Given the recent market environment, many public issuers are reviewing the status of their option plans and grants made under these and other equity-based compensation plans. In many cases, issuers have experienced a precipitous drop in their share price, resulting in many of the existing option grants being out-of-the-money. Issuers are contemplating various ways to continue to motivate and compensate their executives and employees through long-term and short-term equity incentive plans while at the same time balancing the interests of shareholders and complying with stock exchange and regulatory requirements.
Issuers have taken different approaches to deal with underwater equity compensation, including:
- maintaining the status quo;
- repricing options grants to lower the option exercise price;
- adopting option exchange programs to grant holders a smaller number of options at a lower exercise price in exchange for surrendering a greater number of existing options at a higher exercise price;
- implementing additional equity-based incentive plans such as deferred or restricted share unit plans;
- cancelling existing options and regranting new options to optionholders at a lower price; and
- agreeing to additional bonus and other incentive plans not tied to the equity returns of the issuers’ shares.
All of these approaches, with the possible exception of "maintaining the status quo," have legal, accounting and shareholder implications.
One approach that recently has become somewhat popular is the cancellation of options held by optionholders and the subsequent regranting to such holders of replacement options. Subject to the option plan terms, with careful planning it should be possible to implement such an arrangement without requiring shareholder approval.
The Toronto Stock Exchange (TSX) regulates equity-based plans for TSX-listed issuers, but the cancellation of options is generally not regulated by the TSX other than the issuer’s obligation to provide routine monthly reporting. However, the regranting of options to optionholders whose options have been previously cancelled is subject to several requirements set out in the TSX Company Manual and clarified in Staff Notices 2005-0001 and 2006-0004.
Cancellation of Options
Option plans do not typically allow the issuer to unilaterally cancel options except, possibly, in extraordinary circumstances. However, an issuer may allow optionholders to voluntarily forfeit options. An issuer will often set parameters for a forfeiture program so that similarly situated optionholders are dealt with on a consistent basis. For example, the cancellation program may be limited to holders of options with grant prices in excess of a threshold dollar amount set by the issuer.
Issuers will want to provide optionholders with clear written documentation as to the voluntary nature of the forfeiture and the number of options the holder may forfeit, as well as the consequences of the forfeiture, such as the possibility that forfeiters may not receive future option grants. The issuer should also recommend optionholders seek personal and independent legal and tax advice.
Regrant of Options
As a general rule, the TSX requires securityholder approval for any material modifications to an equity-based compensation plan. It is important to keep in mind that the votes of securities held by insiders, in particular, officers and directors benefiting from the modification, will be excluded from any vote to approve such changes. Material modifications would include amendments to an option plan and options granted under the plan to reprice them to a lower price or to implement a straight option exchange program. Some issuers seek to avoid this by having holders voluntarily forfeit old options, then granting new options within the terms of the plan at a lower price. However, the TSX will treat such a cancellation and regrant arrangement as a ‘repricing’ of options and therefore will require securityholder approval to the extent it applies to insiders of the issuer, generally officers and directors, unless the regrant to insiders occurs at least three months after the related cancellation. These restrictions also apply to non-insider optionholders, that is, employees other than those who are officers or directors, unless the option plan permits the specific amendment be made without securityholder approval.
There are no specific prohibitions as to what arrangements may be put in place between the issuer and the insider optionholder at the time of the forfeiture as to future grants after the expiry of the three-month period. However, the issuer and optionholder should consider other factors such as whether such an arrangement would have adverse accounting implications. The issuer should also keep in mind its disclosure obligations and any insider will have to ensure it meets insider reporting requirements. Also, any regrant to both insiders and non-insiders will be limited by the scope of the option plan in place — the price of new grants will usually be set at or above the market price on the date of grant (based on some formula in the plan), and there may be a limited number of new options available for grant under the plan.
It is important to note that issuers listed on the TSX Venture Exchange are subject to different rules. In the event of an option cancellation, such issuer will be required to wait at least 12 months before regranting options. Alternatively, it may be subject to certain requirements including TSX Venture Exchange approval, shareholder approval for options granted to insiders, and restrictions on option pricing.
A number of large pension plans and other institutional investors continue to resist what they perceive as overly generous equity and non-equity-based compensation plans. This extends to option repricing arrangements. While a cancellation and regrant program of the nature described above may avoid the shareholder approval requirements (as well as some of the accounting and approval issues) related to option repricings and option exchange programs, a compensation committee and the board of directors should, in considering its option programs, continue to focus on the best interests of the corporation and, in particular, the interests of all shareholders. An option repricing or regrant program may help motivate executives and employees, but shareholders may view it in a negative light because of a perceived imbalance between shareholders and optionholders.
Boards should also remember that shareholders often have long memories. An issuer may want to seek shareholder approval in the future to increase the option pool for an existing plan or adopt a new equity-based compensation plan. A cancellation and regrant program may address an issuer’s needs in the short-term but may negatively impact ongoing arrangements with shareholders and limit options in the long-term.