Campbell Soup has cut stock options from its director pay mix entirely.  The $7.5 billion company – which formerly used options more liberally than any other ingredient in its director compensation plan – will now pay its board members in equal parts cash and restricted stock.

Campbell is in good company.  Of more than 400 publicly owned Fortune 500 companies that filed their proxies by the end of June, 39% granted options to directors in 2005, according to a Towers Perrin compensation study released last week.  That’s down from 45% the year before.

Sunoco Products, Grubb & Ellis, PNC Financial Services and Merrill Lynch are among the companies whose director pay plans that have removed options.

Campbell declined comment on its change, but Ellen Hancock, a director at the business and technology solutions provider EDS, explained the rationale behind the EDS board’s decision to eliminate stock options from its director compensation plan back in February 2005.

“Since options were being replaced for almost all executives with performance restricted stock units, the EDS board saw this as a way to better align the interest of executives with that of the board members, who obviously represent shareholder interests,” she says via e-mail.  Indeed, Campbell’s director compensation decision also follows its decision last year to abandon stock options entirely for executives in favor of restricted stock.

A major impetus behind companies’ decisions to cut back on both executives’ and directors’ stock option grants is the Financial Accounting Standards Board’s requirement that companies expense stock options on their financial statements, says Paul Dorf, managing director at Compensation Resources.  Though many firms started to do it voluntarily in the 2004-2005 fiscal year, this is the first year it was required.

Now that both restricted stock and options must be expensed, stock grants are more attractive from an accounting standpoint for two reasons, according to Dorf.
First, “you know exactly what the cost on restricted stock is going to be.  It’s the stock price at the time of grant, whereas the stock option can change periodically” he explains.

Second, he sys, about three times as many options as restricted shares generally are required to convey the same dollar value.  Giving out fewer shares costs the company less.  It also results in less dilution.

When asked about the shift away from options in director pay schemes, board members cite reasons beyond the effect of the new accounting rules.  Larry Pinnt, chairman of the board at Seattle-based Cascade Natural Gas, wrote in an e-mail response that he suspects boards will consider compensation plan modifications “based on the reported abuses and the resulting fallout from past stock options grants.”

Alexandra Higgins, a senior compensation analyst at The Corporate Library, agrees the trend away from options has been spurred on by the fact that options recently have been publicized as vulnerable to “all sorts of manipulation.”  She also cites concerns that options don’t incentivize directors to act in shareholders’ longterm interests as a reason for the trend.

“Restricted stock tends to have holding requirements… not something that was ever associated with stock options,” she writes in an e-mail.

John Fluke, chair of the comp committee at $14 billion Paccar, cites more reasons why options might encourage directors to act in the short term.  “The temptation to improve earnings in the quarter in which options vest or backdating options grants to minimize strike price imposes a perverse disconnect between directors’ and shareholders’ respective interests,” he writes in an e-mail.

Hancock lends credence to Higgin’s thesis that options’ reputation for encouraging directors to act in their companies’ short term interest has contributed to the decrease in their use.  “Many of our large shareholders believed that options promote high risk taking,” she writes of the EDS board’s decision to eliminate options from director comp.  “We did not want any view externally that the board was motivated by anything other than creating sustainable shareholder value over a long period of time.”

But not everyone is sold.  Nearly one third of the companies awarding full-value shares in Towers Perrin’s study also granted stock options to directors.  In its proxy statement last year, Colgate Palmolive – where Hancock also serves as a director – says it believes including stock options in the non-employee director compensation program “promotes the long-term success of the company by further aligning the interests of directors with the interests of the company and its stockholders.”  Hancock also sites on the board of Aetna, which, like EDS, also has stopped using stock options to compensate directors.

And Fluke, who says he is “not involved with any companies that have eliminated all elements of stock-based compensation from their director fee structures,” maintains that balancing directors’ decisions between short- and long-term considerations is important.

“The goal is to achieve the maximum sustainable growth in shareholder value while optimizing the level of risk,” he writes.