Can These Options Be Saved?

Falling share prices have left many option holders—both senior management and rank-and-file employees—with severely underwater options. If these options remain underwater for a significant period of time, employee morale and retention could be negatively affected.

To help avoid such consequences, companies may wish to consider repricing options to better reflect current share prices. Before doing so, however, a number of important securities, tax and accounting issues should be considered.

Shareholder Approval May Be Required

In some cases, an option can be repriced through a unilateral amendment to the option award agreement. This is primarily a function of whether the equity incentive plan under which the option was awarded permits such an amendment. If so, the option exercise price can typically be reduced by such means.

If the company is publicly held, however, shareholder approval will likely be required—either because the equity incentive plan itself or NYSE or Nasdaq listing rules require it. Only if the equity incentive plan—as previously approved by the shareholders—expressly permits repricing, can approval be forgone.

Value for Value Option Exchanges

But equity incentive plans are not usually so accommodating. And shareholders—of both public and private companies—are not often favorably disposed to a simple reduction in exercise price of an option. Therefore, it has become far more common to effect an option repricing by means of an option exchange, e.g., canceling outstanding underwater options and issuing replacement options with a lower exercise price.

Because an option exchange can be structured in a manner that decreases dilution to shareholders and reduces (or even eliminates) incremental accounting cost to the company, it can be a far more palatable tactic than repricing.

By decreasing the number of shares subject to the lower-priced replacement option and potentially adjusting other terms of the replacement option, a company can structure an option exchange so the value of new options for accounting purposes is approximately the same as the value of the canceled options. This is known as a "value for value" exchange.

SEC Tender Offer Rules Implicated

In effecting an option repricing by means of an option exchange, the option holder makes an investment decision implicating tender offer rules under the Securities Exchange Act.

The SEC views repricing of options in a manner that requires the consent of option holders, such as in an option exchange, as a self-tender offer by the company. For companies with a class of securities registered under the Securities Exchange Act, a self-tender offer is subject to Rule 13e-4 and related tender offer rules, requiring prescribed filings with the SEC, disclosures to eligible participants and compliance with specified requirements as to the conduct of the offer.

While privately held companies are not subject to Rule 13e-4, they are subject to Regulation 14E under the Securities Exchange Act, which prohibits certain practices in connection with tender offers and requires that a tender offer remain open for at least 20 business days. They may also be well-advised to look to the SEC's tender offer rules for guidance on disclosures to their option holders.

Compensatory Option Exchanges Exempt from Some SEC Tender Offer Rules

SEC staff has indicated that an option exchange involving a limited number of senior company officers may be akin to a series of individually negotiated offers, and therefore, may not involve a tender offer. While the facts and circumstances of a particular situation may support such a conclusion, actual or potential shareholder reaction to an option repricing has more commonly caused companies to take the opposite tack—to exclude senior company officers from a more widespread option exchange offer.

In this regard, the SEC has exempted compensatory option exchange programs from the "all holders" and "best price" rules applicable to other tender offers, enabling companies to exclude or treat differently particular categories of option holders (such as officers and directors) in an option exchange.

Maximize Likelihood of Shareholder Approval

Regardless of how an option pricing is effected, public companies will have disclosure obligations to shareholders regarding repricing. These may including proxy statement disclosures when shareholder approval is sought and Form 8-K and proxy statement disclosures after the repricing has been effected.

To maximize likelihood that shareholders will approve an option exchange program, companies should consider features such as:

• Offering "value for value" exchange
• Excluding directors and officers from the program (or allowing their participation on less favorable terms)
• Adding performance conditions to the vesting and exercisability of the replacement options
• Limiting the exchange program to options that are significantly underwater

Tax Considerations

Incentive stock options. If the options to be repriced are incentive stock options (ISOs), a repricing will be considered the grant of a new ISO, and the rules governing the grant of any ISO will apply. The strike price of the repriced ISOs must not be less than the shares' fair market value at the repricing date. The application of the $100,000 per year first exercisable limitation will also be determined as of the repricing date—again under the theory the repriced option is a new option.

The disqualifying disposition period will begin on the date the option is repriced. If an employee exercises ISOs, and the shares are disposed of within the later of two years from the date the ISO was repriced or one year from the date on which the shares were transferred to the employee, there will be a disqualifying disposition—and at least a portion of any gain will be taxed as ordinary income instead of capital gain.

Companies should be alert to situations in which a repricing program could end up offering alternative rights, thus tainting ISOs that are not repriced. An option will fail to qualify as an ISO if the employee is given an alternative right that effectively avoids the usual ISO requirements. If an ISO holder has a right to elect a lower option price for an existing ISO by participating in a repricing program, he may have alternative rights.

The IRS has taken the position that an offer to exchange an option that is open less than 30-days is not, in itself, a modification of an option. Voluntary repricing programs should, then, run less than 30-days to avoid tainting the ISO status of any non-participating options.

Non-qualified stock options. Repricing a non-qualified stock option (NQSO) should also be treated as a grant of a new NQSO. Because they do not have the same tax-favorable attributes as ISOs, the consequences are not as significant. That is, there are no real adverse tax consequences to receiving new NQSOs as long as the strike price is not less than the then fair market value of the shares.

Section 409A. While Internal Revenue Code Section 409A should always be considered on a case-by-case basis, a one-time repricing of ISOs or NQSOs should not implicate Section 409A as long as the new strike price is not less than the fair market value of the shares at the time of repricing. If, however, a company were to engage in a series of repricings, it is possible the IRS would view the options as part of a nonqualified deferred compensation plan.

Section 162(m). IRC Section 162(m) caps the deduction of certain executive compensation to $1 million unless the compensation is performance based. Options are generally performance-based compensation if they are granted pursuant to a shareholder-approved plan. The analysis under 162(m) is the same as described above— the repricing of an option is the grant of a new option. The regulations give the example of a plan limiting grants to 100,000 options a year. If a grant of 50,000 options is made and then repriced later that same year, the employee will be at the maximum 100,000 options. Any future options that year will fail to be performance-based compensation.

Accounting Issues

Accounting rules governing repricing of options are nuanced. Therefore, before moving forward with repricing, companies should consult with their accountants to confirm the expected accounting treatment.

Generally, repricing an option will be treated as a modification. Companies are required to recognize an incremental expense equal to the difference between the value of the old option immediately before its terms are modified and the value of the repriced option, along with any deferred expense for the old option. By decreasing the number of shares subject to the repriced option and potentially making other changes to the terms and conditions of the repriced option, it may be possible to minimize or eliminate the incremental expense.

Other Forms of Option Exchange

When a company can't—or chooses not to—reprice options, other forms of exchange may be possible. Each of the following will have its own tax, securities and accounting consequences.

Replacing options with restricted stock or restricted stock units. Employees are not taxed on restricted stock until the restrictions lapse or on restricted stock units until the underlying shares are issued. At such time, the employer is entitled to a deduction and the employee has compensation income. For publicly held companies, this course of action will ordinarily require compliance with the tender offer rules described earlier and shareholder approval under NYSE and Nasdaq rules (unless the equity incentive plan specifically permits the exchange).

Cashing out options. Employees could receive a nominal cash value for underwater options, which would then be canceled. Future grants could be in the form of options (perhaps granted once the stock price stabilizes) or restricted stock. There are no tax consequences to the employee or employer upon cancellation of the option. The employee would have compensation income equal to the cash payment, and the employer would have a corresponding deduction. For publicly held companies, this course of action will require compliance with the tender offer rules described earlier, but not shareholder approval under NYSE or Nasdaq rules.

Conclusion

If current market conditions continue, more companies may consider repricing options as a means of motivating and retaining employees. While doing so should be possible in most instances, all tax and non-tax consequences should be considered before committing to a plan.

Reprinted with permission from the June 2009 issue of Employee Benefit Plan Review.