It is difficult for publicly-traded issuers to solve the problems associated with outstanding stock options that are “underwater” (i.e., underwater because the exercise price of the stock option is greater than the fair market value of the underlying shares).  None of the typical solutions are attractive to publicly-traded issuers.  As a result, the underwater stock options continue to exist for 10 years from the date they were granted, and continue to decrease the life expectancy of the equity plan’s share reserve.  But what if a compensatory design existed that, if implemented on the front end, could negate the possible future existence of outstanding stock options that are substantially underwater?  Would such a design be attractive to an issuer so long as the design did not destroy the retention value otherwise inherent in the stock option?  Could a stock-price forfeiture provision be a solution to the foregoing problem?  Discussing a stock-price forfeiture provision as a possible solution to negate substantially underwater stock options is this “Tip of the Week.”

The Problem

Underwater stock options have little or no retention value from an optionee’s perspective.  But what is an issuer to do?  The issuer could reprice the underwater stock options (i.e., reduce the exercise price to the underlying stock’s current fair market value).  The problems or hurdles associated with repricing include:

  • Stockholder Approval.  According to NYSE and NASDAQ listing rules, stockholder approval is required to effectuate a repricing unless the terms of the stockholder-approved equity incentive plan expressly provide that a repricing may be effectuated without stockholder approval (stockholder approval is required if the equity plan is silent on this point).  As a point of reference, most equity incentive plans expressly prohibit repricing of stock options without stockholder approval because such was required in order for the issuer to court ISS support for the equity plan (that said, equity incentive plans adopted immediately prior to an issuer’s IPO will often expressly permit repricing without stockholder approval).  [Note: a cancellation of the underwater stock option followed by a regrant is considered a “repricing” under NYSE and NASDAQ listing rules]
  • SEC Tender Offer Rules.  A repricing of underwater stock options is generally considered a tender offer and triggers a requirement that the issuer comply with the SEC’s tender offer rules and file a Schedule TO (the latter requiring substantial SEC disclosure and legal fees to accomplish the same).  However, the tender offer rules could be avoided if either: (i) the repricing is conducted on an individually-negotiated basis with a small number of key executives (see Exemptive Order, March 21, 2001 and a series of no-action letters); or (ii) assuming the equity plan and the option award agreement permit, the repricing is conducted on a unilateral basis without the optionee’s consent (i.e., if there is no “offer” to the optionee, then the optionee is not making an investment decision, and absent an investment decision, the tender offer rules should not be triggered).
  • Incremental Compensation Expense for Accounting Purposes.  The issuer will have incremental compensation expense unless the repricing is implemented as part of a “value-for-value exchange” (i.e., the fair value of the underwater stock option, as determined using a Black-Scholes valuation model, is exchanged for a new award having an equivalent fair value).  However, a value-for-value exchange requires the optionee to make an investment decision because, in the exchange, he or she will generally receive a lesser number of shares subject to the stock option.  The result is that if incremental compensation expense is a concern, then the repricing cannot be conducted on a unilateral basis, and the SEC tender offer rules will be triggered (unless the repricing is limited to a small number of key executives per (i), above).
  • Tax Consequences.  For tax purposes, a repricing of a stock option is deemed to be the grant of a new stock option.  As a result, any repricing of incentive stock options would trigger new holding requirements under the ISO rules (i.e., to maintain ISO treatment, the ISO must be held until the longer of: (i) two years from the date of grant and (ii) one year from the date of exercise).

Possible Solution – Implement a Stock Price Forfeiture Provision

The concept of a stock-price forfeiture provision is simple.  The form stock option award agreement would contain a provision that requires the stock option and the underlying shares to become immediately and automatically forfeited if the price of the underlying stock ever falls to $x.00 (or falls by $y.00, determined as an average over a 6-month period or some other period).  Possible benefits of a stock-price forfeiture provision include:

  • The underwater stock options are no longer outstanding.
  • The forfeited shares should revert to, and replenish, the share reserve of the issuer’s equity incentive plan.
  • The life expectancy of the equity incentive plan’s share reserve is longer when compared to the issuer retaining the underwater stock options as outstanding awards.  [Cross Note: See “Use Inducement Grant to Protect an Equity Plan’s Share Reserve”]
  • Complying with the SEC’s tender offer rules are avoided, as is the time, expense and some of the stockholder relationship issues relating to the same.

Risk to Consider

After the underwater stock options are forfeited, should the optionees receive an identical replacement grant?  The answer is NO because under NYSE and NASDAQ listing rules, a cancellation followed by a replacement grant is deemed to be a repricing.  But if the new grant is pursuant to the issuer’s annual grant policy (either a formal policy or an operational policy), and otherwise has no relationship to the forfeited underwater stock options, then is the new grant a replacement grant?  Currently, there is no answer to this question.  Legal counsel should be consulted.