This article is reprinted with permission from the
May 31, 2001
edition of
New York Law Journal.
2001 NLP IP Company.

Repricing Stock Options: Current Developments

By Joseph E. Bachelder

DECLINES IN the stock prices of many publicly traded companies over the past year have resulted in many executives holding "underwater" stock options. An underwater option is one in which the exercise price exceeds the current market price of the stock.

Many public corporations face serious problems resulting from underwater options. Assume, for example, the market price of the stock of Company A drops from $ 50 to $ 20 and that many option holders at Company A have options with an exercise price of $ 50. Company A now hires 10 new executives and gives them option grants with an exercise price of $ 20. This obviously creates a major issue with long-term executives who are $ 30 underwater on their options while 10 new executives have options with an exercise price of $ 20. The most obvious solution and the subject of widespread debate is to reprice the old $ 50 options down to $ 20. In its simplest form, repricing of a stock option involves one or the other of the following:

(a) reduction in the exercise price of the underwater stock option (with the new reduced option price generally being set at current market price), or
(b) cancellation of the underwater option and the grant of a new option (again, with an exercise price at current market).

For several decades repricing of stock options has occurred during periodic downturns in the stock market. These repricings have been accompanied by criticism from different groups including shareholders, shareholder advocates and the media. Repricings also have been the subject of litigation, tax and SEC regulations aimed at curtailing them and, most recently, new accounting rules imposing adverse accounting treatment on options that have been repriced.

The following discussion will focus on a recent accounting ruling that imposed adverse accounting treatment on repricings and provided an exception for repricings in which more than six months elapse between the cancellation of an outstanding underwater option and the grant of a new lower-priced option.

FASB Interpretation No. 44

In the Spring 2000, the Financial Accounting Standards Board (FASB) issued Interpretation No. 44 (March 2000) entitled "Accounting for Certain Transactions Involving Stock Compensation -- An Interpretation of APB Opinion No. 25." 1

Interpretation No. 44, paragraphs 38 through 54 (with examples illustrating the application of the interpretation being given at paragraphs 179 through 197), takes the position that if any option is repriced, with limited exceptions, it will lose its status as an item of stock compensation free of an earnings charge under APB Opinion No. 25. The repriced option becomes subject to variable accounting treatment.

Variable accounting treatment means that a stock option results in a charge against earnings based on the increase, if any, of the market price of the stock covered by the option during the accounting period, or periods, being reported. Following is an example of variable accounting treatment. Assume an option granted by Company A with an exercise price of $ 50 followed by a decline in the market price of Company A stock to $ 20. The option is repriced to $ 20. Over the next three years, the market price of Company A stock as of each year-end is as follows:

Year One: $ 35
Year Two: $ 50
Year Three: $ 60

Assume the option is vested throughout this period and is exercised at the end of year three. During each of the three years, the charge against Company A's earnings would be as follows:

Year One: $ 15
Year Two: $ 15
Year Three: $ 10

Thus, instead of an option free of any charge against earnings, the repriced option generates a total of $ 40 of charges against earnings over three accounting periods.

Repricings might well have been shut down by Interpretation No. 44 but for the fact that the interpretation provides an important exception. Paragraph 45 of Interpretation No. 44, reads as follows:

45. An option award cancellation (settlement) shall be combined with another option award and results in an indirect reduction to the exercise price of the combined award if another option with a lower exercise price than the canceled (settled) option is granted to the individual within the following periods:

a. The period prior to the date of the cancellation (settlement) that is the shorter of (1) six months or (2) the period from the date of grant of the canceled or settled option
b. The period ending six months after the date of the cancellation (settlement).

Paragraph 133 confirms the exception. The exception permits the cancellation of the original option and the grant of a new option without loss of no-charge status provided that at least six months elapse between the date of cancellation of the original option and the grant of the new, lower priced option (the "six-months-and-one-day rule").

One problem with cancelling the original option without concurrent commitment to a new option grant replacing the old option is that the executive who has agreed to the cancellation of the original option has no assurance that a new, lower priced option will be granted later. The arrangement described in the next paragraph addresses this problem.

One Alternative

An Alternative: Concurrently Cancelling an Old Option and Committing to Future Grant of a New Option. Interpretation No. 44, in paragraph 133 (by implication) and paragraph 197 (by illustration), provides that the employer can cancel the old option and concurrently with the cancellation agree to grant a new option six months later without loss of the no-charge-against-earnings status provided there is no commitment regarding what the exercise price of the new option will be. In other words, such an agreement, in order to avoid variable accounting treatment for the new option, cannot protect the grantee against increases in the market price of the stock which occur after the date on which the old option is cancelled.

A Second Alternative

Another alternative would be for the employer to grant the executive an additional option at the lower current market price without cancelling the outstanding option at the higher price. However, assuming there are numerous option holders involved, this could increase substantially the number of shares outstanding under the option program and ultimately cause an unreasonable dilution in share values. Also, the number of shares required under this program might exceed the number of shares authorized under the stock option plan.

A Third Alternative

The grantor corporation might, as a third alternative, grant a new option at the current market price and provide that the new option will expire immediately after the market price recovers to the level of the exercise price of the original option, which remains outstanding. To illustrate, assume a set of circumstances similar to that noted above: Company A granted an option originally with a $ 50 exercise price followed by a drop in the market price to $ 20. Company A grants a new option at $ 20. It provides the new option will expire immediately after the market price returns to the original $ 50 level.

This alternative would "mesh" the two options. Under the new $ 20 option, the option holders have been provided the growth in value from the $ 20 back to the $ 50 exercise price of the original option. The new option expires. Continuing to hold the original option, the option holder can enjoy any future growth above the original $ 50 exercise price. From both the corporation's and the option holder's standpoints, this would be an efficient, risk-free design.

The FASB staff, however, in FASB Staff Announcement Topic No. D-91, stated that the new $ 20 option must be allowed to continue for a period of at least six months beyond the date the original $ 50 option exercise price level is reached. Otherwise, in the staff's view, the arrangement is in effect a single transaction, a repricing of the original option, and variable price accounting applies.

Under the FASB staff's approved version, the corporation risks something that it did not risk in the example in which the new option expires immediately upon the market price recovering to $ 50. The risk is that the option holder may exercise the new, lower-priced option at a later point in the six-months-and-one-day period, accumulating further gains beyond the $ 30 spread in the new option if the market price continues to increase. Then, upon later exercise of the original option, the executive can "reap" a second time the gain above the $ 50 exercise price of the original option.

A further disadvantage of this alternative is that, like the Second Alternative, additional options will be outstanding until the expiration of one of the options (presumably, in most cases, the new lower-price option which expires six months and one day after the original $ 50 option price level is reached). Not only are the shares of Company A diluted, but, as also noted in connection with the Second Alternative above, if a large number of options is involved, the number of shares required for such a program may exceed the number of shares authorized under the stock option plan.

A Fourth Alternative

Yet another alternative would be for the grantor corporation to "buy out" the underwater option. For example, Company A might offer to its executives with $ 50 options (current market price of the stock is $ 20) to buy them back at their Black-Scholes value. It could cancel the options in exchange for cash or, perhaps, restricted stock. Paragraph 135 of Interpretation No. 44 provides that if time-based restricted stock is the consideration for the cancellation of the option, the restricted stock will be subject to fixed, not variable, accounting. 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 Fifth Alternative

In the March 2001 issue of its publication Monitor, at, the consulting firm of Towers Perrin discusses the use of a "bounded" stock appreciation right (SAR). 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.

To illustrate, Company A, from the example noted above, might grant an SAR with a base price of $ 20 (current market price of the stock) and a maximum "cash-out value" of $ 50, 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.)

The bounded SAR will be subject to variable accounting, as are SARs generally. 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.

SEC Issues

(A) Disclosure. Since 1992, 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. See Regulation S-K, Item 402(i), 17 C.F.R. § 229.402(i). 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.

(B) Tender Offers. The SEC considers stock option repricings to be transactions that fall within the tender offer rules. A recent SEC Exemptive Order provided for exceptions to certain of the tender offer rules for repricings that meet specified conditions. Exemptive Order, Securities Exchange Act of 1934 (March 21, 20001), at However, even if covered by the exemptive order, a repricing remains subject to Schedule TO, requiring disclosure of certain information and, among other requirements, the requirement that the offer remain open for 20 business days. Under existing practice it appears that the SEC does not treat as subject to the tender offer rules repricings that are individually negotiated arrangements or that involve a limited number of key executives. It indirectly confirmed this in an "update" issued concurrently with the exemptive order on March 21, 2001. There is no suggestion as to what "a limited number" means and care should be taken before concluding that a particular arrangement does not come within the tender offer rules.

Federal Income Tax

Section 162(m) of the Internal Revenue Code of 1986 (the code) limits to one million dollars per year the income tax deduction for certain forms of compensation paid by public corporations to "covered employees" (generally, the CEO and the four most highly compensated executive officers other than the CEO). Exempt from this limitation are option grants under stock option plans that meet certain requirements. These include shareholder approval and the plan's providing for a "maximum number of shares with respect to which options... may be granted during a specified period to any employee." Treas. Reg. § 1.162-27(e)(2)(vi)(A). In the event of a repricing, even though the original option is cancelled, the regulation under § 162(m) treats the cancelled option as still outstanding and therefore it must be counted toward the maximum number of shares under options that can be granted to an employee during the applicable period. This may substantially restrict the number of shares that can be covered by a repricing without causing a problem under § 162(m).

Another tax issue involves incentive stock options (ISOs) under code § 422. Under code § 424(h)(1), if an ISO, entitled to special tax treatment under code § 422, is repriced, the repricing is treated as the grant of a new option. In the year in which the new option becomes exercisable, the dollar value of the stock subject to the new option grant would be charged against the $ 100,000 annual limitation on ISOs. (That dollar value would be the value determined as of the date of grant.)

Other Considerations

Drafting and Corporate Governance Considerations. Existing stock option plans should be examined carefully to determine whether they permit repricing. They may permit no repricing or only some forms of repricing. For example, a plan may permit a cancellation of a stock option and the grant of another stock option to the same option holder but it may not permit a reduction of the exercise price of an outstanding option. If an amendment to the stock option plan is necessary, will it require shareholder approval? If shareholder approval is required, the corporation may find itself in the midst of a very lively debate.


1 The author wishes to express his appreciation to Paula Todd of Towers Perrin for her assistance in connection with the preparation of this column. Two related columns by the author are "Repricing Stock Options," which appeared in The New York Law Journal on Sept. 29, 1998, and "New Stock Option Accounting Interpretation," which appeared in The New York Law Journal on May 31, 2000.