Correction of Discounted Stock Options

[401 Chaos]

I have been researching potential correction alternatives for discounted stock options and am having a difficult time finding recent guidance. In particular, I am concerned with discounted options granted last year that have not yet vested. Correction under the discounted option provisons in Section V (E) of Notice 2008-113 does not appear available because (1) some options were granted to "insiders" and no correction was made in 2008, and (2) all options were granted under a plan / agreement that did not expressly require options to be granted with exercise price at no less than FMV (i.e., the plan says the Board can determine exercise price of NSOs). Both of those seem prerequisites for correcting under 2008-113's express provisions regarding discounted stock options in Section V(E).

Because the express correction provisions for discounted options under 2008-113 do not seem available, we are looking at whether there are other possible alternatives for correcting or modifying unvested discounted options at this time in order to avoid or limit 409A liabilty. Our general theory being that since the options have not vested, they have not triggered taxes for 409A or other purposes yet and there should be something that can be done prior to vesting to avoid 409A issues. Some possible considerations include:

1. Is it possible to correct the discounted options under Sections VI and/or VII of 2008-113 if the options otherwise qualify even though the options do not qualify for correction under Section V(E) of 2008-113. Unlike Section V(E), correction under Sections VI or VII would result in a 20% penalty / excise tax on some amount. What would this 20% tax be assessed on in such cases--20% of the spread between the exercise price and what the exercise price should have been on the date of grant, 20% of the spread between the exercise price and the FMV on the date of the correction, or something else?

2. Could we argue that since the options have not yet vested, under 2008-115 and the proposed tax regulations that we should be able to amend the awards prior to vesting to comply 409A (e.g., by simply increasing exercise price to what it should have been on date of grant or maybe leaving the exercise price but requiring the options to be exercised upon a 409A-defined change in control)? (Seems that would only have chance of working, however, to the extent the amendments could be made prior to the beginning of the year the options otherwise vest. Unfortunately, many of our options will vest in 2009 so it may be too late to amend unvested options?)

3. Could we cancel or terminate the discounted stock options prior to vesting and then simply regrant participants new restricted stock shares to make up the difference (or alternatively arrange for an option exchange program prior to vesting to swap out the discounted options for restricted stock)? Would this constitute a prohibited modification of a stock right under the 409A regulations or otherwise subject the replacement stock grants to 409A and 409A excise taxes?

In short, I am confused about whether the limited provisions in Section V (E) of Notice 2008-113 addressing correction of discounted options is the sole correction alternative for discounted options such that if you do not qualify under that, there is no other fix. If 409A tax event does not occur until discounted options actually vest, can you do something outside of the express discounted option correction procedures outlined in 2008-113 to fix them?

[jpod]

I look at it this way. Absent vesting, no consequences under 409A have been triggered, so surely you can terminate the non-compliant option without triggering 409A. If you can do that, it seems logical that you should be able to cure this problem by re-pricing up, although if the current FMV is greater than the FMV at the time of the original grant I think you would have to re-price up to the current FMV. You have to parse through the pertinent provisions of the regs. and Secton 409A itself. I am not suggesting that this is covered by or that you even need 2008-113.

[401 Chaos]

jpod,

Many thanks for weighing in. I certainly hope you are right and agree that is a logical way to look at things. Unfortunately, in our case granting a new option at current FMV is probably a nonstarter as the current FMV is substantially above the discounted exercise price. The company may be sold in the near-term. As such, optionees would probably be better economically to keep the discounted option price and take the 20% hit for the excise tax than to get new option grants at current FMV. That is the thing that was leading us toward possible grants of restricted stock instead. That has me worried though that converting the option to a restricted stock award might be considered an impermissible modification since it could result in the reduction in the exercise price. Or maybe also be considered an impermissible amendment of the original option grant (which I think would be considered a deferred comp plan even though unvested, just not one that would have triggered 409A taxes) to the extent the amendment / regrant / exchange happens in the same year the discounted option would otherwise vest. Many thanks

[jpod]

Just curious, but is this a public company? If not, what kind of evidence is there that the exercise price was less than FMV given the flexibility allowed by the regs?

[jpod]

Given that they are not vested, another alternative may be available. If nobody is interested in actually exercising, and they are all looking to cash in upon the sale, consider amending the discounted options so that they comply with the 409A rules, rather than attempting to rely on the exemption for stock options. Again, I don't think you have a 409A event prior to vesting, and subject to a review of the pertinent provisions of the regs. I would think that if you amend a deferred compensation arrangement to comply with 409A prior to vesting, I think you should be ok, even post-12/31/08.

[401 Chaos]

Thanks Jpod. This is a private company and we have pressed on whether there is sufficient support for the valuation / exercise price used with the options. At this stage, we're thinking it probably is discounted for various reasons.

We've considered trying to amend the options to address the discount issue by amending the options to actually comply with 409A (e.g., say providing for cash-out / exercise only upon a change in control as defined in 409A). The big concern there, however, seems to be that although the proposed regulations issued on December 8th seem to permit amendment of unvested deferred compensation arrangements to fix them / to comply with 409A, (if I read and understand correctly) they only permit such amendments prior to the year the deferred comp amounts otherwise vest. Put another way, the regulations seem to say that if there is 409A noncompliance during the year in which deferred amounts vest, you basically have to treat the deferred amounts as noncompliant for 409A purposes for that year even if amended / fixed to comply with 409A prior to actual vesting. So, if we had a sale coming up in 2010 or we had corrected this in 2008, I think this would work but not if we have a correction and sale both in 2009. I'm not sure I follow precisely how the proposed regulations envision the taxes playing out in a discounted option context or exactly what to think of the status of the proposed regulations but there seems to be enough concern there that I would worry any sort of change, amendment, modification of the existing option agreement in 2009 (which, again, if all goes well, will be the year all of the options vest due to change in control) would not keep the options from getting taxed as discounted options for 2009. Such amendments might include not only changing to have a fixed schedule or 409A-compliant exercise trigger but also amending to increase the exercise price to FMV on date of grant or maybe even canceling or converting the option to a restricted stock award.

I'd be thrilled though for somebody to tell me I'm reading too much into the proposed regulations or otherwise point out a way around the apparent prohibition on amending / fixing the options in the same year the options vest.