Some years ago, a Hata Yogi declared that he could walk on water and invited a select audience including the media to watch the feat. There were several believers and devotees who all trumpeted the wild promise without applying their minds. On the appointed day, the Yogi stepped out into the pool but went, literally and later figuratively, “under water”. The people, including a famous tabloid, who touted the event, sulked thereafter. There are two lessons of relevance here arising from this well remembered episode of the 70s. One is that expectations, if not tempered with the potential risks, can be disastrous dreams and the other is that the people who canvass should use their minds better than blindly carry out the task.

Majority of the stock options issued during the boom days are all “underwater” i.e. below the exercise price (also called the strike price). Some are even below the face value of the stock. This is a devastating carnage of the illusions and dreams of reaching Infosys levels of wealth. Employees are cursing their companies as much as the top bosses are wailing the erosion in shareholder wealth. The HR manager has been good a whipping boy for mindlessly “selling” the scheme and making short shrift of communications.

The employee who has “underwater” options (exercise price being higher than the market price) or “in the money” options (exercise price being same as the market price) is unlikely to exercise the vested options. If the final date of exercise is close, he may forego the options and if the exercise period is long, he will want to watch the markets closely. The situation for him is not as bad as for those who had exercised their options earlier and had not exited when the going was good. They are decidedly the losers and should feel foolish. Those employees who had to pay income tax for the differential amount between the grant / exercise price and the market value, as required in earlier years, and are stuck with “lemons” now, are probably the worst hit.

They would remember now that stock options are for the sensible and alert people who can understand the dynamics of the market, ask hard questions and critically evaluate information. It is not for the free riders who choose to be blind and wish to rely on others` judgment explaining it away as “trust” for lack of motivation or ability to understand the stock option dynamic. They must learn to take decisions arising from their own reading of the upside and downside. They must learn to bear consequences of their decisions, especially as the markets are often outside the control of the company.

For the company, the main choices are whether to (a) re-price the stocks en block or selectively, (b) issue additional stocks at the current low levels to off-set the loss in some measure, or (c) cancel all outstanding options and abandon stock option schemes as a bad dream never to be entertained in future.

Repricing involves reducing the price in respect of the outstanding options from the level at which they were offered, to the current market price or even lower. Some companies like NIIT have done this. Obviously, this move will not cover losses arising from earlier decisions by the employees of exercising their rights but holding on to the shares without exiting.

On re-pricing, the company realizes lesser amount than originally estimated which would affect the financial position. The guidelines in India have not clarified the accounting impact of such re-pricing. In the case of USA, the Federal Accounting Standards Board has issued guidelines according to which any such concession will be treated as an employee cost and an expense in the books of the company.

Even if the company were not to be bothered about the accounting implications, as it is flush with money, there are two critical points that need to be addressed.

By re-pricing, the company will be creating an impression and expectation amongst the employees that there will be a perpetual safety net against falling prices and that there will never be a downside risk. This agitates against the very foundation of stock options, which imply that employees take the risk of the market variations as they rake in potential benefits. If the company also has a scheme of Stock Appreciation Rights, the concerned employees may expect the same beneficial treatment, which will result in a “freebie” or the culture of a “deferred wage”.

The second critical point in repricing relates to corporate governance. If the markets went down, do companies compensate other shareholders or holders of convertible debentures? Obviously not. It is in this context that the institutional investors in the West have been decidedly against re-pricing of stock options. They feel that re-pricing side steps the original objectives and brings in a culture of “heads-I-win, tails you lose”, as the Director of Centre for Financial Research and Analysis in the USA remarked. Of course, the HR community and the senior management plead that employees are a different lot of shareholding stakeholders – that any cost of repricing can be recovered by the “retention effect” it creates. That the cost of recruiting against potential leavers could be more than the cost of repricing and that the move is in the interests of the rest of the shareholders. This is rather a weak argument though, based on assertions than research.

Within the choice of repricing, companies have a sub-choice of selective re-pricing. Selective re-pricing pre-supposes that some employees deserve to be compensated by re-pricing while others do not. For instance, senior management is expected to be bearing the responsibility for the financial results and the market response. Their reward should be substantially contingent on market performance of the company’s stock. Consequently, the argument is that they should not be given any benefit of re-pricing.

In the case of other employees, the assumption is that stock options are sometimes a proxy to cash compensation in part or full. If such is the case, the company would have records of the assumptions made on the potential benefits due to the stock options and as to how much has been set off against the regular compensation package. Some argue that these employees deserve the benefit of repricing of the outstanding options to the extent of the estimated loss in compensation. Does this answer employees owes fully? Not necessarily, as there are several connected issues of equity and motivation.

Microsoft avoided the terrible mess of re-pricing by giving new/additional options at the current market price to compensate for the assumed loss due to the underwater options. In such cases, it is assumed that the flow of benefit in future due to the rising market prices will offset the notional or actual losses incurred by the employee, on account of the earlier stock options for which the exercise price was relatively high. If the assumption fails, the company will be expected to intervene again with a fresh tranche at even lower prices, with greater impact on the accounts and noises from the other shareholders.

Protestations from other shareholders could be expected due to the apprehended impact of additional stock options on the over all shareholder value. Other shareholders tend to believe that fresh offers will dilute the market and thus reduce the potential value of their shares.

Institutional activists believe that senior management can induce arguments and even artificial conditions by which they can benefit from fresh issues at low prices. They fear that this will become a perpetual cycle to suit sectional financial interests defeating the foundations of the stock option policy. For this reason, senior management is often excluded from the compensatory additional issue of options.

Apart from the repricing and fresh issues, there are other methods of mitigating the effect of the carnage – like prolonging the exercise period or direct compensation on a taxable basis. These reactions to the “bust” conditions appear to mask an inherent problem in the assumptions that is becoming increasingly apparent.

It is evident by now that simplistic design and administration of stock option plans can be as disastrous as the Hata Yogis attempt. They may not match the fundamental principles of capital markets.

Stock options are considered an efficient method of compensating employees on the basis of the returns to the investors. Thus, if the market pushes the stock prices either way, it should get reflected in the employee’s compensation. However, there is an increasing feeling that this indeed is a weak linkage as the stock price movements appear to be less driven by managerial performance or non-performance than a combination of secular, seasonal, cyclical and sectoral trends. A McKinsey report suggests that the total returns to shareholders appear to be determined by market and sectoral movements to the extent of 40% of the returns. Thus, managers` compensation through stock options will appear to be rewards or penalties for events beyond their substantive influence.

Further complications have been noticed in recent periods. For instance, consistent performance of companies does not appear to be rewarded by the market sentiments as much as the difference between the market expectations and actual performance! Commensurately, even if the actual performance were high, there could be a dip in the market prices if it does not meet the expectations of the research analysts who are the opinion makers. Similarly, managers in some badly performing companies may get the benefit of short spikes unrelated to actual efforts at improving the company’s financial performance. For example, a set of good Board decisions or senior management appointments or a potential takeover by a great company may push up the market prices giving wealth to undeserving managers.

Considering the carnage, the horns of dilemmas in compensating for the under water options and the complexities showing the weak linkage between manager performance and stock price movements, the HR professional should be tempted to cancel all stock option schemes as a bad dream. However, these difficulties do not indicate the futility of stock options as a compensation and performance management devise. They actually point to the need for greater sophistication and modeling by which the variations are neutralized so as to capture the linkage between performance and the returns to the shareholders. The challenge is just as complex as it was in measuring improvements in productivity purely due to the labour effort and rewarding them.

Companies running away from stock options will soon find it to be an ill-advised move. Stock options are global phenomena and may go through the same cycles of enthusiasm and disaffection as any other market related instrument. The potency of stock options is in linking the perspectives of managers to the shareholder value even if the correlation is admittedly moderate. It continues to be effective in creating a stake for the senior managers than the salary can possibly offer. More importantly, it is a compensation, which does not imply a cash outflow for the company and introduces the essential element of variability in pay.

Progressive companies should actually get aggressive exactly at these times - when the entire stock option design and its communication needs re-engineering; when the threat of employee turnover is far lesser; when the moods are subdued enough for employees to listen well and comprehend the dynamics, the complexities, upsides, downsides, and their decision points. More importantly, companies will find that a bottomed out market also presents the greatest potential for the upside reward – this should be the best of times for the HR manager to take the bull by the horns than run away from this inevitable globally accepted instrument.