Let's Stand Up to Scandalous Stock Options

"So now that the stock price has doubled, are you going to reprice your options back up?"

That question silenced Home Inns (Nasdaq: HMIN) investor relations manager Ethan Ruan when we met with him at the company's headquarters in Shanghai, during our recent Motley Fool Global Gains research trip to China. He'd just finished telling us how excited management was that they'd gotten such a good strike price ($7.26 per ADR) on the stock options they canceled, then repriced and re-issued.

Newsflash, Mr. Ruan: Potential investors don't like hearing how excited management is about their latest move to bilk outside shareholders.

And your explanation was a stupid one
Asked why the company felt it necessary to re-price all of the unvested, out-of-the-money options it had granted to senior management, Mr. Ruan responded that the company worried that having options with such high strike prices -- Home Inns' stock dropped 85% in the year preceding the October 2008 option reissuance -- would demotivate employees and possibly cause retention issues.

This is a tough pill to swallow. The company's founders and senior officers already owned hundreds of thousands of options with a strike price of $11 per ADR or less. Furthermore, those company directors and executive officers (as of the last 20-F filing) already owned 15% of the stock. I find it hard to believe these key folks were going anywhere.

In addition, it's not like the stock market unfairly turned on this company, costing executives compensation to which they were rightly entitled. The team here took many steps that destroyed value, including the ill-conceived and -executed acquisition of unprofitable rival Chinese hotel chain Top Star, an inability to control rising expenses, and the launch of a new concept -- the H Hotel -- that the company, according to Mr. Ruan, has no intention of growing.

These efforts have consumed capital at an alarming rate. The company recently had to sell an additional 7.5 million shares to Ctrip.com (Nasdaq: CTRP) to raise a needed $50 million. (Incidentally, Ctrip.com was founded, and remains largely owned, by some of the same folks who founded and own Home Inns.)

So stay away from Home Inns
Of course, while Home Inns is a particularly egregious example of the inanity of options repricing -- not to mention the company that gave us the most stupefying quotes of our trip -- it is far from the only culprit. In fact, thanks to the significant stock market decline of the past 24 months, companies around the world are looking at how, and by how much, they can reprice existing stock option compensation packages.

For instance, eBay (Nasdaq: EBAY) shareholders recently approved a plan to reprice employee options. Google (Nasdaq: GOOG), Williams Sonoma (NYSE: WSM), NVIDIA (Nasdaq: NVDA), and MGM Mirage (NYSE: MGM) are among the companies that have completed or proposed some form of repricing to improve morale and sustain retention.

To be fair, some companies -- though not all of them -- have excluded top management from eligibility here. But even so, there isn't a surplus of high-paying jobs out there today. How many employees, faced with worthless stock options, will really pack up and move on?

The fact of the matter is …
Shareholders should be outraged at the suggestion that stock options should be repriced in the wake of this financial collapse. After all, those options were intended to align employee and shareholder interests, and specifically designed not to be a guaranteed form of compensation. Since shareholders can't reprice what they paid to buy a stock, repriced stock options subvert even the illusion of alignment.

Furthermore, repriced options hurt outside shareholders by diluting their ownership stake and therefore their claim on earnings. This makes every individual share worth less over the long run.

The bigger picture
Option repricing is just one more example of a situation where people who were happy to reap enormous profits when things were going well are now unwilling to accept the consequences after things have turned south. Sound familiar? This is precisely the culture that drove the folks at places like Fannie Mae and AIG to take undue levels of risk, because they figured they'd be bailed out if they failed. And the bailouts came -- while executives have largely kept the profits they piled up en route to our current housing collapse.

This is absurd. If you can't handle the downside, don't accept variable compensation.

Stand up to scandalous stock options
A number of us here at the Fool are actually surprised that in our litigious society, there hasn't been some form of shareholder-driven class-action lawsuit brought against companies that reprice options, perhaps based on the fact that doing so means that these companies' financial statements have underreported their actual cost of employment. Google, for example, which does not require shareholder approval to reprice its options under its 2004 plan, will record a charge of $460 million in 2009 as a result.

At the end of the day, companies that grant options one year tend to grant them every year. Thus, why should they reprice any old options in lieu of just issuing new options at today's lower prices? That creates incentive right there.

Getting back to the question that stunned Mr. Ruan of Home Inns, why shouldn't a company reprice options that are deep in the money back upward? After all, if it makes sense to lower option strikes when they are out of the money in order to motivate employees, why not do the exact same thing when options are priced so low that they no longer represent a target?

Those are rhetorical questions
The answer, of course, is that options have been revealed to not be a motivation tool -- at least, not in the way they're actually used. Instead, they've become a way for executives and employees to make money at shareholders' expense, regardless of how those executives and employees actually perform.

Now in some cases, you have the right as a shareholder to vote against repricing plans. But even then, these proposals are likely to pass. So instead, think hard about simply not buying shares of companies that engage in this practice. Because if they do it down the road, it means they're underreporting their real expenses, and thus deserve lower trading multiples than their financials might otherwise suggest.

Finally, economics aside, why would you want to go into business with people who, on the tail of operational missteps and a grievous stock market decline, seek to lock in their own long-term compensation at what may turn out to be the most expensive time possible? It's just not worth the trouble.