Although it is just getting started, the 1999 proxy season is likely to be remembered as the year in which institutional investors began to raise serious questions about corporate America's use of stock options.
Institutional investors have long supported the use of options to motivate and reward employees and to align the interests of shareholders and employees. But permissive accounting standards, excessive dilution of shareholders' economic interests, and especially the widespread practice of repricing underwater stock options are creating a backlash.
A flurry of repricing in late 1998 generated enormous concern among investors and has set the stage for a 1999 showdown.
Shareholder proposals asking companies to obtain shareholder approval before repricing stock options will appear on dozens of company ballots in 1999.
The first already has come to a vote, and the results are ominous for corporations but heartening for investors.
On Feb. 4, shareholders of General Datacomm Industries Inc. voted in favor of a proposal to require the company to obtain shareholder approval before repricing options. The proposal was sponsored by one of the nation's largest pension funds, the State of Wisconsin Investment Board, which long has been an outspoken opponent of unfettered option repricing.
Repricing hits stockholders with a double whammy. The value of their original investment has been eroded by virtue of the lower market price of the stock, and it stands to be further diluted by the reduced price at which insiders may purchase shares.
Repricing of options seems particularly inappropriate in today's market environment. Due to extreme market volatility, especially in the tech sector, some corporations have repriced options only to see their company's stock rise in value in a matter of weeks to a price that exceeds the original exercise price of the options.
The General Datacomm vote was significant for another reason: The result is binding on the company. Most shareholder proposals are drafted as recommendations to the board. Even when these proposals pass, companies are free to ignore the outcome, and many companies have done just that. As a safeguard, Wisconsin drafted its proposal as a binding bylaw amendment. Shareholders have used this tactic in the past, but the Wisconsin proposal is the first bylaw amendment in memory to pass. Already, other shareholders are planning to use bylaw amendments this year to challenge not only repricing, but also the adoption of poison pills without shareholder approval. Inevitably, the courts will be asked to decide whether shareholders have the power to force bylaw changes. If the courts permit the practice, bylaw amendments will proliferate.
The ability to use bylaw amendments to stop option repricing puts muscle behind the effort to stop this abusive practice. The outcome at General DataComm shows these efforts can succeed. If they expect to continue to receive shareholder support for stock option plans in the future, corporations would be wise to agree now not to reprice options without shareholder approval.
James E. Heard is chairman and chief executive officer of The Proxy Monitor Inc., a New York-based firm that advises institutional investors on corporate governance and proxy voting.