SEC eyes revised options deals –

By Michael Schroeder and Ruth Simon

Staff Reporters of The Wall Street Journal

From The Wall Street Journal

No gain, no pain.

That seems to sum up corporate America's view of employee stock options. Some technology companies, facing pinched profits and sinking stock prices, are bailing out workers stuck with worthless stock options by quietly chucking the old options, then resetting the exercise price lower to make the options valuable again.

It's a neat gambit, and it's not new. But now, securities regulators are set to take a hard line on the practice -- and that has got some technology firms up in arms. At issue is a potential plan by the Securities and Exchange Commission that would impose new, stricter filing requirements for companies that revise, or "reprice," employee stock options.

The upshot: The SEC plan would require lengthy disclosure before companies reprice options. Currently, options repricing is disclosed in proxy material that often appears months after such options are granted. The SEC's new approach "is like trying to fit a square peg in a round hole," gripes Thad Malik, general counsel of Lante Corp. of Chicago.

It is the latest skirmish in the battle over efforts by companies to take the downside risk out of stock options. The SEC also recently advised accountants that companies must disclose the financial impact of special agreements that allow workers to rescind soured employee-stock purchases. Option repricings have triggered criticism among some investors, who contend that they reward managers who haven't performed. The repricing ruckus underscores how far companies have gone to provide financial incentives in a bid to retain key executives.

Employee stock options are important to an increasing number of U.S. workers. They are the most widely used form of incentive pay, giving employees the right to buy their company stock at a set price within a number of years. At the peak of the technology bubble last year, options made many workers millionaires on paper. Now, many of those options are "underwater"; that is, the underlying stocks trade at a price lower than the "exercise" price at which the options can be cashed in.

Roughly three-quarters of companies with underwater options have taken or are considering steps to compensate employees for their paper losses, according to a survey by iQuantic Inc., a compensation-consulting firm in San Francisco. Nearly 70% of the businesses considering action are looking at repricing or canceling and reissuing stock, the survey found.

But such actions often put corporations at odds with their shareholders. "The original justification [for stock options] was this was incentive pay," says Patrick McGurn, vice president of Institutional Shareholder Services of Rockville, Md., which advises institutional investors on proxy issues. Actions such as repricing and reissuing shares "clearly destroy the incentive value" of options, he adds. Employees "just assume they will get more repricing or makeup awards" if share prices fall. "It removes the risk for them."

In a typical repricing, employees receive new options with a lower exercise price set to match the value of the underlying stock on the day the grant is made. However, some companies have repriced options at as much as a 15% discount to the underlying stock's value at the time.

The SEC plan was disclosed at a recent legal conference sponsored by Northwestern University, where agency officials said repricing or exchanging options in many cases should be deemed a "tender offer," which requires lengthy filings and disclosures, according to several securities lawyers who attended the session. "They made it clear it's a tender offer at this stage," said Adam Klein of Katten Muchin Zavis in Chicago. The SEC about a year earlier had begun advising securities lawyers privately that it considered repricings to be tender offers in certain cases.

In the strictest sense, tender offers are bids to buy shares of a company, usually at a premium to the stock's market price.

Stan Keller, an attorney at Palmer & Dodge in Boston and chairman of the American Bar Association's federal regulatory and securities committee, says his panel will seek a meeting with the SEC to voice objections. An SEC spokesman said the agency hasn't yet formally decided how to treat filing requirements for option-revision plans.

Option repricings were rampant in the technology sector a few years ago, until a new accounting rule nearly dried up the practice. The accounting rule, which was retroactive to late 1998, forced companies to record as an expense the hefty value of repriced options -- computed as the difference between the new, lower exercise price and the underlying stock price. Repricings dropped to 30 in 1999 from 306 a year earlier, according to Investor Responsibility Research Center in Washington. (The statistics are based on a survey of 3,400 companies.)

But the practice has been making a comeback in recent months, and low prices, rising layoffs and continued weak share prices have emboldened companies looking for ways to retain employees. Most of the businesses have designed the new options programs to benefit employees, while minimizing the impact on total shareholder value.

"A lot of the companies that have actually repriced have been the companies that have been most desperate" to retain their employees, says Ed Speidel, director of executive compensation and total rewards at PricewaterhouseCoopers. Mr. Speidel expects more repricings to occur once a prominent company announces it has taken such action.

The SEC is taking a tough look at a variety of stock-option-revision techniques. For instance, the "value for value" repricing is calculated in such a way to limit dilution of share values. As the plans are set up, employees exchange their existing options for a repriced version. The larger the difference in the new price, the fewer new options workers receive. In addition, the new "in the money" options can't be exercised for at least six months, allowing companies to avoid expensing the new options under accounting rules.

Responding to SEC pressure, companies are now being advised by outside counsel to file the plans as tender offers. Securities lawyers say the SEC has gotten more aggressive about the issue since Sprint Corp., the telecommunications concern, chose not to structure an options repricing in October as a tender offer. The company's shares collapsed after its planned merger with WorldCom Inc. was blocked by U.S. and European regulators in June.

To mitigate financial losses to employees, Sprint said 24,000 people would benefit from the pricing change. Sprint had no comment.

Just last week, another company chose not to file a plan as a tender offer: Seattle-based RealNetworks Inc., an Internet-software maker whose shares have plunged about 90% in the past year, announced that employees can exchange existing stock options for new ones in several months at the market price at the time. The plan won't raise the number of shares outstanding.

In putting together the option-exchange plan, the company is "trying to balance all the interests of institutional investors and employees," said Paul Bialek, RealNetworks' chief financial officer. He said the company has worked with legal advisers and decided not to file tender-offer documents.

But in the past several months, more companies are filing option plans as tender offers, including Inc., Mills Corp. of Arlington, Va., and Lante.

In late January, Amazon became the first major Internet company to reprice options in months. The offer calls for employees with options to exchange them for fewer new options whose strike price would be set at the lowest price the stock trades at from Jan. 1 through Feb. 14 of this year, or at 85% of the Feb. 14 price if that is higher. The new options will vest in six months.

Amazon had no comment.

Lante's general counsel, Mr. Malik, said, "The best way to get shareholder returns up is to properly give incentives to employees."

Greg Neeb, Mills treasurer, said the plan only involved $1.5 million and has successfully helped the company retain middle management.

In particular, securities lawyers expect the Amazon plan to spur a new round of repricings among tech firms -- some of which may run counter to the SEC's preference, setting up a showdown. Securities lawyers argue that the tender-offer rules weren't designed for option repricings, which are set up to help employees and shareholders. They object to delays and the added expense of complying with the rules. For instance, the SEC required amendments to Lante's Dec. 21 filing, causing delays that have prevented the company from completing the option exchange as yet.

Critics point to another disadvantage of tender-offer rules. Most employee-option-repricing plans don't apply to senior executives. But the tender rules say repricings must be offered to "all" options holders -- including the top managers.

The rules, under the Williams Act, were originally intended to prevent corporate raiders from quietly amassing big stock holdings and selectively offering to buy only a certain percentage of shares outstanding as part of takeovers. The tender-offer process requires a purchaser to file a lengthy document explaining the transaction and slows the process.

"It doesn't seem like the type of transaction that [the tender-offer securities law] was designed to address," said Brian Lane, the former head of the SEC's corporation-finance division who now is in private practice in Washington. "A whole host of issues are raised by this."

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