Risk Management

Drowning In Underwater Stock Options

The market's downward slide is forcing employers to rethink their next moves on stock options.
David KatzJanuary 18, 2001

“Help! I’m drowning,” employees holding underwater stock options may be crying.

At the same time, institutional shareholders are singing a song called, “Don’t dilute me, let them go,” meaning employee holders of stock options and the options themselves.

With the stock market’s downward slide, many employers are finding themselves caught in deep water on the issue of stock options. As companies’ stocks dive, the employees they retained and lured with options are waking up to the fact that the current price of the stock has sunk below the exercise price of their options. In current parlance, those options are “underwater.”

Such employees may find that competing companies may be more than ready to pull them out of the drink. The double-whammy of the declining stock market and a labor market holding firm at just 4 percent unemployment is thus forcing many companies to rethink their approaches to equity options just to keep up with the competition for key talent.

Some may, for instance, reprice their underwater options or cancel them and issue new ones. (Both moves involve accounting caveats under the Financial Accounting Standards Board’s Interpretation No. 44, “Accounting for Certain Transactions Involving Stock Compensation.”) Or they may swap restricted stock for their employees’ drowning options.

But some action seems crucial now, if employers want to hold on to their talented, option-holding workers. Some companies may choose to discipline employees by letting them wallow in their underwater options. But that’s a bad idea.

“A company should not use underwater options as a way of disciplining management,” says Marshall Scott, a senior consultant in Chicago, with William M. Mercer Inc., the big benefits-advice firm.

“If you think managers are doing a poor job, then fire them,” Scott says. To continue to allow them to hold underwater options “is death by a thousand cuts,” he adds.

At the same time, besides the tight labor market and the declining stock market, employers are being hexed by means of a third whammy (slang for a “supernatural spell for subduing an adversary,” says The American Heritage Dictionary of the English Language). That’s the loud protests of institutional shareholders, who are battling to gain control of the use of stock options. They also represent a possible source of resistance to repricing options to benefit employees.

When a stock plummets, shareholders may be upset “because nobody’s resetting their share price,” Scott says.

Which factor should weigh more heavily on the minds of senior financial executives as they ponder the use of stock options as a compensation tool: The demands of big shareholders or the need to compete in the tight labor market?

A Simple Answer

I’ve got a simple answer. While shareholders have a right to know what’s going on in terms of the issuance of options at the companies they’re investing in, maintaining a competitive workplace must be a higher priority—for the shareholders’ own good as much as that of management and employees.

Employers, it seems to me, have mounted a good case against shareholder attacks on the use of stock options based on the contention that they dilute shareholder value. Offering greater amounts of stock options to key executives ties the executives’ fate ever closer to the fortunes of the company, the argument goes. If it does well and the executives do well, the stock price goes up. That can only benefit shareholders.

One can dispute the use of stock options as a tool to motivate chief executive officers to increase the value of their shares. Executives with big holdings in options may have the incentive to make inordinately risky moves, confident that they can only gain on the upside without experiencing actual losses on the downside.

That issue of personal enrichment does give shareholders a legitimate claim on gaining the right of approval of all stock-option plans that include directors and officers, a matter now under debate at Nasdaq and the New York Stock Exchange.

Shareholders have the high ground in the debate when they declare that stock option grants may be excessive because of the presence of the risks of self-dealing. As outgoing SEC Chairman Arthur Levitt said, concerning executive compensation packages, “things get a little complicated when [shareholder dollars are] spent by officers and directors for officers and directors….”

In other words, there must be some independent check on the motivation of personal enrichment at the expense of the company. Certainly, stock option grants should be disclosed.

The SEC, in fact, is moving swiftly to get companies to disclose facts about all stock options. Mark A. Borges, counsel for SEC Commissioner Laura S. Unger, is working on a proposed disclosure rule that is “still being considered internally” but could be published soon, he told me recently.

See the story on disclosing stock-option plans. But shareholder arguments sound weak when it comes to the use of stock options purely as a tool to attract and retain employees. That use, in the current labor market, goes to the heart of a company’s ability to compete and its very survival.

In that sense, the interests of an institutional shareholder, which holds stock in a multitude of companies and is interested in maintaining only its own value, are less crucial than that of the employer, whose very existence is on the line.

So, when an employer considering whether to boost or diminish stock options as an employee benefit is being pulled by shareholders on the one hand and employees and potential employees on the other, the employer must tilt to the latter.

Shareholders should indeed take a close look at the quality and integrity of management in the companies they invest in. But, if management passes muster, then shareholders should let executives employ stock options in the way they judge to be in the best interests of the company.