Option "Repricing" One Year After FIN 44

The FASB severely restricted issuers' ability to "reprice" options with its release last March of FASB Interpretation No. 44 ("FIN 44"). Under FIN 44, the once-common practice of canceling higher-priced options and replacing them with options with lower exercise prices now triggers prohibitive financial accounting consequences. The new, lower-priced options become subject to "variable" option accounting. This means that any increase in the value of the underlying stock above the exercise price from the date of grant until the date the option either is exercised or terminates must be recorded as a compensation expense.

Despite this rule, over the past year issuers whose stock price has declined and whose employees hold "underwater" options (options with exercise prices greater than the market value of the stock) have found ways of providing nearly the same economic benefit to optionees without adverse accounting consequences and, in many cases, without additional dilution.

Background

Stock options are issued to attract and retain employees and to align their interests with those of other shareholders. Stock options are attractive to issuers because they receive favorable accounting treatment. When options are granted to employees with exercise prices equal to the market value of the underlying stock on the date of grant, there is no compensation expense to the issuer. At the same time, employees view the potential returns from their options as a major reason for joining and remaining with a growth company.

On the other hand, underwater options quickly lose their luster and cease to motivate and retain the optionees who hold them. Adding insult to injury, in a company where options are granted to new hires while the stock price is falling, long-term employees find themselves holding options with higher exercise prices than those of the new hires.

Under financial accounting rules applicable prior to December 15, 1998, there was no compensation expense when old options were cancelled and replacement options were granted at the market value of the stock. The reasoning at that time was that (i) there is no expense as a result of an option cancellation and (ii) there is no expense if options are granted with exercise prices equal to the market value of the stock. By contrast, under FIN 44, when options originally granted at $20 are cancelled and replaced with options at $10, and those replacement options are later exercised at $50, the issuer must recognize a compensation expense of $40. The reasoning now is that if the exercise price of an option is reduced after the option is first granted, it cannot be considered "fixed" at the time of grant. Instead, the exercise price must be viewed as subject to further change or "variable" for the life of the option. This result is prohibitive for most companies.

Strategies After FIN 44

Notwithstanding FIN 44 and the related accounting rules, there continue to be several less punitive ways of returning value to optionees who hold underwater options:

An employer whose compensation program includes stock options that are currently underwater may find it necessary to restore some of the value of those options to its employees. Otherwise, it risks losing its employees to companies that appear to offer greater potential upside in their equity compensation.

At the same time, there are practical limits to the number of options that an issuer may have outstanding at any one time. In the past, the option repricing rules permitted an issuer to cancel old options and grant new ones, thereby keeping the number of outstanding options relatively unchanged.

Under FIN 44 a traditional repricing generally is prohibitive. However, it is still possible to restore value to optionees whose options are underwater while limiting the adverse consequences of doing so.

You are invited to call any member of the compensation and benefits group at Smith Anderson to discuss the best ways to accomplish both objectives for your firm.

Caryn Coppedge McNeill
Stephen G. Driggers
Jamie H. Hinkle

Smith, Anderson, Blount, Dorsett, Mitchell & Jernigan, LLP
Raleigh, NC

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