Disturbing Trends from RiskMetrics’ Model

Disturbing Trends from RiskMetrics’ Model

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Well, I’ve now seen enough RiskMetrics (RMG) models after the 9/1/2009 quarterly lock-in date that I can tell you that there is trouble brewing.

First, the valuation of stock options (and SARs) under RMG’s binomial option pricing model has climbed dramatically in relation to the stock price.  Just what exactly do I mean by that??? Well, what we’re talking about is the economic value assigned by the RMG model to shares available for grant as stock options under new or existing and continuing plans.  Primarily due to the surge in volatility both in late 2008 and then again through 2009 as the market regained 10,000, the value generated by the binomial model has grown. Volatility is one of the key inputs into the binomial model and as it increases, so does the value of the stock option.

OK, so how bad are things looking? Well, based on the companies I’ve worked with so far, I have yet to see a company where one full value award (an award other than a stock option or SAR that is settled with shares) equaled 2 or more stock options.  Put another way, in all the companies I’ve seen so far, less than 2 stock options equal the value of one full value award (which is set at the 3 month closing stock price). Note that last year, seeing this equation at just 2 stock options equal to 1 full value award was almost unheard of, the vast majority of companies’ had 2+ stock options equal 1 full value award.

In practical terms, as the value of stock options has grown (on a relative basis compared to the stock price) the number of new shares that companies can get approved under the RMG model has dropped. So many companies are in a real share squeeze under the RMG model, that I think RMG will be forced to make some major concessions again this year and tweak the operation of its policies in order to avoid the loss of credibility.

Last year, as you’ll recall, as a result of the precipitous stock price decline of many companies, RMG revised its methodology for determining volatility and stock price:

  • Volatility – prior to 12/1/08 RMG used the 200-day volatility, annualized in its model. After 12/1/08, RMG used the 400-day volatility, annualized in the model.  This change helped by generally lowering volatility (but volatility still increased compared to that measured on 9/1/08).
  • Stock Price – prior to 12/1/08, RMG used the 200-day average closing stock price. After 12/1/08, RMG used the 3-month closing average stock price. This generally caused companies to have lower market values under the model, and helped lower the valuation of stock options and full value awards alike.

I’ve heard a rumour that RMG might be looking at pushing out the period of time it uses to measure performance from 3 years to 5 years.  It is unclear which of the many performance measurements this would impact, but it could include: the 3-year TSR performance used within each4-digit GICS industry group to help determine the top quartile performers upon which RMG bases its regression formulas for determining companies’ allowable caps; it could be the performance measured in the pay for performance policy (1- and 3-year TSR compared to 4-digit GICS industry median); or something entirely different. Apparently RMG received feedback from the survey it conducted this past summer that indicated a number of its clients regarded 5 years as the proper measure of long-term performance.

Even if this change does not get made, RMG still must determine what to do concerning the stock price and volatility.  Last year when RMG modified the way it calculated these figures, it indicated that it would revisit them in a year and determine what it would do, i.e., keep the new methodology, return to the old methodology, or, perhaps, do some further modifying of things (the last is only my speculation at this point).  We’ll have to wait until RMG releases its policy updates (hopefully the week before Thanksgiving this year) to see just exactly what will change, but I bet that the methodology for determining these and other figures must change or RMG could be in a position where its model would otherwise recommend against the majority of companies, instead of just the 30% or so of proposals that it tries to target for failing the model. So stay tuned, as new developments come in, I’ll blog about them here.

Second, the allowable caps being generated by the model when coupled with the high amounts of overhang at many companies are causing much pain when it comes to seeking additional shares.  In many cases companies could not even pass with the shares they currently have available.  In other words, most companies are looking at not being able to get any additional shares and have the RiskMetrics model approve of the share request. I have dealt with some that the model would permit to get additional shares, but for the most part, the amounts that pass the model are down from prior years. Specifically, in my experience, the 15% simple dilution threshold often was far below the shares that the RMG model would approve.  Now the reverse is true.  This puts companies in a precarious position – they’re unable to ask shareholders to approve shares with a proposal that will receive a FOR vote recommendation from RMG.  What to do? There are a number of strategies to consider.  I will discuss several of the more significant ones at the upcoming NASPP conference in San Francisco with a panel of other experts in our presentation, Top Tips to Ensure Shareholder Approval of Your Stock Plan (on November 10 at 2:00 pm local). For more information about the NASPP conference, please visit: www.naspp.com

Next week I’ll take a look at some of the plan features that can cause problems with RMG, as well as some of the other policies you should be aware of for the 2010 proxy season.

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Equity Plan Proposal Update – 9/11/09-9/30/09

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Sorry for the delay in posting this, but things are starting to get busy as more companies turn to preparing for asking shareholders to approve shares for their equity plans next year.  Below you’ll find details about the equity plan proposals submitted by Russell 3000 companies during the period 9/11-30/2009. I’ve included their name, plan name, proposal type (New = new plan being proposed, Amend = amendment of existing plan, and A&R = an amendment and restatement of an existing plan), the scheduled shareholder meeting date, and the % of Common Shares Outstanding (net new shares) represented by the share request:

Company Plan Name Proposal Type Sh Mtg Dt % of CSO
Allis-Chalmers Energy Inc. 2006 Incentive Plan A&R 11/6/2009 8.18%
Archer Daniels Midland Co. 2009 Incentive Compensation Plan New 11/5/2009 4.67%
Cell Therapeutics 2007 Equity Plan Amend 10/20/2009 8.04%
Cisco Systems Inc. 2005 Stock Incentive Plan A&R 11/12/2009 3.61%
First Marblehead Corp. 2003 Stock Incentive Plan A&R 11/16/2009 4.03%
Harris Stratex Networks, Inc. 2007 Equity Plan A&R 11/19/2009 9.17%
Hi Tech Pharmacal Co. Inc. 2009 Stock Option Plan New 11/12/2009 4.23%
Huntsman Corp. Stock Incentive Plan Amend 11/4/2009 4.64%
II-VI Inc. 2009 Omnibus Incentive Plan New 11/6/2009 5.42%
KLA Tencor Corp. 2004 Equity Incentive Plan A&R 11/4/2009 6.44%
LSI Industries Inc. 2003 Equity Compensation Plan Amend 11/19/2009 7.28%
Matrix Service Company 2004 Stock Incentive Plan Amend 10/23/2009 4.20%
Mercury Computer Systems Inc. 2005 Stock Incentive Plan A&R 10/21/2009 6.38%
Meredith Corp. 2004 Stock Incentive Plan A&R 11/4/2009 7.74%
Myriad Genetics Inc. 2003 Employee, Director and Consultant Stock Option Plan Amend 11/5/2009 3.12%
Oplink Communications Inc. 2009 Equity Incentive Plan New 11/4/2009 6.81%
Parker Hannifin Corp. 2009 Omnibus Stock Incentive Plan New 10/28/2009 3.42%
Saba Software Inc. 2009 Stock Incentive Plan New 11/18/2009 10.41%
Western Digital Corp. 2004 Performance Incentive Plan A&R 11/11/2009 6.44%

Some observations about these plans:

  • I’ve noticed that a few companies that amend an existing plan choose to only put the plan language that was amended into their proxy.  That is fine if they want to save space and thus fees associated with printing and distribution of the proxy. However, it does make it more difficult for shareholders to find the existing plan document to be able to understand the amendments in context of the broader plan.  So, if a company wants to save money and only include the amendments, they could make it easier for their shareholders to find the plan by posting their plans on their website, something akin to what they do know for their corporate governance documents. Having done so, they could then simply include a simple line in the text of the proxy proposal indicating the URL where the entire plan (possibly marked to show the changes?) can be found on the company’s website.
  • It is almost a dead tie in these plan proposals for treatment of Full Value Awards (awards other than stock options or stock appreciation rights that are setlled in stock) – about half set no limit on the number of shares that can be granted as Full Value Awards, while the other half used a Flexible Share Pool approach (stock options and SARs count as 1 against the plan’s share authorization while Full Value Awards count at a higher rate against the share authorization). Of course, there was one company that opted to use a good old fixed limit on the number of shares that can be granted as Full Value Shares (let’s hope they don’t end up with too many left-over stock options that they can’t use).
  • At least one company appears to be setting things up to utilize the RiskMetrics’ exemption for in-the-money stock options that have been outstanding greater than 6 years.  Another company that has provided such disclosure was the Walt Disney Company.
  • It looks like a couple of these companies failed RiskMetrics’ Burn Rate Test and had to commit to maintaining their burn rate at a set level for the next 3 years as this was set out in the plan proposal.
  • At least one plan has no limit on Full Value Awards and yet was written so that liberal share counting was prohibited (not typically necessary under the RiskMetrics ISSue Compass model and SVT Cost Policy).  This could cause the plan to run out of shares sooner than if such language was included.

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Plan Proposal Roundup – Week of 9/7/2009

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Looking at the proxy statements that were filed last week (9/7/2009), here are the new plans and amendments that I found (Company, plan name, (date proxy filed) and [share request as a percent of Common Shares Outstanding as of the record date/disclosed in the proxy or 10-K or latest 10-Q]):

New Equity Compensation Plan Proposals

  • Avalon Holdings Corp., 2009 Long-Term Incentive Plan (9/9/2009), 34.2%
  • Phazar Corp., 2009 Equity Incentive Plan (9/10/2009), 11.9%
  • Secure America Acquisition Corp., 2009 Stock incentive Plan (9/9/2009), 9.6%
  • Stone Tan China Acquisition Corp., 2009 Incentive Plan (9/8/2009), 6.1%
  • Sysco Corp., 2009 Non-Employee Directors Stock Plan (9/11/2009), 0.1%
  • Winn Dixie Stores Inc., 2010 Equity Incentive Plan (9/8/2009), 11.2%

New Equity Compensation Plan Amendment Proposals

  • Angidynamics Inc., 2004 Stock and Incentive Award Plan (9/9/2009), 3.1%
  • Arcadia Resources, Inc., 2006 Equity Incentive Plan (9/9/2009), 6.1%
  • Access Integrated Technologies, Inc., 2000 Equity Incentive Plan (9/11/2009), 4.6%
  • Blue Coat Systems Inc., 2007 Stock Incentive Plan (9/8/2009), 5.0%
  • Brigham Exploration Co., 1997 Incentive Plan (9/9/2009), 12.0%
  • Concurrent Computer Corp., 2001 Stock Option Plan (9/11/2009), 6.0%
  • Cowen Group, Inc., 2007 Equity and Incentive Plan (9/10/2009), 7% of post-transaction CSO
  • Gulfstream International Group Inc., Stock Incentive Plan (9/9/2009), 10.1%
  • Matrix Service Co., 2004 Stock Incentive Plan (9/11/2009), 4.2%
  • Noble Corp., 1991 Stock Option and Restricted Stock Plan (9/11/2009), 1.4%
  • Oragenics Inc., 2002 Stock Option and Incentive Plan (9/10/2009), 8.3%
  • SCM Microsystems Inc., 2007 Stock Option Plan (9/10/2009), 8.0%
  • Sysco Corp., 2007 Stock Incentive Plan (9/11/2009), 4.2%

Some interesting items from these plan proposals:

  • At least two of the plans (1 new and 1 amendment) use a flexible share authorization; the amended plan is seeking to change the Full Value Award Count from 1.5 shares to 1.25 shares (their stock options are now worth more relative to their stock price than when the plan was first put in place);
  • Several of the proposals were on proxies that also had proposals that would impact the share proposal in some way, e.g., proposals to increase the total number of authorized common shares. A number of these proposals explained the implications for the plan proposal if these other proposal(s) were and were not approved;
  • At least one of the plans uses an evergreen type provision so that the share authorization is equal to the lesser of (i) a fixed number, or (ii) a percent of the common shares outstanding at any time;
  • A couple of these companies had multiple classes of stock, and the second class of stock typically had a higher number of votes per share. Therefore on a vote dilution basis, the dilution from some of the  above proposals would be lower;
  • At least one amendment including adding Fidelity requirements, e.g., the 5% of the plan’s shares carve-out pool to permit awards to be granted not in compliance with the Fidelity requirements;
  • One of the proposals included a rolling 3-year burn rate limit of 1.5%. Most likely this was needed it in order to overcome RiskMetrics Group’s Burn Rate policy which would have otherwise caused a negative RMG vote recommendation against the proposal.

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CEPI Issues Draft Report on Global Stock Plans

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Last week, the Certified Equity Professional Institute (CEPI) at Santa Clara University released a draft version of its 2009 research project – GPS | Global Stock Plans. “GPS” stands for Guidance, Procedures, and Systems. The draft research report is open for public comment until September 30, 2009

The report covers several different areas of global plan design and administration, and includes “Action Items” at the end of each section to emphasize what a company should consider from a global plan perspective. Several charts laying out processes and responsibilities are also included. Also includes a glossary of common equity compensation terms in the Appendix.

Some of the suggestions detailed in the report include:

  • Undertake country-specific due-diligence to understand the cost of a plan before making final design decisions;
  • Any equity plan should incorporate flexibility to accommodate the needs of non-US locations;
  • Determining the local legal and filing requirements for plan awards;
  • Following global plan “best practices” in order to ensure a plan operates and functions better.

You can find a copy of the report at:

www.scu.edu/business/cepi/gps_draft_releases.cfm

For more information about the CEPI, visit its website at:

www.scu.edu/business/cepi/

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