Executives grow bullish on options.

A new concept has emerged that threatens to undermine the whole performance pay aspect of employee options.

At present only a handful of wealthy senior executives are involved, but if it catches on you might expect to see employee options become a thing of the past.

The practice of rewarding senior executives with equity has been popular with US shareholders for more than a generation. The theory says that by paying up to 75% of CEO remuneration in the form of stock options, the managers have an incentive to increase shareholder value. It is the ultimate form of pay for performance.

For the moment forget the counter argument that says option schemes only encourage short-term management. There is another potential problem starting to vex US investors that could catch on on this side of the Atlantic.

Over the years, the number of US employees given stock options has increased massively.

By the early 1990s, companies had started offering options as incentives to key engineers and other important technical people. By the late 1990s some sectors of the high technology industries had embarked on employee options programmes that offered equity to all but the humblest workers.

Following the March 2000 ‘tech wreck’, many workers around the world found their options to be worthless. Not surprisingly they are no longer as attractive to many people, but there are still plenty of technology companies offering some form of employee equity, particularly to senior executives.

Linking executive pay to share price performance seems an ideal form of performance related pay. It isn’t hard to understand why. If you make shareholders rich, then options mean you can share in the newly generated wealth.

As mentioned before, there can be problems with short-term value manipulation.

For example, executives might sell assets with a considerable long-term value in order to provide a quick boost to the bottom line which, in turn can boost the share price.

In order to get around this, boards tend to insist employees hang on to their options for a fixed period of time before they can be sold.

Likewise, when a company is floated, stock exchange rules mean executive options must be held in a form of limbo, technically known as escrow, for two years. This is mainly to ensure company founders and managers don’t rip off investors. The whole issue of escrow explains why many people became paper millionaires during the internet stock price bubble, but never got their hands on the cash.

In the US, people are finding new ways to circumvent some of the drawbacks associated with share options. The senior executives are engaging in a form of derivatives trading that, in effect, uncouples the wealth locked up in options from corporate performance. The practice is known as ‘collaring’.

Collaring is a form of hedging using financial derivatives. The most popular version is known as ‘zero-cost’ collaring, because it doesn’t actually involve any outlays. Suppose your company issues you in stock options at $20 (#13) and the shares are currently trading at $50.

If you sell a call option at, say, $40, you’ll raise enough money to buy an equal number of put options at, say, $70.

This would allow you to manage the risk involved with the options. Both the downside and the upside are restricted to a limited band. If the share price plummets, you’ll still profit, if the price rockets, you’ll make more – but it won’t be a killing. In other words, you can turn your paper wealth into real wealth – albeit at a discount on the upside potential.

While the practice isn’t exactly widespread among dotcom CEOs, it is gaining momentum and it is worrying investors. And collaring can be worth huge sums.

Investors know executives with carefully hedged options no longer have as much incentive to make their company grow. Of course they don’t have an incentive to see their company lose – so it isn’t quite in the same league as cricketers betting on their opponents. However, it does undermine the pay for performance logic.

So far the practice has been restricted to executives dealing with very large parcels of stock – typically the amounts are over $10m.

There are signs that the practice is taking off lower down the food chain.

Financial investment companies are beginning to put together hedging packages that make it easy for executives with shares worth $1m.

It is a growing trend that could put into perspective the UK’s own share option troubles. Last week the government moved to rush through legislation capping the bills faced by companies over national insurance contributions on share options. It came amid further protests that share option taxation is continuing to damage IT industries.

While opposition MPs said the government did not understand the damage it had been doing, a fresh furore over share options would reignite the whole debate.