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Executive compensation and employee benefits: underwater stock options
Practical Law UK Legal Update 5-385-5663 (Approx. 3 pages)
Executive compensation and employee benefits: underwater stock options
by Doreen E. Lilienfeld, Amy B. Gitlitz and Brenda L. Zelin, Shearman & Sterling LLP
| Published on 02 Apr 2009 • USA (National/Federal) |
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As companies' share values have declined, many 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. Some companies address this is through option repricing. This article examines some of the issues to consider when determining whether to effect an option repricing and the type of repricing to implement.
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:
- Cause companies to take accounting charges for equity that is not providing value to the employees.
- 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 (for example, restricted stock, restricted stock units or phantom stock).
- Option repricing. The exercise price of underwater options is unilaterally reduced by the company.
The following is a summary of some issues to consider when determining whether to effect an option repricing and the type of repricing to implement.
Securities laws
Most option exchange programmes are deemed tender offers for the purposes of the Securities Exchange Act of 1934, as amended (Exchange 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 Exchange 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 on 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 programmes, 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. Some important issues for shareholders include:
- Participation by directors and executive officers.
- The extent to which eligible options are underwater and the length of time they have been underwater.
- Why the options became underwater.
- The exchange ratios.
- The term, future vesting and forfeiture provisions of replacement awards.
US accounting
Under FAS123R, a repricing is deemed a modification to the existing award. FAS123R compares the fair value (based on an option pricing model (for example, 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.
US 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.
Further reading
For further details on underwater stock options and stock option exchange programs, click here.