This article is reprinted with permission from the
December 30, 1991
edition of

New York Law Journal.

1991 NLP IP Company.


Reversal by the SEC on Stock Options

By Joseph E. Bachelder.


THIS COLUMN WILL DISCUSS the significance of the recent reversal by the Securities and Exchange Commission (SEC) of its August 1991 position regarding the consequences of accelerated vesting of an equity security under Rule 16b-3 adopted under 16 of the Securities Exchange Act of 1934 (the '34 Act). It also will note proposed as well as recently enacted legislation directed at regulating executive compensation.

Problems for Executives

A significant change in an employee stock option or other equity grant may lead to unanticipated problems for an executive under the new rules pursuant to 16 of the '34 Act as interpreted by the staff of the SEC. In an August 1991 interpretive letter, discussed below, the staff took the surprising position that accelerated vesting (exercisability) of a stock option or "other security" constitutes a "new grant" starting a new six-month period running for the shares affected.

The staff reversed this position in a letter released December 20, which is also discussed below. In the letter reversing its position, the staff indicates that an amendment of the terms of an option or other security, except for an accelerated vesting (exercisability), may constitute a "new grant."

In Foster Pepper & Shefelman, available Aug. 30, 1991, the staff of the SEC concluded that the acceleration by the Board of Directors of the vesting (exercisability) of a stock option, even in a case under such acceleration is already authorized by the plan, should be treated as a cancellation of the old option and the grant of a new option for purposes of Rule 16b-3(c)(1), which contains the six-month holding period requirement. 1 Since, as noted, the letter also indicated that it applied to the vesting of any "other security," its rationale could have been applied, for example, to the accelerated vesting of restricted stock.

In a letter dated Dec. 20, 1991 2 the SEC reversed its position in the original Foster Pepper & Shefelman letter, but noted that "a discretionary amendment of the terms of an option or other security, other than the acceleration of vesting or exercisability, may be deemed to be [the] cancellation of the old security and [the] grant of a new security."

The December 20 letter, immediately after this caveat, cites footnote 35 of the April release in which the final version of certain new rules under 16 were published (Release No. 34-29131, April 26, 1991). That footnote states that "an extension of an option exercise period is deemed to be a redemption of an old security and grant of a new security for purposes of 16."

The net effect of Foster Pepper & Shefelman and its reversal is to leave unsettled what sort of "discretionary amendment" to an option or other security (except for accelerated vesting [exercisability]) might result in treatment of the amendment by the SEC as the cancellation of the old security and the grant of a new security. The following discussion will consider the implications of this caveat in the December 20 letter.

As background, it is noted that under Rule 16b-3, the grant or award of an equity security, including a stock option or other derivative security, is not treated as a "purchase" under 16(b) if certain conditions are met, including a requirement under Rule 16b-3(c)(1) that the equity security be held for six months from the date of grant or, in the case of a stock option or other derivative security, at least six months elapse from the date of grant to the date of disposition of either the derivative security itself (other than upon exercise or conversion) or the underlying shares issuable upon exercise of conversion.

Exemption for the Grant

If the executive fails to hold the security (including the underlying securities in the case of an option or other derivative security) for six months, the original grant is treated as a "purchase" and matched with any sale within six months before or after the grant. Thus, in the case of a stock option, for example, if the insider exercises the option and sells the underlying stock within six months of the date of grant, the exemption for the grant is lost, and the sale of the underlying stock can be matched with the grant for the purpose of 16(b).

What many practitioners have found troublesome with Foster Pepper & Shefelman is its seeming irreconcilability with the underlying theory of the treatment of options and other derivative securities in the new rules. Under those rules, most specifically, Rule 16a-4, derivative securities and the underlying securities to which they relate are deemed to be the same class of equity securities. The acquisition of a derivative security, like a stock option, is deemed to mark the beginning of the six-month period for both the derivative security and the underlying security since that is when the opportunity to realize a short-swing profit begins.

This is the case, as the SEC pointed out in its adopting release, whether or not the option is presently exercisable. Thus, for 16(b) purposes an optionee is deemed to "own" the underlying stock from the date of grant, whether or not he exercises the option and whether or not it is exercisable. Under these circumstances, acceleration of the exercisability of the option (the subject of the original Foster Pepper & Shefelman leaves open the possibility of future decisions by the SEC that particular amendments to an option, or other security, even if already permitted under the plan, will be deemed to constitute new grants with the running of a new six-month period from the date of amendment. Among the types of amendments that might be made to an outstanding stock option are:

1. An amendment extending the exercise period of the option (as noted, this is specifically referred to in the December 20 letter).

2. The addition of a cash-out right such as a stock appreciation right.

3. The addition of dividend equivalents.

4. The addition of a "reload" feature (upon exercise of the option, the holder is granted a new option at the then applicable exercise price (ordinarily, market price) and, ordinarily, for the same number of shares as the number surrendered).

5. The addition of a right to use stock currently held by the option holder to exercise the option.

6. The addition of a right to borrow against value in the option (subject, of course, to applicable Federal Reserve margin limitations).

Some of the changes noted could be applied to securities other than options. For example, restricted stock might be subject to changes such as noted in 3 and 6. 3 A change not applicable to a stock option that might affect an outstanding grant of restricted stock would be the addition of voting rights not contained in the original grant.

As already noted, even if a particular plan already permits the changes noted above, the December 20 letter indicates the SEC might hold the making of such amendment to be the grant of a new security. It is hoped that the SEC staff, having faced the criticisms of Foster Pepper & Shefelman, will be cautious in treating any discretionary amendment to an outstanding equity security as a cancellation of the old security and a grant of a new one.

Executive Pay

In this column appearing in the July 29, 1991 issue of the New York Law Journal, note was made of proposed legislation introduced in Congress in June directed, in part, at restricting executive compensation. The proposed legislation, entitled "The Corporate Pay Responsibility Act," was introduced in the Senate as S. 1198 and in the House of Representatives as H.R. 2522. Senator Carl Levin, D.-Mich., and Representative John W. Bryant, D.-Tex., are the authors of the respective bills.

On July 25, 1991, Representative Martin Sabo, D.-Minn., introduced a bill entitled "The Income Disparities Act of 1991." It would deny an employer a deduction for any compensation "paid or incurred" for personal services by any employee in excess of an amount equal to 25 times the amount paid or incurred for personal services by the lowest paid employee of that employer.

"Employee" is defined as "a full-time permanent employee" and the term "employer" treats, in certain cases, groups of affiliated employers as a single employer. "Compensation" is defined to mean "salary, wages and bonuses."

Representative Sabo's bill leaves the reader a number of things to ponder. What is included in "salary, wages and bonuses"?

-- Stock options?
-- Restricted stock?
-- Performance shares?
-- Qualified and nonqualified pension arrangements?

Does Representative Sabo really intend that the compensation of the highest paid executives of major U.S. corporations be limited to 25 times that of the lowest paid worker -- or else the employer suffers a loss of tax deductions on the excess? It is noted that this consequence resembles that imposed under 280G of the Internal Revenue Code of 1986 on "excess parachute payments."

Under Representative Sabo's legislation, assuming the lowest paid full-time worker of an employer earns $10,000, the maximum amount of deductible pay to senior level executives would be $250,000. This would apply whether the employer had sales of $50 million or $50 billion. Such procrustean treatment of executive compensation seems inappropriate, to say the least. At the time of writing this column, no companion bill appears to have been introduced in the Senate and no hearing appears to have been scheduled.

Banking Compensation

In November 1991, Congress enacted the Federal Deposit Insurance Corporation Improvement Act of 1991 (1991 FDIC Improvement Act), which was signed by the President on Dec. 19, 1991. A little-noted provision of that act provides for the Federal Banking agencies to adopt standards for compensation, fees and benefits for executive officers, employees, directors and principal shareholders of banks and thrift institutions and possibly bank holding companies.

In 1990, the Federal Deposit Insurance Corporation (FDIC) was given authority to prohibit or limit, by regulation or order, any golden parachute payment or indemnification payment. 4 On Oct. 4, 1991, the FDIC issued proposed rules limiting such payments. 5 Generally, the proposed rules prohibit troubled institutions from making parachute payments and prohibit certain indemnification payments.

As indicated, the 1991 FDIC improvement Act is much broader. Section 132 of that law amends the Federal Deposit Insurance Act 6 to add a new 39 to that act, which provides that each appropriate Federal banking agency shall, for all covered institutions, prescribe standards prohibiting as an unsafe and unsound practice any employment contract, compensation or benefit agreement, fee arrangement, perquisite, stock option plan, postemployment benefit or other compensatory arrangement that would provide any executive officer, employee, director or principal shareholder of the institution with excessive compensation, fees or benefits.

The agency is also required to prescribe standards specifying when compensation, fees or benefits are excessive. To accomplish this, the agency is to determine if the amounts are unreasonable or disproportionate to the services actually performed by considering several enumerated factors, including comparable practices at comparable institutions.

Final regulations under new 39 of the Federal Deposit Insurance Act are to be adopted by Aug. 1, 1993, and 39 is to become effective on the earlier of the adoption of the final regulations or Dec. 1, 1993.

The specific provision of 39 that deals with compensation standards, 39(c), states that it applies to "insured depository institutions." Such an institution is defined to mean any bank or savings association insured by the FDIC or, in certain cases, an uninsured affiliate of a foreign bank. 7 Section 39(a) contains introductory provisions requiring the establishment of various standards -- including in 39(a)(1)(F) compensation standards to be adopted "in accordance with" 39(c).

Section 39(a) is applicable not only to insured depository institutions but also to "depository institution holding companies." The latter are defined as bank holding companies and a bank holding company, in turn, is defined as any company that has control over a bank. 8

A bank is defined as an FDIC-insured bank or an institution that accepts demand deposits and is engaged in the business of making commercial loans. 9 If 39(a)(1)(F) is deemed to apply to bank holding companies, then the executives of companies that are not themselves directly, or even primarily, in the banking business -- but that happen to own banks -- could find their compensation arrangements subject to regulation by Federal banking agencies. 9


1 In the Foster Pepper & Shefelman case, the option provided that it became exercisable as to 20 percent of the shares one year after the date of grant and as to an additional 1.66 percent for each month of employment thereafter and that, upon termination of employment, it could be exercised for a three-month period, but only to the extent it was exercisable at the time of termination. In connection with the termination of an optionee's employment, the board of directors, as authorized by the stock option plan, accelerated the vesting and exercisability of the option as to a number of shares.

2 Foster Pepper & Shefelman, available Dec. 20, 1991.

3 In the case of restricted stock, there could be, for a temporary period, a way out of the problem created by the open-endedness of the December 20 letter or another adverse no-action letter in the near future involving an amendment to a restricted stock grant. Under the transition rules as they affect restricted stock, an issuer may elect to continue under old Rule 16b-3 until Sept. 1, 1992. This could eliminate the problem until that date if under old Rule 16b-3 the amendment would have been treated as a non-event. It should be emphasized that care would have to be taken regarding whether the right to "elect" to continue under old Rule 16b-3 until Sept. 1, 1992 is available in a particular case. Furthermore, exactly what constitutes an "election" is not spelled out in the transition rules.

4 12 USCA 1828(k)(1) (West Supp. 1991).

5 12 CFR Part 359.

6 12 USCA 1811 et seq.

7 12 USCA 1813(c)(2), (3).

8 A depository institution holding company is defined under 12 USCA 1813(w) as a bank holding company as such term is defined under 12 USCA 1841 (the definition is actually contained in 12 USCA 1841 [a][1]), or a savings and loan holding company, as defined in 12 USCA 1467a (the definition is actually contained in 12 USCA 1467a[a][1][D] [West Supp. 1991]).

9 12 USCA 1841(c)(1).