This article is reprinted with permission from the
September 29, 1998
edition of
New York Law Journal.
1998 NLP IP Company.


Repricing Stock Options

By Joseph E. Bachelder


WITH THE RECENT downturn in the stock markets, many public corporations are facing the uncomfortable circumstance of having "underwater" stock options in the hands of their executives. This column addresses a recent challenge by the Financial Accounting Standards Board (FASB) to the repricing of stock options, a traditional step by public corporations after a drop has occurred in the market price of the employer's stock. It also discusses some other issues facing employer corporations considering the repricing of stock options.

Proposed Accounting for Repricing

A tentative decision reached by FASB at a meeting on Aug. 12, if adopted, will mean that companies that reprice their options will be required to treat such repriced options as "variable plan options." This means they will be required to charge as an expense against their earnings any increase in the market price of the company stock above the new, lower exercise price of such options.

It is not expected that any final decision will take effect until after the tentative decision is incorporated into an "Interpretation" with other tentative decisions to be issued regarding stock options and comments have been received on a draft of such Interpretation. If ultimately adopted, such Interpretation is unlikely to take effect before the year 2000.

Accounting for most employer stock options is governed by Accounting Principles Board Opinion No. 25 (APB Opinion 25), issued in 1972. In 1997 FASB issued Statement of Financial Accounting Standards No. 123 (FASB 123), which also addresses accounting for employer stock options. FASB 123, however, generally leaves APB Opinion 25 in effect for purposes of determining whether there is to be a charge against earnings for employer stock option grants unless an employer elects to apply the rules of FASB 123. Most employers have not elected to charge earnings under FASB 123. 1

APB Opinion 25 provides that compensation expense must be accrued with respect to compensatory grants of company stock and stock options in an amount equal to the quoted market price of the stock on the "measurement date" less the amount, if any, that the employee is required to pay for such stock. For this purpose, the measurement date is the first date on which are known both (1) the number of shares that an individual employee is entitled to receive and (2) the option or purchase price, if any.

Thus, for a typical employee stock option granted with an exercise price equal to market price at date of grant, there is no charge against earnings. However, in the case of a "variable" stock option, in which the price or the number of shares is determined at a date later than the grant date, APB Opinion 25 requires the employer to accrue compensation expense based upon the quoted market price of the stock at intervening dates through the date on which the price and number of shares become fixed. Thus, increases in the market price above the exercise price after the grant date will result in compensation expense with respect to variable stock options.

In EITF Issue No. 87-33, the FASB Emerging Issues Task Force (EITF) addressed the consequences of a repricing or its equivalent, the cancellation of an option and issuance of a new option at a lower price to replace it. EITF concluded that a repricing should result in a new measurement date that could result in an increase in compensation expense if the new exercise price was less than the market price on the repricing date. EITF 87-33, however, specifically provided that a repricing (or a cancellation and reissuance) of an option would not cause the option to be considered variable. Current accounting practice has been to require variable plan accounting only after at least three repricings2.

On Aug. 12, as noted above, FASB made a tentative decision to change the rule as adopted in EITF 87-33. Under the tentative decision variable plan accounting would apply with respect to any option that is repriced below its grant price (or that is canceled followed "shortly thereafter" by a grant of a new option at the lower price to the same individual; the tentative decision suggests a six-month interval as an example of "shortly thereafter"). The charge against earnings that would result from such decision, if finalized in its present form, could discourage the practice of option repricing.

Additional Options

Assuming the rule is adopted, some employers may avoid the charge against earnings by granting additional options instead of replacement options. If this requires a substantial addition to the number of options outstanding some problems may face the employer. The additional grants may consume all or a substantial portion of shares remaining available for grant under the existing option program and may require shareholder approval of additional shares under the applicable plan. The potential for enhanced dilution of outstanding shares may be significant. With the lower option price, the impact on earnings per share of any rally in the stock will be felt immediately.

Thus, any special, additional grant of stock options to existing option holders to accommodate them for a drop in the market price of employer stock is likely to bring criticisms from shareholder advocates. These criticisms likely will equal (and may well exceed) the vigor of such advocates' criticisms of a repricing. Such criticism, of course, would not apply to an additional grant of options that simply carries out periodic option awards in accordance with past practices of the employer.

Following are examples that illustrate, in the case of a repricing, the current accounting rule and the rule as proposed by the Aug. 12 tentative decision of FASB.

(Under current accounting rule)

ABC Corp. grants an option to an executive at a price of $40 per share, which reflects the market price of ABC's shares on the grant date. The market price of ABC's shares falls to $25 per share on March 1, 2000. ABC elects to reprice the option on such date at an exercise price of $25, the market price on that date.

Under current accounting interpretations, there would be no charge to ABC's earnings, either at the time of such repricing or on any subsequent reporting date on which the market price of ABC's shares exceeds the new, lower exercise price. Thus, because variable plan accounting would not be required, future increases in the market price of ABC's shares above the repriced option exercise price would not result in any charge to earnings.

(Under FASB proposal)

The facts are the same as in Example 1 except that the tentative decision proposed by FASB on August 12 applies.

As noted in Example 1, under current interpretations, no charge to earnings would be required, regardless of any future movements in the price of ABC's shares. However, under the Aug. 12 FASB tentative decision, if the market price of ABC's shares increases to $35 as of Dec. 31, 2000, ABC would be required to accrue compensation expense of $10 for each share under the option.

If the market price of ABC's shares increased to $45 as of Dec. 31, 2001, an additional compensation expense of $10 per share would be accrued. Subsequent increases in market price would result in additional compensation expense until, ultimately, the option is exercised. (Future decreases following such accruals of increases in market price would result in credits to income.)

The FASB's tentative decision is one part of an ongoing "Repair and Maintenance Project" with respect to APB Opinion 25. The expected outcome of such project is an FASB Interpretation of APB Opinion 25 that will address certain issues (including repricing) raised by APB Opinion 25 without changing the fundamental precepts upon which such Opinion is based. FASB hopes to finish an "exposure draft" of this Interpretation no later than March 31, 1999, after which it will ask for public comment. Opposition to the repricing proposal is expected to be significant and, as noted above, it is unlikely that the FASB proposal would become effective before the year 2000.

Other Repricing Issues

The combination of the current volatility of the stock markets and the Aug. 12 tentative decision by FASB will create pressure on many companies whose stock options are currently under water to consider repricing before the proposed new rule takes effect (if it does).

Before repricing stock options, a company should consider the following:

1. Shareholder Advocacy Groups. Any company repricing should expect criticism from groups representing institutional shareholders and other investors. For example, on Aug. 20, The New York Times reported that Institutional Shareholders Services, which advises approximately 500 large institutional shareholders on how to vote on corporate compensation issues, plans to include the cost of option repricings in a formula that it uses to decide whether a company is shareholder-friendly.

2. Principles of Corporate Governance. Provided disinterested directors determine to reprice stock options, it is unlikely that their action will be challenged successfully under the corporate law of states such as New York or Delaware. Presumably such action will be supported by outside advice that confirms good business reasons for doing it. These reasons may include revitalizing the long-term incentive program and the risk of loss of key executives to other companies unless there is a repricing.

A case such as Zupnick v. Goizueta, 698 A2d 384 (Del. Ch. 1997), reflects the broad discretion left by courts to boards of directors in determining whether consideration exists for paying compensation. Assuming that a group of disinterested directors, after obtaining independent advice, concludes in good faith that repricing is appropriate for the employer, such decision should be protected by the business judgment rule from court scrutiny as to whether the value of the compensation is comparable to the value of the services. Obviously care must be taken that any such action is consistent with a shareholder-approved plan and with any statutory or regulatory rules that may apply in a particular situation.

3. SEC Proxy Statement Rules. Since 1992 the SEC has had proxy statement rules providing that any adjustment in the exercise price of a stock option or the base price of a stock appreciation right held by the chief executive officer or other "named executive officer" during the fiscal year in question will trigger a compensation committee repricing report and a table displaying all repricings of options and stock appreciation rights held by any executive officer over the last 10 fiscal years. 3

4. Section 162(m) of the Internal Revenue Code of 1986, as Amended. Code 162(m) imposes an annual $1 million limitation on the deductibility of compensation earned by certain executive officers of public companies. Income constituting "qualified performance based compensation" under Treasury Regulation 1.162-27(e) is not included within such $1 million limitation. One requirement for stock options to be included within qualified performance-based compensation is that the option's exercise price be no less than the fair market value of the underlying stock on the date of grant. Treas. Reg. 1.162-27(e)(2)(vi)(A).

The repricing of an option's exercise price below the market price of the stock on the original grant date should not cause any income generated from the option to fail to constitute qualified performance-based compensation, provided the new exercise price is at least equal to the market price on the date of the repricing. See Treas. Reg. 1.162-27(e)(2)(vi)(B) (repricing treated as cancellation of old option and grant of new option).

It should be noted, however, that the canceled option, as well as the new option (and for this purpose a repricing is treated as a cancellation and a re-grant) will both be counted against the maximum number of shares for which options may be granted to the employee as to whom cancellation/re-grant (or repricing) is being done for a plan-specified period. (In order to qualify for exemption from the $1 million cap under 162(m) a stock option plan must provide a maximum number of shares that can be granted to any one employee during a specified period.)

5. Pooling Requirements. Care must be taken in any change in a stock option program that is outside existing practices at a company to be sure that such change does not constitute an event that could jeopardize pooled accounting objectives the employer may have in connection with any possible future merger or other business combination.

6. Regulated Industries. Industries such as commercial banking, insurance and utilities that are subject to federal or state regulation may have to deal with specific rules regarding stock options and modifications to them.

Designing Repricing

There are a number of ways in which repricing of stock options may be done to make it more acceptable to shareholders. An employer might offer option holders a choice of keeping their underwater options or accepting lower-priced options that may have one or more of the following characteristics:

(a) a reduced number of shares, such as 50 percent of those covered by the old option;

(b) a reduced price but one that still is at a premium above the current market;

(c) a vesting schedule that subjects vested options to extended vesting periods and subjects unvested options to longer periods before vesting takes place.

The conditions of repricing are described as an offer because most option holders are protected against any change in the option adverse to them without their approval. Obviously, an option holder with an option exercise price significantly above the current market price will be inclined to accept an offer such as described above in order to have the exercise price reduced to the current market price.

It should be noted that making the numbers of shares exercisable (or the ultimate exercisability of an option) subject to performance hurdles will result in variable option accounting, and hence a charge against earnings. On the other hand, accelerated exercisability of an option that otherwise becomes exercisable after a fixed period does not result in variable option accounting.

Finally, an employer might subject the repricing itself to shareholder approval. In light of the current status of the repricing issue among shareholder advocate groups, it is unlikely that very many employers contemplating repricing will seek shareholder approval absent a requirement in the plan pursuant to which the stock options have been granted or other requirement compelling the employer to do so.


1 FASB 123 requires that an employer that elects to continue under APB Opinion 25 must show in footnotes to the financial statements what would be the impact on earnings if a charge were taken for stock option grants.

2 The minutes of the Aug. 12 meeting of FASB contain the following statement that suggests the accounting practice noted in the text is not always followed: "Mr. Leisenring [a member of FASB] noted that although current practice claims to require variable-plan accounting with three repricings, he has observed cases in which repricing has occurred ten times with no recognition of compensation expense. He said that it would be clearer to require variable-plan accounting upon one repricing." [Insert added.] From Revised Minutes of the August 12, 1998 [FASB] Meeting.

3 17 CFR 229.402(i). For definition of "executive officer," see 17 CFR 240.3b-7. For definition of "named executive officer," see 17 CFR 229.402(a)(3). (Generally speaking, "named executive officers" refers to the five executive officers typically named, with compensation identified, in the compensation tables appearing in the proxy statement.)