Executive share options are meant to align the interest of executive with that of the company and shareholders - but in the US new derivative techniques mean executives can cash in on their options almost immediately. Paul Ali and Geof Stapledon* report.
The vast majority of senior executive compensation packages include entitlements to share options issued under an executive share option plan, or ESOP. It is increasingly common, especially at the CEO levels of major corporations, for these entitlements to dwarf the cash component of the compensation package. Participation in an ESOP, like the award of cash bonuses, is designed as a reward for superior managerial performance. Unlike cash, the ESOP performs the important role of aligning managerial self-interest with the interests of the company's shareholders. A properly designed ESOP achieves this by linking managerial performance and thus remuneration to the creation of shareholder wealth - since the ultimate option value depends on the value of the company's shares. This linkage endures only while those options are retained by the executives. Accordingly, ESOPs impose a number of restrictions on the exercise or disposal of options, the most important of which is the "vesting period" during which exercise or disposal is banned. Now the very instrument - the option - that has made this linkage possible can be utilised to circumvent the vesting period.
In the US, the combination of options known as "fences" and "zero-cost collars" are being resorted to with increasing frequency by executives to crystallise the value of their options. It is difficult to say whether Australian executives are also engaging in this practice, because these devices effectively fall outside the disclosure requirements of the Corporations Law.
ESOPs and derivatives Since the alignment of managerial and shareholder interests endures only while the options are retained by the executives, the ESOP invariably prescribes a vesting period during which participants are not permitted to exercise, transfer or otherwise deal with their options. Commonly, the options may be exercised at any time during a further specified period after the vesting period. Thus, the executive is prevented, during the vesting period, from using options to capitalise on short-term spikes in the market price of the underlying shares. Further, the executive is fully exposed to the risk that the share price may on expiry of the vesting period - and for some time afterwards - be lower than the strike price of the ESOP options. Should that eventuate, the options may expire worthless. Derivatives, provide a straightforward means of "managing" the risk that the options will expire worthless, by enabling the executive to extract value from the options and lock-in gains on the underlying shares, ahead of the time at which the ESOP can be exercised.
This unlocking of value, coupled with the avoidance of the risks described above, is a powerful economic incentive for executives to use these instruments. Such benefit to the executive is, however, accompanied by a countervailing detriment to the company. By using derivatives to extract value or lock-in gains, the executive is insulating equity in the company from price fluctuations to which other shareholders are subject. This effectively severs the link between managerial performance and shareholder wealth and destroys the economic rationale for issuing ESOP options.
Fences and zero-cost collars Fences, and in particular the sub-set known as "zero-cost collars", have emerged as the derivatives instrument of first-choice for executives in the US wishing to crystallise the value of their ESOP options. The key attraction of the fence is that it permits that value to be locked-in or realised without the need for a significant outlay of cash. A "fence" is an option strategy involving the simultaneous purchase of a "protective option" and the sale of a "covered option", with the premium payable on the former being offset by the premium received on the latter. These three terms are best explained by reference to an example. Assume a senior executive has been issued 100,000 ESOP options, each entitling the executive to purchase a share in the company at $10 per share against a current market price of $5. And assume the vesting period for the options is two years.
Selling covered options
The simplest means by which the executive could immediately extract value from the ESOP options is by selling (or "writing") matching "covered" European call options at a strike price of $10 with a maturity of two years. The European call options are "covered" in the sense that they are being written over a position held by the writer. By mirroring the ESOP options, the covered call options will allow the executive to crystallise the time value of the ESOP options. If, at the end of the two-year period, the market price of the company's shares is below $10, both the ESOP and the covered call options will expire worthless, but the executive will retain the premium paid by the holder of the covered call options. If, however, the market price is $20, both sets of options will be exercised. The executive will, on the exercise of the ESOP options, make a profit of $1,000,000 (ie buying 100,000 $20 shares for $10 each). On the other hand, the executive will be obligated to deliver to the holder of the covered call options 100,000 shares that are worth $20 each for $10 each (thus making a $1,000,000 loss). The profit on the ESOP options will cancel out the loss on the covered call options, leaving the executive, again, with the amount of the premium received on writing the covered call options.
Buying protective options
A major disadvantage with this strategy is that the executive has, in exchange for immediately crystallising the value of the ESOP options, given up his or her ability to benefit from any appreciation in the share price above the $10 strike price. Irrespective of the movement in the company's share price, the net position is that the value extracted from the ESOP options is limited to the premium received from the sale of the covered call options. An alternative strategy involves the purchase of protective put options over the company's shares ("protective" since they lock-in or protect a position). Protective put options do not, on their own, extract value from ESOP options but they do enable an executive to lock-in price gains on the company's shares during the ESOP vesting period. For example, if the price of the shares were to rise to $15 during the vesting period, the executive could purchase protective put options with a strike price of $15. This would immediately lock in a price of $15 but would not require the executive to forego the benefit of any further appreciation in the share price, say to $20, as regards the ESOP options.
However, this time it is the executive who will be paying the premium. Locking in the current market price, especially where that price is volatile, is likely to attract a significant premium. Thus, the gain above the $10 ESOP strike price that the executive wishes to lock-in must be assessed against the cost of buying that level of protection and its impact on the potential gains from exercising the ESOP options. Returning to the example, if, on the vesting date, the share price reaches $20, the put options will expire worthless and the gain of $1,000,000 on the exercise of the ESOP options may be substantially eroded by the premium paid to the seller of the put options. Constructing fences and zero-cost collars
The fence, by combining the two strategies described above, removes the need for the payment by the executive of a significant up-front premium. Another benefit is that the executive is not required to bargain away the entire benefit of any appreciation in the price of the underlying shares. A fence might involve, for instance, the executive selling covered call options with a strike of $20 and purchasing protective put options with a strike of $15, with maturities that match the ESOP options, where the market price of the shares is $15. If the market price for the shares on the vesting date is below the ESOP exercise price of $10, say $5, the ESOP options and the covered call options will expire worthless. However, the protective put options will deliver a net profit of $1,000,000 (ie selling 100,000 $5 shares for $15 each.) as adjusted for the difference between the put and call option premiums. If, on the other hand, the market price for the shares reaches $30 by the vesting date, the protective put options will expire worthless. The executive will accrue a profit of $2,000,000 on the ESOP options (ie buying 100,000 $30 shares for $10 each) and a loss of $1,000,000 on the covered call options (ie delivering 100,000 $30.00 shares for $20 each), leaving a net profit of $1,000,000 as adjusted for the difference between the put and call option premiums.
Recalling that the market price is $15 when the executive constructs the fence, the put option leg of the fence permits the executive to lock-in the gain of $5 on the underlying shares, with that protection being funded by the premium received in respect of the call option leg. While the fence will not prevent the executive benefiting from any future appreciation in the share price, it will, in this example, cap the potential gain at $10 per share. As noted above, what makes fences attractive is the fact that the cost of one leg is off-set by the proceeds of the other; the extraction of value from the ESOP options is used to finance the locking-in of gains or spikes in the company's share price during the vesting period. Further, fences can be constructed with strike prices delivering both protection and up-side potential at no cost - hence the name "zero-cost collar" - or even at a credit.
Regulating the use of fences and zero-cost collars There are few formal regulatory constraints on the use of fences and zero-cost collars by executives during a vesting period. No disclosure requirements
The substantive disclosure requirements of the Corporations Law do not apply to cash-settled fences (including zero-cost collars):
* Substantial shareholder and takeover provisions - these provisions are predicated on the acquisition of a relevant interest in voting shares. If the fence is cash-settled there will be no question of that instrument having conferred a relevant interest on the executive.
* Disclosure to Australian Stock Exchange - the provisions which require directors of a listed public company to notify the ASX of relevant interests held in the securities of the company or a related body corporate, or contracts under which the director is entitled to call for or required to deliver shares in the company or a related body corporate, do not extend to cash-settled fences. Limited application of insider trading prohibitions
The prohibitions against insider trading can also be avoided by an appropriately structured fence. As regards options over a company's shares, the operative definition of "securities" in the Corporations Law applies only to option contracts under which "a party acquires from another party an option or right, exercisable at or before a specified time, to buy from, or sell to, that other party a number of" shares or units of shares in the company. It is considered that this definition does not extend to cash-settled options. However, given the severity of the penalties for insider trading, the executive may prefer to resolve any doubts about this matter by instead utilising a fence over an index that is strongly correlated to the performance of the company's shares (eg S&P/ASX 20, S&P/ASX Midcap Industrials, etc).
Corporate governance concerns The economic imperative for ESOPs is a matter of corporate governance. ESOPs are one of several mechanisms that help to reduce "agency costs". Agency costs exist in large, widely held companies because the interests of those who run the company's business - the CEO and senior executives - do not always correspond with the interests of the company's shareholders. Because of this divergence of interests, there is a risk that executives may make decisions to advantage themselves at the expense of shareholders. For instance, executives may act to entrench themselves in office. Or the executives may implement business plans that, while producing short-term gains for the company with a consequent increase in remuneration for the executives, may not produce corresponding or sustainable benefits for shareholders. ESOPs seek to limit any divergence between the interests of senior executives and shareholders by aligning the wealth interests of executives with those of shareholders. Providing leveraged equity interests, in the form of share options, to executives gives them the same stake as shareholders in the consequences of executive decision-making - and thus considerably enhances the executives' incentive to maximise the wealth of the shareholders.
Corporate governance guidelines invariably recommend that ESOP options should be exercisable only if challenging performance criteria have been met during the vesting period, or some part of it. For example, the Combined Code appended to the FSA Listing Rules (which apply to UK companies listed on the London Stock Exchange) recommends that consideration should be given to hurdles which "reflect the company's performance relative to a group of comparator companies in some key variables such as total shareholder return". The UK's Greenbury Committee urged that executives "should not be rewarded for increases in share prices or other indicators which reflect general price inflation, general movements in the stock market, movements in a particular sector of the market or the development of regulatory regimes". Corporate governance guidelines typically also recommend that ESOP options be issued with a strike price at or above the current market price of the company's shares, the rationale being that indicia of managerial performance (eg increased market share, increased profitability, curtailment of operating costs) will often be reflected in the share price.
Accordingly, superior managerial performance will often mean that both shareholders and executives are rewarded - the former by the higher share price and the latter because that higher share price will translate into an increase in the value of the ESOP options. On the other hand, a slump in the company's share price occasioned by inferior managerial performance is likely, among other things, to be reflected in a decline in the value of the ESOP options. Bearing in mind that ESOPs are an important corporate governance mechanism, the use by executives of fences and zero-cost collars is an alarming development. By using derivatives to extract value or lock-in gains, the executive is insulating his or her equity interest in the company from the share price fluctuations to which the other shareholders are subject. This effectively severs the link between managerial performance and shareholder wealth and consequently destroys the economic rationale for issuing the ESOP options to the executive in the first place. The possible use of fences and zero-cost collars is a matter that - at a bare minimum - should promptly be addressed in corporate governance guidelines.
* Paul U Ali is postdoctoral research fellow, University of Queensland and Geof Stapledon, Faculty of Law, University of Melbourne, is principal of Institutional Analysis, Melbourne
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