Squall on the sea of easy options riches - Minneapolis/St. Paul Star Tribune - June 2008
Squall on the sea of easy options riches
The current slump in the stock market has put many executives' stock options underwater -- meaning they're now worthless.
By DAVID PHELPS and PATRICK KENNEDY, Star Tribune staff writers
Last update: June 23, 2008 - 1:31 PM
When the economy was strong, the granting of stock options was an
almost-guaranteed pathway to financial riches for corporate executives
who would collect millions of dollars when they cashed them in.
But as the stock market has moved mostly down or sideways in 2008,
more top executives are coming to understand and loathe the concept
known as "underwater," when their options become worthless because the
company's share price is less than the option price.
Whether because of a weak economy or strategic miscalculations,
executives of some prominent Minnesota companies are out of the money
with options that were supposed to be incentive-inducing to get the
kind of performance that inspires investors.
Among those who are holding underwater options are the CEOs of such
Minnesota corporate stalwarts as Ameriprise Financial, MoneyGram
International, Ecolab, Piper Jaffray and UnitedHealth Group.
For example, all 453,276 option shares held by former MoneyGram CEO
Philip Milne are underwater, largely the result of his firm's ill-timed
investment in subprime mortgages. Milne resigned Thursday.
UnitedHealth CEO Stephen Hemsley has 3.45 million options currently
lacking value, as performance problems and nagging questions about the
future of Medicare have driven share values down across the health
insurance sector.
Similarly affected is former UnitedHealth CEO William McGuire, who
will have 3.675 million options underwater after agreeing to reprice
his shares at a higher value, as did Hemsley, in the wake of a
backdating investigation and settlements with the Securities and
Exchange Commission and a special litigation committee formed by the
company.
The credit crunch has hit the financial sector hard too, driving
down the shares of those companies by an aggregate of approximately 22
percent, according to Standard and Poor's Financial Index. As a result,
Piper CEO Andrew Duff has 52,400 nonperforming options to his name,
while Ameriprise's James Cracchiolo has 458,000 shares underwater even
though Ameriprise has fared better in the market than its peers.
Shares of Ecolab took a big hit this year when the German partner
Henkel said it intends to sell part or all of its 30 percent stake in
the manufacturer of industrial cleaning products. The decline in share
prices gave Ecolab CEO Douglas Baker Jr. more than 717,000
out-of-the-money shares.
Options theory
Options are designed to reward innovation and execution.
"When you give options, you use price as a performance measure,"
said P. Jane Saly, accounting department chair at the University of St.
Thomas' school of business. "If the price goes down due to decisions
they [management] made, compensation goes down and that's a legitimate
penalty. However, options may reward a manager when the market is going
up, and penalize them when it's going down."
In the Star Tribune's 2008 Executive Compensation Report published
in May, 35 of the 100 highest-paid CEOs exercised options in 2007. The
biggest gain went to former Target CEO Robert Ulrich, who netted $93.5
million.
Ulrich, who has retired, has 3.6 million exercisable and
unexercisable options and approximately 22.2 percent of those are
underwater. The options not underwater have a value of approximately
$34.6 million based on a share price of $50.85.
The use of stock options in executive compensation plans has fallen
somewhat, in part because of a 2006 accounting rule that requires
companies to record a charge against earnings over the period that the
options vest.
In its annual survey of executive pay this year, the Economic
Research Institute reported that option awards were down by 16.6
percent in 2007, while executive salaries rose 23.4 percent and bonuses
increased by 18.6 percent.
Restricted shares
In the past 10 years, options have gone from making up 42.5 percent
of a typical executive's total compensation to 25.4 percent, the
institute reported.
But the institute's Linda Lampkin warned not to read too much into those numbers.
"Companies are moving from options to restricted stock," Lampkin
said. "It's advantageous from an accounting point of view, although the
impact is not that different for the recipient because the money you
get is still tied to the price of the stock."
Restricted shares are granted to employees after a vesting period
either based on time or, increasingly, on time and performance
measures. When the stock vests, the executive is granted the shares at
the market price.
Stock options are the right to buy shares in the future at a preset
price -- generally the price of the stock at the time the option is
granted.
Once the options vest (typically in three to five years), an
executive can exercise them, then sell the options at the higher market
price and pocket the difference. But if the stock does not rise above
the exercise price, then the options would have no value.
Not so with restricted shares, which are gaining favor. Let's say an
employee were to get both stock options and restricted stock when the
company's share price is $50 per share. If, after vesting, the stock is
trading at $40 per share, the options would have no value but the
restricted stock would be worth $40 per share.
A recent analysis of 2007 executive compensation by the Corporate
Library found that fewer than half of the CEOs they sampled cashed in
any options during the year "in part because falling stock prices
rendered many options underwater."
But the organization also determined that more than half of the
surveyed CEOs vested in some other form of equity compensation during
the year, "which indicates that boards have been turning to full-value
stock over stock options as a compensation device."
dphelps@startribune.com • 612-673-7269 pkennedy@startribune.com • 612-673-7926
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