Companies with deeply underwater stock options held by employees at various levels are starting to struggle for lifelines, triggering an unprecedented magnitude of reporting and compliance issues.
Equilar, a firm that tracks executive compensation data, says 99 percent of Fortune 500 CEOs held underwater options in November, and the situation improved only slightly through mid-February. The firm says only 40 companies took action in 2008 by exchanging underwater options for something else. But in the first quarter of 2009, 31 companies completed or proposed exchanges, and experts say the number will grow in coming quarters if market conditions don’t improve soon.
Stock options end up “underwater” when the grant-date value is greater than the current market price for the underlying stock, making them worthless until the market price recovers at least to the original grant-date value. In theory, the options fail to serve as an incentive to employees when the prospects for recovery are weak or far off.
That leads boards of directors to weigh some difficult choices: exchanging the options for something of greater value to employees (which could rankle shareholders), or ride out the flood and hope the underlying stock price eventually finds high ground. Exchanging options, or “repricing” them, can be done in a number of different ways.
Ma
“A lot of companies are at least considering it, and some companies are doing it,” says Cindy Ma, a valuation expert and managing director at Houlihan Lokey. “Especially if it is a fair-value exchange with no profit-and-loss effect.” Ma says companies essentially can pursue one of three avenues if they decide to rescue underwater options.
First, companies can exchange underwater options for cash at their current fair value, giving employees an immediate benefit but no future upside potential. That option requires companies to have adequate liquidity (at a time when conserving cash is paramount for most businesses), but it eliminates uncertainty for employees.
Second, companies can exchange underwater options for restricted stock or restricted stock units, Ma says. The exchange would take into account the current value of the restricted stock and the current value of the underwater options, and exchange them in a ratio that leads to an even trade. The restricted stock, then, at least has current value as long as the stock price is greater than zero.
Third, companies can make a fair-value trade of underwater options for fresh options granted “at the money.” Employees would trade in more underwater options for an equivalent value in new options, but they would be at the money immediately. It renews the upside earning potential for employees, but still carries some underwater risk if stock market prices erode further.
Sarno
John Sarno, a partner with Deloitte & Touche, says companies will choose different approaches depending on their circumstances and their compensation strategies. “It’s a business decision,” he says. “Do you want to reprice that award? Do you want to issue more awards? Do you want to end up with additional compensation cost? We’ve seen situations where companies have done all those things.”
Top of mind for companies considering some kind of repricing or exchange is the accounting consequences. “You have to make sure the accounting consequences have been thought through,” Sarno says.
When companies grant stock options initially, they are valued according to the requirements of Financial Accounting Standard No. 123R, Share-Based Payment, and charged as expense to earnings. It’s not an upfront charge, however, says Sarno. Rather, the amount is spread out over the life of the award and charged to earnings as employees earn it over time.
“Some companies might conclude in this market if there’s nowhere (for employees) to go, maybe they don’t even need to do a retention award.”
— Carol Silverman,
Lawyer,
Mercer
FAS 123R provides instructions on how to account for a modification of an award, requiring a company to recognize any remaining value of the original award plus any incremental cost that arises from a modification. When exchanging old awards for new ones, “you’re modifying the original award and granting them a new one,” Sarno says. “You record the value associated with original award, then some value with the new award. You’re trying to get to the incremental value.”
Carol Silverman, a lawyer with human resources firm Mercer, says companies typically are looking for solutions that are accounting-neutral. “You might exchange four underwater options for one at-the-money option,” she says. “Do you want to give up your existing options for something smaller but with a better chance of earning money?” Then a ratio is determined to create the most accounting-neutral outcome, she says.
Not every company, however, is taking action to reprice or rescue underwater options. “Some companies might conclude in this market if there’s nowhere [for employees] to go, maybe they don’t even need to do a retention award,” she says.
Companies weigh a number of issues to determine their course of action, Silverman says, including the types of shares outstanding, the company’s competitive position, and the prospect elsewhere that may exist for key employees. An exchange or a repricing is a complex undertaking that triggers a number of stock exchange, accounting, and tax rules, not to mention filing requirements with the Securities and Exchange Commission, she says.
Companies will stumble into SEC tender offer rules when they exchange options, and they’ll trigger some disclosure requirements in the compensation discussion and analysis portion of their annual proxy statements. They’ll also trigger tax considerations with respect to deferred compensation, deduction caps for top executives, and incentive stock options.
SWIMMING IN OPTIONS
What Is Driving Exchanges?
98.8 percent of Fortune 500 CEO’s held underwater options as
of Nov. 20, 2008. The situation has improved only
slightly since.
71.6 percent of Fortune 500 companies had outstanding
options with a WAEP above their market price in mid-February.
Over 75 percent of Silicon Valley’s 150 largest companies
had outstanding options with a WAEP above their
market price in mid-December.
Source
Equilar, Inc. (Feb. 17, 2009).
And of course shareholders also factor into the equation. “There are a lot of companies where an exchange is the last resort because there are so many negative connotations associated with an exchange or repricing,” Silverman says. Shareholders may assert that management and employees should suffer losses right along with shareholders, she says.
Investor advisory firm RiskMetrics provides some guidelines companies should consider if they plan to exchange or reprice underwater options to assure shareholder interests are still being taken into account. The guidelines say an exchange shouldn’t be undertaken if the stock price has been depressed for less than a year and shouldn’t include the highest named executive officers, directors, or former employees. It should be clear the repricing isn’t meant to take advantage of a short-term downward movement in prices, and that it supports a retention strategy.
McGurn
“From the investor perspective, it all starts with a good story,” says Patrick McGurn, special counsel to RiskMetrics. “If this is a knee-jerk reaction in the market, and the market is likely to rebound in a narrow window of time, shareholders may be unsympathetic if a company is placating employees who are angry at this time.” On the other hand, if there are serious concerns about retention, shareholders will be more open to exchanges, he says.
Companies are moving more cautiously with option exchanges than, for example, in the early part of the decade with the bursting of the dotcom bubble, McGurn says. Now that companies have to expense stock options under FAS 123R, it’s not as easy a decision. “This is a new moving part that didn’t exist in the early part of the decade,” he says. “It’s changed the board’s calculus in deciding to go forward with these things.”
No comments yet