gives the CEO an incentive to manipulate the short-term stock price, so he can reap the windfall of selling so many shares at a high price. Fried says that can be addressed by requiring CEOs to unwind grants gradually on a pre-arranged schedule, but says few firms have such restrictions.
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