Client Alert Latham & Watkins Tax Department

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1 Number 544 September 27, 2006 Client Alert Latham & Watkins Tax Department SEC Staff Issues Important Practical Guidance on Stock Option Accounting Issues The practical and commonsense guidance provided by the Office of the Chief Accountant... constitutes the most welcome news that many companies ensnared in option investigations and reviews have received since the option backdating imbroglio broke this Spring. On September 19, 2006 the SEC s Chief Accountant, Conrad Hewitt, issued a letter (the letter ) to representatives of Financial Executives International and the American Institute of Certified Public Accountants providing much needed and longawaited public guidance with respect to the determination of measurement dates for determining stock option accounting charges under APB Opinion No. 25 (Accounting for Stock Issued to Employees (APB 25)) and FASB Interpretation No. 44 (Accounting for Certain Transactions Involving Stock Compensation (FIN 44)), which governed the accounting consequences of employee equity compensation prior to the adoption of FAS Statement No. 123 (revised 2004) Share-Based Payment (FAS 123R). The letter provides important guidance to many companies that intended to make contemporaneous or prospective option grants, valued at fair market value as of the date of grant, but that did so under circumstances which have raised measurement date questions because the grants may have been administered imperfectly under the plans they were granted or applicable law, or because there were delays in processing the relevant paperwork (socalled option misdating issues). While the letter is limited in scope and leaves many important issues unresolved, it provides companies, and their auditors and lawyers with practical and commonsense guidance which may save some companies (including the more than 135 public companies that have publicly disclosed either external or internal option investigations and many others that have not publicly disclosed their option reviews) from having to change reported measurement dates for at least some of their prior grants. This, in turn, may save some of them from having to restate prior financial statements. The Accounting Basics Under APB 25 and FIN 44 Under APB 25 and FIN 44, no compensation expense was required to be recorded for an option granted to an employee if the exercise price of the option was at least equal to the fair value of the company s stock, on a per share basis on the accounting measurement date and the option was not thereafter modified. But if the exercise price of the option was less than the fair value of the stock on the measurement date, the difference (sometimes referred to as the intrinsic value, spread or discount ) was deemed to constitute compensation and was amortized over the vesting period of the option. Moreover, if an option was modified in certain ways, the modification could result in a new measurement date and Latham & Watkins operates as a limited liability partnership worldwide with an affiliate in the United Kingdom and Italy, where the practice is conducted through an affiliated multinational partnership. Copyright 2006 Latham & Watkins. All Rights Reserved.

2 additional compensation charges based on the intrinsic value as of the new measurement date. Finally, under certain circumstances, an option that was granted subject to certain conditions (such as performance vesting) or was amended to reduce its exercise price (a so-called repricing ) would not be subject to this fixed accounting treatment, but instead would be subject to variable accounting which would result in any intrinsic value being charged as compensation on a mark-tomarket basis at each financial reporting date until the option was exercised, was forfeited or expired unexercised. The Staff s General and Practical Approach to Option Misdating Issues The letter affirms the rule that the proper measurement date for determining the amount of compensation expense for an option granted to an employee under APB 25 and FIN 44, if any, is the first date that both (i) the number of shares that an optionee is entitled to receive upon exercise of the option and (ii) the exercise price of the option are determined and known with finality (these necessary terms are hereinafter referred to as the option terms ). Most importantly, and obviously reflecting comments from companies, accounting firms and others, the letter offers useful pragmatic guidance by concluding that where the option terms have been actually decided with finality, short delays in the completion of administrative procedures to document the grants do not change the measurement date or result in accounting consequences. The letter then applies this general and practical principle to a number of relatively common fact patterns that have emerged in pending options timing investigations and analyzes their implications for option measurement date determinations. Guidance on Specific Misdating Issues Impact of Administrative Delays The letter notes that in some cases companies have used measurement dates that precede the date on which all of the corporate formalities necessary to grant options under the plan or state law have been completed, noting especially instances where boards of directors or compensation committees have orally authorized grants of options and completed the paperwork later, or delegated the authority to members or committees of management. The letter concludes that in such cases, if in fact the option terms were known with finality prior to the completion of the paperwork, the measurement date would properly be the date on which the option terms were determined, even though there was an administrative delay in completing the paperwork. On the other hand, if the option terms were not determined with finality until the corporate formalities were completed, no measurement date would occur until the date such formalities were completed. The letter states that in order to conclude as of what date the option terms became fixed and unchangeable, the company and its advisors would need to consider all of the relevant information, including the company s historical pattern of option grants, the presence or absence of documentation for other grants, the identities of the affected employees and the absence or presence of any evidence of fraudulent or manipulative conduct. 2 Number 544 September 27, 2006

3 Questions Regarding Validity of Grants Continuing with its pragmatic approach to option measurement date issues, the letter concludes that even where the validity of option grants is subject to question because the grants may have been in excess of plan authorized share limits or in violation of plan provisions (such as common requirements that the options have exercise prices no less than the fair value of the company s stock on the date of grant), these facts should not invalidate the options or change their measurement dates if all of the facts indicate that the company and the optionees mutually understood the substantive terms of the option grants and where the company had the ability to settle the options in stock, had in the past honored the exercise of such options and intends to continue to honor outstanding unexercised options. Most notably, this approach does not turn on state law niceties on such issues as whether the grants were void or voidable or are formally ratified or reaffirmed. The letter also states that the staff does believe that a company would be required to obtain a legal opinion with respect to the validity of the options in order to determine the accounting consequences of the grants. Impact of Uncertainty as to Individual Optionees The letter recognizes that the option terms necessary to establish a measurement date can be determined with finality even in situations where the board or committee did not actually approve a list of optionees and number of shares for each optionee, but delegated to management the task of allocating the options to individual optionees in accordance with definitive instructions (for example, with numbers of shares to be awarded based upon salary grades or positions within the company). On the other hand, if management was provided with discretion to determine the number of options to be granted to individual optionees, no measurement date would have occurred until such allocation had been made with finality. Further, the letter provides that if the list of optionees or their option terms were changed after board or committee action granting the options, this could be consistent either with a grant as of the initial action, with subsequent modifications of some of the grants (which would only affect the measurement date of the changed options), or with no grant to any of the optionees until the entire list was finalized (which would affect the measurement date for all of the options). Again, this would depend upon all of the relevant facts and circumstances. Impact of Exercise Prices Set by Reference to Future Market Prices The letter also addresses a relatively common fact pattern in which a board or committee determines to grant options at the lowest market price of the stock at some future date or over a specified period of time (such as 30 days after the approval of the grant). The letter concludes that if the original terms of the award provided for a reduction of the exercise price below the fair market value as of the date of the award if the price dropped within the stated period, variable accounting would be required for the award until the uncertainty as to the exercise price was resolved, namely at the end of the stated period, at which time the measurement date would be known and the amount of compensation cost would be the difference between the market price of the stock on that date and the lowest price during the stated period. On the other hand, if the original terms of the award did not provide for an adjustment of the exercise price after the date of grant and if the price was in fact reduced, this would constitute a repricing of the option 3 Number 544 September 27, 2006

4 which would trigger variable accounting for the duration of the award. Effect of Grants Made Prior to Commencement of Employment The letter states that even where an option grant was effective and satisfied the option terms requirements, no measurement date could occur under APB 25, as interpreted by FIN 44, prior to the date that the optionee began rendering services as an employee. To the extent that the fair value of the stock was higher at the employment commencement date than on the date of grant, fixing the measurement date as of the employment commencement date would result in compensation charges for this intrinsic value. Impact of Missing Paper One of the most vexing problems confronting many companies reviewing historical option grant practices is the absence of complete documentation, such as missing board or committee minutes or missing documentation of actions by unanimous written consent, with respect to option grants made as long as five to 10 years ago. In certain instances, the only documentation which can be located for some grants are copies of option agreements which are often simply dated as of a specified date and entries of option grants into Excel spreadsheets or stock option tracking software. Once again, reflecting a real world perspective on these issues, the letter states that a lack of complete documentation does not necessarily result in a conclusion that the grants had no measurement date or that the grants should be subject to variable accounting or be treated as never having been granted. In such circumstances, the letter states that companies must use all available relevant information to form a reasonable conclusion as to the most likely option granting actions that occurred and the dates on which they occurred in order to determine the correct measurement date. However, also consistent with real world experience, the letter observes that the absence of paper, combined with other relevant factors, may in fact indicate the use of inappropriate measurement dates or even fraudulent conduct, depending upon all of the facts and circumstances. Impact of Spring Loading and Bullet-Dodging The letter confirms that the accounting cost under APB 25 of options granted by public companies must be based upon the unadjusted market price of the company s stock of the same class as traded freely on an established market. Accordingly, the timing of option grants or the timing of the disclosures of material non-public information in advance of or after the grant of options in order to influence the market value of a company s stock, which would be used to determine the exercise price (so-called spring loading in the case of manipulation of grants or disclosure relating to positive information and bullet-dodging in the case of manipulation of grants or disclosure relating to negative information), does not affect the stock value for purposes of determining compensation charges. However, the letter notes that if the exercise price of a previously granted option is reduced to reflect the release of negative information, such a reduction constitutes a repricing which would result in variable accounting for the option. Limitations on the Guidance While the letter provides vitally important guidance, there are limitations on the guidance that should be noted, as follows: The letter only expresses the views of the Office of the Chief Accountant and has not been approved by the SEC. 4 Number 544 September 27, 2006

5 The letter expressly states that if option grant documents are dated as of a date earlier than the date of the award (so-called backdating ), the measurement date cannot occur until the date of the award or such later date as the option terms are determined. Hence, the letter provides no accounting relief for backdated options. The guidance provided by the letter is limited to the financial statement implications of measurement date issues and does not affect issues relating to option grant disclosure outside of the financial statements or footnotes thereto, or the circumstances under which any disclosure practices could violate laws or regulations. Hence, the letter in no way binds the SEC s enforcement or other divisions or private litigants with respect to option dating issues or option grant practices. The letter expresses no views as to how the appropriate grant date of an option should be determined for plan or income tax purposes. However, we are hopeful that the IRS will take a reasonable and real world view of historical option grant practices, as has the Office of the Chief Accountant, and will also conclude that imperfect execution of corporate formalities, paperwork issues and administrative delays do not change option grant dates or create discounted option problems for incentive stock options, income tax deduction purposes under IRC Section 162(m) or nonqualified deferred compensation characterization issues under IRC Section 409A, where the facts indicate that the option plan administrator intended to make contemporaneous or prospective option grants. The letter does not address how the materiality of stock option measurement date accounting errors should be determined under SAB 99 or how financial statements should or should not be restated or amended under APB 20, SFAS 154 or SAB 108. However, in an important note, the letter states that any companies that propose to correct material errors without amending all previous filings should contact the SEC s Division of Corporate Finance. Conclusion In a speech in July of this year, SEC Commissioner Paul Atkins said, [t]here is no securities law issue if backdating results from an administrative, paperwork delay. A board, for example, might approve an options grant over the telephone, but the board members signatures may take a few days to trickle in. One could argue that the grant date is the date on which the last director signed, but this argument does not necessarily reflect standard corporate practice or the logistical practicalities of getting many geographically dispersed and busy, part-time people to sign a document. It also ignores that these actions reflect a true meeting of the minds of the directors, memorialized by executing a unanimous written consent. Similar observations have been made by other regulators in the intervening months. The practical and commonsense guidance provided by the Office of the Chief Accountant s letter is consistent with these real-world views and the sound principle that accounting consequences should be based on all of the facts and not on legalisms. As such, it constitutes the most welcome news that many companies ensnared in option investigations and reviews have received since the option backdating imbroglio broke this Spring. 5 Number 544 September 27, 2006

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