Employee Stock Options Become Transferable

Nonqualified employee stock options commonly have the following characteristics: They are granted at the money (i.e., the strike price equals fair market value at grant); they have a limited life (often ten years); they require the employee to perform services over a period of years (typically three to five years) before they vest; and they are not transferable for value. This last feature—nontransferability—has been an almost universal feature of nonqualified employee stock option plans. However, recent developments suggest that it is possible to make nonqualified stock options transferable, although securities law considerations will probably make this attractive only for large public companies that are able to participate in a complex structure similar to that described below.

As a tax matter, nonqualified employee stock options typically are structured to preclude having the employee be taxed at the date the option is granted and, instead, having the employee taxed at the date the option is exercised or otherwise disposed of. The key to achieving this result is that the option must not have a readily ascertainable fair market value at the time the option is granted.

An employee stock option has a readily ascertainable fair market value at grant if it is actively traded on an established market, which is almost never the case. Alternatively, an option has a readily ascertainable fair market value if certain conditions exist at the time of grant, including (among others): (1) that the option is transferable by the optionee; and (2) that the option is exercisable immediately in full by the optionee. Therefore if an option is subject to vesting, or if the option is not transferable at grant but becomes transferable only at a later date, then the option does not have a readily ascertainable fair market value at grant and taxation is deferred.

Microsoft's One-Time TSOs

In July 2003, Microsoft announced the first large-scale stock option transfer program as part of a plan to: (1) replace the granting of stock options with the granting of restricted stock units; (2) begin expensing its equity-based compensation for accounting purposes; and (3) give employees an opportunity to sell certain of their underwater options for cash. The Microsoft program created one-time transferable stock options ("TSOs") which allowed eligible employees (all except members of the Board of Directors) to sell on an "all or nothing" basis their vested and unvested options with an exercise price of $33.00 or more to J.P. Morgan. J.P. Morgan agreed to pay a price negotiated with Microsoft that was determined in part by reference to Black-Scholes and other option pricing models, and was based on Microsoft's average stock price over a specified period). However, the option terms were shortened to two or three years. Employees elected to sell approximately 55% of the eligible options to J.P. Morgan. J.P. Morgan, which was required to hold the purchased options, created an offsetting hedge by selling Microsoft shares short in the market to avoid taking on Microsoft stock price risk.

Microsoft obtained a private letter ruling from the Internal Revenue Service, which agreed that amending the options to make them transferable did not mean that the options had a readily ascertainable fair market value at the date of grant. Thus, an employee would not have income at the date of grant or at the time the options were amended to add the transferability feature. An employee would have income at the date of transfer to J.P. Morgan equal to the amount received or, if he did not transfer and later exercised, he would have income at the date of exercise equal to the difference between the fair market value and the strike price. Microsoft would be entitled to a compensation deduction in the same year as the amounts would be includible in the income of its employees.

Writing in 2004, Professor Brian Hall of the Harvard Business School noted:

Press and media coverage of this transaction has focused on Microsoft's switch to restricted stock, and the unusual way the company decided to "clean up" its underwater option problem. But there is a sleeper in this story—a largely unrecognized consequence of this transaction—that has the potential to transform the prevailing norms of equity-pay design. The introduction of transferable stock options (TSOs) for the purpose of a one-time clean-up effort also opens the door for the broader use of TSOs as an ongoing equity-pay instrument, perhaps replacing standard stock options (which are not transferable). Until the Microsoft transaction, the nonexistence of TSOs in U.S. companies made it difficult and potentially costly for any company to consider granting TSOs to their executives and employees because of uncertainty about how the IRS and regulatory bodies would treat them for tax and accounting purposes. A potentially more serious problem was uncertainty as to whether TSOs (and hedging of TSOs) would even be allowed under current U.S. securities law. Thanks to the Microsoft/J.P. Morgan experiment, we now know that none of these potential difficulties is a major obstacle.

Journal of Applied Corporate Finance (Winter 2004). Professor Hall predicted, correctly, that corporations would begin to consider ongoing TSOs. He noted that ongoing TSOs have significant benefits as compared with ordinary stock option plans, one of which is that they significantly mitigate the problems caused by underwater options, which may be ineffective as a retention device and possibly damaging to morale. Unlike ordinary stock options, TSOs may have value even if the employer's stock price falls below the strike price.

Google's Ongoing TSOs

On December 12, 2006, Google became the first employer to announce an ongoing TSO program. Google is amending its existing nonqualified employee stock option plan to allow employees (other than senior management) to offer vested options granted after Google's initial public offering for sale to pre-qualified financial institutions in an online auction market that will be managed by Morgan Stanley.

Employees may offer vested options for sale using a company website. Potential buyers will bid on the options, presumably using proprietary formulas based on the strike price, current Google stock price, the volatility of Google stock, current interest rates, the life of the option and market conditions. When sold to a bidder under the TSO program, options with a remaining term longer than two years will be truncated to two years. Options with a remaining term less than two years will become 18, 12 or 6 month options. Upon sale under the program, option terms will also be amended to remove any forfeiture conditions related to the employee's employment with Google, and anti-dilution provisions will be conformed to market-standard provisions. The participating investors must bid on all options that are offered. Also, the investors may not re-sell the options. Google expects that the investors will hedge by short-selling Google stock.

Employees can offer any number of vested options for sale, even if the options are underwater. Of course, an option that is significantly underwater may have little or no value. Employees can also place limit orders, i.e., they can stipulate the minimum price at which they are willing to sell. Google expects that this program will enhance the utility of its stock option program because employees will be able to see, on a daily basis, that their options have value—not just the intrinsic value (i.e., the difference between market price and strike price), but also the time value (i.e., the value of the right to hold the option for potentially greater gains). Also, employees will be able to cash out the time value after the options become vested.

What are the tax consequences? They are essentially the same as with a traditional nonqualified stock option plan. There is no income to the employee (or deduction to the employer) at the time of grant or vesting. If the employee chooses to sell the option, he will have ordinary income on the sale proceeds. The employer must withhold income and payroll taxes and deliver the net proceeds to the employee. The employer receives a compensation deduction at that time. If the employee chooses to exercise the option, he has compensation income equal to the excess of the fair market value of the stock over the strike price. Again, the employer must withhold, and there is a compensation deduction available.

Of course, any time a company grants options or changes an existing option plan, it should consider whether Section 409A of the Internal Revenue Code will apply. In general, Section 409A imposes income tax (and interest and possibly penalties) on discounted options when they vest. Although the IRS has proposed regulations under Section 409A, it has not yet finalized them. Nonetheless, as long as options are issued at or above fair market value, it appears as if Section 409A will be inapplicable.

Securities Law Issues

Because all eligible stock options will be modified to permit their sale under the TSO program, Google has indicated that it will take a stock-based compensation charge on the date the program is initiated equal to the difference between the value of the modified stock options and their value immediately prior to the modification. Going forward, Google expects that the fair value of each option granted that incorporates this transferability feature will be greater than it would have been before the TSO program was initiated (because of a longer expected option life), resulting in more stock-based accounting expense per option.

As Professor Hall noted in the article referenced earlier, the Microsoft/J.P. Morgan transferable option experience answered many of the securities law questions that surround a transferable option program. The critical issue of registration under Section 5 of the Securities Act of 1933 was dealt with by focusing on whom should be considered the "real" purchasers of the Microsoft shares that J.P. Morgan would acquire through the exercise of the Microsoft options it was purchasing, and who therefore should be entitled to the protections afforded by registration under the Securities Act, including its prospectus delivery requirements. Presumably with a view toward complying with interpretive letters issued by the Securities and Exchange Commission in the context of short sales used to hedge positions taken in derivatives transactions, Microsoft and the SEC staff apparently agreed that purchasers of Microsoft stock in the short sales effected by J.P. Morgan to hedge its position in Microsoft options were the "real" purchasers. As a result, a registration statement on Form S-3 was filed by Microsoft to register (in a Rule 415 shelf offering) J.P. Morgan's short sales of Microsoft stock as a primary offering by Microsoft. J.P. Morgan was named as an underwriter in the related prospectus. This analytical framework, of course, reflected the fact that neither the transfer of the options to, nor the exercise of the options by, J.P. Morgan could be effected pursuant to a registration statement on Form S-8, the form typically used to register securities issued pursuant to employee benefit plans.

Consistent with this view and the interpretive positions taken by the SEC staff in analogous contexts, the Microsoft shares subsequently acquired by J.P. Morgan through the exercise of the options that it had purchased could be used, without registration or the delivery of any prospectus, to close out open borrowing transactions related to the short sales entered into for hedging purposes.

While the Google TSO program will presumably use the same Securities Act analytical framework, there may be additional securities law complexities by virtue of the fact that the program will be an ongoing one involving multiple bidders in an auction system, rather than Microsoft's one-time program involving a single purchaser. Although Google has not yet, as of this writing, filed a registration statement or other TSO program-related documents with the SEC, it has given some indications of how it plans to deal with at least some these issues.

For example, an ongoing program would involve ongoing short sales of Google stock for hedging purposes. This will then entail periodic updating of the prospectus and related due diligence, as well as the risk that the registration statement may not be available from time to time due to material undisclosed developments involving Google. To address these issues, the Google TSO program will be active only when Google's quarterly trading windows are open (which appear to be three-week periods of time after Google releases its quarterly results). Beyond that, Google has indicated that even during these trading windows, the TSO program will be suspended whenever Google is in possession of material non-public information. Recognizing that suspending the TSO program could itself be considered material non-public information, Google has stated that during these suspension periods, employees will also be precluded from selling shares issued upon the exercise of options in the traditional way.

The ongoing nature and multiple bidder features will affect other issues such as the contractual arrangements with the "pre-qualified institutional investors" who will be bidding in the auctions, providing appropriate disclosure to Google employees who participate or are considering whether to participate in the program, and the hedging transactions in which auction system participants will engage. The manner in which each of these issues was dealt with in the Microsoft situation (individually negotiated arrangements with J.P. Morgan, a 20 business day issuer tender offer by Microsoft for its employees' options, and the ability of the purchaser/underwriter to short a known maximum number of shares) does not easily carry over to the Google TSO program. It will be interesting to watch how these and other issues are resolved as this program is implemented.