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Underwater Stock Options Get a Lifeline From Firms

By Tomoeh Murakami Tse
Washington Post Staff Writer
Saturday, March 7, 2009

Nearly 100 companies have undertaken programs that allow employees, many of them executives, to exchange sharply depreciated stock options for new awards with more generous terms.

The companies, from Google to Silver Spring-based United Therapeutics, argue that the exchange -- which increases the chances that executives will be able to collect rewards even though the company stock has plummeted -- is necessary to retain and motivate personnel.

Critics say the practice undermines the purpose of performance-based bonuses and puts the company's executives and workers on a different plane from ordinary shareholders who have no choice but to hold on to battered stocks or sell them at a loss.

"It goes to a sense of entitlement, which I think is misplaced," said Con Hitchcock, a lawyer who advises activist investors on corporate governance. "There are a lot of people other than executives who could use good-performing stock in their portfolio."

Stock options can account for a significant portion of pay for some employees, especially executives. They give the holder the right to buy stock at a future date for a specified price. For example, 100,000 vested stock options with a "strike price" of $30 would translate to a $2 million profit if the company's stock is trading at $50. The strike price is typically the price of the stock on the day the options are awarded.

The collapse of the stock market has dimmed prospects for cashing in existing options. Since the beginning of last year, at least 96 companies have implemented or proposed option repricing or exchange programs, according to Equilar, a compensation research firm.

As of late last year, nearly 99 percent of Fortune 500 chief executives held options with strike prices above the current stock price, Equilar said. Such options are "under water."

As a result, Equilar expects 21 companies will implement exchange or repricing programs in the first quarter of 2009, compared with only seven during the same period last year. An additional 24 companies, including Starbucks and chipmaker giant Advanced Micro Systems, have proposed such programs, most of which are subject to shareholder approval.

Many other companies are expected to take similar action, compensation advisers and directors say. As the recession deepens, they say, shareholders should expect a surge in the number of companies repricing options.

Google is in the process of implementing a program that allows holders to exchange their options for new ones with a strike price equal to the closing price Friday of $308.57. It reached a high of $741.79 about 15 months ago.

"It just makes sense given our goal to retain employees," said Google spokeswoman Jane Penner, adding that 85 percent of employees had options that are under water. "We just want to reward people and keep them engaged and focused on serving users. This is a great way to do it."

Google is expected to take a $460 million charge on the options exchange program.

United Therapeutics undertook an options exchange approved by the compensation committee of the board of directors shortly after the company announced that a drug it was developing had produced unfavorable results in a clinical trial.

The company's stock plunged on the Nov. 17 news, although it has recovered some since. A spokesman said this week that the exchange was appropriate given the market environment and the company's continued desire to utilize stock options as a retention tool.

Options that are way under water do little to encourage employees to stay or work harder, advocates of option repricing say, but companies still must take a charge for them on their books under new accounting rules.

Patrick McGurn, special counsel for proxy adviser RiskMetrics Group, said exchange programs are "never a good thing." But, he added, "If everybody is walking out the door, what are you going to do? Hold back on principle? Or find something that's workable in a shareholder-friendly way?"

To that end, companies such as Starbucks have excluded executives and directors from its proposed program. It also seeks to minimize the cost to shareholders by making employees turn in more than one outstanding option for every replacement option. The Starbucks program is scheduled for a shareholder vote later this month.

Home builder Toll Brothers last year implemented a program with some features similar to the Starbucks plan. "At a time when you have troubles in the industry and you have cuts, you don't want to lose (employees) to someone else," said Joel Rassman, Toll Brothers's chief financial officer.

"We're in a three-and-a-half year recession in home building," he added. "It's a little hard to say we can do anything to improve the stock price compared to where we were."

After the dot-com bubble burst, companies took similar steps to accommodate employees with underwater options. This time around, however, companies that decide to put forth such programs will be dealing with a public sensitive to compensation issues. Populist sentiment is running high after disclosures that Wall Street, which received billions in taxpayer funds, doled out billions in year-end bonuses. None of the institutions that took the funds have implemented or proposed option exchange programs.

"We don't get to exchange our stock," said Richard Ferlauto, director of pension-investment policy at the American Federation of State, County and Municipal Employees. "I think it just shows lack of sensitivity to their shareholder base."

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