The Corporation: EXECUTIVE COMPENSATION
`RELOADS': STOCK OPTIONS THAT KEEP ON GIVING
Here's how they work--and why they have their critics
They're the gifts that keep on giving. "Reload," or "restoration," stock options are gaining favor as a way for companies to boost executive stock ownership. Another likely reason they're hot: The best-known recipient of reloads--Sanford I. Weill, CEO of Travelers Group Inc.--is one of Corporate America's wealthiest CEOs. In 1997, he topped BUSINESS WEEK's Executive Pay survey with compensation of $230.7 million, some $220 million of which came from the exercise of reload options. Weill has been one of BUSINESS WEEK's 10 best-paid CEOs since 1992. "I love reload options," exults Weill.
What, exactly, is a reload, and how does it differ from a regular stock option? A normal option disappears when it is exercised, or turned in for stock. But a reload, in its simplest form, is a bonus of stock options that a company gives its executives when they convert existing options into shares. The goal is to get executives to exercise options early and hold them as shares so that their wealth is more tightly linked with that of stockholders. Used as a reward, reloads effectively give executives an automatic refill from the options piggy bank.
While a good idea in theory, in reality reloads--like many other quirky elements of executive pay--are wide open to abuse. By encouraging an executive to lock in profits earlier than he or she might have done otherwise, reloads take some risk out of the pay process--the risk that stock-based pay was supposed to create in the first place. Although the reload is always for fewer options than the original grant--and executives must "buy" those options by tendering shares they own--it allows them a hedge that shareholders don't get.EXECUTIVE PRIVILEGE. What's more, reload decisions occur without the input of the compensation committee on the board of directors. Unlike regular option grants, which are awarded by the board every year or two to reward a job well done or provide incentive to improve performance, with reloads, the board only makes a decision once--at the original grant. The reloads happen whenever the executive thinks they are appropriate. "Fundamentally, you are depriving the compensation committee of discretion," says James E. McKinney of pay consultant Hirschfeld, Stern, Moyer & Ross Inc.
As a result, reloads are controversial. "The greatest thing to happen to stock options since they were invented is the reload," says Frederic W. Cook, president of pay consultant Frederic W. Cook & Co. Counters Alan M. Johnson, managing director at Johnson Associates: "They're horrible."
First used by Norwest Corp. in 1988, reloads were included in 17% of new stock option plans in 1997, up from 14% in 1996, according to the Investor Responsibility Research Center (IRRC). Besides Travelers, companies such as Bell Atlantic, Toys `R' Us, Sara Lee, and The McGraw-Hill Companies, parent company of BUSINESS WEEK, have added them to their executive pay arsenal.
Until now, reloads haven't been the focus of much investor outcry. But that could change: A 1996 survey by the IRRC showed that nearly 50% of institutional investors said they might oppose a plan. "We're generally not in favor of them," says Michael P. McCauley, corporate affairs manager at the Florida State Board of Administration, a $74 billion pension fund. Reloads "convolute the whole [pay] plan, and there are no restrictions."
Here's how it works. Say an executive owns 1,000 shares and holds 1,000 options granted at $10, with a 10-year life. Five years later, the stock has risen to $20. So the options have a gain of $10,000. Now, a three-step transaction occurs: The executive uses 500 of his 1,000 shares--also worth $10,000--to exercise the 1,000 options. Those are then converted back into 1,000 shares. His reward for changing all his old options into stock is 500 new options set at the new market price of $20 with a five-year term.
Now, the executive holds 1,500 shares and 500 new options instead of 1,000 shares and 1,000 options. If the stock price falls back down--to $10, for example, putting the options under water--the 1,500 shares are still worth $15,000, vs. the $10,000 without reloads. "He has dividends and voting rights," says Cook, "and he has insulated himself a little bit to a stock price decline." Also, he still has options to capture future jumps.
Reloads give executives the same tax advantage that they get from converting normal options into shares. Although they must pay ordinary income tax on the original options profit, once the options become shares, any future appreciation will be taxed at the much lower capital-gains rate. The 1997 lowering of that rate means that if the shares are held for at least 18 months, the taxes could be 19 percentage points lower.BLOOD OATH. The complexity of reloads makes them vulnerable to different interpretations. The Financial Accounting Standards Board, for example, considers reloads new options. But Travelers Group says that all of Weill's 7.1 million existing reload options--and many of his 14.8 million shares--have come from one original grant of 3.6 million options in 1986. The stock has split six times. But how can the options still exist, since the original term was for 10 years? As Weill exercised his options, many of his reloads magically gained a new lease on life: Their terms were extended for another 10 years when the original options were exercised. So rather than expiring in 1996, the terms of his options last until 2002 and 2003. Says a Travelers spokeswoman: "[Weill] is a firm believer that we should all be as large owners as we can be."
There is an end in sight. Travelers changed its policy in 1995, so the last of Weill's reload options is set to expire in 2003. Unlike many executives, however, Weill is not able to take the money and run. Senior management and the board have agreed to a "blood oath" in which they promise not to sell any stock until they leave the company. "[Weill] does eat his own cooking," says compensation expert Graef S. Crystal. "I just wish he would stop playing so many [reload] games." At most companies, however, holding the stock isn't a requirement. So the reload lets the exec cash out whenever he or she likes and still have the chance to make money if things improve.
While not every executive can perpetually reload his or her options, all can use them to hedge volatility. Johnson says the biggest potential abuse comes when a company's stock jumps up and down but doesn't post any gains over the option's life. Reloads let executives convert to stock when the price is up, and then do so again on subsequent bounces. A normal options holder could cash out once, but he would lose the chance to profit from future upticks. "They can capture a temporary gain and still have the options in place," says Johnson. Multiple transactions let execs do this without losing any money.
Ironically, reloads--marketed as a way to get executives to hold stock--are gaining popularity at a time when CEO levels of stock ownership are already rising to record levels, thanks to the general boom in stock-based pay. "If all these executives already have [high ownership levels]," says Eric P. Marquardt, senior vice-president of pay consultant Compensation Resource Group, "what is it that the company is promoting by doing this?" Good question.By Jennifer Reingold, with Leah Nathans Spiro, in New YorkReturn to top