Stock options: weighing the impact of bailouts; a survey by investment bank Houlihan Lokey Howard & Zukin examines trends in the use of option cancellations and repricings since the economic bubble burst.

Stock options rode the bull market of the 1990s to a peak of popularity, then fell amid one of the severest bear markets in history, leaving employees at many companies with deeply out-of-the-money options. As a result, these enterprises face the danger that vital employees with underwater options will effect their own "repricings" by changing jobs and receiving new, at-the-market options.

Management appears to be taking stock of this scenario. Since the start of 2001, more than 330 companies have bailed out underwater options, and Microsoft Corp. made headlines last year when it announced plans to jettison its options program in favor of restricted stock and cash out employees' existing out-of-the-money options.

Nonetheless, the issue of option repricing is a difficult needle to thread. In the wake of corporate scandals and the meltdown in equity prices, investors have little tolerance for compensating employees handsomely while they swallow severe stock losses. To learn how companies are handling these issues, Houlihan Lokey Howard & Zukin studied 280 option bailouts offered in 2001 and 2002. To see how successful those bailouts were, we compared stock and strike prices as of September 2003. The findings are outlined in this article.

In March 2000, the Financial Accounting Standards Board (FASB) issued Interpretation No. 44 to make option repricings more difficult and more expensive, from an accounting perspective, for public companies to implement. The interpretation defines a "repricing" as a reduction of an option's exercise price or the cancellation of options, with subsequent granting of new options at a lower price to the same person within six months.

Repricing is treated trader the variable accounting approach, which requires a company to recognize a compensation expense equal to the difference between the exercise price and the fair market value of the stock until the option is exercised or expires. The expense is measured quarterly. In addition to depressing earnings, the expense may increase earnings volatility as it fluctuates with the company's stock price.

Public companies and accounting firms have developed four alternatives to repricing that can bail out underwater options while avoiding variable accounting treatment. Companies can:

* Cancel or surrender underwater options, replacing them with new options six months and a day later (the so-called 6&1 approach);

* Replace options with restricted stock;

* Leave underwater options untouched while shortening the time to the next option grant cycle or make additional one-time grants; or

* Buy out underwater options with cash.

Bailouts have several drawbacks, in addition to creating a compensation expense. They are at odds with the shareholder-alignment model underlying most executive compensation programs. In other words, while employees benefit from repricing, nonemployee shareholders suffer dilution. Repricings that occur six months and one day after cancellation of the old options also may result in a perverse incentive for option holders to hold down the stock price before new options are issued. Some critics regard bailouts as tantamount to rewarding failure, since employees benefit despite poor stock price performance.

Lastly, some arguments speak against 6&1 option exchanges as an employee retention tool. For example, employees with no equity ownership in the company outside of their options have little incentive to stay during the six months-and-a-day period. Employees who get cashed out or receive restricted stock in exchange for their options might similarly lose their motivation to stay.

Study Overview

Houlihan Lokey Howard & Zukin studied how companies are conducting option bailouts in the wake of the new era of corporate governance. (The term "option bailout" is used as it is used by the Investor Responsibility Research Center, to capture both immediate repricings and company actions that serve similar purposes, although they may or may not be considered repricings under FASB definitions.) The study of 4,000 of the largest publicly traded companies showed that in 2001-02, a total of 280 companies made option bailout offers --181 in 2001 and 99 in 2002.

Technology companies accounted for 78 percent of all of these bailouts. Twenty percent were listed in the S&P 1500 Supercomposite Index, and only 6 percent in the S&P 500. Approximately 83 percent were trading on the Nasdaq Stock Market. Among the non-technology companies providing bailouts during the study period were Nautica Enterprises (6&1 in August 2002), Korn/Ferry International (6&1 in March 2002) and Eastman Kodak (6&1 in January 2002). Among those doing bailouts this past year were Delta Airlines and BJ's Wholesale Club, which both did 6&1 transactions in May 2003.

Methods Used

In the vast majority of bailouts, companies used the 6&1 method--72 percent in 2001 and 87 percent in 2003. Traditional repricings, with the negative variable accounting effect, declined from 12 percent of total in 2001 to 5 percent of total in 2002.

Some companies combine different methods in their bailouts. In July 2003, CheckFree Corp. offered restricted stock or cash (if less than $3,125) in exchange for stock options, vested or not vested, with exercise prices equal to or greater than $44. In September 2002, Siebel Systems offered stock or cash in exchange for options, depending on the employee's total holdings.

By definition, companies choose to bail out their options when exercise prices are higher than the trading price of their common stock. InfoWorld has noted that, given the volatility of the market and how quickly businesses can turn around, employees should be careful about exchanging options that are within 20 percent to 25 percent of the underlying stock's fair market value.

Houlihan Lokey's study compared the companies' stock prices leading up to the bailout to the exercise price of those options eligible in the exchange. The calculations are based on the lowest exercise price of the group of options eligible. For example, in March 2003, Brooks Automation offered to exchange options with strike prices of more than $20, at a then-current trading price of $9.44; however, some options had exercise prices as high as $164.76.

Most bailouts in 2001 and 2002 occurred when exercise prices were at least 20 percent underwater. In only 22 percent of bailouts were options eligible in-the-money or close to in-the-money. Although some in-the-money options may have been eligible for the bailout, employees may not have chosen to exchange them. Because of limited information available, this study did not analyze the exercise prices of those options that were exchanged.

In a little less than half the cases, eligible options had been underwater for less than six months, though the time span in which bailed-out options were underwater was very wide. In August 2002, for instance, PMC Sierra offered to exchange a group of options that had exercise prices starting at $8, while the then-current trading price was $7.87. The $8 options had been underwater for one day. That same month, Nautica Enterprises offered to exchange options with exercise prices higher than $24, while the stock was trading at $12.79. These options had been underwater for more than four years.

Exchange Ratios

The vast majority of companies offered new options at a ratio of 1:1 to holders of the eligible options. However, in 2002, companies more often chose either to offer less than one new option for each option exchanged or to use a sliding scale exchange ratio. For example, CNET Communications, which offered an option exchange in June 2002, used these ratios for each new option:

Participation and Other Observations

With increased scrutiny of executive compensation, companies have restricted the eligibility for option exchange offers. In 2002, fewer bailouts included companies' top five executives and directors, and companies with a market capitalization greater than $1 billion were more reluctant than their smaller-cap brethren to include top management or directors in bailouts. In 2002, only 14 percent of large companies allowed top executives to participate, compared to 61 percent of companies with less than $1 billion in market cap. No large companies allowed directors to participate in 2002, while 15 percent of smaller companies did.

A few companies limited the exchange offer to executives only. Out of the 280 companies, seven extended the offer exclusively to executives. All these bailouts occurred in 2001.

Success Rate of Bailouts

In theory, a 6&1 exchange could motivate employees to hold down the price of the underlying stock during the six months leading up to the reissuance of options in order to take advantage of a low exercise price. However, no such trend emerges from the market data. Although 35 percent of companies' stock prices dropped more than 20 percent between the cancel date and the date of the new issuance, these drops occurred within a longer-term downtrend that outlasted the reissue date. Fifty percent of the surveyed companies showed significant share-price declines over the year following the cancel date.

To implement an option bailout, companies generally are required to follow SEC tender offer rules. They must file a Schedule TO when the offer commences, and disseminate a purchase offer containing the disclosure to option holders. The exchange offer must be held open for at least 20 business days, and option holders must be able to withdraw their tenders as long as the offer is open.

How successful have the option bailouts been? One measure of success could be how many new options are now in the money. Of the companies analyzed, 43 percent were out of the money as of mid-September 2003, and in 13 percent of cases, the trading price was less than 50 percent of the exercise price.

Today, institutional shareholders closely scrutinize equity compensation practices that they previously had accepted with little debate. Effective June 30, 2003, the New York and Nasdaq stock markets define repricings, 6&1 exchanges and restricted stock swaps as "material" revisions to equity compensation plans that require shareholder approval, unless the plan specifically allows for such an action.

The rule changes created somewhat of a rush to finalize option-exchange programs, without shareholder approval, before June 30. Other companies are abandoning options altogether and using other tools such as employee stock purchase plans or issuing shares outright.

In the end, an option bailout is a logical method for companies to replace out-of-the-money employee options with new options or restricted stock that once again offer retention and performance incentives. In today's environment, one can argue that the decline in a company's share price stems from the economic downturn and bear market, rather than a failure by management and employees.

Therefore, the market's negative perception of option bailouts may be unfair. However, the counter-argument remains: An option bailout benefits employees while other shareholders suffer dilution, which suggests that at least some equity is inequitable to some stakeholders.

                     Options
Exercise Price       Surrendered

$12.01 to $16.00     1.5
$16.01 to $20.00     2.0
$20.01 to $25.00     2.5
$25.01 to $30.00     3.0
Above $30.00         3.5

Jennifer S. Muller (415.974.5888) is Senior Vice President and Lucia Blatnicky (415.974,5888) is an Associate in the San Francisco office of Houlihan Lokey Howard & Zukin, an investment banking firm. The authors acknowledge Thomas Reicher, a partner in the law firm of Cooley Godward LLP in San Francisco, for his contributions to the article.