Reprinted from A Director’s Guide to Executive Compensation, Issue 2, May 2006.
UNDER ATTACK BUT HERE TO STAY
Increasingly criticized yet still popular, stock options currently occupy a position of controversy in executive compensation. Companies and executives favour options because they are a well-established and recognized form of incentive that continues to provide optionholders with favoured tax treatment under Canada’s taxation regime. In the last few years, institutional investors and governance organizations have led the charge to replace options with whole share compensation. Concerns over options are based on, among other things, lack of correlation with the optionholder’s performance and the inability to motivate the optionholder at all stages in a company’s growth. In response, companies are supplementing options with other forms of remuneration and altering option plans to address identified shortcomings. The following provides an overview of stock options, their tax treatment, common design flaws and solutions.
What Are Options?
A stock option is a right, but not an obligation, to acquire a specified number of shares at a certain price (the "exercise price") during a predetermined period of time. The exercise price is almost always set at not less than the fair market value of the share at the date of the option grant. Stock options generally vest, or become exercisable, after a specified time. Once the options vest, the optionholder has the right to purchase the underlying securities.
When the exercise price exceeds the grant price, the option is said to be "in-the-money." When the grant price exceeds the exercise price, the option is said to be "underwater." When an option is in-the-money, the value created is an incentive for the option recipient to remain employed with the option grantor on a long-term basis. When underwater, the option represents no value to the optionholder.
How Are Options Taxed?
A stock option grant that meets the requirements of section 7(3)(a) of Canada’s Income Tax Act is not taxable at the time of grant, vesting or exercise of an option. Rather, the employee is taxed when disposing of or transferring the shares acquired when exercising the option. The increase in share value over the exercise price is usually taxed at capital gains rates. This means that one-half of the gain is included in taxable income. However, the employer is not entitled to deduct the value of the shares issued to the employee from its income.
Where an option is granted with a tandem share appreciation right, the employee will generally be entitled to the same tax treatment on exercising the share appreciation right as if he or she exercised the option. Further, the employer is generally entitled to a deduction in respect of the cash payment made to satisfy the share appreciation right.
Problems with Option Plans and Potential Solutions
Part of the difficulty with stock options is that they are a form of leveraged compensation. This type of compensation rewards executives only for the increase in the value of the company’s shares. The share value may increase as a result of inflation, market conditions or other factors unrelated to the company’s or executive’s performance. Companies may modify the options to respond to some of these concerns. For example, options may provide for annual increases in the exercise price, for periodic increases in the exercise price to correspond with the performance of peer companies, for vesting only on the achievement of specified performance targets or for the decrease or elimination of initial awards or options where performance targets are not met.1
Option plans are criticized for failing to improve the executive’s long-term role in a company’s growth and development. With careful attention to option plan design, companies can use options to help motivate and reward executives who achieve successful landmarks. For example, plans should have clauses that motivate key employees to remain with the company for a reasonable time after an initial public offering or a sale of a business. Compensation packages, including the grant of options, can be made contingent upon an executive’s agreeing to non-solicitation and non-competition obligations. Lastly, vesting schedules can be made longer, providing incentives for the executive to remain with the company for a longer period of time and to make business decisions that take into account the long-term health of the company.
NEW TRENDS IN EXECUTIVE COMPENSATION
From Options to Whole Share Compensation
Increasingly companies are focusing on whole share awards rather than leveraged awards such as stock options. Whole share compensation includes share grants, deferred, restricted and performance share units and share grants. This type of compensation increases and decreases in value in direct relationship with changes in share value and continues to provide an incentive to executives even when the share value decreases below the original grant value. Common forms of alternatives to options are summarized below.
1. Restricted Share Units
A restricted share unit (RSU) is a right to receive the full value of a share at a future time. RSUs are generally funded by converting a portion of the executive’s bonus compensation into RSUs. The number of RSUs is generally determined by dividing the compensation amount by the fair market value of a share at the date of a grant. At the end of the relevant period, the employee receives either one share of the company for each RSU or an amount of cash determined by multiplying the number of RSUs by the fair market value of a share at the end of the period.2In some cases, the incentive plan will allow the executive to choose to settle in cash or in shares. RSUs generally are redeemed no later than three years after date of grant to avoid the salary deferral arrangement rules under Canada’s Income Tax Act.
2. Performance Share Units
A performance share unit (PSU) is similar to an RSU and is the right to receive the full value of a share at some future time. However, a PSU generally vests on the achievement of performance criteria, rather than on the passage of time. PSU plans will generally provide for either cash settlement or share settlement, although some plans allow the executive to choose to settle in either cash or shares. PSUs provide incentive regardless of the share price.
3. Deferred Share Units
A deferred share unit (DSU) is a right very similar to an RSU, except that to meet requirements under the Income Tax Act (Canada), the holder may not redeem the DSU until cessation of employment or, in the case of a director, at the end of the term of office. The plan will generally provide for either cash settlement or share settlement, and in some circumstances may permit the executive to elect between the two settlement options.
KEY GOVERNANCE CONSIDERATIONS
Directors’ Approval of Stock-Based Plans
Directors and, in particular, compensation committee members reviewing stock option plans must consider shareholder as well as executive interests. Under the Toronto Stock Exchange Company Manual rules, in addition to the approval of each of a majority of the issuer’s directors and a majority of the issuer’s unrelated directors, shareholder approval is required in respect of certain security-based compensation arrangements.3 In Canada, institutional investors such as pension funds, mutual funds and independent money managers have significant ownership positions in publicly traded corporations. Directors will need to consider the preferences and attitudes of institutional investors when making decisions involving incentive plan design.
Stock options are one of a myriad of topics canvassed in the detailed proxy voting guidelines developed by institutional investors to establish specific standards that determine how shareholder votes are exercised. Below are a number of option plan design elements and the corresponding view of institutional investors that directors should keep in mind when contemplating proposed option plans or option plan amendments.
1. Link to Performance or Ownership
Many stock option plans currently base rewards on general market or sector performance rather than on individual company out-performance of the market or sector.4 The Canadian Coalition for Good Governance emphasizes that stock options are more effective vehicles for aligning executive and company interests when they are linked to performance objectives or share ownership guidelines. When linked to share ownership, the purpose of the option grants is to facilitate share ownership since it is expected that a large part of the after-tax gains on options would be held as stock in the company.5 When linked to performance objectives, option vesting and grant schedules are more effective when contingent upon the executive or company achieving performance targets.6
2. Provide for Corporate Change
Executive compensation arrangements sometimes provide that a change of control is a triggering incident, leading to an acceleration of vesting or additional entitlements. While change of control provisions may be desirable in some circumstances, the scale of the value provided to the executive on a change of control may be disproportional to the value provided to shareholders.
Institutional investors are unlikely to approve stock option plans with change of control provisions that allow optionholders to receive more value than shareholders receive. Institutional investors also emphasize the importance of setting out the change of control entitlements of executives prior to the actual change of control. This approach ensures that options are linked to long-term growth rather than attempting to retain executives in a hostile situation of corporate change where unreasonable demands may be made. Option plans that are instituted during a time of corporate change may also reflect rewards based on factors that are divorced from the executive’s performance. As a result, institutional investors have taken the position that they will not support change of control arrangements developed in the midst of a takeover fight, specifically to entrench management.7
3. Avoid Concentration of Option Grants
Institutional investors are also concerned about concentration of option grants, particularly where provided disproportionately to senior management. Institutional investors are likely to vote against plans or grants of a concentration of more than 20%–25% of all the available options. Further, total potential dilution of ownership should ideally be less than 5% and should never be more than 10%. Institutional investors prefer that the number of options granted in a given year expressed as a percentage of shares outstanding (known as the "burn rate") is restricted to less than 1% of the shares outstanding.8
4. Avoid Discretionary Grants of Options
Institutional investor guidelines do not favour option plans that give the board of directors broad discretion in setting terms of grants. Shareholders and other stakeholders are better able to assess the appropriateness of a proposed option plan that provides set schedules for vesting and grants. Generally, vesting schedules of no more than about five years are preferred. This length of time provides ample opportunity to motivate executives on a long-term basis, but also allows for reasonable cost projections to be made. At the other end of the spectrum, immediate vesting is also not favoured because the long-term quality of the option as a form of remuneration is eroded. Uncertainty resulting from "evergreen", or "reload", option plans is also considered undesirable, since shareholders cannot reasonably assess the potential dilution of option grants (for more information, see below "Evergreen Plans").9
5. Provide for Current Recognition of Expenses
Shareholders require a high level of scrutiny and disclosure for option plans. Disclosure of option grants and their treatment in financial statements should be clearly and carefully laid out on an ongoing basis. This requires public companies to expense the value of the stock options granted during the year. Failure to properly account for options may cause companies to be less concerned with the true cost of granting options and steer them toward granting more options than would be appropriate under a true accounting of their costs.
TIMING OF OPTION GRANTS
The Toronto Stock Exchange rules prohibit companies from setting the exercise price for an option at a market price that does not reflect undisclosed material information. In reminding companies of this prohibition, TSX staff recently cautioned listed issuers about "granting options during a blackout period, whether or not the blackout period is directly related to the material undisclosed event."
Blackout periods represent the approximate periods when a company might possess undisclosed material information. If the company is satisfied that no such information exists, the mere existence of a blackout period should not preclude granting options or establishing the exercise price.
However, the TSX has serious concerns about what it believes is a poor governance practice, and has put listed companies on notice that it will scrutinize these grants to ensure that no undisclosed material information existed at the time of pricing. The TSX may require the company to cancel or re-price options granted during these periods.
If some doubt exists about whether there is undisclosed material information, boards should consider delaying the grant of options until the blackout period has expired.
WHAT'S NEXT? FUTURE TRENDS IN OPTION PLANS
Companies in the United States have been offering up "cafeteria-style" or omnibus plans to executives and senior management for some time. These plans consolidate all forms of mid-term and long-term incentives offered by a company into one plan. The plans generally allow broad discretion to the company to choose the form of incentive award. Canadian incentive plans are usually specific to the type of award (i.e., an option plan or RSU plan), each of which has its own limit on shares available for issuance.
In Canada, we have yet to see the emergence of omnibus plans; indeed, Canadian institutional investors are wary of omnibus plans and warn against their use. The Ontario Teachers’ Pension Plan clearly states in its proxy guidelines that it will not generally support omnibus stock option plans. Rather, shareholders should be provided with the option to accept or reject each type of compensation proposed by management, rather than considering incentives in an aggregate format.10 This criticism of omnibus plans stops short of an outright ban. Instead, institutional investors are likely to carefully scrutinize each element to determine whether the specific benefits being offered are at odds with other guidelines on incentive plan design.
Companies wishing to provide omnibus plans to employees will need to think carefully about both shareholders and employees. Shareholders may approve a plan whose specific elements meet the standards they demand of individual plans. For example, plan designs should continue to make links to performance and use longer-term vesting schedules for each type of incentive offered.
The TSX in Ontario requires that option plans specify a maximum number of shares that can be subject to options, rights or entitlements.11 Since January 2005, the TSX has permitted that number to be expressed either as a fixed number or as a fixed percentage of outstanding shares. In the case of a fixed percentage, a "rolling maximum" allows the number of shares under an arrangement to increase automatically with increases in the total number of shares outstanding. As well, since January 2005, option plans may be "evergreen." Evergreen plans are plans under which shares that are subject to an option or right that has been exercised are reloaded into the available pool.12 These types of plans must be re-approved by shareholders every three years.
Institutional investors will not ordinarily support evergreen plans because of their dilutive effect.13 Further, evergreen plans do not allow shareholders to limit the extent of the dilution of shareholder interests in the future. Although evergreen plans are now permitted by the TSX, they are unlikely to become widespread because of the uncontrolled dilution they permit.
1. C. Medland and J. Sandford, "Tax Treatment of Share Based Compensation in the New Era" (Forthcoming, Taxation and Executive Compensation, Winter/Spring 2006).
2. Medland and Sandford, supra note 1.
3. Where more than 10% of the company’s shares are available for issuance under share-based compensation arrangements, securityholders who have limited or no voting rights will be entitled to vote on the plan in proportion to their equity ownership. Toronto Stock Exchange Company Manual, looseleaf ed. (Toronto: Toronto Stock Exchange, 1975) Rule 613.
4. Ontario Teachers’ Pension Plan, Good Governance Is Good Business: Corporate Governance Policies and Proxy Voting Guidelines (Toronto: Ontario Teachers’ Pension Plan, 2005) at 19.
5. Canadian Coalition for Good Governance, Good Governance Guidelines for Principled Executive Compensation (Canadian Coalition for Good Governance: June 2005) at 9.
6. Ontario Teachers’ Pension Plan, supra note 4.
7. Ibid. at 20.
8. For a complete list of Ontario Municipal Employees Retirement System guidelines, see OMERS, "Proxy Voting Guidelines," online: OMERS www.omers.com/English/nts_1_903_1.html. See also Ontario Teachers’ Pension Plan, supra note 4.
9. For a complete list of OMERS guidelines, see ibid.; see also Ontario Teachers’ Pension Plan, ibid.
10. Ontario Teachers’ Pension Plan, ibid. at 22.
11. Toronto Stock Exchange Company Manual, looseleaf ed. (Toronto: Toronto Stock Exchange, 1975), Rule 613.
12. Torys’ client memo no. 2004-29, Major Amendments to the TSX Company Manual, November 29, 2004.
13. Philips, Hagar and North Investment Limited, Proxy Voting Guidelines, December 22, 2005, at 8; Public Sector Public Investment Board, Proxy Voting Guidelines, February 6, 2002, at 3.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.