With the recent market downturn adversely affecting the stock prices of a large number of companies, many stock options are underwater — that is, their exercise prices are higher than the market price of the underlying stock. Such stock options, issued as part of a company's equity compensation plan, have lost one of their most vital elements — incentive. One method that companies may pursue to address underwater stock options is to undertake a repricing. Option repricings take the form of a wide variety of different exchange programs, including those that involve the issuance of different forms of equity compensation, such as restricted stock and restricted stock units ("RSUs"), in exchange for underwater stock options.

Due to recent regulatory, accounting and market-practice developments, simply lowering the exercise price of the underwater option to the new prevailing market price of the company's common stock, an approach that was often used during the 2001 and 2002 technology-stock bear market, is no longer common practice. The adoption of FAS 123R increased the accounting cost of a one-for-one option exchange and generally eliminated any accounting advantage that stock options had over other forms of equity compensation. To further complicate the repricing landscape, companies now face securities-law issues in connection with their interactions with their shareholders when conducting a repricing. In 2003, the New York Stock Exchange and the Nasdaq Stock Market adopted a requirement that public companies seek shareholder approval of any material change to an equity compensation plan, which generally includes an option repricing under most plans. Shareholder approval requires companies to undertake a proxy solicitation by filing a proxy statement containing, among other things, clear reasoning behind the exchange offer and disclosure regarding its impact. The need for shareholder approval has also been enhanced as a result of the growing influence of proxy advisors who believe that shareholders should approve repricings irrespective of whether exchanges so require. In addition, because option repricings involve the purchase, modification or exchange of a security, companies need to comply with the U.S. tender offer rules (with minor modifications permitted by the SEC in connection with option repricings), which are triggered when such investment decisions relating to repricings are involved.

There are a number of alternatives for companies wishing to reprice underwater stock options. Companies now generally undertake a "value-for-value" exchange, which affords optionholders the opportunity to cancel underwater options in exchange for an immediate re-grant of new securities with an exercise price equal to or less than the fair market value of such shares. A benefit of the value-for-value exchange is that such an exchange may be treated as a neutral event from an accounting expense perspective. A value-for-value exchange can involve the cancelation of existing options and the issuance of new options at a ratio of less than one-for-one or the grant of restricted stock or RSUs, in each case, with the same or a lower economic value than the canceled options. In addition, instead of an exchange, a company may simply repurchase underwater options from employees for an amount based on Black-Scholes or another option pricing methodology.

The issue of option repricings is likely to increase in importance during the last quarter of 2008 as companies consider items for inclusion in their 2009 proxy statements. If shareholder approval will be required to undertake a repricing (as is generally the case) companies with underwater options should consider now their strategy for addressing this challenge in connection with their annual meeting. Sufficient time should be allowed to obtain advice from compensation consultants, advance review of option repricing proposals by proxy advisors and requisite compensation committee and board approvals. Companies may also want to consider now how to address underwater options so that they can condition their 2009 annual grant of options (or other securities) on employees relinquishing their underwater options. This approach will not remove the need for shareholder approval and a tender offer, but it will likely reduce the compensation expense associated with the annual grant and will likely result in a larger number of underwater options being canceled.

We have distributed a detailed memorandum discussing these matters, and possible strategies, in more detail. Please click here to download (PDF). We stand ready to discuss these matters with you at your convenience.

If you would like to know more about the topic mentioned above, please contact the White & Case lawyer with whom you regularly discuss securities matters or any of the following lawyers:

Colin J. Diamond
Partner, Securities Practice
New York
+ 1 212 819 8754

Gary Kashar
Partner, Securities Practice
New York
+ 1 212 819 8223

Andrew L. Oringer
Partner, Executive Compensation
and Benefits Practice, New York
+ 1 212 819 8561

Kenneth A. Raskin
Partner, Executive Compensation
and Benefits Practice, New York
+ 1 212 819 8508
 

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