The Downside of Restricted Stock

Here's what to watch for as companies raise dividends and switch from options to restricted stock.
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Executives have their eyes on your dividend. Worse yet, investors seem to think this is a good thing.

In recent months, high-profile companies have been raising their dividends and seeking to switch compensation plans from stock options to restricted stock. This trend supposedly aligns executives with shareholders, who want more capital returned to them and less money going to speculative-growth strategies that are designed to pump stock prices. But the last time we had our interests "aligned" with management was with the now-derided stock option. This ingenious invention was supposed to reward executives only when the stock went up.

Regardless, options weren't the problem any more than restricted stock is the cure. The problem was shortsighted chief executives. Some CEOs with a fistful of options saw a ticket to Easy Street: Do what it takes to juice a stock, however fleeting, and cash out. Options set the stage for mountains of debt, ill-fated mergers and acquisitions, preposterous growth strategies, stock buybacks, and yes, even withholding dividends from shareholders.

Option holders don't receive stock dividends. Only when the option vests and the holder exercises it and acquires the underlying stock can he receive dividends. With the traditional option structure, there is a disincentive for management to pay out dividends. You've heard the expression "A bird in the hand is worth two in the bush"? Well, a dollar on the balance sheet is worth two paid out to shareholders, at least when you're an option holder who benefits from higher stock prices and has no claim to the dividend.

Investors started questioning the logic of option grants before the Bush tax cut, after noting certain imperial CEOs selling options for hundreds of millions before their stock tanked. But the straw that broke the option's back was the fact that dividend income is now taxed at just 15%. Before the cut, most dividends were taxed at normal income tax rates, which on the high end used to be 39.6%.

Careful What You Wish For

Investors want their share of company profits distributed as low-tax dividends. Executives, well aware of this shift in investors wants, are going to adjust their own compensation plans accordingly. As with the careless use of stock options in the 1990s, this move could hurt some businesses.

Restricted stock is not a new idea, but neither was the stock option before it blossomed. It took a combination of shareholder and board acceptance and a regulatory kick to make their use widespread. The latter came from a ban by Congress in 1993 on corporations deducting salaries of more than $1 million from their taxes unless the fat pay package could be tied to performance measures that shareholders approved. Fine, pay me in stock options. Shareholders love stock options -- they align interests.

Restricted stock represents real stock ownership, not just the right to buy shares at a certain price, as is the case with options. The restrictions typically involve the time frame when the stocks can be sold and the situations in which they may have to be surrendered back to the company. Restricted stock has been used as a way to avoid high taxes from stock options.

If you own options and your company is bought out, your options can immediately vest and convert to common stock. You would then receive cash or the acquiring company's stock as payment for your stock. This is a short-term capital gain, taxed as income, which used to be 39.6% at the high end. Why tax the windfall-'90s profits as income when they can be taxed as long-term capital gains, which were taxed more favorably?

If you are allocated restricted stock, you set the clock of ownership earlier. This way, in a buyout, you realize tax-favorable long-term capital gains. The recent reduction in the capital gains rate only increases this benefit.

But there are downsides. Getting restricted stock usually means receiving a tax liability, as you are actually getting something of value. Today, options are considered as valuable as air, though this is a hot area for debate. Companies have figured out ways around this problem; they can loan executives money to pay for this tax liability, to be repaid later when the stock is sold. Loans aren't taxable unless they are excused.

Owning the stock vs. merely having an option to buy it means you can receive dividends along with the other shareholders. Now that shareholders want dividends, executives have another reason to own restricted stock over stock options: They can get in on the dividend pool.

What all this means is that executives have a major incentive to pay themselves in stock as opposed to salary or options, and then increase the payout -- the amount of profits paid out as dividends, which are currently at historic lows of around 35%.

Executives have just as much power in deciding how much dividend to pay out as they did in deciding what companies to acquire in the '90s. The biggest single problem with stock options still exists: Executives are in charge of the decisions that will make them the most money, which may or may not benefit other shareholders in the long term.

For the record,

Microsoft's

(MSFT) - Get Report

plan for restricted stock is a bit unusual: Employees won't actually get ownership of the stock until it vests, so they won't have a tax liability at grant date, and they won't be able to receive any dividends along the way until the stock vests. Call it restricted stock for the everyman. The plan also allows any dividend payments to go to founders and shareholders, not to employees who are going to convert their options to the new "sucker" restricted share class.

What Lies Ahead

Things to expect in coming years if this dividend infatuation goes too far:

1. A new class of restricted stock (for executives) that lets the recipient claim dividends but somehow allows them to have optionlike upside -- like a warrant with dividends.

2. More companies filing for bankruptcy after paying out high, unsustainable dividends.

3. Higher dividend payout ratios.

4. Even more companies paying interest on debt while simultaneously paying out dividends to their shareholders.

5. Stagnant stock prices with little growth in core businesses as growth capital is "paid out" to executives/shareholders.

6. A government clampdown on tax-avoidance schemes using restricted stock to convert ordinary salary into long-term capital gains and low-tax dividends.

7. No extension from the government on dividend tax breaks past 2008 after ongoing budget deficits and a general disgust with how executives abused a good thing, again.

Trouble Brews

The stock market as a whole pays out only about a 1.5% dividend yield. At this rate, the after-tax yield for those who own stocks directly has climbed to 1.27% from as low as 0.90%. If executives start overpaying dividends and adding themselves to the recipient list, investors may see total returns from owning stock -- which come from dividends and share-price gains -- stagnate.

There are many companies that have more than 10% of their float represented by stock options. If such liberal use of restricted stock becomes the norm, the dilution could cause earnings per share to fall as well as dividend yields, with no increase in stock price necessary to trigger the dilution, as is the case with options. Companies could also be drained of growth capital -- the opposite of letting CEOs use too much capital for growth.

Income is income. Once you start creating favored classes of income, trouble starts. Executives can still tailor corporate finance and structure to the current acceptable executive compensation plan.

Jonas Max Ferris is co-founder of

MAXfunds.com, a fund research and analysis company, and partner in an investment advisor offering managed accounts in mutual funds. He welcomes column critiques, comments or baseless accusations at

jferris@maxfunds.com.