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.

• Author: Muller, Jennifer S.
• Position: Compensation

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...