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by Peter Atrill 30 May 2007 Diploma in Financial Management Relevant to Module B

The Combined Code states that a significant proportion of the rewards paid to executive directors should be related to performance. One way in which long-term performance can be rewarded is through the granting of directors’ share options. This type of reward, however, has provoked considerable controversy. For years a debate has raged over whether granting share options to directors is consistent with good corporate governance. Peter Drucker, an eminent management thinker, has been a vociferous critic of this practice and has referred to it as ‘an encouragement to loot the corporation’.

This article examines the main features of directors’ share options and then explores the case for and against using options to reward directors. We shall see that a company implementing a share option scheme for executive directors must grapple with a variety of issues and problems.

What are directors’ share options?

A directors’ share option scheme gives directors the right, but not the obligation, to buy equity shares in their company at an agreed price. The scheme will usually stipulate that the option to buy must be exercised either on, or after, a specified future date. A final date for exercising the option will also usually be specified.

Directors’ share options are a form of call options, which will be exercised only if the market value of the shares exceeds the options exercise price. When the option is exercised, the company must issue the agreed number of shares to the director, who will make a profit from the transaction. Unlike most financial options, a director will not normally be required to pay for the option rights: they are granted for free. Directors’ share options, however, cannot be traded and will usually be forfeited if the director leaves the company before the option can be exercised.

In the UK, directors’ share options are normally issued at an exercise price which is equal to the current market price of the underlying shares. In the past, share options were sometimes issued at a discount to the market price, however, the Greenbury Report discouraged this practice. The terms of a share option scheme often allow the directors to exercise their option no earlier than three years, but no later than 10 years, after the option has been granted. Her Majesty’s Customs & Revenue (HMRC) rules and best practice guidelines from institutional investors limit the value of options to £100,000 or four times current salary1. The exercise of the option may be subject to certain performance targets, such as growth in earnings per share, being met2.

What are the benefits of granting options?

Directors’ share option schemes have been a popular method of rewarding the directors of large listed companies and various arguments have been put forward to support their use. It is often suggested, for example, that a well‑designed scheme will benefit shareholders because it will help to align the interests of directors with those of shareholders. Although directors are appointed to act in the best interest of their shareholders, there is always a risk that they will not do so. Instead, directors may be concerned with pursuing their own interests, such as increasing their pay and ‘perks’. It is argued that this ‘agency’ problem may be avoided through the use of share options because they provide directors with a financial incentive to increase the value of the company’s shares, and thereby to increase the wealth of shareholders. 

Some supporters of share options argue that they may even help to strengthen the psychological bond that a director has with the company. Through exercising an option and acquiring shares, the directors may identify more closely with the company and feel a sense of shared purpose with other shareholders. This argument does depend, however, on the directors retaining, rather than selling, the shares acquired under the option agreement.
It has also been suggested that share options may also help to retain board members. The fact that a director’s share options are normally forfeited if a director leaves the company can provide a strong incentive to stay. Thus, options can provide a set of ‘golden handcuffs’ for talented directors who may be offered other employment opportunities.

Unlike other forms of directors’ remuneration, share options involve no financial outlay for the company at the time that they are granted. If the share price does not perform well over the option period, the option will be allowed to lapse and no cost will be incurred by the company. If, on the other hand, the shares perform well and the options are exercised, they represent a form of deferred payment to the directors. This deferral of rewards may be particularly attractive to a growing company that is short of cash.

What are the problems of options?

Many believe that share options are a poor means of rewarding directors. Warren Buffet, one of the world’s shrewdest and most successful investors, has made clear his opposition to the use of options. One problem that concerns him is that share option schemes cannot differentiate between the performances achieved by individual directors. He argues:

‘Of course stock (share) options often go to talented, value-adding managers and sometimes deliver them rewards that are perfectly appropriate. (Indeed, managers who are really exceptional almost always get far less than they should.) But when the result is equitable, it is accidental. Once granted, the option is blind to individual performance. Because it is irrevocable and unconditional (so long as a manager stays in the company), the sluggard receives rewards from his options precisely as does the star. A managerial Rip Van Winkle, ready to doze for 10 years, could not wish for a better ‘incentive’ system…’3

A further problem concerning the incentive value of share options, to which Buffet refers, is that, where the share price falls significantly below the exercise price, the prospects of receiving benefits from the share options may become remote and any incentive value will be lost.
It is worth remembering that both rises and falls in share price may be beyond the control of the directors and may simply reflect changes in economy-wide or industry-wide factors. Any incentive scheme that is subject to the vagaries of the stock market is, therefore, likely to present problems. There is always a risk that directors will either be under‑compensated or over-compensated for their achievements.

Buffet’s criticism of share options is not confined to their dubious incentive value. He also challenges the view that share options place directors in the same position as that of shareholders. He argues:

‘Ironically, the rhetoric about options frequently describes them as desirable because they put owners and managers in the same financial boat. In reality, the boats are far different. No owner has ever escaped the burden of capital costs, whereas a holder of a fixed-price option bears no capital costs at all. An owner must weigh upside potential against downside risk: an option holder has no downside. In fact, the business project in which you would wish to have an option frequently is a project in which you would reject ownership. (I’ll be happy to accept a lottery ticket as a gift – but I’ll never buy one3.)’

This latter point, concerning the lack of ‘downside’ risk associated with the acquisition of options, may have an impact on the directors’ risk-taking behaviour. As options are granted for free, directors have an incentive to take risks when these options are ‘underwater’ (that is, they are out-of-the-money options). By taking risks, there is a prospect of a rise in share prices and resulting benefits. If, on the other hand, by taking risks there is a fall in share prices, the directors will incur no financial loss. 

Where share options are exercised, the directors may find themselves holding a large proportion of their total wealth in the form of company equity. The concentration of wealth in this form may have a number of unintended consequences. First, it may lead to risk-averse behaviour as directors may be concerned with maintaining their wealth. This behaviour may not, however, find favour with the shareholders, who are likely to have a more diversified portfolio of investments and so may be more willing to take risks. Second, it may reduce the value of further share options in the eyes of the directors, who may feel that their wealth is insufficiently diversified. For this reason, the value of a share option to a director is likely to be lower than the value of the option to the company granting it, in terms of the opportunity cost of selling the option in the market. As a result, share options can be an expensive way of motivating directors from the company’s perspective.

Share option schemes are based on the assumption that shareholders are concerned with share price increases and that directors’ behaviour and incentives should reflect this concern. An excessive focus on share price, however, may not be in the best interests of shareholders. Share price represents only one part of the shareholders’ total return from the company: the other part is dividend income. There is a risk that undue concern for share price may lead the directors to restrict dividend payments so that profits are retained to fuel share price growth. Indeed, as directors are rewarded on the basis of share price growth rather than dividend growth, they have an incentive to act in this way. (This potential problem has led some companies to incorporate dividend protection conditions in the share option schemes offered to directors.) Using similar reasoning, it can be argued that directors also have an incentive to re-purchase shares in the company as this too may lead to increases in share price.

Directors’ share options have declined in popularity in recent years and various factors appear to have contributed towards this decline. One factor is likely to have been the changes in the corporate governance environment. In the UK, the Greenbury Report discouraged the use of share option schemes and a number of large institutional investors have voiced their concern over their cost and effectiveness. A further factor is likely to have been that International Accounting Standards now require the ‘fair value’ of share option schemes to be included in the financial statements. Shareholders can now see more clearly the cost incurred by granting share options as it is shown as a charge against profits. A final factor is likely to have been that share option schemes are open to abuse. The particular forms of abuse that have been identified usually relate to the conditions of the share option scheme and to the pricing of options.

For UK companies in particular, a share option scheme will often include a condition that certain performance targets, such as earnings per share, must be met before the directors can exercise their options. There have been allegations, however, that some companies have set performance targets too low for them to have any real incentive effect. The pricing of options has often been a target for manipulation by unscrupulous individuals and, in the US, a number of scandals have been unearthed. Some high-profile US companies have been found to have reissued share options to directors at a lower price when the share price of the company fell below the option price. This practice effectively eliminates any risks for directors and may also eliminate any incentive effect that share options may have4. Sometimes, however, ‘re‑pricing’ options in this way may re-incentivise directors, particularly when stock market prices are falling. More recently, there have been accusations that directors have benefited from the backdating of options. One study, for example, found that 1,400 directors of 460 US companies benefited from the backdating of share options to the lowest price in a monthly period5.

In the UK, many companies have now abandoned share option schemes in favour of long-term incentive plans (LTIPs) as a means of rewarding executive directors. These plans often involve the issue of shares subject to the achievement of certain performance targets. A common measure of performance for these plans is total shareholder return (TSR), which takes account of both share price changes and dividend received during a period. The TSR of the company is usually compared to that of similar companies to assess relative performance. This measure, however, is not free from problems. Difficulties is finding similar companies as a suitable basis for comparison, the inability to identify the contributions of individual directors to the performance of the company, the inability to identify changes in share price that are outside the control of the directors, and the fact that TSR can be manipulated over the short-term, all conspire to make this a less-than-perfect measure. As a result, earnings-based measures may also be used to supplement TSR. These former measures, however, will usually bring their own problems.

Summary

In this article, we have seen that using share options as a basis for rewarding executive directors is fraught with difficulties. It is, therefore, not surprising that they have declined in popularity in recent years. However, there is no easy solution to the problem that directors’ share options seeks to address, which is to incentivise directors in such a way that they align their interests and goals to those of the shareholders. The recent move towards LTIPs may be a step in the right direction but they do not provide a perfect solution to what is a complex problem.  

Peter Atrill is examiner for Module B

References

1. Pope P and Young S, Executive share options: an investor’s guide
2. Bender R, Just rewards for a new approach to pay, Financial Times, 2 June 2005.
3. Buffet W, Annual Report to Shareholders Berkshire Hathaway Inc, 1985, p12.
4. Monks R and Minow N, Corporate Governance second edition, p226 Blackwell Publishing, 2001.
5. Quoted in Guerrera F, Study links directors to options scandal, Financial Times, 18 December 2006.
   

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