Executives of Imperial Bancorp of California, confronted with a 66% decline in the bank's stock price from July through October 1998, saw their stock options become worthless. Rather than risk defections of managers, the company decided to reprice the options, enabling its executives to once again buy the stock at cut-rate prices.
Other banks may face a similar dilemma if their stocks decline sharply. Banks are among the biggest issuers of employee stock options, trailing only securities firms and technology companies, according to Pearl Meyers & Partners Inc., an executive compensation firm in New York.
Stock prices of several banks have been falling steeply, and if the decline continues or accelerates, more banks may have to make the tough decision whether to reprice. First Union Corp.'s stock, for example, has dropped 29% since the beginning of the year.
Michael Mayo, a New York-based analyst with Credit Suisse First Boston, compares issuance of options with making loans. "On the day an option is issued, nobody plans to lower the strike price-no more than they plan to write off a loan the day it is originated."
Options can be "very effective in motivating employees," said Mr. Mayo, who recently issued a report on the effects of employee stock options on bank earnings. "On the other hand, they have costs."
The cost is to shareholders whose stake in the bank is diluted because shares are created when the options are exercised. If a stock's price drops so that the options become worthless, there is no dilution for shareholders, because the options are not exercised.
At Imperial's original strike price of $26, no options would have been exercised and the stock would not have been diluted. Option holders could have bought the stock more cheaply directly from the stock market than by trading in their options. On Friday, Imperial shares were trading at $21.25, or $4.75 below the $26 strike price. At the new, lower price, holders of Imperial's options could buy the stock from the company at $16 and immediately sell it for $21.25.
Repricing was fairly easy for Imperial, because institutional investors own only 35% of its stock, and its shareholders readily agreed to the new pricing.
But banks with a large portion of their stocks held by sophisticated institutional investors may find it more difficult to reprice because of shareholder resistance, said Charles Peck, a compensation expert for the Conference Board in New York.
"The major companies stay away from repricing, because it is anathema to shareholders," Mr. Peck said. "It doesn't sit well with them when management is given an out."
"It's completely unethical," said Nel Minow, a shareholder activist with Lens Inc., a Washington-based fund manager. "What is the justification for stock options? They are supposed to align the interests of management and shareholders," she said.
Mr. Mayo estimates that Imperial Bancorp's issuance of options lowered 1998 earnings by 36%, a figure disputed by Imperial, which said the impact would have been 12%. Earnings at three other banks-Citigroup Inc., BankBoston Corp., and California's City National Corp.-would be 10% lower if options issued were taken into account, according to Mr. Mayo's estimates.
Though companies do not have to account for stock options in earnings, they may soon have to do so for their repricings. The Financial Accounting Standards Board proposed in March that companies would have to include the cost of options once they have been repriced, until the time they are exercised.
"Growing use of employee stock option plans at banks and financial companies is going to raise the specter of option repricings much more often," said Patrick McGurn, vice president and director of corporate programs at Institutional Shareholder Services, a Maryland company that compiles proxy data on behalf of investors.
Options repricing has mainly been the domain of high-technology firms, which tend to be cash-poor and use options to entice management with the hope of a skyrocketing stock price.
But options have caught fire among financial companies as well. Indeed, stock options have become as popular as mobile telephones. Shares authorized for management and employees increased to 13.2% of all stock outstanding in 1998, up from 6.9% in 1989, according to a study last year by Pearl Meyer. The average amount of stock a company sets aside annually for options rose to 2% of all outstanding shares in 1998, from 1.15% in 1993.
Banks issued options equivalent to 3.09% of their outstanding stock in 1997 and 1998, according to the Pearl Meyer study. That compared with 5.13% for brokerages, and 3.76% for technology companies.
Opponents of repricing say employees should suffer the consequences. With stock option repricing, gone is the accountability of management.
Some analysts argue that at times management must consider repricing if they are to retain staff.
"You have to keep your people," said Jeffrey T. Runnfeldt, an analyst who covers banking and financial services for First Security Van Kasper in San Francisco. "As a shareholder, it's not something you love to see, but for the right reasons it makes sense."
Aside from providing employees with incentives to produce more, employee stock options are attractive to banks because they are a way to pay employees well-or at least give them hope of a bonanza if the stock price climbs-with no impact on the bottom line.
This is encouraging many banks to include more and more employees in their options programs.
Wells Fargo & Co., Chase Manhattan Corp., Bank of America Corp., First Union, and Bank of New York Co. have begun broad-based stock options for all employees.
"Part of the rationale is to make a broader group of employees think like owners," said Vicki Elliot, principal at William M. Mercer, a human resources company in New York. "Their goal in doing so is to create more identity with the shareholder with concern of the company's success."
Norwest Corp., now known as Wells Fargo, was one of the first banks to issue options to all employees. The third grant-200 options for all 102,000 employees-will vest in 2003 or when the price closes at $70 a share, whichever comes first.
"We have understood the importance of using options for some time," said Paula Roe, senior vice president and director of compensation and benefits at Wells Fargo. "In our heart of hearts we believe that our team members make the difference in making us great."
"If you have a bull market like this, there is nothing better than throwing options in front of people," said Scott Edgar, director of research for the $1.1 billion-asset Sife Fund. "It is a cheaper way from an accounting standpoint to incentivize your employee."
Still, if there is a market downturn, company morale will be hard hit, said Institutional Investor Services' Mr. McGurn. If stocks spiral down, so will employee sentiments and good will.