This article appeared in the July 2000 issue of The Metropolitan Corporate Counsel

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1 This article appeared in the July 2000 issue of The Metropolitan Corporate Counsel Underwater Options Exchange: 6+1 Can Equal Zero (Book Expense) Authors: Gary S. Rothstein & Joseph E. Ronan, Jr. * Background Traditionally reserved for top-level management, stock option plans have become broadbased vehicles providing options to lower level management and even to unionized employees. Options are considered a critical component of an overall compensation package, particularly in the technology sector. Companies use stock options as a tool to attract, retain, and motivate talent. Granting options can conserve (and even increase) company cash flow, give employees a sense of ownership, link compensation to company performance, and generate significant tax benefits, all without an adverse impact on the company s bottom line. Thus, options in a rising stock market can be a highly effective tool. However, due to the recent decline in the stock market, large numbers of employees have been left holding underwater options-- options that cost more to exercise than the cost of purchasing the stock at its fair market value. This can create dissatisfaction among employees, and have a demotivating effect. Consequently, many companies have considered ways to address the underwater option problem in fear of losing employees to competitors, where the employee would likely start fresh with an option striked at market. The Repricing Controversy * The authors gratefully acknowledge the valuable assistance of Laurie Nelson, a summer associate with Morgan Lewis. 1

2 The traditional way to handle this problem was through a simple adjustment in the option exercise price to the current market value, a practice known as option repricing. Shareholders, especially institutional shareholders, who have realized a significant decline in their investments, frown upon repricings. They view repricing as a way of making options risk free. If the stock price goes up, the employee profits; if the stock price goes down, the options are repriced, a process arguably contrary to the intended purpose of equity compensation-- using the option grants to tie employee interest to company performance. The dissent voiced by shareholders has not fallen on deaf ears. Both the Securities and Exchange Commission ( SEC ) and the Financial Accounting Standards Board ( FASB ) have looked more closely at options repricing. The flack over the repricing issue led the FASB to change the accounting rules; and, as discussed in greater detail below, due to the harsh financial consequences, the number of traditional repricings has declined. Accounting Effects of Repricing Options In financial accounting parlance, equity compensation is accounted for on either a fixed basis or a variable basis. From the perspective of a company s bottom line, fixed accounting is preferable because the value of the stock is measured on the date of grant, and future increases in stock price are not relevant. In the case of an option accorded fixed accounting treatment, there will be no charge to earnings if the exercise price is at least equal to the market price on the date of grant. This is true notwithstanding that their value of the stock may have appreciated above the exercise price on the date of exercise. Under financial accounting rules applicable before December 15, 1998, a repricing did not result in any compensation expense so long as the option price was not reduced below the 2

3 fair market value of the stock on the date of repricing. Under the new rules, embodied in FASB Interpretation Number 44 ( FIN 44 ), the FASB effectively determined that the repricing of an employee option causes that option to be accounted for on a variable, rather than a fixed, basis from the point of repricing forward, resulting in a compensation expense in each accounting period for any appreciation in the shares during such period. These expenses are recorded for so long as the option remains outstanding -- not just throughout the vesting period, but until they are exercised, forfeited, or expire unexercised. The reasoning is that if the exercise price is reduced after the option is initially granted, the exercise price cannot be considered fixed at the time of grant; it must be considered subject to future change, or variable. In light of the new negative accounting rules, companies have explored alternatives to traditional repricing. Alternatives to Repricing Underwater Options According to FIN 44, a cancellation of outstanding options and regrant of new options within a six-month period is an effective repricing. The likely rationale is that the issuer and the optionee should be exposed to market risk for at least six months to avoid treating the cancellation and regrant as part of the same transaction. In light of FIN 44, some companies have opted for a delayed repricing by canceling underwater options and granting new options-- with an exercise price equal to the market value of the stock on the new grant date to be issued at least six months and one day later. This 6&1 option exchange, also known as a slow motion swap, is an alternative to traditional repricing and can avoid the negative accounting consequences of FIN 44. Because the re-grant at least six months and one day later is not linked 3

4 to the initial issuance, variable accounting that would otherwise be imposed under FIN 44 is avoided. The downside to the 6&1 option exchange is that the employee loses any potential value that may be realized from stock appreciation during the six month period between the cancellation and the subsequent re-grant. The drawback for shareholders is that employees arguably have incentive to keep the stock price down during the waiting period. Nevertheless, the 6&1 remains a popular alternative to traditional repricing. Sprint Corp., whose stock price fell significantly in the NASDAQ sell-off and after its failed merger with WorldCom, has been deemed the pioneer of the 6&1 option exchange. Sprint announced last November that it would allow employees, but not certain officers or directors, to give up their underwater options and receive an equal number of new options six months and one day later, at the prevailing market price. Sprint thus realized no charge to earnings. In 2001, at least 25 companies have already followed suit by implementing a 6&1 option exchange program. An alternative to the 6&1 option exchange is to simply grant more options with an exercise price equal to the stock s current value, but leave the underwater options alone. This will not result in adverse accounting treatment, but results in double dilution and once the stock price recovers, employees receive a double benefit. Mircosoft and Intel, among others, have gone this route. To potentially eliminate the double benefit, a truncated or wraparound option could be granted, which would link the expiration date of the new options to the exercise price of the underwater options. So long as the new options remain outstanding and exercisable for at least six months, regardless of whether the stock price reaches the underwater options exercise price, FIN 44 allows the new option grant to be treated as a separate fixed grant award so that variable accounting is avoided. 4

5 Another strategy is swapping underwater options for shares of company stock at the new lower price. Underwater shares are typically exchanged on a ratio basis for restricted stock -- i.e., one share of stock for every four underwater options. A restricted stock swap will typically result in less expense than variable accounting on repriced options, since the accounting hit for restricted stock is limited to initial value of the issued stock. To minimize the need for future repricings, companies may consider awarding more frequent grants with an exercise price equal to the market price at each grant date. Such cost averaging can buffer the effect of volatile stock prices by the issuance of smaller options more frequently, such as on a quarterly rather than an annual basis. Shorter option terms may also be valuable to a broad-based employee group. Underwater options expire more quickly which allows for new grants, manages dilution, and minimizes the need to reprice. Companies may opt to combine options exchange strategies. In February 2001, Vignette Corporation, a Texas-based provider of software products and services, announced a combination 6&1/Restricted Stock Swap that created only a limited charge to earnings. In April, Broadcom Corporation, a California telecom equipment maker, announced a 6&1/Make-up Grant that created no charge to earnings. This year, at least five companies have announced a combined options fix. Issues To Consider 5

6 Institutional investors will inevitably scrutinize a repricing. While stock option repricing plans are not typically welcomed, Polycom, Inc. s 6&1 proposal has become an exception. For its options exchange program--where employees receive options to purchase 0.85 share for every option to purchase one share that they exchange-- the California-based conferencing-equipment maker has the backing of Institutional Shareholder Services ( ISS ), a global provider of proxyvote recommendations. Polycom is the first company to ask shareholder permission for a 6&1 exchange. ISS acknowledges that most repricing plans are put in place without shareholder say in the process; but when shareholder permission for a 6&1 is sought, the majority of companies receive ISS s vote, particularly where the exchange is on a less than one-for-one basis. There are pluses and minuses to any repricing strategy. Initial issues to be considered in deciding whether and how to reprice options should include: the extent to which options are underwater and by how much; reasons why the options are underwater; the real risk of employees being lost to competitors, and the likely reaction of institutional investors. There are also significant tax issues to be considered. Further, in light of recent SEC pronouncements, it has become clear that a cancellation and future issuance is technically a tender offer. Currently, exchange offers that are subject to the tender offer rules and are conducted for compensatory purposes are exempt from having to comply with the requirement that tender offers be extended to all security holders of a class at the same price, so long as certain conditions are met. However, it is still the obligation of a listed company to notify the SEC and ensure they are in full compliance with securities regulations including filing a form TO, adequately disclosing financial information about the issuer and risks employees should consider in deciding whether to accept the exchange offer. The SEC warns 6

7 that companies considering these offers should consider the anti-fraud and anti-manipulation provisions of the federal securities laws. Once a repricing strategy is selected, a set of macro messages should be used with all key audiences including why the change in the plan, who will be affected, what will be implemented, and how and when the program will work. Then more specific messages to target audiences should be developed (i.e., for shareholders, the board of directors, executives, managers, eligible employees, analysts, and business press). Typical employee communications should include an exchange offer memorandum, frequently asked questions and answers in laymen s terms, personalized statements, and an election form. 7