Many of Canada's largest corporations are continuing to make heavy use of stock options, handing out large annual grants and allowing executives and even some directors to exercise options immediately. A Report on Business study of 207 companies on the benchmark S&P/TSX index found that even as some firms grabbed headlines for their option reforms last year, others continued to use this controversial form of compensation to excess. One-quarter of companies in our sample had plans with potential dilution of more that 10 per cent. That means that if all available options were exercised, common shareholders would see their stake in the company reduced by more than 10 per cent. As well, an examination of the use of option plans at these companies revealed that many continue to hand them out at a dizzying rate and in ways that run counter to their use as an incentive for long-term growth.
The study found that more than 20 per cent of companies had annual option grants that exceeded 2 per cent of outstanding shares.
More than one in five of the firms on the index -- generally looked to for examples of best practices -- did not require executives or directors to hold their options for at least one year before exercising them and benefiting from rising share prices.
Such mandatory vesting periods are considered critical by institutional investors and advocates of shareholders' rights because they ensure that the individual who receives an option -- essentially the right to buy a share at a specific price -- does not simply pocket the cash after a short-term runup in the stock price without any regard for future performance of the company.
"If options vest immediately, you might as well just give them cash and get it over with," said Robert Bertram, executive vice-president of the powerful Ontario Teachers Pension Plan Board. "Don't go through the illusion that you are trying to tie them into shareholder value. This is just giving them money . . . Clearly the shareholders' interests are not being taken care of in those plans."
The ROB investigation also found that 68 per cent of firms had options available for granting to directors -- another hotly debated issue. In about 40 per cent of these cases, directors were in a separate option plan or received a fixed option grant. This feature prevents directors from having the ability to give themselves more options, a potential conflict that exists when directors are included in the executive option plan without any limits.
But even with such safeguards, many say that giving directors options is inappropriate because it could cause them to focus on short-term stock price gains, rather than the long-term interests of the company.
"I would rather have the directors buy shares with their own money," said Michel Magnan, an accounting professor at Concordia University who has done research on options and other forms of compensation.
"The directors are supposed to be there as representatives of the interests of stockholders, not option holders, which are not exactly the same thing. They are supposed to be there for the long run. Options create more of a trader mentality. I'm not sure the mindset of trader is something you want from your directors," he said.
That view is also held by the Canadian Coalition for Good Governance, the newly formed group of powerful investors that's pushing for reforms.
"The coalition is absolutely opposed to the directors having options," said David Beatty, the group's managing director. "They don't think it's appropriate for somebody representing a shareholder to have a free one-way call on the potential progress in the stock market."
The ROB study also found that some companies give options to directors without any vesting period, although that too is changing. Suncor Energy Inc. used to give fixed annual grants to its directors that could be exercised immediately, but this summer instituted a mandatory vesting period. "Times have changed and we're responding to that," a company spokeswoman said.
Bill Mackenzie, president of proxy adviser Fairvest Corp., said there are those that argue director options should vest immediately to prevent directors from feeling beholden to the board. The fear is, he said, that a director might pull his punches in the boardroom because he wants to stick around until his options vest.
While his organization has pushed for caps on directors' options, Mr. Mackenzie said he is starting to think the simpler solution is to get rid of options for directors altogether.
"Directors, they have the keys to the printing presses for stock," he said. "They can give themselves some fairly substantial option grants."
Mr. Mackenzie said he believes the heavy use of options at all levels of a company -- from directors to workers on the shop floor -- can create the wrong incentives and may lead to increased volatility in a stock. He expects most firms to reduce their use of options. "Probably the writing was on the wall when Microsoft stopped using them," he said.
Indeed, some firms are thinking the same way and are taking steps to reform their option plans or decrease their reliance on them.
The results of this year's study show fewer firms with potential option dilution of more than 10 per cent, compared with a year ago, although changes made by the S&P/TSX mean that many companies included in last year's study are no longer part of our sample.
Some companies such as Torstar Corp., Sun Life Financial Inc. and Royal Bank of Canada have eliminated grants for their directors in the past 12 months. Others have scaled back their use of options or introduced performance measures that must be met before options can be exercised. Twenty-two per cent of the firms in our sample now have some type of performance measure included in their option program or have reduced their use of options.
There is also a movement by some firms to scrap their use of options altogether as Microsoft Corp. has done.
Here in Canada, Imperial Oil Ltd. ended its option plan less than a year after its inception. "Recognizing current concerns over stock option incentive programs and their proper accounting treatment, the company decided to return to straightforward, cash-based incentive compensation," the Toronto-based firm explained in its proxy circular this spring.
That's a move that has the strong support of John MacNaughton, president and chief executive officer of the Canada Pension Plan Investment Board. In February, the board, which manages $18-billion in assets for the Canada Pension Plan, turned some heads by announcing it would vote against all stock option plans. Mr. MacNaughton also caught many by surprise when he revealed his conviction on this issue led him to give up $3.5-million gained from cashing in options he received as a director of the high-tech firm JDS Uniphase Corp.
"At the time we were pretty lonesome out there in our position, I have to say," Mr. MacNaughton said. But in the brief period since the announcement, he has observed a shift in thinking that he predicts will end in firms weaning themselves from their heavy options habit.
"Some companies have gone cold turkey, some are saying it will be a gradual withdrawal, some are reducing their reliance on them, but still keeping them. These are all positive developments."
Mr. MacNaughton applauds all the "thoughtful enhancements" firms are making to their plans, but at the end of the day, he said no option program can beat good, old fashion shares for aligning the interests of executives and investors.
Prof. Magnan at Concordia does not go quite that far. He does not advocate the complete elimination of options, but says many firms in traditional businesses with low executive turnover have introduced options without thinking about the consequences or if they are necessary. "I would not ban them," he says, "But my concern is, is the board aware of the value of these options and are we giving options when they are really needed? Are these people really going anywhere?"
Ray Murrill, head of the executive compensation practice at Watson Wyatt Worldwide in Toronto, says corporate boards are starting to ask more questions about the appropriate use of options. Like Mr. MacNaughton, he sees recent changes made by some firms as the beginning of a trend away from the option frenzy that developed during the technology boom, although he predicts the trend will need some time to take hold.
"We are seeing a lot of soul searching but the actual reaction is taking its time," he said. "Everyone is kind of doing a wait and see. There is going to be a rethinking and my hope is that companies will have much clearer objectives about why they are granting options, rather than here they are, it's a free lunch."
That rethinking, he says, is taking place for a number of reasons, including greater pressure from vocal institutional investors as well as new accounting regulations that will force firms to put a value on options in order to expense them. That very process, he says, could be a wakeup call for many boards who may not have realized the potential worth of the options they were handing out.
But so far, Mr. Bertram at Teachers says the pension fund has seen few signs of any sea change in the use of options.
"Its a large ship and it takes time to turn it around," he said. "I think it is being looked at the board level. There is a much higher level of concern, but we haven't seen any evidence of big changes."
In fact, figures compiled by the pension fund for the most recent 12 months show that it voted against far more option plans than it approved. The pension fund voted against 80 per cent of the 144 stock option proposals that came to it from Canadian and U.S. companies it invests in, usually because of high potential dilution or because there was not a mandatory vesting period.
Prof. Magnan says he is somewhat cynical about why options are losing favour, pointing to the awful performance of most stocks in recent years. "As an outside observer you might ask why the shift toward something else is in the fourth year of a market when most options are underwater," he said. "I do see a trend to use fewer options, but maybe the reason is that they are not as effective as people thought because they haven't paid out in the last four years."
Compensation experts such as Mr. Murrill at Watson Wyatt predict performance measures will likely gain popularity as a way to make options more acceptable, but he cautioned that coming up with the right benchmarks can be a major challenge. "There is no simple solution," he said.
Indeed, Mr. Mackenzie at Fairvest worries that if companies attach more hurdles to options, executives will just demand that they get more. Special features make options less valuable as a tool for retention, he said, and the current market makes all options less attractive than they once were.
So it may well be that companies reduce their use of options because the people getting the options just don't want them any more.
TransAlta, Royal Bank on top
Governance report card
FirstService Corp. moves up
Options debate rages on
CEO, director share ownership
Dual classes still prevail
The gender gap hasn't closed
Regional blocks remain intact
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