Many publicly traded companies use equity compensation to motivate and retain their top-performing employees and to align the interests of employees with those of shareholders. Due to the COVID-19 pandemic, many employees are currently holding “underwater” stock options (options whose exercise price is above the current fair market value of the underlying stock). Stock options that are significantly underwater offer limited incentive and retentive value because employees are unable to envision how their underwater stock options will ever become valuable. A stock option exchange program may provide a company with a solution to these issues.
Basic Approaches
Three basic approaches have emerged for implementing a stock option exchange program:
- Options-for-Options: The existing underwater stock options are cancelled and replaced with a grant of new stock options. Under a value-neutral exchange program, a new grant of stock options typically covers fewer shares than were covered by the existing underwater stock options.
- Options-for-Stock: The existing underwater stock options are cancelled and replaced with a grant of either restricted stock or restricted stock units. Because restricted stock or restricted stock units are full value awards, the new grant of stock is typically for significantly fewer shares of stock than was covered by the existing underwater stock options.
- Options-for-Cash: The existing underwater stock options are cancelled and replaced with an immediate cash payment.
Stock Option Exchange Program Design Considerations
Regardless of which approach is chosen by a company, the major program design considerations for a stock option exchange program remain essentially the same. The five major design considerations are:
- Option Holder Eligibility. A company must first decide which option holders will be eligible to participate in the stock option exchange program. This decision most commonly focuses on which, if any, executive officers, officers under Section 16 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and non-employee directors of the company will be eligible to participate in the exchange program. As discussed below, this issue is a topic of increasing importance to institutional investors and proxy advisors who believe that performance-based compensation for senior-level executives and directors must be directly linked to stock price performance.
- Grant Eligibility. A company must next decide which outstanding stock options will be eligible for the stock option exchange program. The company must decide whether it will allow any outstanding underwater stock options to be exchanged, or whether the program will be limited to stock options that are “substantially underwater.” Limiting the program to substantially underwater stock options requires a company to set a price floor such that outstanding stock options with an exercise price below the price floor are ineligible for the program. There are several considerations that go into this decision. Stock options that are priced near the current stock price still provide an achievable incentive to increase stock price, and including these options could send the message that the company’s management has little faith in the recovery of the company’s stock price. Additionally, institutional shareholders and proxy advisors may also have a policy on this issue, as discussed below.
- Exchange Ratio. The exchange ratio defines the amount of consideration that is being provided in exchange for the existing underwater stock options. The exchange ratio is the ratio of the number of existing stock options that must be exchanged in order to receive one new stock option, one share of restricted stock, or one restricted stock unit. This is one of the most important design considerations for an exchange program because it will have a direct impact on the employees’ perception of, and participation in, the exchange program. A basic starting point is that the exchange should be a “value-neutral” exchange. A value-neutral exchange occurs where the fair value of the grant of new stock options is equal to (or slightly less than) the fair value of the exchanged underwater stock options. The fair value of a stock option is calculated using a fair value model such as the Black-Scholes model or the binomial lattice model. For example, if the fair value of an existing stock option was $5.00 and the fair value of the new stock option was $10.00, then the exchange ratio would be two-to-one (i.e., two existing underwater stock options would be required to be exchanged for each new stock option granted under the exchange program).
- Award Vesting. Another design consideration that is critical to employees’ voluntary participation in a stock option exchange program is the vesting schedule for the new stock options, shares of restricted stock, or restricted stock units. The existing underwater stock options almost certainly have a vesting schedule and portions of the existing stock options may already have vested. A company must consider how the vesting schedule of the new stock options will compare with the vesting schedule of the outstanding underwater stock options. The three basic approaches to this issue are (1) to map the vesting of the outstanding stock options to the new stock options, (2) to use a full vesting reset, or (3) to use a partial vesting reset.
- Treatment of Net Shares Recaptured. Unless one existing stock option is exchanged for one new stock option (an exchange ratio of one-to-one), the exchange program will result in the cancellation of a greater number of underwater stock options than are granted as new stock options. Most equity compensation plans provide that the shares that are subject to the cancelled awards may be returned to the equity plan pool for reissuance in connection with subsequent equity awards. However, some companies elect to voluntarily commit to retiring the net shares recaptured from the exchange program in order to prevent further shareholder dilution. This helps make the exchange program more appealing to institutional investors and proxy advisors, as discussed below.
Shareholder Approval
Both the New York Stock Exchange and the Nasdaq Stock Market require shareholder approval prior to implementing a stock option exchange program unless a company’s equity plan specifically permits repricings or exchange offers. If shareholder approval is required, the company will have to file the proxy statement being used to solicit shareholder approval with the SEC. In addition, institutional investor and proxy advisors may require the stock option repricing or exchange be conducted on certain terms, as discussed below.
Proxy Advisor Considerations
Institutional Shareholder Services (“ISS”)
ISS evaluates stock option exchange proposals on a case-by-case basis. Under its policy, ISS will generally recommend opposing any repricing that occurs within one year of a precipitous drop in the company’s stock price. Among other factors, ISS will also examine whether (1) the design is shareholder value-neutral (a value-for-value exchange), (2) surrendered options are not added back to the plan reserve, (3) replacement awards do not vest immediately, and (4) executive officers and directors are excluded.
In addition to the above considerations, ISS believes that the grant dates of surrendered options should be far enough back (two to three years) so as not to suggest that the repricing is being done to take advantage of short-term downward price movements, and the exercise price of surrendered options should be above the 52-week high for the stock price.
ISS has expressly confirmed that it considers this approach to continue to be appropriate during the circumstances of the COVID-19 pandemic.
Glass Lewis
Glass Lewis generally opposes all option repricings, but notes that there is one circumstance in which a repricing or option exchange program may be acceptable: if macroeconomic or industry trends, rather than specific company issues, cause a stock’s value to decline dramatically and the repricing is necessary to motivate and retain employees. In this circumstance, Glass Lewis will recommend supporting a repricing if (1) officers and board members cannot participate in the program, (2) the stock decline mirrors the market or industry price decline in terms of timing and approximates the decline in magnitude, (3) the exchange is value-neutral or value-creative to shareholders using very conservative assumptions and recognizes the adverse selection problems inherent in voluntary programs, (4) the vesting requirements on exchanged or repriced options are extended beyond one year, (5) the shares reserved for options that are reacquired in an option exchange will permanently retire (i.e., will not be available for future grants) so as to prevent additional shareholder dilution in the future, and (6) management and the board make a cogent case for needing to motivate and retain existing employees, such as being in a competitive employment market.
Tax Treatment
Generally, under federal income tax laws, employees are not required to recognize income for federal income tax purposes upon the cancellation of stock options or the grant of new stock options, restricted stock, restricted stock units or other equity awards that are subject to future vesting. Cash payments made in exchange for stock options are immediately taxable, unless they are subject to vesting or other forfeiture conditions. However, there are tax implications to be considered, including making sure that the stock options will continue to qualify for an exemption from Section 409A of the Internal Revenue Code of 1986, as amended (the “Code”), and, if applicable, ensuring that stock options will continue to qualify as incentive stock options under Section 422 of the Code.
Accounting Treatment
Under ASC Topic 718, a stock option exchange is deemed a modification to the existing stock option. ASC Topic 718 requires that the fair value of the stock option immediately before modification be compared to the fair value immediately after modification, and if additional fair value is being delivered through the modified stock option, then that value is recognized as an expense over the remaining vesting period of the modified stock option. However, stock option exchange programs structured as value-for-value exchanges should not result in any accounting impact. Companies should consult with their auditors before proposing an option exchange.
Tender Offer Rules
Stock option exchange programs are generally deemed tender offers for purposes of the Exchange Act. Because employees must make a voluntary investment decision when electing to participate in a stock option exchange program, such programs are generally subject to the tender offer rules under the Exchange Act. Under the tender offer rules, upon commencement of a stock option exchange program, a company is required to issue a formal Offer to Exchange and leave the offer open for at least 20 business days. The Offer to Exchange outlines the terms of the stock option exchange program and includes a summary term sheet describing, among other things, the background, purpose, material terms and conditions, risk factors, eligibility, duration, interests of directors and officers with respect to the tender offer, tax and legal consequences of the program, as well as any other information necessary for an employee to make an informed investment decision.
The Offer to Exchange must be distributed to all eligible employees either electronically or by mail. Generally, a company must file with the SEC all written communications made prior to, or following, the commencement of the tender offer, including any press releases and employee communications. Once a tender offer has commenced, it is subject to SEC review and comment, and the SEC may require a company to submit supplemental information or an amended filing. The tender offer rules are not difficult to satisfy, but do require a significant amount of design, planning and implementation, during which time market conditions can significantly change, which may change the economics and underlying motivation for implementing the program.
Conclusion
In response to the COVID-19 pandemic, many companies are considering various alternatives to realign their compensation programs in an effort to retain and incent their most valuable employees. While stock option exchange programs are an effective strategy to counteract concerns related to employee retention and motivation that may arise in connection with a company’s low stock price, the creation, implementation and administration of these exchange programs can introduce a myriad of legal, regulatory, and shareholder issues that companies must consider before commencing such a program.