JPMorgan Stock Option Plan Throws a Lifeline to Employees When Shares Are Underwater

By Jessica Marquez

Aug. 4, 2005

S ome companies are beginning to doubt the value of stock options as a compensation tool, and it’s easy to see why. There has been a spate of lawsuits involving company stock, brought by employees who believed they were misled about how well the stock was performing. Meanwhile, new accounting rules will require firms to expense stock options on their income statements beginning in their next fiscal year.

    But if a new program by JPMorgan catches on, options could regain some of their cachet.

    Giving company stock options to employees was a prevalent compensation and retention strategy in the ’90s, particularly at technology companies. But after three years of bear markets, more than 50 percent of employees found themselves with options that were “underwater”—their value was less than the exercise price.

    Microsoft was one company to experience this. “Human resources executives were getting calls from employees saying, ‘My options may vest, but they are going to be worthless,’ ” says Robert Barbetti, managing director at JPMorgan Private Bank.

    The technology company decided to stop offering stock options in favor of giving restricted stock, which are grants of shares that vest at the end of a given period if an employee remains on staff. This allowed employees to earn actual shares of Microsoft stock over time, rather than just the option to purchase stock at a set price. But that didn’t help the employees who still had options that were underwater.

    That’s where JPMorgan came in. The investment bank offered to buy the employees’ underwater stock options through a transferable stock option program so that it could use the options as another trading tool in its hedging strategy. With the deal, JPMorgan could trade each option it bought with a separate trade in the stock market that both hedges the bet and gives the bank a margin of profit. “We don’t necessarily care if stock goes up or down, just that it does go up or down,” says David Seaman, a managing director at JPMorgan.

    The move would allow employees to sell a third of their shares upfront and then the rest after two years. The price the employee would get would depend on the maturity of the options. “This was part of a retention strategy,” Seaman says.

Protecting shareholders
To avoid hurting shareholders of Microsoft by potentially diluting the value of the stock, the company truncated the maturity of the options sold to employees. While this meant that Microsoft employees sold the options for below the potential full market value, the shorter maturity period also reduced the potential for dilution of company stock.

    “Microsoft wanted to design this in a way that it split up the benefit between the employees and the shareholders,” Seaman says. Employees were still able to get cash for options that could be worthless, depending on how the stock performs in the future, he says.

    For example, if an employee was granted options at $33 a share with an expiration of five years and the stock was now at $26 a share, the employee could sell the options to JPMorgan for $4.59 a share. “The majority of employees feel that options are not worth the theoretical value in the first place,” Seaman says.

    Fifty-one percent of the 36,539 eligible employees participated in the program. “Employees said, ‘I would rather get cash even if it’s truncated in value,’ ” Seaman says. JPMorgan is pitching its transferable stock option program as an initiative that companies could implement on an ongoing basis. “This is good for companies that want to stay with options,” Seaman says.

    Microsoft is not the only company to have conducted a one-time transferable stock option program. Comcast made a similar move in September 2004. When the company acquired AT&T Broadband in 2002, former holders of AT&T employee stock options had their options converted into Comcast options. Sixty-three thousand of these options owners were not employees of Comcast, and so the company wanted to give them the ability to cash out and sell their options to JPMorgan.

    The program was designed to help reduce the administrative burden associated with managing the options, Seaman says. “The company was spending millions to maintain these accounts,” he says.

    Unlike Microsoft, Comcast allowed those options owners to cash out immediately and did not truncate the value of the options. Twenty-six percent of owners accepted the offer.

An ongoing incentive?
    Although Comcast and Microsoft chose to do one-time transferable stock option programs, JPMorgan believes that companies could offer these programs on a quarterly basis and use them as an ongoing retention tool, similar to a profit-sharing program.

    “This could provide an ongoing form of compensation,” Seaman says. All growing companies go through periods when their stock is underwater, and a transferable stock option program could enable these firms to continue to compensate employees during those times, he says.

    Observers are skeptical whether such a program would make sense for most companies. “Most compensation plans don’t allow for this kind of move, which means you have to create a business plan behind it,” says Rick Beal, division practice leader for compensation at Watson Wyatt Worldwide. Beal says he is skeptical about whether most boards of directors and compensation committees would see the business value of such a program versus offering restricted stock. Also, companies would have to watch out for what kind of message that enacting such a program would send to the public. They are essentially saying that they do not believe their stock will continue to go up, says Paula Todd, managing principal at Towers Perrin.

    But Seaman says that there is no difference between employees selling their shares for cash and exercising their options, which they usually do as soon as they are vested. While a one-time program like Microsoft’s might only make sense for companies whose stock is underwater, offering transferable stock options on an ongoing basis would make sense for a wide array of companies.

    “Growth companies know that half the time their options are underwater,” he says. So if companies have to expense the theoretical value of the options over time, it makes sense to deliver that value of the option to the employee, Seaman says.

    For companies getting ready to expense their options in the next few months, the program offers definite advantages, says George Paulin, president and CEO of Frederic W. Cook & Co., a compensation consulting firm. One of the big gripes that companies have about expensing stock options is they are listing an expense that they are not necessarily realizing.

    With this program, however, the expense they would list on their income statements wouldn’t be theoretical, he says. “Now those are real expenses, and not just the intrinsic value of them.”

Mixing incentives

The most popular long-term incentive instrument is stock options, with 41 percent of firms surveyed offering stock options only, while 42 percent of firms have chosen to use restricted stock, performance-based long-term incentive packages or a combination of awards. Shifting away from a stock-options-only plan, firms have adopted varied approaches to delivering long-term incentive compensation.

Source: 2005 DC&P Tech 00 Executive Compensation Study, by DolmatConnell  & Partners

Workforce Management, August 2005, pp. 76-77Subscribe Now!

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