'Not waving, but drowning': Dealing with 'underwater' options

09 March 2009

http://www.shoosmiths.co.uk/news/2043.asp

The worldwide recession has seen almost three quarters of FTSE 100
companies' employee share options slip 'underwater', according to
recent research.

It means the price employees have to pay to exercise their stock
options is more than the market value of the stock; so buying their
company's shares on the open market is cheaper than exercising their
options.

The economic boom of the last decade saw an increase in share
option schemes and performance related pay as incentives to both retain
and motivate staff. But with recent stock falls, employers may need to
consider what steps to take – if any – to reincentivise their employees.

Should companies do anything?

Stock options have traditionally been granted to employees in order
to encourage their personal investment in the company, and to align
their interests with those of shareholders.

Shareholders may feel that if they are suffering from the
consequence of a low share price, so should employees. If this is the
case, it may be appropriate to simply wait out the downturn without
further action.

It may also be appropriate where options have just been granted, and are still in the early stages of their vesting period.

However, where the drop in the company's share price is due to the
overall economic downturn rather than the actions of the employees, and
where there are concerns that employees may leave the company, some
action may be appropriate in order to keep valued staff.

Possibilities for dealing with underwater options
Do nothing – but grant further shares at the next annual grant

In line with the Association of British Insurers (ABI) guidelines
for listed companies, companies are encouraged to make regular grants
of options.

If this is the case, the company could simply make an increased
grant of options to employees at the next grant. Options are normally
granted at an exercise price equivalent to the market price of the
shares at the time. Consequently, the current low share price could be
extremely beneficial for employees, as options granted now could
provide a substantial upside.

However, listed companies must be aware that both the old and the
new options will count towards their institutional ‘dilution' limits.
There are also individual limits in relation to CSOP, SAYE and EMI
schemes, which should be taken into account.

Additionally, if options are intended to act as a short-term
incentive – for example where there is the prospect of an imminent
merger or takeover – then waiting for the next annual grant in order to
‘fix' the problem would not be appropriate.

Parallel options

This is where new options are granted on the basis that if they are
exercised, the existing options lapse, and vice-versa. Employees then
have a choice:

• take advantage of the low exercise price on the new options


• exercise their options earlier

Generally, only one set of the options granted should count for dilution purposes.

Grant replacement options

The majority of share option scheme rules normally provide that
cancelled or lapsed options cease to count for dilution limit purposes,
so it may be possible to arrange for current options to be surrendered
by options holders, and re-granted as new options at the current, much
lower, market price.

While the re-granting of options has previously been frowned upon by
the ABI, the current climate is such that it is likely to take a more
flexible stance.

In the USA there have been high profile examples of firms using this
option, most specifically at Google, which announced on 22 January that
it would begin offering employees a one-for-one stock exchange program
that would allow employees to trade their current stock options for
options equal to the closing price per share of the stock on 2 March.

However, companies choosing this may need to amend their share option plans and consider whether they need shareholder approval.

Re-price current options

Essentially, this simply changes the exercise price by lowering it
to the current market value. Use of re-pricing, however, is very
unusual, and would require listed companies to gain shareholder consent
prior to the re-pricing, or risk breaking Listing Rule 9.4.4., which
requires prior shareholder approval of the grant of any discounted
executive options over newly issued shares.

Companies following ABI guidelines would not be permitted to
re-price, as they state very clearly that the re-pricing of options is
not appropriate.

If the company issues options under a share option scheme approved
by Her Majesty's Revenue & Customs they will be prohibited from
re-pricing as HMRC does not allow re-pricing within tax approved
schemes.

Avoiding underwater options in future

• Change to a Save as You Earn (SAYE) scheme instead of the company's current share option scheme.
  If a company operates a SAYE scheme it is understood that employees can
  cancel their underwater options and apply for new options every year
  the scheme is operated. 


• Switch to a Long Term Incentive Plan (LTIP). With
  an LTIP, the employee is given the right to claim share awards if the
  company has reached certain performance targets over a given period.
  Unlike options, share awards deliver the absolute value of shares,
  rather than an exercise price, and so cannot sink underwater. 


• Use a bespoke arrangement. A company may prefer to use a bespoke arrangement in order to cater to its own particular needs.
  
  This
  could include granting restricted shares to employees, making one-off
  awards to reward exceptional performance – structured so that they do
  not require shareholder approval – or making more use of deferred bonus
  arrangements, as these can be structured so they do not need
  shareholder approval.

While underwater options may cause firms some short-term difficulty,
companies may be able to turn a negative into a positive by using the
downturn as an opportunity to consider whether their current share
incentive plans provide an effective and motivating aspect of employee
remuneration.

This may, in fact, be the ideal time to restructure current
arrangements into a forward-looking and well planned employee
incentives programme appropriate both for the near future and for the
economic upturn – when it comes.