Download Having Your Options and Eating Them Too

Having Your Options and Eating Them Too: Fences, Zero-Cost Collars and
Executive Share Options
Paul U Ali
Postdoctoral Research Fellow
University of Queensland
Geof Stapledon
Faculty of Law, University of Melbourne
Principal, Institutional Analysis, Melbourne
[Published in (2000) 18 Company and Securities Law Journal 277-282]
Introduction
The vast majority of senior executive compensation packages include entitlements to
share options issued under an Executive Share Option Plan or “ESOP”. It is
increasingly common, especially at the chief executive and chief operating officer
levels of major corporations, for these entitlements to dwarf the cash component of
the compensation package.
Participation in an ESOP, like the award of cash bonuses, is designed as a reward for
superior managerial performance. Unlike cash, the ESOP performs the important role
of aligning managerial self-interest with the interests of the company’s shareholders.
A properly designed ESOP achieves this by linking managerial performance and thus
remuneration to the creation of shareholder wealth – since the ultimate value of the
ESOP options awarded to the executives depends on the value of the company’s
shares.
This linkage endures for only so long as those options are retained by the executives.
Accordingly, ESOPs impose a number of restrictions on the exercise or disposal of
ESOP options, the most important of which is the “vesting period” during which
exercise or disposal is banned. Now the very instrument – the option – that has made
this linkage possible is capable of being utilised by executives to circumvent the
vesting period.1
This note focuses on combinations of options known as “fences” and “zero-cost
collars” – which are being resorted to with increasing frequency by executives in the
United States to crystallise the value of their ESOP options.2 The first part of this
note explains the operation of these devices, while the second part discusses the
regulatory and corporate governance implications.
Executive share option plans and derivatives
Since the alignment of managerial and shareholder interests endures only for so long
as the ESOP options are retained by the executives, the ESOP will invariably
prescribe a vesting period during which the participating executives are not permitted
to exercise, transfer or otherwise deal with their options.3 On the expiry of this
2
vesting period, the executive is free to exercise the options. Commonly, the ESOP
will permit the options to be exercised at any time during a further specified period,
following the expiry of the vesting period.
Thus, the executive is prevented, during the vesting period, from using the ESOP
options to capitalise on short-term spikes in the market price of the underlying shares.
Further, the executive is fully exposed to the risk that that share price may on expiry
of the vesting period – and for some time afterwards – be lower than the strike price
of the ESOP options. Should that eventuate, the options may expire worthless.
Derivatives, and in particular the options the subject of this note, provide a
straightforward means of “managing” the risk that the ESOP options will expire
worthless, by enabling the executive to extract value from the ESOP options and lockin gains on the underlying shares, ahead of the time at which the ESOP options can be
exercised. This unlocking of value, coupled with the avoidance of the risks described
above, constitutes a powerful economic incentive for executives to use these
instruments.
This benefit to the executive is, however, accompanied by a countervailing detriment
to the company. By using derivatives to extract value or lock-in gains, the executive
is insulating his or her equity interest in the company from the price fluctuations to
which the other shareholders are subject. This effectively severs the link between
managerial performance and shareholder wealth and consequently destroys the
economic rationale for the issuance of ESOP options to the executive. 4
Fences and zero-cost collars
Fences, and in particular the sub-set known as “zero-cost collars”, have emerged as
the derivatives instrument of first-choice for executives in the United States wishing
to crystallise the value of their ESOP options.5 The key attraction of the fence is that
it permits that value to be locked-in or realised without the need for a significant
outlay of cash on the part of the executive.
A “fence” is an option strategy involving the simultaneous purchase of a “protective
option” and the sale of a “covered option”, with the premium payable on the former
being offset by the premium received on the latter.6 These three terms are best
explained by reference to an example. 7
Assume a senior executive of a company has been issued 100,000 ESOP options, each
entitling the executive to purchase a share in the company at $10.00 per share against
a current market price of $5.00. And assume the vesting period for the options is two
years.
Selling covered options
The simplest means by which the executive could immediately extract value from the
ESOP options is by selling (or “writing”) matching “covered” European call options
at a strike price of $10.00 with a maturity of two years.8 The European call options
are “covered” in the sense that they are being written over a position held by the
3
writer. By mirroring the ESOP options, the covered call options will allow the
executive to crystallise the time value of the ESOP options.9
If, at the end of the two-year period, the market price of the company’s shares is
below $10.00, both the ESOP and the covered call options will expire worthless, but
the executive will retain the premium paid by the holder of the covered call options.
If, however, the market price is $20.00, both sets of options will be exercised. The
executive will, on the exercise of the ESOP options, make a profit of $1,000,000 (ie
buying 100,000 $20.00 shares for $10.00 each). On the other hand, the executive will
be obligated to deliver to the holder of the covered call options 100,000 shares that are
worth $20.00 each for $10.00 each (thus making a $1,000,000 loss).10 The profit on
the ESOP options will cancel out the loss on the covered call options, leaving the
executive, again, with the amount of the premium received on writing the covered call
options.
Buying protective options
A major disadvantage with the above strategy is that the executive has, in exchange
for immediately crystallising the value of the ESOP options, given up his or her
ability to benefit from any appreciation in the share price above the $10.00 ESOP
strike price. Irrespective of the movement in the company’s share price, the net
position is that the value extracted from the ESOP options is limited to the premium
received from the sale of the covered call options.
An alternative strategy involves the purchase of protective put options over the
company’s shares (“protective” since they lock-in or protect a position). Protective
put options do not, on their own, extract value from ESOP options but they do enable
an executive to lock-in price gains on the company’s shares during the ESOP vesting
period.
For example, if the price of the shares were to rise to $15.00 during the vesting
period, the executive could purchase protective put options with a strike price of
$15.00. This would immediately lock in a price of $15.00 but would not require the
executive to forego the benefit of any further appreciation in the share price, say to
$20.00, as regards the ESOP options. However, this time it is the executive who will
be paying the premium. Locking in the current market price, especially where that
price is volatile, is likely to attract a significant premium. Thus, the gain above the
$10.00 ESOP strike price that the executive wishes to lock-in must be assessed
against the cost of buying that level of protection and its impact on the potential gains
from exercising the ESOP options. Returning to the example, if, on the vesting date,
the share price reaches $20.00, the put options will expire worthless and the gain of
$1,000,000 on the exercise of the ESOP options may be substantially eroded by the
premium paid to the seller of the put options.
Constructing fences and zero-cost collars
The fence, by combining the two strategies described above, removes the need for the
payment by the executive of a significant up-front premium. Another benefit for the
executive is that s/he is not required to bargain away the entire benefit of any
appreciation in the price of the underlying shares.
4
A fence might involve, for instance, the executive selling covered call options with a
strike of $20.00 and purchasing protective put options with a strike of $15.00, with
maturities that match the ESOP options, where the market price of the shares is
$15.00.11 If the market price for the shares on the vesting date is below the ESOP
exercise price of $10.00, say $5.00, the ESOP options and the covered call options
will expire worthless. However, the protective put options will deliver a net profit of
$1,000,00012 as adjusted for the difference between the put and call option premiums.
If, on the other hand, the market price for the shares reaches $30.00 by the vesting
date, the protective put options will expire worthless. The executive will accrue a
profit of $2,000,000 on the ESOP options 13 and a loss of $1,000,000 on the covered
call options,14 leaving a net profit of $1,000,000 as adjusted for the difference
between the put and call option premiums.
Recalling that the market price is $15.00 when the executive constructs the fence, the
put option leg of the fence permits the executive to lock-in the gain of $5.00 on the
underlying shares, with that protection being funded by the premium received in
respect of the call option leg. While the fence will not prevent the executive
benefiting from any future appreciation in the share price, it will, in this example, cap
the potential gain at $10.00 per share. As noted above, what makes fences attractive
is the fact that the cost of one leg is off-set by the proceeds of the other; the extraction
of value from the ESOP options is used to finance the locking-in of gains or spikes in
the company’s share price during the vesting period. Further, fences can be
constructed with strike prices delivering both protection and up-side potential at no
cost – hence the name “zero-cost collar” – or even at a credit.15
Regulating the use of fences and zero-cost collars
There are few formal regulatory constraints on the use of fences and zero-cost collars
by executives during a vesting period.
No disclosure requirements
The substantive disclosure requirements of the Corporations Law do not apply to
cash-settled fences (including zero-cost collars):
•
Register of option-holders – disclosure is only required in the case of options over
unissued shares.16
•
Substantial shareholder and takeover provisions – both the substantial shareholder
provisions in Part 6C.1 of the Corporations Law and the takeovers prohibition in
section 606(1) are predicated on the acquisition of a relevant interest in voting
shares. If the fence is cash-settled there will be no question of that instrument
having conferred a relevant interest on the executive. 17
•
Disclosure to Australian Stock Exchange – section 205G(1)(a), which requires a
director of a listed public company to notify the ASX of relevant interests held in
the securities of the company or a related body corporate, does not extend to cashsettled fences. Similarly, section 205G(1)(b)(ii), which requires disclosure to the
ASX of contracts under which a director of a listed company is entitled to call for
5
or required to deliver shares in the company or a related body corporate, is, by its
terms, limited to physically-settled instruments.
Limited application of insider trading prohibitions
The prohibitions against insider trading in Pt 7.11, Div 2A can also be avoided by an
appropriately structured fence.18 As regards options over a company’s shares, the
operative definition of “securities” in that Division applies only to option contracts
under which “a party acquires from another party an option or right, exercisable at or
before a specified time, to buy from, or sell to, that other party a number of” shares or
units of shares in the company.19 It is considered that this definition does not extend
to cash-settled options.20 However, given the severity of the penalties for insider
trading, the executive may prefer to resolve any doubts about Div 2A’s application by
instead utilising a fence over an index that is strongly correlated to the performance of
the company’s shares (eg S&P/ASX 20, S&P/ASX Midcap Industrials, etc).21
Corporate governance concerns
The economic imperative for ESOPs is a matter of corporate governance. ESOPs are
one of several mechanisms that help to reduce “agency costs”. Agency costs exist in
large, widely held companies because the interests of those who run the company’s
business – the CEO and senior executives – do not always correspond with the
interests of the company’s shareholders.22 Because of this divergence of interests,
there is a risk that the executives may make decisions to advantage themselves at the
expense of the shareholders. For instance, the executives may act to entrench
themselves in office. Or the executives may implement business plans that, while
producing short-term gains for the company with a consequent increase in
remuneration (eg cash bonuses) for the executives, may not produce corresponding or
sustainable benefits for the shareholders. 23
ESOPs seek to limit any divergence between the interests of senior executives and
shareholders by aligning the wealth interests of executives with those of shareholders.
Providing leveraged equity interests, in the form of share options, to executives gives
them the same stake as shareholders in the consequences of executive decisionmaking – and thus considerably enhances the executives’ incentive to maximise the
wealth of the shareholders.24 Corporate governance guidelines invariably recommend
that ESOP options should be exercisable only if challenging performance criteria have
been met during the vesting period (or some part of the vesting period). For example,
the Combined Code appended to the FSA Listing Rules (which apply to UK
companies listed on the London Stock Exchange) recommends that consideration
should be given to hurdles which “reflect the company’s performance relative to a
group of comparator companies in some key variables such as total shareholder
return”.25 The UK’s Greenbury Committee urged that executives “should not be
rewarded for increases in share prices or other indicators which reflect general price
inflation, general movements in the stock market, movements in a particular sector of
the market or the development of regulatory regimes”.26
Corporate governance guidelines typically also recommend that ESOP options be
issued with a strike price at or above the current market price of the company’s
shares, the rationale being that indicia of managerial performance (eg increased
6
market share, increased profitability, curtailment of operating costs) will often be
reflected in the share price.27 Accordingly, superior managerial performance will
often mean that both shareholders and executives are rewarded – the former by the
higher share price and the latter because that higher share price will translate into an
increase in the value of the ESOP options. On the other hand, a slump in the
company’s share price occasioned by inferior managerial performance is likely,
among other things, to be reflected in a decline in the value of the ESOP options.
Bearing in mind that ESOPs are an important corporate governance mechanism, the
use by executives of fences and zero-cost collars is an alarming development. As
mentioned earlier, by using derivatives to extract value or lock-in gains, the executive
is insulating his or her equity interest in the company from the share price fluctuations
to which the other shareholders are subject. This effectively severs the link between
managerial performance and shareholder wealth and consequently destroys the
economic rationale for issuing the ESOP options to the executive in the first place.
The possible use of fences and zero-cost collars is a matter that – at a bare minimum –
should promptly be addressed in corporate governance guidelines.
1
See eg “Share Options”, The Economist, 3 April 1999.
R D Ellis, “Equity Derivatives, Executive Compensation, and Agency Costs” (1998) 35 Houston L
Rev 399 at 402-403; J C Bettis, J M Bizjak and M L Lemmon, “Insider Trading in Derivative
Securities: An Empirical Examination of the Use of Zero-Cost Collars and Equity Swaps by Corporate
Insiders” (Working Paper, Arizona State University, May 1999) pp 5-6; D M Schizer, “Executives and
Hedging: The Fragile Legal Foundation of Incentive Compatibility” (2000) 100 Columb L Rev 440; L
K Meulbroek, “The Efficiency of Equity-Linked Compensation: Understanding the Full Cost of
Awarding Equity Stock Options” (Harvard Business School, 2000), p 7.
3
Schizer, op cit n 2. This ban on early exercise is not usually absolute; however, such an exercise of
ESOP options will almost certainly be limited to exceptional circumstances. For example, where (a) a
successful takeover bid has been made for the company, (b) the company is to be delisted, and (c) the
major undertaking of the company is to be sold.
4
Bettis, Bizjak and Lemmon, op cit n 2, pp 2-3, 11-12.
5
Refer n 1.
6
See generally S Natenberg, Option Volatility and Pricing (McGraw-Hill, 1994), pp 258-265; T
Weithers, “Options Fundamentals” in J C Francis, W W Toy and J G Whittaker, The Handbook of
Equity Derivatives (revised ed, John Wiley & Sons, 2000), pp 28-30. Fences are also known as
“corridors”, “cylinders”, “range-forwards”, “risk reversals”, “split price conversions” and “tunnels”.
7
See Schizer, op cit n 2. Alternatively, the executive could extract value from the ESOP options by
selling cash-settled call options over the ESOP options (“call-on-call compound options”), giving a
third party the right to call for the cash equivalent of the ESOP options on the expiry of the vesting
period. Similarly, the executive could take advantage of gains in the company’s share price during the
vesting period by purchasing cash-settled put options over the ESOP options (“put-on-call compound
options”), giving the executive the right to put the cash equivalent of the ESOP options to a third party
on the expiry of the vesting period. See further K Ravindran, Customised Derivatives (McGraw-Hill,
1998), pp 129-141.
8
Aligning the expiry date of the covered call options with the end of the vesting period for the ESOP
options removes the risks of a settlement mismatch between the ESOP and covered call options since,
if the call options are exercised, the executive will be obligated to deliver the underlying shares or their
cash equivalent. Alternatively, the executive could sell a “Bermudan” option – that is, an option
exercisable not only on the expiry of the vesting period but at any time during the exercise period of the
ESOP options.
9
The premium received will also be affected by the current market price for the underlying shares, the
volatility of that price and prevailing interest rates: P Wilmott, Derivatives: The Theory and Practice of
Financial Engineering (John Wiley & Sons, 1998), pp 30-31.
2
7
10
The example describes a physically-settled option. The option could equally be cash-settled, with the
advantage that transaction costs (such as brokerage and stamp duty) will be avoided.
11
A fence that involves the sale of a covered call option and the purchase of a protective put option is
known as a “long fence” or “synthetic bull vertical spread”, while a fence that involves the sale of a
covered put option and the purchase of protective call option is known as a “short fence” or “synthetic
bear vertical spread”: Natenberg, op cit n 6, p 266.
12
ie Selling 100,000 $5.00 shares for $15.00 each.
13
ie Buying 100,000 $30.00 shares for $10.00 each.
14
ie Delivering 100,000 $30.00 shares for $20.00 each.
15
Natenberg, op cit n 6, p 266. Zero-cost collars are not, however, an exception to the truism that there
is no such thing as a free lunch. The option provider’s spread will be priced into the strikes for the put
and call option legs of the collar.
16
Corporations Law, s 170.
17
S Ansell, “The Application of Equity Derivatives in Mergers and Acquisitions” (1997) 15 C&SLJ
218 at 221. Section 609(6) specifically provides that futures contracts and exchange-traded options do
not create a relevant interest in securities prior to the obligation to make or take delivery of the
securities arising. It remains uncertain whether that is also the case with physically-settled over-thecounter equity options (which are not futures contracts: refer n 18, below). Nonetheless, the application
of Part 6C.1 and s 606(1) to physically-settled fences will only be an issue where the executive’s
acquisition of a relevant interest results (a) in the case of Part 6C.1, in the executive or someone else
beginning to have a “substantial holding” (defined as 5% or more of the total votes) in the company or
their existing substantial holding changing by at least 1%; or (b) in the case of s 606(1), in the
executive’s or someone else’s voting power increasing beyond 20%.
18
The prohibitions against insider trading in futures contracts in Pt 8.7 Div 1 do not apply to
physically-settled or cash-settled options over shares. The former are securities (see s 92(1)(e)) while
the latter are not “futures contracts”: see Sydney Futures Exchange v Australian Stock Exchange (1995)
16 ACSR 148 at 182-183 (per Gummow J) and 208 (per Lindgren J); Companies and Securities
Advisory Committee (CASAC), Law of Derivatives: An International Comparison (CASAC, Sydney,
1995), p 14; J Lawrence, “The Regulation of Derivatives and the LEPOs Litigation” (1996) 14 C&SLJ
90 at 94-95; M G Hains, “The Two-Sided Nature of a Futures Contract: Its Meaning and Relevance to
OTC Derivatives” (1997) 8 JBFLP 185 at 195-199. In addition, s 183(1) prohibits an executive from
making “improper use” of information acquired by virtue of his or her position to gain an advantage.
Section 183(1) is not limited to “securities” or “futures contracts”. Although it is directed towards
ensuring that officers and employees do not divert business opportunities presented to the company to
themselves, it could arguably apply where an executive has sought to extract the value of his or her
ESOP options on the basis of information that is confidential to the company.
19
Section 1002A(1).
20
Ansell, op cit n 17, at 225. See also CASAC, “Regulation of the OTC Derivatives Market” (CASAC,
Sydney, 1995), pp 73-74.
21
eg “Plan Sponsors Snap up Equity Collars” (Derivatives Week, 19 April 1999).
22
The seminal works on the “agency problem” are: A Berle and G Means, The Modern Corporation
and Private Property (revised ed, Harcourt, 1994), p 35; M Jensen and W Meckling, “Theory of the
Firm: Managerial Behavior, Agency Costs, and Ownership Structure” (1976) 3 J Fin Econ 305; E
Fama, “Agency Problem and the Theory of the Firm” (1980) 88 J Pol Econ 288.
23
F H Easterbrook and D R Fischel, The Economic Structure of Corporate Law (Harvard University
Press, 1991), pp 217-218; G S Rehnert, “The Executive Compensation Contract: Creating Incentive to
Reduce Agency Costs” (1985) 37 Stan L Rev 1147; H Mehran, “Executive Compensation Structure,
Ownership, and Firm Performance” (1995) 38 J Fin Econ 163; D Yermack, “Do Corporations Award
CEO Stock Options Effectively” (1995) 39 J Fin Econ 237; S M Quintero, L Young and M Baur,
“Executive Stock Options: Risk and Incentives” (1997) 10 J Financial & Strategic Decisions 59 at 5960, 68; L A Bebchuk and C Jolls, “Managerial Wealth Diversion and Shareholder Wealth” (National
Bureau of Economic Research, 1998), pp 2-4.
24
L De Alessi, “Private Property and Dispersion of Ownership in Large Corporations” (1973) 28 J Fin
839; M Stano, “Executive Ownership Interests and Corporate Performance” (1975) 42 S Econ J 272; P
Beck and T Zorn, “Managerial Incentive in the Stock Market Economy” (1982) 37 J Fin 1151; J
Brickley, S Bhagat and R Lease, “The Impact of Long-Range Managerial Compensation Plans on
Shareholder Wealth” (1985) 7 J Acc & Econ 115; A Agrawal and G Mandelkar, “Managerial
Incentives and Corporate Investment and Financial Decisions” (1987) 42 J Fin 823; Schizer, op cit n 2;
8
A Brooks, K Chalmers, J Oliver and A Veljanovski, “Issues Associated with Chief Executive Officer
Remuneration: Shareholders’ Perspectives” (1999) 17 C&SLJ 360 at 362-364.
25
FSA Listing Rules, The Combined Code, Sch A, para 4.
26
Directors’ Remuneration: Report of a Study Group Chaired by Sir Richard Greenbury (Gee
Publishing, London, 1995), para 6.39.
27
See, eg, the Practice Note issued by the former Australian Investment Managers’ Association:
Executive Share Option Schemes Guidelines (AIMA, Sydney, 1994), para 11: “Options should always
be issued with an exercise price at a premium to the current share price, which at least reflects the time
value of the option. The exercise price should never represent a discount to the current share price …”
Despite best practice recommendations of this nature, the strike price of ESOP options issued by some
listed Australian companies has been slightly lower than the market price of the shares at the time the
options were issued. The FSA Listing Rules prohibit a listed company from granting an ESOP option
with a strike price at a discount to the current market price unless prior shareholder approval has been
obtained: para 13.30. There are limited exceptions: para 13.31.