Last week, Herbalife (NYSE:HLF) CEO Michael Johnson exercised and sold 250,000 stock options awarded to him 10 years ago. The strike price of the option – the price he paid for the shares – was $7.75, and the price he sold the shares at varied between $60 and $61, showing a 10-year growth of almost 690%. Pretty impressive. The profits on the sale of the options came to just over $13 million.
Infamously, Bill Ackman's Pershing Square made a $1 billion investment in Herbalife, a vitamin and supplement company. But he "shorted" the investment, which is much the same as borrowing money to buy the stock and then selling it, hoping that the price will go down so it can be bought again at a lower price, thus making a profit.
Herbalife announced that it was being investigated by the U.S. Federal Trade Commission on March 3 this year. At issue here is what is at the heart of Ackman's short investment: Is Herbalife a pyramid selling scheme? The FTC is demanding records, which Herbalife's 550,000 U.S. distributors must keep, that will prove or disprove whether its vitamins and protein shakes are being bought by consumers or just by the distributors, recruiting other distributors, and trying to get rich quickly. Herbalife's stock price fell from around $65 at the time of the announcement to less than $50, though it has since recovered.
Johnson made the decision to exercise and sell the options the day after this announcement – March 4. Although he obviously knew about the investigation, so did everyone else, so he was not operating with inside information. In fact, Johnson made the decision using what is known as a 10b5-1(c) trading plan. These are plans authorized by the SEC whereby insiders can set specific dates to trade in their own stock and be free of accusations of insider trading, because the trade dates are set in the future.
What's a stock option for?
But that's not the issue here. The issue is the sale, rather than retention, of the stock. Stock options are awarded to executives so that they can profit from long-term growth in stock prices in the same way as shareholders. Options are awarded at market price, and vest over a number of years, and must be exercised, typically, within 10 years. At the time of exercise, if the stock price has grown – like Herbalife's – then the spread between the two prices is profit for the executive. But stock options have more than just one purpose. They are also supposed to make executives shareholders. According to the filing that announced the exercise and sale, Johnson already owned 847,320 shares of company stock, worth today more than $51 million. That sounds like a lot of exposure for a single person to a single stock. But not for a CEO of that company.
Over only the last three years the company has paid him $45 million in cash and stock, and he has been CEO since 2003, so over his entire tenure, compensation would add up to a lot more than that.
Therefore, I would argue that, in line with the original purpose of stock options, at least some of the shares acquired should have been retained. Johnson would have had to pay taxes on the profit, but the net amount of shares would still have been substantial. All of them should not have been sold.
Why is this important? Because a CEO who retains his equity awards rather than simply cashes them out sends a message to shareholders that he is confident in the company's long-term value growth which, given the current investigation, would seem to be a particularly important message to send.
Paul Hodgson has no position in any stocks mentioned. The Motley Fool has the following options: long January 2016 $57 calls on Herbalife. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.