Equity Awards 101 – Underwater Options
By:
Richard Roth
What executive compensation event that once was relatively simple is now potentially impacted by stock exchange listing agreements, proxy voting
guidelines of Risk Metrics Group (formerly ISS), SEC proxy rules, SEC exchange offer rules, and IRS tax rules? Stock option repricings.
Repricing can occur by amending outstanding options to lower the exercise price, canceling outstanding options and granting new options with a
lower exercise price, or exchanging cash or new equity awards for outstanding options. Due to share price declines, many companies now have
employees who hold options with exercise prices greater than current market prices and no longer view those options as incentive compensation
because of the large gap between the two. Before undertaking an option repricing program, companies must maneuver through the following:
Stock Exchange Listing Agreements
NYSE or NASDAQ listed companies may not reprice outstanding options without prior shareholder approval unless the equity compensation plan under
which the stock options were granted specifically allows repricing without shareholder approval. Since many equity compensation plans were
implemented before the adoption of these requirements by the exchanges, many plans are silent regarding the repricing of options.
Proxy Voting Guidelines
Risk Metrics Group (RMG) guidelines indicate that it will recommend a vote against approval of any equity compensation plan that allows
repricing of options without shareholder approval. In addition, RMG most likely will recommend a vote against repricings of outstanding options
if the stock price decline occurred in the last year, only the exercise price is reduced with no changes to vesting provisions and the options
held by executive officers or directors are to be repriced.
SEC Proxy Rules
If, due to the previous two items, shareholder approval will be sought, all disclosures required by the SEC’s proxy rules will have to be made
prior to the shareholder meeting. Fortunately, Rule 14a-6(a)(4) does not require filing a proxy statement with the SEC in preliminary form
(i.e., prior to mailing it to shareholders) to effect stock option repricings.
SEC Exchange Offer Rules
If a company wishes to avoid a RMG recommendation against repricing, it most likely will have to extend the vesting provisions of the options to
be repriced. Amending vesting provisions would render the option a new security and trigger the need to conduct an exchange offer of a new
option for the previously granted option. Likewise, an offer by a company of cash for outstanding options would have to comply with applicable
tender offer rules, although the SEC has granted relief from the all holders rule if board members and executive officers who hold options are
excluded from these types of offers.
IRS Rules
Federal tax rules also come into play in stock option repricings. The new Section 409A nonqualified deferred compensation rules exempt most stock
options from the strict compliance and severe penalties imposed by Section 409A. However, the ability to reprice an option more than once may
show that the exercise price of the option was never fixed and, therefore, the exercise price may be less than the fair market value of the
underlying stock on the option's grant date. In that event, the option would no longer be exempt from Section 409A and would be subject to the
same payment date rules and tax penalties that apply to traditional nonqualified deferred compensation plans. Another regime of tax rules applies
to stock options that qualify for the performance-based exception to the compensation deduction limit in Section 162(m). A repriced option that
is subject to those rules is treated as a new option, yet the number of shares underlying both the old option and the new option is subtracted
from number of available awards under the equity plan.
Many companies may conclude that issuing new awards to incentivize employees is a path much easier to implement than repricing outstanding options,
assuming sufficient amounts of awards remain available under previously adopted equity plans. Even if there are not sufficient remaining
awards, the adoption of a new plan to create capacity for new awards may be more efficient than repricing outstanding options, since only the SEC
proxy rules and the RMG proxy voting guidelines would have to be considered.
Let Jackson Walker guide you successfully through the regulatory landscape to effective employee compensation in the current economic
environment. If you have any questions regarding this e-Alert, please contact
Richard Roth at 713.752.4209 or
rroth@jw.com.
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