Stock Option Exchanges and Repricings - Vinson & Elkins, 2 March 2010

Stock
Option Exchanges and Repricings



V&E
Employee Benefits and Executive Compensation E-communication, March 2,
2010 

Due to the turn of events in the financial
markets in 2008 that resulted in the downward movement of stock prices,
many public companies have found their outstanding stock options
underwater. Underwater stock options are problematic to companies for
many reasons, not the least of which is that they may have lost their
primary purpose: to incentivize management and other employees. As a
result, many companies are considering stock option exchange programs or
a repricing of stock options. There are a number of considerations
surrounding such programs, including accounting issues, stockholder
approval requirements, and sometimes the necessity of institutional
stockholder support. Many companies find this last factor the most
complex to navigate. 


While there are several issues to consider in obtaining the support of
your institutional investors, garnering this support is not an
insurmountable task. Therefore, we have compiled a list of
considerations taken from the most recent Riskmetrics Group
(Riskmetrics) voting policies for our clients and friends of the firm to
consider when contemplating the institution of a stock option exchange
or repricing program. As discussed below, because Riskmetrics requires
that the next exercise price should be at or above the 52-week high of
the company’s stock, the 2010 proxy season will be the prime opportunity
for repricing or exchange programs.

The Riskmetrics voting
policies regarding whether a “for” or “against” vote will be recommended
for a stock option exchange or repricing note that while Riskmetrics
will vote on a case-by-case basis on any proposal regarding this issue,
they will take the following items into consideration: 

• The
  historic trading patterns at the company; the stock price shouldn’t be
  so volatile that the stock options are likely to be back in the money in
  the near future.


• The rationale for the repricing; was the stock
  price decline beyond the company management’s control? Presumably a
  drop that correlates with the fall of the overall markets would be
  beyond management’s control.


• Will the program be a
  value-for-value exchange? An exchange involving the stock option holder
  receiving one new stock option for each individual underwater stock
  option would be considered by Riskmetrics on a case-to-case basis to
  determine whether it could provide support for the program; however, a
  program that provides one new stock option for two or more underwater
  stock options would more likely be considered a value-for-value
  exchange.


• Are surrendered stock options added back into the
  applicable plan’s share reserve? If so, Riskmetrics will also consider
  the total cost of the company’s equity plans, the average three year
  burn rate, and the company’s historic annual award granting rate. If the
  numbers are deemed excessively high, it can be difficult to achieve
  Riskmetrics’ approval of the proposal; however, these items are
  determined on a case-by-case basis, and Riskmetrics will analyze these
  numbers in light of other more favorable aspects of the repricing or
  exchange program, the plan itself, or the company’s equity-based
  compensation policies in general.


• If the stock options are
  exchanged, will the new stock options have a black-out period or will
  they vest immediately?


• The term of any new stock options should
  remain the same as that of the replaced stock option. Riskmetrics will
  evaluate the grant date, the exercise price, the vesting schedule, and
  other similar terms individually. 


• The exercise price of the
  newly granted or repriced stock options should be set at fair market
  value or a premium to market.


• Executive officers and directors
  should be excluded from participating in the program.

Additionally,
Riskmetrics will evaluate the intent, rationale, and timing of all
repricing or exchange proposals. Hence, the proposal presented to the
company’s stockholders should clearly articulate why the company’s board
of directors is choosing to conduct the repricing or exchange program
at that particular time (repricing underwater stock options after a
recent precipitous drop in the company’s stock price demonstrates poor
timing, and the drop should have not occurred within the one year period
immediately prior to the date of the exchange or repricing). Repricing
stock options following a recent decline in stock price triggers
additional scrutiny and a potential “against” vote on the proposal. The
grant date of any surrendered stock options should also be far enough in
the past (two to three years is recommended) so as not to suggest the
repricing is an attempt to take advantage of a short-term downward price
movement. Finally, the exercise price of the stock options to be
surrendered or exchanged should be above the 52-week high for the
company’s stock price, counted back from the date of the exchange or
repricing. Since the most significant drops in the stock market, namely
those losses incurred in September 2008 and March 2009 should be a year
in advance of the next stockholders’ meeting, most companies should not
find significant difficulties in abiding by these timing and pricing
guidelines.

A stock option exchange program or a repricing
provides a significant benefit to a company over simply issuing new
stock options to the holders of underwater stock options in that the
company no longer needs to worry about the then-underwater stock options
coming back into the money and providing an unintended twofold benefit
to the stock option holders. In light of the uncertainty of the market
and future stock prices, companies that initiate stock option exchange
programs or repricings rather than simply granting additional stock
options can be assured that employees will not be gratuitously
compensated.

Lastly, stock options are largely intended to provide
incentives to stimulate and retain the employees who are expected to
contribute to the success of the company. Unlike other types of
equity-based awards, stock options are unique in that they align
employee’s interests directly with those of the company’s stockholders;
when the company’s stock price improves, stock option holders and
stockholders receive a similar benefit. When the exercise price of a
stock option is significantly higher than the value of the company’s
stock, the incentivizing and motivating element of the stock option is
lost. Even in a weak economy, a company’s key employees often have other
employment opportunities, and the lack of effective equity-based
incentives may make the departure of important employees to competitors —
where the employees may receive new stock option awards with exercise
prices reflecting current market conditions — more likely. As a result, a
stock option repricing or exchange program can be a vital element of
retaining talented individuals who are instrumental to the company’s
future success.

If you are considering a stock option exchange
program or a repricing in order to revitalize the business incentive
portion of your underwater stock options, you will be required to make
several decisions pertaining to tax, securities, stock market exchange,
and accounting rules in order to tailor a program to your company’s
needs.

http://www.velaw.com/resources/pub_detail_print.aspx?id=17024

For more information, please contact Vinson
& Elkins lawyers David
D'Alessandro, Shane
Tucker, or Melissa
Jester. Visit our website to learn more about V&E's Employee
Benefits and Executive Compensation practice, or e-mail one of the
V&E Employee Benefits and Executive Compensation practice
contacts.