When the stock price of Brocade Communications Systems, a fast-growing publicly held computer networking equipment maker based in San Jose, Calif., skidded in late 2002, the pain was widespread. But it did not fall equally on all investors. Like a significant number of other companies in similar situations, Brocade protected one class of investors – employees with stock options whose strike, or exercise price, had fallen below the market value – by simply issuing new stock options at the market price, effectively restoring their value. The company said that by doing so, it could retain talented employees who might otherwise jump ship.

A paper written by Wharton accounting professor Mary Ellen Carter and Luann J. Lynch, a professor at the Darden Graduate School of Business, examines the relationship between repricing underwater stock options and retaining employees. Titled “The Effect of Stock Option Repricing on Employee Turnover,” the paper focuses on firms that did and did not reprice underwater stock options in 1998 and on the subsequent employee turnover in 1999. The results indicate that although repricing underwater stock options does not appear to affect executive turnover, evidence shows that overall employee turnover decreases significantly in repricing firms.

Interestingly enough, the relationship of repricing to retention appears to hold up across industries. “Despite the tight labor markets in which high technology firms may operate and their heavier use of stock options, we find no evidence that the relation between executive or overall employee turnover and repricing differs between high technology and non-high technology firms,” according to Carter’s paper. The results are valid for both large and small firms, she added in a recent telephone interview.

While reviewing her study, one question naturally comes to mind: Are her results still relevant? After all, in 1998 through 1999 the economy was still expanding and companies were worried about finding workers, not shedding them. But as Carter explains, the conclusions from that rosy period remain sound, even in today’s stormy market.

“Obviously, the time frame we were studying (1999) was when labor markets were tight,” says Carter. “But I think the findings are still valid for two reasons. First, it may be even more important to retain good employees when the economy is bad since they are the ones that will help the firm get through it. Second, even in 2002, firms continue to reprice stock options, and the stated reason is still because of retention.”

Potential Windfall, or Worthless Piece of Paper?
Stock options are basically a promise made by a company to offer a number of its shares at a set price, for a set period of time. If the stock price rises to a level above that offered by the option (the “strike” price), it can mean a windfall for the person who holds the option. If the market price falls below the strike price, however, the option – now said to be “underwater” – may be worthless.

“One key element of a compensation package is stock options,” says Carter. “Prior research suggests that firms recognize this, and use stock options for retention. However, the effectiveness of options for retention can decrease substantially if the option sinks underwater.”

The cause-and-effect relationship appears to be fairly straightforward. But in fact, the strategy of repricing underwater options has (along with the larger issue of stock option-based compensation) generated significant controversy. Many observers argue that a company’s financial results are the responsibility of its management and employees, and that they shouldn’t be shielded from the consequences of poor performance.

Companies, however, characterize such action as an investment in the long-term health of the enterprise, saying repricing is necessary to retain talented employees during lean times. According to recent surveys, turnover is expensive for firms, says Carter. “Compensation consultants have estimated the costs of turnover—which include termination costs, vacancy costs until a job is filled, costs of hiring and training a replacement, and lost productivity with a new employee—at 50% to 200% of an employee’s annual salary.”

So despite the controversy, repricing underwater options may in fact conserve funds by giving employees a stake in their current company.

Carter’s paper notes, for example, that one study found “…positive and significant stock returns surrounding repricing announcements in Canada that seem to be motivated by the desire to restore incentives and retain employees.” In other words, when everyone gets a corporate life jacket, more employees tend to stay on board and the company’s bottom line may be revitalized.

A Controversial Strategy Gains Momentum
Either way, the practice appears to be gaining ground. According to the Investor Responsibility Research Center, a Washington, D.C.-based organization that follows corporate governance, proxy voting and corporate responsibility issues, 99 publicly held companies repriced (or announced plans to reprice) their underwater employee stock options in 2002. By the end of February 2003, 26 companies had already announced employee-option-repricing plans; and up to 160 companies are expected to announce such plans this year, according to a Center spokesman.

Meanwhile, if new rules proposed by the New York Stock Exchange (NYSE) and under consideration by the Securities and Exchange Commission (SEC) are adopted, those companies might have to do a bit more explaining to their shareholders.

Submitted in October 2002, the NYSE’s “Notice of Filing of Proposed Rule Change by the New York Stock Exchange, Inc. Relating to Shareholder Approval of Equity Compensation Plans and the Voting of Proxies” notes that, “To increase shareholder control over equity-compensation plans, shareholders must be given the opportunity to vote on all equity-compensation plans, except inducement awards, plans relating to mergers or acquisitions, and tax qualified and parallel nonqualified plans.”

According to the commentary that accompanies the proposed rule, a provision that prohibits repricing of options – or any revision that deletes or limits the scope of such a provision – would generally require a shareholder vote. Further, if a plan does not contain a provision that specifically permits repricing of options, the plan will be considered (for this purpose) to prohibit repricing, and any actual repricing of options will also generally trigger a shareholder vote (with some exceptions). NASDAQ also proposed similar changes, although that exchange’s proposal does not appear to directly address the repricing issue.

So far, management has usually been able to initiate option repricing without shareholder approval. No one can predict, with certainty, what will happen to repricing if a shareholder vote is required. But investor sentiment, which is traced by the Investor Responsibility Research Center, may provide a clue. “As an impartial information-gathering organization, we do not take a position on option repricing or other issues,” says Carol Bowie, director of Governance Research Services at IRRC. “But we have taken note that the practice is generally looked upon unfavorably by investors [who] don’t have the opportunity to have their options reset.”

Mark Neagle, a partner at the national office of PricewaterhouseCoopers in Florham Park, N.J., also thinks that repricing could take a beating if it’s put to a shareholder vote. “One suspects that shareholders would be averse to approving benefits that they would not be able to enjoy,” he says. “But repricing options is only one of a number of strategies that companies can use to retain talent.”

He notes that as an alternative, companies could simply issue additional options that are “at the money” (a strike price equal to market value) or “in the money” (a below-market strike price).

In any case, he adds, the overall issue of stock options could shift if the Financial Accounting Standards Board (FASB) adopts a rule currently under consideration that would require companies to recognize the value of compensation-based stock options as an expense on the income statement. Currently, businesses can limit the reporting of these charges to footnote disclosure.

“Companies would have less of an incentive to grant stock options if they were required to recognize the associated charges on their profit and loss statement,” explains Neagle. “If FASB issues this rule, we may see a reduction in the volume of stock options issued.”

Carter notes that Brocade Communications Systems, the company referred to earlier, is doing what is called a “6+1” option exchange. “Companies may have to take a charge to earnings if they reprice options or if they cancel and regrant new options within six months,” she says. “This new form of repricing, called a 6+1 because the company waits six months and one day, does not require a charge to earnings.”

Returning to the overall issue of repricing underwater options, Carter says that, regardless of its merits, the strategy may generate its own conflicts. “One reason to grant options is to align the interests of the employees with that of the shareholders,” she says. “However, when employee options are repriced after a stock price decline, but investors are stuck with the lower priced stock, the alignment is gone.”

She says that when talented employees are holding underwater options and are being tempted to leave, “management has to ask itself if the shareholders are better off if we reprice and keep these employees. If they are, then the benefit of repricing to retain employees may exceed the cost of the negative publicity.”

Perhaps the controversy over repricing stock options was to be expected in the wake of Enron and other debacles, at a time when the stock market seems mired in a slow-performance phase, and as investors, regulators and the general public call for greater transparency in corporate transactions.

In the meantime, Carter and Lynch’s paper may give shareholders and regulators alike some second thoughts about the issue of repricing underwater options. “If keeping these employees would benefit shareholders (and we don’t speak to this in our paper), then repricing may indeed be beneficial to shareholders,” says Carter. “Certainly, our results provide insight into the controversy over dealing with underwater options by suggesting that there may indeed be some benefit to shareholders.”