Given the recent tumult in the financial markets,
resulting in the downward movement of stock prices, many public
companies are required to manage the challenges associated with an
increasing number of underwater stock options. Underwater 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 option exchange
programs. Option exchange programs, or repricings, typically involve
the exchange of underwater options for new options with a lower
exercise price or the exchange of existing options for other forms of
equity awards or cash. There are a number of considerations surrounding
option exchange programs, including shareholder approval requirements,
the necessity of institutional shareholder support, compliance with
tender offer rules, proxy statement and other SEC disclosure
requirements, accounting and tax consequences and the potential to
increase overtime costs.To assist our
clients who are facing the challenges of underwater options, we have
compiled the following list of issues to consider when contemplating an
option exchange program.

• What will the structure be?  One of the first
  decisions a company must make in connection with an option exchange
  program is whether the underwater options will be exchanged for new
  options, stock (e.g., restricted stock or restricted stock units) or
  cash. This decision will be based on the company’s equity compensation
  philosophy, the goals of the option exchange, the alternatives
  available under the company’s current equity compensation plans and the
  company’s cash resources. When structuring the program as an exchange
  for a new option or other equity award, a company also must decide
  whether to structure the exchange program as (i) a one-for-one
  exchange, where the exercise price of the underwater options is lowered
  to the current market price of the company’s common stock, or (ii) a
  value-for-value exchange, where optionholders exchange and cancel their
  underwater options for a grant of new options (with an exercise price
  of at least current market price) or other equity awards at a ratio of
  less than one-for-one. In the current environment, given the views of
  proxy advisors and institutional shareholders, a value-for-value
  exchange may likely be the most viable structure for most public
  companies. Domestic companies listed on the New York Stock Exchange or
  on The Nasdaq Stock Market, must obtain shareholder approval of an
  option exchange program unless the company’s option plan expressly
  permits repricing. Many domestic companies listed on the NYSE or
  Nasdaq, however, are unlikely to have option plans that expressly
  permit repricing. An option plan that is silent as to option repricing
  is considered to prohibit repricing for purposes of NYSE and Nasdaq
  rules. If underwater options are to be exchanged for cash, no
  shareholder approval is required. It should be noted, however, that
  some institutional shareholders and proxy advisors consider an option
  for cash exchange to be a “poor pay practice.”


• Will the option exchange program require shareholder approval?
  Domestic companies listed on the New York Stock Exchange or on The
  Nasdaq Stock Market, must obtain shareholder approval of an option
  exchange program unless the company’s option plan expressly permits
  repricing. Many domestic companies listed on the NYSE or Nasdaq,
  however, are unlikely to have option plans that expressly permit
  repricing. An option plan that is silent as to option repricing
  is considered to prohibit repricing for purposes of NYSE and Nasdaq
  rules. If underwater options are to be exchanged for cash, no
  shareholder approval is required. It should be noted, however, that
  some institutional shareholders and proxy advisors consider an option
  for cash exchange to be a “poor pay practice.”


• Will institutional shareholders and proxy advisors support the option exchange program? Obtaining
  the support of institutional shareholders and proxy advisors is a
  critical step in the challenge of securing shareholder approval for an
  option exchange program. Some leading proxy advisors have published
  detailed voting guidelines related to option exchange programs, while
  others have indicated only that exchange programs will be considered on
  a case-by-case basis. A company should review these guidelines if
  relevant to its shareholder base.


• Who will be eligible to participate in the option exchange program?
  If an option exchange program requires shareholder approval, companies
  should give consideration as to whether they should exclude directors
  and officers from participating in the program. Certain institutional
  shareholders and proxy advisors have indicated that they would not
  support option exchange programs that include directors and officers.


• Which options will be exchanged? A company must
  decide whether all underwater options will be eligible for exchange, or
  only underwater options with an exercise price above a specified
  threshold. At least one proxy advisor, for instance, recommends that
  only options with an exercise price in excess of the 52-week high be
  eligible for option exchange programs.


• What is the exchange ratio? In a value-for-value
  exchange, a company must decide how many underwater options must be
  tendered in exchange for each new option or other equity award. The
  exchange ratio may have an impact on the rate of optionholder
  participation.


• What are the terms of the replacement grants? A
  company must decide whether to extend the vesting schedule of the
  replacement grants, which may also affect the rate of optionholder
  participation.


• What happens to the canceled options?
  Many option plans allow the options that are canceled in an option
  exchange program to be returned to the plan pool and become available
  for future issuances. Companies seeking shareholder approval of the
  option exchange program may want to consider permanently retiring the
  canceled options (i.e., the excess of the canceled option shares over
  the new options shares) because such a feature may enhance the
  likelihood of receiving shareholder approval.


• What are the primary securities law requirements?
  An option exchange program that is conducted as an exchange will often
  require a company to comply with the tender offer rules, which includes
  filings with the SEC, employee communications and administrative costs.
  In addition, companies seeking shareholder approval for an option
  exchange program must solicit proxies in accordance with Section 14(a)
  of the Securities Exchange Act of 1934 (the “Exchange Act”) and the
  rules thereunder, including the filing of a preliminary proxy. Option
  exchange programs also trigger other disclosure requirements. For
  example, if a company reprices or exchanges options of any of its named
  executive officers, then it must explain its rationale in its
  Compensation Discussion and Analysis and must also disclose the
  incremental fair value with respect to such an exchange program in its
  “Grant of Plan-Based Awards” table in the next proxy statement. In
  addition, an option exchange program involves the disposition of the
  existing option and the acquisition of the new option or other equity
  grant, both of which are reportable under Section 16(a) of the Exchange
  Act.


• What are the accounting consequences? Companies
  will want to determine whether their option exchange program will
  result in an additional accounting charge. Value-for-value exchanges
  are commonly structured to avoid any incremental accounting charge
  under FAS 123R. Any accounting consequences must be stated in the
  tender offer filings with the SEC. Also, FAS 123R requires that
  companies describe the exchange program in the stock plan footnote to
  their financial statements.


• What are the potential tax consequences?
  Companies should consider whether the structure of an option exchange
  program will comply with Section 162(m) of the Internal Revenue Code.
  In addition, to qualify for incentive stock option (”ISO”) treatment,
  the maximum fair market value of stock with respect to which ISOs may
  first become exercisable in any calendar year is $100,000. When an ISO
  is canceled pursuant to an exchange program, any options scheduled to
  become exercisable in the calendar year of the cancellation would
  continue to count against the $100,000 limit for that year, even if
  cancellation occurs before the options actually become exercisable. The
  length of time for which an exchange program offer is open can also
  result in negative tax consequences. If an exchange program offer is
  open for more than 30 days with respect to options intended to qualify
  for ISO treatment, those ISOs are considered newly granted on the date
  the offer was made, whether or not the optionholder accepts the offer.
  Another consequence of the new grant date is that the holding period to
  obtain capital gains treatment is restarted.


• Will the option exchange program increase overtime costs?
  Subject to compliance with Section 7(e) of the Fair Labor Standards Act
  (”FLSA”), any income that a non-exempt employee earns from the exercise
  of stock options is excluded from the employee’s regular rate of pay
  for purposes of determining overtime pay. One of the conditions of
  Section 7(e) of the FLSA is that the option cannot be exercisable for
  at least six months after the grant, with limited exceptions for death,
  disability, retirement or a change in control. Therefore, a company
  should consider the potential increase in overtime pay if it intends to
  grant a repriced stock option to a non-exempt employee without imposing
  a vesting condition of at least six months.


• What are some other practical issues? A company
  contemplating an option exchange program should plan for sufficient
  time for board of director and committee review and approvals, and
  advance review of the program by proxy advisors, accountants and legal
  advisors. The company may also want to retain a proxy solicitor to
  assist with obtaining shareholder approval of the option exchange
  program, as well as a compensation consultant, whose input on the
  program terms may prove helpful in structuring a program that will be
  able to clear the hurdle of shareholder approval. Finally, a company
  should be mindful that any communications, written or oral, it makes to
  its employees regarding a possible option exchange program will likely
  need to be filed with the SEC on the day on which such a communication
  is made as part of the tender offer documents, including as a
  pre-commencement communication if such communication is made prior to
  launch of the option exchange program and the filing of the exchange
  program documentation.