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Fool On The Hill

Tuesday, January 26, 1999

FOOL ON THE HILL
An Investment Opinion
by Warren Gump

Should Management Profit from Screwing Up?

Many companies have jumped on the bandwagon of offering employee stock options (ESOs). Generally, these plans are touted for their ability to align management's interests with those of shareholders. The theory goes that if management has exposure to stock options, they will be monetarily rewarded as the company's stock price increases. Such incentives make intuitive sense. Unfortunately, a nefarious twist to these options plans is becoming increasingly popular. Several companies have been taking the risk out of their options plans by "repricing" the options if the stock price falls.

An option provides the owner the right, but not the obligation, to purchase a security over a specified period of time. Upon grant, the employees are notified of the exercise price, or the price at which the stock can be purchased. Most of the time, ESOs have an exercise price at or above the current market price of the company's stock and are valid for several years.

If the stock price of the company rises, the employee gets to benefit from this increase through the stock options. Let's say that the fictitious Options'R'Us issues its employees 5-year options at the current stock price of $20. The employee receiving these options would be able to purchase a share of the company for $20, regardless of what price the stock was trading.

If the stock falls under $20 after five years, the option is basically worthless because it is cheaper to go out and buy the stock on the open market. If the stock was trading above $20, the option would be worth at least the difference between the stock trading price and $20. For example, if the stock were trading at $25, each option would be worth at least $5 ($25 - $20). If the company gets really hot (you know, changes its name to Options'R'Us.com) and soars to $100, each option is worth at least $80 ($100 - $20).

Providing ESOs helps employers motivate employees to work toward the better good of the entire company. Producing overall results that are well received by the stock market results in a higher option value. On the other hand, if the company's stock price performs poorly, the options do not gain any value. Such a system obviously increases employee awareness of the company's stock price. (Another benefit for the company is that options aren't charged against net income, but that's the subject of a Fool on the Hill column for later this spring.)

Recently, after significant drops in their stock prices, several companies have decided to "reprice" their options. This means that the exercise prices for the options are reduced because the stock has fallen dramatically. Let's say that the stock of Options'R'Us falls to $5 per share due to poor earnings. In a repricing, the company would exchange the old options that were issued and grant new ones with an exercise price of $5.

Once the repricing is complete, employees get to benefit from any gains in the stock price over $5. It's like when you are a kid playing a game and things didn't go as you expected so you say, "Do over." We messed up the first time, so we're going to start again. That's great for the employees and top management (which tends to own a disproportionately large share of options). On the other hand, shareholders don't have an opportunity to shout "Do over" and exorcise the losses experienced in the stock from their portfolios.

Several companies have recently disclosed the repricing of their employee options as described below.

Last September, Ciena Corp. (Nasdaq: CIEN) announced that it was repricing options with an exercise price above $12 3/8, the fair market value on Sept. 16, down to this level. All of those options that were issued when the company's stock was trading at $23 (its initial public offering price), $30, $50, or $92 (its peak this past July), were repriced at $12 3/8. At today's stock price, the repriced ESOs have an intrinsic value of about $22 million, despite the fact that the stock has fallen 63% in the last year.

Ciena commented in a press release that options held by the company's executive officers issued prior to the IPO would not be affected by the repricing. Such a statement indicates a punitive action on the leaders who led the firm when it experienced significant problems. As it turns out, however, that's not really the case. Most of these options wouldn't have been repriced under the program because well over 90% of them have exercise prices below $5.

Another recent repricing was that of Cendant (NYSE: CD), the company trying to recover from massive accounting fraud uncovered when management performed due diligence on a major acquisition. The company's stock plunged from a high of $42 in April to a low of $7 last October. On July 28, in the midst of the brouhaha, the company announced that it was going to reprice options for 4,000 middle managers that were granted between December and March because of the price decline.

At the time of the repricing, company president and CEO Henry R. Silverman commented, "We do not believe it is appropriate to, nor will we reset the terms of the options awarded as compensation to our most senior executives." Less than two months later the company announced a new equity ownership program for senior management.

Under this program, about 42% of the outstanding options were repriced to fair market value, 33% were repriced to levels above fair market value, and 25% were canceled. The board compensation committee apparently felt that senior management, those people most responsible for the debacle, deserved to have all of their options exchanged, not just those issued in one quarter. Once again, management and employees got a great deal while shareholders were stuck with their negative 42% one-year return.

One last example -- and there are plenty of other ones out there -- is FelCor Lodging Trust (NYSE: FCH). This company has apparently implemented a repricing program, but details are sketchy. FelCor didn't issue a press release discussing its repricing. Rather, we became aware of the issue because an astute Fool on our message boards read obscure Form 4 filings with the Securities and Exchange Commission (SEC).

According to these documents, outstanding options of the senior management team were canceled and replaced with a lesser number of new ones with a strike price of $22 1/8. Again, management is not subjected to the ramifications of decisions that caused shareholders to suffer a 31% loss over the past year.

Overall, ESOs are a good idea since they help motivate employees and allow them to participate in the growth of the company. Repricing previously issued options after a decline in the stock, however, is unfair to shareholders. Such action diminishes the incentive impact of the options while increasing the dilution in ownership among current owners.

A reasonable argument can be made that employees who did not have any influence on the decisions leading to the adverse stock movements should not bear the cost of the pain. My first response is tough luck, that's a risk assumed when receiving options as part of your compensation structure. A more realistic perspective given today's tight labor markets is that lower-level employees be offered a modest "retention" option grant. Such a grant would not be intended to replace previously issued options, but would allow employees to profit from increases in the stock from extraordinarily low levels.

What truly appalls me is seeing a senior management team -- those responsible for making the company's key strategic decisions -- have their options repriced. These people, already receiving a hefty salary, are granted options so that they benefit from guiding the company in a direction that boosts shareholders' returns. The system should not be redesigned to allow senior management to profit from screwing up.

Call Your Boss a Fool.

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