Friday August 29, 2014

When the Going Gets Tough, Opt for Option Exchange Programs

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.

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