This article is reprinted with
permission from the
May 31, 2001
edition of
New York Law Journal.
© 2001 NLP IP Company.
Repricing Stock Options: Current Developments
DECLINES IN the stock prices of many publicly traded companies over the past year have resulted in many executives holding "underwater" stock options. An underwater option is one in which the exercise price exceeds the current market price of the stock.
Many public corporations face serious problems resulting from underwater options. Assume, for example, the market price of the stock of Company A drops from $ 50 to $ 20 and that many option holders at Company A have options with an exercise price of $ 50. Company A now hires 10 new executives and gives them option grants with an exercise price of $ 20. This obviously creates a major issue with long-term executives who are $ 30 underwater on their options while 10 new executives have options with an exercise price of $ 20. The most obvious solution and the subject of widespread debate is to reprice the old $ 50 options down to $ 20. In its simplest form, repricing of a stock option involves one or the other of the following:
(a) reduction in the exercise price of the underwater stock
option (with the new reduced option price generally being set at current market
price), or
(b) cancellation of the underwater option and the grant of a new option (again,
with an exercise price at current market).
For several decades repricing of stock options has occurred during periodic downturns in the stock market. These repricings have been accompanied by criticism from different groups including shareholders, shareholder advocates and the media. Repricings also have been the subject of litigation, tax and SEC regulations aimed at curtailing them and, most recently, new accounting rules imposing adverse accounting treatment on options that have been repriced.
The following discussion will focus on a recent accounting ruling that imposed adverse accounting treatment on repricings and provided an exception for repricings in which more than six months elapse between the cancellation of an outstanding underwater option and the grant of a new lower-priced option.
FASB Interpretation No. 44
In the Spring 2000, the Financial Accounting Standards Board
(FASB) issued Interpretation No. 44 (March 2000) entitled "Accounting for
Certain Transactions Involving Stock Compensation -- An Interpretation of APB
Opinion No. 25." 1
Interpretation No. 44, paragraphs 38 through 54 (with examples illustrating
the application of the interpretation being given at paragraphs 179 through
197), takes the position that if any option is repriced, with limited exceptions,
it will lose its status as an item of stock compensation free of an earnings
charge under APB Opinion No. 25. The repriced option becomes subject to variable
accounting treatment.
One Alternative
An Alternative: Concurrently Cancelling an Old Option and Committing to Future
Grant of a New Option. Interpretation No. 44, in paragraph 133 (by implication)
and paragraph 197 (by illustration), provides that the employer can cancel the
old option and concurrently with the cancellation agree to grant a new option
six months later without loss of the no-charge-against-earnings status provided
there is no commitment regarding what the exercise price of the new option will
be. In other words, such an agreement, in order to avoid variable accounting
treatment for the new option, cannot protect the grantee against increases in
the market price of the stock which occur after the date on which the old option
is cancelled.
A Second Alternative
Another alternative would be for the employer to grant the executive an additional
option at the lower current market price without cancelling the outstanding
option at the higher price. However, assuming there are numerous option holders
involved, this could increase substantially the number of shares outstanding
under the option program and ultimately cause an unreasonable dilution in share
values. Also, the number of shares required under this program might exceed
the number of shares authorized under the stock option plan.
A Third Alternative
The grantor corporation might, as a third alternative, grant a new option at
the current market price and provide that the new option will expire immediately
after the market price recovers to the level of the exercise price of the original
option, which remains outstanding. To illustrate, assume a set of circumstances
similar to that noted above: Company A granted an option originally with a $
50 exercise price followed by a drop in the market price to $ 20. Company A
grants a new option at $ 20. It provides the new option will expire immediately
after the market price returns to the original $ 50 level.
This alternative would "mesh" the two options. Under the new $ 20
option, the option holders have been provided the growth in value from the $
20 back to the $ 50 exercise price of the original option. The new option expires.
Continuing to hold the original option, the option holder can enjoy any future
growth above the original $ 50 exercise price. From both the corporation's and
the option holder's standpoints, this would be an efficient, risk-free design.
The FASB staff, however, in FASB Staff Announcement Topic No. D-91, stated that
the new $ 20 option must be allowed to continue for a period of at least six
months beyond the date the original $ 50 option exercise price level is reached.
Otherwise, in the staff's view, the arrangement is in effect a single transaction,
a repricing of the original option, and variable price accounting applies.
Under the FASB staff's approved version, the corporation risks something that
it did not risk in the example in which the new option expires immediately upon
the market price recovering to $ 50. The risk is that the option holder may
exercise the new, lower-priced option at a later point in the six-months-and-one-day
period, accumulating further gains beyond the $ 30 spread in the new option
if the market price continues to increase. Then, upon later exercise of the
original option, the executive can "reap" a second time the gain above
the $ 50 exercise price of the original option.
A further disadvantage of this alternative is that, like the Second Alternative,
additional options will be outstanding until the expiration of one of the options
(presumably, in most cases, the new lower-price option which expires six months
and one day after the original $ 50 option price level is reached). Not only
are the shares of Company A diluted, but, as also noted in connection with the
Second Alternative above, if a large number of options is involved, the number
of shares required for such a program may exceed the number of shares authorized
under the stock option plan.
A Fourth Alternative
Yet another alternative would be for the grantor corporation to "buy out"
the underwater option. For example, Company A might offer to its executives
with $ 50 options (current market price of the stock is $ 20) to buy them back
at their Black-Scholes value. It could cancel the options in exchange for cash
or, perhaps, restricted stock. Paragraph 135 of Interpretation No. 44 provides
that if time-based restricted stock is the consideration for the cancellation
of the option, the restricted stock will be subject to fixed, not variable,
accounting. Thus, Company A's charge against earnings will be an amount equal
to the cash or the market value of the restricted stock paid for the cancellation.
A Fifth Alternative
In the March 2001 issue of its publication Monitor, at http://www.towers.com,
the consulting firm of Towers Perrin discusses the use of a "bounded"
stock appreciation right (SAR). A "bounded" SAR has a base price equal
to the fair market value of the stock on the date of grant and a maximum "cash-out
value" equal to the exercise price of the original option.
To illustrate, Company A, from the example noted above, might grant an SAR with
a base price of $ 20 (current market price of the stock) and a maximum "cash-out
value" of $ 50, the exercise price of the original option. (Economically
this would be a solution very similar to the "meshing" of options
described above in the Third Alternative.)
The bounded SAR will be subject to variable accounting, as are SARs generally.
But will variable accounting treatment apply to the original stock option which
the optionee continues to hold? The FASB staff may view the use of a bounded
SAR in conjunction with an underwater option as a single repricing transaction
resulting in variable accounting for the original option as well. (This would
be similar to its treatment of "meshing" stock options discussed in
the Third Alternative above.)
A Sixth Alternative
Some practitioners have suggested the possibility of a sale of an underwater
stock option to a third party (for example, an investment bank) as a way of
extricating the employer and the employee from the underwater option problem.
Subject to the views of the FASB staff, the transaction might allow the employer
to grant a new, lower-priced option without the variable accounting treatment
for the new option. Obviously, there are legal problems involved, including
securities law and tax issues.
In addition, there would be the complications of amending a stock option plan
to permit the transfers as well as serious "good practice" issues.
Would boards of directors and shareholders agree that it is appropriate for
a stock option plan to permit executives to sell their underwater options to
third parties?
Any employer considering repricing, including one or more of the six alternatives
noted above, should carefully review the accounting implications with its outside
independent accountants.
Non-Accounting Issues
Repricing involves numerous legal and tax issues. While detailed discussion
of these issues is beyond the scope of this column, note is made of the following.
SEC Issues
(A) Disclosure. Since 1992, the SEC has required that any repricing of an option
or SAR held by a "named executive officer" (generally, the CEO and
the four most highly compensated executive officers other than the CEO) results
in special proxy statement disclosure requirements including information regarding
certain repricings for the last ten fiscal years. See Regulation S-K, Item 402(i),
17 C.F.R. § 229.402(i). SEC proposals regarding expanded proxy statement
disclosure and a report by a New York Stock Exchange Special Task Force have
suggested that expanded proxy statement reporting on repricings should be considered.
No specific changes in currently required disclosures of repricings in proxy
statements are expected in the near future.
(B) Tender Offers. The SEC considers stock option repricings to be transactions
that fall within the tender offer rules. A recent SEC Exemptive Order provided
for exceptions to certain of the tender offer rules for repricings that meet
specified conditions. Exemptive Order, Securities Exchange Act of 1934 (March
21, 20001), at www.sec.gov/divisions/corpfin/repricingorder.htm. However, even
if covered by the exemptive order, a repricing remains subject to Schedule TO,
requiring disclosure of certain information and, among other requirements, the
requirement that the offer remain open for 20 business days. Under existing
practice it appears that the SEC does not treat as subject to the tender offer
rules repricings that are individually negotiated arrangements or that involve
a limited number of key executives. It indirectly confirmed this in an "update"
issued concurrently with the exemptive order on March 21, 2001. There is no
suggestion as to what "a limited number" means and care should be
taken before concluding that a particular arrangement does not come within the
tender offer rules.
Federal Income Tax
Section 162(m) of the Internal Revenue Code of 1986 (the code) limits to one
million dollars per year the income tax deduction for certain forms of compensation
paid by public corporations to "covered employees" (generally, the
CEO and the four most highly compensated executive officers other than the CEO).
Exempt from this limitation are option grants under stock option plans that
meet certain requirements. These include shareholder approval and the plan's
providing for a "maximum number of shares with respect to which options...
may be granted during a specified period to any employee." Treas. Reg.
§ 1.162-27(e)(2)(vi)(A). In the event of a repricing, even though the original
option is cancelled, the regulation under § 162(m) treats the cancelled
option as still outstanding and therefore it must be counted toward the maximum
number of shares under options that can be granted to an employee during the
applicable period. This may substantially restrict the number of shares that
can be covered by a repricing without causing a problem under § 162(m).
Another tax issue involves incentive stock options (ISOs) under code §
422. Under code § 424(h)(1), if an ISO, entitled to special tax treatment
under code § 422, is repriced, the repricing is treated as the grant of
a new option. In the year in which the new option becomes exercisable, the dollar
value of the stock subject to the new option grant would be charged against
the $ 100,000 annual limitation on ISOs. (That dollar value would be the value
determined as of the date of grant.)
Other Considerations
Drafting and Corporate Governance Considerations. Existing stock option plans
should be examined carefully to determine whether they permit repricing. They
may permit no repricing or only some forms of repricing. For example, a plan
may permit a cancellation of a stock option and the grant of another stock option
to the same option holder but it may not permit a reduction of the exercise
price of an outstanding option. If an amendment to the stock option plan is
necessary, will it require shareholder approval? If shareholder approval is
required, the corporation may find itself in the midst of a very lively debate.