Let's Stand Up to Scandalous Stock Options

"So now that the stock price has doubled, are you going to reprice your options back up?"

That question silenced Home Inns (Nasdaq: HMIN  ) investor relations manager Ethan Ruan when we met with him at the company's headquarters in Shanghai, during our recent Motley Fool Global Gains research trip to China. He'd just finished telling us how excited management was that they'd gotten such a good strike price ($7.26 per ADR) on the stock options they canceled, then repriced and re-issued.

Newsflash, Mr. Ruan: Potential investors don't like hearing how excited management is about their latest move to bilk outside shareholders.

And your explanation was a stupid one
Asked why the company felt it necessary to re-price all of the unvested, out-of-the-money options it had granted to senior management, Mr. Ruan responded that the company worried that having options with such high strike prices -- Home Inns' stock dropped 85% in the year preceding the October 2008 option reissuance -- would demotivate employees and possibly cause retention issues.

This is a tough pill to swallow. The company's founders and senior officers already owned hundreds of thousands of options with a strike price of $11 per ADR or less. Furthermore, those company directors and executive officers (as of the last 20-F filing) already owned 15% of the stock. I find it hard to believe these key folks were going anywhere.

In addition, it's not like the stock market unfairly turned on this company, costing executives compensation to which they were rightly entitled. The team here took many steps that destroyed value, including the ill-conceived and -executed acquisition of unprofitable rival Chinese hotel chain Top Star, an inability to control rising expenses, and the launch of a new concept -- the H Hotel -- that the company, according to Mr. Ruan, has no intention of growing.

These efforts have consumed capital at an alarming rate. The company recently had to sell an additional 7.5 million shares to Ctrip.com (Nasdaq: CTRP  ) to raise a needed $50 million. (Incidentally, Ctrip.com was founded, and remains largely owned, by some of the same folks who founded and own Home Inns.)

So stay away from Home Inns
Of course, while Home Inns is a particularly egregious example of the inanity of options repricing -- not to mention the company that gave us the most stupefying quotes of our trip -- it is far from the only culprit. In fact, thanks to the significant stock market decline of the past 24 months, companies around the world are looking at how, and by how much, they can reprice existing stock option compensation packages.

For instance, eBay (Nasdaq: EBAY  ) shareholders recently approved a plan to reprice employee options. Google (Nasdaq: GOOG  ) , Williams Sonoma (NYSE: WSM  ) , NVIDIA (Nasdaq: NVDA  ) , and MGM Mirage (NYSE: MGM  ) are among the companies that have completed or proposed some form of repricing to improve morale and sustain retention.

To be fair, some companies -- though not all of them -- have excluded top management from eligibility here. But even so, there isn't a surplus of high-paying jobs out there today. How many employees, faced with worthless stock options, will really pack up and move on?

The fact of the matter is …
Shareholders should be outraged at the suggestion that stock options should be repriced in the wake of this financial collapse. After all, those options were intended to align employee and shareholder interests, and specifically designed not to be a guaranteed form of compensation. Since shareholders can't reprice what they paid to buy a stock, repriced stock options subvert even the illusion of alignment.

Furthermore, repriced options hurt outside shareholders by diluting their ownership stake and therefore their claim on earnings. This makes every individual share worth less over the long run.

The bigger picture
Option repricing is just one more example of a situation where people who were happy to reap enormous profits when things were going well are now unwilling to accept the consequences after things have turned south. Sound familiar? This is precisely the culture that drove the folks at places like Fannie Mae and AIG to take undue levels of risk, because they figured they'd be bailed out if they failed. And the bailouts came -- while executives have largely kept the profits they piled up en route to our current housing collapse.

This is absurd. If you can't handle the downside, don't accept variable compensation.

Stand up to scandalous stock options
A number of us here at the Fool are actually surprised that in our litigious society, there hasn't been some form of shareholder-driven class-action lawsuit brought against companies that reprice options, perhaps based on the fact that doing so means that these companies' financial statements have underreported their actual cost of employment. Google, for example, which does not require shareholder approval to reprice its options under its 2004 plan, will record a charge of $460 million in 2009 as a result.

At the end of the day, companies that grant options one year tend to grant them every year. Thus, why should they reprice any old options in lieu of just issuing new options at today's lower prices? That creates incentive right there.

Getting back to the question that stunned Mr. Ruan of Home Inns, why shouldn't a company reprice options that are deep in the money back upward? After all, if it makes sense to lower option strikes when they are out of the money in order to motivate employees, why not do the exact same thing when options are priced so low that they no longer represent a target?

Those are rhetorical questions
The answer, of course, is that options have been revealed to not be a motivation tool -- at least, not in the way they're actually used. Instead, they've become a way for executives and employees to make money at shareholders' expense, regardless of how those executives and employees actually perform.

Now in some cases, you have the right as a shareholder to vote against repricing plans. But even then, these proposals are likely to pass. So instead, think hard about simply not buying shares of companies that engage in this practice. Because if they do it down the road, it means they're underreporting their real expenses, and thus deserve lower trading multiples than their financials might otherwise suggest.

Finally, economics aside, why would you want to go into business with people who, on the tail of operational missteps and a grievous stock market decline, seek to lock in their own long-term compensation at what may turn out to be the most expensive time possible? It's just not worth the trouble.

What do you think about company plans to reprice employee stock options? Let us know by leaving a comment in the box below.

Ctrip.com is a Motley Fool Hidden Gems recommendation. Google is a Motley Fool Rule Breakers pick. eBay and NVIDIA are Motley Fool Stock Advisor picks. eBay is also a Motley Fool Inside Value selection.

Tim Hanson is the co-advisor of Motley Fool Global Gains. You can read about the stocks in China that did impress him by joining Global Gains free for 30 days. He does not own shares of any company mentioned. The Fool's disclosure policy doesn't expect Home Inns to invite us back.


Read/Post Comments (17) | Recommend This Article (76)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 22, 2009, at 6:57 PM, TMFDiogenes wrote:

    This is a fantastic article, Tim. Moreover, you've demonstrated that you truly are master of the subhead.

  • Report this Comment On July 23, 2009, at 5:26 AM, enk1du wrote:

    This is a great article. I agree with the major points regarding option repricings which enrich directors and executives, provide marginal retention incentive and place all of the burden on stockholders. I will however argue with some of your assumptions concerning eBay's repricing of stock options.

    eBay's stock exchange program doesn't convert options into lower priced options, it converts them into restricted stock units equivalent to approximately 90% of the fair value of the options. The cost to stockholders is negligible if not non-existent. Employees whose stock options are affected give up practically worthless stock options in exchange for many fewer stock grants which vest over time giving them incentive to remain. Named executive officers and directors are excluded from this program. The March 9, 2009 proxy filing <http://investor.ebay.com/secfiling.cfm?filingID=891618-09-71... has all of the details which you seem to have missed. Especially note page 28 which details the ratios of options to grants which range from 12-1 to 35-1.

    I don't know about the other company's programs, but eBay's option exchange program hardly seems to be scandalous or aimed at bilking investors.

  • Report this Comment On July 23, 2009, at 7:01 AM, TMFMarlowe wrote:

    Awesome article, Tim.

  • Report this Comment On July 23, 2009, at 1:31 PM, kazenpoint wrote:

    Interesting article. So how does a CEO deals with ringing phones? Phone calls with this opening: "I am xyz, executive recruiter for abc. One question: how are you dealing with your equity plan? We can fix this almost overnight."

    You're the CEO/board member and you have 2 options (no pun).

    You can reprice existing options to market or ready yourself to face exodus and hire a new management team, with no proven record within your company, no assurance they will work well together, and the same cost (or more...) to the shareholders. What would you do?

    Don't take this wrong; executive compensation is out of control in many ways. I believe that job market efficiencies (more than regulations) are the main culprit. But that is the way it works today. Don't blame the CEOs or the boards. They are doing their best in face of the situation.

  • Report this Comment On July 23, 2009, at 1:59 PM, DargFool wrote:

    If you are only working for money, you should not be at the company.

  • Report this Comment On July 23, 2009, at 2:34 PM, lmlight77 wrote:

    "Shareholders should be outraged at the suggestion that stock options should be repriced in the wake of this financial collapse. After all, those options were intended to align employee and shareholder interests, and specifically designed not to be a guaranteed form of compensation. Since shareholders can't reprice what they paid to buy a stock, repriced stock options subvert even the illusion of alignment."

    Why is this true? Specifically the part "options were intended to align employee and shareholder interests, and specifically designed not to be a guaranteed form of compensation?" I completely disagree - stock options are VERY much compensation.

    When you hire an individual, you are recruiting them based on the perceived value of stock options. In a sense, the share holders are telling a potential employee, "come work for us - yes, normal compensation is not what it could be, but look here, we are giving you these great options that soon will have this fantastic return and that's why your other compensation isn't as much."

    Now when the market collapses and all those options are massively under water, now the stock hodlersa are saying, "no it really wasn't compensation, you should be aligned (i.e., in the same boat) as us."

    Sounds like bait and switch.

  • Report this Comment On July 24, 2009, at 2:30 PM, 2beonthemark wrote:

    What really happened over the years to stock options is they have morphed from a portion of total compensation originally intended to supplement salaries, bonuses within smaller generally start-up organizations that were unable to compete outright on the pay scale to attract highly sought after persons into some form of runaway comp structured to line the pockets of the highest paid employees who control the comp structure.

    Unfortunately like many other things, it has become a standard perk or at worst a highly compensated employee bragging right. Anyone familiar with the issuance of options knows, that in most cases, they go to highest paid employees. And again in those cases are reserved for the very highly compensated employees in a disproportionate amount to others who share in an option program.

    In other words, the people who need and appreciate this form of compensation the least actually receive the most and vice versa. Check out any annual report of a publicly traded company and you will see that in most cases - the top dog (CEO) gets the most options and right on down the line.

    I would argue from a motivational or employee retention perspective companies should utilize stock options to compensate those at the lowest end of the pay scale. These hard working employees who earn a fraction of what the highly comped persons do would be eternally loyal and likely experience much higher job satisfaction if they knew their work would be recognized financially.

    Stock options are hardly an incentive to hire or keep already highly compensated people - and if they are I would again argue that you don't want these mercenaries working/guiding the direction of the firm. These people have the highest salaries along with almost every other perk a company can offer like: deferred comp, participation in exclusive comp plans, insurance paid for them by the company, taxes paid for them to compensate them for paying them too much in the first place (yes its true companies do this), company cars, use of the company jets and much much more.

    The gap between highest paid and lowest paid employees has reach the breaking point. We now have 15 million ( 9% to 11% ) unemployed in the U.S.... could be significantly more or less depending on who does the calc. and who they include.

    So to use the argument that options are designed to retain certain ( can't do without ) persons.... what a joke !!!

    Where are they going to go ? To the competition who is doing the same thing and mired in the same economic malaise ??? Why are we here in the first place ?

    Because the same decision makers (ie. highest compensated employees with most of the stock options) made bad decisions to leverage their company and focus on the wrong thing (how to drive the stock price higher so they could extract even more value from the company).

    Repricing stock options in either direction defeats the purpose and original intent of the stock option as the previous writer stated: to align the interests of the employee with that of the shareholder. Repricing is akin to changing the structure of a deal or contract in mid stream because it isn't working out in your favor.... sorry that's why the comp is structured that way. You win if the company does and you lose if the company does. Plain and simple - let's not complicate it !

  • Report this Comment On July 24, 2009, at 5:06 PM, kazenpoint wrote:

    A few comments:

    - I am not working at NVDIA

    - In companies like NVDIA and many others, stock options have become by far the #1 contributors to executives' income'. If it was not the case they would not exist anymore.

    - Stock options were invented by BODs to compensate executives with no impact to cash or IS. The government made it visible to income statement but there is still no impact to companies' real growth potential. All financial analysts know that and discount stock option expenses in their models.

    - None of the comments above addresses the retention problem: repricing stock option is a BOD decision, is not a problem for instutitional investors and is intended to avoid major management turnaround.

    - Yes the optics are disgusting.

  • Report this Comment On July 25, 2009, at 1:17 PM, jgmjgm wrote:

    I always categorically vote against any revision of incentive compensation plans, and any end-run ploy to over-ride such a vote.

    But, as you pointed out, they always pass anyway.

    Are the shareholders so eager to be raped, or are the elections easy to rig?

    The possible upcoming legislation to give shareholders a voice in company compensation should include all incentives as well as salaries.

  • Report this Comment On July 26, 2009, at 9:26 AM, IlanBigfoot wrote:

    Great, we know all this. "Let's Stand Up..." by doing what? Voting our measily 100 shares? Shareholder votes are always non-binding, anyway. Looking at different companies? Everyone's doing it, to quote some pothead movies.

    I got an idea. How about the Fool really get behind this issue? Do we have a discussion board devoted to corporate policy action? Do discussion boards for specific companies talk about these and other issues, like which board members to vote for? Can we use the CAPS screener to remove companies who sell out shareholders to executives from our buy lists?

    This I'd like to see.

  • Report this Comment On July 26, 2009, at 3:41 PM, sparcr wrote:

    Need to send the article to CALPERS as they seem to fit in as wanting to get in on the good times, but don't like things when all goes south. They could also exert a little more effort to assuring the boardroom does what is best in the long run and get out of this short term return mentality. Thanks for a good article.

  • Report this Comment On July 26, 2009, at 11:27 PM, kazenpoint wrote:

    One last comment: company boards are typically much more long term oriented than the average investor. Take NVDIA as an example: look at the market cap ($21B) and at the daily exchange (about $250M). What is the average time of ownership of a NVDIA share? I sure hope the boards have a longer time horizon than this...

  • Report this Comment On July 27, 2009, at 8:36 AM, IRS706 wrote:

    This will not stop until Boards are more aligned with shareholders.

    No more options for board members.

    Require them to use _?__% of their fees to buy stock in the open market which they must hold until 6 months after they leave the board. Make them long term investors.

  • Report this Comment On July 27, 2009, at 8:29 PM, memoandstitch wrote:

    What's wrong with giving employees shares of the company directly (instead of stock options)? Taxes? Then changing the tax rules so that options and shares are taxed the same way should solve this problem.

  • Report this Comment On July 29, 2009, at 1:55 PM, Melaschasm wrote:

    Great article. In the case of US employees, it would be helpful to point out that stock options are not incentive pay, bur rather, they are a form of compensation designed to avoid the extremely high marginal tax rates on earned income.

  • Report this Comment On July 29, 2009, at 1:56 PM, PauvrePapillon wrote:

    Stock options are not the problem. They are only the symptom of a much larger and more serious problem, i.e., the disenfranchisement of the shareholders, the actual owners of corporate America.

    Here are the reforms that are needed and should be applied to all publicly traded companies.

    1. Cumulative voting. All elections of directors should be subject to cumulative voting of shares. It works like this. If there are seven directors up for election and you hold 100,000 shares. You can vote 100,000 for each of seven directors or you can vote all 700,000 for a single director or any combination thereof. The practical effect is that it enables large shareholders to at least have some representation on the boards of directors of the companies in which they have purchased a large equity interest.

    2. Confidential voting. All issues put to a vote of shareholders should be conducted by secret ballot. This precludes management from knowing who is on their side before the polls are closed and the votes are officially counted. This is a huge advantage for management as is enables them to be able to contact only those large shareholders they need to turn in order to decide an issue in their favor. Confidential voting of shares helps to level the playing field.

    3. Elimination of staggered boards. Most companies only put a third of their directors up for reelection each year. This means that even if shareholders were able to elect an alternative slate of directors, they would have to do so two years in a row in order to effect a change in control of the board. Again, this gives entrenched managements an advantage over their shareholders when it comes to deciding on the composition of the board of directors. The solution is for all directors to serve for one-year terms and come up for reelection every year.

    4. Ballot access for nomination of directors. Holders of five percent or more of the outstanding shares of a publicly traded corporation have to file a Schedule 13D or 13G with the SEC. We already know who these shareholders are. If they were allowed to nominate a number of directors, say proportional to their shareholdings, all shareholders would benefit in that they would have an alternative to “none of the above”. The way it works now, management nominates the directors it wants and they run essentially unopposed. Literally, shareholders get to vote yes or no. What they really need is to be able to vote for an alternative candidate (or slate of candidates), not just yes or no to the candidates that management nominates.

    5. Elimination of the “business judgment” rule with respect to shareholder initiatives. Ever wonder why nearly every publicly traded corporation reincorporates in Delaware? It’s because Delaware corporation law is constructed to favor management. Here’s one example. Even if shareholders put a proposal on the ballot and passed it by a unanimous vote, management can still ignore the proposal based on the “business judgment” rule. This is nonsense. The shareholders own the company. It’s their money at stake. If they feel strongly enough about any issue to put it on the ballot and vote a majority of the company’s total outstanding shares in its favor, it should be binding, final and enforceable. It should direct, not advise, management.

    6. Elimination of poison pills. If there is competition for jobs at the bottom of the corporate ladder, there should be competition at the top (and all levels in between.). A free market for corporate control would put management on notice that they must reform or face the prospect of being replaced. In a free society, potential buyers of a company should be able to make an offer to the shareholders who should be able to accept or reject such offer as they please, unfettered by euphemistically entitled “Shareholders Rights” plans that structurally preclude such transactions

    If these changes were enacted, there would be no problem with executive compensation on any level. Managements would be under the gun to perform. If they didn’t, they would be facing replacement.

    Can you imagine how baseball, football or basketball would work if the same rules applied to their owners as apply to corporate America. You would have teams losing year after year after year with the same coaches (or managers) getting paid more and more money and the owners structurally unable to even advise much less fire them. Do you think that would make their teams (and their leagues) more or less competitive? Of course the answer is less, much less, in fact.

    The same dynamic is at work today in corporate America but with a lot more at stake.

    For more on shareholder rights issues, please visit http://www.icahnreport.com.

  • Report this Comment On August 17, 2009, at 3:54 PM, ralfie3 wrote:

    I TOTALLY agree that repricing of options is a giant rip-off of the shareholders. The question really is: How do we address this issue in a really effective way????Dumping the stock just cements the SH losses while mgt. can sit around with repriced options which cost them nothing. Maybe a big class-action might be the answer, but I'm not sure. What other strategies could SHs employ that would be effective?? Tons of stock options are a problemfor SHs, even without repricing.

    ralfie3

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