Are stock option rescissions unfair?

Reports had filtered into the SEC indicating that some companies experiencing steep stock-price declines last year had allowed executives, and perhaps lower level employees as well, to cancel previous options-based stock purchases that had left them with deep losses. Such a cancellation would reduce a company's options-related tax deductions, which could undermine profits or deepen losses, possibly damaging the company's stock price.

While boards of directors see such accommodations as necessary to motivate and to keep top talent, shareholder activists and other critics see a double standard that protects insiders from the stock downturns suffered by ordinary shareholders. Rescissions thus join the list of oft-criticized practices designed to rescue executives and employees who hold options that have become worthless--practices like repricing older options, exchanging high-priced options for cheaper ones or granting of new options with more favorable terms.

"I think you've got something that's obviously very unfair," says Wharton accounting professor emeritus Peter H. Knutson. Executives and employees should not be protected from downturns in a company's stock, but "should be forced to eat what they have cooked," Knutson says.

Graef Crystal, one of the best-known executive-compensation experts in the country, declares rescissions "totally reprehensible." Many companies are overly generous in granting stock options, he says, giving enormous blocks of options even to executives and employees who have failed to deliver for shareholders. While stock options can align insiders' interests with those of ordinary shareholders, rescissions turn insiders into a preferred class, Crystal argues.

And yet, counters Wharton accounting professor David F. Larcker, companies do need to retain talented executives and valued employees who have seen their net worth plummet. "It need not be a bad thing to do," he said. "From a company's standpoint, it may be better to make (an executive) whole, so he won't walk out the door."

Executive and employee stock options became the rage in the 1990s, especially among young technology companies that couldn't afford to pay high salaries. Options were an inexpensive way to lure and retain top talent, and the late 1990s were full of stories of 20-somethings who became multi-millionaires overnight when initial public offerings drove share prices into the stratosphere. Even shareholder activists praised the growing use of options, arguing they motivated executives and employees to promote shareholders' interests.

But when the tech-stock bubble burst last year, legions of would-be options millionaires found their hopes dashed. A typical option grant gives its owner the right to buy a set number of shares at a given "exercise" or "strike" price--usually the stock price on the "grant" date, or day the options are issued. Generally, the options cannot be exercised until they are vested one, two or three years after the grant. Then they can be exercised anytime before they expire in 10 years.

If the stock traded at $10 a share on the grant date and $100 five years later, the owner could exercise options to purchase shares at $10, then either hold the shares or sell them immediately for $100. The option holder could thus make a $90 per-share profit--all without having any money tied up in the shares until the options were exercised. But if the share price fell below $10, there would be no point in exercising. The options would be worthless, or "under water".

Stock price declines left many options under water in 2000, leading a number of companies to seek ways to keep executives and employees from jumping ship. At Microsoft, for instance, employees were granted new options with lower strike prices than ones that had been granted a year earlier. In other cases, companies "repriced" or lowered the strike price of existing options, though this is now less popular because new accounting rules last year count repricing in a way that undermines earnings.

Rescissions are the newest twist, and the names of companies that have done them are likely to become known this spring. The SEC issued rules early in February requiring companies to disclose rescissions in their annual reports. "While we don't know which companies specifically have rescinded exercised employee stock options, we expect that they are predominantly among the high tech companies," Jane B. Adams, a CPA with Credit Suisse First Boston, wrote in a late-January analysis.

Rescissions can involve both incentive stock options and the more common "non-qualified" options. With a non-qualified option, income tax as high as 39.6 percent is triggered by the difference between the stock's market price at the time of the exercise and the lower strike price. Holders of these options traditionally sell immediately upon exercising to avoid the risk of a subsequent price collapse and to reinvest profits in portfolios that are more diversified. But many people who exercised early in 2000 may have held on to the shares in hopes that prices would continue to soar as they did in 1999, Adams wrote. (If the shares are retained and sold later, profits incurred after the exercise are taxed as income if the shares were owned for a year or less, or at the maximum 20 percent long-term capital gains rate if held longer than a year.)

Incentive stock options are treated differently. There is no tax incurred by exercising; tax is triggered only when the shares are sold. So long as they are sold more than a year after the exercise and more than two years after the options grant, the tax is limited to the 20% capital gains rate. Sell earlier and some or all of the profits are taxed at the higher income tax rate.

People exercising these options therefore have a strong tax incentive to hang on to the shares after exercising. But that exposes them to the risk of a price drop in the meantime. To add a further twist, many incentive options holders are subject to the alternative minimum tax, based on the difference between the market price at the exercise date and the strike price.

With the enormous price drops experienced by many tech stocks in 2000, people who exercised either kind of option when prices peaked early in the year, and who then continued to hold the stocks, may have incurred taxes that by the end of the year were higher than the value of the shares they owned. To pay their tax bills, they might have to sell all their shares and come up with other money as well.

To protect these people, some boards of directors have reportedly allowed them to, in effect, cancel their stock purchases after the fact, wiping out any tax bill and investment loss. They would get their options back and be refunded the money they spent on the exercise. The shares they had bought would be returned to the company.

Is this appropriate? Larcker argues it can only be judged on a case-by-case basis, making it essential that companies be required to publicly disclose the practice, as the SEC has ordered.

Boards of directors have long been able to use a variety of moves to insulate top executives from stock losses, sometimes granting new options, bonuses or interest-free loans, he says, adding that it is not clear how widespread such secret deals are. The key issue for shareholders isn't whether an insider is made whole but whether that individual was valuable enough to justify the move.

While outside investors are free to diversify their holdings to avoid having too many eggs in one basket, executives and other insiders often have nearly all of their net worth tied up in their company's stock, Larcker adds. It may be reasonable, then, to furnish them some protection.

But critics like Crystal and Knutson argue that insiders should have to suffer stock-price declines along with everyone else.

Even granting the pragmatic argument that some insiders are so important that extra costs to keep them are justified, it's not appropriate to insulate them from all losses, just some of them, Crystal says. Whatever method a company uses to replace underwater options or unwind a money-losing transaction, the new deal should not be as rich as the old one, he contends.

After all, people who exercise options are not required to continue holding the shares. They could sell immediately at handsome profits; otherwise, they would not exercise. The decision to hold shares after exercising an option is driven by a desire to minimize taxes or bet on future gains. Why should a person who chooses this course not face the risks any investor does in buying stock?

 
To read more articles like this one, visit Knowledge@Wharton.

All materials copyright © 2001 of the Wharton School of the University of Pennsylvania.