This article is reprinted with
permission from the
October 24, 1989
New York Law Journal.
© 1989 NLP IP Company.
Stock Options: Recent Developments
By Joseph E. Bachelder.
THIS COLUMN WILL DISCUSS current developments affecting stock options. First is a note on the current status of the proposed changes in the rules affecting stock options under §16(b) of the Securities Exchange Act of 1934 (1934 Act). Also discussed are so-called "reload" options and arrangements in which stock options are in tandem with restricted stock. Finally, comment is made on the uncertain tax status of options with discounted exercise prices.
Proposed §16(b) Rules
The treatment of stock options under §16(b) of the 1934 Act would change dramatically under the rules originally proposed by the Securities and Exchange Commission (SEC) last December and reissued for comment on Aug. 18. 1 The option award would be deemed to be a "purchase" of the underlying stock, 2 unless issued under a plan meeting the requirements of revised Rule 16b-3. More important, however, any exercise of the option -- currently treated as a "purchase" -- would be exempt from §16(b). 3 The change would permit a statutory insider to sell the shares received upon exercise of his option immediately, without liability, if he had held the option for at least six months (and made no matching "purchase" during the previous six months).
The proposed changes should enhance significantly the attractiveness of stock options to insiders. They could take advantage of "cashless exercise" procedures, heretofore unavailable to insiders, offered pursuant to Regulation T. 4 For the same reason, there should be a decline of interest in stock appreciation rights (SARs) and other vehicles designed to enable insiders to realize the economic benefit of their options without putting up cash and without risking liability under §16(b). From the standpoint of the employer, the changes would permit cashless exercises of option rights by insiders without a charge against earnings, which is required in the case of SARs. 5
A "reload" option is one that gives the holder the right to (i) pay the exercise price by delivering employer stock equal in value to the exercise price, and (ii) receive a fresh option grant for a number of shares equal to the number used in exercising the option.
For example, assume an executive is granted a nonstatutory option by his employer to purchase 10,000 shares at $50 per share. The term of the option is 10 years. Five years after the date of grant the market price of the stock is $75 per share. If the executive exercises his option by means of a stock-for-stock swap he will receive 10,000 shares. To pay for such shares, however, he will have to deliver 6,666 shares so that his net share gain is 3,334 shares. If he had exercised his option for cash he would have received 10,000 shares (at a $500,000 purchase price: 10,000 shares x $50).
With a reload option, the executive would receive a new option at $75 per share to purchase 6,666 shares. Through a combination of the shares that he acquired and the new reload option, the executive has preserved his potential for gain on 10,000 shares, rather than on the 3,334 shares remaining after a conventional stock-for-stock option exercise.
Another potential advantage to executives in a possible takeover situation is the opportunity to exercise an option in a taxable year prior to a change in control, thereby increasing the executive's "base amount" for purposes of §280G of the Internal Revenue Code of 1986 (Code), without jeopardizing the number of shares as to which the executive retains an upside potential. For example, in the case of the option for 10,000 shares described above, with an exercise price of $50 and the underlying stock at $75, the executive could exercise the option and acquire 3,334 shares, with a value to him of $250,050. As noted below, this value would be taxable income to the executive. This amount also would increase the executive's "base amount," assuming the option was exercised in a taxable year before a change in control, for purposes of Code §280G.
The advantage to the employer is that it is able to provide the executive with the opportunities just described without any charge against earnings, as noted below.
It has been suggested that a number of shares equal to the number received by the executive in excess of the number needed to exercise the option -- 3,334 in the above example -- be subject to a requirement of continued employment for a period of time, such as two or three years. This would be as consideration for the reload option -- a kind of golden handcuff. However, this might undercut the interest of the executive, who would lose the flexibility to cash out at a time when he thought appropriate. A satisfactory compromise might be to "handcuff" only 50 percent of the shares Another quid pro quo, without restricting the executive's timing on the sale of his shares, would be to subject the new option to new vesting schedule, such as two or three years.
Effect on Federal Taxes
For federal income tax purposes, as the executive surrenders shares of stock in exercise of the option, he will be deemed to have exchanged the surrendered shares for the same number of shares issuable upon exercise of the option. Under Revenue Ruling 80-244, 6 no gain or loss will be recognized at that time with respect to the share exchange, and the newly acquired shares will retain the basis of the surrendered shares. With respect to the balance of the shares received upon exercise of the option, the executive will be required to include in income the market value of those shares (and the employer will receive a corresponding deduction). The executive's basis in these shares will be that same market value.
For accounting purposes, assuming the exercise price of the option equals or exceeds the fair market value of the stock on the date the option was granted, there should be no charge against the employer's earnings in respect of the option. The fact that the arrangement provides for the use of stock to exercise the option should not change this result, provided the executive is required to hold the stock used to exercise the option for at least six months before exercise. 7
For §16(b) purposes, under the proposed new rules discussed above, a reload option should not cause any problem so long as it and the newly issued option are issued under a plan meeting the requirements of Rule 16b-3 (and the executive makes no other purchases of employer stock within six months before or after the exercise of his option). Under current §16(b) rules, an insider's election to exercise a reload option by delivery of already-owned shares should not expose him to any liability if it meets the conditions of Rule 16b-3(e), including the "window period."
This column has previously discussed the use of stock options in tandem with other incentive awards to defer compensation8. A tandem arrangement with restricted stock may also be an attractive incentive without regard to the deferral aspect. An illustration of this type of arrangement is a grant by an employer to an executive of 5,000 shares of restricted stock with a market value of $20 per share in tandem with an option to purchase 15,000 shares at $20 per share. The executive ultimately would choose, depending on the price of the stock, either to keep the restricted stock and not exercise the option or to exercise the option, thereby cancelling the restricted stock. It is assumed that the opportunity to choose would become effective as the restricted stock vests (and, presumably, the stock option becomes exercisable). In this example, if the stock exceeds $30 per share, it would be more advantageous for the executive to exercise the option. Below that price the restricted stock would be more valuable than the option. Thus, the executive would have the security of the restricted stock grant (which has substantial value even if the price does not rise), together with the leverage of the larger stock option award if the price rises significantly, in this case by more than 50 percent.
If the company already has a share-holder-approved stock plan that permits the grant of restricted stock and stock options or separate shareholder-approved restricted stock and stock option plans, there may be no impediment under the plan to the grant of a tandem arrangement. For example, the plan or plans may give broad discretion to the board of directors or the appropriate committee to establish conditions to the exercise of an option. However, a plan should be carefully reviewed to determine whether a tandem arrangement appears to be permitted and, if not, whether an amendment is required (and, if such amendment is required, whether shareholder approval should be obtained).
As each installment of the restricted stock vests, the executive would be required to include in income the value of that installment based on the market price on the vesting date. If the executive later elects to exercise the option, he would be required to turn in the stock described in the preceding sentence and, in addition, would be required to pay the exercise price. Using the example given above, but assuming a market price of $40 per share on the date of option exercise, the executive would turn in the 5,000 shares now worth $200,000, would pay the exercise price of $300,000 and would receive 15,000 shares worth $600,000.
If the Internal Revenue Service applied its holding in Revenue Ruling 80-244, described above in connection with reload options, it would hold that the 5,000 shares turned in resulted in a non-taxable exchange for 5,000 of the 15,000 shares delivered upon exercise of the option. The remaining 10,000 shares delivered upon exercise of the option would have a value of $400,000, for which the executive would have paid an exercise price of $300,000, resulting in taxable income of $100,000.
On the other hand, the IRS might take the position that the 5,000 shares of stock canceled under the tandem arrangement were simply forfeited and the executive could claim only a capital loss (a significant detriment to the executive after having paid tax at ordinary rates on the stock at the time of vesting). Upon exercise of the option, the executive's taxable income attributable to the exercise would be $300,000, the difference between the $300,000 exercise price for the option and the $600,000 of stock value (15,000 shares) delivered upon the exercise of the option.
Choice Before Vesting
One way to avoid this tax dilemma would be to require the executive to elect between the alternatives immediately prior to the date the restricted stock vests. Another approach would be to make it clear that the executive could use any stock (not just the stock subject to the restricted stock grant) to exercise the option (together, of course, with the payment of cash as discussed). This arrangement would make it difficult for the IRS to ignore the tax-free exchange rationale of Revenue Ruling 80-244, discussed above. Finally, the employer might simply award "share units" (a share unit being the equivalent of a share of stock, payable in actual stock if, and only if, the executive chose the stock alternative). This last approach might avoid the tax dilemma noted above but probably would be the least attractive to the employer from an accounting standpoint under current accounting rules.
Going back to the original example, for accounting purposes, the stock option grant, by itself, should result in no charge to earnings. The grant of restricted stock would result in an aggregate charge over the vesting period equal to the market price on the date of grant multiplied by the number of shares granted. With the two grants in tandem, it is possible an accountant might require additional charges to earnings based on increases in the price of the stock until the stock price reaches the "cross-over point" -- the point at which exercise of the option becomes more advantageous than retaining the restricted stock. 9 If the stock price later falls below the crossover point, prior charges to earnings should be reversible to the extent of the price decline.
If the company's existing shareholder-approved plan (or plans) permits tandem awards, the awards will probably already be covered under Rule 16b-3. (Of course, the relevance of Rule 16b-3 may be changing; see the discussion of the proposed new rules under §16(b) at the beginning of the column). Even if an amendment were necessary, shareholder approval may not be required under Rule 16b-3. This would depend on whether the amendment would be deemed to materially increase the benefits accruing to participants under the plan, the relevant standard under Rule 16b-3(a).
In Revenue Procedure 89-310, as modified by IRS Announcement 89-42, 11 the IRS has indicated it will not issue rulings regarding nonstatutory options granted at a purchase price that is less than the fair market value of the underlying stock on the date the option is granted. In a subsequent private letter ruling (PLR 8928035, April 17) the IRS indicated that it would not provide any guidance with respect to the tax consequences of discount stock options.
The IRS rulings do not mean that any option granted at a discount will result in immediate tax consequences to the optionee. They do indicate that taxpayers receiving stock options with deep discounts may find themselves challenged as to whether they are taxable at the time of option grant rather than at the time of option exercise.
1 Ownership Reports and Trading by Officers, Directors and Principal Security Holders, 54 Fed. Reg. 35,667 (Exchange Act Release No. 27148, Aug. 18, 1989) [hereinafter cited as SEC Release].
2 SEC Release at 35,685 (Proposed Rule 16a-4[a]).
3 Id. at 35,688 (Proposed Rule 16b-6[b]).
4 A 1987 amendment to the Federal Reserve Board's Regulation T permits brokers to facilitate a sale of option shares immediately following or in conjunction with an executive's exercise of a stock option. See the discussion of this change in this column in the Feb. 29, 1988, issue of the New York Law Journal.
5 Current accounting principles require periodic charges to earnings equal to the increase in the value of "variable" awards such as SARs. No such charge is required for a nonstatutory employee stock option if the exercise price is no less than the fair market value of the underlying stock on the date of grant. Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (AICPA, Oct. 1972); Fin. Accounting Standards Bd. Interpretation No. 28, Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plans (Dec. 1978).
6 1980-2 C.B. 234.
7 Fin. Accounting Standards Bd. Emerging Issues Task Force Issue 84-18, Stock Option Pyramiding.
8 See this column in the Dec. 20, 1988, issue of the NYLJ.
9 Fin. Accounting Standards Bd. Emerging Issues Task Force Issue 87-33, Stock Compensation Issues Related to Market Decline (Issue No. 4).
10 1989-1 IRB 29.
11 1989-13 IRB 53.