Repricing Options Just As Painful
Rob McConnachie
Financial Post
Monday, September 11, 2006
The number of U.S. companies being investigated for allegedly backdating stock options seems to be growing every week and could reach 100 by some estimates.
Stock options give a person the right to buy shares at a certain price. The reason for backdating is simple. By dating them back to a time when the stock was cheaper, the holder has a right to purchase the stock at that lower price, thereby enhancing the profit to the holder.
Unfortunately, the scheme only works if the stock was cheaper in the past.
But what if you are one of the numerous companies whose stock price has only gone down under your stewardship? There is a simple and arguably even more sinister solution which largely goes unnoticed. Instead of changing the date of the options, just change the price.
So far, we haven't seen Canadian companies caught up in the backdating stock option scandals. But what Canadian companies do pull off is repricing options.
Perhaps that's because repricing of stock options is perfectly legal. Or to get around actually repricing, and to make it more palatable to shareholders, management sometimes claims to take the high road by voluntarily surrendering their "way out of the money" options. They then conveniently replace them with options carrying a lower strike price, so as to not actually reprice the existing options.
Option backdating is getting all the headlines, but repricing is just as painful. To understand how truly unfair re-pricing is to shareholders, I refer to the coin toss analogy. If you flip a fair coin, your chance of guessing the right outcome is 50%. But for management who engage in option re-pricing, their idea of fair is closer to the old joke of 'heads I win, tails you lose.'
While stock option abuses come in many forms, here are some particularly flagrant examples that come to mind.
One large Canadian institution paid out a special dividend a couple of years back, but realizing this would reduce the value of their options, conveniently repriced them by the same amount. Question for management: It is shareholders money, not yours, so why do you think you should be rewarded for returning some of their own money for which you could find no use?
Another large Canadian firm's management thought it appropriate to load up on options significantly below the price of the company's initial public offering. No need to back-date -- just set them at any arbitrary price well below the IPO price and, since they are not traded, you can put the price anywhere you want. This way, they would be richly rewarded the day the company goes public, regardless of whether management added any value to public shareholders. This management clearly didn't grasp the concept learned by most in grade school of 'I slice, you choose', instead believing they should get to both slice and choose.
We also recall an extremely poor decision by management that was a primary driver toward knocking the bulk of the value off the company's stock. Did the directors fire management? No, they rewarded them by issuing them stock options at the lower level, causing shareholders further pain through dilution.
Let's think about that logic. You just wiped out most of your shareholders' investment in your company, then unilaterally grant yourself the option to dilute their holding further as an incentive to try and make them back the money you lost them. After several years at the helm, the stock was finally back to about the same price as when management took over, resulting in a windfall gain for management, versus virtually zero returns for long suffering shareholders. Note to management and directors, the term 'setting the bar' refers to the high jump, not the limbo dance.
As money managers, we are always looking to buy good businesses for a reasonable price, run by management teams with high integrity. We believe the aforementioned companies are all good businesses fortunate enough to have dominant and entrenched market positions, with limited competition - the types of businesses we like to buy. However, when evaluating corporate management, we defer to Warren Buffet who says "In looking for people to hire, look for three qualities: integrity, intelligence and energy. And if they don't have the first, the other two will kill you." Management who abuse stock options just don't cut it.
Rob McConnachie, CFA is a portfolio manager at Dixon Mitchell Investment Counsel.