The Financial Accounting Standards Board has floated a plan to clarify the accounting rules for repricing underwater options, which to many compensation and corporate governance watchers is one of the most controversial practices around.
FASB is reportedly preparing a proposed rule under which companies that lower option exercise prices after their stock prices fall must take a charge against earnings equal to the difference between the new, lower prices and any subsequent increases in share prices. Currently, companies merely have to disclose in a financial statement footnote the theoretical effect of their options on earnings.
In tackling this issue, FASB joins a number of vocal shareholders, notably the State of Wisconsin Investment Board, in trying to instill some market discipline into what has become an almost knee-jerk response to falling stock prices.
Still silent, however, is the Securities and Exchange Commission, whose disclosure requirements (or lack thereof) make it extremely difficult to measure the amounts of shareholder equity being transferred with each repricing event that extends beyond top officers.
MISALLOCATION OF RESOURCES
A serious effort to impose some limits on repricing is long overdue. Repricing in most cases is not a response to bad things happening to good companies. Rather, academic studies show that most repricings follow management foulups. The stock price wounds are self-inflicted.
Faced with serious maladies, many boards forsake the radical surgery required to return their firms to good health in favor of using repricings as a form of corporate life support. Typically, corporate performance only worsens and repricings, which once were considered vices, become habits. Along the way, millions or billions of dollars of shareholder value are destroyed and a valuable national resource (highly skilled labor) is misallocated.
Consider Apple Computer Inc. Apple lingered in a corporate coma for years, and multiple rounds of option repricing did nothing to improve performance. True recovery came only after the surgical removal of the company's board and management.
Repricing also can have the perverse effect of rewarding volatility. At Ascend Communication Inc., and other so-called "serial repricers," option holders have profited time and again from the simple fact their companies' stocks are volatile. Indeed, Ascend twice repriced its options in late 1997, only to see its shares quickly rebound in value. Faced with the prospect of a massive profit hit, Ascend and other repricers might seek to limit the scope of their actions or delay them.
In short, unfettered repricing will result in significant misallocations of capital over the long term. If the recent Asian crisis has proven anything, it is that markets that reward good performers and punish poor ones ultimately will outperform those with artificial subsidies for weak performers.
COMPANIES, SHAREHOLDERS AT ODDS
Most companies, especially high-tech firms, argue an exodus of skilled employees is inevitable if companies don't bring options back above water. Pointing to the archetypal software engineer or superstar manager whose desk drawers are stuffed with offer letters, they exclaim, "If we don't reprice, they'll walk!"
Serious investors recognize that companies often face cutthroat competition for talent, and therefore most investors don't seek to outlaw repricings altogether. Instead, they simply demand meaningful oversight of a fundamental corporate decision.
As a result, many institutional shareholders with written policies on stock option proposals include a provision to vote against any option plan that allows the board of directors to reprice options without limits and without shareholder approval.
Because most existing plans already grant the board carte blanche authority to reprice, the Wisconsin Investment Board proposed binding bylaw resolutions to a bevy of recidivist repricers, aimed at requiring them to hold shareholder votes.
The SEC nixed this measured response, however, stating the Wisconsin Investment Board's bylaw constitutes "ordinary business" by focusing on stock options repricings for all employees, not just top executives.
The SEC urged the Wisconsin board and other investors to come back with data detailing the economic costs of such broad-based repricings.
While that sounds reasonable, there's a catch: The SEC doesn't require meaningful disclosure of repricings that are limited to nonexecutives, so analysis is next to impossible.
Seeking to fill this void, the Wisconsin Investment Board recently sued one company, Cardiothoracic Systems Inc., to gain access to data on the firm's broad-based repricings.
Although the Wisconsin board prevailed in its lawsuit, investors hardly relish the notion of camping out at courthouses to get hold of information they should be entitled to receive.
IS THERE A MIDDLE GROUND?
To their credit, some firms have taken steps to make repricings more palatable and less expensive. Top-level executives and directors, who typically bear the brunt of the blame for market stumbles, are sometimes excluded from repricings. Other reforms -- such as "value-for-value" swaps in place of more traditional share-for-share exchanges, resetting vesting for new awards and setting "blackout" periods for post-repricing exercises -- are becoming more common.
Shareholders who watch this issue closely may examine their voting guidelines and decide if and how to accommodate plans that allow a board to authorize a restricted repricing, when the need is justified, without shareholder approval. Once again, however, limited disclosure requirements make this a daunting task. Even if shareholders wanted to accommodate corporate demands for some leeway in repricing a limited class of employees without a shareholder vote, the lack of clear SEC disclosure requirements may make it impossible to monitor any policy that is more nuanced than voting "for" or "against" any plans that allow for repricing.
Repricing isn't going away any time soon. But if the FASB holds firm in the face of the inevitable outcry that will meet its proposal, more companies will be forced to adopt cost-effective forms of repricings. Firms with compelling arguments to support their actions need not fear investor backlash, but those without a good explanation will be punished by the market. Meantime, companies should do the right thing and let shareholders vote before they reprice underwater options. Shareholders in turn should support FASB's initiative and lobby the SEC for improved disclosure so the cost of repricing can be truly measured.