ESOP / stock option / employee ownership update for July 10, 2003

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Update for July 10, 2003

By Corey Rosen

Microsoft Replaces Options With Restricted Stock

On July 8, Microsoft announced that it would replace its stock option grants with restricted stock. The company would continue to give stock awards to most employees; only the form of the award would change. The stock would be time vested for most employees but performance vested for the top 600. Much of the restricted stock for executives would be performance vested. Microsoft also announced that it would now take a charge against earnings for its stock options as well as its future grants of restricted stock (the latter is required under current accounting rules; the former is not). The company will account for prior grants as well as current options. The change came as a result of employee concerns that their options had not done very well over the last few years; restricted stock provides value even if the stock price declines or stays steady. Employees will also have the opportunity (but not requirement) to sell their underwater and unvested options to J.P. Morgan for a fraction of their current face value.

There are several significant elements to this development:

The story generated enormous publicity (six major stories in the Wall Street Journal in one day). Most of the stories suggested that options may be declining as a compensation strategy, but most also said that Microsoft's strategy was significant as well in that it continued the tradition of broad-based employee ownership. The tremendous publicity will itself help shape future corporate decisions.
Microsoft is so large and such an industry leader that many other companies will at least seriously consider this approach.
Microsoft itself very explicitly stated that it believed broad-based ownership is a key to the company's success.
Microsoft is one of fewer than 10 companies to choose to expense not just current, but prior option grants. This may give them a chance to reconsider how they expensed these grants in the past for footnote disclosure. More moderate assumptions about volatility, as well as their new dividend policy, could lower the cost charged to earnings (the cost of options in the standard formula is greater with higher expected volatility and if no dividends are paid).
J.P. Morgan's arrangement with Microsoft to purchase underwater options provides an intriguing possibility. Other investment banks have indicated a strong interest in entering this market. What makes this market work is the different risk profiles of employees and the investment banks. J.P. Morgan can buy underwater options, then reduce its risk through hedging strategies that would not be practical for most employees. So options that might seem "worthless" to employees have greater value to an investment bank. For these plans to work, however, companies must make their options transferable. This means incentive stock options cannot be used (by their terms, they are not transferable in this way). Most non-qualified options are not transferable under the grant agreement, so companies would need to change that.

Whether other companies will jump on board the restricted stock bandwagon is unclear. A recent Mercer survey of 134 large companies indicated that 57% had already added equity programs that did not exist before, but the substitution of restricted stock for options in a broad-based plan is still rare (companies might be substituting restricted stock for options for some executives, for instance). A reasonable supposition is that some (but not a majority of) more mature companies will move in this direction, while younger and more volatile companies, where options are more valuable, will not.

For details on how restricted stock works, see our article on the subject.

California Retirement System to Push Broader Ownership

California's vast public employee and teacher retirement systems, CalPERS and CalSTRS, have agreed to a new options policy for their investments in the 1,000 largest public companies. Under the policy, the systems will oppose new option grants that give more than 5% of the equity to the top five executives. State Treasurer Phil Angelides said a main goal of the program was "to encourage corporations to offer broad-based equity compensation plans for all their employees." Given the clout of these systems, and the leadership role they have taken among institutional investors, the new policy could have significant ramifications.

FAS 150 and ESOPs: Still Up in the Air

There is still no consensus on just what the Financial Accounting Standards Board (FASB) really means by its new FAS 150, an accounting protocol effective May 2003 that requires companies to record a liability on their balance sheets for mandatorily redeemable obligations, including "puttable stock." On the one hand, shares held by ESOP participants and put to the company certainly seem to fall within this definition. On the other hand, the statement explicitly exempts ESOPs following current AICPA standards for ESOP accounting. Moreover, it is unclear whether this would apply to plans in which the shares are redeemed prior to an employee leaving (as would be the case in S corporations and companies in which the by-laws state that "all or substantially all" of the stock be owned by employees) or plans in which the employee only owns the shares on a temporary basis (the IRS, in rulings on S corporations, has said that such transient ownership does not constitute ownership for S corporation purposes, for instance).

Unfortunately, FASB allowed for no comments on this new procedure and clearly did not have ESOPs in closely held companies in mind when drafting it. Some accounting firms have told clients they believe it may require showing repurchase obligations as a balance sheet liability; others have said they believe it does not. If this standard were adopted, some companies could face significant unanticipated problems. Some loan covenants, for instance, would be violated because the company could show a negative net worth or at least a debt-to-equity ratio below what the covenant specifies. Unless these agreements can be renegotiated, ESOP companies could conceivably have loans called. It is unclear how or if this matter is going to be addressed; there are no current plans for FASB to address it specifically.

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