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.