Repricing challenges: directors need to weigh many competing considerations.(LEGAL BRIEF)

BOARDS FACE NEW and difficult challenges in their oversight of executive compensation. Rising sentiment against what many see as overpaid and underperforming executives has focused additional attention on this already sensitive topic. And with "say on pay" apparently just around the corner, directors increasingly find their decisions on executive pay subject to new and often hostile scrutiny. Nowhere is this more evident than in the difficult area of option repricing.

Executives who have lost many of their assets in the stock market rout are often skeptical that the markets will return to their former levels anytime soon. In particular, those holding deeply underwater options may consider them of marginal value, largely eliminating the value of the options to motivate performance and encourage the executive to stay.

In response, boards are struggling to find new ways to restore these incentives. A key strategy for many has been an option exchange or repricing. In a repricing, the strike price of the executive's underwater options is lowered--sometimes to as low as the current market price. In an exchange, the executive gives up the underwater options and instead receives a new award with greater potential value. While repricings and exchanges can restore meaningful incentives to a company's compensation program, this may come at the high cost of angry shareholders, who have watched the value of their own shares decrease dramatically over the past year without the luxury of resetting the price of their stock.

Shareholder watchdogs like RiskMetrics Group are demanding shareholder votes on repricings and threatening to unseat compensation committee members who authorize repricings without shareholder approval. Furthermore, Nasdaq and the NYSE require shareholder approval for a repricing, unless the underlying option plan expressly provides otherwise. Today, the outcome of that vote is often problematic.

In any repricing, the critical question is the new price. One-for-one exchanges, where the optionholder receives a new, market-priced option for each underwater option, are the most controversial, as the executive recovers the entire value lost in the stock market decline, and so is relieved of the pain felt by the shareholders.

On the other hand, in a value-for-value exchange, the optionholder absorbs at least some of the stock devaluation, and receives, in a new award, the value remaining in the underwater option. Of course, in a full value-for-value exchange, there may be precious little value remaining, and so this kind of repricing may not be worth the trouble unless coupled with new grants.

In addition to navigating the issues of price and the potential for a shareholder vote, the board should consider the reasons for the decline in the company's stock price. A repricing is all the less palatable if the decline can be attributed to management missteps. Also, any repricing should be structured to avoid, if possible, two unappealing alternatives: that the underwater options will be back in the money in the relatively near future even if not repriced, or that a repriced option will become underwater shortly after being repriced.

Finally, any board considering a repricing or exchange should evaluate the scope of the proposal. Given RiskMetrics' stated intention to generally oppose any repricing or exchange proposal that applies to options held by directors or officers, a board proposing such a plan must consider two separate repricing or exchange plans, one for the rank-and-file employees and a second one for management. Being forced to divide the proposals makes it easier for shareholders to vote against management repricing while not punishing the rank and file.

As shareholder hostility to repricing and exchanges continues, a company struggling with retention and incentive compensation problems will also need to look at other strategies, such as granting executives cash bonuses or restricted stock. Cash bonuses, paid periodically based on performance goals, may provide real incentives, but, unlike options, may not invest the executive in the long-term success of the company. Furthermore, such a cash payout can be a drain on the resources of already cash-strapped companies.

On the other hand, restricted stock or restricted stock units, with no set exercise price and vesting contingent on the achievement of certain goals, align the interests of the executive more closely with those of the stockholders, while eliminating fears of options returning underwater if stock prices fall again.

At the end of the day, directors will need to weigh these competing considerations and decide whether repricing or exchanging equity awards is in the best interests of the company and its stakeholders. Although directors must be prepared for criticism from some quarter no matter what their decision, in the long run the board must ensure that its management team remains committed to the success of the enterprise, and is willing to work for that success.

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Doug Raymond is a partner in the law firm Drinker Biddle & Reath LLP. He heads the firm's Corporate and Securities Group (www.drinkerbiddle.com).

The author can be contacted at douglas. raymond@dbr.com. Catherine Macomber, an associate with Drinker Biddle & Reath, assisted in the preparation of this column.

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