Study on Stock-options

Study on Stock-options This report tends to provide a comprehensive study on stock options. The report focuses primarily on dealing with all the major aspects of the subject, that is the characteristics, incidence and effects of stock options. The key issues being whether stock options are a desirable and effective instrument. The context to the report is the major growth in the use of stock options since the late 1980s. This growth has been most dramatic in the United States, where by 2003, 94 per cent of top american companies granted options to their top executives. The value of these option grants at the date of grant accounted for nearly 50 per cent of total remuneration of CEOs in these companies. In most European Member States, stock options have arrived on the scene somewhat later, but rapid growth can now be observed in some economies. There have been initiatives in several Member States to facilitate the use of stock option grants, whilst, at European level, the European Commission has also sought to promote stock options. However, consecutively to some corporate scandals (Enron, Worldcom, Tyco, Adelphia, ABB...), criticisms are gaining a wider appeal, meaning the subject becomes more and more questionable. This aspect will be dealt further on. In order to provide a useful framework, this report will be divided in two main parts. The first part will give an overview of the distinguishing characteristics of stock- options and their objectives, when the last one describes the incidence of stockoption plans and their effects on behaviour. The Character of Stock Options An option is a security giving its holder the right to buy or sell an asset, subject to certain conditions, within a specified period of time. An employee stock option is a variant of this, whereby employees are provided with the right to acquire an option to purchase company stock at a future point at a price set at the grant date. The option has an expiry term and a vesting period commencing with the grant date. The primary benefit to the beneficiary is the potential for capital gain between grant and exercise. The optimal perspective on stock options argues that this feature aligns the interests of option recipients with those of shareholders. Compared with options in general, employee stock options have certain unique features. One, unlike „conventional‟ options they cannot be traded, and employee option holders cannot usually hedge against the risk of declines in option value. These prohibitions may be found in general securities legislation or in legislation specifically governing the use of stock options. The inability to trade stock options provides a degree of risk that is not present with conventional call options. Since most employees can be seen as risk averse (unlike the professional investor) the riskiness of options may provide a powerful incentive tool. A second, related feature of options is that they are normally subject to forfeiture prior to vesting should the employee voluntarily leave the firm. This can provide an incentive to remain in employment with the firm, thereby helping to secure returns on human capital investments made by the firm. The stated objectives of options are usually to attract, retain, and motivate its executives and employees and the unique features of employee stock options outlined above can help to achieve these objectives. Options enable firms to attract better quality and less risk-averse employees by raising compensation levels and by providing for performance-based upside earnings potential. They help to retain employees because of vesting provisions and long expiry terms. They can motivate employees by providing a direct link between company performance and employee wealth, thereby providing incentives for employees to take decisions that increase share prices. Nevertheless, do these objectives are really achieved ? Indeed, at this point, the critical question is whether stock options have this impact in practice. The stake of the second part will be to respond to this request. Incidence and Effects of Stock Options The aim of this part is to provide an overview of the incidence of stock option plans in companies in the United States and in major European economies but also to discuss their effects on behaviour. In the United States, stock option plans are now very common but the majority appear to be narrow-based, plans restricted to top executives and managers, with the exception of start-ups (“new economy” small firms). By 2003, nearly every public firm (94 per cent) listed in the New York Stock Exchange granted stock options to their top executives while a study of 415 firms by the Federal Reserve Bank in 2002 indicated that just over one third operated a stock options plan open to a wider group of employees than top executives. Nearly all of these plans offered stock to managers and professionals whilst only 6.7 per cent of firms in the survey offered options to lower-graded employees. It should also be noted that the US Bureau of Labor Statistics surveyed the incidence of stock option plans in 2003 and found that overall 1.7 per cent of all private sector employees received stock options in that year. As would be expected, participation rates are linked to occupational level. 12.9 per cent of employees earning more than $75,000 per year had options in 2003 compared with 0.7 per cent of those earning $35,000 or under. In Europe, the situation is more complex because it is necesary to distinguish between the United Kingdom (UK) and the other euopean countries. In the UK, options are also widely used, and have been so since the early 1980s. There are currently 1400 „Sharesave‟ approved stock option schemes. With certain eligibility constraints, these schemes are required to be open to all employees. Approximately one million employees – between 3 and 4 per cent of the employed labour force – received grants of options in 2003-2004 (Inland Revenue 2005) with the combined total of grants worth over £2,500 million at initial market value. The average subscription in that year was £2,800. In 2003, 93 per cent of the largest London-listed firms had a stock option plan. Most firms offer more favourable eligibility criteria than the five years employment stipulated in legislation, with a majority requiring one year's employment or less. However, it should be noted that the situation remains heterogeneous ; stock option plans being more common in financial services and very uncommon in manufacturing for instance. In the mainland European nations, the extant evidence suggests very little use of stock options, though the incidence is starting to rise. A study conducted by Abowd and Kaplan of comparative CEO and Human Ressources Director compensation found that in 2003 only France, Italy and Switzerland used „long term compensation‟ (the present value of stock options). Of the mainland European nations, France has the longest tradition of stock options owing to legislation in this area in 1970. A survey by COB (Commission des Opérations de Bourse) in France in 2002 of publicly quoted firms found that over one in two firms had a stock option plan (Plan d‟Options en Actions, or POA), and that over 90 per cent had introduced these since 1987 (the year that tax treatment on option gains changed). Most of these schemes are selective with only 15 per cent being all-employee. Another recent study of 34 listed firms found that about 1 per cent of employees in these firms participated in the option plans (Tchobanian and Nohara 2001.In Germany, the use of stock options is very recent because until 1998 company law effectively prohibited stock options. Instead, Germany firms wishing to use incentive reward systems used either profit sharing or profit-related bonuses, Stock Appreciation Rights, or convertible bonds. Until the Control and Transparency in Enterprises Act (KonTraG) became effective in April 1998, employee stock option plans were for the most part applied by international concerns and usually aimed at the higher echelons. To conclude this second part, a key question arising in policy and popular discussions of stock options concerns the extent to which stock options influence behaviour. If stock options provide incentives, what kind of behaviour does option holding encourage? The stock options defenders argue that options serve to align employee interests with those of shareholders, and will therefore encourage actions that are beneficial to shareholders. Nevertheless, more and more critics say that options are manipulated by employees, exploiting insider governance and informational advantages, and may therefore function against shareholder interests. One argument is that options encourage actions that are damaging to the long-term interests of the firm and its shareholders. There is an emphasis on relatively shortterm stock price performance rather than longer-term measures of economic or market success. The recent Enron and Worldcom cases in the United States are an extreme version of this possibility – managers of these firms stated accounting earnings in a way that boosted earnings, whilst at the same time damaging the longterm balance sheet. This type of argument also rests on the assumption that the stock market is myopic, and that managers adopt short-term horizons to meet investor expectations. The second and last critique of the pro-options argument argues that options induce behaviour which is damaging to other stakeholders, such as employees, customers, or local residents, even though it may be conducive to „shareholder value‟. There may be a net welfare loss induced by stock options. This issue is particularly pertinent in some European countries where the growing use of stock options is seen to herald a shift away from corporate governance systems that attempted to integrate the interests of all or most major stakeholders. This is often encapsulated as „shareholder value‟ versus „stakeholder capitalism‟. In the end, stock options have been designed as a tool for recruiting, motivating and retaining high calibre employees, whatever their position. However, aside from the “new economy” small companies, where stocks were widely targeted at all levels of employees, this mainly affects managerial employees. It means that option plans have partly failed to achieve their goals, due to their mixed results. Moreover, it should be reminded that some major corporate scandals (Enron, Worldcom, Tyco, Adelphia...) during the past years have sadly contributed to discredit the positive impact of option schemes for millions of employees. Following these affairs, US and european corporate laws have been hardened. It is notable that key US decisionmakers (for instance Harvey Pitt, former Chairman of the Securities and Exchange Commission ; Eliott Spitzer, the current governor of New York) are now explicitly critical of executive stock options. The influential corporate governance body – The Conference Board – has recently called for stock options to be replaced by stock awards in executive remuneration packages (The Conference Board 2004). New requirements for shareholder votes on all stock options plans in the US and moves by the New York Stock Exchange (NYSE) to increase the number of independent directors may make US stock option plans more answerable to shareholders ; move that is already partly followed by some recent european regulations. References and Bibliography Useful websites -http://money.howstuffworks.com/question436.htm -http://www.nceo.org/library/option_corpperf.html -http://aom.pace.edu/amjnew/2006.june/oconnor.pdf Useful books -“Valuing employee stock options”, by Johnathan Mun -“All about options”, by Thomas McCafferty -“Current practices in stock option plan design”, by Ryan Weeden