Keeping Options Afloat

The dominant issue this proxy season? What to do about those underwater options.

Some are starting with small steps. San Jose, California-based Cisco Systems Inc., for example, whose nearly 20,000 new hires from last year are holding options priced almost 50 percent higher than the current share price, decided to grant this year’s options last November–two months earlier than the previous year. It is also considering stepping up the frequency of its grants to a quarterly or monthly basis.

Others have taken more drastic measures. A November survey of dot- coms and technology firms by San Francisco­based consultancy iQuantic Inc. found that 80 percent of the companies surveyed had underwater options; of those, 50 percent have already issued new grants or made interim awards to employees. And a broader survey of CFOs conducted in December by the Fuqua School of Business at Duke University and Financial Executives International determined that 43 percent of public companies that issue stock options intended to compensate executives for their underwater options.

The simplest cure for underwater options, of course, is to reprice them, as did in early February. However, with Financial Interpretation Number 44 (FIN 44), the Financial Accounting Standards Board has essentially ruled that out. The new rule forces companies to use variable accounting treatment for repriced options, which can result in large charges against earnings, if the value of the shares (and repriced options) rises.

Rockville, Maryland-based software maker Manugistics Group Inc. is one of the few companies that have already had to deal with FIN 44, which applies retroactively to December 15, 1998. In early 1999, the company received shareholder approval to reprice options to purchase 3 million shares, after the stock’s collapse the previous year. The good news: Manugistics and its share price have made a remarkable recovery. But in the last two quarters, the company has taken a charge of $21 million and a gain of $6 million because of fluctuating value of the repriced options. And with the stock up significantly in the last several months, the company will likely be booking additional charges in coming quarters.


As the iQuantics survey proves, one popular alternative is to simply ignore the previous option grants and issue new ones. Last April, after its stock had plunged by 40 percent, Microsoft doubled its option grants to 34,000 full-time employees to make up for the underwater options issued in 1999. The company, however, may have acted prematurely. The market price for its stock continued to slide through the rest of the year, and it still trades well below the $67 strike price of the new April options.

From the shareholders’ point of view, such makeup grants are the most objectionable response to underwater options. “It’s like writing a check,” says Patrick McGurn of Rockville, Maryland-based Institutional Shareholder Services, a proxy advisory service. McGurn says he’ll advise against a slew of corporate proposals to replenish employee option plans recently depleted by makeup grants. Not only do the proposals undermine the pay-for-performance objective that is theoretically behind options compensation, but they also expose shareholders to double dilution. “Companies that do it will find they’ve harmed their relations with investors,” says Peter Clapman, vice president and chief counsel for pension fund TIAA-CREF. And companies may also run afoul of regulators, now weighing in on the issue. At a recent legal conference, Securities and Exchange Commission officials suggested that additional disclosures should thoroughly explain changes to options plans, although no formal rule has been proposed.


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