Exploring Options

Companies are under increasing pressure from investors to overhaul their pay packages, but how?

The problem with taking a bold step is that often you can't take just one. With institutional investors and policymakers urging them on, dozens of companies have decided to sign on to the reform movement sweeping boardrooms and begin deducting the cost of stock options from their reported earnings. But that is compelling companies to confront another, far more complex issue: If options aren't going to be free anymore, should companies now seize this opportunity to overhaul their entire incentive-pay system? Indeed, should they try to get more bang for their buck with other tools to motivate employees and make them think like shareholders? Or should they merely scale back their options grants to prune the cost?

The choices involve billions of dollars. American Express Co. (AXP ) alone issues options worth about $200 million each year. And time is short: Companies with calendar fiscal years must finalize their plans by early March to include them in proxy statements for this year's annual meetings. Without shareholder approval, the new schemes may not be tax-deductible. "It is a hot issue," says Peter T. Chingos, head of the compensation practice at Mercer Human Resource Consulting LLC. "There isn't a boardroom that I walk into that is not contemplating some action."

How quickly Corporate America rebuilds trust among investors depends on the outcome. If company directors simply camouflage new ways to enrich executives, their actions might prolong the agony of the bear market. But if they choose pay packages that are clearly fair to both shareholders and employees, the market might heal that much more quickly. In fact, the issue is shaping up as a litmus test of whether directors are on board for reform and exercising more independence from their chief executives.

There's no magic bullet. Many companies are switching from options to restricted stock, which carries conditions for how long an employee must stay with the company and hold the stock. Online retailer Amazon.com Inc. (AMZN ) and e-tailing-and-travel outfit USA Interactive are replacing most options with such stock. Insurer Chubb Corp. (CB ) and pizza chain Papa John's International Inc. (PZZA ), on the other hand, are converting some of their options to cash bonuses. Chubb will continue to grant some premium-priced options, which in the past haven't paid off unless the company's stock rose 25%. Papa John's is making its bonuses contingent on hitting goals such as operating-income growth.

What's striking is how few companies have announced changes so far. They worry that new plans will be difficult to sell to employees and shareholders. Other companies had expected to unveil their changes by now but found that crafting new plans turned out to be far harder than they imagined. Blair Jones, a compensation expert at Sibson Consulting, says one client considered setting performance requirements tied to business units, only to realize that such a plan could make employees in high-performing units fight transfers. "We had 10 years of following the pack [with options], and now you have to think about your own company's dynamics," says Jones. "That is very uncomfortable for companies."

Still, the pressure to rethink stock options is unrelenting. Many executives and employees hanker for something new because the bear market shredded their options. Institutional investors want options curtailed lest they produce another windfall for execs in the future. The Financial Accounting Standards Board is soliciting comment on whether all companies should have to expense options. The International Accounting Standards Board has posted an expensing standard for comment. So far, 176 companies are expensing options, or say they will--up from just 16 as of last June, according to Mercer.

Employees worry that they'll end up paying for these reforms. Their fears may be justified. If expensing is mandated, options are likely to be slashed by one-third, with the cuts falling heaviest below the executive ranks, according to New York pay consultant Pearl Meyer. Alfred P. West Jr., CEO at publicly traded SEI Investments Co. (SEIC ), says that if the company must expense options, it will stop making grants for at least a third of the 572 employees who now get them.

Others won't try to pay less, but they will pay differently. At USA Interactive (USAI ), employees will be getting what the company figures is equal value: one restricted share for every three options they used to get. The company will be nearly options-free within a year, says Chief Financial Officer Dara Khosrowshahi. "Options did encourage a bit of the get-rich-quick attitude [during] the bubble market," he says. American Express and Cendant Corp. (CD ) also are replacing some of their options with restricted stock.

Companies like restricted shares. They're easier to account for than options and make employees feel like long-term shareholders, with their fortunes fluctuating alongside those of investors. Options, by comparison, can pay off big or expire worthless; holding them is more like buying a lottery ticket, engendering less long-term loyalty. If the stock falls, restricted shares encourage employees to stay, while options lose whatever retention value they had.

Amazon has already switched from options to restricted shares as its main form of stock-based pay, but it won't say how many shares it will grant. In 2001, accounting rules forced Amazon to begin expensing options after it had repriced them because they were underwater. "Once you decide to expense an equity award, you have more arrows in your quiver than if you want to avoid expensing," says spokesman Bill Curry.

Amazon is winning some plaudits from Legg Mason Funds Management Inc., its biggest outside investor with about 15% of its stock. "The more you create long-term holders out of employees, the more they are going to act like long-term owners, which is what I am," says Lisa Rapuano, director of research and an outspoken critic of Amazon's past options grants.

But she is reserving judgment on Amazon's plan until the company discloses its exact terms. She wants to know how many shares the company is giving out and under what restrictions. "We fought against the options excesses, and now we don't want to be getting restricted-stock excesses," says Rapuano. She and other investors will be watching what executives and directors do with the chance to change their pay plans. Given the revelations of bull-market greed, they had better not blow it.

By David Henry and Louis Lavelle in New York

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