article is reprinted with permission from the
April 30, 1990
New York Law Journal.
© 1990 NLP IP Company.
Purchased 'Options and Stock-Funded' Pensions
By Joseph E. Bachelder.
AS PREVIOUSLY NOTED in this column 1, a number of interesting new uses of equity have been introduced recently in connection with executive compensation programs. Now two more interesting ideas have come to the attention of the author, both appearing in commentary by Jesse Brill in his newsletter, The Corporate Executive.
One of the ideas involves the use of stock options to replace at least part of cash compensation. 2 The case described is an arrangement adopted by International Multifoods Corp. for its chief executive officer, Anthony Luiso. 3 (The arrangement is described as part of Proposal 2 to stockholders: 1989 Stock-Based Incentive Plan, starting at page 13 of the 1989 proxy.) Mr. Luiso waived the right to receive $200,000 per year in cash compensation for five years in exchange for the grant of an option to acquire 172,413 shares. 4
The option grant is for a 10-year term. The option exercise price was based on a formula intended to approximate the fair market value of the company stock on the date of option grant. The option vests periodically at a rate of approximately 20 percent per year for the first five years. Portions becoming vested thereafter become exercisable about two years after vesting.
Mr. Luiso enjoys the opportunity to enhance his cash compensation substantially if the stock does well. (He also has the risk of seeing it evaporate if the stock does not grow in value). If the stock doubles in value over the next five years, for example, the $1 million will become $5 million.
The size of the option grant was determined as follows. First, the company valued the option at 20 percent of the value of the underlying shares. For purposes of the example given in the proxy statement, the company assumed an exercise price of $29 per share. It multiplied this by 20 percent to obtain a per-share value for the option of $5.80. Finally, it divided the $1 million of cash compensation waived by Mr. Luiso by $5.80 to obtain the 172,413 shares as to which it would grant Mr. Luiso the option under the example. (The proxy used an example because the proxy preceded the proposed date of grant by several weeks.).
Mr. Brill, in his newsletter, raises an important question: What is the real value of an option like that granted Mr. Luiso? The company does not disclose in the 1989 proxy statement the basis on which it selected a value equal to 20 percent of the underlying shares.
There are numerous ways in which to value an option. A very well known one, as noted by Mr. Brill, is the Black-Sholes model. That model combines such factors as the current value of the right to exercise a call at a future date (ordinarily the last day of the option term) at a purchase price set today (usually today's market price in the case of executive stock options). Other factors include absence of dividends (a subtraction) and a factor generally described as "volatility." Volatility is derived through a complicated calculation and is intended to reflect the potential for change in price in light of previous changes in the stock's price (usually over a relatively recent period).
From the executive's standpoint, the option "purchase" approach, through waiver of future cash compensation, offers a substantial leverage opportunity. There is no tax to the executive at the time of option grant. Thus, instead of paying tax on the cash compensation that has been waived ($1 million in the International Multifoods case), the executive in effect is being allowed to "invest" that amount (pretax) in the option and to realize the growth in value on the stock (pretax, of course). Ultimately he will pay tax at the time of option exercise. In the meantime, however, he enjoys the investment opportunity with pretax dollars.
Assuming the stock doubles in value over the next five years, at the end of year five he could exercise the option and realize an aftertax gain of $3.25 million. (This assumes a combined federal, state and local tax rate of 35 percent.) If, instead, the executive had received the cash compensation of $200,000 per year for five years, paid tax on it each year and invested the aftertax amount in some other investment, he would have needed a 59.51 percent internal rate of return (aftertax) to end up with $3.25 million after taxes! Even if the stock grew only 50 percent over the five years, thereby producing an aftertax gain of $1.625 million, the executive would have needed a 32.28 percent internal rate of return after tax on his $200,000 per year cash compensation to end up with $1.625 million after taxes.
The "purchased" option described above does not pose any unique securities problem. In this connection, it is noted that the situation of insiders holding stock options should be improved in the near future if the proposed new regulations under §16 of the Securities Exchange Act of 1934 are adopted.
From the standpoint of the company, the option raises a possible opportunity to reduce earnings charges. On the one hand, the option is being granted in lieu of annual cash compensation that would have been a charge against earnings. On the other hand, a nonqualified stock option does not result in a charge against earnings either at the time of grant or at exercise. For tax purposes, the company would receive the benefit of a tax deduction on the spread between the exercise price and the market value of the stock on the date the option is exercised (the same as the amount then being taxed to the executive).
Restricted Stock Alternative
What if the executive did not like the idea of committing part of his cash compensation to a stock option? Perhaps he would be interested in having it paid in restricted stock at some discount from market price. At a 50 percent discount and assuming the stock doubles in value over the next five years, he would still be better off with a stock option. To illustrate: At a 50 percent discount, Mr. Luiso might have been awarded 68,966 shares in lieu of the $1 million of cash compensation. Assuming the stock doubled in value over the five-year period, Mr. Luiso's 68,966 shares would be worth about $4 million (not including the benefit of dividends received). After tax (35 percent) this would be worth $2.6 million. Again, this may be compared with receiving cash compensation of $200,000 per year, which would have to realize an aftertax 50.49 percent internal rate of return to produce $2.6 million dollars after taxes in year five.
Mr. Luiso would not have realized as much gain as he did with the stock options; however, his risk would have been much less. The stock option will result in a loss on his "investment" (the $1 million of cash compensation waived) absent a growth of at least $5.80 per share (the premium he originally paid to acquire the option). The restricted stock would have been worth something to him even if it declined in value.
Still another possibility would be to give an executive a restricted stock grant and a stock option grant in tandem with it. In other words, the executive could ultimately elect to receive the benefit of one or the other but not both. Assuming a discount of 25 percent on the stock (45,977 shares [$1 million divided by $21.75]) and a stock option grant equal to three times the number of shares subject to the stock grant (137,931) and assuming the stock price doubles, Mr. Luiso would be better off electing the stock option. On the other hand, if the stock goes up only 40 percent Mr. Luiso would be somewhat better off with the restricted stock. The breakeven point is a growth of 50 percent. (The foregoing does not take into account dividends on the stock.)
By comparison with the stock option covering 172,413 shares, in the event of a doubling of the stock price, Mr. Luiso would earn substantially less, approximately $2.6 million after taxes, with the tandem option for 137,931 shares. On the other hand, he would be protected on the downside with 45,977 shares at his disposal if the stock price did not grow, and he would have considerably more upside potential (137,931 shares) than with the straight restricted stock grant (68,966 shares) assuming the stock more than doubles in value.
For the restricted stock/stock option tandem, the only charge against earnings that should be made is, arguably, the grant date value of the restricted stock -- the usual charge for restricted stock. Future growth would not be a charge. The stock option feature should not add cost because a stock option with an exercise price equal to market price at date of option grant is not a charge against earnings. There is a view, however, that as long as it is not known whether the stock option or the restricted stock alternatives will be elected, the growth in value of the restricted stock should be a charge against earnings. 5 That point in time presumably would be the cross-over point when the exercise of the option is more favorable to the executive than the restricted stock.
Another interesting idea noted by Mr. Brill involves the use of restricted stock to "fund" at least part of supplemental retirement income for executives. 6
The proliferation of unfunded executive retirement plans is quite extraordinary. These include plans intended to supplement arrangements allowed under the Employee Retirement Income Security Act (ERISA), plans intended to provide additional pension amounts without reference to the technical ERISA limitations and individual executive agreements intended to provide special arrangements on an individual basis.
Various methods of securing supplemental retirement plans, including rabbi trusts, secular trusts and executive employee stock option plans (EXOPs) performance guarantees (including surety bonds) and letters of credit, have been discussed in prior columns. 7
The "funding" arrangement discussed in the recent Brill newsletter involves the grant of restricted stock of the employer to a participant. The stock, under the basic approach suggested in the newsletter, would be subject to restrictions constituting a substantial risk of forfeiture under §83 of the Internal Revenue Code of 1986 and the stock would continue to be subject to restrictions until retirement. Many executives would find this delayed vesting unsatisfactory as a method of funding for at least two reasons. First, company stock does not provide a diversified funding vehicle and, second, the executive would risk losing it all if, for example, he left voluntarily before retirement.
If the "funding" involved an "all or nothing" approach, most executives probably would not consider it a very satisfactory arrangement. On the other hand, if the executive, upon a premature departure, would forfeit the restricted stock, but the company would continue to have an obligation to pay the pension on an unfunded basis, the use of the restricted stock might be more appealing. Mr. Brill suggests that the use of a restricted stock program as described should not be accompanied by any kind of floor guaranteeing a minimum cash payment in the event of a decline in the stock price. Presumably he also would not support a continuing obligation of the company notwithstanding a forfeiture of the stock.
Without such continuing commitment by the employer (that is, the employer's continuing to be obligated notwithstanding forfeiture of the restricted stock), the author has some doubt as to the idea's acceptability. It is true that the use of restricted stock to "fund" retirement benefits may provide some very attractive accounting features for the employer. Assuming the "all or nothing" approach, the use of restricted stock puts a "cap" on the charge against earnings, and the use of such an arrangement may, in some cases, provide a basis for eliminating some of the retirement liability from the balance sheet. In order to achieve these accounting consequences, however, the executive would be subject to a risk that he probably would not find acceptable.
Even assuming the employer continues to be obligated to pay the pension notwithstanding a forfeiture of the stock, the restricted stock approach does not give the protection against future financial difficulties of the employer that a secular trust provides (although, presumably, the executive, at the time of his retirement and vesting of the stock, would then diversify his holdings). Nor does it offer the security of diverse investments afforded by a rabbi trust (although, again, the executive presumably would diversify upon retirement). It resembles somewhat the financial security offered by an EXOP, described in an earlier column. 8
A premature termination of employment is also a significant concern to an executive -- in many cases, undoubtedly, as significant a concern as the risk of insolvency of the employer. Restricted stock cannot protect against the risk of premature termination of employment unless it vests gradually over the course of the employment period rather than all at once at retirement. If the stock vests gradually over the period of employment, however, there will be tax consequences to the executive during employment as the stock vests. The risk of premature termination can be protected against by vesting arrangements under rabbi trusts, secular trusts (if grossed up) and EXOPs without adverse tax consequences to the executive during employment.
1 New York Law Journal, Dec. 28, 1989.
2 The subject of stock or stock-related awards to substitute for annual cash bonuses was discussed in the column appearing in the NYLJ, Dec. 28, 1989.
3 The Corporate Executive, March-April 1990, Vol. IV, No. 2. The newsletter gives credit to Ira T. Kay, managing director of the executive compensation practice at Hay Management Consultants for bringing this idea to the attention of Mr. Brill.
4 The type of option being discussed is not intended to supplant the executive's participation in the regular stock option program or other ongoing long-term incentive arrangements of the employer. Thus, for example, Mr. Luiso presumably will continue to participate in the regular stock option program and any other long-term incentive programs that International Multifoods Corp. may from time to time have in effect.
5 The accounting issues involved in such a tandem arrangement were discussed in the column appearing in the NYLJ, Oct. 24, 1989.
6 The Corporate Executive, January-February 1990, Vol. IV, No. 1. The newsletter gives credit to George B. Paulin of Frederic W. Cook Co. for bringing this idea to Mr. Brill's attention.
7 NYLJ, Dec. 28, 1989 (discussing the concept of EXOP); May 2, 1989 (discussing "shadow" trusts); Aug. 29, 1988, June 29, 1987 and April 19, 1985 (discussing rabbi trusts); June 29, 1987 (discussing secular trusts).
8 NYLJ, Dec. 28, 1989.