IBM Ends Director Stock Options as Payment in favor of Retainers

A few weeks ago, we discussed Yahoo!'s policy of compensating directors and potential problems, as well as our suggestion of the importance of outside directors having "skin in the game." Today, the WSJ reports of IBM's decision to get rid of stock options in favor of paying directors a retainer. We agree with Professor Elson that stock ownership does better align directors with shareholders. The solution, again, is that directors be required to purchase meaningful amounts of stock themselves (not through grants) and then be paid in cash. Read more on our suggestions here. The full story is listed below.

IBM Ends Director Stock Options,Spotlighting Popular Perk's Decline

By JOANN S. LUBLIN and WILLIAM M. BULKELEY

December 21, 2006; Page A1

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 problems.

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 about it.

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 management.

"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 said.

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 boom.

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 compensation.

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 the board.

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 share.

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 director compensation.

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 Holdings Corp.

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.

--Charles Forelle contributed to this article.

Write to Joann S. Lublin at joann.lublin@wsj.com and William M. Bulkeley at bill.bulkeley@wsj.com

Sphere: Related Content