arthur h. kroll


Are TSOs a New Trend?

When Microsoft adopted third-party option transferability in 2003, the program made waves as an unorthodox way to incent and retain employees. The software giant's one-time offer for employees to get value for below-market options by selling them to JPMorgan Chase had Wall Street speculating about a potential secondary market for vested options. Four years later, Google is making headlines for a more permanent transferable stock option (TSO) program that will allow employees to sell their vested options to preapproved financial institutions in an online auction managed by Morgan Stanley. This time, because the advantages are many, the prospect of a TSO trend looks promising.

Inside Google's TSO Plan

Participants in the plan may exercise their vested options under a traditional option program or sell them at auction. Employees will use a company Web tool to review prices offered by competing financial institutions. From their perspective, the right to sell options adds considerable value to each grant. The financial institutions, meanwhile, will seek a spread-namely, the difference between the fair market value and the exercise price-at which they can hope to make a profit.

Because the company does not want to encourage key management to sell options, only employees below Google's executive management group will be eligible to participate. Indeed, some companies require CEOs to hold stock equal to 500 percent of their annual compensation. Others allow CEOs to exercise options and sell shares to pay taxes, although they often put a restriction on the sale of stock. MCI, for example, precludes executives from selling more than 25 percent of their stock until they reach early retirement age. Citicorp has a similar rule, and such restrictions may become common over time.

Only options granted on or after the date of Google's initial public offering will be eligible for sale. Options granted prior to the IPO made many employees millionaires and billionaires. The option prices were as low as $10, and the stock now trades close to $500. To complete the sale, the usual restriction prohibiting transferability except to family members must be amended.

By the Numbers

Options currently have a 10-year term. However, once sold to a third party, the option expires two years from the date of transfer or on the original expiration date of the option, if earlier. So the buyer has no more than two years in which to make its gain. Options with a remaining term of less than six months are not eligible for sale under the program due partly to SEC concerns. To avoid being considered a public offering, no further transfers to the public will be permitted after employees sell their options to a financial institution.

There will be an increased compensation charge relative to the traditional option for currently outstanding options. The increase will equal the difference between the value of the modified stock option and the value immediately prior to modification, as measured using the Black-Scholes-Merton option-pricing model. The right to sell increases the charge because the option is more valuable. The charge will be taken on the date the program is initiated for all vested options and will be spread over the remaining vesting periods for unvested options. New grants will also have a higher value because Google, in valuing the option, will anticipate the exercise period to be six years rather than the present four years.

Benefits of TSOs

The principal benefit of the Google TSO is that compensation expense will be more closely aligned with pay delivery. In addition, if options are granted "underwater," the TSO eliminates the need to take corrective measures, such as making additional grants like Microsoft has done, or repricing the options as Apple did. These grants still have incentive and retention value.

The change makes TSOs quite similar to restricted stock, which is used more frequently now that there is an accounting charge on the grant of options. (Remember, the accounting advantages of options have been eliminated.) In the case of a TSO, participants will have the ability to time their taxable income since they choose when to sell or exercise the option, unlike restricted stock, which is taxable at a fixed period-namely, the date it vests. Employees perceive a higher value for both restricted stock and TSOs. Traditional options only have value if they go up in price.

The company and shareholders also benefit. The company will be able to grant a lower number of option shares to deliver the same compensation value since value of a TSO option will be greater than that of a traditional option. This is a key advantage to employers and shareholders because the number of shares outstanding is reduced, thus reducing dilution. The sale feature also should allow companies to make stock grants more often because shareholders are generally more likely to approve new share authorizations when the number of outstanding options held by employees, i.e., overhang, is lower.

The company still receives a tax deduction for the amounts realized by the participants on the sale to financial institutions. Thus, it could receive a deduction for underwater options that are sold. These options will not be exercised and ordinarily the deduction would be lost. For employees, competitive bidding by several financial institutions will help ensure receiving a fair price for options.

Caveats for Companies

Some advisers suggest that institutional investors and related advisory services may not distinguish between options held by employees and those transferred to financial institutions in calculating overhang. However, analysts will generally recognize the key value of selling underwater options in reducing overhang. Institutional holders are more likely to object to the right of participants to realize compensation even when the exercise price exceeds fair market value. This same objection is made to restricted stock that vests upon a period of service, dubbed "pay for pulse."

Initially, compensation expense will increase for new options and previously outstanding options affected by the program because they are more valuable, but that is unlikely to generate a lot of criticism.

Backdating Backlash?

This is not a good time for changing the nature of option grants (see "The Truth Behind the Backdating Brouhaha," December 2006). So far, at least 66 top officers, including approximately 20 CEOs, have been terminated as a result of backdating scandals. It is estimated that 150 companies are under investigation, and the number continues to grow. In the midst of the resulting turmoil, compensation committees and boards may be reluctant to change any options until this is accomplished.

Compensation experts foresee more widespread adoption of these programs. TSOs may not be appropriate for smaller firms due to their higher administrative costs, but for larger firms the benefits to employers and employees outweigh the additional costs. The transition, however, will take time. TSOs constitute a major change, and compensation committees will need time to adjust, especially in light of the backdating issue.

Arthur H. Kroll is CEO of Hartsdale, N.Y.-based KST Consulting Group, and author of Compensating Executives.

The Truth Behind the Backdating Brouhaha

Approximately 100 companies have come under fire for the backdating of stock option grants. The resulting investigations, in turn, have led to the resignation of 30 officers- many of them CEOs, CFOs and general counsels. Notable casualties include Altera and UnitedHealth Group, as well as SafeNet, KLA-Tencor and Sapient-with more announced daily.

So, what exactly is backdating? Options-or the right to buy a set number of shares at a fixed price- are usually granted under a plan approved by shareholders. The idea is to reward executives for increasing the price of the stock. Option plans typically call for granting options at their fair market value on the date of grant. The backdating of options, on the other hand, involves selecting a previous date when the stock price was lower so that the options granted are immediately in the black. In short, backdating gives the option grantees an unfair head start. However, discounting options through backdating is legal if disclosed and accounted for properly and if intended by the compensation committee to be additional compensation. The backdating situations under investigation purported to be options that were not discount options but options at fair market value.

UnitedHealth: Double Dipping?

UnitedHealth's option program won attention because its stock performed so well. The case involved Dr. William McGuire, a pulmonologist who negotiated a contract with William G. Spears, chairman of the compensation committee. The resulting options were backdated to the time of the year when the stock price was at its lowest. In essence, McGuire got a $12 million head start.

Another wrinkle for McGuire emerged in an October 15, 2006, report from the law firm of Wilmer- Hale concerning double options. In 1999, the options offered in the prior five years were "under water," meaning the exercise price greatly exceeded the fair market value, rendering the options worthless. The company addressed this by "suspending" the 2 million options already held by McGuire and granting an equal number at a lower price. Unfortunately, at the time, the repricing of options was subject to variable accounting-as the market went up, earnings would be reduced by the increase. While not strictly a repricing, this suspension and regrant should have been treated as such because that was the effect.

But the greed did not end there. As the stock soared in value, the suspended options gained substantial value. The suspension was then lifted so that McGuire got a double option. It is not clear whether the board knew about this; if they were deceived, then the lifting of the suspension would be an additional problem for McGuire and possibly for the chairman of the compensation committee.

Many-and Varied-Risks 

There are many risks in backdating. In previous years, when the options currently under investigation were granted, options awarded at fair market value did not require an accounting charge. However, discounted options involved additional compensation and did require a charge. Accordingly, the backdating of options requires restating earnings for many years to reflect the charges for options-an expensive proposition. For example, Mercury Interactive, a Silicon Valley software company involved in a backdating scandal, reported spending $70 million just to clean up and restate earnings.

Not reporting discounted options is a violation of SEC disclosure rules and can lead to civil penalties and charges. If done with intent, those involved can face criminal charges and jail time. Comverse Technology's CFO pled guilty to securities fraud relating to backdating. In the first such criminal guilty plea, he eventually settled civil charges of $51 million for $2.4 million. However, he may also serve up to 10 years.

The risk of class actions seeking damages is significant. And there are tax concerns for top executives, such as the deductibility of the options when granted at a discount.

Finally, at least on the NASDAQ, a company's stock can be delisted and relegated to the pink sheets, which could affect the price of the stock as well as its liquidity. Nyfix and Mercury Interactive have been delisted. In addition, four other companies may be delisted-Apple Computer, Altera, Bea Systems and Comverse. Under the new tax act, discounted options are immediately taxable to the executive. However, previously granted, unvested and discounted options can be replaced on or before December 31, 2007, without any negative tax effect. Backdated options are not subject to this release; IRS Notice 2006-79 makes this quite clear.

Defense Moves

The maneuvers at United- Health are examples of the uproar that ensues when independent directors, CEO, general counsel and compensation committee members consider their individual liability and reputations. When backdating prompts an investigation, directors who knew nothing about the suspect actions and were simply deceived by the CEO and general counsel are in the best possible position.

As chairman of the compensation committee at UnitedHealth, Spears was deeply involved and was asked to resign. The independent members of the board, including the other members of the compensation committee, have stated that they did not know about the backdating. Basically, UnitedHealth's general counsel, CEO and one director are potentially subject to civil and possibly criminal charges. The other directors will have to rely on the defense that they were deceived.

Now the board will be faced with the question of what to do about the CEO's severance package when he is terminated without cause. (Cause does not apply since in this case it requires conviction of a felony-not merely a charge.) Misconduct could qualify as cause, but the contract `requires a warning and then time for correction, which was not possible in McGuire's case. The money at stake is a package estimated in excess of $500 million. What's more, all options that have not vested in McGuire's hands will vest immediately and be exercisable for six years rather than 90 days, making them even more valuable. In addition, there is a pension of $5 million a year and a lump sum of $6.4 million.

There is also the question of coverage for McGuire under the indemnification and directors and officers insurance. Until the matter is resolved, however, his legal fees and defense charges will have to be covered.

The Spears Conflict

Spears has serious problems due to his actions as chairman of the compensation committee. He was listed as an independent director, but the SEC investigation ascertained close ties that had not been disclosed. Spears was chosen to serve as a paid trustee for the two trusts that benefit McGuire's children, and he was an investment adviser for approximately $55 million of McGuire's billions. McGuire also invested $500,000 to help Spears buy back his money management firm from a financial conglomerate that had acquired it.

Disclosure of "some conflict" had reportedly been made to the full board, but the board denies any such knowledge. Two directors stated that they would have remembered this had they been told. The other board members insist that they learned of the conflicts only when investigators uncovered the matter.

It will be interesting to see whether the general counsels involved in these situations implicate outside accounting firms or outside counsel as part of their own defense. It has been suggested that all of these actions occurred prior to the change in culture and the change in law involved in the passage of Sarbanes- Oxley. This hardly seems like a defense. The board and chairman of the compensation committee clearly have fiduciary duties.

Likewise, the allegation that this was common practice does not hold water. A study by economist Erik Lie, a professor at Iowa University, estimated that 2,200 companies backdated options.

The Board: A Plan of Action

  • The board should retain independent counsel as well as independent accountants to determine whether backdating existed in their company going back at least three years; others have suggested 10 years.
  • The board should review and approve minutes of all meetings to ensure the accuracy of entries regarding the approval of backdating options without disclosures.
  • The directors will not hesitate to point to others in establishing that they were not involved and were deceived the same way as other shareholders.
  • All conflicts are required to be disclosed. The board should take action so that the alleged nondisclosures by Spears or McGuire and their intricate relationship, which involved the clearest conflict of interest, are disclosed.

The CEO's Defense

The CEO will not hesitate to say that the backdating of options was legal because discounted options were legal, and such discount was approved by the board or the compensation committee. The board must be prepared to disprove this allegation.

The CEO should obtain his own counsel as promptly as possible and should be aware that he may need to require separate counsel to negotiate the severance package. Also, a criminal lawyer may be needed to defend against criminal charges and the plaintiff's class action lawsuits that will inherently follow.

Spears will need separate counsel because of his alleged direct involvement in backdating and his conflict of interest, which was not disclosed.

Backdating is a serious problem coming as it does at a time when executive compensation is under intense criticism by unions, compensation experts and corporate governance experts. The Grasso decision may influence the committee's decision as to whether to pay. The court has already held that former NYSE CEO Dick Grasso was overpaid by the nonprofit corporation for which he worked.

Backdating problems will not disappear; in many cases, they are just starting. Determining who is responsible in addition to the CEO, and possibly inside counsel, will be litigated. Criminal charges are hard to prove but reportedly, some are about to be filed. In addition, the plaintiffs bar has a new cause of action against board members and CEOs that they will not hesitate to litigate. There are damages-and they can be substantial. The damages involve not only the discount but the charges required to clean up the mess and to restore the good reputation of a company.

Arthur H. Kroll is CEO of Hartsdale, N.Y.-based KST Consulting Group, and author of Compensating Executives.

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