Repricing “Underwater” Stock Options

Conclusions An employer whose compensation program includes stock options that are currently underwater may find it necessary to restore some of the value of those options to its employees. Additionally, when considering a make up grant, a company should consider the potential unwarranted dilution to existing shareholders. This means that any increase in the value of the underlying stock above the exercise price from the date of grant until the date the option either is exercised or terminates must be recorded as a compensation expense. Traditionally repricing simply involved canceling the existing stock options and granting new stock options with a price equal to the current fair market value of the underlying stock; but over the years alternative approaches to traditional repricing have been developed to avoid the unfavorable accounting treatment now associated with a simple repricing. RMG voting guidelines state that it evaluates option repricing proposals on a case by case basis, giving consideration to a number of factors, the three most critical of which are: Otherwise, it risks losing its employees to companies that appear to offer greater potential upside in their equity compensation.

Traditionally repricing simply involved canceling the existing stock options and granting new stock options with a price equal to the current fair market value of the underlying stock; but over the years alternative approaches to traditional repricing have been developed to avoid the unfavorable accounting treatment now associated with a .

Contributors

Grants of "Paired" Options Options can be granted that expire six months and a day after the market value of the stock reaches the exercise price of the original options. In addition, an indirect repricing occurs if an option is granted on the condition that a higher-priced option will be cancelled after six months, or if an option is cancelled on the condition that the issuer compensate the optionee for any increase in the stock price that occurs between the cancellation and a subsequent grant after six months.

The underlying rationale for this rule is that the issuer and the optionee should be exposed to market risk for at least six months. This rationale permits a higher-priced option to be cancelled and a replacement option granted six months later at the then market value, without compensation to the optionee for any foregone increase in the share price. Similarly, a replacement option may be granted at any time and six months later a higher-priced option cancelled, if the subsequent cancellation is not a condition of the prior grant.

Stock Grants to Replace Options If the market value of the stock has declined precipitously, an issuer may cancel options and replace them with stock. Note that the grantee would be subject to taxation on the same amount at the time of grant, if a Section 83 b election is timely filed, or on the difference between the price paid, if any, and the value of the shares as they vest, if no such election is made. Conclusions An employer whose compensation program includes stock options that are currently underwater may find it necessary to restore some of the value of those options to its employees.

Otherwise, it risks losing its employees to companies that appear to offer greater potential upside in their equity compensation. At the same time, there are practical limits to the number of options that an issuer may have outstanding at any one time.

In the past, the option repricing rules permitted an issuer to cancel old options and grant new ones, thereby keeping the number of outstanding options relatively unchanged. Under FIN 44 a traditional repricing generally is prohibitive. However, it is still possible to restore value to optionees whose options are underwater while limiting the adverse consequences of doing so.

You are invited to call any member of the compensation and benefits group at Smith Anderson to discuss the best ways to accomplish both objectives for your firm.

Over the past year several of our clients have considered repricing their underwater stock options and we have participated in at least three repricing approaches that seek to avoid the accounting concerns described in the prior section.

This is put into place by canceling the underwater stock option and then offering the employee the grant of a replacement option, six months and one day later, with an exercise price equal to the then fair market value of the underlying stock, whatever that may be at the time.

Under this approach, a company cancels the underwater stock options and replaces them with an outright restricted stock award. Under this approach a company grants additional stock options at the lower stock price on top of the old underwater options without canceling the old underwater options. Each of these approaches should avoid variable accounting treatment. However, each of these approaches is not without its own separate concerns and should be reviewed in light of the facts and circumstances of the particular situation.

For example, when considering a six and one day exchange, there is risk to the employee that the fair market value will rise as of the reissuance date; or when considering a restricted stock award a company should consider whether the employees will have the cash available to pay for the stock at the time of award. Additionally, when considering a make up grant, a company should consider the potential unwarranted dilution to existing shareholders.

Paragraph of Interpretation No. Thus, Company A's charge against earnings will be an amount equal to the cash or the market value of the restricted stock paid for the cancellation. A "bounded" SAR has a base price equal to the fair market value of the stock on the date of grant and a maximum "cash-out value" equal to the exercise price of the original option.

Economically this would be a solution very similar to the "meshing" of options described above in the Third Alternative. But will variable accounting treatment apply to the original stock option which the optionee continues to hold? The FASB staff may view the use of a bounded SAR in conjunction with an underwater option as a single repricing transaction resulting in variable accounting for the original option as well.

This would be similar to its treatment of "meshing" stock options discussed in the Third Alternative above. A Sixth Alternative Some practitioners have suggested the possibility of a sale of an underwater stock option to a third party for example, an investment bank as a way of extricating the employer and the employee from the underwater option problem.

Subject to the views of the FASB staff, the transaction might allow the employer to grant a new, lower-priced option without the variable accounting treatment for the new option. Obviously, there are legal problems involved, including securities law and tax issues.

In addition, there would be the complications of amending a stock option plan to permit the transfers as well as serious "good practice" issues. Would boards of directors and shareholders agree that it is appropriate for a stock option plan to permit executives to sell their underwater options to third parties? Any employer considering repricing, including one or more of the six alternatives noted above, should carefully review the accounting implications with its outside independent accountants.

Non-Accounting Issues Repricing involves numerous legal and tax issues. While detailed discussion of these issues is beyond the scope of this column, note is made of the following. Since , the SEC has required that any repricing of an option or SAR held by a "named executive officer" generally, the CEO and the four most highly compensated executive officers other than the CEO results in special proxy statement disclosure requirements including information regarding certain repricings for the last ten fiscal years.

SEC proposals regarding expanded proxy statement disclosure and a report by a New York Stock Exchange Special Task Force have suggested that expanded proxy statement reporting on repricings should be considered.

No specific changes in currently required disclosures of repricings in proxy statements are expected in the near future.

Related Solutions

The future payoff with the repricing would equal (projected stock price − stock price on the option grant date) x number of shares, because the new exercise price, after the repricing, is the stock price on the option grant date. Changes in the required accounting treatment of stock options have reduced the potential accounting barriers to repricing, although it remains imperative that the company discuss the accounting implications and financial reporting requirements of any proposed repricing program with its accountants. ACCOUNTING FOR STOCK COMPENSATION UNDER FASB ASC TOPIC Overview Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic , Stock a value-for-value stock option repricing or exchange of awards in conjunction with an equity restructuring does not result in .