This article is reprinted with permission from the
May 30, 2002
edition of
New York Law Journal.
2002 NLP IP Company.


'Fixing' the Underwater Stock Option Problem

By Joseph E. Bachelder

WITH A LARGE NUMBER of "underwater" stock options outstanding due to lower stock prices, many employers are trying to revitalize their stock option programs.

This column discusses what employers have been doing to address the problem.

The simplest way to revitalize an "underwater" stock option (that is, an option with an exercise price higher than the current market price of the shares subject to it) would be to reduce the exercise price to the current market price. Most option plans do not permit a reduction in an option's exercise price. They do generally permit cancellation of outstanding options and issuance of new options.

A concurrent cancellation of an underwater option and issuance of a new option at the current market price, even if permitted under the option plan, causes accounting problems and also may cause SEC disclosure and tax problems as noted further below.

Under accounting rules, a concurrent cancellation of an underwater option and grant of a new lower-priced option causes the new option to become a charge against earnings. Furthermore, instead of being a fixed charge (that is, based on its value on the date of grant), the option becomes a "variable" option. That means it will be a charge against earnings over its life based on any increase in its "intrinsic value" (its spread) during any accounting period.1, 2

A large number of public companies have repriced under a special rule - called the "six-months and one-day rule." Provided its specific requirements are complied with, that rule permits the cancellation of an underwater option and the grant of a new option after six months without jeopardizing the no-charge- against-earnings status of the new option.3 In cancelling the old option the employer can agree to make a new grant after six months but it cannot guarantee a specific exercise price for the new option.4

Following is a summary of this and other alternatives being used by public companies trying to solve the problem of outstanding underwater options. It appears that few, if any, employers are concurrently cancelling outstanding underwater options and regranting lower priced options.

Cancellation

1. Cancellation of outstanding underwater option and grant of new option more than six months later at the then-current market price. An example of this type of program is reported in the current proxy statement of Sprint Corporation. In 2000, Sprint offered executives the opportunity to cancel stock options granted to them in 2000 in exchange for new options, to be granted over six months later, covering options shares equal in number to those cancelled. (In fact, the replacement grants were made in May 2001). The exercise price of the 2000 options reflected a premium for the proposed merger with WorldCom Inc. that was never consummated. The proxy statement noted that Sprint's board of directors "determined that existing options no longer had sufficient value to motivate and retain employees in the tight employment market." Following are consequences to employers generally who enter into such a program (this is not intended as a comment on the specifics of the Sprint case):

Accounting Consequences. No charge against earnings is incurred as to the cancellation of the old option and the grant of a new "at-the-money" option and the new option continues without being a charge against earnings. As noted in the introductory comments to the column, if an underwater option is cancelled there must also be a six-months "look back" to be sure the cancellation does not result in imposing variable price accounting treatment on any option granted within that six-months "look-back" period.

SEC Disclosure. The instructions to Item 402(i) of SEC Regulation S-K provide that if an option grant to any "named executive officer" is "reasonably related" to any prior or potential option cancellation, a "repricing" has occurred requiring special reporting, including a repricing table, in the proxy statement. "Named executive officers" for this purpose generally mean the chief executive officer and the other four most highly compensated officers of the issuer. The fact that the new option grant meets the "six-months-and-one-day" test for accounting purposes does not mean it is not considered connected with a prior cancellation for purposes of the Item 402(i) repricing table.5

Tax Consequences

Tax Consequences Under Code 162(m). Assuming it is granted at the market price of the stock on the date of grant, the replacement option does not necessarily lose its exemption from being counted toward the $1 million limitation on deductibility under 162(m) of the Internal Revenue Code (code). The $1 million limitation applies to certain types of compensation to the top officers of a publicly traded corporation (the equivalent of the "named executive officers" for purposes of the proxy statement disclosure rules). However, the cancelled option and the replacement option both count toward determining whether the options granted to any of the covered officers are within the maximum number of shares that can be granted to any one individual under the company's stock option plan. Treas. Reg. 1.162.27(e)(2)(vi)(B). Any option grants to these officers that exceed this maximum number are not eligible for exemption from the $1 million deduction "cap" under Code 162(m).

Shareholder Reaction. A repricing at this time - whether or not it qualifies for the six-months-and-one-day-rule - is likely to produce shareholder criticism. The most frequent complaint is that shareholders take the risk of a downturn in the stock price and executives should be subject to the same risk. A repricing eliminates the consequence to the executives of having assumed the risk of a decline in the stock price. Institutional shareholders are especially vocal in their criticism of repricing.

Additional Options

2. Grant of additional options without cancelling the underwater options. An example of this type of program is that of Pitney Bowes Inc. as reported in its 2001 proxy statement. Pitney Bowes' board of directors accelerated option grants scheduled for 2001 and 2002 and made a special stock option grant in October 2000. According to the proxy statement, the October 2000 grants replaced the grants that would have been made to the executives involved under the regular stock option program for 2001 and 2002. The options were granted without cancelling the underwater options.6

A special one-time grant not related to a cancellation of underwater options is like any other "non-repricing" grant of options. Following is a summary of consequences (this is not intended as a comment on the specifics of the Pitney Bowes case):

Accounting Consequences. As noted, there is no charge against earnings for the new options. However, without cancellation of the old options there is a doubling-up of outstanding options (that is, to the extent of the new options) with the result that there is greater potential dilution to shareholders.

SEC Disclosure. This will not require reporting as a repricing.

Tax Consequences Under Code 162(m). The new grants (as well as the already outstanding grants) count toward the maximum number that can be granted to any employee under the company's stock option plan. (If that maximum number is exceeded the option shares in excess of that are not eligible for exemption from the $1 million deduction "cap" under code 162(m).)

Shareholder Reaction. In terms of potential shareholder criticism, there may be little difference between this and alternative 1 above - the cancellation of underwater options in exchange for the new option grant (albeit if the grants replace future scheduled grants they do not add, in the long run, to the planned outstanding option grants).

3. Cancellation of underwater options in exchange for restricted stock. Under the exchange program adopted by some companies, an employee can exchange the value of certain stock options (based on the Black-Scholes value of the stock options) for restricted stock of the same value. To aid in retention, some companies have extended the vesting date for the restricted stock beyond the date the cancelled stock options would have fully vested. The following is a summary of consequences:

Accounting Consequences. The restricted stock will be a charge against earnings (a fixed charge - that is, a charge based on the value of the stock on the date of grant without further charge for any future increase in value).This is so whether or not the restricted stock grant made in exchange for cancellation of the underwater option occurs within six months of the cancellation.7 It also will result in dilution to shareholders (although less so than would stock options since fewer shares, presumably, will be involved).

SEC Disclosure. The SEC staff, as reported in The Corporate Counsel (Nov.-Dec. 2001), has indicated that it views this type of transaction as a repricing subject to the specific disclosure rules under SEC Regulation S-K, Item 402(i). However, some companies that cancelled underwater stock options in exchange for restricted stock during their last fiscal year did not treat the exchange as a repricing requiring a repricing table in their proxy statements for the 2002 proxy season.

Tax Consequences Under Code 162(m). Unlike stock options, restricted shares cannot qualify as performance-based awards eligible for exemption from the code 162(m) "cap." As a result they would count toward the current compensation of the covered officers that may be subject to non-deductibility if their non- exempt compensation exceeds $1 million. For purposes of 162(m), the cancelled options will continue to be counted toward the applicable share limitation under the company's stock option plan.

Shareholder Reaction. Shareholders are likely to be critical for reasons already noted in connection with cancellation of underwater options in exchange for new option grants.

Granting Restricted Stock

4. Granting restricted stock without cancelling underwater options. An example of this type of program is that reported by Compaq Computer Corp. in its 2001 proxy statement. In its report in the proxy statement, the compensation committee of Compaq's board of directors noted that "[m]arket data indicates an increasing trend toward the use of restricted stock, and the committee believed that the grant would aid in critical retention efforts." The compensation committee report does not, however, make reference specifically to outstanding underwater options. The restricted shares were granted in May 2000 and vest based on meeting performance goals established by the committee, with full vesting in May 2004 regardless of whether the performance goals are met. The consequences of this type of program for employers generally would be the same as those just noted in connection with cancellation of underwater options in exchange for restricted stock except that this transaction presumably would not be treated as a repricing for purposes of SEC Regulation S-K, Item 402(i) and there would be no cancelled options that raise tax or accounting issues as noted above.

Performance Shares

5. Granting Performance Shares. An example of an alternative direction for future equity awards is that taken by BellSouth Corp. The form of award is called a performance share. In the case of BellSouth, as reported in its 2002 proxy statement, this award did not appear to involve any related cancellation of stock options. In fact, the BellSouth proxy statement makes no references to underwater options.

BellSouth's performance shares are tied to achievement of Total Shareholder Return targets over a three-year period. The actual number of shares earned out may be adjusted based on a comparison of BellSouth's Total Shareholder Return with that of peer companies.

The following is a summary of consequences generally of a performance share program assuming the award is not in exchange for cancellation of underwater stock options (this is not intended as a comment on the specifics of the BellSouth case):

Accounting Consequences. This award would be subject to variable price accounting.

SEC Disclosure. Grants made in the last fiscal year to a named executive officer are reported in the Long-Term Incentive Plan Awards Table. See SEC Regulation S-K, Item 402(e). Any payouts in the last fiscal year are reported in column (h) of the Summary Compensation Table. See Regulation S-K, Item 402(b)(2)(iv)(C).

Tax Consequences Under Code 162(m). This type of award should be eligible to qualify as a performance-based award exempt from code 162(m).

Shareholder Reaction. Because of its being tied to Total Shareholder Return, it is likely that this plan design would receive favorable reception from shareholders. (This observation is made without taking into account other factors such as size of award that can result in shareholder complaints.)

If underwater stock options were cancelled in consideration for performance share awards, the accounting for the performance shares would be the same (variable price accounting) but the SEC staff position on reporting as a repricing presumably would be the same as its reported position on a substitution of restricted stock: that a repricing has occurred for purposes of Item 402(i) of Regulation S-K. Cancelled underwater stock options would continue to be counted as outstanding for purposes of code 162(m) as discussed earlier in connection with other arrangements cancelling underwater stock options. Negative shareholder criticism should be anticipated, as discussed above in connection with cancellations that take place in exchange for a new equity-based grant.

Extending the Term

6. Extending the term of an underwater option. Extending the life of an underwater option gives the executive the economic benefit of more time to realize the potential value of the option. The governing plan may limit, or prevent, extension of the original term of an option. If it does not, there appears to be no adverse accounting consequences to extending the term of an underwater option. (Even though such action is treated as a grant of a new fixed-price option under APB Opinion No. 25 (1972) there would be no charge against earnings because the option is underwater.) There should be no adverse SEC disclosure consequences either. However, there may be a question as to the tax consequences under code 162(m). Extension of the term of the option may be deemed to make it impossible for shareholders to estimate the value of an option grant at the time they approve the stock option plan (such approval is required for the option to be exempt under code 162(m)). See Treas. Reg. 1.162-27(e)(4)(iv).


FOOTNOTES:

1 If the spread in a variable price option declines during an accounting period, a credit to income may be taken to the extent that charges for that option have been taken in prior accounting periods.

2 The Financial Accounting Standards Board (FASB) Interpretation No. 44 (March 2000) treats as a repricing, resulting in variable accounting, the cancellation of an option and the granting of a "replacement" option with a lower exercise price within the six-month period preceding or the six-month period following the cancellation of the old option. See Paragraph 45 of FASB Interpretation No. 44.

Variable accounting treatment is not limited to the new option. It also applies to the cancelled underwater option. This latter consequence, of course, is theoretical only because the underwater option has been cancelled. However, if an option "swap" is offered to the holder of an underwater option and the offer is declined, the underwater option continues to be outstanding and it becomes a variable price option.

3 The Emerging Issues Task Force (EITF) has clarified that granting a replacement option at the current market price of the underlying stock on the date of grant more than six months after the cancellation of the underwater option is not a repricing. See EITF Issue No. 00-23, Issues Related to the Accounting for Stock Compensation under APB Opinion No. 25 and FASB Interpretation No. 44, Issue 36(c). Accordingly, in the latter circumstance, the new option would not result in any charge against earnings (assuming it was granted at the market price of the stock on the date of grant). It should be noted, however, that the cancellation of an underwater option may cause a grant of an option during the six-month period preceding the cancellation to become a variable-priced option. As stated in footnote 1 above, the six-month rule of Paragraph 45 of FASB Interpretation No. 44 is both a "look-forward" and "look- backward" rule.

4 See EITF Issue No. 00-23, Issue 36(c).

5 If there is a repricing of any options held by a named executive officer within the last fiscal year, the Compensation Committee Report in the proxy statement must include a reasonably detailed explanation of the repricing. A separate 10-year option repricing table must also be included which provides information on repricings, during the last 10 fiscal years, of options held by any executive officer (including a past officer) - not just the named executive officers whose options were repriced during the fiscal year being reported. See SEC Reg. S-K, Item 402(i).

6 Pitney Bowes' 1991 Stock Plan limits to 400,000 the maximum number of option shares that can be awarded annually to any one individual. As reported in its 2002 proxy statement, if the acceleration of the 2001 and 2002 grants into 2000 resulted in an executive reaching the 400,000 share cap in 2000, Pitney Bowes subsequently made a grant in 2001 for those shares underlying the accelerated option grant that exceeded the 400,000 share cap.

7 The offer results in variable accounting for all existing stock options that are subject to the offer. As explained in footnote 2 above, the variable accounting treatment that automatically applies to underwater options that are subject to the offer will only be relevant if the option holder declines the offer and continues to hold the underwater options. See EITF Issue No. 00-23, Issue 39(b). A different problem could arise if the number of restricted shares is less than the number of shares subject to the option being cancelled in exchange for the restricted shares. In such event, the "excess" shares (that is, those covered by the cancelled option in excess of the number of restricted shares granted) will cause any stock option granted within six months prior to or six months following the exchange to be subject to variable accounting treatment to the extent of the number of such excess shares.