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22. a A criticism often made against ESO compensation is that ESOs encourage
excessive manager risk taking, since he/she has everything to gain and little to
lose. Paying bonus in company bonds reduces the incentive to take risks since,
unlike for ESOs, there is little effect on the value of bonds if the risky strategies pay
off.
However, the incentive for UBS senior managers to adopt only safe operating
conservatism increases the probability that the firm survives, the manager will
benefit from such policies through increased debt security (but lower interest rates).
c. It is unlikely that the manager’s temptation to shirk and cover up through
opportunistic earnings management would be affected. This temptation remains in
the presence of bonus paid in debt. One reason is that the manager’s concern
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Additional Problems
10A-1 Following major declines in their share prices, firms frequently reprice outstanding
stock options issued to executives and employees as part of their incentive
compensation. Reproduced here is an article from The Financial Post (April 3,
1997), describing such a repricing by Rogers Communications Inc. According to the
article, Rogers’ stock options with exercise prices ranging from $12.64 to $19.38
were lowered to an exercise price of $8.31.
ROGERS REPRICES COMPENSATION OPTIONS
Rogers Communications Inc. repriced all the options its executives and other
employees have received as part of their compensation packages in 1994 and
1995 because the company’s share price has fallen so far, Rogers’ annual
shareholder circular says.
The options’ new exercise price is $8.31, significantly lower than the earlier prices,
said Rogers’ spokeswoman Jan Innes.
Previously, exercise prices ranged from $12.64 to $19.38. Also, the exercise period
was extended to 2006.
“If you’ve got options and they’re well above what the stock is trading at, they’re
certainly not very interesting,” explained Jan Innes.
Rogers’ circular says the company awards options to “focus executives’ attention
on the long–term interests of the corporation and its shareholders.”
Analysts were surprised by the move.
“I can imagine that shareholders will be a bit perturbed,” said one. “After all, their
shares didn’t get repriced. But I suppose it will help keep people motivated.”
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Roger’s shares have fallen drastically since 1993, when they hit a $21.88 high. The
shares (RCIb/TSE) closed yesterday at $8, down 55¢.
Ted Rogers’ options, along with other non–management directors’ options, will not
be repriced.
Rogers’ class A shareholders, the only ones entitled to vote, will vote on the
arrangement at the company’s annual meeting May 2. Ted Rogers controls over
90% of the A shares, so the vote should pass.
Meanwhile, working two jobs is paying off for Ted Rogers, president and chief
executive of Rogers Communications and acting president of Rogers Cable–
systems Ltd.
Rogers got a 21% salary increase to $600,000 for 1996, plus a 160% rise in his
bonus, to $260,110, for a total of $860,110. In addition, he was given 300,000 new
options.
But he was not the highest paid executive at the cable and telecommunications
company he founded.
That distinction went to Stan Kabala, chief operating officer of telecommunications
and chief executive of Rogers Cantel Mobile Communications Inc.
Kabala, who joined Rogers Jan. 1, 1996, got a salary of $600,000, plus a bonus of
$925,000, for a total of $1,525,000. He was also awarded 119,000 stock options.
Kabala’s big bonus was related to a deal completed in November 1996 with U.S.
phone giant AT&T Corp., as well as for Cantel’s performance.
The last time Rogers paid bonuses of such magnitude was in 1994 after it
completed its takeover of Maclean Hunter Ltd.
SOURCE: The National Post, April 3, 1997. Reprinted by permission.
Required
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a. Give reasons why firms frequently issue stock options to executives and
senior employees as part of their incentive compensation.
b. If options are always repriced when share prices fall, regardless of the
reason for the fall, what effects may there be on the incentives to work hard of
officers and employees involved?
c. If you were a shareholder of Rogers Communications, how would you react
to the repricing?
d. It has been argued that options held by the CEO should not be repriced,
even if repricing is extended to less senior executives and employees. Note that the
article reports that options held by Ted Rogers, president and CEO of Rogers
Communications, are not being repriced. Why?
10A-2 Refer to Theory in Practice 10.3 in Section 10.6 concerning BCE Inc. Reproduced
below are the 1997 consolidated statement of operations and Note 2 to the
financial statements of BCE. The statement of operations shows an extraordinary
charge of $2.950 billion for stranded costs. After this extraordinary charge,
operations showed a net loss for the year of $1.536 billion.
Required
a. Would you support exclusion of the charge from earnings for the purpose of
managers’ short–term incentive awards? Discuss.
b. What is the persistence of the $2.950 billion component of 1997 earnings?
Your answer should be in the range [0–1]. Explain your answer.
c. On April 23, 1998, The Globe and Mail reported “Earnings results fuel BCE
shares to 52–week high.” This headline refers to BCE’s record reported earnings for
its first quarter, 1998, of 48 cents per share excluding “onetime items.” This is a
46% increase over 33 cents per share for the same quarter of 1997. The article
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quoted the CEO of BCE as saying, “We continue to see solid growth in all areas of
our operations.” According to the article, these first–quarter results suggest a good
performance by BCE in 1998, after a $1.5 billion loss in 1997 due to a record $2.9
billion charge at its telephone company subsidiary.
Give another reason, in addition to “solid growth,” that may explain the record first–
quarter results. As a member of the BCE compensation committee contemplating
the 1998 annual short–term incentive awards, would you support basing these
awards on the record first–quarter earnings? Explain your position.
Consolidated Financial Statements—BCE Inc.
Consolidated Statement of Operations
($ million, except per share amounts)
For the years ended December 31 1997 1996 1995
Revenues 33,191 28,167 24,624
Operating expenses 25,795 22,011 19,434
Research and development expense 2,911 2,471 2,134
Operating profit 4,485 3,685 3,056
Other income 365 393 238
Operating earnings 4,850 4,078 3,294
Interest expense – long–term debt 1,111 1,160 1,154
– other debt 121 141 172
Total interest expense 1,232 1,301 1,326
Earnings before taxes, non–controlling interest and
extraordinary item 3,618 2,777 1,968
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Income taxes (1,522) (1,118) (819)
Non–controlling interest (682) (507) (367)
Net earnings before extraordinary item 1,414 1,152 782
Extraordinary item (2,950) — —
Net earnings (loss) (1,536) 1,152 782
Dividends on preferred shares (74) (76) (87)
Net earnings (loss) applicable
to common shares (1,610) 1,076 695
Earnings (loss) per common share1
Net earnings before extraordinary item 2.11 1.70 1.12
Extraordinary item (4.64) — —
Net earnings (loss) (2.53) 1.70 1.12
Dividends per common share1 1.36 1.36 1.36
Average number of common shares
outstanding (millions)1 636.0 632.7 622.9
1Reflects the subdivision of common shares on a two–for–one basis on May 14,
1997.
Extraordinary Item
As at December 31, 1997, BCE determined that most of its telecommunications
subsidiary and associated companies no longer met the criteria necessary for the
continued application of regulatory accounting provisions. As a result, BCE
recorded an extraordinary non–cash charge of $2,950 million, net of an income tax
benefit of $1,892 million and a non–controlling interest of $38 million. Also included
in the extraordinary item is an after–tax charge of $97 million representing BCE’s
share of the related extraordinary item of its associated companies.
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The operations of most of BCE’s telecommunications subsidiary and associated
companies no longer met the criteria for application of regulatory accounting
provisions due to significant changes in regulation including the implementation of
price cap regulation which replaced rate–of–return regulation effective January 1,
1998, and the concurrent introduction of competition in the local exchange market.
Accordingly, BCE adjusted the net carrying values of assets and liabilities as at
December 31, 1997, to reflect values appropriate under GAAP for enterprises no
longer subject to rate–of–return regulation.
The determination by BCE that most of its telecommunications subsidiary and
associated companies no longer met the criteria for the continuing application of
regulatory accounting provisions is the result of a review, which began in 1997, to
assess the impact of the introduction of price cap regulation coupled with the
introduction of competition in the local exchange market. Before the advent of
these two factors, accounting practices were based on a regulatory regime which
provided reasonable assurance of the recovery of costs through rates set by the
regulator and charged to customers. These regulatory accounting provisions
resulted in the recognition of certain assets and liabilities along with capital asset
lives which were substantially different from enterprises not subject to rate–of–return
regulation.
The extraordinary charge consists of a pre–tax charge of $3,602 million related to
capital assets and a pre–tax charge of $1,181 million to adjust the carrying values of
other assets and liabilities to arrive at carrying values appropriate for enterprises
not subject to rate–of–return regulation. The amount of the charge related to capital
assets was determined based upon an estimate of the underlying cash flows using
management’s best estimate assumptions concerning the most likely course of
action and other factors relating to competition, technological changes and the
evolution of products and services. The net carrying values of capital assets were
adjusted primarily through an increase in accumulated depreciation. The primary
component of the $1,181 million charge relates to the write–off of deferred business
transformation and workforce reduction costs.
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Source: BCE Inc., 1997 annual report. Reprinted by permission.
10A-3 Many firms “reprice” ESOs following major declines in their share price by lowering
the exercise price. This is because ESOs issued before the decline are deep out of
the money, hence unlikely to be of any value. Such moves usually outrage
shareholders, who have seen the value of their shares also fall but who receive no
comparable benefits, and are prominently reported in the media.
Saly (1994) did an original analytical study of the repricing of ESOs. Her analysis
applies to repricing after a market downturn, such as the downturn experienced in
the early 2000s, and not to a firm–specific fall in share price that may be due to
manager shirking.
As Saly points out, compensation contracts are incomplete. That is, it is unlikely
that provisions for adjustments to compensation following a market downturn are
anticipated and written into the compensation plan. The question then is, should
the contract be “renegotiated” following a market downturn by repricing ESOs? If
so, this would violate a general rule that, once signed, contracts tend to be rigid.
In Saly’s model, the answer is yes. Renegotiation of the ESOs’ strike price
increases the correlation between manager effort and the performance measure
(share price), since a market downturn is not a result of low manager effort. Without
the possibility of renegotiation, the risk–averse manager would have to be
compensated for the risk inherent in the possibility of a market downturn if he/she is
to attain reservation utility. If a downturn occurs and there is no repricing, the
manager’s expected utility of compensation will fall, since the expected proceeds
from ESOs are effectively zero. This will cause him/her to either shirk or leave the
company.
In June 2001, Nortel Networks Corp. announced that it was cancelling its existing
ESOs and replacing them with new ESOs with a lower strike price. Nortel’s share
price, which had been in excess of $100 when many of the ESOs were issued,
suffered following the market collapse of share prices of high-tech firms, and was
trading in the $20 range at the time of the announcement. Nortel’s move was widely
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reported in the financial media and drew significant negative comment. For
example, The Globe and Mail (June 5, 2001) quoted Carol Bowie of the Investor
Responsibility Research Center as saying “… you can’t make the 50–yard kick. So
we’ll cut it down to 35.” It also quoted J. Richard Finlay, head of the Centre for
Corporate and Public Governance, as saying “We’d all like to be told our high
school physics test where we got 35 out of 100 is now 35 out of 50, but
shareholders don’t have that luxury.”
Nortel defended its move by claiming it was necessary to retain key employees,
pointing out that top manager ESOs were not being repriced (this would require
shareholder approval) but only those of lower level employees. In the same issue of
the Globe, Brian Milner pointed out that the cost to Nortel of repricing the ESOs is
zero, and that no further dilution of shareholders’ equity will result since the old
ESOs are being cancelled. Nevertheless, Milner comments that in the public eye
the repricing is still “a reward for crummy performance.”
Required
a. In the light of Saly’s model, do you agree with Nortel’s ESO repricing?
Explain why or why not.
b. Nortel planned to cancel existing ESOs and replace them with new ones,
rather than simply repricing the existing options to a lower exercise price. Recall
that in 2001, GAAP did not require expensing of ESOs. Rather, most firms,
including Nortel, followed APB 25 (see Section 8.6) in the financial statements
proper. Why do you think Nortel replaced the old ESOs with new ones, rather than
simply repricing the existing ones?
c. In its 2003 proxy statement, the Compensation Committee of General
Electric Company reported that the company has a policy of not repricing ESOs.
Why would a company have such a policy?
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Suggested Solutions to Additional Problems
10A-1
a. Some reasons why firms issue options as executive and senior employee
compensation are:
• Managers with a short–term decision horizon may engage in short–run
income maximization if the incentive plan is based only on reported
net income. Options are intended to lengthen the manager’s decision
horizon, thereby reducing the incentive to engage in this behaviour.
Note: To the extent that options encourage “pump and dump” and other types of
opportunistic ESO behaviour, the force of this argument is reduced.
Note: The preceeding argument no longer applies since GAAP now requires ESO
expensing.
419
420
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10A-2
a. If it is accepted that the charge is not management’s “fault,” (i.e., low
informativeness with respect to manager effort) then it seems reasonable to
support exclusion for purposes of BCE’s short–term incentive awards. If the charge
b. Persistence is 1, assuming that the estimated $2.950 billion cost of the
stranded costs is accurate. While the losses leading to the extraordinary charge are
not yet realized (i.e., the charge is an accrual), they do seem to have been validly
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10A-3
a. The collapse of share prices of high–tech firms suggests that economy–wide
events were responsible for the drastic decline in Nortel’s share price. This
suggestion is reinforced by behavioural finance, which suggests that share prices
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b. Under APB 25, an expense had to be recorded to the extent that the
exercise price of an employee option was less than share price when the options
were granted. If the existing options were repriced downwards, the new exercise
c. Reasons why GE would have a policy of not repricing ESOs include:
• To avoid the strong media and investor criticism that follows repricing.
This could trigger shareholder backlash, such as a fall in share price
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