Keeping Options Afloat

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

Sprint Corp., whose stock price collapsed after its merger with WorldCom was quashed by EU regulators, has at least found a creative way to get around FIN44. Last November, the Westwood, Kansas-based telecom company announced it would allow employees to give up their underwater options and receive an equal number of new options six months and one day later, at the prevailing market price. Per FIN 44, the six-month waiting period enables Sprint to use fixed accounting for the new options. McGurn calls it a pseudo-repricing, and one that arguably provides a short-term disincentive for employees. The lower Sprint’s stock price is six months hence, the more potential upside to the new options.

“It was necessary to achieve stability in our workforce,” says E.J. Holland Jr., vice president of compensation, benefits, and labor relations at Sprint. And given that senior executives are not eligible for the swap, management can’t be accused of self-dealing. “It’s a service to our shareholders that we retain our workforce without causing further dilution,” he argues.

Another alternative for firms that fear employee turnover because of underwater options is to replace option grants with restricted stock. Stock awards may not offer the potential windfalls that options do, but they retain value better in a volatile market. Companies can keep fixed accounting treatment for their equity compensation, and at the same time reduce the option overhang. So far, however, few companies have scrapped options for stock awards, says McGurn.

SHOW THEM THE MONEY

The final alternative is to come up with more cash. The Fuqua­ Financial Executives International survey found that only 3 percent of CFOs intended to compensate employees who hold underwater options with more cash. However, consultants confirm that renegotiated employment contracts and pay packages being offered to new hires involve a larger cash element. Executives, particularly at early-stage firms, are demanding it. The amazingly itinerant Joseph Galli, for example, got a signing bonus of $4 million from VerticalNet last July, although he’ll forfeit much of it, since he moved on to consumer-goods manufacturer Newell Rubbermaid as CEO in January.

Still, with a slowing economy, consultants say the trend toward higher salaries will be limited. Stock options will continue to be a major part of corporate pay strategies. And if companies feel that for competitive reasons they need to reprice or otherwise adjust the terms of their equity-based incentive plans, then dealing with shareholders will be part of the pain. “It’s easier to live with unhappy shareholders than it is to lose your top talent,” suggests Korn/Ferry’s Wilson.

Just don’t offer that as an explanation at this year’s annual meeting. Things might get ugly.

Andrew Osterland is a senior editor at CFO.

No Option Tax–For Now

Companies plagued by the burden of collecting withholding taxes on employee stock purchase plans (ESPPs) and incentive stock options (ISOs) will find some relief in a recent two-year moratorium on such collections announced by the IRS.

The announcement is the latest reversal on a matter that has caused uncertainty for years. In the late 1960s, the IRS issued a revenue ruling indicating that employers were not required to impose withholding taxes on ESPPs and ISOs. However, during some audits in the mid-1990s, the agency argued that companies needed to collect the payroll taxes. The result, says John Scott, director of retirement policy at the Washington, D.C.-based American Benefits Council, has been “a lot of uncertainty.”

The moratorium brings welcome relief to many companies, according to Paul Dorf, managing director of Compensation Resources Inc., an Upper Saddle River, New Jersey­based compensation consulting firm. Although employees are responsible for eventually paying a capital-gains tax when they sell upon appreciation of a stock, the onus, in many cases, has been on the company to collect those taxes. In the event that it was unable to collect, it had to pay the tax or be subject to a fine. “[The IRS is now] saying, ‘Look, forget about it, guys. People are still responsible for the tax, but we’re not going to hold the company responsible for it,’” says Dorf.

Melissa Cruz, CFO of Concord Communications Inc., a Marlboro, Massachusetts-based E-business performance management firm, adds that the move will “reduce the reporting requirements” involved in collecting withholding tax on ISOs.

The purpose of the unusually long moratorium is to give the IRS some time to decide on a course of action. Dorf, for one, believes the noncollection policy will become permanent, in order to encourage companies to use the plans. – Lisa Yoon

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