Option revaluation and the weakness it causes
The recent bear market prompted more than 100 companies in October 1998 to cushion the blow of their falling stock prices by repricing their stock options for executives. This is hardly surprising considering that, according to compensation experts, 2/3 of a US CEO’s total pay package comes from the cashing in of stock options. As declining stock prices make option targets harder to obtain, companies simply lower the exercise price of existing options so that employees can clear performance hurdles as easily as if the bear market hadn’t struck. (Ugh, the stock crashed and … ugh, we need to lower our goals so we can archive them.)
If you can believe this, Cendant recently revamped its top executives’ stock option program after its share price dove from a high of $41.375 to $10.00 amid allegations of accounting fraud. A sane investor should question whether the options should have been repriced at all, given Cendant management’s napping at the helm.
The reaction is an increasingly loud shareholder protest that executives must suffer the same consequences as do other shareholders. Repricing saddles public owners with the entire loss in stock value and rewards the ones in control of the company for a stock price drop. All this, and they need never see an angry shareholder.
An Institutional Shareholder Services survey of 118 large shareholders from 1997—well before the current surge of repricing— shows that 71% would vote for proposals to prohibit repricing without shareholder approval. Further, in August the US Financial Accounting Standards Board (FASB) said that it may push companies to treat repricings as operating expenses. In response, some companies have devised more shareholder-friendly repricing programs. If the share price rises after a company reprices, it would report the gain as operating expense. High-tech companies are already talking of a counter offensive similar to their efforts several years ago that forced FASB to retreat from a plan to account for options as a charge against earnings.
The repricing trend is beginning to spill into Canada. While some Canadian companies are lowering their option exercise prices without consulting shareholders, others, including Calgary’s Bolt Energy, are making repricing contingent upon shareholder approval. Companies can make repricing more shareholder palatable through mechanisms such as granting fewer new options, restarting the vesting schedule, maintaining the term of old options, and seeking shareholder approval. But companies that reprice without regard to investors will likely face growing resistance. This type of raid of shareholder value through excessive dilution will cause nothing but class action suits from shareholders and institutional investors. The management of these companies will be hard pressed to defend their actions. In essence a case would go like this…We (the Executives of the Company – soon to be collectively know as the Defendants) based our compensation on stock prices since shareholder wealth maximization is the most important measurement. Stock prices tumbled and the shareholders lost money and we repriced our options to get paid anyway, even though the shareholders lost money….
Expect class action litigation in 1999 to exceed all of 1997 and 1998 combined, on this issue alone. The tort reforms public companies have sought for so many years are finally in place, but nobody reformed the greedy management of over 100 public companies. The spread of the year: Short company’s that repriced their stock options, and go long on law firms!
This article has been put into the Competitive Intelligence section because it points out a unique weakness in those companies that have had “option revaluations”. These companies will be subject to shareholder suits and the distractions and management reshuffles they almost always cause. The focus of these businesses will not be on competition, but on how to cover their butts. It further reveals a company that is run by managers, and leadership that has little or no equity stake in the company because of the dilution these executions of options cause. These are mature stale companies with no entrepreneurial sprit – other than to that dedicated to re-arranging their compensation plans.
