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Expensing Options
04/01/03
Board Alert
A new recognition exists in corporate America that stock options will inevitably have to be expensed. As a result, it’s increasingly apparent to directors that they need to develop alternatives for when options are no longer considered free money.
The Financial Accounting Standards Board has added expensing stock options to its agenda, and indications abound that the FASB staff looks favorably upon mandatory expensing.
What’s more, the accounting industry has abandoned its longtime opposition to such a move. The American Institute of Certified Public Accountants has gone on the record as supporting expensing stock options. So have the nation’s top five accounting firms.
And for the first time, the SEC has stopped letting companies omit from their proxies shareholder proposals to expense options. In the past, the SEC disallowed the proposals under what’s called an ordinary business exemption.
The SEC’s action has invigorated a proxy proposal submitted by several labor unions, including the United Brotherhood of Carpenters, the International Brotherhood of Electrical Workers and the Laborers International Union. Already, more than a dozen large companies that have been targeted, among them BellSouth, Lehman Bros. and ExxonMobil, have acquiesced to the unions’ demands. More firms are likely to follow. The unions have targeted about 100 companies with the proposal.
“All of a sudden, it looks like there’s virtual unanimity on this subject,” says Pat McGurn, VP at Institutional Shareholder Services. He calls options expensing “a fait accompli” and suggests that formal implementation might take place as early as the start of 2005.
In response, comp committees are taking a renewed look at alternatives to plain-vanilla options. Directors, notes Paul Dorf, managing director of Compensation Resources, see that it’s futile to keep fighting options expensing.
“Therefore, if we’re going to have to do that, we might as well figure which programs to use more effectively,” he says.
Even before the tide turned so decisively toward options expensing, comp committees were already shifting their pay plans toward restricted stock and cash. That trend is accelerating. Progressive Corp., Amazon.com and Cendant, among others, have either stopped or scaled back issuing stock options in favor of restricted stock.
Other boards are turning to stock units, which unlike restricted stock don’t have voting rights. Verizon, for instance, started expensing stock options this year. Its senior management group’s long-term compensation is now a mix of non-qualified stock options and performance stock units.
The stock units, which rise and fall in value along with the firm’s public stock, are payable after three years depending on how Verizon’s stock performs against its peer group.
Stock units and restricted stock are viewed by many as compensation tools that more closely align recipients’ interests with those of regular shareholders than do options. And stock units don’t dilute shareowners’ holdings because they’re not real shares.
Early indications are that comp committees are also starting to consider performance-based or indexed stock options, which vest only when management meets certain predetermined criteria. Such options were long resisted by boards since they had to be expensed. If regular options are to be expensed as well, that puts performance-based options on a more equal footing.
Today, “boards are looking at performance-based stock options,” notes Dorf. Pressure to use indexed options is also coming from shareholders. This year, the UBC and its allies in the labor movement have filed proposals with 80 companies demanding that comp committees approve only indexed options in the future.
Still, performance-based options remain a hard sell. “Management resists them like hell because they have to do something to make money,” notes Warren Batts, a former CEO of Tupperware and Premark International. Batts sits on the comp committees of Cooper Industries and Methode.
Most boards, however, are waiting for the new rules to come out before making any changes. “We’re sort of sitting back watching what’s going on it the trendsetters and just sort of biding our time,” Batts says.
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