This article is reprinted with permission from the
October 30, 2002
edition of
New York Law Journal.
2002 NLP IP Company.


Impact of Current Turmoil on Executive Pay

By Joseph E. Bachelder

WILL THE current economic, accounting and legal turmoil, including pending charges of illegalities involving CEOs and other executives, result in significant changes in executive compensation?

The basic design of executive pay is likely to remain much the same despite the current environment including civil and criminal actions involving senior management of major U.S. companies. Salary levels (subject to customary periodic increases) and annual bonuses are unlikely to change except to the extent that annual bonuses, which generally reflect earnings, are likely to be lower during the current economic downturn.

More likely to reflect the impact of the current environment is the 'third brick' of executive pay: long-term incentives, most particularly stock options and other forms of equity awards.

The following discussion will focus primarily on current questions involving stock options and also will note possible developments in other forms of equity awards.1

Impact of Current Environment

A. What will be the impact of the current environment on stock options?

General observation. The current criticism of stock options will not significantly diminish their importance as part of executive pay. The fact that 'outlier' CEOs made tens of millions (in some cases hundreds of millions) of dollars from stock options in the 1990s will not discourage continued use of this basic element of executive compensation.

1. Will the size of stock option grants decrease significantly? Experience during 2001 and 2002 does not indicate dramatic reduction in sizes of option grants. However, alternative forms of equity awards may grow in popularity in the new environment, as discussed below. Thus, the relative weight of stock options as a component of the 'third brick' may be reduced. A long-term, lackluster stock market (as existed from the late 1960s to the early 1980s) would encourage alternative forms of equity awards. Stock options, however, are likely to be a dominant form of equity incentive for the immediate future.

2. Will stock option repricings continue? Limited repricings will continue, in particular in those corporations that depend heavily on their stock option programs to attract and retain executives and that have had substantial stock price declines (e.g., sectors of the high-tech industry). This is so notwithstanding the very negative consequences repricings have for accounting and U.S. Securities and Exchange Commission (SEC) reporting purposes, as well as the harsh criticisms directed at repricings by the media. Alternatives to repricings may include additional grants of stock options (that is, in addition to the normal cycle of grants) without cancellation of the underwater options. This avoids repricing consequences but obviously can represent substantial extra dilution of outstanding equity. Repricings in the form of cancellations and subsequent grants that conform to the FASB 'safe harbor' rules, and thus avoid negative accounting consequences, also may continue in some cases.2

3. Will stock options become a charge against earnings? Some in Congress, some public and private regulatory agencies and numerous institutional investors are making considerable effort to require employee stock options to be charged against earnings. Some major U.S. corporations, such as General Electric, General Motors and Coca-Cola, have announced that they are voluntarily adopting a policy of charging stock options against earnings.

In the course of the next year or two, Congress, the SEC, the new Public Company Accounting Oversight Board and other accounting regulatory groups will be addressing the issue of whether stock options should become a charge against earnings. It is premature to conclude whether the current and near-term examination of this issue will result in any change in the current accounting rules. Those rules, as embodied in APB Opinion No. 25 adopted in 1972, provide generally that there is no charge against earnings for stock option grants in the form most such grants take today. 3 Whether all stock option grants are required to be charged against earnings or, as in the current situation, no stock option grant is required to be charged against earnings (assuming it meets the requirements of APB Opinion No. 25), stock options undoubtedly will continue to be a major part of executive compensation.

4. Will more stock options be tied to achievement of performance targets?

General observation. So long as 'plain vanilla' stock options are not a charge against earnings, broad-based use of 'performance conditioned stock options' - that is, options that require the satisfaction of performance criteria as a condition of exercisability - is unlikely. This is because introduction of such a condition results in the option becoming a charge against earnings. There may, however, be some increase in the use of performance criteria to accelerate exercisability rather than as a condition of exercisability. Under current accounting rules, accelerated exercisability based on attainment of performance targets does not take away the no-earnings-charge status of a stock option.

Performance-Based Option Awards

Following are discussions of three versions of performance-based option awards:

a. Market-indexed options.

An indexed option is one tied to an external index such as the Standard & Poor's 500 (it could be a narrower index base such as a peer group of companies). The exercise price of the option is adjusted as the index changes. One company that has made use of indexed options is Level 3 Communications Inc.

Corporate employers generally have not exhibited interest in market-indexed options in part because management does not like the idea that option holders only enjoy the benefit of increases in the employer's stock price to the extent the employer's stock price increases at a rate ahead of the applicable index. In addition, to the extent the price of the employer's stock exceeds the index the option would appear to be subject to variable cost accounting treatment. (For a discussion of variable cost accounting, see the discussion of corporate performance options below and this column appearing in The New York Law Journal June 29, 1998.)

b. Options based on achievement of corporate performance targets.

An example of a corporate-performance-based option would be one tied to a target cumulative increase in earnings per share. As noted above, the earnings based performance option that conditions exercisability upon achievement of performance targets results in a charge against earnings. In the case of such an option, the charge against earnings is a 'variable' charge. This means that a charge against earnings will be imposed to the extent there is an increase in the option's 'spread' from one accounting period to the next. (A decrease in spread between accounting periods results in a credit.) So long as 'plain vanilla' stock options do not cause a charge against earnings, corporate interest in attaching corporate performance targets to options is likely to be generally limited to circumstances in which attainment of targets accelerates (but is not a condition of) exercisability.

c. Premium-priced and hurdle-priced options.

Many so-called mega-option grants (very large one-time grants) over the past several years have contained premium exercise prices (for example, an exercise price that is 25 percent above market price on date of grant). Premium-priced options do not result in a charge against earnings.

Hurdle-priced options, in contrast to premium-priced options, contain a 'price hurdle.' For example, such a hurdle might be the attainment of a market price that is 25 percent above the market price at date of grant and, if the hurdle price is achieved, the option becomes exercisable at the market price on the date of grant. For accounting purposes, the hurdle-priced option results in a charge against earnings, except to the extent achievement of the hurdle simply accelerates exercisability that would occur if the executive remains employed until a specified future date. The current environment in which stock options are being scrutinized may encourage increased use of premium-priced options or options with price hurdles that simply accelerate exercisability.

5. Will new restrictions, such as a holding period for shares of stock following option exercise, be imposed? A number of commentators and consultants have suggested that executives with stock options should not be allowed to exercise and 'bail out' of their stock (except to the extent needed in order to pay the exercise price and to meet tax liabilities incurred on exercise). This school of thought does not consider 'black-out' periods (whether government- imposed or self-imposed by the employer corporation) sufficient to hold executives' 'feet to the fire.' These commentators propose that executives be required to hold the stock for a period such as two years (some have suggested even longer periods) after option exercise before being allowed to sell. Stock bailouts by top executives at companies like Enron have encouraged this point of view. It has been suggested that such a holding period requirement might be imposed by Congress as a condition to the deductibility of the stock option by the employer for Federal income tax purposes. More likely would be self- regulation by corporations electing to include such a holding period as a requirement in the option grant itself.

Effect on Equity Awards

B. What will be the impact of the current environment on the use of equity awards other than stock options?

General Observation. Equity awards representing the full value of shares provide the executive with less risk than an option. Even if the stock price declines from the price on the date of award the executive will at least realize the value at the time the share award is earned out. (In today's environment of close scrutiny of equity awards, this reduction in risk may be the subject of criticism from some institutional shareholders and commentators.) Under current accounting rules, deferred share awards and restricted share awards are a charge against earnings based on the value at the date of grant. Performance shares, as to which payout is dependent on attainment of performance targets, require variable cost accounting. (A form of variable cost accounting was discussed above in connection with 'performance conditioned stock options.')

1. Deferred Share Awards.

Deferred share awards are more prevalent today than they were 10 years ago and they are likely to increase in use. A deferred share award (sometimes called a deferred stock unit) results in no tax to the executive until the stock is delivered (notwithstanding its vesting in the interval prior to delivery). Tax is incurred at the ordinary income tax rate and the employer obtains a deduction at the same time the executive incurs a tax.

For an employer confronted with concerns over stock option awards the deferred share award provides an alternative that can deliver to the executive an equivalent value with fewer shares than a stock option. As noted, for the executive a deferred stock award assures at least some ultimate value (if earned out) whereas a stock option will provide no benefit unless the stock price goes up in value.4

2. Restricted Shares.

In most respects, restricted shares carry the same characteristics from both the employer's and employee's standpoints as do deferred shares except for certain tax considerations. Deferred shares are not taxed until the shares are delivered to the executive (at which time they are taxed at ordinary income tax rates as noted in the preceding section). Restricted shares, at the election of the executive pursuant to code 83(b), may be taxed at time of original transfer notwithstanding their being subject to a substantial risk of forfeiture. With such an election, the executive pays ordinary income tax on the date-of-transfer value and is eligible for long-term capital gains taxon any gains realized on subsequent disposition of the shares. On the other hand the executive may choose not to make an election as just noted and is taxed at the time the restricted shares vest (at which time the executive is taxed at the ordinary income tax rates). In any event, the corporation obtains a tax deduction at the time the executive incurs the ordinary income tax (i.e., at the time of grant, if that is elected by the executive; otherwise at the time of vesting).

As in the case of deferred shares, restricted shares provide value even if the stock price declines from the point of grant to the point the executive earns out the stock (the point of vesting). If an employer is trying to reduce the size of option grants, restricted shares may provide the employer an attractive alternative, at least in part, to stock options.

Restricted shares, like deferred shares, may avoid the impact of code 162(m) in respect of named executive officers if vesting is deferred until after retirement. However, deferred shares are better for the executive in this respect because they can vest during employment and yet not be taxed until after retirement (when delivered) whereas restricted shares, to extend taxability beyond employment (and avoid applicability of Code 162(m) to the employer), must remain unvested until termination of employment. In contrast, stock options that are approved by shareholders and meet the requirements of the regulations under code 162(m) avoid any 162(m) problem whether they are exercised during or after a named executive officer's employment.)

Performance Shares.

3. Performance Shares.

Over the past 10 to 15 years, intermediate term incentive plans (generally with three-year terms) have been developed at many U.S. companies. It is possible that such plans, tied to stock awards, may be developed further in the near future as alternatives, at least in part, to stock options. One example is a performance share award. Under such a plan, if a performance target such as a specified cumulative growth in earnings per share over the applicable period is achieved, a specified number of shares will be paid out, with upward or downward adjustment within a pre-established range if actual performance is above or below target. The disadvantage to the employer in the performance share award is that it is a variable cost award as discussed above in connection with certain performance-based options. From a tax standpoint, the executive will be taxed at the time the actual shares are paid out following attainment of performance targets. The employer will receive a deduction at the time the executive is taxed.


FOOTNOTES:

1This column does not take into account the impact of the Sarbanes- Oxley Act of 2002 (PL No. 107-204) on executive pay, most particularly on loans to officers and directors. For discussion of parts of the Sarbanes-Oxley Act, see this column appearing in The New York Law Journal Aug. 30, 2002 and Sept. 6, 2002.

2 See this column appearing in The New York Law Journal May 30, 2002.

3 For those companies electing to charge earnings for stock options, the accounting treatment is addressed in FASB Statement No. 123.

4 Deferred shares also can be used in conjunction with stock options. Assuming tax rules relating to elective deferrals are satisfied, an executive can elect to defer the spread in an option at the time of exercise in the form of deferred shares. The executive does not incur tax until a subsequent point when the deferred stock is paid out. (Payment of the exercise price with shares already owned by the executive rather than by cash avoids loss of tax basis. See Revenue Ruling 80-244, 1980-2 C.B.234.) The arrangement just described also enables the employer, under current accounting rules, to avoid any charge against earnings for the option or the deferred shares. (This accounting treatment assumes that if shares are used by the executive to exercise the stock option they are shares acquired in the market or are 'mature' shares (meaning shares held by the executive for at least six months)).