Goodwin Insights September 28, 2022

Public Companies: Time to Consider Repricing Underwater Stock Options?

Given the recent volatility in the national markets, the stock prices of many publicly-traded companies have declined significantly, resulting in an increasing number of service providers holding underwater stock options. As a result, companies that have issued stock options may be considering repricing them to help retain and appropriately incentivize employees and other service providers. This article outlines key stock option repricing considerations for companies listed on the New York Stock Exchange (NYSE) and The Nasdaq Stock Market (Nasdaq).[1]

In determining whether to proceed with a stock option repricing, and determine which method is most suitable, publicly-traded companies should evaluate the following key considerations, each of which is discussed in more detail below:[2]

  • Whether stockholder approval is required
  • Which stock option repricing method should be used
  • Which stock option holders will participate
  • The necessity of institutional stockholder support
  • The perception of a stock option repricing by stockholders (which may drive decisions on several of the preceding bullets)
  • The impact of the stock option repricing method to company employees
  • U.S. Securities and exchange commission (SEC) tender offer rules and SEC disclosure requirements
  • Accounting and tax consequences
  • Whether the company’s equity plan accommodates a stock option repricing

There are multiple methods that companies may employ when implementing a stock option repricing program. The key features and considerations of each stock option repricing method are summarized below:

One-for-One Exchange

The company unilaterally (i) amends underwater stock options to reduce the exercise prices to at or above the fair market value of the underlying stock on the repricing date or (ii) cancels underwater stock options and replaces them, on a one-for-one basis, with stock options at the reduced exercise price.

Pros + Cons –
  • Easily communicated and understood by stock option holders (assuming no other changes to the stock option terms)
  • Allows stock option holders to maintain control over the taxable event (i.e., tax at exercise)
  • Not likely to trigger SEC tender offer rules or require stock option holder consent
  • Often considered a “windfall” for stock option holders and likely to face stockholder resistance given that stockholders do not receive the same economic benefits as stock option holders
  • Likely to face negative recommendations from proxy advisory firms
  • Repriced stock options remain susceptible to going underwater

Option-for-Option Exchange

Underwater stock options are replaced with a new stock options to purchase a lower number of shares with an exercise price equal to the fair market value of the underlying stock on the repricing date. Unlike the one-for-one repricing method discussed above, underwater stock options are exchanged for new stock options on a “value-for-value” basis, where the value of the exchanged stock options, based on a commonly accepted valuation method (e.g., Black-Scholes or binomial lattice model), is equal to, or less than, the value of the underwater stock options being canceled, resulting in an exchange ratio of less than one-to-one.

Pros + Cons –
  • Allows stock option holders to maintain control over the taxable event (i.e., tax at exercise)
  • Viewed more favorably by institutional stockholders and proxy advisory firms than a one for-one exchange
  • Reduces dilution and equity overhang and preserves the equity plan’s share reserve
  • Avoids an accounting charge if the value of the new stock options is equal to or less than the value of the exchanged underwater stock options
  • More difficult for stock option holders to understand than a one-for-one exchange and may require more employee communication efforts
  • Requires determination of proper exchange ratio to use
  • Will likely trigger SEC tender offer rules
  • Repriced stock options remain susceptible to going underwater

Option-for-Stock Exchange

A variation of the option-for-option exchange where, instead of exchanging underwater stock options for new stock options, underwater stock options are canceled in exchange for a different form of equity award (e.g., restricted stock or restricted stock units), generally on a value-for-value basis.

Pros + Cons –
  • Eliminates the possibility of future underwater stock options
  • Viewed more favorably by institutional stockholders and proxy advisory firms than a one for-one exchange
  • Significantly reduces dilution and equity overhang and preserves share reserve under the equity plan
  • More difficult for stock option holders to understand than the methods described above and may require more employee communication efforts
  • Requires determination of proper exchange ratio to use
  • Will likely trigger SEC tender offer rules
  • Company employees do not maintain control of the taxable event (i.e., tax at vesting for restricted stock or at settlement for restricted stock units)
  • Full value equity awards, such as restricted stock or restricted stock units, may be viewed as presenting a lower upside compared to stock options, arguably reducing the incentive value of the equity award
  • Full value equity awards more directly reward employees for remaining in service but less directly reward growth in enterprise value

Option-for-Cash Exchange

Cancelation of underwater stock options in exchange for the cash value of those stock options based on a commonly accepted valuation method.

Pros + Cons –
  • Significantly reduces issued equity overhang and preserves share reserve under the equity plan
  • Easily explained and understood by employees
  • Eliminates the possibility of future underwater stock options
  • Provides immediate value to participants
  • Requires determination of proper exchange ratio to use
  • Immediately taxable upon payment
  • Will likely trigger SEC tender offer rules
  • Requires a cash outlay, which may not be prudent for a company looking to conserve cash
  • The long-term incentive and retention features of equity awards are lost

 

All in all, the decision of which stock option repricing method to use will be based on the company’s equity compensation philosophy, the goals of the stock option repricing, alternatives available under the company’s current equity plans, and the company’s cash resources. The one-for-one, option-for option and option-for-stock methods are most common, with option-for-cash exchanges being much less common, especially during a market downturn or in circumstances where the company is not in a good cash position. Given the views of proxy advisory firms and institutional stockholders, a value-for-value stock option repricing in the form of either an option-for-option or option-for-stock exchange is likely to be the most viable stock option repricing method for public companies.

Frequently Asked Questions

Below are answers to frequently asked questions for public companies that are contemplating a stock option repricing.

1. Who will participate in the stock option repricing?

If the stock option repricing requires stockholder approval, companies may want to consider excluding directors and officers because, as discussed below, proxy advisory firms strongly disfavor director and officer participation in stock option repricings. In addition, if the company wants to include any non-U.S. participants in its stock option repricing, it should discuss this with local counsel and tax advisors before effectuating the repricing.

2. Which stock options will be exchanged?

Will all underwater stock options be eligible for exchange or only deeply underwater stock options with an exercise price above a specified threshold? As discussed below, proxy advisory firms have specific recommendations for determining which stock options should be subject to the repricing.

3. What is the exchange ratio?

Determination of several exchange ratios may be required if a company desires to effectuate a value-for-value stock option repricing in the form of either an option-for-option or option for-stock exchange. The exchange ratios used will have a significant effect on the rate of stock option holder participation.

4. What are the terms of the replacement stock options?

Will existing vesting terms be preserved or will additional vesting be required for the replacement stock options or other equity awards? As discussed below, proxy advisory firms favor including additional vesting terms. The vesting schedules will also affect the rate of stock option holder participation and may have potential tax consequences. In addition, as noted above, any changes in the terms of the replacement stock options will likely trigger SEC tender offer rules.

5. What happens to the canceled stock options or shares?

Many equity plans allow the canceled stock options or shares to be returned to the plan’s share pool for future issuances. However, companies may want to consider permanently retiring the canceled shares to increase the likelihood of receiving proxy advisory firm support and stockholder approval.

6. What do stockholders need to approve?

NYSE and Nasdaq listing rules require stockholder approval for any stock option repricing unless a company’s equity plan expressly permits repricing without stockholder approval. Many U.S. public companies do not maintain equity plans that expressly permit stock option repricings without stockholder approval because such a feature is viewed negatively by institutional stockholders and proxy advisory firms.
Both NYSE and Nasdaq listing rules consider the following repricing events to be material amendments requiring stockholder approval (unless expressly permitted by a company’s equity plan):

  • Lowering the exercise price of a stock option after it is granted
  • Canceling a stock option at a time when its exercise price exceeds the fair market value of the underlying stock in exchange for another stock option or other equity award, unless the cancelation and exchange occurs in connection with a merger, acquisition, spin off or other similar corporate transaction
  • Any other action treated as a repricing under generally accepted accounting principles (e.g., the grant of new stock options shortly following the cancelation of underwater stock options)

Stockholder approval is not required under NYSE or Nasdaq listing rules for the cancelation of underwater stock options in exchange for cash, but equity plans often prohibit cancelation of underwater stock options for cash without stockholder approval because proxy advisory firms consider it be a “problematic pay practice.”

7. Does the company need to worry about institutional stockholders and proxy advisory firms?

Likely, yes. Obtaining the support of institutional stockholders and proxy advisory firms is an important factor in the uphill battle to securing stockholder approval for a stock option repricing. Leading proxy advisory firms, such as Institutional Shareholder Services (ISS) and Glass Lewis, have published detailed voting guidelines related to repricings.

ISS Considerations

In its guidelines, ISS has indicated that it will generally recommend a vote “against” any equity plan that expressly permits the repricing of underwater stock options, including through an option-for-cash exchange, without prior stockholder approval. Additionally, ISS will recommend an “against” or “withhold” vote for members of the company’s compensation committee (and potentially the full board of directors) who have approved such a repricing, without stockholder approval even where permitted by the terms of the equity plan. ISS will also generally issue an “against” recommendation on the company’s “say-on pay” vote where a repricing was conducted without prior stockholder approval.
ISS will consider recommending a vote in favor of a stock option repricing submitted for stockholder approval on a case-by-case basis based upon the following factors:

  • Historic trading patterns (i.e., the stock price should not be so volatile that the stock options are likely to be back “in the money” over the near term)
  • Rationale for the repricing (i.e., was the stock price decline beyond management’s control?)
  • Whether it is a value-for-value exchange
  • Whether canceled stock options are added back to the equity plan’s share reserve
  • Timing (i.e., repricing should occur at least one year following any precipitous drop in a company’s stock price)
  • Stock option vesting (i.e., does the new stock option vest immediately or is there a black out period?)
  • Term of the stock option (i.e., the term should remain the same as that of the canceled stock option)
  • Exercise price (i.e., the exercise price should be set at fair market value or a premium to fair market value)
  • Participants (i.e., executive officers and directors should be excluded)

In addition, ISS will evaluate the intent, rationale and timing of the stock option repricing proposal. For example, ISS has indicated that a repricing following a recent precipitous drop in a company’s stock price demonstrates poor timing and will warrant additional scrutiny and that the grant dates of canceled stock options should be far enough in the past (e.g., two to three years) so as not to suggest that repricings are being done to take advantage of short-term downward price movements.

Glass Lewis Considerations

Glass Lewis firmly opposes the repricing of stock options regardless of how it is accomplished, unless uncontrollable circumstances, rather than company-specific issues, are responsible for the dramatic decline in value of a company’s stock and the repricing is necessary to motivate and retain employees. Even so, Glass Lewis approaches stock option repricings with great skepticism, and will support a repricing only if the following conditions are met:

  • Officers and board members are excluded from the program
  • The stock decline mirrors the market or industry price decline in terms of timing and approximates the decline in magnitude
  • The exchange is value-neutral or value-creative to stockholders with very conservative assumptions and with a recognition of the adverse selection problems inherent in voluntary programs
  • The vesting requirements on exchanged or repriced stock options are extended beyond one year
  • Shares underlying reacquired stock options will be permanently retired (i.e., will not be available for future grants) so as to prevent additional stockholder dilution
  • Management and the board make a cogent case for needing to motivate and retain existing employees, such as being in a competitive employment market

In the end, companies that are seeking the support of such firms should give careful consideration to whether it is possible to structure a repricing program that addresses retention and motivation concerns within those guidelines. For example, companies need to exclude executive officers and directors from participating in a stock option repricing program to obtain the support of proxy advisory firms; however, since such individuals, especially executive officers, may hold a large number of stock options, excluding them could undermine the retention and motivation goals of the program. Companies that want to allow directors and officers to have their stock options repriced might consider employing a different repricing method with less favorable terms and/or a separate stockholder proposal for directors and officers to avoid putting the broader repricing proposal at risk. Alternatively, companies may wish to exclude directors and officers from any repricing program and instead consider providing refresh grants to continue to motivate and retain such individuals.

8. What is needed to comply with SEC tender offer rules?

SEC tender offer rules are generally implicated when a stockholder is required to make an investment decision with respect to the purchase, modification or exchange of their security. A one-to-one exchange for stock options with a lower exercise price will generally not trigger SEC tender offer rules as there is virtually no investment decision required. However, a value-for-value exchange will implicate tender offer rules as it requires stock option holders to decide whether or not to accept a stock option to purchase fewer shares or to exchange their existing stock options for other forms of equity awards or cash. Additionally, the SEC considers a repricing of stock options requiring the consent of stock option holders to be a self-tender offer by the issuer of the stock options.

SEC tender offer rules are onerous and require issuers to file a Schedule TO with the SEC that includes detailed disclosures about the tender offer including, among other things, the following information:

  • A summary term sheet describing the material terms of the tender offer
  • Copies of written communications it distributes to potential participants
  • The terms of the offer/transaction
  • Procedures for participation
  • Risk factors
  • Historical share price information
  • Financial statements
  • Tax consequences

The SEC may elect to review and comment on the Schedule TO, which could delay the repricing program. Moreover, a tender offer must remain open for at least 20 business days and a final amended Schedule TO must be filed, stating the number of individuals who have accepted the offer.

9. Are there other proxy statement and SEC disclosure requirements that the company should be considering?

Companies seeking stockholder approval for a stock option repricing should solicit proxies to approve the repricing, and companies that successfully reprice stock options will need to address other SEC disclosure requirements.

In its proxy statement, a company seeking to conduct a stock option repricing must disclose the terms of the stock option repricing, discuss the accounting and tax impact of the new stock options, make certain disclosures relating to officers and directors, and include a description of the reasons for undertaking the stock option repricing and any alternatives considered by the board.

Because the primary goal of the proxy statement disclosure is to persuade stockholders to vote in favor of the repricing (including by persuading proxy advisory firms to recommend in favor thereof), companies should include a clear rationale for such repricing. In market downturns, stockholders often experience the same decrease in share price as stock option holders and will not receive the direct benefits of a stock option repricing, so convincing stockholders (and proxy advisory firms) to approve such repricing may be challenging. An additional hurdle is that brokers are generally prohibited from voting on a “non-routine” matter (such as a stock option repricing) without instructions from beneficial owners. Companies considering a stock option repricing may want to engage a proxy solicitor early in the repricing process to assist with evaluating the stockholder base, conducting stockholder outreach and gaining stockholder approval.

Additionally, if a company reprices stock options held by any of its named executive officers, it must disclose the following in its annual proxy statement for the following year:

  • The rationale for the repricing in the Compensation Discussion and Analysis
  • The incremental fair value, computed as of the repricing or modification date, of any modified stock options in the “Option Awards” column of the “Summary Compensation Table”
  • The grant date fair value of any replacement awards in the “Option Awards” or “Stock Awards” column of the “Summary Compensation Table” and the “Grant of Plan-Based Awards” table
  • A narrative disclosure describing the repricing

If a company reprices the stock options held by any of its directors, similar disclosure is required in the “Director Compensation Table.”

Information regarding the stock option repricing may also need to be addressed pursuant to other SEC disclosure requirements (e.g., Form 8-K, Form 10-K, Form 4s).

10. What are the accounting consequences of a repricing?

Companies will want to determine whether their repricing method will result in an additional accounting charge. Under ASC Topic 718, a repricing will generally require a company to recognize incremental compensation expense to the extent that the repriced stock options have higher fair values than the replaced ones. Any such accounting consequences must be stated in the Schedule TO filed with the SEC if SEC tender offer rules are implicated. Accounting rules also require that public companies describe the repricing program in the stock plan footnote to their financial statements, including the terms of the program, the number of employees who participated in it and any incremental compensation cost to be recognized.

11. What are the tax consequences of a repricing?

IRC Section 162(m)

Internal Revenue Code Section 162(m) disallows a federal income tax deduction for public corporations of remuneration in excess of $1 million paid for any fiscal year to “covered employees” except with respect to certain qualified performance-based compensation arrangements in effect as of November 2, 2017 (and not subsequently materially modified), which are “grandfathered.” Companies repricing stock options granted on or prior to such date to “covered employees” should note that a repricing of such stock options is a material modification, which will cause the loss of grandfathered status for those stock options.

Incentive Stock Options

For stock options intended to qualify as incentive stock options (ISOs), a stock option repricing, even if only the exercise prices are amended, is considered the cancelation of existing stock options and the grant of new stock options. The maximum aggregate fair market value of stock with respect to which ISOs may first become exercisable in any one calendar year is $100,000. In applying this limitation, the stock underlying a stock option is valued when the stock option is granted and if there are multiple stock options, such stock options are taken into account in the order in which they were granted. Thus, when an ISO is canceled pursuant to a stock option repricing, any stock option shares scheduled to become exercisable in the calendar year of the cancelation would continue to count against the $100,000 limit for that year, even if the cancelation occurs before the stock option shares actually become exercisable. As a result, to the extent that any shares underlying the new repriced ISO become exercisable in the same calendar year as the canceled ISO, the aggregate number of stock option shares that can receive ISO treatment is reduced (because the latest grants are the first ones to be disqualified).

In addition, if a stock option repricing offer with respect to ISOs is open for 30 days or longer, then those ISOs are considered modified (and therefore newly granted) on the date the offer was made, whether or not the stock option holder accepts the offer. The consequence of the new grant date is that the holding period for ISOs to obtain capital gains treatment (i.e., the later of two years from the date of grant and one year from the date of exercise) is restarted from the date of repricing.

12. How does a repricing affect the company’s equity plan’s share reserve and its Form S-8?

Before proceeding with a repricing, companies should determine whether they have adequate share capacity under their existing equity plan registered on an already filed registration statement on Form S-8, particularly if shares subject to canceled stock options are not added back to the share reserve under the plan (as such non-recycling of shares is favored by proxy advisory firms). Care should also be taken to ensure that other limits within the equity plan (e.g., ISO or individual grant limits) are not exceeded by the stock option repricing.

As is evident above, stock option repricing programs are generally complicated and the company’s tax, accounting, and legal advisors should be consulted prior to undertaking such a program. Goodwin serves as legal counsel to many public companies, and we regularly partner with our clients to address challenges, including the impact of volatile markets on executive compensation.

Contact Us

If you would like to discuss any of the topics covered by this Alert, please reach out to Alex Denniston, Grace Wirth, or any other member of Goodwin’s ERISA + Executive Compensation practice.


[1] This article does not address considerations for privately-held companies, nor does it address repricing options held by service providers located outside of the United States. For issues facing private companies, see the article “Private Companies: Time to Consider Repricing Underwater Stock Options?
[2] This article similarly applies to stock appreciation rights granted by public companies that are intended to be exempt stock rights under Section 409A of the Internal Revenue Code.