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Underwater options – Beyond the theory

May 13, 2009

In March, we gave an overview of stock options giving some background on the current phenomenon of underwater options and companies trying to figure out what to do about them. In April, we discussed some of the methods that companies are using to re-price underwater options, and considered some of the pros and cons of each method. Like many other parts of the human resources world, this concept is governed by a host of rules – statutes, regulations, standards and some other names that sound less formal. For the unwary, they collectively represent a minefield that some may find difficult to navigate. In this article, we’ll attempt to inform our readers.

Shareholder approval

Each of the major US listing bodies or exchanges has different rules for its member organizations. For our present purposes, some key guidance (depending on the relevant listing body) can be found in NASDAQ Rule 4350(i) and Interpretive Manual IM-4350-5, New York Stock Exchange (NYSE) Listed Company Manual Section 303A(8) and American Stock Exchange Company Guide Section 711. These rules were updated by both the NYSE and NASDAQ earlier this decade in response to the market downturn in 2000-2002. They require shareholder approval for any material amendment to an equity compensation program listed with them. Both rules define a material amendment with respect to re-pricing of stock options to cover any change to an equity compensation plan permitting “a repricing [sic] (or decrease in exercise price) of outstanding options …[or one which by effect may] reduce the price at which shares or options to purchase the shares may be offered.” Plans must (according to those rules) have specific wording to allow for re-pricing or they will be considered to specifically prohibit it. However, neither listing body has any rule that prevents a company from allowing an exchange of equity compensation for cash. This does not mean, however, that proxy advisors would look favorably on a company that does this, especially without shareholder approval.

What is a re-pricing for this purpose? Again, the NYSE and NASDAQ have identical rules telling us that any of the following constitute a re-pricing:

lowering the strike price of an option after it is granted,

canceling an option at a time when its strike price exceeds the fair market value of the underlying stock, in exchange for another option, restricted stock, or other equity, unless the cancellation and exchange occurs in connection with a merger, acquisition, spin-off or other similar corporate transaction, or

any other action that is treated as a repricing [sic] under generally accepted accounting principles.

Proxy issues

As we have discussed in our earlier articles, when underwater options are re-priced, shareholders would seem to have an almost automatic reaction: why should employees not suffer the same stock downturn that we have? This may make the proxy solicitation process difficult. In addition, the major proxy advice firms have some very specific guidelines on the subject (discussed below). One can see that this process may not be easy.

While the minute details of the proxy process are beyond the scope of this article, it is worth looking at the key items that are disclosed under the SEC’s revised proxy rules, adopted in 2006. They are:

a description of the program, including who is eligible to participate (by name or by classification), the securities subject to the offer, the exchange ratio, and the terms of the new securities,

a description of the reasons for undertaking the program including a discussion of all alternatives considered by the Board and its Compensation Committee,

the accounting treatment and federal income tax treatment of the new program, and

a table disclosing the benefits and/or amounts that will be received by or allocated to Named Executive Officers, all current executive officers taken together, all current directors who are not currently executive officers, and all employees who are not current executive officers taken together.

Proxy advisors

According to a report from the US Government Accountability Office (GAO), the five leading proxy advisory firms are (in alphabetical order) Egan-Jones, Glass-Lewis, Institutional Shareholder Services (ISS), Marco Consulting Group and Proxy Governance. With respect to Egan-Jones, Marco Consulting and Proxy Governance, we were not able to find their guidelines specifically stating how they will advise on option re-pricing, other than that they will each handle this on a case-by-case basis. With respect to Glass-Lewis and ISS, we were able to locate specific guidelines.

ISS states that it will consider factors including historic trading patterns, rationale (was the stock price decline within the control of management or due to external factors), type of exchange (e.g., value-for-value), burn rate, vesting period, term, exercise price and participants (executive officers and directors should be excluded). They state in pertinent part that they will evaluate the “intent, rationale and timing” of any proposal to re-price options.

Glass-Lewis states affirmatively that it will recommend a vote in favor of re-pricing if officers and Board members do not participate in the re-pricing, the stock decline mirrors market or industry price declines in timing and is similar in magnitude, the re-pricing either is neutral to shareholders or creates value for shareholders, and management and the Board make a persuasive case that the re-pricing is necessary to retain existing employees in a competitive market.

Tax issues

Readers should acknowledge in their reading of this discussion that J.P. Morgan does not provide tax advice. However, no discussion of the issues would be complete without mention of certain of the tax issues surrounding re-pricing of options.

First, let’s look at the period of time that the offer of re-pricing is open. According to the regulations under Code section 424, if the period is less than 30 days, then with respect to incentive stock options (ISOs), only those who accept the offer will be deemed to have received a new grant. But, if the period should be 30 days or longer, all of the options are considered newly granted without regard to acceptance of the offer. This is important because a new grant will cause a new start date for the holding period required to gain favorable tax treatment with respect to the ISOs.

If the re-pricing occurs with respect to nonqualified options (those which are not ISOs), care must be taken to avoid falling subject to the additional tax under Code section 409A. The final regulations indicate that such a re-pricing not below the fair market value of the stock on the date of the re-pricing will not, by itself, cause the program to be subject to 409A. Instead, it is treated as a new award exempt from 409A.

Finally, for purposes of the deduction limit under Code section 162(m), options will be considered to have been re-granted and will count against any per person limitations in the plan that are required to provide an exemption from the limit.

Financial accounting

The accounting for stock options (including re-pricings) is governed in the United States by FAS 123(R). Under this standard, the charge for any new options is only for the incremental value. Thus, in a value-for-value exchange (or one that is less favorable to the grantees), the re-pricing may be a shareholder-neutral event from an accounting expense standpoint.

Issues that we have specifically not covered

A re-pricing should not be undertaken without engaging proper counsel with regard to securities law, tax law and accounting. Since we believe it to be beyond the scope of this series, we have only briefly touched on a number of topics, including but not limited to: tender offer rules, section 16 insider rules, rules for foreign private issuers, and certain third-party exchange programs that have been implemented in the last several years. Readers should understand that option re-pricing is a complex topic that cannot be covered in full without the benefit of a lengthy treatise.

Conclusion

This concludes our series on underwater stock options. We hope that our readers have found this to be of interest and that they appreciate the series approach. We look forward to providing more series in the future and would consider input from readers in the development of future topics.