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Investor Relations Business

August 03, 1998

Options for Everyone?

BYLINE: Matthew Greco

Pushing options down to most or all of a company's workers is spreading like wildfire in corporate America. A recent study by the National Center for Employee Ownership estimates that at least 3,000 U.S. companies-a 600% increase from 1991-now have "broad-based" programs that could provide options to more than six million workers.

This movement toward "options for everyone" is not limited to small firms. A recent study of 350 large-cap companies by William Mercer Inc. found that 30% offer (on paper at least) options to at least one-half of their employees. When companies adopt these broad-based programs, they typically intone what has become the holy trinity of equity-based pay: attract, retain, and motivate. There is growing evidence, however, that broad-based option programs often fail to advance these goals. Actual practice contradicts the notions that options provide long-term incentives or encourage alignment. Simply put, most lower-level employees view stock awards as short-term pay.

A 1996 study by Mark Lang and Steven Huddart (professors of accounting at the University of North Carolina and Duke University, respectively) found that most workers exercise their options quickly and then sell the shares prematurely. Two-thirds of the exercise activity of lower-level workers occurred just six months after the holders are vested and their options were "in the money."

Overall, 90% of the employees in the study sold their stock right after exercise. In addition, a market downturn could demoralize rank-and-file workers, who will see paper profits upon which they planned to retire go up in smoke, which in turn could result in a costly tidal wave of option repricings.

The uncertain benefits of broad-based option programs call into question their traditional exemption from shareholder approval. The absence of shareholder approval was relatively unimportant when broad-based plans were small in size and few in number. In addition, various federal and state legal requirements and the listing standards of the national stock exchanges afforded investors a certain degree of protection by requiring shareholder approval of allocations of new shares to plans for top executives and directors.

Recent changes in federal law and the listing standards, however, have eroded this important check and balance. Most notably, the New York Stock Exchange's (NYSE) recent move to formally eliminate shareholder approval for broad-based plans undermines shareholders' ability to oversee managements' stewardship of equity.

Under the rule, adopted this past April, NYSE-listed companies would not be required to go to shareholders for approval of any plan if 20% of the companies' employees could receive awards and not more than half of the eligible participants are top executives or directors. In the face of a backlash by shareholders, the NYSE has agreed to put the new rule out for additional comments. (The comment period ended last month.)

Recent increases in the size and cost of broad-based option plans demand a uniform national listing standard that will determine which plans should be put to shareholders for approval. The potential cost of a plan, rather than eligibility or participation rate, should trigger the approval requirement. Some groups urge the NYSE to allow shareholders to approve any plan (regardless of broad-based eligibility or participation) that provides for awards that could result in "material" dilution.

A number of investors suggest waiving votes where potential all-plan dilution is 10% or less of the shares outstanding. However, such a high threshold could lead to widespread usage of so-called "full-value" awards, such as restricted stock and discount options, which carry a higher price tag for shareholders.

Accordingly, a vote on any proposed plan or amendment should be required whenever the aggregate dilution is in excess of 5% of the outstanding shares. Such a standard is fair because it will maintain the integrity of the capital markets and provide a safeguard against the willy-nilly growth of equity-based compensation plans by allowing shareholders meaningful oversight.

Copyright 1998 Securities Data Publishing

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Steven Huddart
Smeal College of Business, Penn State University, University Park, PA 16802-3603 USA
(814) 865-3271
(814) 863-8393 fax
huddart@psu.edu
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