Investment Banking

Gasping for Air

When stock prices sink, repricing keeps holders of stock options afloat.
Stephen BarrJune 1, 1998

Everyone–except possibly the Financial Accounting Standards Board–loves stock options. Employers hope employees will act more like shareholders. Employees hope they’ll get rich. But in the enthusiasm for these incentives, the downside has been ignored: What if the stock price falls? Should workers suffer, as shareholders do, when the stock tanks?

At a growing list of companies, the answer turns out to be no. Using a variety of techniques, such companies as shirtmaker Philips Van Heusen, retailer Kmart, and computer software makers Oracle and Adobe Systems have devised repricing mechanisms that replace “underwater” options with fresh options keyed to less ebullient market prices. So have RJR Nabisco, Continental Airlines, Federated Department Stores, Ralston-Purina, Fruit of the Loom, and IBM.

Several companies, including Advanced Micro Devices Inc. (AMD), Apple Computer Inc., and Cypress Semiconductor Corp. have repriced options repeatedly. Harrah’s Entertainment Inc. repriced twice in less than two years– once in January 1995, after the stock price fell about 40 percent, and again in November 1996, after its shares dropped an additional 25 percent.

Some think this is a bad idea. Critics insist that repricing options amounts to nothing more than managerial greed. Shareholders don’t get to reprice their investments when they lose value, and neither should employees. Otherwise, options begin to look more like an entitlement than an incentive.

“What they’re saying is that these people weren’t responsible for the fact that the stock price fell,” says LENS Inc. partner Nell Minow, an outspoken critic of policies that drive wedges between corporate managers and shareholders. “Well, then they should not have been in a compensation program that was based on the stock price going up.”

Institutional Shareholder Services (ISS), a proxy advisory firm in Bethesda, Maryland, proclaims a zero-tolerance policy: It tells its institutional clients to vote against replenishing stock option pools for any company that has repriced without shareholder approval. “Resetting the strike price is not pushing people to enhance the value of the firm,” says Peter Gleason, an ISS director, “but rewarding them when the stock goes down, which is counter to the argument for options.”

Finance executives argue that, without repricing, workers might flee to employers who offer fresh options, and that would hurt shareholders more in the long term. “Our intuition told us that if we didn’t do something, we would incur more turnover than we would like,” says Jeffrey Henley, CFO of Oracle Corp. “Speed was critical. We wanted to stop people from being distracted.”

In December 1997, Oracle shares plummeted 29 percent, to $22.94, on news that the company expected slower sales growth. Within a week, the board of directors had wiped out all the options issued since the previous April and repriced them at less than the market price of $23 per share. “The whole idea was, if we do it, let’s do it fast,” Henley says.

The same line of argument persuaded Adaptec Inc., a PC-adapter card maker in Milpitas, California, to reprice its stock options last January, after predictions of a revenue shortfall sent shares tumbling from $40 a share to $20. “We felt we didn’t have much choice,” says Rick Olivieri, the company’s director of compensation. Two-thirds of the outstanding options were under water, many by more than 50 percent. Employees were depressed, he explains, and Adaptec wasn’t prepared to wait for evidence of an exodus before resetting the options’ strike price to $22.31, the market value when Adaptec gave options holders two weeks to accept the repricing.

“We thought it was only a matter of time before we saw some repercussions,” says Olivieri. “Employees believe in Adaptec, but when you’re holding options at $50, that’s a long way to trust the company.” Olivieri reports that thanks to the repricing, employee turnover at Adaptec in the first three months of 1998 is 30 percent lower than in 1997 and well below the 20 percent to 22 percent turnover rate that prevails nowadays in Silicon Valley.

Advanced Micro Devices saw its turnover rate triple in 1996 as its stock was dragged down by late new-product deliveries. That July, with almost all its outstanding options worthless and its stock price one-third of what it had been a year earlier, the San Jose, California-based chip maker repriced at $11.88, the market price on July 15, 1996. “The way I look at it, would I rather support a repricing or [support] losing and rehiring key people?” asks Reid Linney, director of compensation. By pushing out the vesting date for every option and excluding the company’s top officials, AMD headed off the charge of excessive self-dealing.

“We could have lost people and reissued those options [to the new hires] at $11.88,” says Linney, “but that would have meant a tremendous amount of lost time in a business in which time to market is critical. Instead, we make an equivalent transaction, but we don’t lose the people.”

Nonetheless, there has always been a stigma attached to repricing stock options. Until 1993, when new proxy disclosure rules forced companies to report repricings, the practice usually remained under wraps. As a consequence, the historical record on repricing employee stock options is incomplete. But a stigma clearly persists: More than a dozen companies that had repriced did not return CFO’s phone calls or declined to comment.

The evidence suggests repricings are on the rise. According to research compiled by William M. Mercer Inc. on companies from a broad cross-section of industries, repricings more than quadrupled between 1993 and 1995. More-current findings assembled by WestWard Pay Strategies Inc., a San Francisco­based compensation consulting firm, show that 14 percent of the 250 technology companies it recently surveyed repriced options in 1996. Another technology consulting firm, iQuantic Inc., also of San Francisco, found that as of 1996, half of the 67 companies it surveyed had repriced in the previous 10 years. That total represented an increase from 1995 of 25 percent.

Prime Candidates

Endemic stock price volatility makes high-tech and other fast-growing sectors prime candidates for repricing, but they are not alone. Companies with flat or falling stock prices likewise may find repricing enticing.

In early 1996, flailing Kmart Corp. was about to embark on a last-gasp turnaround effort. It had a new chairman and CEO in Floyd Hall. As Hall brought in new people, he gave them stock options in a company that had seen its stock tumble from nearly $25 per share to less than $7 over the previous three years. The upside was tremendous for the new hires, but Hall was also concerned about the 5,000 or so longtime employees who held options that were under water.

“We were in danger of creating a new team and an old team,” says the divisional vice president of investor relations, Robert Burton. “We wanted to put everybody on an equal footing. This [repricing] went a long way to telling key middle managers, down to the store-manager level, that the new management team wanted to make everybody a winner.” Repricing also sent a less sanguine message to shareholders: their shares might not change hands for $21 any time soon.

In March 1996, more than 15 million Kmart stock options were reset at $7.81. Investors supported the move, Burton argues, in part because the 12-member executive committee did not participate in the exchange. Hall’s initial options, granted at $12.38 when he joined Kmart in June 1995, remained worthless. “It was obviously not a self- interested transaction,” says Burton, “other than if the company kicks into gear, everybody benefits.”

Oracle also excluded its officers and directors when it repriced stock options in December, as did 3Com Corp., which repriced in January. In contrast, after internal research found that 8 of 12 other companies that had repriced had included top people, Adaptec decided to do likewise. “What should be done and what is done are not always the same,” counters Dave Bisson, a senior consultant with WestWard Pay Strategies, “and a lot of what’s done is not necessarily good for shareholders.”

Making Pricing More Palatable

Compensation experts agree that excluding senior executives can make repricings more palatable to investors. Toward that end, several repricing strategies have evolved. Perhaps the most shareholder-friendly practice involves having employees trade for fewer options at the lower share price (see box, above). “The ones that do it wrong do a 1-for- 1 exchange, include top officers, and do not reset vesting,” Bisson grouses.

In its most recent high-tech compensation study, WestWard outlined the option repricing programs of 30 companies. A review of that data by CFO found that 6, or 20 percent, used none of the suggested best practices; 14 used one; and 9 used two. Only one of the 30 companies, Apple Computer, used all three of the most recommended practices. Even more astonishing, 25 of the 30 companies let employees trade in all their underwater options for an equal number at the current market price–a move that increases dilution because it increases the likelihood that the options will be cashed in.

The approach of more-shareholder-friendly companies is to do an economic exchange when repricing stock options, says Ira Kay, practice director, compensation consulting, at Watson Wyatt Worldwide. By using the Black- Scholes options pricing model to determine the fair value of the options employees hold, a company can, in turn, grant new, lower-priced options that are of equal value. Employees will end up with fewer shares than they traded in, but these options will now be at the money. Moreover, this kind of exchange will not increase shareholder dilution and, in fact, may help reduce potential dilution.

Kmart, Adobe Systems, and Phillips Van Heusen are among the handful of companies that have used this approach when repricing stock options. “If you do a true economic exchange that’s fair to all stakeholders,” Kay says, “you gain more satisfied employees without diluting the value of shareholders.” Mercer principal Susan Eichen advises companies to consider making larger grants during the subsequent option cycle, so employees get more shares at the lower stock price. “Like an investor, you buy low and have a chance to participate in the future growth of the company,” she says.

Similarly, Carl Weinberg, a principal with The Kwasha Lipton Group of Coopers & Lybrand, suggests a “dollar-cost-averaging” approach in which companies make smaller, more-frequent option grants over the course of a year. “This way,” he explains, “you solve the problem of volatility without the pain and embarrassment of repricing.”

Unmoved by the pro-shareholder argument, and fearful that the trend is getting out of hand, ISS has been urging companies to put explicit prohibitions against repricings in their stock option plans. And the State of Wisconsin Investment Board recently wrote to 22 companies requesting that they seek shareholder approval to reprice. The large pension fund has received agreements from 16 companies, but an attempt to place such a resolution on the proxy of one, Shiva Corp., was denied. The Securities and Exchange Commission refused to take action on Wisconsin’s appeal.

By rewarding people for price volatility or for disappointing performance, companies run the risk of becoming like permissive parents who never teach their children that bad behavior has consequences. What could emerge is a culture of repricing–one in which executives buy-in completely to the theory that employees will skip out when options are under water, and employees expect to be bailed out not only when their options are worthless, but whenever they lose a lot of their former value.

LENS’s Nell Minow wonders how many more executives will allow themselves to be held hostage by bummed-out employees when the current bull market slows down. “I’m seriously concerned,” she says, “that that’s when we’ll see massive attempts at repricing.”

Stephen Barr is a contributing editor of CFO.

———————————————– ——————————— The Best Options
Ask any compensation consultant about repricing employee stock options, and the first thing you’ll hear is, “Don’t do it!” Ask again and the next thing you’ll hear is, “Do it this way.”

  • Consider only a true economic value exchange, never a one-for-one swap of shares.
  • Restart vesting or impose a moratorium or “black-out” period on exercise for a reasonable period after repricing.
  • Exclude Section 16(b) officers and directors.
  • Check with your accountants to verify that the repricing does not create any accounting problems.
  • Because repricing will attract shareholder attention, a description of the rationale for the repricing is a necessity, and should be included in SEC filings.
  • As a last resort, consider requesting shareholder approval.

Source: WestWard Pay Strategies Inc.