The decline in the stock market has meant many companies have lost the retention and incentive effects of stock options for employees. If employees don't expect the price of the stock to ever rise above the options' exercise price, then these underwater options have little value.
Some public companies have implemented various option-exchange programs to address this problem. These include issuing additional options with a lower exercise price, cashing out underwater options, replacing options with restricted stock or new options, and amending option terms to a lower exercise price.
These programs, however, present potential pitfalls. Many shareholders of public companies, including large institutional investors, regard such programs unfavorably, arguing that employees should not be rewarded for poor performance at the expense of shareholders. Although most states' corporate laws do not require shareholder approval for these steps, institutional investors frequently demand prohibitions on them when their votes are sought for approval of new option plans or authorization of additional shares under existing plans.
In addition, for companies traded on the New York Stock Exchange, it is contemplated that a new rule to be effective June 30 will require shareholder approval for option-exchange programs, unless the underlying option plan specifically allows for such action without approval. This may create a rush to finalize option-exchange programs, without shareholder approval, before this rule takes effect.
When exchanging options for new, lower-priced options, public companies must consider applicable securities laws. The Securities and Exchange Commission has determined that offers by public companies to exchange underwater options for new options constitute issuer tender offers that are subject to complex rules. Under these rules, companies must prepare and file disclosure documents with the SEC and disseminate required disclosure materials to option holders.
Of particular interest is the applicability of provisions of the tender offer rules known as the "all holders" and "best price" rules, which require a company to offer any option exchange to all employees under the applicable stock option plan at the same price. Although a recent SEC exemptive order states these rules do not apply to option exchanges, this order has not been interpreted broadly by the SEC staff, especially with respect to excluding foreign employees based on the financial, administrative and legal burdens of including them. The SEC staff position has been that these employees may not be excluded without a compensation-based reason.
Companies must also consider possible adverse accounting issues associated with implementing an option exchange. Of primary concern is avoiding variable accounting treatment for the new options granted, which would require a company to recognize a quarterly compensation expense over the term of the new options. This expense is equal to the amount by which the market value of the underlying stock exceeds the exercise price of the options. Under current accounting standards, variable accounting treatment will be required if any replacement options with lower exercise prices are granted to employees either within six months before the commencement of an exchange program or within six months after the cancellation of options. Compensation experts generally advise companies to avoid variable accounting treatment at almost any cost.
One popular exchange program is known as the "six months and a day" approach and is specifically structured to avoid variable accounting treatment. Under this program, companies offer to cancel underwater options and replace them with new options to be granted at least six months and one day after cancellation of the existing options. Employees may be required as a condition of this offer to give up any options granted within six months before the start of the program. In addition, companies implementing a "six months and a day" program may not provide any guarantee on the exercise price of the replacement options or any other protection against market risk to employees.
Despite the complex considerations surrounding exchange programs, with proper guidance, companies with underwater options can regain their benefits for employee attraction, retention and motivation.
The information contained in this article is not intended as legal advice or as an opinion on specific facts. For more information about these issues, please contact us through our Web site at www.kilpatrickstockton.com.
© Kilpatrick Stockton LLP.
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