Morgan Stanley Cuts Gorman’s Time to Profit From Options
Options awarded to Gorman and five other top executives for 2012 will expire in five years, Morgan Stanley disclosed in regulatory filings last month. About 75 percent of executive options granted by companies in the Standard & Poor’s 500 Index have 10-year terms, according to Aaron Boyd, director of research at Equilar Inc., a compensation data firm based in Redwood City, California.
Morgan Stanley, the biggest financial brokerage, also split from Wall Street by awarding most top executives their year-end bonuses in the form of options rather than restricted stock. The bank needed to take the step after charges tied to the valuation of company debt wiped out most of the firm’s pretax income, said a person familiar with the matter who asked not to be named because the information isn’t public. The shorter-dated options present greater risks and potential rewards than restricted stock, depending on how successful Gorman is in turning Morgan Stanley around.
“In order for the option grant to have meaningful value, you have to get the stock price up,” said Brian Foley, a New York-based compensation consultant. “If you look at their trading history, it just hasn’t happened.”
Mark Lake, a Morgan Stanley spokesman, declined to comment on the awards. When the bank last gave options to top executives for 2010, the securities were exercisable for seven years instead of five.
During the five years ended Feb. 1, Morgan Stanley shares fell 51 percent while the U.S. benchmark Standard & Poor’s 500 Index rose almost 14 percent, a gap that reflects the toll that the 2008 financial crisis took on bank stocks. Morgan Stanley gained 55 percent since the start of last year.
From an executive’s perspective, restricted shares are a less risky form of compensation because they retain some value even if a company’s stock price drops, according to Foley. Options entitle the holder to purchase shares at a set price in the future, so they become worthless if the stock falls below that level and fails to recover during the exercise period. Restricted stock vests at market value once conditions are met.
Many of the nation’s largest banks have avoided awarding options since the recession and stock-market decline late in the prior decade. Goldman Sachs Group Inc. last issued options for 2007 and Bank of America Corp. last did so for 2008, according to their annual proxy statements. Wells Fargo & Co. executives, who haven’t gotten any new option packages since 2008, have received so-called reload grants that automatically replace exercised options under terms of the older awards.
JPMorgan Chase & Co., in issuing option-like awards to CEO James Dimon and other top executives for 2011, used the 10-year term favored by most S&P 500 companies, according to last year’s proxy. Vikram Pandit, the former CEO of Citigroup Inc., received 10-year options as a retention award for 2011, while some of the company’s other executives, including ex-President John Havens, got options with a six-year life, the firm’s filings show.
“Usually the CEO or CFO will hold the option as long as they can,” said Alan Nadel, managing director at Strategic Apex Group LLC, a New York-based management-consulting firm. “Many senior executives understand the opportunity for the long-term appreciation and wish to benefit from that as best as they can.”
Morgan Stanley favored restricted-stock awards over options for most of the last decade. Since fiscal 2002, the firm awarded options to executives only in 2005 and 2011, and both times the grants were accompanied by larger restricted-stock payouts.
Things changed last year when the firm recorded $4.4 billion of expenses tied to an accounting rule requiring companies to value outstanding debt at the end of each quarter. The debt-valuation adjustment increases in cost as the company’s financial health improves and its bonds rise in value based on the theory that it would cost more to buy back outstanding debt.
The adjustment left Morgan Stanley with pretax income of $515 million for 2012. Under a compensation plan approved by shareholders in 2001, before the accounting requirement existed, Morgan Stanley capped the amount of “performance-related” compensation that can be paid out to any top executive at 0.5 percent of pretax income.
By tying cash and stock bonuses to an executive’s performance, Morgan Stanley can get a tax deduction for the entire amount of the award. Otherwise, the portion of a bonus to the CEO or another highly paid officer exceeding $1 million isn’t tax deductible under a provision of the Internal Revenue Code known as Section 162(m). Stock options are considered performance-based and thus are fully deductible.
Similarly, Morgan Stanley’s 0.5 percent cap on performance- related compensation applies to cash and restricted stock bonuses but not options, according to the firm’s proxy statements. The latest option awards allowed Morgan Stanley to provide both cash and equity-based bonuses to top officers without running afoul of its own internal restrictions.
Gorman got a deferred cash bonus of $2.6 million last year, the maximum amount he could receive under the performance- related plan. He also earned options enabling him to buy 484,827 shares at $22.98 each until January 2018, according to documents the company filed with the U.S. Securities and Exchange Commission.
Morgan Stanley, which closed yesterday at $23.40 in New York trading, awarded such options on 2.3 million shares to six executives altogether. They include Gregory Fleming and Colm Kelleher, who head the bank’s wealth-management and institutional-securities units, respectively.
Morgan Stanley estimated that the fair value of Gorman’s most recent option package equaled $2.6 million, compared to $3.5 million for the grant he received in 2011. The total value of his 2012 pay package was $9.75 million, down about 7 percent from the year before.
Gorman and the others will gain the right to exercise their options through January 2016, with one-third of each grant vesting annually during the next three years. That means they will only have two years from the vesting point to exercise the final third of their grants.
U.S. accounting rules require employers to record compensation expense equaling the fair value of options awarded to employees, a figure Morgan Stanley and many other companies calculate using a formula devised by Myron Scholes and Robert Merton. The key factors in determining such expense under the so-called Black-Scholes model are current interest rates, the volatility of a company’s shares and the number of years the holder has to exercise the options.
Morgan Stanley’s option grants to the six executives had a total fair-market value of $12.6 million, or $5.41 a share, equaling 24 percent of the price at which the options can be exercised, according to the filings. In early 2011, the company issued executives options for 2010 on 1.3 million shares that expired in seven years and had a fair value of $11 million, or $8.24 a share. That equaled 27 percent of the $30.01 exercise price, filings show.
“Using five versus seven will lower the Black-Scholes cost so you can deliver a play on more shares without driving the price up,” said Foley, the compensation consultant. “But the individual is going to have a shorter play.”