Keeping Options Afloat

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

On March 6, The Walt Disney Co.’s shareholders will gather in Fort Worth for one of the first major annual meetings of the year. And, as always, CEO Michael Eisner’s pay package will be a favorite topic. Last year, the famously well-compensated chief Mouseketeer took home a tidy base salary of $1 million, and a whopping bonus of $11.5 million. This in a year when Disney shareholders saw a return of just 5 percent.

Still, the bigger bone of contention looks to be Eisner’s stock option compensation. In 1996, Disney granted him 24 million stock options vesting over the subsequent 10 years. He has already realized gains of $60 million on 3 million exercised options, and his as-yet unvested options were valued at $267 million at the end of September. This year, Disney is seeking shareholder approval to reserve another 100 million shares for issuance under the companywide incentive plan, but it may not get it. In fact, if a shareholder proposal to limit the number of options granted to senior executives is passed at the meeting, Disney may have to revamp its entire incentive plan.

The Disney meeting could foreshadow a lively proxy season this spring, say corporate-governance experts, with stock-option compensation the hottest topic. “It’s the number-one issue this season,” says Cynthia Richson, investor responsibility program officer for the State of Wisconsin Investment Board.

The heart of the issue is what to do about last year. Nasdaq posted its worst year ever in 2000, meaning thousands of senior executives and rank-and-file employees are sitting on options with strike prices that are far above the current share price. Those options, particularly at technology firms, are now less a motivation than a reminder of how much they lost last year. And corporate managers now have to determine how to retain and motivate employees without incurring the wrath of investors. “How to deal with underwater options is the 600-pound gorilla of the compensation world right now,” says senior executive compensation consultant Yale Tauber, of New York­based William M. Mercer Inc.

Corporate-governance purists like Nell Minow, editor of The Corporate Library, a Washington, D.C.-based Web site that covers executive compensation and corporate governance, say the solution is simple: Do nothing. “Management should suffer along with shareholders,” says Minow. “Options are supposed to rise and fall. If they don’t, there’s no credibility to the granting of them.”

BLOOD IN THE WATER

Maybe not. But pay-for-performance principles aren’t what most corporate managers are thinking about. With the still-tight labor market, and the potential for employees to get more cash or new lower- priced options elsewhere, they’re more worried about the headhunters who smell blood in the water. “It’s a lot easier to lure people now,” says Paul Dinte, CEO of executive recruiter Dinte Resources Inc., in McLean, Virginia. “I’ve had more calls in the last three months than at any time since 1992.” Adds John Wilson, a San Francisco­based financial officer with executive recruiters Korn/Ferry International: “There’s a lot of pressure within organizations that have been slammed to do something to retain top talent.” Not surprisingly, many firms are weighing whether to reprice, replace, or otherwise restructure their option plans to keep the troops happy.

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 Amazon.com 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.

A REPRICING BY ANY OTHER NAME

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.

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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