When the Going Gets Tough, Opt for Option Exchange Programs

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Stock Options Viewpoint

When the Going Gets Tough, Opt

for Option Exchange Programs

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.

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 op-tions held by many employees of public companies. Large numbers of stock options are currently out-of-the-money, causing the incentive and re-tention features of many public company stock option programs to be diminished or, in some cases, obliterated. To address this issue, in 2009, approxi-mately 150 companies put an option exchange program, in which underwater options are exchanged for new options or restricted stock, to a sharehold-er 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 ex-change program could be both beneficial and feasible.

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. Previ-ously, “one-for-one exchanges,” which involve reducing option exercise prices or substituting new options for underwater op-tions 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 share-holders and stock exchanges. Now, “value-for-value exchang-es,” where new options are

ex-changed for old underwater op-tions based on the value, often calculated under Black-Scholes, of the underwater options being canceled, have become more popular, as evidenced by ex-change programs recently insti-tuted or announced by several public companies.

Stock option exchange pro-grams are often preferable to granting new options in addition to previous grants. First, under-water 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

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Stock Options Viewpoint

level of executive compensation. Companies considering an op-tion exchange will need to de-termine the structure and terms of the exchange offer, including the number and type of options to be exchanged, whether direc-tors 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 replace-ment options and whether the canceled underwater options will be available for future issu-ance. If non-US employees are eligible to participate, compa-nies should also consider appli-cable foreign legal and regula-tory requirements.

In considering whether an op-tion exchange program is an ap-propriate 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 ex-change. 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 scruti-nized by institutional sharehold-ers and proxy advisors.

Legal Considerations

Tender Offer Rules

Value-for-value exchanges require that participating em-ployees make an investment decision to “tender” one option award in exchange for another

option award with different terms (such as a different num-ber of options, different strike price and/or different vesting schedules). Accordingly, this type of exchange is deemed a “tender offer” under the Secu-rities Exchange Act of 1934, as amended (the “Exchange Act”) and must generally comply with the requirements of Rule 13e-4 under the Exchange Act, in-cluding a requirement that the offer remain open for at least 20 business days. Under a global exemptive order issued by the Division of Corporation Fi-nance of the Securities and Ex-change 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 in-clude a detailed summary of the terms of the exchange offer. In addition, any communica-tions in connection with the of-fer must be promptly filed with the SEC (generally on the same day the communication is first disseminated). Oral communi-cations may need to be reduced to written form and filed if they contain material information that is not already on file with the SEC.

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.

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Stock Options Viewpoint

Disclosure Requirements

As discussed below, disclo-sure requirements may arise in connection with an option ex-change 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 prelimi-nary proxy statement with the SEC disclosing the proposed terms and rationale for the op-tion exchange program. The preliminary proxy statement will be subject to review and com-ment 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. Spe-cifically, the Compensation Dis-cussion and Analysis section of the proxy statement will need to discuss any participation by named executive officers in the exchange. In addition, the Sum-mary Compensation Table and

Grants of Plan-Based Awards Table must discuss and disclose the incremental fair value of re-priced awards granted to named executive officers.

The Financial Accounting Standards Board (FASB) Ac-counting Standards Codifica-tion (ASC) Topic 718 (formerly, FASB Statement 123R) (“Topic 718”) requires additional disclo-sure following completion of an option exchange program. Topic 718, which governs the accounting treatment of stock options (discussed below), re-quires that exchange programs be described in footnotes to the financial statements. The foot-note disclosure must include the terms of the program, the num-ber of participating employees, and any incremental compensa-tion 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 op-tions and the new option grant must be reported on a Form 4.

Accounting and Tax Consider-ations

Topic 718: Valuation of Stock Options

Topic 718 treats a stock option exchange as a “modification” to the existing stock option and re-quires a comparison of the fair

value of the stock option before and after the modification to de-termine if there is any increase in value of the stock option. If there is an increase, an ac-counting 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 In-ternal Revenue Code of 1986, as amended, which imposes an excise tax with respect to certain nonqualified deferred compen-sation, 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 implica-tions. However, if an option undergoes a series of repricings, rather than just one, it could indicate for Section 409A pur-poses that the exercise price was never fixed at the time of grant and the repricing would there-fore no longer be exempt from Section 409A, potentially result-ing in a substantial excise tax.

Incentive Stock Options

Under the Incentive Stock Op-tion (“ISO”) rules, an opOp-tion exchange is also considered a cancellation coupled with a concurrent grant. This would

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Stock Options Viewpoint

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 disquali-fication of ISOs held by employ-ees who do not participate in the exchange.

Shareholder Approval

Under New York Stock Ex-change (“NYSE”) and NAS-DAQ rules, a company must ob-tain shareholder approval of an option exchange program un-less the company’s option plan expressly provides for repricings. It is rare for option plans to in-clude such a provision and the requirement to obtain a share-holder vote can present a sig-nificant challenge to crafting and implementing an option exchange program. Moreover, even if a vote is not technically required, conducting an op-tion exchange program without shareholder approval could lead to the possibility of a “withhold” recommendation from RiskMet-rics Group (formerly ISS) on the company’s compensation com-mittee members in the future. When seeking shareholder ap-proval 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 use-ful for the company to retain a proxy solicitor in order to facili-tate an effective campaign. In-stitutional investors and others often look to proxy advisors such as RiskMetrics Group for in-sight 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 pro-posals on a case-by-case basis, they have outlined the consid-erations 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: n Whether executive officers and directors are excluded from participation and the various levels of employees who would be eligible to participate in the program.

n 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. n The rationale for the repric-ing and whether the stock price decline was due to conditions beyond management’s control or as a result of poor manage-ment policies.

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

n Whether to exclude certain underwater options (for exam-ple, 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).

n 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 mar-ket value or at a premium to the market.

n What happens to the surren-dered 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 ex-change program to increase the likelihood that proxy advisors

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Stock Options Viewpoint

will support their proposal.

Practical Considerations

While option exchanges can renew the vitality to a com-pany’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 gov-ernance and a breach of share-holder trust. It may even suggest a lack in faith in the company’s future value. Ultimately, share-holders will consider these is-sues 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, com-panies should carefully consider whether an exchange program is necessary and appropriate to meet their needs. Exchange pro-grams are most appropriate in en-vironments where one or more of the following factors exist: n 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;

n Stock price is significantly down and not expected to re-cover soon, as option holders will receive a windfall if there is a “pop” following an exchange; n A determination is made that the company must provide some value through the options in or-der to motivate employees to help get the company back on track and retain employees who have other viable employment opportunities;

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

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

n Underwater options are “inef-ficient” because the value per-ceived by holders is considerably less than the accounting expense. In addition, once the exchange is completed, the job is not com-plete. Companies must con-tinue to monitor the design and mix of ongoing compensation programs in light of the newly revitalized equity to ensure re-tention 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 in-centive and retention programs following significant declines in equity value resulting from broad market trends. While securities law requirements, ac-counting concerns, tax consid-erations and the need to craft a program that is acceptable to shareholders all must factor into a company’s decision-mak-ing process, these obstacles are not insurmountable. If a com-pany sets clear and reasonable objectives and plans in advance in consultation with its legal counsel and other advisors, it is possible to implement a suc-cessful option exchange pro-gram as a cost-effective means of helping to align the inter-ests 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 & Jacob-son LLP. Rachel Posner is senior man-aging director and general counsel at Georgeson, and Deborah Lifshey is managing director at Pearl Meyer & Partners.