The Nuclear Option for Dolby Labs

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In the wake of the options- backdating scandal that deposed the CEO of UnitedHealth Group and sent the CEO of Brocade Communications to jail, the lie was exposed that stock options align the interests of management and shareholders.

Although the clamor and rancor of repricing options died down, the problem hasn't gone away. Companies continue to bail out executives and employees whose options are underwater, and sound specialist Dolby Labs (NYS: DLB) is only the latest to try its hand at giving them a mulligan.

It's an option, not a guarantee
Stock options give the holder the right to buy a stock at a certain price -- called the "exercise" or "strike" price -- at some point in the future. The theory is that options are an incentive to have management (and employees) work hard to ensure that the company's value increases, and as its share price grows, management and shareholders can profit together in its future.

The backdating and repricing schemes reveal that companies don't look at options as an opportunity, but rather as a guarantee of profit. Where common shareholders bear the full cost of any decline in a stock's price, executives and employees want to bear none of the cost. They want to profit no matter how the company performs.

Fine young cannibals
With the iPad cannibalizing computer sales in 2011, and with the threat that Microsoft (NAS: MSFT) will cut Dolby from its Windows operating system, the value of the sound specialist's stock was cut in half. That's left some 82% of all its options (and 96% of unvested employee options) underwater, and it wants to exchange them for a lesser number of restricted stock units to restart the clock and give everyone time to profit.

No doubt Dolby's plan is better than most other schemes and in fact conforms to many of the principles the good corporate governance folks at Risk Metrics Group advocate:

  • The plan should first receive shareholder approval.
  • It should minimize the number of shares subject to replacement awards.
  • The exchange should occur at least 12 months after the stock's decline in value.
  • Only stock options that were granted at least two years before the exchange should be eligible for the exchange.
  • The value of the consideration received in the exchange should be no greater than the value of the surrendered stock options.

But Dolby ignored other areas, such as excluding senior management. Considering that they have millions of options underwater, it's likely the exchange program is being done primarily for their benefit as much as for the employees.

Yet outside investors don't get a do-over. Dolby's employees prospered when the company was raking in millions in licensing revenues from Microsoft almost without having to do anything. As long as PCs were selling, the stock price soared. So if the options rewarded them for circumstances for which they had nothing to do, why shouldn't they bear the burden like everyone else when the decline is also beyond their control?

Apologists for companies caught up in the tangle readily dismiss the issue as little more than an accounting-definition hubbub. Indeed, Apple (NAS: AAPL) shareholders in particular were willing to forgive Saint Steve when he was found to have been in the middle of a backdating options scandal. Yet Apple's stock, which traded at well under $100 when it fudged the options dates, now trades for more than $400 a stub.

Now hear this!
As a Dolby shareholder, I plan to vote "No" on the proxy proposal. While there are good reasons for getting rid of the overhang associated with the options -- the accounting charges, for example, that companies have to record even though the options will probably never get exercised -- it doesn't change the fact the exchange gives everyone but regular shareholders who are nursing the hurt of an "underwater" stock price a second bite at the apple.

Dolby's management generally acts with shareholders' interest at heart, and even the current scheme is better than most. But management and employees should bear impact of a changed business environment just as much as outside investors do. There's no need to use the nuclear option to benefit one group over the other.

Is this much ado about nothing? Will you also vote "No" on your proxy ballot? Let us know in the comments section below.

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At the time this article was published Fool contributorRich Dupreyowns shares of Dolby Laboratories, but he holds no other position in any company mentioned. Check out hisholdings and a short bio. The Motley Fool owns shares of Apple, Amazon.com, and Microsoft.Motley Fool newsletter serviceshave recommended buying shares of Amazon.com, Dell, Goldman Sachs, Apple, Microsoft, Dolby Laboratories, and Netflix and creating a bull call spread position in Apple and Microsoft. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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