Underwater stock options: timeless Issue for Tough Times; the continuing stock market meltdown poses a difficult question that many companies confront in economic downturns: what to do about "underwater" stock options.

• Author: Friske, Doug
• Position: Survey

Many of the issues companies face with regard to underwater options are timeless. On one hand, boards may 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 unfair to investors who suffer real losses. That perception isn't new and isn't likely to change.

Recent Towers Perrin research has found a growing number of companies wrestling with underwater options in the current environment, although relatively few have fully addressed the issue thus far. In our January 2009 survey of more than 500 U.S. companies, most reported that their shares have declined by more than 30% in recent months, while 28% reported share price declines of more than 50%. Just over a quarter of the companies surveyed either had already taken action to address their underwater options or were actively considering it at the time of our survey. If the market downturn is prolonged, we would expect to see more companies address the issue.

Unfortunately, there's no answer to the question of whether or not to do something about underwater options that will work for every company. However, there are some guiding principles that can help companies reach the best decision for each unique situation.

For more than a decade, we have followed these guiding principles for evaluating how to address underwater options:

Decisions to reprice should be made with a very long-term perspective.

Repricings should not be used to "bail out" underwater options resulting from what is likely to be a temporary market decline. Repricings should not be viewed as a routine event.

Those most directly responsible for the stock price decline should not be held harmless. Repricings and related actions are more appropriate for lower-level managers and other employees than for senior managers and directors who have the most direct obligation to shareholders.

There should be a "quid pro quo" connected with receiving repriced options, requiring recipients to give up something in...