Personal Finance > Investing
The next outrage in CEO pay?
As their stock options become worthless, executives are loading up on restricted stock.
April 24, 2003: 3:09 PM EDT
By Gordon T. Anderson, CNN/Money Contributing Writer

NEW YORK (CNN/Money) - Apple Computer has always prided itself on being a trend-setting company. Still, CEO Steve Jobs couldn't have been happy when recent headlines trumpeted his revised compensation package as the latest innovation in corporate gluttony.

The story begins in January 2000, when Apple's board granted Jobs options to buy 20 million Apple shares at a strike price of $43.59. When the tech bubble popped, that contract became worthless. So in October 2001, Jobs was granted another 7.5 million options, exercisable at $18.30.

Today, Apple shares (AAPL: Research, Estimates) are trading near $13 -- about their split-adjusted level of five years ago -- and in March, Jobs "voluntarily cancelled" the contract.

He didn't walk away empty-handed, though. He exchanged the options for five million shares in restricted stock. Upon vesting over three years, he'll own them free-and-clear, regardless of Apple's stock price.

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It's the latest trend in CEO compensation: swapping out-of-the-money options for restricted stock. In effect, what Jobs and scores of other corporate officers have done is to accept the bird-in-hand virtues of direct stock ownership over the more ephemeral prospects of option grants.

In a bear market, free shares trump underwater options.

Take the cash

Three years into the longest stock market decline of the post-war period, corporate fat cats are as chubby as ever. In 2002, a year in which the Dow Jones industrials fell by 16.8 percent, total compensation for the average big-company CEO rose by 15 percent, according to a survey by Mercer Consulting.

"Stock options have been absolutely crucified by the corporate governance gurus," says Ed Archer, managing director of Pearl Meyer & Partners, a New York-based executive compensation consultancy. "Everybody says they're the root of all evil."

While pay packages are still expanding, their composition is changing. Watchdogs and the media have drawn attention to the potential dilution that large option packages represent. "There's been a consistent focus to try to find ways to reduce overhang," says Archer.

About 6 percent fewer companies in the Mercer study issued stock options last year. The options that were granted and exercised weren't so lucrative, either.

The median realized gain from exercised stock options last year was $1.7 million, down from $2.1 million in 2001 (an already depressed number). Unrealized gains from options equaled $3.1 million, down from $5 million the year before.

If stocks are falling and options growing less valuable, how is it that CEOs are making more money? For some, old-fashioned salary increases did the trick. Mercer found that bosses averaged a 10 percent increase in salary and bonuses.

In tough times, though, pay increases are difficult to defend, so boards have been ratcheting up compensation in the form of restricted stock.

Like options, free shares provide an economic incentive that increases along with share value. But unlike options, there is generally no strike price that must be reached to exercise.

Compensation expert Graef Crystal, a columnist for Bloomberg News, recently conducted a survey of 209 major companies. While the size of stock-option grants has been shrinking, "the average grant of free shares," he found, "rose 9.9 percent."

The median value of such grants more than doubled in 2002, according to the Investor Responsibility Research Center.

Sibson Consulting also looked at the corporate governance practices at major U.S. companies. Of the firms Sibson studied, 41 percent planned on changing their stock option plans within the next two years, and nearly half expected to introduce new free-share vehicles.

Retention tool or pay-for-performance?

To illustrate the benefits to a CEO receiving such shares, let's pick on Apple's Jobs again.

At today's prices, his five million free shares would be worth about $67 million when they vest. If Apple stock rises to $20 -- a 50 percent increase -- he'd make another $33 million.

Compare that to his earlier, now-cancelled grant of 7.5 million options. Under that contract's $18.30 strike price, the same gain in share value would earn Jobs just $12.7 million.

Historically, restricted stock has been used as a tool to retain executives. Grants have been based on longevity of service. Options, on the other hand, were developed explicitly to reward performance -- the stock price must hit certain targets in order for them to be worth anything.

Today, however, companies are trying to figure out ways to combine the pay-for-performance aspects of options with retention incentives of traditional restricted stock.

For example, Progressive Corp., the Ohio-based insurance company, plans to swap restricted stock for options for its executives. The granting of awards, however, will be contingent upon a manager's meeting clear performance goals.

Tying awards to performance is essential, say experts. Unless companies do so, switching from options to restricted shares amounts to an unwarranted freebie. "I would call that the "lay-low effect: just lay low and don't get fired,'" says Matt Ward, CEO of Westward Pay Strategies in San Francisco.

Many companies (including Apple) are also citing the excessive dilution of options as a reason to switch. Outright share grants tend to be much smaller than options-related grants.

Almost predictably, though, restricted-stock grants are getting bigger. And the number of executives getting such awards rose 42 percent last year, according to a study performed for Fortune magazine.

Larger payouts for an increasing number of CEOs? Sounds like a trend.  Top of page

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