Electronic Arts ( ERTS) has decided to be a little less generous to employees who hold underwater stock options. The video-game maker has tweaked the terms of a proposed program that would allow insiders to exchange out-of-the-money options for fewer shares of restricted stock, according to regulatory documents filed with the Securities and Exchange Commission on Thursday. Under the new terms, fewer options would qualify for the exchange and EA could cancel the whole program if the company's stock continues to rise. EA made the changes after gaining input on the program from investors and Institutional Shareholder Services, the leading proxy voting advisor, said company spokesman Jeff Brown. "People felt the floor needed to be slightly higher" for the options eligible for the exchange, Brown said. "We wanted this to be a win for employees and shareholders." Stock options give insiders the right to buy shares of the company's stock at a certain price for a certain period of time. When employees exercise options, they typically sell the underlying stock immediately and recognize a gain on the difference between the market price of the stock they sell and the exercise price of the option. If an option carries an exercise price above the market price of the underlying stock, the option is underwater, or essentially worthless, at least for the time being. As part of the program, employees would be able to exchange options that carried an exercise price 25% or more above the average closing price of EA's shares on the five days prior to the day the exchange program begins. Previously, the company proposed that employees would be able to exchange options that carried an exercise price of 15% or more above the average closing price of EA shares over that period. Additionally, the company added a provision that would call off the exchange program if the average price of the company's stock was $55 or greater over the five-day period. Shares of EA closed trading on Friday up $1.79, or 4%, to $45.31. The company's stock is up 13% since hitting a 52-week low of $39.99 last month.
The net effect of the change is to cut the number of options that employees could exchange. Assuming an average share price of $41.21, insiders would be able to exchange a total of 12.8 million shares under the revised terms, compared to about 16 million under the old terms. The rest of the terms remain the same. EA plans to give employees one share of restricted stock for every three to four options they trade in, depending on the options' exercise price. Although the company's board members and top five executives won't be eligible to participate in the exchange program, the company still plans to hand out a total of 2.2 million new options and 600,000 additional restricted shares to a select group of employees -- potentially including those executives -- as retention bonuses. The option-exchange plan is subject to shareholder approval. Investors will vote on it and other issues, including expanding the company's pool of shares available for restricted stock awards, at the company's annual meeting on July 27. EA has said the options-exchange program will help the company retain employees. With the company's stock off 16% over the last two years, insiders now hold millions of options with exercise prices far above the current share price, meaning that they may not be able to cash them in for years, if ever. Because employees hold potentially worthless options, they have less of an incentive to remain with the company, EA says. Restricted shares, which vest over time, would help the company better hold on to employees, because they would be guaranteed some payout once those shares vest, the company argues. EA also argues that the exchange program would help reduce its options overhang. The company now has about 39.7 million options outstanding, equivalent to about 13% of the company's outstanding shares, according to the regulatory documents filed Thursday. Assuming the insiders exchange all options that would be eligible under the program, the company's overhang could drop by about a quarter.
Even with the changes, the company could still face significant opposition to the exchange program. Such plans have often been controversial with shareholder advocates and some investors. They argue that such programs unfairly remove the risk that insiders assume when they accept options as payment. In other words, it removes the risk that the options will expire worthless. That said, ISS, whose opinion is typically followed by a sizable cross-section of large shareholders, is recommending that investors vote in favor of the proposal. ISS noted that the terms of the exchange meet its criteria for approving such plans, including barring participation by directors and top executives. Shares of EA have slumped amid a difficult time for the video-game industry. Sales of game software have dropped at the same time that companies have been investing heavily in the next generation of game technology. Despite the recent troubles, many analysts expect the industry to rebound as new game machines from Sony ( SNE), Microsoft ( MSFT) and Nintendo start to reach a mass audience. But EA's exchange program may raise some doubts for investors about management's view on just how much the company's stock will benefit from the industry's expected upturn. Essentially, what the exchange program may be saying is EA executives have their doubts about whether the company's stock will exceed the prices of early last year anytime soon. Regardless of the message from management, it's up in the air how shareholders will respond to the exchange proposal. Given the stock's slump, long-suffering shareholders, who obviously won't be able to participate in the exchange program, may not be feeling particularly generous.