What Can Companies Do About Underwater Stock Options?

01 December 2008 Publication
Authors: Linda Y. Kelso Leigh C. Riley John K. Wilson Michael H. Woolever

Legal News Alert: Transactional & Securities

What can companies do about stock options that are now underwater as a result of recent precipitous stock price drops? It depends. Companies that have sufficient shares available in their equity plans can take advantage of lower market prices and grant additional options with lower strike prices. Companies with available cash may choose to implement additional cash-bonus programs or offer to purchase underwater options for cash. If companies lack sufficient share reserves under their plans to grant new options, are concerned about not using up their plan reserves, or have constraints on making additional cash awards, then they may want to consider repricing their existing options, which usually means exchanging existing options for new options with a lower strike price in non-taxable transactions, or exchanging the options for other forms of equity awards such as restricted stock or restricted stock units (RSUs). However, companies listed on the NYSE or NASDAQ generally must obtain shareholder approval to reprice options or exchange options for other equity awards. As a result, companies may be swimming against the tide in seeking shareholder approval from investors, who do not have a similar opportunity to revisit investments made at yesteryear’s stock prices.

Rationale for New Grants, Option Exchanges, or Repricings
Employees with skills in demand can accomplish their own repricing by jumping ship to other employers in a position to grant options to new hires with strike prices based on today’s depressed stock prices. Even if their employees are less likely to switch jobs in today’s distressed economic environment, companies that rely heavily on equity incentives face morale issues as a result of underwater stock options. These companies are in the anomalous situation of providing better incentives to new hires who receive options based on current stock prices than to longstanding employees who hold options with exercise prices that greatly exceed today’s market prices. Companies are therefore looking for ways to deal with underwater stock options in today’s economic climate, particularly if their cash situation requires them to rely on equity incentives to motivate employees and enhance retention.

Alternatives
New grants with low strike prices based on today’s stock prices will enable existing employees to lower their average exercise price. However, some companies may not have sufficient unused shares available under their incentive plans or they may be concerned with triggering an excessive “burn rate” under their plans. Grants of restricted stock (granted subject to forfeiture if vesting conditions are not satisfied) or RSUs (which represent the right to receive stock or cash in the future upon satisfaction of vesting conditions) require fewer shares because they confer value even if the stock price does not increase. However, employees will have taxable income when the restricted stock or RSU grants vest, based on the fair market value of the stock on the date of vesting. By contrast, employees with stock options will trigger taxable income only when they make the affirmative decision to exercise (or to sell, in the case of options that qualify as incentive options under the Internal Revenue Code).

The burn rate can be reduced by exchanging existing underwater options for a fewer number of options with a lower exercise price and having the same value as the underwater options, or a small number of shares of restricted stock or RSUs.

Shareholder Approval Considerations
Repricings in which existing options are amended to lower the exercise price and cancellations of options that have an exercise price greater than the current stock price in exchange for other options, restricted stock, or other forms of equity awards, require shareholder approval under NYSE and NASDAQ listing standards, unless the company’s equity plan expressly permits repricing without shareholder approval. Many institutional shareholders and proxy advisory services expect a company to obtain shareholder approval for such transactions even if not required under NYSE and NASDAQ listing standards and expect shareholder approval for the cancellation of options in exchange for cash.

Even when companies seek shareholder approval, many institutional shareholders and proxy advisory services oppose exchange or repricing programs unless these programs meet a number of investor-friendly criteria, particularly when the programs are adopted after a recent decline in stock price. According to its proxy voting guidelines, RiskMetrics Group, one of the most well known proxy advisory firms, will recommend voting for or against option exchange or repricing programs on a case-by-case basis, focusing on the following criteria as well as the overall rationale for the programs:1

  • Historic volatility patterns suggesting that the options will not return to being “in-the-money” in the near term
  • The stock price decline was beyond management’s control (e.g.,, caused by macroeconomic factors affecting stock prices generally)
  • Directors and executive officers, who typically receive a significant share of option grants and also are responsible for the company’s overall performance, will be excluded from participation
  • The options to be surrendered have an exercise price above the 52-week stock price high
  • The options to be surrendered were granted at least two to three years ago, suggesting that the exchange is not for the purpose of taking advantage of short-term stock price declines
  • The new options will have an exercise price at or above fair market value, will not vest immediately (since the purpose is to promote retention), and will not extend beyond the term of the surrendered options
  • The new grants will have the same value as the surrendered options (i.e., a “value-for-value” exchange) rather than being exchanged on a share-for-share basis
  • If the surrendered options will be added back to the plan’s share reserve, then the company’s three-year average burn rate should not exceed the industry mean plus one standard deviation and also should not exceed two percent of the weighted average number of outstanding shares of common stock

Companies considering an exchange or repricing program should engage a proxy solicitor early in the process and consult with major investors and proxy advisory services for guidance n fashioning a program that is more likely to receive shareholder approval. Soliciting shareholder approval requires appropriate proxy disclosures with clearly stated justifications for the exchange program. Issuers must file preliminary as well as definitive proxy materials with the U.S. Securities and Exchange Commission (SEC) and allow time for dealing with the SEC comment process if the filing is selected for staff review.

Tender Offer Rules
In addition to filing preliminary and definitive proxy materials for annual or special meetings to obtain shareholder approval for the exchange or repricing program, companies listed on the NYSE or NASDAQ must comply with the SEC’s issuer tender offer rules to implement shareholder-approved exchange programs, which involve an investment decision on the part of option holders to give up existing options for new options or other equity awards with different terms. Cash payments in exchange for the surrender of underwater options likewise involve an investment decision. Only a unilateral lowering of the option strike price by the company, without any other changes, would not involve a tender offer.

SEC tender offer rules require the company to file disclosure documents for the tender offer with the SEC. These tender offer documents may be filed with the SEC on the same day that they are disseminated to option holders, allowing issuers to commence tender offers without waiting for SEC staff review. In addition, SEC tender offer rules mandate that the offer be held open for 20 business days and extended for an additional 10 business days in the event of an increase or decrease in the consideration offered by the company. A 2001 SEC exemptive order, adopted in the wake of the dot.com bust when a number of repricings took place, provides an exception from the “all-holders” rule (which requires issuers to afford equal treatment to all security holders of the same class) to permit companies to exclude certain categories of option holders such as senior executives, from the exchange program, and the “best price” rule (which requires issuers to provide the highest consideration paid to all security holders of the same class).

Accounting and Valuation Considerations
Companies will want to check on the accounting treatment of exchange or repricing programs to determine whether there will be an accounting charge under generally accepted accounting principles (GAAP). Value-for-value exchanges, as opposed to one-for-one exchanges, can minimize or eliminate any accounting charge. Companies also need to consider how to factor current stock price volatility into their valuation of new options for accounting purposes.

Tax Considerations
Almost all repricings or exchanges can be effected on a non-taxable basis for both employees and the company and in a manner that does not violate Section 409A of the Internal Revenue Code, which covers any legally binding right to compensation that could be paid to an employee in a future tax year. Publicly traded companies also will need to consider the extent to which new equity or cash-based awards granted in exchange for the cancellation of underwater options will be structured to comply with the requirements of Code Section 162(m), which limits the deductibility of certain compensation above $1 million unless it is performance-based compensation. For example, if an option, which is generally considered performance-based compensation under Code Section 162(m), is cancelled in exchange for a time-based restricted stock grant, which is not considered performance-based compensation under Code Section 162(m), the company may ultimately forego a tax deduction that would otherwise be available upon vesting of the award.

One Size Does Not Fit All
In considering how to deal with underwater stock options, companies need to consider their own business needs, employee morale, plan reserves, burn rates, stock price history, shareholder base, and proxy advisory firm recommendations. One size does not fit all. Some companies may be in a position to supplement underwater options with new options. Other companies may decide to issue a smaller number of shares of restricted stock or RSUs, the value of which does not necessarily depend on stock price appreciation. Companies without cash constraints may choose to provide more cash incentives. Other companies may want to explore the feasibility of option exchange programs.

 

 


Legal News Alert is part of our ongoing commitment to providing up-to-the-minute information about pressing concerns or industry issues affecting our clients and colleagues.

If you have any questions about this alert or would like to discuss the topic further, please contact your Foley attorney or any of the following individuals:

Linda Y. Kelso
Jacksonville, Florida
904.359.8713
lkelso@foley.com

Leigh C. Riley
Milwaukee, Wisconsin
414.297.5846
lriley@foley.com

John K. Wilson
Milwaukee, Wisconsin
414.297.5642
jkwilson@foley.com

Michael H. Woolever
Chicago, Illinois
312.832.4594
mwoolever@foley.com

 


1 ISS Governance Services, 2008 U.S. Proxy Voting Guidelines Concise Summary (December 21, 2007) at p.9. See also RiskMetrics Group, U.S. Corporate Governance Policy 2009 Updates (November 25, 2008) at p.22.