Are Stock Options Ideal for Execs?

Stock Options, Executive Pay, Long Term Incentives, Pay in the Mining Industry

The financial crisis in 2008/9 focused attention on executive incentives and whether in their efforts to earn higher compensation executive behavior created excessive, and in some cases, enterprise-jeopardizing risk. This led to to new regulations in multiple jurisdictions intended to limit this risk. Highly leveraged stock options were seen as the primary cause of high risk behavior.

The Enron and WorldCom situations resulted in the Sarbanes-Oxley Act in the U.S. and forced corporate boards to address weaknesses in financial controls to avoid overhyping the short term, to inflate compensation at the expense of long term stability and the shareholders.

In the financial services sector, overly leveraged pay programs led to inflated asset values and their ultimate collapse. The Economist Intelligence Unit estimated 70% of financial companies viewed “risk management failures” as a leading cause of the world’s then current economic problems.

The subsequent Toxic Asset Relief Program in the U.S., the Productivity Commission’s proposals in Australia, and the punitive incentive tax in the U.K. worked to further limited or control executive compensation. Risk started to be addressed in the “compensation discussion and analysis” portion of Management Information Circulars.

Stock options were widely favored by employers as a form of compensation as there was no cost to the company; the market funded any upside gain and initially no requirement to expense the cost although that was remedied through revised accounting rules. In bull markets compensation awards tended to increase to take advantage of the leveraging.

The software industry lobbied hard against the new accounting rules on the basis that  startups had no other affordable choices for both rewarding and retaining designers working on products that would not emerge for some time.

However, compensation systems without limit on variable earnings, or at least comprehension by the Compensation Committee of the earnings that could result under different scenarios, could encourage executives to pursue action for compensation purposes at the expense of shareholders.

The consequence of this thinking and a growing awareness amongst boards of the risks associated with stock options as compensation, was a fall from grace as an executive incentive with Proxy Advisory firms and shareholders at large preferring other compensation methods.

Similar to tech starts ups Junior miners continue to depend heavily on stock options as a cash-effective way of incentivizing and retaining senior teams.

Should we expect more regulation? Not at the moment, changes to customary practice such as better long term planning, shorter holding periods have tended to focus on  creating sustainable long- term value. “Bonus banks”, claw-backs and performance based vesting enable recovery or limitation of incentive pay if longer term performance is subpar.

Compensation design features today that may be considered high-risk include low fixed pay relative to potential incentives, annual rather than multi-year (long term) incentives, uncapped arrangements, and the use of stock options as a short-term incentive.

Stock options are also out of favor because they have no downside and while they continue to be the best option for aligning executive and shareholder interests in Junior companies  who by definition, have only a vague view of what the future of the company may be.

When combined with performance share units (PSUs) and/or restricted share units (RSUs), in more established miners, stock options remain an effective instrument that can align shareholders and executives.

Boards and their Compensation Committees face increased scrutiny for compliance with both best practice and market trends in all areas of executive compensation. Meaning that any element of pay should be subject to internal control and scenario planning.

Total compensation should be aligned with strategy and be reflected in the mix of short- and long-term compensation. Long-term incentives are intended to retain and reward. Short-term usually annual, incentives are generally paid in cash for the achievement of key metrics that represent milestones to longer term strategic objectives. Cash is often in short supply for Juniors and mid-tier miners, and so in considering mix and how that should be delivered, RSUs and PSUs could be an additional or alternative deferred incentive tools.

Balanced scorecards are prevalent where multiple objectives are used in an incentive plan featuring say production, permitting, feasibility or even drilling, and increasingly measures related to culture, safety and succession are included.

Compensation Committees need to understand and visibility of,  through business planning tools, all potential scenarios  e.g. “what if” scenarios of options payout at an exceptional share price, the combination of  several “home runs” amongst balanced scorecard goals, the impact of unintended scenarios, and how severance, change-in-control or incentives might be affected.

With smaller market caps it is unlikely that Juniors will attract the attention of Proxy Advisors but Juniors are prime targets for their consulting so this will change.  An external compensation consultant advising the Compensation Committee will ensure independent and current market input.

Managing compensation is often referred to as an Art-Form rather than a Science – perhaps this blog helps to explain why.

View in Original Format – The Northern Miner Sept 2010

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