When the Going Gets Tough, Opt for Option Exchange Programs - Directorship.com, 2010 April 21

 

Stockholders and company
management are finding stock option exchange programs more appealing
than in the past.

The substantial declines in public equity share prices that
occurred as the result of the economic difficulties over the last two
years have significantly impacted the value of stock options held by
many employees of public companies. Large numbers of stock options are
currently out-of-the-money, causing the incentive and retention features
of many public company stock option programs to be diminished or, in
some cases, obliterated. To address this issue, in 2009, approximately
150 companies put an option exchange program, in which underwater
options are exchanged for new options or restricted stock, to a
shareholder vote. In contrast, only a few dozen proposals were put to a
shareholder vote in 2008. With the slow pace of the economic recovery
and uncertainty in the equity market, companies are continuing to
consider whether implementing an option exchange program could be both
beneficial and feasible.

This article was written by Laraine Rothenberg, Amy
Blackman, Todd McCafferty, Rachel Posner and Deborah Lifshey.

Stockholders and company management are finding stock option exchange
programs more appealing than in the past due to changes in the manner
in which options are exchanged. Previously, “one-for-one exchanges,”
which involve reducing option exercise prices or substituting new
options for underwater options on a one-for-one basis, were more common.
However, this type of exchange created a host of problems and
ultimately became the subject of significant scrutiny from institutional
shareholders and stock exchanges. Now, “value-for-value exchanges,”
where new options are exchanged for old underwater options based on the
value, often calculated under Black-Scholes, of the underwater options
being canceled, have become more popular, as evidenced by exchange
programs recently instituted or announced by several public companies.

Stock option exchange programs are often preferable to granting new
options in addition to previous grants. First, underwater options
exchanged for new options are canceled, resulting in no (or limited)
shareholder dilution. Second, if a company merely granted new options
without canceling underwater options, both the new options and the
underwater options held by certain executives would need to be disclosed
in proxy compensation tables, inviting potential confusion over the
level of executive compensation.

Companies considering an option exchange will need to determine the
structure and terms of the exchange offer, including the number and type
of options to be exchanged, whether directors and executive officers
will be eligible to participate in the offer and whether restricted
stock will be exchanged for all or a portion of the underwater options.
Companies will also need to establish the terms and exercise price of
the replacement options and whether the canceled underwater options will
be available for future issuance. If non-US employees are eligible to
participate, companies should also consider applicable foreign legal and
regulatory requirements.

In considering whether an option exchange program is an appropriate
and effective means of aligning the interests of a company’s employees
and its shareholders, a company should first consider the legal, tax,
and accounting implications, as well as the rationale, terms, structure,
and optics of the exchange. It should also conduct a diagnostic to
assess whether there is sufficient reason for the exchange and whether
the exchange is practical given the particular facts specific to the
company. Many of these issues are especially relevant for option
exchange programs that require shareholder approval, as these programs
will be closely scrutinized by institutional shareholders and proxy
advisors.

Legal Considerations

Tender Offer Rules

Value-for-value exchanges require that participating employees make an
investment decision to “tender” one option award in exchange for another
option award with different terms (such as a different number of
options, different strike price and/or different vesting schedules).
Accordingly, this type of exchange is deemed a “tender offer” under the
Securities Exchange Act of 1934, as amended (the “Exchange Act”) and
must generally comply with the requirements of Rule 13e-4 under the
Exchange Act, including a requirement that the offer remain open for at
least 20 business days. Under a global exemptive order issued by the
Division of Corporation Finance of the Securities and Exchange
Commission (“SEC”), most option exchange programs have been granted
limited relief from the “all holders” and “best price” rules.

Specifically, the company must file a Schedule TO with the SEC in
connection with the commencement of the offer. The Schedule TO must
include a detailed summary of the terms of the exchange offer. In
addition, any communications in connection with the offer must be
promptly filed with the SEC (generally on the same day the communication
is first disseminated). Oral communications may need to be reduced to
written form and filed if they contain material information that is not
already on file with the SEC.

Disclosure Requirements

As discussed below, disclosure requirements may arise in connection with
an option exchange program both before the program is implemented, in
the event shareholder approval is required and after the program has
taken place, particularly if the company’s named executive officers
participate. First, under requirements imposed by the stock exchanges
and the terms of the particular stock option plan, many companies will
be required to obtain shareholder approval in order to initiate an
option exchange program, in which case the company must comply with the
SEC’s proxy rules. In that case, the company will be required to file a
preliminary proxy statement with the SEC disclosing the proposed terms
and rationale for the option exchange program. The preliminary proxy
statement will be subject to review and comment by the SEC staff before
it is disseminated to stockholders.

Second, once the exchange offer is completed, additional disclosures
may be required in future proxy statements. Specifically, the
Compensation Discussion and Analysis section of the proxy statement will
need to discuss any participation by named executive officers in the
exchange. In addition, the Summary Compensation Table and Grants of
Plan-Based Awards Table must discuss and disclose the incremental fair
value of repriced awards granted to named executive officers.

The Financial Accounting Standards Board (FASB) Accounting Standards
Codification (ASC) Topic 718 (formerly, FASB Statement 123R) (“Topic
718”) requires additional disclosure following completion of an option
exchange program. Topic 718, which governs the accounting treatment of
stock options (discussed below), requires that exchange programs be
described in footnotes to the financial statements. The footnote
disclosure must include the terms of the program, the number of
participating employees, and any incremental compensation cost
recognized as a result of the program. This disclosure obligation
continues for as long as the expense is recognized.

Finally, for employees subject to Section 16 reporting, both the
cancellation of underwater options and the new option grant must be
reported on a Form 4.

Accounting and Tax Considerations

Topic 718: Valuation of Stock Options

Topic 718 treats a stock option exchange as a “modification” to the
existing stock option and requires a comparison of the fair value of the
stock option before and after the modification to determine if there is
any increase in value of the stock option. If there is an increase, an
accounting charge must be taken. Value-for-value exchanges are
structured to avoid this charge.

Section 409A of the Internal Revenue Code: Nonqualified Deferred
Compensation

Under Section 409A of the Internal Revenue Code of 1986, as amended,
which imposes an excise tax with respect to certain nonqualified
deferred compensation, an option exchange is treated as the equivalent
of a cancellation of the outstanding options and a new grant. As long as
the new option exercise price is equal to or greater than the current
fair market value of the underlying stock, there should be no Section
409A implications. However, if an option undergoes a series of
repricings, rather than just one, it could indicate for Section 409A
purposes that the exercise price was never fixed at the time of grant
and the repricing would therefore no longer be exempt from Section 409A,
potentially resulting in a substantial excise tax.

Incentive Stock Options

Under the Incentive Stock Option (“ISO”) rules, an option exchange is
also considered a cancellation coupled with a concurrent grant. This
would trigger the recalculation of the $100,000 limitation on ISOs and
the two-year holding period would restart from the time of the new
grant. Also, if the offer to reprice an ISO is outstanding for more than
30 calendar days, the ISO is deemed to have been modified as of the
offer date. This could result in the disqualification of ISOs held by
employees who do not participate in the exchange.

Shareholder Approval

Under New York Stock Exchange (“NYSE”) and NASDAQ rules, a company must
obtain shareholder approval of an option exchange program unless the
company’s option plan expressly provides for repricings. It is rare for
option plans to include such a provision and the requirement to obtain a
shareholder vote can present a significant challenge to crafting and
implementing an option exchange program. Moreover, even if a vote is not
technically required, conducting an option exchange program without
shareholder approval could lead to the possibility of a “withhold”
recommendation from RiskMetrics Group (formerly ISS) on the company’s
compensation committee members in the future.

When seeking shareholder approval to satisfy the NYSE and NASDAQ
rules, companies should consider whether their shareholders would
ultimately support an option exchange program. A company should have a
clear understanding of its shareholder base and how certain key
shareholders have historically voted. It may be useful for the company
to retain a proxy solicitor in order to facilitate an effective
campaign. Institutional investors and others often look to proxy
advisors such as RiskMetrics Group for insight in determining whether to
support a proposal. Companies should seriously consider the form of
their exchange program and provide clear reasons for its implementation.

Although RiskMetrics Group approaches management proposals on a
case-by-case basis, they have outlined the considerations they use in
determining whether to recommend a vote for or a vote against an option
exchange program. Some of their primary concerns relate to:

• Whether executive officers and directors are excluded from
  participation and the various levels of employees who would be eligible
  to participate in the program.


• The historic trading patterns and volatility of the stock price.
  Underwater options should not likely become in-the-money in the short
  term. As a rule of thumb, the threshold exercise price for eligible
  options should be the higher of the 52-week high or 50 percent above
  the current stock price. As a result, only deeply underwater options are
  eligible for the program.


• The rationale for the repricing and whether the stock price decline
  was due to conditions beyond management’s control or as a result of poor
  management policies.


• The intent and timing of the exchange program, such as the length of
  time the options have been underwater.


• Whether to exclude certain underwater options (for example, options
  granted within two years of the proposed exchange or options with an
  exercise price below the 52-week high of the company’s stock price).


• The characteristics of the replacement options, such as whether
  there are new vesting schedules, whether the new terms differ from the
  replaced options terms, and whether the exercise price is set at fair
  market value or at a premium to the market.


• What happens to the surrendered options and whether they are
  canceled or returned to the plan reserve.

Management should take all of these factors into account when
crafting an option exchange program to increase the likelihood that
proxy advisors will support their proposal.

Practical Considerations

While option exchanges can renew the vitality to a company’s equity
compensation program, there are important issues that must be
considered. First, exchange programs may undermine pay-for-performance
principles. They also contradict the premise that employee and
shareholder interests are aligned in long-term wealth creation, and may
be viewed as poor governance and a breach of shareholder trust. It may
even suggest a lack in faith in the company’s future value. Ultimately,
shareholders will consider these issues as most exchanges will be
submitted for shareholder approval. Aside from optics, companies must
consider the monetary costs of conducting the exchange – the tender
offer process, for example – as well as the time and effort of various
employees and outside advisors to complete the transaction.

As the costs associated with an exchange may be high in terms of
money, time and optics, companies should carefully consider whether an
exchange program is necessary and appropriate to meet their needs.
Exchange programs are most appropriate in environments where one or more
of the following factors exist:

• The right employees would be motivated and retained – if the goal is
  to motivate/retain only officers and directors, who may be required to
  be excluded if RiskMetrics Group’s approval is important, an exchange
  may not be effective;


• Stock price is significantly down and not expected to recover soon,
  as option holders will receive a windfall if there is a “pop” following
  an exchange;


• A determination is made that the company must provide some value
  through the options in order to motivate employees to help get the
  company back on track and retain employees who have other viable
  employment opportunities;


• Employees hold a number of underwater options such that the exchange
  would have an important impact on motivation and retention;


• Dilution is high and the company has insufficient shares available
  to make new equity grants; and


• Underwater options are “inefficient” because the value perceived by
  holders is considerably less than the accounting expense.

In addition, once the exchange is completed, the job is not complete.
Companies must continue to monitor the design and mix of ongoing
compensation programs in light of the newly revitalized equity to ensure
retention and incentive objectives are being met effectively and in an
appropriate manner.

Closing

Stock option exchanges can be a useful and effective tool in maintaining
equity-based incentive and retention programs following significant
declines in equity value resulting from broad market trends. While
securities law requirements, accounting concerns, tax considerations and
the need to craft a program that is acceptable to shareholders all must
factor into a company’s decision-making process, these obstacles are
not insurmountable. If a company sets clear and reasonable objectives
and plans in advance in consultation with its legal counsel and other
advisors, it is possible to implement a successful option exchange
program as a cost-effective means of helping to align the interests of a
company’s employees and shareholders.

Laraine Rothenberg is a partner and chair of Employee Benefits
and Plans, and Executive Compensation Department, and Amy Blackman and
Todd McCafferty are associates, at Fried, Frank, Harris, Shriver &
Jacobson LLP. Rachel Posner is senior managing director and general
counsel at Georgeson, and Deborah Lifshey is managing director at Pearl
Meyer & Partners.