Executive Compensation

This will follow-up on my July 1 blog titled "Stock Options Opened for 'Call Writing'" issue. On June 17, 2009, the Securities and Exchange Commission (SEC) approved a rule that would permit a public company to allow its employees to use vested stock options as collateral for writing exchange-listed calls. (SEC Release No. 34-60127)

This blog will discuss:

1. Why did the SEC eliminate the margin requirements when an employee utilizes his or her employee stock option as collateral for a call option?

2. Why would an employee sell a call option when the employee owns a vested employee stock option?

3.  Whether a company should allow its employees to sell a call option in the company's stock.

The primary purpose of the collateral or "margin" requirement for selling call options is to protect the broker-dealer or other counter-parties from the sellers' inability to provide the stock. The margin requirements ensure that the seller of the call option has the money to buy the stock on the open market when the holder of the call option exercises the call option. SEC Release No. 34-60127 eliminates the margin requirement when an employee uses his or her vested employee stock option as collateral because those options ensure that the employee (or the broker-dealer in his stead) can acquire shares at a specified price.

The Release requires that an employee pledge his or her vested employee stock option to the broker-dealer and provide the broker-dealer with an irrevocable power-or-attorney authorizing the broker-dealer to exercise the vested employee stock option on the employee's behalf. If the holder of a call options exercise his or her call options, the broker-dealer will exercise the vested employee stock option and purchase the stock from the issuer. The broker-dealer will then sell the stock to the holder of the call option at the call option's strike price. The broker-dealer will keep a portion of the proceeds to reimburse the broker-dealer for purchasing the stock, and the broker-dealer will keep a portion of the proceeds to pay his or her brokerage commission. The broker-dealer will then pay the remainder of the proceeds to the employee.

For example, assume an employee who holds a vested option to purchase company stock at an exercise price of $50 per share sells 10 call options (100 shares per call option) with a strike price of $120 per share. Also assume and the company's stock price increases to $140 per share.

If the holders of the call option were to exercise the option, the employee then would exercise his or her stock option, purchase the company's shares at $50 per share, and sell the shares to the holders of the call options at $120 per share, thereby generating a gain of $70,000. If the company's stock price rises above $120 per share, the employee would have given up some of that upside gain, in exchange for the proceeds of the sale of the call option. On the other hand, if the company's stock price did not rise above $120 per share, the call option holders would not exercise the call options and the employee would pocket the proceeds and keep the stock option.

(Under this scenario, if the employee held no vested stock options, he/she would have to purchase the company's stock at $140 per share and sell it to the holders of the call options at $120 per share, causing the employee to incur a loss of $20,000.)

Stock options serve many purposes, including aligning the incentives of a company's employees with its shareholders. Allowing an employee who holds a stock option to sell a call option does not seem to further the purpose of aligning the incentives of the company's employee and shareholders because the employee has no incentive to increase the company's stock price over the call option's strike price. In fact, one could argue that the call option creates a disincentive for the option holder to work to increase the stock price too quickly.

Allow employees to use vested options as collateral for writing exchange-listed calls would require some affirmative actions by the company, such as revise plan documents and putting in place guidelines.