Dealing with Underwater Stock Options: Some New Twists on a Timeless Quandary

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The quandary posed by underwater options isn't new. Companies face it whenever stock prices tumble for a prolonged period, whether the decline cuts across the market as a whole or falls only on certain hard-hit sectors. The issue attracts the most widespread attention during and after major market downturns such as the 1987 market crash, the 1992-1993 recession, the dot-com meltdown, the 9/11 aftermath in 2001 and again today, especially among financial services firms.

Many of the issues companies face with regard to underwater options are timeless. Most feel they must take action to:

• Restore the options' ability to provide a meaningful performance and retention incentive to holders who view out-of-the-money options quite negatively
• Promote fairness between holders of underwater options and new hires who receive at-the-money options with far lower exercise prices
• Limit the negative effect of underwater options when companies have low levels of share reserves available under shareholder-approved plans

At the same time, companies understand that shareholders tend to view repricings of underwater options (in their various forms) as an unfair "do over" that wasn't available to investors who suffer real losses. That perception isn't new and isn't likely to change.

Recent Technical Developments

There are, however, some significant technical developments that have occurred since the last broad market downturn in 2001 that should be carefully factored into today's decisions. These affect:

• the accounting treatment (under FAS 123(R)) for repriced awards
• the need for shareholders to approve many repricings and whether proxy advisors such as RiskMetrics/ISS will support such actions
• the need to treat repricings as a tender offer and publicly file Schedule TO (along with requiring additional time and filing fees)
• whether and how repricings will have to be shown in a proxy statement and/or Form 8-K
• whether any adverse Section 409A (deferred compensation) implications will result.