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Underwater Stock Options and Stock Option Exchange Programs

By Harvard Law School Program on Corporate Governance

(Editor’s Note: This post comes to us from Doreen E. Lilienfeld and Amy B. Gitlitz of Shearman & Sterling LLP.)

With the market decline, many companies have found that their outstanding employee stock options are ?underwater? or ?out-of-the-money? because the exercise price is higher than the company?s current stock price. Underwater stock options do not provide their intended incentive and retention benefits. Moreover, they are an inefficient use of a company?s equity reserves as they (i) cause companies to take accounting charges for equity that is not providing value to the employees and (ii) count against plan share limits thereby limiting the number of new awards to be granted to employees. One way companies deal with their underwater options is by effecting an option repricing. The term ?repricing? broadly refers to a number of practices, including:

? Option Buyout or Cash Exchange. Underwater options are purchased by the company for cash.

? Option for Option Exchange. Underwater options are cancelled and replaced with ?at-the-money? options.

? Option for Other Security Exchange. Underwater options are exchanged for a different type of equity-based award (e.g., restricted stock, restricted stock units or phantom stock).

? Option Repricing. The exercise price of underwater options is unilaterally reduced by the Company.

Various legal and regulatory issues must be considered when electing whether to implement an option exchange program including securities laws, accounting rules, tax laws and shareholder approval requirements.

Securities Laws. Most option exchange programs are deemed ?tender offers? for purposes of the U.S. Securities Exchange Act of 1934 (the ?Act?). As a result, a company must file a Schedule TO with the Securities and Exchange Commission (?SEC?), and comply with all tender offer requirements, including the obligation to leave the offer open for at least 20 business days. The SEC, however, has provided limited relief from the ?all holders? and ?best price? rules under the Act for option repricings that are affected for a ?compensatory purpose.? This enables a company to limit which options are subject to the repricing and provide different consideration for each tranche of options. For example, a company can have different exchange ratios based upon the exercise price or remaining term of underwater options.

Shareholder Approval. Both the NYSE and NASDAQ require shareholder approval for the majority of option repricing programs, unless a plan explicitly states that shareholder approval is not required. Many shareholder activist groups, including RiskMetrics, provide guidelines regarding their considerations with respect to repricing.

U.S. Accounting. Under FAS 123R, a repricing is deemed a modification to the existing award. FAS 123R compares the fair value (based upon an option pricing model, e.g., Black Scholes or binomial lattice) of the award immediately before and after modification. If there is an increase in value, an accounting charge must be taken.

U.S. Tax. The cancellation or repricing of an option is not a taxable event. Cash payments are immediately taxable; grants of stock options and restricted stock or units that are subject to future vesting are not immediately taxable. Companies should also consider Sections 409A and 162(m) in structuring an option repricing.

Our memorandum entitled “Underwater Stock Options and Stock Option Exchange Programs” deals with these and related issues. It is available here.

Full post as published by The Harvard Law School Corporate Governance Blog on April 16, 2009 (boomark / email).