Shareholder Forum for Options Policies

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Program Reference


For response to Mr. Johnson's comments below,  see

Additional Comments on Forum Objectives

Hermes Equity Ownership Services

January 26, 2006


See also previous Forum Reports:

Initial Open Meeting of the Options Policies Forum

December 6, 2006


Information to be Provided in Compensation Survey Report

January 8, 2007




Forum Report


Participant Comments on Forum Objectives


            Keith Johnson, who is currently coordinating the International Roundtable on Executive Remuneration, has provided a very thorough and thoughtful commentary on the Forum program.  Copied below, it urges


(a)    the evaluation of options policies in the broader context of executive compensation and the associated interests of shareholders in long-term business performance, and


(b)   the need to tailor practices to individual companies, reflecting particular strategies and competitive conditions.


            The focus Mr. Johnson recommends is clearly consistent with the Forum’s defined objectives and established direction.  His carefully organized observations therefore provide a very effective framework for defining specific goals of the five projects we defined.  We should make good use of this to stimulate our thinking about what, specifically, each of the projects should be presenting for review at the Forum’s open meeting in February.


            As Mr. Johnson concludes, “success will depend on how boards, shareholders and consultants implement their responsibilities on a company-by-company basis.”  Please let me know how you think the Forum program can best address the information needs of these decision-makers.


           GL – 1/19/07


Gary Lutin

Lutin & Company

575 Madison Avenue, 10th Floor

New York, New York 10022

Tel: 212-605-0335

Fax: 212-605-0325







Responses to December 2006 Options Policies Forum

Submitted by: Keith L. Johnson, Chairman

Reinhart Institutional Investor Services



After reflection on results of the Initial Open Meeting, the following comments are submitted for consideration by participants in the Forum.



It would be most productive to evaluate stock option policies in the larger context in which they fit.  Failure to look at the bigger picture is one of the problems that has contributed to unpleasant surprises and mismatched executive compensation practices with shareholders.  Option policies should be tailored to each individual company and structured to fit each company's strategic plans and competitive position.  Where these are out of alignment, either the compensation policies or the context in which they exist must eventually change or company wealth and shareholder value will be put at increasing risk.


Development of options and executive compensation policies also cannot be evaluated outside the context of the board's fiduciary duties to shareholders.  The franchise granted to corporations by corporate law contains a series of legal obligations.  One of those is the overriding obligation to manage the company in the best interests of shareholders.  This necessarily requires that, in the event of a conflict of interest between management and the company's owners, the board cannot choose to favor management at the expense of outside shareholder interests.  Although shareholders often have diverse goals and demands (e.g., active and passive owners, short-term and long-term horizons, risk tolerance variations, use of short sales and hedging versus long-only positions), boards are legally obligated to do their best to make informed decisions about executive compensation issues, identify shareholder interests, evaluate them, and ensure that the company is managed in the overall best interests of shareholders. 


Options are a particularly challenging compensation vehicle because they inherently involve dilution to future ownership of outside shareholders and introduce potential divergence in interests with shareholders (e.g., from vesting schedules and differences in downside risk and upside value).   Consequently, they usually need to be used with other compensation vehicles that keep balance in the compensation scheme. 


Policies on the use of options should only be considered in the context of the entire compensation package within which they fit and the circumstances of the particular company.  From a shareholder perspective, a one-size-fits-all approach to options could be very dangerous.


Effective Communication of Compensation Policies

Given that options are only one of many executive compensation tools, they are best evaluated with a view toward the larger compensation plan context in which they are used on a company-specific basis.  However, in order for shareholders to effectively perform their function (both as part of the governance structure of the individual corporation and as decision makers on allocation of capital in the marketplace), best practices on use of options require a high degree of transparency in communications from directors to shareholders.  Conversely, direct and clear communications flow from shareholders to directors also facilitates effective board performance of its functions.


Disciplined implementation of the recent SEC executive compensation disclosure requirements will determine, to a large extent, whether more effective options and compensation policies will develop.  Fulfilling the underlying transparency principles, rather than merely complying with the new SEC rules, will be the key.  Forum participants should commit to encourage increased communication between boards and shareholders on the full context in which options are being used at each company.


Evaluation Criteria

The following issues are among those that could be addressed by boards and shareholders when evaluating option programs and the compensation plans within which they are contained.  To a large extent, what is measured and evaluated will determine how options plans and compensation are managed.  Relevance and implementation would be expected to vary from company to company. 


  • Independence: Both compensation committee members and the consultants they use should be free of conflicts and fully able to function independently of influence by company management. That does not mean that company management should not have input into the process.  However, it does mean that integrity of the process is crucial to outside shareholders and the marketplace.  If stakeholders do not trust the players and the process, effective communication and acceptance of the program will be undermined.
  • Compensation Discussion and Analysis (CD&A): The board's compensation philosophy and how use of options fit within the overall company strategy should be communicated clearly.  The CD&A is part of a conversation with shareholders and the marketplace about how the board approaches compensation practices.  Shareholders should demand that the CD&A meet their requirements and that it demonstrate how compensation is aligned with their interests.  Boards must ensure that shareholders understand the company's compensation philosophy.
  • Shareholder Base: Proactive board attention to the company's shareholder base was a central recommendation of the Conference Board's Commission on Public Trust and Private Enterprise.  A shareholder base of short-term investors is unlikely to support a strategic or compensation plan that focuses only on long-term goals.  Companies that need a particular base of shareholders might need to develop a plan to seek out those shareholders as part of the compensation planning process.
  • Competitive Comparisons: Boards and shareholders could be more careful in evaluating how option programs and compensation plans use market comparisons.  Pay delivery consultants have not always focused on apples to apples comparisons in job matching.  Global companies with a global shareholder base may find it increasingly difficult to limit themselves to local US market comparables.  If shareholders demand that boards fulfill their fiduciary responsibilities and apply the same standards to locating qualified and competitively priced executive personnel as they do to any other labor contract, global companies will be increasingly forced to include executive compensation comparables from outside the US.  At underperforming companies, greater attention to comparables might mean not using executives at outperforming companies for current compensation award comparables.  Companies with single product lines might not compare their executives to others at complex conglomerates (even in the same industry), where a higher skill set is required.  Executives with few strategic planning responsibilities might not be compared to those at companies where executive strategic planning duties are more closely associated with shareholder value. 
  • Total Holdings: Should option plan design reflect how much an executive has already accumulated in company equity exposure?  The marginal increase in incentives associated with additional equity awards might vary depending on size of existing holdings.  Shareholders and boards could question plans that fail to address this.  Tally sheets with total company career compensation received might be enlightening in this regard. 
  • Pay for Performance: On an all-in basis, are the shareholders obtaining a reasonable return on their investment for the compensation paid to company management?  If the board and shareholders are not comfortable that pay is aligned with performance and that both management and shareholders are receiving a fair split of company profits and losses, the board has failed in performing its executive compensation responsibilities.
  • Internal Pay Equity: Credit rating agencies have begun to recognize increased investor risk is associated with CEO compensation levels that are more than about three times greater than a company's next level of executives.  Should boards and shareholders begin to view unexplained internal equity issues as indicative of "iconic CEO risk" or an unrealistic CEO succession plan?  Boards would be well-advised to consider succession planning in conjunction with compensation.
  • Integration with Strategic Plan: The board and its consultants should be able to clearly articulate how option and other compensation plan components are tied to the company's goals.  For example, will compensation reward sustained shareholder returns, reflect the company's cost of capital or return on assets, include internal operational goals and facilitate healthy relationships with the company's other influential stakeholders.  Shareholders could focus on evaluating how incentive plan targets and metrics are integrated with the company's strategic plan and whether the board is regularly reviewing the goals to ensure their relevance and consistency.  Distinctions between operational duties and strategic responsibilities targeted to build future value should be particular interest to shareholders.  Information about ability of the compensation consultant to provide services beyond mere pay survey comparisons might also help shareholders determine whether the board has been adequately advised.
  • Company Specific Evaluation: Companies should obtain regular feedback from their shareholders on how the market evaluates the job they are doing on executive compensation.  Directors would benefit from both interaction with large, sophisticated shareholders and from advisory shareholder votes that provide information from all shareholders, including those not in direct communication with the board.  Shareholder advisory votes on compensation plan disclosures currently used in the UK, Australia and several other countries have been effective in providing boards with this information.  These votes also ensure that directors receive an unvarnished market reaction that is not filtered by intermediaries (e.g., management, compensation consultants or politically motivated shareholders) with potentially conflicting interests.
  • Gratuitous Compensation: The underlying fiduciary duty of directors precludes them from giving away compensation without receipt of some benefit to the company.  Compensation received through option awards should be evaluated in combination with other compensation (e.g., change in control payments, retirement awards, perks, etc.) to ensure each form of compensation is procuring an added benefit for the company that is consistent with shareholder interests.  Complex compensation schemes, duplicative awards under annual bonus and long-term incentive plans and redundant rewards to different executives for the same achievement are areas particularly ripe for evaluation in this regard.  Differentiating between operational and strategic goals could also help identify redundancies in executives' responsibilities and flag related compensation payment waste.
  • Clawbacks: Failure to include provisions in option plans to recover awards improperly made for meeting financial or performance targets that are subsequently restated should be treated as a red flag.  Aversion to clawbacks raises questions about integrity and whether the compensation plan is aligned with the interests of shareholders.



Option policies cannot be designed or evaluated in a vacuum.  They fit into a broader context and should be viewed on a company specific basis as part of an overall compensation plan.  One way to improve option plans would be to encourage clear communication about their design to the marketplace and facilitate direct shareholder response at each company.  The SEC disclosure requirements and implementation of an advisory shareholder vote on executive compensation would provide a market based process to help identify best practices over time.  However, success will depend on how boards, shareholders and consultants implement their responsibilities on a company-by-company basis.  Attention to the issues set forth above would help make the process more effective.






This Forum program is open, free of charge, to all shareholders of the invited corporate participants, and to any fiduciaries or professionals concerned with the investment decisions of those shareholders, according to the posted Conditions of Participation.  The Forum's purpose is to provide shareholders with access to information and a free exchange of views on issues relating to their investment interests described in the Forum Summary As stated in the Conditions, all Forum participants are expected to make independent use of information obtained through the Forum, subject to the privacy rights of other participants.  It is a Forum rule that participants will not be identified or quoted without their explicit permission.

This Forum program has been organized with the support of Hermes Equity Ownership Services, Ltd.  It is the first in an expected series that will be managed by a not-for-profit “Institute” to be established for the purpose of continuing the Forum programs conducted by Gary Lutin.

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