Introduction

Stock options are often a significant, and critical, component of a public company's compensation and benefits programs as they align the interests of employees and stockholders—when the company's stock price increases, option holders and stockholders alike benefit. When a company's stock price falls below the exercise price of outstanding options (that is, when the options become "underwater"), the incentive value of the options is reduced and, if the stock price falls significantly and/ or experiences a sustained decline, the incentive value can be all but eliminated. When options have been underwater for a prolonged period of time, public companies invariably consider a variety of ways to restore that lost value, including by "repricing" the options.

The term "repricing" can be effected with several different types of structures, ranging from a straightforward reduction in the exercise price of an outstanding option to the exchange of the option for a different type of equity award and/or a cash payment. For a public company, whether to pursue a repricing and the structure of any repricing that is pursued will be informed by a number of compensation, governance, legal, accounting, tax and investor relations considerations. In this alert, we provide an in-depth discussion of the key considerations that are relevant to any option repricing program (the highlights of which are provided in the box below), a summary of common repricing structures (including advantages and disadvantages of those structures), and a discussion of the approval and implementation process for a repricing.

Repricing Considerations in a Nutshell

Profile of Underwater Options – Companies must understand how many underwater options are outstanding (in absolute numbers and as a percentage of outstanding options), how deeply underwater those options are, what the remaining terms of the underwater options are, who holds the underwater options, whether key employees necessary to drive the business have other equity awards or compensatory arrangements that are sufficiently incentivizing and retentive, as well as the number of remaining shares available under the company's equity plan and the ability to successfully increase the shares available under the plan if needed. Scoping the compensation and business need for a repricing in this way provides the framework through which the considerations below can be analyzed more deliberately.

Stockholder Approval and Investor Relations – Companies traded on a stock exchange generally must obtain stockholder approval of an option repricing. This may be because the exchange's listing rules and the terms of the underlying equity plan require it or, even where they do not, because it may be prudent to seek such approval to avoid jeopardizing stockholder approval of subsequent equity compensation proposals (such as equity plan or say-on-pay proposals), to avoid receiving votes against members of the company's compensation committee and to mitigate the likelihood of stockholder litigation. As a result, companies must understand their stockholder base, which repricing structures are more likely to obtain a favorable proxy advisor recommendation, which structures are most likely to receive stockholder approval and whether such structures accomplish the company's intended compensation and business goals.

Equity Plan Terms – In addition to any terms relating to whether or not stockholder consent may be required, terms such as the number of shares that remain available for issuance under the company's equity plan, the plan's share recycling provisions, any per-participant limits (including limits on non-employee director compensation) and minimum vesting provisions may all inform the appropriate (and permissible) structure of a repricing.

Accounting and Tax Considerations – The structure of the option repricing will determine whether or not the repricing will generate incremental compensation expenses. And while option repricings can generally be undertaken without any significant adverse tax consequences, a repricing may result in a loss of "incentive stock option" status for the original underwater options.

Future Outlook – If the company's circumstances or market forces are such that the stock's trading price may (or is likely to) further decline after a repricing has been undertaken, the company may achieve the desired compensation and business goals only if underwater options are exchanged for a different type of equity award and/or cash rather than relying on a structure that simply reduces the exercise price of underwater options.

Eligible Participants – The tax, securities and other local law requirements applicable to non-U.S. employees must be analyzed on a jurisdiction-by-jurisdiction basis.

Time and Expense – If stockholder approval of an option repricing is required, significant internal resources will be needed (as well as external legal, accounting and compensation consultant costs incurred) as the company must solicit that approval by preparing, filing and disseminating a proxy statement, which may be included as part of the annual meeting proxy statement, but may be in connection with a special meeting of stockholders. In addition, to effect the repricing itself often requires a tender offer (effected by filing a Schedule TO with the Securities Exchange Commission (the "SEC")) which will also result in significant internal and external costs.

Repricing Considerations

Option repricing is a complex, time-consuming and costly undertaking that must be approached cautiously and deliberately, with significant input from the company's counsel, independent compensation consultant, accountants and other outside advisors. That time, cost and planning may be well worth it, though, if the company can successfully undertake a repricing that achieves its compensatory and business goals. In order to realize that result, the company will have to carefully consider the following:

1. Employee Incentives. Stock options are intended to align the interests of employees and stockholders—when the company's stock price increases, option holders and stockholders alike benefit. When a company's stock price falls below the exercise price of outstanding options, the incentive value of the options is reduced and, if the stock price falls significantly and/or experiences a sustained decline, the incentive and retentive value can be all but eliminated. Even in a poor economy, a company's executives and key employees often have other employment opportunities, and the lack of effective equity incentives may make the departure of those individuals—where the employees can receive new options with exercise prices reflecting the prevailing market conditions—more likely. As a result, a company may believe that option repricing is necessary to retain employees who are instrumental for the company's success.

2. Stockholder Approval and Investor Relations. The New York Stock Exchange (NYSE) and Nasdaq require listed companies to obtain stockholder approval of any repricing unless the underlying equity plan explicitly permits options to be repriced without stockholder approval. The exchanges take an expansive view of what qualifies as a repricing that is subject to stockholder approval, including the following actions: (1) reducing the exercise price of an option after it is granted, (2) canceling an option at a time when its exercise price exceeds the fair market value of the underlying stock in exchange for another option, restricted stock or other equity, except in connection with a merger, acquisition, spin-off or other similar corporate transaction, (3) any other action that is treated as a repricing under generally accepted accounting principles, or (4) any other action that has the same effect as any of the foregoing. While the stockholder approval requirement may be avoided if the company's equity plan permits repricings without stockholder approval, few plans include such explicit authority to reprice options without stockholder approval because the company's institutional investors often rely on the recommendations of proxy voting advisory services like Institutional Shareholder Services (ISS) and Glass Lewis, and those services strongly disfavor option repricings generally, and repricings that can be effected without stockholder consent in particular. ISS, for example, will recommend against stockholder approval of any equity plan that permits repricing without stockholder approval and will recommend against the members of the company's compensation committee if a company with such authority actually goes ahead and reprices options without stockholder approval. Similarly, Glass Lewis notes that an equity plan should not permit repricing of stock options and reviews any repricing history and any express or implied rights to reprice when assessing equity plan proposals. Glass Lewis will also generally recommend against the members of a company's compensation committee if the company reprices options without stockholder approval. Thus, in most cases, a company that is listed on the NYSE or Nasdaq will need, or consider it prudent, to obtain stockholder approval before repricing outstanding options and, for many companies, obtaining a favorable recommendation from the proxy voting advisory services will be a critical factor in obtaining stockholder approval.

ISS Voting Guidelines

ISS 2023 voting guidelines state that it evaluates option repricing proposals on a case-by-case basis, giving consideration to the following factors:

  • Historic trading patterns—the stock price should not be so volatile that the options are likely to be back "in the money" over the near term.
  • Rationale for the repricing—was the stock price decline beyond management's control?
  • Is this a value-for-value exchange?
  • Are surrendered stock options added back to the plan reserve? If so, then also take into consideration the company's total cost of equity plans and its three-year average burn rate.
  • Timing—repricing should occur at least one year out from any precipitous drop in company's stock price.
  • Option vesting—does the new option vest immediately or is there a blackout period (i.e., limitation on exercisability)?
  • Term of the option—the term should remain the same as that of the repriced option.
  • Exercise price—should be set at fair market or premium to market.
  • Participants—executive officers and directors must be excluded.

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