Stock options: reprice or hold fast?

HR Magazine, April, 1999 by Stephenie Overman

Shareholders may dislike option repricing, but competitors may force you to follow suit.

When should a company, buffeted by a volatile stock market, reprice stock options?

The answer from shareholder groups is never. The answer from compensation consultants and from companies themselves is ... almost never.

Stock options generally give employees the right to purchase stock at a stipulated price over a specific period of time. Problems arise when stock options go "underwater" - the current market price drops significantly below the options' exercise price, reducing the chances they will someday be valuable.

Repricing handles the problem by revaluing the price at which stock options can be exercised. For example, if options originally could be exercised at $50 and the share price dropped to $30, the company could cancel the first option grant and issue new options to be exercised at a price nearer the current market value.

Shareholders - who don't get any chance to repurchase their shares at lower prices - generally oppose repricing, seeing it as all unfair advantage to employees. A company that decides to reprice "is saying, in essence, that it doesn't feel the stock is going to come back to the higher price," says Karin Estes, director of U.S. research for Institutional Shareholder Services in Rockville, Md. "But when the stock market is volatile, the stock could be back up three months later. So if the company reprices stock options, employees get a huge benefit."

Repricing should be done "very, very rarely," she says. "It's not something shareholders should be expecting companies to come back with every year."

Reasons for Repricing Resistance

Companies with "underwater" options cited the following reasons for
not repricing their option grants.

Reason for                                    Percent citing
avoiding repricing                               as reason

Undermines purpose of long-term incentive            83%

Leads to shareholder objections or                   49
negative votes on future plans

Not permitted under plan terms or                    44
agreement with shareholders

Creates onerous proxy requirements                   36

Triggers potentially onerous accounting              30
treatment

Leads to objections from or issues with              10
employees or unions

Source: Towers Perrin survey of 148 mid-sized to large companies,
October 1998.

Companies seem to agree, even when the market is mercurial. Ninety-one percent of 489 companies surveyed by Watson Wyatt Worldwide, a Bethesda, Md.-based management consulting firm, said they had no plans to reprice their stock options. Eighty-five percent of 148 respondents to a Towers Perrin survey said they were not considering repricing, even though almost all had options that were underwater. Both surveys were released last December.

"Management won't quite say 'never,'" says Paula Todd, principal and senior consultant on executive compensation with Towers Perrin, a New York-based management and HR consulting firm. "But it has to be very unusual, and you have to commit to do it only once. Otherwise, like parents and kids, [employees] think they can get away with something. They assume if the stock goes underwater again they will be let off the hook."

There are situations where repricing makes sense, according to Todd, such as when there has been an initial purchase offering (IPO) or a major acquisition, "and you conclude with the benefit of hindsight that the [stock] market wasn't efficient at the time of the options [grant]. You thought you were granting an at-the-market option, but it turned out to be a premium option" - one with an exercise price higher than the current market value.

The repricing message then is, "We're not letting you off the hook, but there was something fundamentally wrong with the stock price at the time the options were issued." The question is, "At what point do you cross the line and say this isn't an incentive for anybody and it wasn't the people's fault who were holders of the options."

Todd notes that the Towers Perrin survey found that many companies with stock options that were deeply underwater were not considering repricing. "Stocks go up and down," she says. "It's common in volatile industries for options to drop shortly after they are granted; it shouldn't shock anybody."

The guiding principle is the longterm perspective, Todd says. "That implies that you don't do it repeatedly, that it's an extremely unusual thing. Don't take repricing lightly. Wait it out. If you don't know, wait. If the stock comes back, you didn't need to do anything anyway. If it hasn't found the bottom, wait until it finds the bottom."

Shareholders may want to vote on when and how stock options are repriced, but plan administrators are responsible for such decisions in most stock option plans. "Usually the compensation committee of the board of directors has the authority to cancel options and reissue new ones. Typically shareholders are not required to approve" the action, Todd says.