Members of leading accounting firms in the United States have recently advised companies that their stock compensation plans may need to be amended to avoid future accounting charges on outstanding stock awards in the event of capitalization or stock adjustments such as stock splits, spin-offs, and stock dividends. Depending on the current terms of their stock plans, companies granting stock-based awards may wish to amend their stock plans to avoid such accounting charges. However, care should be exercised in amending such stock plans to avoid unintended consequences.
Common Capitalization Adjustment Provisions in Stock Plans
Most existing compensatory stock plans include a provision providing that in the event of a capitalization adjustment – such as a stock split, a spin-off or a substantial stock dividend – the company’s board of directors or the administrator of the plans may or must adjust the number of shares subject to the outstanding stock awards and, if applicable, the exercise or purchase price of the stock awards.
For example, if a corporation declared a two-for-one stock split, then an outstanding option to purchase 100 shares of stock of the corporation at $10 per share would become an option to purchase 200 shares of stock of the corporation at $5 per share. The total exercise or purchase price would not change.
The capitalization adjustment provisions in the stock plans are commonly drafted in one of three ways: (1) the adjustment is mandatory and the method of the adjustment is set forth in the plan document, (2) the adjustment may be made at the discretion of the board of directors or administrator of the plan, or (3) the adjustment is mandatory but the method of the adjustment will be determined at the discretion of the board of directors or administrator of the plan. Companies have included one of these provisions in their stock plans depending on how much discretion they wished to retain in making capitalization adjustments for outstanding stock awards.
New Concerns With Discretionary Capitalization Adjustments
Members of leading accounting firms in the United States interpreting Financial Accounting Standards No. 123R (Accounting for Share Based Compensation) have recently advised companies that if the stock plan capitalization adjustment is discretionary with the board of directors or administrator of the plan, then any future adjustments made in the event of a capitalization adjustment may result in an accounting charge for any affected outstanding stock awards (such as a stock option or restricted stock unit). The accounting charge will be a "modification" accounting charge based on the additional economic value of the stock awards on the adjustment date.
The issue applies primarily to stock awards under which stock will be purchased or issued in the future, such as stock options, stock purchase rights or restricted stock units. Stock appreciation rights would also likely be affected. On the other hand, restricted stock which has been granted to the service provider but is subject to forfeiture would likely be adjusted along with all outstanding shares of stock without an adjustment provision.
Companies wishing to avoid future accounting charges on outstanding stock awards will want to amend their stock plans to make such adjustment mandatory. As to the method of the adjustment, some accountants have taken the position that discretion may be retained as long as the adjustment is mandatory.
Unintended Consequences of Stock Plan Amendments
Companies that wish to amend their stock plans to make the adjustments mandatory should take care in adopting such amendments to avoid any unintended consequences. Some accountants have taken the position that if there was a discretionary adjustment provision, making the adjustment provision mandatory will not result in a modification accounting charge provided the amendment is not adopted in anticipation of a capitalization adjustment.
Companies amending their stock plans may also need to amend outstanding stock awards if the mandatory adjustments are to apply to the outstanding stock awards. However, amending outstanding stock awards may result in adverse tax consequences for the holders of the stock awards.
Although there is guidance in the current tax regulations that apply to incentive stock options1 ("ISOs") that indicates that an amendment of an outstanding ISO to provide for an adjustment to reflect a stock split or stock dividend should not automatically cause the option to lose its status as an ISO or cause the option to have to satisfy the conditions for an ISO on the date of the amendment, provided that there is no other enhancement made to the ISO,2 whether the change from a discretionary provision to a mandatory provision would be considered such an enhancement is unclear.
Similarly, proposed regulations issued under Section 409A of the Internal Revenue Code, which provides for new tax rules for deferred compensation, include provisions which may be read to permit an amendment to outstanding stock awards exempt from Section 409A to provide for a capitalization adjustment without the amendment causing the stock award to lose the exemption from the application of Section 409A.3
In some circumstances, it may be necessary to obtain the consent of the stock award holder to the amendment of the stock award depending on the terms of the stock plan and the stock award agreement.
Finally, when amending a capitalization adjustment provision, companies and legal counsel should consider all of the provisions of the plan. For example, companies and their counsel should examine the interaction between the capitalization adjustment provision and any separate change in control provision.
Working with Outside Auditors and Legal Counsel
Companies amending their stock plans to provide for mandatory adjustments should work with their outside auditors and legal counsel to avoid any unintended accounting and tax consequences, while preserving as much discretion and latitude as the companies desire.
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Pillsbury Winthrop Shaw Pittman Client Alert, Stock Compensation Provisions in Proposed Regulations Under Section 409A of the Internal Revenue Code, 18-Oct-2005
Footnotes
1. ISOs receive favorable federal income and employment tax treatment under Section 422 of the Internal Revenue Code. No ordinary income tax or FICA tax apply to the gain on exercise of an ISO (although the alternative minimum tax may be triggered) and if the purchased stock is held at least one year from exercise and two years from grant of the ISO, then any gain on the stock will be taxed at federal capital gains rates.
2. Generally, under the ISO tax regulations, amendments to an ISO that enhance the value of the ISO or provide a new benefit to the option holder will cause the amended option to be deemed a new stock option grant for ISO purposes. If the option cannot satisfy the requirements for an ISO on the amendment date – for example, if the original exercise price is less than the current fair market value – then the option cannot continue to qualify as an ISO. The ISO tax regulations provide an exception for an amendment if the exercise price and number of shares subject to the option are proportionately adjusted by the amendment to reflect a stock split (including a reverse stock split) or stock dividend that applies to all outstanding shares of the corporation.
3. Section 409A provides that stock options that are incentive stock options will be exempt from the application of Section 409A. The proposed regulations under Section 409A issued by the Internal Revenue Service also provide an exemption for non-statutory options on common stock that have an exercise price that is not less than the fair market value of the underlying common stock and do not have any other feature of deferral. For a discussion on the application of Section 409A to stock awards, please see Pillsbury Winthrop Shaw Pittman LLP Client Alert dated October 18, 2005.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
