Director Stock Options, Spotlighting Popular Perk's Decline
By Joann S. Lublin and William M. Bulkeley
The Wall Street Journal
Thursday, December 21, 2006
Stock options, long touted by many companies as a vital tool
for rewarding board members and aligning their interests
with those of shareholders, are falling out of favor as a
perk amid scandal and accounting and legal changes.
Yesterday, International Business Machines Corp. said it no
longer will grant outside directors stock options -- which
give recipients the right to purchase company shares in the
future at a set price. Instead, starting Jan. 1, those
directors will be paid an annual $200,000 retainer, which
they can take either in IBM shares or partly in cash --
though rules strongly encourage them to take the shares.
IBM is only the latest big company to abandon options --
which are worthless unless a stock price rises -- in favor
of compensation involving cash, restricted stock or outright
equity stakes that both rise and fall with the share price.
The move by the iconic company underscores a broader
repudiation of options for board members two decades after
many companies began to embrace them -- and could even
accelerate the trend because of IBM's reputation as a
bellwether of corporate behavior. Among others that have
dropped the practice in recent years are retailer Gap Inc.,
recruiter Heidrick & Struggles International Inc. and food
company Tyson Foods Inc.
In 2001, as the stock-market boom of the 1990s crested,
nearly eight in 10 big companies were giving their directors
options, according to a proxy analysis of 350 major
companies conducted for The Wall Street Journal by Mercer
Human Resource Consulting in New York. By last year, the
figure was down to 53%.
The percentage may drop to as low as 10% by 2010, because
boards now consider options "somewhat problematic," said
Charles Elson, head of the Weinberg Center for Corporate
Governance at the University of Delaware's business school,
and a director of two public companies. Abandoning options
"reduces the controversy" because "any potential for
manipulation just goes away," said Peter Gleason, chief
operating officer of the National Association of Corporate
Directors in Washington.
Options are suffering a heavy backlash after big corporate
scandals such as the accounting frauds at Enron Corp. and
WorldCom Inc. and the more recent backdating scandal,
corporate-governance experts said. In those and other
cases, critics have claimed directors, motivated to boost
returns on their stock options, turned a blind eye to
The backdating scandal has revealed that dozens of companies
altered their grant dates to days when their stock was
trading at a lower price -- thereby boosting profits on
options. More than 130 companies currently are under
investigation for the practice in the biggest
corporate-fraud probe in decades. An academic study
released this week suggested that as many as 1,400 outside
board members at 160 companies received questionable option
grants, though the study didn't address whether they knew
Companies also are responding to new accounting rules
requiring options to be counted as an expense after more
than a decade in which they weren't. Under proxy-disclosure
rules that took effect for fiscal years ending after Dec.
15, moreover, businesses must reveal far more detail about
the elements and costs of board compensation packages --
which could make options less attractive.
More broadly, post-Enron changes in laws and corporate
practices have imposed greater demands on outside directors
-- that is, those who have no other ties to a company. The
New York Stock Exchange, for instance, now requires that a
majority of board seats, and all compensation- and
audit-committee members, be independent.
That has prompted plenty of discussion about how best to
compensate outside directors and keep them focused on
shareholder interests while protecting their independence.
Outside directors are supposed to play a special role
safeguarding against cozy board relationships with
"The overall governance thrust today is to have board
members be [stock] owners rather than optionees," said Pearl
Meyer, senior managing director of Steven Hall & Partners, a
pay consulting firm in New York. Options focus recipients
"too much on short-term movements in the stock price," she
Director compensation has been a subject of heated debate
and experimentation for more than two decades. In the
1980s, corporate reformers and some large institutional
investors argued that options would help motivate directors
to focus harder on shareholder returns by giving them
ownership incentives. The idea gained fuel thanks to tax
and accounting policies that kept options tax- and
expense-free, and the large fortunes that began to be made
by companies going public in the early days of the 1990s
According to Executive Compensation Reports, a newsletter
that covered executive pay, just 1.6% of the nation's 1,000
largest companies gave directors some kind of stock in
1983. By 1994, nearly one in five did.
No one has suggested that IBM's directors received backdated
grants. An IBM spokesman said the Armonk, N.Y., computer
giant's action was consistent with its practice of "broadly
reducing our reliance on stock options" as compensation for
employees and officers.
IBM started expensing options in 2005 because of new
accounting rules. But even before that, "we'd been saying
we were reducing our reliance on equity compensation," he
said. People familiar with the matter said IBM also
believes options tend to make recipients more oriented
toward short-term results than they are with other forms of
IBM said the additional cash compensation for directors is
equal to the value of the stock options outside directors
have been receiving; each year they were given 4,000.
Ironically, IBM's elimination of options increases the
likelihood that outside directors will acquire sizable share
stakes -- thanks to its substantial stock-ownership
guidelines. The company pays 60% of these board members'
annual retainer in a type of deferred stock known as
"Promised Fee Shares," the latest proxy noted. Those shares
are based on the market price of IBM stock. They accumulate
dividends in the form of more Promised Fee Shares, and they
can't be redeemed until retirement or departure from the
board, at which time the director can receive either IBM
stock or the cash equivalent.
Under IBM's corporate-governance guidelines, such directors
are expected "to have stock-based holdings in IBM equal in
value to five times the annual retainer," the proxy added.
With the retainer doubled to $200,000, each outside IBM
board member must now aim to own $1 million worth of shares.
The IBM spokesman said all the company's outside directors
this year chose to invest all of their cash compensation in
such shares. IBM directors include Lucio Noto, former chief
executive of Mobil Corp.; James W. Owens, chief executive
of Caterpillar Inc.; Kenneth I. Chennault, chief executive
of American Express Co.; and Minoru Makihara, former
chairman of Mitsubishi Corp. IBM Chairman and Chief
Executive Samuel J. Palmisano is the only IBM employee on
Recent years have seen companies take a wide range of
approaches to compensating directors. Coca-Cola Co. earlier
this year unveiled a plan to pay directors solely through
annually allocated "equity-share units," which can't be
cashed until three years have passed -- and then only if
Coke posts compounded annual growth of 8% in earnings per
Similarly, Campbell Soup Co. board members will no longer
get options as of Jan. 1. Instead they will receive an
equal mixture of actual shares and cash, the big food maker
disclosed in its latest proxy statement. "We have moved
away from stock options as a form of compensation in part
due to the change in accounting rules," a spokesman said.
When Heidrick & Struggles eliminated options for directors
in 2002, it replaced them with restricted stock units,
believing that "would better align the interests of the
directors with our stockholders," its 2002 proxy said. In
light of later controversy over options, "it looks like it
was a wise decision," said Gerard Roche, senior chairman.
"We're in a position where we don't have any worries" about
Some companies eschew any stock-based compensation for
directors at all. Those that pay outside directors only in
cash include Alcoa Inc., Berkshire Hathaway Inc. and Sears
IBM won mixed reviews yesterday. "It's a welcome move"
because options create incentives "that aren't in the
interest of long-term shareholders," said Dan Pedrotty, head
of the AFL-CIO's Office of Investment. But he said he
wishes the company would go further and adopt a
performance-share plan for directors. Union-sponsored
pension funds have assets of about $400 billion.
But Mr. Elson, of the University of Delaware, said he was
troubled by the move -- even though outside directors must
hold a high multiple of their cash retainer in IBM shares.
"To show continued confidence, you have to own stock over
the long term" and also be partly paid in stock, he said.
"You should increase your [stock] position over time."
Separately, American Tower Corp. said yesterday that
directors and officers who received options at prices below
the fair-market value on the legal grant date have agreed to
"eliminate any benefit" by compensating the company in cash,
or by canceling vested but unexercised options. The company
will increase the exercise price of any unexercised options
to the fair-market value. American Tower, a Boston-based
owner of cellphone towers, said that the value of
eliminating the benefit is $7.5 million.
American Tower said it plans to eliminate similar options
benefits totaling $7.6 billion for three former executives.
American Tower has said that "there were a number of
deficiencies in the company's stock option granting
practices." Last month it restated results for 2005 to
reflect a review of the options. A spokesman didn't
immediately return calls seeking comment on the options
issue or the names of the executives and directors involved.
contributed to this article.
Write to Joann S. Lublin at
firstname.lastname@example.org and William M. Bulkeley at