Given the recent tumult in the financial markets, resulting in the downward movement of stock prices, many public companies are required to manage the challenges associated with an increasing number of underwater stock options. Underwater options are problematic to companies for many reasons, not the least of which is that they may have lost their primary purpose: to incentivize management and other employees.
As a result, many companies are considering option exchange programs. Option exchange programs, or repricings, typically involve the exchange of underwater options for new options with a lower exercise price or the exchange of existing options for other forms of equity awards or cash. There are a number of considerations surrounding option exchange programs, including shareholder approval requirements, the necessity of institutional shareholder support, compliance with tender offer rules, proxy statement and other SEC disclosure requirements, accounting and tax consequences and the potential to increase overtime costs. To assist our clients who are facing the challenges of underwater options, we have compiled the following list of issues to consider when contemplating an option exchange program.
- What will the structure be? One of the first decisions a company must make in connection with an option exchange program is whether the underwater options will be exchanged for new options, stock (e.g., restricted stock or restricted stock units) or cash. This decision will be based on the company’s equity compensation philosophy, the goals of the option exchange, the alternatives available under the company’s current equity compensation plans and the company’s cash resources. When structuring the program as an exchange for a new option or other equity award, a company also must decide whether to structure the exchange program as (i) a one-for-one exchange, where the exercise price of the underwater options is lowered to the current market price of the company’s common stock, or (ii) a value-for-value exchange, where optionholders exchange and cancel their underwater options for a grant of new options (with an exercise price of at least current market price) or other equity awards at a ratio of less than one-for-one. In the current environment, given the views of proxy advisors and institutional shareholders, a value-for-value exchange may likely be the most viable structure for most public companies.
- Will the option exchange program require shareholder approval? Domestic companies listed on the New York Stock Exchange or on The Nasdaq Stock Market must obtain shareholder approval of an option exchange program unless the company’s option plan expressly permits repricing. Many domestic companies listed on the NYSE or Nasdaq, however, are unlikely to have option plans that expressly permit repricing. An option plan that is silent as to option repricing is considered to prohibit repricing for purposes of NYSE and Nasdaq rules. If underwater options are to be exchanged for cash, no shareholder approval is required. It should be noted, however, that some institutional shareholders and proxy advisors consider an option for cash exchange to be a "poor pay practice."
- Will institutional shareholders and proxy advisors support the option exchange program? Obtaining the support of institutional shareholders and proxy advisors is a critical step in the challenge of securing shareholder approval for an option exchange program. Some leading proxy advisors have published detailed voting guidelines related to option exchange programs, while others have indicated only that exchange programs will be considered on a case-by-case basis. A company should review these guidelines if relevant to its shareholder base.
- Who will be eligible to participate in the option exchange program? If an option exchange program requires shareholder approval, companies should give consideration as to whether they should exclude directors and officers from participating in the program. Certain institutional shareholders and proxy advisors have indicated that they would not support option exchange programs that include directors and officers.
- Which options will be exchanged? A company must decide whether all underwater options will be eligible for exchange, or only underwater options with an exercise price above a specified threshold. At least one proxy advisor, for instance, recommends that only options with an exercise price in excess of the 52-week high be eligible for option exchange programs.
- What is the exchange ratio? In a value-for-value exchange, a company must decide how many underwater options must be tendered in exchange for each new option or other equity award. The exchange ratio may have an impact on the rate of optionholder participation.
- What are the terms of the replacement grants? A company must decide whether to extend the vesting schedule of the replacement grants, which may also affect the rate of optionholder participation.
- What happens to the canceled options? Many option plans allow the options that are canceled in an option exchange program to be returned to the plan pool and become available for future issuances. Companies seeking shareholder approval of the option exchange program may want to consider permanently retiring the canceled options (i.e., the excess of the canceled option shares over the new options shares) because such a feature may enhance the likelihood of receiving shareholder approval.
- What are the primary securities law requirements? An option exchange program that is conducted as an exchange will often require a company to comply with the tender offer rules, which includes filings with the SEC, employee communications and administrative costs. In addition, companies seeking shareholder approval for an option exchange program must solicit proxies in accordance with Section 14(a) of the Securities Exchange Act of 1934 (the "Exchange Act") and the rules thereunder, including the filing of a preliminary proxy. Option exchange programs also trigger other disclosure requirements. For example, if a company reprices or exchanges options of any of its named executive officers, then it must explain its rationale in its Compensation Discussion and Analysis and must also disclose the incremental fair value with respect to such an exchange program in its "Grant of Plan-Based Awards" table in the next proxy statement. In addition, an option exchange program involves the disposition of the existing option and the acquisition of the new option or other equity grant, both of which are reportable under Section 16(a) of the Exchange Act.
- What are the accounting consequences? Companies will want to determine whether their option exchange program will result in an additional accounting charge. Value-for-value exchanges are commonly structured to avoid any incremental accounting charge under FAS 123R. Any accounting consequences must be stated in the tender offer filings with the SEC. Also, FAS 123R requires that companies describe the exchange program in the stock plan footnote to their financial statements.
- What are the potential tax consequences? Companies should consider whether the structure of an option exchange program will comply with Section 162(m) of the Internal Revenue Code. In addition, to qualify for incentive stock option ("ISO") treatment, the maximum fair market value of stock with respect to which ISOs may first become exercisable in any calendar year is $100,000. When an ISO is canceled pursuant to an exchange program, any options scheduled to become exercisable in the calendar year of the cancellation would continue to count against the $100,000 limit for that year, even if cancellation occurs before the options actually become exercisable. The length of time for which an exchange program offer is open can also result in negative tax consequences. If an exchange program offer is open for more than 30 days with respect to options intended to qualify for ISO treatment, those ISOs are considered newly granted on the date the offer was made, whether or not the optionholder accepts the offer. Another consequence of the new grant date is that the holding period to obtain capital gains treatment is restarted.
- Will the option exchange program increase overtime costs? Subject to compliance with Section 7(e) of the Fair Labor Standards Act ("FLSA"), any income that a non-exempt employee earns from the exercise of stock options is excluded from the employee’s regular rate of pay for purposes of determining overtime pay. One of the conditions of Section 7(e) of the FLSA is that the option cannot be exercisable for at least six months after the grant, with limited exceptions for death, disability, retirement or a change in control. Therefore, a company should consider the potential increase in overtime pay if it intends to grant a repriced stock option to a non-exempt employee without imposing a vesting condition of at least six months.
- What are some other practical issues? A company contemplating an option exchange program should plan for sufficient time for board of director and committee review and approvals, and advance review of the program by proxy advisors, accountants and legal advisors. The company may also want to retain a proxy solicitor to assist with obtaining shareholder approval of the option exchange program, as well as a compensation consultant, whose input on the program terms may prove helpful in structuring a program that will be able to clear the hurdle of shareholder approval. Finally, a company should be mindful that any communications, written or oral, it makes to its employees regarding a possible option exchange program will likely need to be filed with the SEC on the day on which such a communication is made as part of the tender offer documents, including as a pre-commencement communication if such communication is made prior to launch of the option exchange program and the filing of the exchange program documentation.