Your share price has tumbled. Your stock options are out of the money. Your employees are uninspired by their equity compensation and your institutional shareholders are unhappy about the value of your stock. How do you attract, motivate and retain employees in a way that is palatable to investors in the current economic crisis? At a time when the stock options of over two-thirds of Fortune 500 companies are underwater,2 many companies are struggling with this question and are considering modifications to their stock option programs such as re-pricing options, granting additional options and exchanging outstanding options for restricted stock or restricted share units.

The Board’s Role in Addressing the Effect of the Decline in Stock Price on Options

In determining whether or not to modify equity compensation programs as a result of a decline in the company’s share price, directors must have regard to their fiduciary obligations to act honestly and in good faith with a view to the best interests of the company. In considering what is in the company’s best interests, directors may look to the interests of its stakeholders, including employees and shareholders. While courts will accord deference to directors’ business decisions, directors will only be protected from liability to the extent that their actions evidence the exercise of business judgment. In this respect, boards should be diligent in their deliberations and thoroughly document the discussions surrounding them. Boards should also consult with experts, such as accountants and legal counsel, regarding the expected costs and benefits of the various alternatives.

A defensive approach to decision making is particularly important when considering whether to permit employee option holders to fare better than shareholders when the company’s stock price falls. In deciding whether to modify a company’s stock option plan, the board should examine whether the purposes of the existing plan are being met. This analysis may turn on, among other matters:

  • the probability of outstanding options becoming in-the-money prior to expiry;
  • the extent to which outstanding options represent a substantial portion of employee compensation;
  • the relative levels of risk and cost associated with unwanted, and higher than expected, employee turnover; and
  • the presence or addition of other features to the program which are favourable to the interests of the company (such as longer vesting schedules, forfeiture, claw-back or repayment obligations in the event of a financial restatement or breach of a non-competition covenant, double trigger change of control provisions, etc.).

The board should also consider the pros and cons of the alternatives available to the company, some of which are described in this article.

Option Re-pricing

In recent months, issuers ranging from Starbucks Corporation to Motorola, Inc. have proposed to re-price their outstanding options by providing existing option holders with an opportunity to surrender their underwater options for cancellation in exchange for a smaller number of new options at a lower exercise price. The exercise price of the new option is often equal to the current market price of the underlying share. Because each optionee receives fewer stock options than were cancelled, the number of outstanding options decreases, thereby reducing the company’s stock option overhang — a measurement used to determine the dilutive effect of options.

If a company’s option plan contains amendment provisions approved by shareholders which permit re-pricing of outstanding options, the Toronto Stock Exchange (“TSX”) will not require that shareholders approve the re-pricing programs unless insiders are entitled to benefit from the re-pricing program. If the re-pricing program benefits insiders of the issuer, shareholder approval (excluding the votes of the insiders who will benefit) must be obtained regardless of the terms of the plan.3 The TSX will consider any cancellation and re-issuance of options to insiders under different terms to require such approval, unless the re-issuance occurs at least three months after the related cancellation. These principles may also apply to Canadian companies that are foreign private issuers listed on the New York Stock Exchange or The NASDAQ Stock Market.4 They are permitted to follow their applicable home country practices with respect to revising their equity compensation plans.

Even if shareholder approval is not legally required to implement a re-pricing program, companies may be leery of proceeding without such approval given investor antipathy to such programs and the adverse publicity the introduction of such programs can generate, as was the case with Nortel Networks Inc. in 2001 and Google Inc. earlier this year. Moreover, the decision can affect the number of votes a director receives when standing for election at the company’s next annual shareholder meeting. RiskMetrics Group (“RMG”), a well-known proxy advisory firm, recommends voting against re-election of (or withholding such votes from) members of the compensation committee of an issuer that re-prices options without shareholder approval, even if the re-pricing is permitted under the company’s equity compensation plan.5 If the level of withhold votes for directors on the compensation committee is high enough, it could trigger the board’s “majority voting for directors” policy, if there is one, requiring such directors to submit their resignations from the board to the other independent directors for consideration.

If a company does seek shareholder approval of a re-pricing program, it should be aware that many institutional shareholders and proxy advisory firms have taken strong positions against repricing programs. In Canada, RMG generally votes against proposals to re-price outstanding options, unless the re-pricing is part of a broader plan amendment that substantially improves the plan and the following conditions are met:

  • a value-for-value exchange is proposed;6
  • the five top-paid officers are excluded; and
  • exercised options do not go back into the plan or the company commits to an annual burn rate cap.7

Companies contemplating a re-pricing program should also bear in mind the following disclosure obligations:

  • if shareholders vote on the program, a detailed description of the proposal must appear in the meeting materials circulated prior to the vote;
  • whether or not shareholders vote on the program, if the issuer is listed on the TSX, the program must be described in the company’s information circular for its annual shareholder meeting the following year;
  • statistics reflecting dilution levels and a brief description of the material features of equity compensation plans adopted without shareholder approval must appear in the company’s information circular for its annual shareholder meeting the following year; and
  • if named executive officers or directors take part in the program, detailed information about their participation in it must be included in the issuer’s executive compensation disclosure;8

Unless done properly, for Canadian income tax purposes, a re-pricing which occurs by way of an option exchange could be considered a taxable disposition of the old option for consideration equal to the value of the new option which may not be nominal based on valuation methods like Black-Scholes. Moreover, , such a re-pricing could, in certain circumstances, deny the option holder the 50% deduction that might otherwise have been available in respect of the stock option benefit realized on the exercise of the old option. Appropriate steps should therefore be taken by the company to comply with the detailed rules in the Income Tax Act (Canada) regarding option exchanges. The exercise price of the new option issued in exchange for the cancellation of the old option should not be less than the fair market value of the underlying share at the date of the exchange. The “in the money” value of the new option must not exceed the “in the money” value of the old option. Where those conditions are met, a special rule in the Income Tax Act (Canada) deems the old option not to have been disposed of and deems the new option to be the same options as, and a continuation of, the old option. Consequently, no tax is triggered on such an exchange and the ability to claim the 50% deduction is preserved (if it would otherwise have been available in respect of the old option). Pending amendments to the Income Tax Act (Canada) will provide for the same tax results and allow a company to simply re-price an option by reducing its exercise price, without requiring an exchange of the old option for a new option (provided that the re-pricing could have been achieved through such an option exchange).

In the United States, the gain on exercise of a re-priced incentive stock option (“ISO”) can only be treated as a capital gain if the stock is held for at least two years from the date of the re-pricing and more than one year from the date of exercise. In addition, only $100,000 of an employee’s options (based on the market value of the underlying stock at the time of option grant) that become exercisable in a year may be treated as ISOs. If an option is re-priced in a year that the option vests, a company must count both the original option and the new, re-priced option in making this calculation. Further, for all types of options, U.S. tax law (Section 409A of the Internal Revenue Code of 1986 (the “Code”)) requires the re-pricing to be a single re-pricing and not indicating a pattern or practice, that the new price be at least the fair market value of the underlying stock on the date of the re-pricing and that no other “material modification” be made that would tend to enhance the option benefit or provide for further tax deferral.

Additional Option Grants

Companies may also consider awarding additional stock options to optionees (without cancelling outstanding options). If the exercise price of each additional option is at least equal to the market value of the underlying share at the time of the grant, the new option will provide its holder with a greater potential for gain than will existing options. However, this type of expanded stock option program will also exacerbate both dilution and overhang, and the company should be comfortable there is sufficient room in the option plan.

Shareholders of a TSX-listed company need not be asked to approve additional awards, unless an increase in the number of shares reserved for issuance under the existing option plan is required. That could well be the case, since more awards will have to be made to deliver the same theoretical value as historical grants in light of the depleted price of the underlying shares. Because additional grants are dilutive, issuers seeking shareholder approval of an expanded stock option program may encounter resistance from institutional investors. The proxy voting guidelines of the Ontario Municipal Employees Retirement System (“OMERS”), for example, indicate that OMERS:

  • will not support plans that authorize shares representing 10% or more of the company’s outstanding shares;
  • will closely scrutinize and may not support dilution in excess of 5% with respect to large or mature companies; and
  • will generally not support option plans that authorize the granting or exercise of options in excess of 2% of outstanding shares annually.

In deciding whether to issue additional options to employees, companies should also take the following into account:

  • not only will new options be a charge to earnings, but because outstanding options will not be cancelled, accounting charges in respect of them will continue to be reflected on its books;
  • if the exercise price reflects a current market price for the underlying shares which is depressed because of general market conditions, optionees may receive a windfall if the share price subsequently rises as the financial market and general economy stabilize, rather than because of individual optionee or corporate performance; and
  • the increased level of dilution and, if additional options are awarded to named executive officers, details respecting the awards made to them must appear in the company’s information circular for its annual shareholder meeting the following year.

Awards of Restricted Stock or Restricted Share Units

Subject to the tax discussion below, besides re-pricing, another alternative involves cancelling existing stock options in return for grants of restricted stock or restricted share units (“RSUs”) with the same theoretical value than the cancelled options. Restricted stock is stock that is generally subject to a substantial risk of forfeiture at grant but that will vest upon the occurrence of certain time or performance-based conditions. RSUs are economically similar, but involve a deferred delivery of stock or cash at a time that is concurrent with, or after, vesting. Since both restricted stock and RSUs (collectively, “full-value awards”) ordinarily have no purchase or exercise price, fewer of them are required to grant a comparable award value than are needed in an option re-pricing. As a result, there is less dilution and lower equity overhang than in a repricing exchange of options.

While both Williams-Sonoma, Inc. and eBay Inc. recently requested that shareholders approve their RSU exchange programs, the TSX only requires an issuer to obtain approval of a full-value award plan if treasury shares are reserved for issuance under it. Cash-only arrangements or those that are only funded by securities purchased in the secondary market do not require shareholder approval. Shareholders may be reluctant to accept a full-value award plan because holders of the awards may receive value even if there is no increase in the value of the underlying shares. That said, institutional investors and proxy advisors generally support greater use of full-value awards rather than option awards because they tend to result in less dilution to shareholders and result in reduced compensation where the company’s share price declines due to poor company performance.

If named executive officers benefit from them, full-value awards granted in any year are required to be described in the company’s information circular for its annual shareholder meeting in the following year, including details respecting the awards made to such officers in the year.

With respect to Canadian tax considerations, as a general rule, underwater stock options cannot be cancelled and exchanged for either restricted stock or RSUs without triggering a taxable benefit to the holder in an amount equal to the value of the restricted stock or RSUs. Accordingly, in such circumstances, companies should issue restricted stock or RSUs in addition to the existing, underwater stock options and not in exchange for the cancellation of the options. Moreover, because the value of restricted stock is taxable to the employee when the stock is issued (albeit subject to a possible discount for the restrictions), RSUs are more common in Canada. RSUs which provide a holder with a right to receive a treasury share at a future date are taxed only when the RSU is actually settled for such shares (or surrendered at the holder’s instance, for cash). However, where settlement may only be made in cash (or may be made in cash at the company’s instance), the terms of the RSUs must require that they be settled within three years after the year of services to which the RSUs relate. Care should be taken not to exceed the relevant three-year period where RSUs are awarded in connection with underwater options that relate to services rendered more than three years prior to the award. Restricted stock and RSUs are generally not eligible for the 50% deduction referred to earlier.

In the United States, restricted stock is often a desirable replacement award because the share can be issued to the holder, but the value of the award is not included in income until it vests. However, Section 83(b) of the Code allows individual elections that accelerate income taxation to the award date so that all gain after the award date (and after income inclusion) can be treated as capital gain.

Conclusion

The current economic environment is forcing companies to re-examine their business strategies including the philosophy and assumptions underlying their compensation strategies. There is no universal right answer. Each company must decide on what course of action is in its best interest and the best approach — be it a re-pricing, additional grant, full-value award exchange or another solution altogether — will depend on many factors, including employee morale, business needs, shareholder base, investor views, plan reserves, burn rates and stock price history. Therefore, if a company elects to develop an underwater option strategy, it should give careful consideration to which alternative is right for it prior to planning, developing and implementing the program.