A difficult birth was beginning to give way to a promising future - until Kenneth Clarke decided to step in. Must the tax break on share options be closed so cack-handedly? Chris Blackhurst.
Looking back on it now it was a crazy period. Fat cat frenzy in the press was at its height; Cedric Brown, the quiet, technocrat chief executive of British Gas had, incredibly, become the most hated man in Britain; one of the highest paid executives in Britain, Sir Richard Greenbury, had been asked to chair a committee into directors' remuneration - a role in which he was distinctly uncomfortable and ill-suited; and Labour was having a field day.
The days at Westminster were long and hot; the political temperature kept on rising. Day after day, the tabloids, notably those which once exhibited slavish loyalty towards the Conservative Party, kept upping the pressure as another greedy privatised utility boss trousering yet another thick wad - to coin a tabloid phrase - was paraded before us. For the Opposition, Gordon Brown, the shadow chancellor, loomed over the proceedings, sounding ever more sonorous and forbidding.
Somewhere, during this heat haze, the Chancellor cracked. Among the 10 main action points to be proposed by the Greenbury Committee, one shone out as a forceful recommendation to the Government: 'Gains from executive share options should in future be taxed as income rather than capital gains. The Government should bring forward the necessary amendments to the tax legislation.' While Greenbury later pointed out, somewhat unconvincingly, that such an action was to be applied exclusively to the directors who were the subject of the report, this was the straw at which Kenneth Clarke, Chancellor of the Exchequer, chose to clutch. On the morning of Monday 17 July, immediately before publication of the Greenbury Committee report, Clarke struck. In what some commentators referred to as a 'dawn raid' he decreed that henceforth share options would not be subject to capital gains tax but income tax. What is more, the change would operate retrospectively - those with existing options would also be hit.
By removing the tax break of the capital gains threshold of £6,000 and making all profits from the exercising of options liable to income tax, Clarke committed an act of political folly. Suddenly, the airwaves were filled - not with executive fat cats bemoaning their own fate - but with the lads and lasses of companies such as Asda, where most employees, not just the high-ups, benefited from share option schemes. Thanks to Clarke, they now found themselves having to pay tax on what they had understood to be a free perk.
As an advertisement for Conservative policy flying in the face of previously declared aims and values, it could not have been worse. In speech after speech from the early '80s onwards, the Tories portrayed themselves as the party of popular capitalism. Enabling people to share in the wealth of the nation, creating a wide, share-owning democracy were the rallying calls of Thatcherism - and of Major, too. The 1987 Conservative general election manifesto trumpeted: 'First, we introduced major tax incentives for employee share-ownership. Seven out of the last eight budgets have included measures to encourage people to purchase shares in the company in which they work.' The 1992 manifesto again emphasised: 'We also believe that people at work should be helped to build security for themselves and their families. Employees should be given every opportunity to acquire a stake in the business for which they work.' The abridged 1992 version sent to about one million homes, boasted: 'A capital owning democracy is the prize for Britain in the 1990s under a Conservative government ... We will work to bring home ownership, share ownership and personal pensions within the reach of even more families.' And in his keynote address to the 1991 Conservative Party conference, Major said of wider share ownership: 'In the 1990s we must carry it further. We must extend savings and ownership in every form.' All that was quite different from 17 July and Clarke's dramatic intervention. Or was it? When all was said and done, all the Chancellor was talking about was closing down a tax break - albeit one which had been deliberately created 10 years before. Anyone would think, listening to the at times, hysterical reaction, he had banned options altogether. Even Lord Lawson, the former chancellor, who gave the green light to share option schemes in his 1984 Budget, declared Clarke's move would be 'very damaging' for industry. What he may have meant to say was, very damaging to the image of the Tory Party. Anyone would also be entitled to think that it was Clarke's decision alone - that officials were not involved, advisers had not weighed up the pros and cons, that the Prime Minister had not been consulted. What was really happening was that the Chancellor had fired a symbolic shot against fat cats and boardroom pigs in the trough. Unfortunately, instead of taking a sniper's rifle and and picking off his victims, he has indulged in carpet bombing.
Doubts began to surface: if he could do this, what else could he do? Was this really the best way to run the country, by announcing changes to legislation on the radio first thing in the morning? That feeling of insecurity was compounded a week later when, after coming under withering fire, he thought again. His ruling would not apply retrospectively, those with existing options were safe, and could stick to paying CGT.
If the Government thought that was the end of the row, it was mistaken. Stopping a tax break for future beneficiaries might seem reasonable to officials in Whitehall but not to the many supporters of options. They were, and are, outraged. The problem for Clarke is that he failed to distinguish between the two types of recipient of options: well-paid senior executives versus their junior managers and ordinary workers. His blurring was, to an extent, understandable: it has existed almost from the very moment share options schemes were introduced.
That initial lack of clarity is now haunting the Government. Rather than requiring that options be made available to the bulk of the workforce - as the desire for wider share ownership would have suggested - Lawson blundered. 'A number of practitioners were keen to establish the principle that companies should only grant selective options to senior people if they were also using similar schemes for the mass of their employees,' says Richard Lamptey of Sedgwick Noble Lowndes, the leading incentive scheme advisers. 'It was a surprise when they were brought in without any linkage at all.' Instead of acting as an incentive that was accessible to all, and would actively promote wider share ownership, the share option was hijacked by the privileged few. 'Senior people jumped in immediately and had options granted at levels three or four times their pay,' says Lamptey.
Ken Robbie of the Centre for Management Buyout Research at Nottingham University, agrees. 'The original idea was to achieve wider employee share ownership. What has happened is that schemes have been introduced at the discretion of the directors.' The result, says Robbie, is that in his own area of buyouts, 'lots of them have seen share ownership retained in a very small group of managers. Usually, a buyout will have four or five management equity owners, whereas it will have a few hundred employees.' It was also never the Government's idea that options should be a get-rich quick device. To qualify for the income tax break, options had to be exercisable between three and 10 years. In reality, says Lamptey, 'everyone started to exercise as soon after the third year as they could. All the surveys show the average exercise period is four years.' Again, Robbie concurs. 'The incentive should be that you exercise the option and keep the shares but that is not what happens. People sell and the option is looked at as a one-off bonus.' That, he says, was not the plan. 'It was the way it grew up.' Add a few more ingredients - the sheer greed of some bosses and privatisations at basement prices in order to guarantee success - and the recipe for disaster was complete. So-called 'super options' awarded to the likes of Sir Ralph Halpern at Burton, at eight times salary, got the tabloids going. Then came the state sell-offs, where again nobody envisaged that at the point of going private, directors would be granting themselves options at the flotation price. With the certainty of the share price rising - thanks to being sold too cheaply - they could not fail.
Recently, however, clued-up remuneration committees had started to respond to such drawbacks in share option awards for directors. Indeed the Greenbury Committee focused extensively on how share options at the highest level should not be abused. Its recommendation on the subject is crystal clear: 'Companies can improve further, and in some cases have already improved, share option schemes by making exercise of the options conditional on challenging performance criteria ... All new schemes should be subject to such criteria.' The era of share options as an unconditional get-rich-quick scheme for top dogs was thus drawing to a close. Instead they were becoming established as an excellent route to secure the commitment of middle managers and junior staff to the overall prosperity of their company. The tax-break which the Chancellor closed so punchily was precisely the one which fostered this noble cause.
One of the Government's sternest critics has been one of its own backbenchers, David Shaw MP. His Campaign to Save Options has met with an overwhelming response from business and special interest groups. At a meeting with officials and Treasury ministers he claims to have discovered a strength of opposition which took him by surprise. It was as if, the Government, his own party, had set its face against one of the tenets of the past 16 years.
The Treasury fielded Shaw with three arguments against the status quo - he calls them the 'three myths'. The first is that by taxing them as capital gains, the Government will recover £80 million a year in lost tax. This widely-quoted figure presupposes the value of options will be replaced by increases in salary. But salary rises are tax-deductible against profits, and, after employers' National Insurance costs are included, will reduce the earnings on which tax is calculated. Only the senior people are likely to receive increases - it is hard to imagine that companies will respond by across-the-board pay rises. Finally, share options only show a profit if the value of the company goes up. That gain is usually influenced by a rise in profits, which means higher corporation tax receipts for the Chancellor. Second, 90% sell their shares immediately. A lot do sell but there is no available evidence for that sort of proportion. And third, that share option profits are income not capital. But options exhibit none of the characteristics of income. They are not annual; they cannot be relied upon and they can only be spent when realised, between three and 10 years.
This last 'myth' has its roots in the notion that options are a salary substitute. Asda chief, Archie Norman, reacted with anger to the suggestion: 'We gave our employees this year an above-average market wage award, we aim to pay as competitively as we possibly can, regardless.' Asda's granting of options to 36,000 employees - just over half its workforce - was not, says Norman, driven by some quixotic desire to save National Insurance. Besides, says John Maguire, Asda's remuneration manager, the company has already spent £17 million buying-in the shares for the scheme. By the time it is extended to more employees, the bill will be even higher. Asda, says Maguire, had nothing else on its mind other than fostering loyalty among staff and motivating them for the future. 'We are saying, if you stay with us you will get the benefit. We're a people business, if they have got a stake in the business, they will be motivated. It is all about us trying to be a modern, single-status employer,' says Maguire.
Options, says Shaw, are not granted in place of salary. They are a genuine transfer of wealth from existing shareholders to employees. There is no doubt, as any practitioner will tell you, that they are a much better proposition than the alternatives. They may not be as widespread as when they were introduced but they are still a long way ahead of the rivals. In March 1995, there were 6,170 businesses in Britain with option schemes, 1,400 with Save-As-You-Earn, and 1,158 who gave away shares under profit-sharing arrangements. Each of the latter have serious drawbacks.
Under SAYE, employees must enter into a savings contract and find cash every month for at least five years. Employees can get a refund at any time so the scheme can come under pressure during the holiday-booking season or at Christmas. Many low-paid workers treat SAYE simply as a way of saving cash. Profit-sharing schemes award shares on the basis of last year's performance, not the years ahead. They offer no financial incentive to stay with the employer. All employees must be allowed to participate - so the company cannot distinguish between the deserving and undeserving. Then there is profit-related-pay. This is in cash, has nothing to do with share ownership and of the four, is the most widely abused by companies seeking to keep salary awards down.
Such arguments do not wash with the Treasury which, in the words of Shaw, chose 'to put the boot in' to options. When he says there was no Inland Revenue study of the use of options, he appears to be right. 'They did not realise many large companies give them to junior employees, they thought it was just about having a go at senior employees,' he says.
While the damage to industry may not be as great as Lawson suggested, one area will be harmed. Fast-growing, high-tech companies give options as a matter of course to new employees - they are competing with the US where such schemes are the normal part of any management package. While stable companies which are not taking on staff and not granting new options will be immune, initially - thanks to the rethink not to make it retrospective - growing firms will be affected immediately. New employees will not be as well-off as those already in the scheme.
Clarke could dig himself out of this hole in a variety of ways. He could restrict the percentage of options to be exercised each year, to, say, 30% after three years and 10% after that. He could, as Robbie suggests, link options more firmly to individual company, rather than market, performance by making them dependent on rises in earnings per share. 'He should say to all executives they cannot have any options unless they increase EPS from 10p to 15p in a set period,' says Robbie. Or, he could exempt the first £6,000 for schemes which extend to many staff, not just the privileged few at the top. Or, he could apply exemptions to the low paid only.
However clever the ideas, they may all be a waste of time. All the signals from Treasury sources are, that having had one rethink already the Chancellor is not going to have another. That would be a mistake - but then the whole sorry saga of options to date is littered with them. It would not be for the first time.
Chris Blackhurst is on the staff of the Independent.