Performance Options and Section 409A

[Guest Justin Case]

I am looking for some independent thoughts on a feature of an existing long-term incentive plan that has resulted in many 409A group discussions.

This award has a performance-based stock option component where the number of options that will eventually vest can range from none to 140% of a target number detailed in the agreement. The determining performance achievement levels will be measured at the end of a 3-year period.

The feature that is causing robust debate is the provision that sets the ultimate exercise price at the fair market value (fmv) of the underlying stock at the time the award was granted.

As an example: In 2004, 100 performance options were awarded with an exercise price of $4.00 which equaled the fmv of the stock on the grant date. Based on a 140% performance achievement level, the employee received 140 vested options at the end of the 3-year performance period with the grant date exercise price of $4.00. The employee will have 7 years to exercise the options.

Question: At the end of the period, the stock value is $10.00. How do you think the provisions of 409A would look at the spread between the vest date fair market value of $10.00 and the grant date based exercise price of $4.00?

Would the spread be immediately recognized as income or would the income be recognized when the employee chose to exercise? This is a performance based plan and these are non-qualified options.

I would provide my guess, but I would rather read the feedback.

[401 Chaos]

Justin,

I have not seen a 409A analysis of this particular type of performance-based arrangement before but my initial thought is that the fact that the options are granted at FMV at the date of grant should exempt them from 409A. It seems to me the chief difference between this arrangement and a standard nonqualified stock option plan is the fact that the total number of options ultimately received by participants in this plan may vary depending upon performance. At no point, however, does it seem that any options are actually granted as discounted options. Using the example you provided, it seems that if you originally granted 140 options at the $4 FMV and had no performance component then you should not have any 409A concerns. I am not sure that the fact that the exact number of options ultimately vested is unknown on the grant date is critical if the general range of total options that may be granted is spelled out at grant. This plan seems to be roughly equivalent to agreeing to grant a participant 140 options at FMV at grant but then including vesting requirements (or forfeiture / clawback provisions) to decrease options if certain performance goals are not met along the way. I would not think that type of arrangement would raise 409A issues and so wonder if your arrangement would as well. I will be interested in others' thoughts.

[TCWalker]

OK, I'll bite. I'll guess the controversy is the vesting scheme looks like an discounting scheme, that is to say the option price and isn't actually fixed at time of grant, it's effectively offering a contigent discount by increasing the option grant later at the fixed FMV. So if this analysis has any merit, any "vesting" in excess of 100% would trigger 409A because the exercise price becomes effectively less than the FMV of the stock at time of grant.

[E as in ERISA]

At a minimum, I'd think that you'd have 40 shares subject to 409A.

The initial 100 might arguably meet the requirements for exemption from 409A -- issued at FMV. I haven't paid attention to discussions to see what the feeling is about performance vesting -- i.e., whether that is a feature that is considered an additional deferral and violates the exemption. If I recall correctly, under 162(m) that would be a feature that would take it out of the exemption there and subject it to the requirements. But that is a different exemption.

But isn't the actual grant date for the other 40 actually 2007? So the strike price is probably lower than the FMV at that date? And therefore, it doesn't meet the exemption?

Then the timing of the taxation depends on whether you comply with 409A election and distribution rules. If you don't comply, then you're probably taxed at vesting. But if you do comply, then you defer taxation until the time of "distribution" under plan rules or the participant's election. And then the question is whether you have a performance-based plan, so the participant can make their elections six months before the end of the performance period? But that's the problem with options...it doesn't really make sense to follow 409A rules...so you're probably back to taxation at vesting.

[401 Chaos]

I agree that the issues raised by others are real concerns; however, I think there is still an argument to be made that the additional vesting should not constitute discounted options if the performance criteria and corresponding vesting percentages are spelled out at the time of grant. What if instead of the 140% vesting terminology there was simply a chart provided at grant that showed number of options to be received based on the scaled performance criteria. Nobody knows what will ultimately be distributed but the maximum grant amount is clearly spelled out. Perhaps this answer depends on the nature of the performance criteria and how objective they are. I certainly agree that if it is to be based on subjective criteria that there is potential for abuse and manipulation but I would not easily concede this if the criteria were truly objective. This just seems to me to be something of a different issue than the classic discounted option situation where a participant has an income spread beginning with the initial grant.

In the end, however, I am not sure it is possible to receive a definitive answer based on current guidance.