Executive Compensation and Stock Option in the UK
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1 - Introduction
Today's highly competitive world consists of numerous corporations and these corporations are so huge and so large that it cannot be controlled by the people who own them. The control of these corporations is separated from shareholders who are the owners and vested into the hands of professional executives who are specifically hired for its management. This separation of ownership and control gave rise to agency problem or the principal-agent problem. Principal is referred to the stockholders and the agents are the executives who work for the stockholders. Although stockholders are the owners of the company to whom the executives are accountable, their actual powers are restricted except in the case of those corporations where stockholders are also the directors of that corporation. Stockholders have no right to inspect the books of accounts nor are they aware of the exact functioning and position of the firm. As a result, executives tend to work inefficiently without even bothering to look for profitable new investment opportunities, as well as they may use the firm's assets for private purposes and also work to achieve their personal goals - all at the expense of the shareholders. Some managers do not take any action whatever state or condition the corporation may be as they are risk averse and fear the threat of losing their job if a decision taken by them goes wrong. Therefore in order to avoid the various problems that arise due to the agency problem, executives must be properly and promptly compensated along with proper monitoring.
In the beginning of 1990s, debates on corporate governance mainly focused on directors' remuneration and 'fat cats'. 'Fat cats' are referred to those executives who provided themselves with huge compensation packages without any performance criteria. In UK, the most famous Fat Cat episode which saddened the shareholders of many large public companies and dragged the attention of the media was the notorious British Gas incident of the mid 1990s. Various issues arising out of executive compensation and the trouble of framing the deserved level of compensation, that has to be provided to an executive, made executive remuneration a main area of concern under corporate governance. According to Jensen (1993), providing the right level of remuneration to the executives and creating positive incentives in order to achieve the interest of the shareholders has been an important study conducted in many academic literatures. An improvement in corporate governance is brought about by filtering certain aspects of executive remuneration.
There exists a wide gap between the remuneration paid to the executives and the remuneration paid to the other employees on the company. This gap keeps on increasing year after year as executives demand more and more for their services and decision making process to boosts the productivity and reputation of the firm which thereby increases the market price of the company's share. In a research mentioned in the Higgs Report (2003), chairmen of FTSE 100 companies in 2003 earned an average of £ 426,000 as remuneration. Moreover, executives are being rewarded with stock options which would enrich them with abnormal profits in the future when the options granted to them are exercised. Critics argue that, executives are not worth for the remuneration paid because of their poor and unsatisfactory performance. According to Blitz (2003), MORI - a leading market research company in the UK, through a survey, found 78% of the people unsatisfied by the remuneration paid to the executives. The public in UK believe that executives are being overpaid for the amount of work they actually do.
2 - Methodology
This paper is a critical review on the various aspects of executive compensation in the UK and how the executive compensation especially the executive stock option encourage the managers and top executives, for their personal benefit, to take short term high risks and boost up the current value of shares rather than looking into the future and acting in favour of the stakeholders of the company. The tools used for the research mainly consist of various literature reviews of past articles and current working papers with some analysis of some statistical data regarding executive compensation. On the basis of the above mentioned area of research certain questions have been framed which will be critically looked into:
a) Brief description of the executive compensation and corporate governance in the UK.
b) Basic structure of executive remuneration in the UK and their disclosure requirements in United Kingdom.
c) Are stock options considered the best means of remuneration in an executive compensation package?
d) A brief historical overview of the introduction of executive stock option in the UK.
e) What are the various manipulations done with executive stock option and what are the risk incentives created by executive stock option?
f) Brief comparison of the UK executive compensation with the US executive compensation.
g) The role of executive compensation in the UK banking towards the current financial crises.
3 - Executive Compensation and Corporate Governance in the United Kingdom:
During the past decade, various issues on corporate governance established the emergence of many reports and codes of best practice in the United Kingdom. These include the Inland Revenue (1988), Cadbury Report (1992), Greenbury Report (1995), Hampel Report (1998), The Combined Code (1998), Hermes Statement on Corporate Governance and Voting Policy (1998), Internal Control: Guidance for Directors on the Combined Code (Turnbull Report)(1999), Company Law Reform (1999) and Financial Services Market Act (2001) (Konstantinos Stathopoulos, Susanne Espenlaub, Martin Walker, 2003). Among these reports the Cadbury Report, Greenbury Report and the Combined Code, which emerged from the Hampel Report, focused on issues regarding executive compensation.
3.1 - Cadbury Report (1992):
The first guidelines of "good practice" on various issues of corporate governance were provided in the year 1992 by the Cadbury Committee which was established in May 1991 and was chaired by Adrian Cadbury. The Cadbury Committee discussed issues that were broader in nature than the executive remuneration but certain suggestions the committee made on altering the executive pay was accepted as permanent. The Cadbury report was titled as the Financial Aspects of Corporate Governance and came out with the Code of Best Practice, which insisted that decisions based on executive remunerations should not be made by the executive directors nor they have to get involved in making such a decision (1992, paragraph 4.42 p. 31). The report therefore recommended the appointment of a remuneration committee which will act in the interest of the shareholders of the firm and express a good opinion on various matters regarding executive compensation to the board. Companies in the UK responded spontaneously to this recommendation made in the Cadbury Report and established a remuneration committee within the firm (Bostock, 1995). The remuneration committee consists of a non-executive director as the chairperson and non-executive directors as its members who are all independent and free from the influence of the management. According to Williamson (I985), there always arises a question of doubt whether the directors make remuneration contracts for their own huge benefits and sanction it, if an independent pay committee does not exist. The role of remuneration committee is to ensure that executive compensation levels are set up in a formal, transparent way along with the goals required to be achieved by the executives for any schemes that are performance related. The remuneration committee can take advice from outside sources whenever necessary. The Cadbury report also suggested the establishment of an audit committee within each company which comprises of three non-executive directors (Martin Conyon, Paul Gregg and Stephen Machin, 1995). According to a questionnaire survey conducted by Conyon and Mallin (1997), by 1995, 98% of the companies followed the suggestions made by the Cadbury report and has reported the involvement of the remuneration committee in their annual reports.
3.2 - The Greenbury Report (1995):
Cadbury report failed to provide detailed guidance on how compensation packages have to be structured. However, it pointed out 'executive compensation' to be the main area of study for the next committee known as the Greenbury Committee. The Greenbury Committee chaired by Sir Richard Greenbury, was formed by the United Kingdom Confederation of Business and Industry, and in 1995 it submitted the Greenbury report which dealt with matters regarding the determination and accounting of top executive pay. The main issues discussed in the Greenbury Report includes the role of the remuneration committee in an organisation, the disclosure requirement required by the shareholders of the organisation, the remuneration policies for compensating the executives and the service contracts provided to the executives. The remuneration policies recommended in the Greenbury Report are:
a) Compensation packages must be provided by the remuneration committee to quality executives in order to influence, secure and encourage them and any payments extra to this intention must be avoided (Greenbury Report - Paragraphs 6.5 – 6.7).
b) The payments made and the subsequent resulting performance by other companies in the same industry must be evaluated by the remuneration committee. On the basis of this evaluation, the remuneration committee should relatively place their company (Paragraphs 6.11 – 6.12).
c) While making changes to the annual salary of the executives, the remuneration committee should look into the payment and employment situations in other areas of the company rather than only concentrating on the executive pay and increasing them so as to satisfy the executives (Paragraph 6.13).
d) The part of remuneration that is related to performance should be designed in such a way that the executive's incentives go hand in hand with the interest of the shareholders and the executives are motivated to perform their duties with high standards (Paragraph 6.16).
e) The performance conditions for executives to avail their annual bonuses, if any, should be designed to support and widen the operations of the business. The maximum possible amount of annual bonus an executive can avail should be taken into consideration by the remuneration committee and in some cases a part of these bonus payments can also be made by shares (Paragraphs 6.19 – 6.22).
f) Under the long term incentive scheme, the Greenbury Report suggested that the shares and options granted to the executives should neither vest nor be exercisable, at least for a period of 3 years after such grant. The remuneration committee should encourage its executives to keep possession of their shares, after its vesting or exercise, for a long period of time (Paragraphs 6.23 – 6.34).
g) The present existing long term incentive scheme should either be replaced by the new incentive scheme proposed or, the new incentive scheme proposed when combined with the old existing scheme should formulate a well structured incentive plan. The remuneration committee should make sure that the new long term incentive plan does not pay in excess than what is actually required for the executives and this new plan is accepted by the shareholders (Paragraph 6.35).
h) The criteria for any long term incentive grant should be challenging and the performance of the executives should help achieve the goals set by the company in order to stand out from rest of its competitors. Key variables like the total shareholder's return are used to judge the performance of the company with respect to its competitors (Paragraphs 6.38 – 6.40).
i) Executive stock option grant or any other long term incentive grant must not be presented in lump-sum but should be awarded in series of stages. Moreover, no discount should be provided to the executives on the issue of executive stock option (Paragraph 6.29).
j) While increasing the annual basic salary of the executives, the remuneration committee should look into the effect of such increase on the executives' pension entitlement and on the future expenses of the company particularly in case of those executives who are nearing retirement. The annual bonuses paid or any benefits paid in kind are not entitled for any pension payment (Paragraph 6.42 – 6.45).
The aim of the Greenbury Report was not to cut down the executives' remuneration but was to establish a balance between the compensation paid to the executives and their respective performance. On publishing the report in 1995 by the Greenbury Committee, certain tax advantages that was permitted on newly issued share options which comes under the approved executive share option scheme was withdrawn by the UK government. A new type of option scheme was introduced in November 1995 which had an upper limit of only £20,000 on individual option holdings. Further, executive share options whose exercise price was earlier accepted at a discounted price of 15% on the existing share price at the time of grant was prevented (Konstantinos Stathopoulos, Susanne Espenlaub & Martin Walker, 2003). According to Conyon (1994) in UK, the top executive director of a company was also made member of its remuneration committee before the launch of the Greenbury Report. However, the old fashioned executive share options schemes was not benefitted from the recommendations made by the Greenbury Committee as it not only seized the tax benefits but also encouraged to substitute options with long term incentive plans which in the UK is just awarding shares and not cash. The recommendations made by the Greenbury Report were not widely accepted as many of the critics believed that the report failed to link the executive pay with the performance of the company.
3.3 - The Combined Code (1998):
The Combined Code of the London Stock Exchange controls the various remuneration practices adopted by the companies listed in the London Stock Exchange. It has combined the recommendations given by the Cadbury Report and the Greenbury Report in order to form a regulation for efficient remuneration practice. The annual report of the companies listed should contain in a separate section the remuneration policy adopted by the company. The Combined Code requires a statement, in the annual report, showing that the remuneration standards mentioned in the code are being followed by the company and if any set standard is not complied with, the statement should point out the reason for the non compliance. A high level of executive remuneration disclosure is also required under the combined code and clear explanations about the various compensation packages provided to each executive director and non executive director should be stated (Konstantinos Stathopoulos, Susanne Espenlaub & Martin Walker, 2003).
4 - Structure of Executive Remuneration in the UK:
The typical structure of executive compensation in UK comprise of base salary, annual bonus, share options and long term incentive plans along with certain additional components like restricted stock and retirement plans. In 1997, an average executive compensation package consisted of 54% of base salary, 24% of annual bonus and 22% of non cash items which include share options and long term incentive plans (Martin J. Conyon, Simon I. Peck, Laura E. Read and Graham V. Sadler, 2000).
Base Salary -
Determination of the base salary of an executive is done by taking into consideration the base salaries paid to executives of other companies in the same industry through surveys and analysis. This system of setting up and providing base salary is known as "competitive benchmarking". Certain modifications are carried out on the base salary depending on the size of the firm, thereby linking executive compensation and firm size. In UK, base salary form the major part of the total executive remuneration paid. Base salary is that component of executive remuneration which is fixed and do not vary according to the performance, experience, age, etc of the executives. A £1 increase in the base salary is preferred by executives who are risk averse than a £1 increase in other components of executive compensation that are variable.
Annual Bonus -
Bonus is provided to the executives on the basis of their performance during the relevant financial year. It is provided on an annual basis and the amounts paid as bonus to each executive vary from year to year. The performance of the executives is generally measured by taking into consideration accounting numbers which can be cross checked and audited. Executives have a clear idea of their daily performance by looking at the accounting numbers and they can forecast how overall profit of the company is going to look like at the end of the year. The drawback of relying on accounting numbers for measuring performance is that it is fully under the control of the executives and if wanted executives can manipulate the accounts in order to increase their annual bonus entitlement.
Share Options -
Share options are contracts provided to the executives that cannot be traded which gives the executives the right to buy the shares of the firm at a price that is pre-determined known as the exercisable price for a specified time period. These contracts become void and have to be surrendered if the exercisable period mentioned has elapsed or if the executive resigns from the company before the exercisable period. This component of executive compensation is looked more into detail in the later section.
Long-Term Incentive Plans –
Long-Term Incentive Plans are provided to the executives in order to motivate and compensate them for achieving long term performance for the company. Grant of shares is the most typical form of LTIPs provided in the UK. These shares are vested to the executives only on achieving the objectives set by the company that is related to future performance. Earnings per Share and Total Shareholders Return are the two main elements by which the performance of the company is measured in the UK.
Retirement Plans –
Apart from the basic pension plans provided by the company, in UK, executives are encouraged to participate in an additional retirement benefit plan. These plans are a major source of concern because it symbolises invisible compensation. The actual value of executive retirement plan cannot be calculated by the available information provided in the books of accounts and the annual report.
4.1 - Disclosure Requirement of Executive's Remuneration in the UK:
The Greenbury Report in 1995 identified three fundamental principles, which are accountability, transparency and performance linkage, in respect to executives' remuneration. In UK, the current best practice disclosure pattern failed to compile with these fundamental principles therefore the government introduced certain necessary additions to the existing disclosure pattern. These latest requirements regarding disclosure of UK executives' remuneration unifies the existing law, regulation and best practices that are mentioned in the UK Companies Act of 1985, the UK Listing Rules and the UK Combined Code of Principles of Good Governance and Code of Best Practice. The new requirement requires every company in the UK to adopt and prepare the directors' remuneration report along with other necessary requirements.
4.1.1 - Directors' Remuneration Report (DRR):
Companies listed in the London Stock Exchange should prepare the directors' remuneration report for every financial year (Section 234B Companies Act) and should publish this report along with the accounts and annual report of the company (Section 244 Companies Act). The preparation of the remuneration report is done by the board of directors and not by the remuneration committee being, a committee accountable and responsible to the board and consisting only the non executive directors of the company. The remuneration of both the executive and non executive directors is clearly mentioned in the remuneration report. The fully prepared remuneration report should be filed with the registrar of companies (Section 242 Companies Act) and made available and provided to all the parties interested in the company such as the shareholders, debenture holders, and other persons who are required to attend the general meetings (Section 238 Companies Act).
The remuneration report should contain all the information regarding the remuneration of the directors for the financial year completed i.e. the "relevant financial year" which includes disclosure of the amount receivable by the directors, whether paid or not, during the financial year as well as the disclosure of any amount paid as directors' remuneration for any other period during the financial year (Companies Act, Schedule 7A, paragraph 19). The remuneration report should include the payments made to a third party for any services provided to the directors (Companies Act, Schedule 7A, paragraph 18(3)) and a statement showing the future remuneration policy of the directors. In UK, only the disclosure of directors' remuneration is needed in the remuneration report. The name and information of every person who is the director, during the relevant financial year, has to be mentioned in the remuneration report.
The remuneration report contains information that has to be audited by an external auditor (Companies Act, Schedule 7A, Part 3) and information need not be audited (Companies Act, Schedule 7A, Part 3).
a) Information in DRR subject to audit:
With regards to information subject to audit, the external auditor in his own consent should mention whether the information provided are prepared according to the necessary requirement and if any information is not complied as needed, the auditor should provide a statement showing them (Sections 235 and 237 Companies Act). The auditor will also look into disclosure information that are not subjected to audit and verify them with the company accounts as well as with the disclosure information that are audited. The various information included in the DRR that are subject to audit are:
Emoluments and compensation -
For the services provided to the company as an executive or for any other services relating to the company's management, the salary, bonus, fees or compensation as termination of "qualifying services" received or receivable by the executives should be disclosed in the DRR. The overall value of non monetary benefits provided to the executives should be mentioned and the total aggregate of each kind of executive compensation provided in the relevant financial year should be compared with the previous financial year (Companies Act, Schedule 7A, paragraph 6).
Share Options –
The different types of shares options a company have should be mentioned along with their terms and conditions and besides each share option the total option each executive hold in the beginning of the relevant financial year as well as in the end should be disclosed. Detailed information of the various options provided during the year, its date of grant, its exercise price, date of expiry, number that have become void and number exercised and unexercised by the executives should be mentioned. If the share options are subject to any performance condition then the criteria has to be clearly described. For those shares that have been exercised, the market price during the time of exercise and for those shares unexercised ,the highest, lowest and the year end market prices have to be also mentioned. Since the disclosure of share options is a lengthy process, the aggregate of options each director hold is stated and the disclosure can be made on the basis of weighted average exercise prices (Companies Act, Schedule 7A, paragraphs 7-9).
Long-term incentive schemes –
Disclosure of "scheme interests" at the beginning and end of the current financial year which each executive hold must be made. Details of the type of scheme interest provided to the executives, its value and when it is vested in the year should be mentioned. If there are any conditions on the basis of which scheme interests will be granted then the relevant conditions should be specified (Companies Act, Schedule 7A, paragraphs 10 and 11).
Other Information -
Details of executives' pension scheme transfer value, any benefits that are accumulated over time and amount paid or payable by the company towards the money purchase pension scheme and retirement benefit scheme should be mentioned (Companies Act, Schedule 7A, paragraph 12). Amount received or receivable by the executives as benefits over and above the retirement benefit which he is entitled after 31st March 1997 should be included in the DRR (Companies Act, Schedule 7A, paragraph 13). If any person, who was once the executive of the company, has been given a special reward or if any third party is paid for their services provided to the executives during the relevant financial year it should be stated and disclosed (Companies Act, Schedule 7A, paragraph 14 - 15).
b) Information in DRR not subject to audit:
The information in the DRR that are not subject to audit is:
Remuneration Committee –
If any decision regarding the remuneration of the executives is taken by a committee during the financial year then the DRR must contain the name of all the non executive directors who were the members of such a committee and also should mention the name of any other person who is not the member of the committee but has been appointed by the members to assist them with certain services and advice. The details of the services rendered by the outside party should be clearly mentioned and this is done to ensure that the executive director play no role and influence the decision making of the committee (Companies Act, Schedule 7A, paragraph 2).
Statement of policy on executives' remuneration –
A statement of future policy on executives' remuneration for the coming financial years has to be included in the directors' remuneration report (Companies Act, Schedule 7A, paragraph 3). The statement of policy should therefore disclose the conditions of performance, by an executive, for the entitlement of share option and long term incentive scheme along with the reasons for setting up such performance condition and the method used to assess the performance condition. If any executive fails meet the performance condition and does not benefit from the stock option grant or long term incentive scheme, the report should clearly state the conditions that are unsatisfactory. Details of the company on the basis of which the performance is measured should be provided in the report. Changes or amendments proposed to the existing terms and conditions for executive's entitlement should be highlighted. Explanation should also provide for non-performance related remuneration and company policies on executives' service contracts. This statement covers all directors from the end of the current financial year till the time when the report is put for voting by the shareholders of the company
Performance graph –
Publication of preceding 5 years performance graph should be included in the DRR showing the "total shareholder return" for holding shares whose listing transformed the company into a "quoted company" and for holding shares on the basis of which calculations are made for a broad equity market index. A "fair method" is used for the calculation of the total shareholder return along with various assumptions like the interest received on shares being reinvested (Companies Act, Schedule 7A, paragraph 4).
Service Contract –
During the relevant financial year if any executive is provided with a service contract, the date at which the service contract has been provided, its duration and its terms and conditions should be mentioned in the remuneration report. A detail of the termination compensation the executive is entitled to receive along with the company's liability on early termination is to be included (Companies Act, Schedule 7A, paragraph 5).
On the complete preparation of the remuneration report, in the annual general body meeting it is introduced and called for a vote by the shareholders of the company (Section 241A Companies Act). This concept of voting the remuneration report was a controversial topic as many commentators suggested the voting to be limited to only the remuneration policy rather than the whole remuneration report. The reason they point out is that the executives' remuneration policies are futuristic in nature so the shareholders can express their opinion on the policies adopted rather than making aware of the actual remuneration paid to each individual director.
4.1.2 - Other Requirements:
a) Along with the preparation of the DRR, disclosure of the aggregate compensation of the executive, loan given to the executives and other company transactions with the executive should be done in the notes of the annual accounts as mentioned in Schedule 6 of the Companies Act.
b) As per Section 251 of the Companies Act and Companies Regulations (1995), listed companies in their summary financial statements should as a statement, state its policies regarding the remuneration of executives and the company's performance graph.
5 - Stock/Share Options – Are they the Best in an Executive Compensation package?
The most prominent and important component of executive compensation, in order to merge the interests of the executives with that of the interests of the shareholders, is providing the executives with stock options in the firms they serve (Jensen and Meckling, 1976). According to Jeffrey A. Williamson and Brian H. Kleiner, "A stock option is a security that represents the right, but not the obligation, to buy or sell a specified amount of stocks at a specified price within a specified period of time". Stock options granted to executives of many large multinational firms are much higher in value than the annual cash pay they are entitled to be paid which in-turn boosts up the overall total compensation provided to the executives. This makes stock options the single largest ingredient in the current scenario of executive compensation. In the United States itself, stock options are held by more than 10 million employees (Simon R. and Dugan J., 2001) out of which around 160,000 of them turned out to be millionaires (Tate E.A. and Wilson T.E., 2001). Initially stock options were provided as a bonus to all the key executives of a company, but during the recent years its use is restricted only to the top level management. Providing stock options have resulted in increased productivity of the organisations. Executives are aware that their gain is linked with the stock performance of the organisation therefore they strive harder and work more efficiently to achieve progress.
The main objective behind granting stock options is to make sure that executive make a profit on the success of the company's operations and in case of failures they suffer. Hence executive stock options link pay to performance. Critics argue to provide shares of stock rather than providing stock options in order to link pay and performance. The value of a stock option is only one third the value of a share, in case of companies having an average volatile stock price and yielding an average dividend the reason being stockholders receiving the whole value along with the dividend payment and the option holders benefitting only from the additional returns that is over and above the exercise price. This implies that options have a greater leverage and at the same cost, a company can provide its executives with options that are three times as much as that of shares. Stock options are incentive plans that are future aimed and forward looking in nature as it includes a vesting period for its exercise and is greatly influenced by the stock price. Therefore executives forecast how the various decisions taken and implemented in the present, will affect the future earnings of the company (Brian J. Hall, 2000).
Companies have three main advantages for granting stock option. Firstly, by providing stock option, companies attract quality executives without any cash expenditure. Companies can avail the services of the executives and as a result companies provide high compensation that is variable and future oriented. However, risk-averse executives will not be attracted by providing stock options as the returns are future oriented and variable. They prefer increase in pay that is fixed and not variable returns. Options attract highly motivated, risk willing executives who believe in themselves and are confident in boosting up the stock prices of the company. Therefore option grants is usually meant for to attract executives more than the other employees in the lower level of the company because it is only the executives who can take various actions and decisions that influence the price of the stock which results in future personal gains from exercising their stock option. The second main advantage of granting stock option is that it helps in retention. Certain restrictions like achievement of performance criteria or vesting of shares after a specified time period and forfeiture of options that are not vested if the executive leaves the company create retention incentives for the executives. If the market price of the share is well above the exercise price of the options, highly skilled quality executives will have a tendency to reject the competitor's offer and retain their current position in the firm in order to exercise their options and make huge profits. Retention incentive provided by stock option is strong in case of bull markets where the market price is above the exercise price but is weak in case of bear market as executives tend to leave the firm and join the competitor firm which would offer better remuneration package. Thirdly, stock option motivates executives to perform. Executives enjoy benefits from stock option only when there is an increase in the performance of the company's stock. Therefore executives will efficiently come up with innovate ideas and communicate their strategies and plans in order to maximize the wealth of the shareholders, will maintain a good relation with the other employees of the organisation and encourage them to work with at most dedication and unity to achieve company goals and objectives.
5.1 - Types of Executive Stock Option and Executive Stock Option Plans:
The two major types of stock option plans are the Incentive Stock Option Plan (ISO) and the Non-Qualified Stock Option Plan (NSO or NQSO).
Incentive Stock Option Plan (ISO):
Incentive Stock Option is a stock option plan with special tax benefits. The executives holding such option shall not be liable to pay tax when such options are granted to them or exercised by them but the profits made by them shall be taxed from the date of exercise till the date of sale of stock according to the existing long-term capital gains rate or the ordinary income tax rate at the time of sale. In the present scenario, incentive stock option is gaining popularity as much as that of the nonqualified stock options. At the time of grant of an ISO the stock's fair market value should be either equal to or lesser than the exercise price of the option. Moreover, the executives must exercise his options when he still is an employee of the organisation or within three months of his resignation and he cannot hold more than ten percent of the voting stock. Unless it is the case of death of an executive, the ISO granted cannot be transferred in favour of someone else (Jeffrey A. Williamson and Brian H. Kleiner, 2004).
Non-qualified Stock Options (NSO):
This type of stock option is generally provided by the companies as it is flexible and convenient for both the executive and the company. The ISO requirement of discovering the fair market value of the stock is not required for NSO therefore firms whose shares are not traded publicly adopt this type of stock option plan. Here the executive is entitled to pay higher tax but when the stock option is exercised. The executive having this type of stock option will have to pay Alternative Minimum Tax (AMT) which is the difference between the fair market price of the stock and exercise price of the option during the time of exercise (Jeffrey A. Williamson and Brian H. Kleiner, 2004).
Executives of many companies are unaware of the type of stock option grant provided to them and the various alternatives available for them. They are just interested in knowing whether the company have in its agenda any stock option plan for them. How the options are granted does play a very important role in achieving the objectives of the company. This unawareness and ignorance of the executives can turn out to be dangerous. According to Brian J. Hall (2000), there are basically three types of executive stock option plans:
Fixed Value Plans:
Under this plan, the total value of the stock options to be granted yearly is determined in advance on the basis of the salary or any other criteria and the executives receive their options accordingly till the expiry of the plan. Formulas which take into account the remaining number of years, uncertainty of the stock price, current interest rates and stock's dividend rate are generally used to calculate the value of the stock option granted every year. This type of plan help to keep a check on the percentage of compensation received therefore it is gaining popularity. Companies that carefully analyse reports submitted by the compensation consultants on executive compensation and alter their compensation package every year, can minimize the risk of losing their smart executives due to high compensation offered somewhere else. The biggest demerit of this plan is that it the pay and performance link is weakened due to future planning of the value and during years of extraordinary performance, executives receive very few options. These types of plans are called low-octane plans.
Fixed Number Plans:
Under this plan, the number of the stock options to be granted yearly is determined in advance and the executives receive their options accordingly till the expiry of the plan. Irrespective of the performance of the company, in any year, the executives will receive the specified number of options and such grants do not depend on the stock price of the company. These types of plans are called medium-octane plans.
Under this plan the number of the stock options to be granted is decided along with their exercise price and provided to the executives as lump sum. This plan is not as commonly used as other multi-year plans as they are very highly leveraged. Such executive stock option plans can make an executive fabulously wealthy. These types of plans are called high-octane plans.
5.2 – A Historical Overview of the introduction Stock Option in the UK:
Changes in the market prices of the share with respect to the exercise price during the exercisable period determine the value of share options. The increase in the market price of a share, over and above its exercise price, increases the value of the share option. In UK, the exercise period of an option generally varies from three years to ten years from the date of grant, thus giving the executives an exercise 'window' of seven years. The returns gained as a result of exercising the option granted and immediately selling it by the executives in UK is taxed because such returns are considered as capital gain. Till April 2005, until the sole existence of the Inland Revenue (a British Government department engaged in direct taxation collection), all executives who came under the Company Share Option Plan approved by the Inland Revenue had restrictions not to hold options that valued more than four times the annual base salary provided to them as remuneration. In UK, stock options are limited to the executives but decisions regarding its grant are done by the remuneration committee consisting of non-executive directors. The various tax efficiencies associated with executive stock option schemes compared to other rewards was the major reason for an early adoption of stock options as a compensation instrument to the executives in the UK. In the later years the most of tax advantages enjoyed by executive stock option were weakened by the UK government.
In UK, the period from mid 80s to early 90s saw a tremendous increase in the grant of options to the executives of large corporations as remuneration. Through the grant of stock option the inferiority complex that existed in the minds of British executives that they are at a disadvantage in the international executive labour market was removed and in return they gave strong competition to their rivals in other economies. In 1985, the Inland Revenue sanctioned over 2700 executive stock option plans and by 1986, almost all the companies in the UK economy provided their executives with share options. During 1990's stock option gained more popularity and became a standard component in the executive compensation package because companies in the UK realised that without any possibility of an adverse reaction on the company, the average pay of an executive can be strongly enhanced through the issue of stock option. There were three main reasons for this realisation. Firstly, options do not reward the executives immediately as its exercise can be done only after a minimum of three years from the date of grant nor can it be traded. The second reason was options cannot be valued by the executives until it is exercised. The final reason was in relation to the old disclosure requirement. According to the old disclosure requirement, disclosure of stock option granted was not stringent enough that other interested parties had very limited access to know more about the option grants.
Lack of stringent disclosure of stock option in the UK was a major concern for shareholder groups therefore they gave more attention into this aspect. During the later years, taking into consideration the various recommendations given by the Greenbury Committee (1995), Association of British Insurers (a shareholder group) and National Association of Pension Funds (a shareholder group), there has been a fall in the provision of stock option to the executives. The guidelines provided by these bodies threw light on the various abuses and concerns regarding option schemes which the earlier adopters followed in order to provide themselves with huge benefits. Some of these include reissuing options, which were "under water" because of the unsatisfactory performance of the executives or due to the development of the market, at an exercise price lower than the previously issued exercise price and discounting the exercise price of the option much below the actual market price at the time of grant. In UK, a modest discount is only allowed to companies that provide share ownership scheme to all its employees according to the current guidelines. Only 68% of the total companies provided their executives with stock options in 1997 (Conyon & Murphy, 2000).
In the recent years following the guidelines suggested by the institutional shareholders, it is ensured that share options are only granted to executives of the company on the achievement of specific performance criteria set by the remuneration committee which enhances the overall performance of the corporate. However the experience in UK regarding the development and use of executive stock option is around ten years behind when compared to the experience of its use in the US.
5.3 - Trouble with Executive Stock Option:
The grant of stock option costs the firms granting the options much more than how much it is worth to the executives receiving it. Option's "opportunity cost" to the firm is measured in terms of the amount an outside investor will have to pay for that option having similar terms and conditions imposed on the executives with regards to its exercise and forfeiture. The cost incurred is more than the value gained because executives expect a bigger reward for bearing certain risks. Executives cannot sell the options granted to them nor can they hedge the various risks related to the options as it can be done by outside investors. Executives are also not well diversified like the outside investors. Therefore stock option which are granted recently, i.e. the exercise price of the option is equal to the market price of the share, are valued by the executives at only half the cost incurred to the firm in granting such options. For those options where the exercise price of the option is much higher the market price of the share or in case of those options where the vesting period is very long, the ratio of the value and cost will be much lower. This implies that stock options are only effective if the "incentive effect" which includes attraction, retention and motivation incentive to the executives is higher than the difference between the cost incurred to the company and the value gained by the executives. Critics argue that stock option do not provide strong retention incentive, which is considered as one of the major advantage of granting stock option, to the executives. According to them there are many other ways, like giving delayed compensation, pension or "retention bonus", for retaining quality executives and also making their stay in the company worthwhile rather than providing them with stock option.
5.4 - Manipulations with Executive Stock Option:
Manipulation of stock option can be done through a number of ways. Manipulation of stock option is considered as a serious offence and can lead to severe punishments. Some of the most common types of manipulation of stock option include:
a) Backdating -
The practice of reducing the exercise price of an option much lower than the current existing market price of the stock by selecting a date earlier than the actual date of grant where the price of the stock was relatively lesser in order to reduce the risk of the option as well as to increase its value is known as backdating of options. Backdating is criticised because it provides immediate gain to the executives exercising these options and the basic incentive of providing stock option i.e. to make better the value of the stock is weakened. Normally immediate gains or profits are cannot be realised by the executives from the stock option granted to them as it is subjected to a vesting period before its exercise and the profits realised by the executives depends on the extent to which the price of the stock has been improved during the vesting period. Therefore backdating is considered as illegal.
b) Repricing –
If the price of the stock fail to increase, due to the poor performance of the company, during the vesting period of the stock option which would result in the exercise price of the option being greater than the market price of the stock, then the companies facing such a condition will reprice their stock option and lower its exercise price. The right to amend the terms and conditions in the option contract is reserved by some organisations (Don M. Chance, Raman Kumar and Rebecca B. Todd, 2000). Executives of such organisations, for their personal benefit, misuse this right and make changes to the exercise price of their options accordingly. Repricing of stock option done for such personal benefits rather than doing for future positive outcomes, i.e. to encourage the executives to help the company come out of a financial distress caused due to some market driven or industry driven reasons, is considered illegal.
c) Spring-loading -
Granting stock option at a date earlier than the actual planned date of grant so that the options are granted just before a positive news announcement by the company, which would increase the market price of the company's stock, is known as "Spring-loading". Such options will enable the executives to make profits as the price of the stock will definitely rise more than the option's exercise price on such announcements. A similar type of practice that created controversies is "Bullet-dodging". Here stock option grant is delayed from the actual date planned so that options are granted after the company's announcement of negative news. Executives will benefit from such option grants because they will receive options having a low exercise price according to the existing market price. In future, when the price of the stock goes up executives make profits by exercising their options. Spring-loading and Bullet-dodging practices are regarded as insider trading and they both are considered as market abuses.
In UK, the corporate governance requires strict disclosure of stock option grants in the Directors Remuneration Report. For every financial year, all quoted companies in the UK have to compulsorily publish the Directors' Remuneration Report according to the Directors' Remuneration Report Regulations, 2002. If any quoted company fail to publish the DRR or fail to get the DRR approved by their shareholders then, that company is considered to have committed a criminal offence and will be penalised. Generally in the UK, after the publication of the annual report, every quoted company is allowed only 42 days in order to declare the grant of stock options to their executives. According to the Financial Services Authority, stringent rules regarding the disclosure of stock option reduces the extent of manipulation, like backdating, in the UK economy when compared to the US. But the actual fact is, in spite of strict disclosure requirements, shareholders do not give much attention to various information disclosed, like the date of stock option grant, until any downfall which affects them, thus enabling the executives to manipulate the stock options. Shareholders are only focused and concerned about their profits earned as a result of an increase in the market price of the share and will not question any activities done by the executives if they satisfy the needs of the shareholders.
In the present scenario, options are granted based on their performance of the executives therefore achievement of the required performance by the executives is very essential for stock option entitlement. Financial Services Authority, in September 2006, issued a newsletter to all the listed companies in the UK pointing out the various risks relating to "Spring-loading" and "Bullet-dodging". Any company practicing this type of manipulation will be considered as committing a market abuse and is subject to further actions under Section 118(2) of the Financial Services and Market Act.
5.5 - Risk Incentives created by Stock Options
Options are claimed to be something that provides executives with incentives to increase the level of risk taking and to decrease the dividends paid because maximising the uncertainty of firms and minimising the payment of dividend, increases the value of the options executives hold. Jolls (1998) found that executives would increase their compensation levels by making certain amendments to the firm's financial policies. Executives holding stock-price sensitive options that are much greater than their wealth are motivated to take decisions like increasing the firm leverage which eventually increases the volatility of the firm whereas, executives who are risk averse and who hold shares of financial and human capital in the company will not entertain themselves in risk taking activities because their money is also at stake and also fear of incurring huge losses in case the decisions they take go wrong, therefore solving the agency problem (Randolph B. Cohen, Brian J. Hall and Luis M. Viceira, 2000). Guay (1997) found that firms new to an industry and having strong favourable chance of development and expansion provide their executives with stock options more frequently thereby encouraging its executives to take risky decisions which will in turn help the firms in its success.
Factors determining the value of options are the riskless rate of interest, the price of the underlying security, the exercise price of the option, the time remaining until the option expires, the rate of dividend payment of the underlying security and the volatility of the underlying security. The value of stock options, being a call option, increases with an increase in the price of an underlying security therefore executives has incentives to increase the stock price of the company through vigorous activities. Executives to a certain extend have direct control over the rate of dividend payment and the volatility of the firm's equity (Randolph B. Cohen, Brian J. Hall and Luis M. Viceira, 2000). According to Jolls (1998), executives rely on share repurchases as a substitute to dividend payments in order to reduce the payment of dividends to the least possible.
On the basis of stock price, options are generally granted to the executives. Managers create uncertainty in the stock price either by taking up only risky projects or increasing the leverage of the firm in order to increase the value of stock options. Executive stock options sometimes are very hazardous as it encourages managers of firms that are doing well and are at optimal capital structure to take value destroying decisions rather than value creating actions. However risk taking incentives created by increased executive stock option holdings neither creates any benefits to the shareholders nor incur any cost to the firm as the response from the market is insignificant and there is only a limited increase in the firm risk (Randolph B. Cohen, Brian J. Hall and Luis M. Viceira, 2000).
Given the value of assets, if the strike price of the stock options is high, it creates a high risky and high leveraged position for those executives engaged in low debt firms whereas if the strike price of options is low, it creates similar incentives for firms having high debt. This implies a weak link between the capital structure of the employers and the executive's incentives to take risk due to the adoption of stock option plans. There is a negative relation between firm leverage and executive's incentive to take equity risk. In any stock option grant, the risk incentives are maximised at a special stock price which is a price very similar or close to the option exercise price. Adopting a strike price similar to that of stock price help managers to get rid of risk aversion as the risk sensitivity of the option is maximised at this level (Garvey and Mawani, 2005). Hall and Liebman (1998) and Guay (1999) found that tremendous use of stock options increases the manager's risk taking incentives with regards to the traditional straight stock grant due to the convex nature of executive pay in the stock value.
Stock options also create incentives for C.E.Os to change the structure of total risk. Meulbroek (2001a) shows that C.E.Os, in order to decrease unsystematic risk or firm specific risk with regards to a company's stock, has incentives to increase the systematic risk. The valuation of company's stock and options is done at a much lesser rate as compared to its market value by the managers because a very large part of their earnings and wealth depends largely on the company's wealth and progress. An exception to this was provided by Tian (2002) through a framework similar to utility and certainty. According to him, stock options give C.E.Os incentives to reduce both idiosyncratic and systematic risk. Due to the compromising nature of manager's risk aversion and higher option payoffs, the motive behind the incentive concerning systematic risk is sometimes not very evident. However it is found that, lower the level of total risk, stronger are the risk incentives (Jin-Chuan Duan and Jason Wei, 2003).
6 - Brief Comparison of the UK Executive Compensation with the US Executive Compensation
The United Kingdom is regarded as a less problematic country on matters of excessive executive remuneration when compared to the United States. The huge level of compensation provided to the executives in the US is generally referred to as "managerial rent-extraction" by many of the academic researchers. The governance structure in the UK and the US, with regards to executive compensation, are similar. According to Conyon and Murphy (2000), US executives are provided with larger equity incentives as compared to the UK executives. Due to the differences in culture and institution, US executives are generally provided with large number of stock options as compared to the UK executives (Conyon and Murphy, 2000). The remuneration committees in the US over compensate their executives with large stock option grants by undervaluing its actual cost (Hall and Murphy, 2002 and Jensen, Murphy and Wruck, 2004). In 2003, the average equity incentives provided to the US executives was five times higher to that of the average equity incentives provided to the UK executives; therefore, the executives in US are exposed to huge risks than the UK executives. This implies that, US executives are generally compensated higher than the executives in the UK in order to sustain the large equity incentives. However, nowadays the composition and the extent of executive pay in the UK are becoming similar to that of the pay practices followed in the US.
The structure of executive remuneration provided in the UK and the US are same. Executives of both the countries are entitled for a fixed sum as base salary and they also receive variable pay in the form of annual bonus according to the accounting performance of the firm. The main type of bonus the executives in both the countries receive is in the form of stock options. In UK, the vesting of these stock options are generally linked to the achievement of certain set criteria of performance where as in US, stock options vest after a certain fixed period of time i.e. no performance criteria has to be met by the executives in order to avail benefits of stock options. Stock options constitute the major portion of total executive compensation in the US whereas the base salary constitutes the major portion in UK. According to Martin J. Conyon, John E. Core and Wayne R. Guay (2005), in 2003, the total executive pay in the US was 1.6 times higher than the total executive pay provided to the British executives. However it is also noted that, not only some certain companies in the US economy are over paying their executives but all the companies are over paying their executives.
7 – Current Issue: The Role of Executive Compensation in UK Banking towards the Financial Crises
The financial crises in 2008 have forced attention on the executives' remuneration in the banking sector. It was the banks' inability to control their risks which lead to this major financial crisis. Bank executives were awarded huge performance related remuneration and this encouraged them to take short term high risks which boost up the current performance and was eventually a treat to the bank's future. A 'reward for failure' culture was developed in the banking sector due to this. The British government did huge investments on those banks that were badly affected by the crises in order to recapitalise them. This led to strict scrutiny on the bonuses paid to bank executives.
7.1 - Remuneration paid to Banking Executives pre crises:
Delivery of tremendous performance by the executives is the end result of providing remuneration in the form of bonuses. The bonuses provided to the bank executives in UK comprised of payment of cash annually and multiple rewards based on shares which include share options. The extent of bonuses paid to each executive depends on the executive's individual performance and the performance of the division for which he is in-charge, according to the criteria set.
In UK, executives' entitlement to bonus in the form of cash vary from 150% to 250% of the basic salary whereas, on completion of goals and objectives that are long term it fetches from 150% to 700% of the basic salary (FSA, 2009). CEOs of large banks, on a regular basis, received huge cash bonus as compared to the CEOs of other small banks. According to John Marshall (2009), Sir Fred Goodwin, CEO of Royal Bank of Scotland received annual cash bonuses that amounted to more than £2 million before the financial crises. The office which the executive hold does not generally determine the level of cash bonuses they are entitled to receive. In UK, executives dealing with the capital market received more cash bonus when compared to the CEOs. In 2006 and 2007, the CEO of Investment Banking and Investment Management and President of Barclays, Mr Robert Diamond Jnr, received cash bonus worth £10.5 million and £6.4 million whereas, in 2007, HBOS corporate banking division head, Mr Peter Cummings, received cash bonus worth £1.8 million which was much higher than the cash bonus provided to the CEO of HBOS, Mr Andy Hornby. The CEO of Lloyds TSB Mr Eric Daniels, in 2007, received cash bonuses on the basis of the performance of the bank as well as on the basis of his individual performance which amounted to 90% and 95.6% of his basic salary (Marshall, 2009).
The bonus provided to the executives in the form of share plans, which includes options, vary from 250% to 500% of their basic salary (Arrowsmith, 2009). The value of the share plans provided, depend on the volatility of the share price and the judgment of the executives whether to exercise their options or not. Share bonus is provided in large to banking executives dealing in the corporate division. As per the Financial Times (March 2009), in 2007 under the Barclays long term Performance Share Plan, Mr Robert Diamond Jnr received an overall compensation of £21.1 million out of which £6 million worth remuneration was paid in shares.
b) Pension accrual:
There were two types of pension schemes available for the banking executives in UK. The first type of pension scheme is a scheme that is not related to the performance of the executives and it is a pension plan developed by the bank itself. The number of years served and the basic salary determine the amount of pension an executive is entitled, which generally accumulate at the rate of 1/60th - 1/30th of the executive's basic salary. Personal contribution the pension scheme can be made by the executives. The retirement age attached to this type of pension scheme is 60 years and if needed, by the will of the executives an early retirement at the age of 50 is permitted subject to a reduction in pension benefit. The second type of pension scheme is providing the executives with annual pension allowance that usually ranges between 15% - 55% of the executive's basic salary (Marshall, 2009).
c) Overall Executive Remuneration:
In UK, the total remuneration of executives in the banking sector comprises of the basic salary, bonuses related to performance, pension and certain extra benefits paid in cash. Taking into consideration the major seven banks in UK which includes Barclays, Bradford and Bingley, HBOS, HSBC, Lloyds TSB, Northern Rock and the Royal Bank of Scotland it can be seen that almost all the CEOs was provided with annual cash remunerations of at least £1 million during the years 2003 to 2007. In 2007, the annual cash remuneration of the CEOs of the above mentioned banks comprised of 32.5% in basic salary, 36.8% in performance related bonuses and 28% in pension entitlements where as the executive directors' annual cash remuneration comprised of 22.0% in basic pay, 36.8% in performance related bonuses and 41.2% in pension funds. The average annual cash remuneration a CEO earned for the year 2007 was valued to be £3.2 million and the average an executive director earned for the year 2007 was valued at £2.4 million, excluding the bonuses provided in the form of share plans which can further increase the average remuneration by 33
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