Stock Option Repricings for Employees Draw Increasing Criticism
By GRETCHEN MORGENSON -- August 20, 1998
NEW YORK -- It's happened recently at Netscape
Communications, Apple Computer, Bay Networks,
Oracle, Best Buy and Oxford Health Plans, among others.
The company's stock plunges, and its board of directors
immediately acts to reduce the price at which employees
can buy shares through the stock option program. A new,
lower exercise price, the company argues, keeps workers
from abandoning ship to a competitor. In a tight labor
market, anything that keeps employees happy is crucial.
But as more companies choose to reprice their option
plans, criticism of the practice grows increasingly
vocal. Shareholder activist groups say option
repricings are inherently unfair. Why should one set of
shareholders be able to reduce the cost of getting into
the stock while others cannot?
Now, a tentative
decision reached by
the Financial
Accounting
Standards Board last
week may be the
beginning of the end
of repricings. "If the
decision stands, it
would more than
likely end repricings
as we know them,"
said Robert Willens,
partner in tax and
accounting at
Lehman Brothers in
New York.
In a unanimous
decision on Aug. 12,
the board took the
first step toward forcing companies that reprice their
options to consider as an operating expense the
difference between the new, lower price and any
subsequent increase in the share price. The board did
not act to quash the repricing tactic. It simply moved
to make the practice too expensive for many companies
to stomach.
Even though stock options could easily be considered an
employee expense like a salary or bonus, under current
accounting rules, companies issuing option grants are
not required to consider any part of them a cost of
doing business. Instead, according to Statement 123,
companies simply must flag, in footnotes to the
financial statements, the effect that stock options
would have had on their earnings had they been
recognized as a compensation expense.
Last week's decision came as the accounting board set
about to clear up a continuing cloud over how companies
account for stock issued to employees. Given the
increasing devotion to stock options by American
companies, and the heavy toll that expensing them would
take on corporate earnings, the accounting decision is
certain to be challenged.
"Compensation consultants are apoplectic," said Patrick
McGurn, director of corporate programs at Institutional
Shareholders Services in Bethesda, Md., a shareholder
activist group. "They're going to try to gin up some
opposition pretty quickly, especially in Silicon
Valley. It's something they're likely to get pretty
exercised about."
Indeed, the money at issue makes the accounting move
plenty compelling. Consider what expensing the cost of
its repriced options would mean to Netscape, which in
January reduced the price on an 8.6 million-share
option grant to workers, but not to top executives. The
shares, repriced at $16.8125 from a variety of higher
prices, fetched $30.875 at Wednesday's close.
The difference between those prices multiplied by the
8.6 million shares comes to about $121 million. If this
were a business expense, as the accounting board has
tentatively concluded, it would be among Netscape's
largest. Research and development at the company
totaled $130 million last year. To put it in even
greater perspective, $121 million is equal to almost 27
percent of the company's gross profit in 1997.
Why did Netscape reprice so many shares? "We did it
because we'd like to attract and retain employees,"
said Chris Holton, a Netscape spokeswoman. "We had a
lot of employees that were under water, and we felt it
would be a big benefit for all employees to reprice the
stock. Our employees are very happy with where the
stock is today." Outsiders who paid more than $50 a
share for Netscape last year are undoubtedly not so
happy.
Of course, if the shares had fallen after the
repricing, the company would receive a credit, instead
of an expense, the accounting board has concluded. If
the stock price were unchanged, there would be no
financial consequences. The company would report the
charge or the credit every quarter.
Because option repricing usually follows a precipitous
decline in a company's share price, the practice will
probably become even more prevalent after the market
swoon this summer. Matt Ward, chief executive officer
of WestWard Pay Strategies, a compensation consulting
firm, said that he counts at least 30 companies that
have repriced their option grants so far this year.
That is roughly equal to the total that repriced their
option grants in all of 1997, by his count.
Ward's numbers are by no means comprehensive.
Companies that choose to reprice option grants do not
usually publicize the decision. Information about
option repricings is typically buried in financial
statements and found by only the most vigilant
investors.
Shareholder activist groups like McGurn's are among the
few who see the escalation in option repricing and
deplore the trend. These groups find repricings
inherently unfair since the practice allows some
shareholders -- employees, in this case -- to get their
stock at much diminished prices while outside
shareholders do not. This is particularly troubling
when a stock rebounds quickly after an option program
has been repriced, rewarding management and employees,
while other shareholders simply get back to even.
"Clearly, it is a major concern for investors, if not
the No. 1 concern," said McGurn. "The real fear is that
all participants in the plan do is profit from
volatility in the stock." McGurn reports that he has
had more phone calls regarding stock option repricings
in the last 2 weeks than he had received in the last 12
months.
A second reason to object to option repricings is that
they can carry a substantial but largely imperceptible
cost to shareholders. That cost comes in the dilution
that large option programs bring to existing
shareholders' stakes. According to Pearl Meyer &
Partners, a compensation consulting firm in New York,
shares authorized for management and employee equity
incentive plans at the 200 largest U.S. companies
almost doubled in the last eight years. Last year, the
options in these plans amounted to 13.2 percent of the
weighted average of shares outstanding at these
companies. As additional shares covered by options
programs are added to the whole, existing shareholders'
stakes are worth less.
Of course, any option plan dilutes existing
shareholders' stakes. But option plans that are
repriced add insult to injury by letting insiders take
advantage of a plummeting stock to increase their
potential profits.
Why did accounting rule makers single out repriced
options as a cost to the income statement? The decision
goes back to a 1972 accounting rule that distinguished
between fixed option plans and so-called variable
plans. Known as APB Opinion 25, it stated that while
fixed option plans did not need to be considered a
business expense, variable plans did. In the accounting
board's opinion, applying a new price to an option
grant program automatically makes it a variable plan.
"This is consistent with the basic logic of APB 25,"
said Tim Lucas, director of research and technical
activities at the accounting board in Norwalk, Conn.
"The measurement is the known number of shares and
known price. Once you change it, there's some
variability involved."
Lucas went on to explain that although the board's
conclusion on this matter was unanimous, it is a first
step. The board hopes to finish a so-called exposure
draft on this and related matters by the end of the
year, after which it would ask for public comment on
the decision.
"We'll receive letters, we'll review them. Perhaps
we'll have a public hearing," he said. After
deliberating again, the board would then issue a final
statement. When would the proposal become effective?
Lucas said: "If all goes according to plan, it is
unlikely before Jan. 1, 2000."
Lucas does not expect a bruising battle over the
proposal. "I expect some people would prefer another
answer," he said. "We'll hear from them. That's what
the comment period is all about."
Others expect corporate America to fight the proposal
hard. "I think the reaction will be harsh," Willens
said. "They will argue that repricing options is an
important tool. To take away their ability to readjust
their sights based on market performance undermines
their ability to compete."
But any debate is unlikely to be as bloody as what the
accounting board endured several years ago when it
considered making companies expense all stock option
programs. Then, companies blasted the proposal,
claiming that having to expense stock option costs
would be so detrimental to American business as to make
it uncompetitive. The very existence of the accounting
board was threatened.
For this reason, the board is careful to point out that
it is simply interpreting what's already on the books
about repriced options. Willens said: "FASB will be
able to make a principled argument, 'Look, you wanted
us to adhere to original accounting in this, you urged
us to retain that literature as a guide for option
accounting. And that very document that you embrace
requires us to treat repricing in this manner.' It's a
reasonably hard argument to refute."
Still Willens says the language in the existing rule is
not ironclad. And even if the rule makers effectively
shut down the repricing practice, corporate America is
sure to work overtime to find other ways to compensate
employees.
Shareholder groups like McGurn's are not waiting for
the accounting board to act. They are making their own
waves about the repricing practice. McGurn's company
advises 500 large institutional shareholders on how to
vote on such issues as executive compensation and stock
option plans. He said he is going to begin to add the
cost of option repricings into a formula that he uses
to decide whether a company operates in a
shareholder-friendly manner.
McGurn also would like to see a cooling-off period
between the time a share price declines and the company
chooses to reprice its options. "All too often the
board's reaction has become knee-jerk," he said. "As
soon as its stock price drops, there's immediate
discussion of repricing."
Matt Ward at WestWay Pay Strategies advises his clients
considering an option repricing to follow several
fairness guidelines, beginning with prior shareholder
approval. "My view on repricing is it should never be
afforded to top management and never on a one-for-one
basis," Ward said.
"There should always be an economic tradeoff, so a
repricing should always involve fewer shares." He
thinks a repricing should also involve a change in the
vesting rules. For example, if an employee were halfway
vested in a four-year program, a fairer repricing might
extend the vesting by another year.
"All those tweakings have been lessons learned from
repricings gone bad," Ward said.
Copyright 1998 The New York Times Company |
