John Brincat is the president and chief executive of Mercury Finance, an auto lender specializing in high credit-risk customers. The company’s proxy statement contains the following description of Brincat’s pay package.
Mr. Brincat is eligible for an annual incentive bonus equal to 1% of Net After-tax Earnings of the Company and is eligible for an additional bonus based upon annual increases in Net After-tax Earnings per share only after earnings exceed 20% over the prior year. The additional bonus is determined as follows:
• Earnings per share increases of 0% to 19.99%, no additional bonus is paid.
• Earnings per share increases of 20% to 29.99%, additional bonus will be equal to 2.5% of the amount of increase from the prior year.
• Earnings per share increases of 30% to 39.99%, additional bonus will be equal to 3.0% of the amount of increase from the prior year.
• Earnings per share increases of 40% or more, additional bonus will be equal to 3.5% of the amount of increase from the prior year.
In addition, at the time the employment contract was entered into, Mr. Brincat was issued a stock option grant . . . of 2,500,000 shares at a price of $17.375 per share, the fair market value on the date of the grant. The options vest equally during the next five years of the contract and are exercisable in increments of 500,000 shares annually only if earnings per share each year exceeds the prior year’s earnings per share by 20%. If earnings per share do not increase by 20%, Mr. Brincat forfeits that year’s options and has no further right or claim to that year’s options.
Source: Mercury Finance 1995 proxy.
1. Suppose Mercury Finance had $50 million of net after-tax earnings for the year. How much of a bonus would Brincat receive if the EPS increase that year was only 10%?
2. How much of a bonus would Brincat receive if the EPS increase was 30%?
3. As a shareholder, how comfortable would you be if your company’s managers had contracts with these types of bonus and stock option incentives? Why?