One question facing public companies is whether or not to implement a stock ownership policy for its senior executives. In essence, a stock ownership policy requires each covered executive to hold a specified minimum amount of company stock. Corporate governance reform advocates routinely call for companies to establish stock ownership requirements including imposing hold until retirement (HTR) policies for equity awards held by company officers (see for example the September-October 2008 issue of The Corporate Executive). As a result of the on-going dialogue on this issue, I wanted to proffer the following concept for consideration by public companies and practitioners.

More specifically, the concept is for public companies to consider implementing a policy of requiring its senior executives to exercise vested nonqualified stock options which have an intrinsic spread value (i.e., the difference between employer stock price and option exercise price) that exceeds a specified threshold percentage or value. Such a policy could be adopted whether or not the company has stock ownership or HTR requirements.

So, the basic idea is that vested in-the-money nonqualified stock options would be automatically exercised once their spread value exceeded a predetermined amount established by the employer. The threshold amount that would trigger the automatic exercise could be expressed either in relative or absolute terms. And, the threshold value could of course be specified as a historical average (e.g., ten day trading price average of employer shares) if desired to avoid hair-trigger option exercises resulting from a temporary upward spike in prices. While in today's generally bearish stock market, a mandatory option exercise policy may not be as apt to currently trigger many option exercises, let’s nevertheless examine the potential benefits of a mandatory option exercise policy (which could be more applicable upon a return to a bullish or even normal stock market in which prices typically rise over time).

Potential Benefits to Employer

  1. Greater alignment of executives' interest with shareholders since executives' equity holdings would inevitably be weighted more to stock, rather than option, ownership. Option holders, while generally in alignment with the interests of shareholders are nevertheless in a different class of securities than shareholders and an option holder's capital is not truly at risk until the option is exercised. Until option exercise, an option holder arguably is viewing the option purely as a compensatory instrument whereas post-exercise, he/she really has become an investor with respect to his/her acquired shares in the same way as other shareholders who are not service providers.
  2. Executives, by virtue of their option exercises, would arguably be more invested in their employer since their capital (even if the executive’s holdings were only comprised of after-tax shares obtained from option exercises) would now be at risk. Executives would perhaps be less likely to engage in overly risky business strategies to maximize their option spread (as might be the case if options constituted the bulk of their holdings since options can provide a leveraged opportunity to maximize returns without risking capital).
  3. In the tax year of the option exercise, the employer would receive an income tax deduction for the amount of option spread value at the time of option exercise. This can provide a nice cash flow benefit for the employer since the tax deduction can create a direct positive cash inflow with no corresponding direct cash outlay.
  4. If the option contained a "net exercise" provision and if this feature was utilized, then there could be a reduction in shareholder dilution and, assuming a share recycle provision in the underlying stock plan, more shares would become available for future grants to other employees. Of course, one drawback for the employer if a net exercise is effected is that the employer must make a cash outlay to cover the tax withholding that is due under the option exercise.
  5. While I am not an accountant, the FAS 123r expense amount for a stock option with a mandatory exercise feature upon attaining a specified spread value would perhaps be reduced because the assumption for the expected life of the option could have a shorter time span than an option that did not contain such a feature. Ceteris paribus, this would result in lower FAS 123r amounts which translate to lower financial accounting costs for the employer’s option compensation program.
  6. As discussed below, the employer can end up better preserving the income tax deductibility of change in control contingent payments that are made to executives that could be otherwise lost as a result of the federal golden parachute excise tax rules.

Potential Benefits to Executive 

While normally an option holder wants maximum flexibility as to when he/she can exercise his/her stock option, there are some potential benefits for executives too.

1. The exercise of the in-the-money nonqualified stock option will mean that the executive has a higher amount of compensation reflected in his/her year-end Form W-2. This can be beneficial to both employer and executive in the event that the employer experiences a change in control thereby triggering potential application of golden parachute exercise taxes under Internal Revenue Code Sections 280G/4999.

In particular, the executive's "base amount" (which is an average of the executive's prior five year compensation) under section 280G would be higher (due to the option exercise(s)). A higher base amount will reduce or even eliminate the imposition of parachute excise taxes. Moreover, an executive who does not have excise tax gross-up protection will presumably be more apt to be supportive of a potential change in control transaction if he/she believes that there will be minimal or no excise taxes imposed on his/her change in control payments.

And, avoiding or reducing excess parachute payments also helps the employer since excess parachute payments cause the loss of income tax deductibility that result from such parachute payments. Furthermore, higher base amounts means that employers who provide excise tax gross-up protection can presumably report lower estimated parachute values in their annual proxy statement disclosure of potential change in control payments to named executive officers.

2. A pre-arranged mandatory option exercise coupled perhaps with a related sale/share withholding net exercise of the acquired shares could be implemented through a Rule 10b5-1 trading plan or program. This can provide the executive with an affirmative defense to allegations of unlawful insider trading.

While a mandatory nonqualified option exercise program presumably would represent a new arrangement at most, if not all, public companies and would likely be met with resistance by executives who would prefer unfettered control as to when/whether they exercise their stock options, such a policy can potentially generate benefits to both employer and employee. With sufficient education on the merits of a mandatory option exercise policy, employers can potentially benefit from such a policy and executives can recognize that such a policy can be consistent with their employer's best interests similar to other executive compensation policies.