Misdated Options and Section 409A:  A Toxic Mix

Employee Benefits Alert
10.20.06

Summary

The recent news has been replete with stories about companies granting discounted stock options (i.e., options with an exercise price below the fair market value of the underlying shares at date of grant) to their employees. In some cases, this practice has occurred through the company’s intentional backdating of the options; in others, the discount was the unintended result of the company’s inadvertent failure to observe the requirements of its internal grant procedures. In either case, the grant of a discounted stock option may have resulted in a financial expense under the applicable accounting rules.

Public companies that have reported or that expect to report a financial expense due to misdated options for a prior period are now confronted with a pressing federal tax issue: December 31, 2006, is the deadline for correcting such stock options that are held by corporate insiders. If these discounted stock rights are not corrected by the deadline, they will be in violation of section 409A of the Code. As a result, corporate insiders holding discounted stock rights that are vested may be subject to immediate income tax on the amount of spread compensation attributable to the option plus a 20% additional tax. Other adverse tax consequences may also come into play.

For the reasons set forth below, it will be important for tax directors of public companies to coordinate with their counterparts in corporate law and finance in the evaluation of (i) their company’s exposure to having to report financial expenses for prior periods due to discounted stock rights and (ii) any corrective action to be taken under section 409A by the end of 2006. One of the principal reasons for mounting a coordinated effort is that the tax rules may not necessarily coincide with the accounting rules, thus raising the possibility of a grant or series of grants being viewed as issued at a discount under one regime (e.g., accounting), but not under the other regime (e.g., tax). These differences are explained more fully below.

IRS Notice 2006-79

The December 31, 2006, deadline for correcting discounted stock rights arises as a result of IRS Notice 2006-79, which was issued on October 4, 2006. Under the Notice, although the section 409A transition period was generally extended until December 31, 2007, transition relief beyond December 31, 2006, was denied to any stock right (i.e., stock option or SAR) that --

(1) was granted by a corporation with respect to its stock that as of the date of the grant had issued any class of common equity securities required to be registered under section 12 of the Securities Exchange Act of 1934 (“Exchange Act”);

(2) was granted to a person who, as of the date of grant, was subject to the disclosure requirements of section 16(a) of the Exchange Act with respect to such issuer; and

(3) with respect to the grant of such stock right, such corporation either has reported or reasonably expects to report a financial expense due to the issuance of a stock right with an exercise price lower than the fair market value of the underlying stock at the date of grant that was not timely reported on financial statements or reports for the period in which the related expense should have been reported under generally accepted accounting principles.

Thus, for stock rights issued by a public corporation to its directors, officers, or more than 10% shareholders, the exposure to the December 31, 2006, deadline depends on whether the corporation has or reasonably expects to report a financial expense because the stock rights were issued at a discount, the effect of which was not timely reported at an earlier date. Whether or not a stock right was issued at a discount for financial reporting purposes depends on the applicable accounting treatment.

Potential for Reporting Financial Expenses Where No Intentional Backdating

In this connection, the Office of the Chief Accountant of the Securities Exchange Commission issued a letter dated September 19, 2006, summarizing the staff’s views regarding the accounting for stock options in the historical financial statements of public companies (“SEC Letter”). In particular, the SEC Letter discusses the accounting consequences under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”), in a number of different circumstances, including the consequences of option grants that are accompanied by administrative delays in formalizing the grants, such as instances of oral awards of options where the documentation was completed later, and situations in which the award authority was delegated within specific parameters to management, with the appropriate approvals not obtained until a later date. The SEC Letter is relevant for prior periods inasmuch as APB 25 has been superseded by Statement of Financial Accounting Standards No. 123(R).

The SEC Letter points out that proper accounting under APB 25 relies heavily on the determination of the “measurement date,” which is defined as “the first date on which are known both (1) the number of shares that an individual employee is entitled to receive and (2) the option or purchase price, if any.” The SEC Letter goes on to note that typically the date when the “required granting actions” specified by a company’s corporate governance provisions, stock option plans, and applicable laws are completed has generally been regarded as the measurement date. The SEC Letter observes that any conclusion that a measurement date has occurred before the completion of the required granting actions must be carefully considered, inasmuch as the applicable corporate governance provisions, the terms of the relevant stock option plan, or the provision of applicable laws may require certain procedures to be completed in order to effect a stock option grant, and these provisions would otherwise suggest that the underlying terms of an option may not have been final (or “known”) until those procedures were completed.

The SEC Letter refers in this regard to FASB Interpretation No. 44, “Accounting for Certain Transactions Involving Stock Compensation” (“Interpretation 44”) in which it is noted that a measurement date for an option cannot occur before shareholder approval except in the very limited circumstances that management and the board of directors control sufficient shareholder votes to approve the plan. It is possible that required granting actions, other than shareholder approval, may also delay the measurement date. Under APB 25, the final amount of compensation cost of an option is measured as the difference between the exercise price of the option and the market price of the underlying stock at the measurement date. The option is “in-the-money” if the market price exceeds the exercise price on the measurement date (or, for income tax purposes, on the grant date). An option is said to be “at-the-money” if the market price and exercise price are the same on the measurement date or grant date, as the case may be.

Tax Rules for Determining Grant Date

The income tax rules relating to the time and date of granting statutory options, i.e., ISOs and options granted under an employee stock purchase plan, are set forth in Treas. Reg. § 1.421-1(c). These regulations provide that “the date of the granting of the option,” “the time such option is granted” and similar phrases refer to the date or time when the granting corporation completes the corporate action constituting an offer of stock for sale to an individual under the terms and conditions of a statutory option. A corporate action constituting an offer of stock for sale is not considered complete until the date on which the maximum number of shares that can be purchased under the option and the minimum option price are fixed or determinable. Although the regulations specifically address statutory options, it may be appropriate to turn to the principles established in these regulations in determining the grant date of nonstatutory stock options, as well. However, at least one court has rejected the application of the predecessor of these regulations to a nonstatutory stock option, in favor of applying state law. See Robinson v. Commissioner, 82 T.C. 444, 453 & n.16 (1984).

Tax Consequences of Discounted Stock Options and SARs

Section 409A provides an exclusion for certain stock rights but only if their exercise price is equal to or greater than the fair market value of the underlying stock on the date of grant. Accordingly, an option granted with an exercise price below fair market value on the grant date, i.e., a discounted option, would not meet this exclusion and therefore would be deemed to violate the distribution restrictions of section 409A unless the option were otherwise grandfathered or corrected during the relevant section 409A transition period. This violation occurs because once a discounted option becomes vested, it may be exercised at any time during the option term, meaning for section 409A purposes that the optionee may draw down the deferred amount (i.e., the spread) without the restriction of any pre-established time or event other than the expiration of the option term. As indicated above, the consequences of being subject to section 409A and not complying with the distribution restrictions may mean immediate taxation for holders of vested discounted options, plus a 20% additional tax, and possibly interest. The tax consequences for discounted SARs are similar.

Such a discounted option or SAR also would result in the compensation element of the stock option failing to constitute qualified performance-based compensation for purposes of avoiding the $1 million cap imposed under section 162(m) of the Code on deductible compensation paid to certain corporate executives. If the holder of the option or SAR is a covered employee in the year that the compensation element attributable to the option or SAR is deductible, the company’s deduction for such compensation element will potentially be limited under section 162(m).

In addition, a stock option with an exercise price that is below the fair market value of the underlying stock on the date of grant would not satisfy the pricing requirement imposed on options for qualification as incentive stock options (“ISOs”) under Code section 422, and likely would not satisfy the pricing requirement imposed on options for qualification under section 423 of the Code, e.g., if the option price were already discounted. As a result, assuming no earlier inclusion under section 409A, the executive would be subject to ordinary income tax on the option spread at the time the option was exercised, and the company would be subject to employment tax withholding at that time.

Potential Differences Between the Tax Rules and the Financial Accounting Rules

It should be noted that the rule under section 424(i) of the Code (pertaining to statutory options) is that if the grant of an option is subject to approval by stockholders, the date of grant of the option shall be determined as if the option had not been subject to such approval. This grant date timing rule is different from the measurement date timing rule relating to shareholder approval under Interpretation 44 cited in the SEC Letter. This difference, as well as others, may be the reason that the SEC Letter notes that the determination of the “grant date” for income tax purposes may differ from the determination of the “measurement date” pursuant to APB 25, and expresses no view as to the appropriate grant date of an option for income tax purposes, or on the manner in which the issues addressed in the SEC Letter should be evaluated in regard to income tax considerations.

Since the section 409A anti-deferral rules do not apply to stock rights that are at-the-money at grant date, such stock rights need not be replaced to avoid the application of section 409A. Therefore, even though such stock right might be in-the-money at the measurement date for purposes of APB 25, and, therefore, might be denied transition relief beyond December 31, 2006, no replacement of the options or SARs would appear to be required since the options or SARs would be exempt from section 409A. Such an option should also satisfy the requirements for ISO treatment and as qualified performance-based compensation under section 162(m). If the stock right is in-the-money at the grant date for income tax purposes and at-the-money on the measurement date for purposes of APB 25, it would appear that transition relief is available beyond December 31, 2006, because, presumably, the corporation has neither reported nor reasonably expects to report a financial expense due to the issuance of an at-the-money option under APB 25.

Consequences of Being Treated as a Discount Option Under Both Regimes

The denial of transition relief becomes significant, however, where the stock right is in-the-money both at the grant date for income tax purposes and at the measurement date for purposes of APB 25, which is likely to be a common situation for in-the-money options. If the stock option or SAR is grandfathered under section 409A, i.e., was exercisable on December 31, 2004, then no correction under section 409A is necessary. However, if the stock option or SAR is not grandfathered, then, as noted above, in order to avoid the application of section 409A for corporate insiders, affected public corporations must take corrective action before January 1, 2007. Corrective actions may take one of several forms depending on the goals and expectations of both the corporation and the affected option or SAR holders.

Corrective Actions

One action that may be taken on or before December 31, 2006, is to replace the discounted stock option or discounted SAR with a stock option or SAR that is at-the-money, based on the FMV of the underlying stock at the original (actual) grant date. Thus, the replacement option will be treated for purposes of section 409A as if granted on the grant date of the original option. It is important, though, that the cancellation and reissuance of options with an increased strike price not be part of an exchange that involves a payment of cash or vested property in 2006. For example, if the corrective action results in an increase in the strike price, the corporation may decide to grant the employee option or SAR holder a bonus to compensate for the reduction in the economic benefit attributable to the original lower exercise price. In order to comply with section 409A and the transition rules, the bonus cannot be paid in 2006 and must otherwise comply with the section 409A deferred compensation rules. Corporations and executives may also consider curing the section 409A problems associated with discounted options or SARs by leaving in place the original strike price but amending the terms of the discounted options or SARs prior to the deadline to provide for fixed payment terms or to permit holders of such rights to elect fixed payment terms. Here, again, any such curative action must be accomplished in a manner that is consistent with section 409A and the rules providing transition relief.

Discounted options or SARs that were exercised in 2006 prior to being corrected present special problems under section 409A. It is not clear whether these stock rights may be corrected after the fact, e.g., by rescission. Corporate insiders (and also other employees eligible for Notice 2006-79 relief) will not want to exercise any stock right that may be subject to recharacterization as a discounted stock right before such stock right is corrected or determined with certainty to meet the exception under section 409A.

Other Important Considerations

Given that stock rights are subject to nontax considerations, such as corporate governance, financial accounting and securities law regulations, we would strongly advise that any such curative action be taken in consultation with the company’s corporate, securities and accounting advisors. In addition, a corporation should consider the tax issues under section 162(m) and the statutory option rules pertaining to ISO and section 423 plans, in addition to the section 409A rules, in planning to correct their discounted options and SARs. In this regard, it must be noted that the transition relief applicable to the 409A issues does not expressly provide commensurate protections to issues arising in these other areas.

As noted, transition relief beyond December 31, 2006, may be denied if a corporation “reasonably expects” to report a financial expense because stock rights were issued at a discount that was not timely reported as an expense. Where events unfold after 2006 that indicate that options were issued at a discount, the IRS may be in a position to apply 20-20 hindsight in asserting that the corporation should have “reasonably expected” that it would be required to report a financial expense and, therefore, the December 31, 2006, deadline applied. Because of this possibility, some corporations may, as a protective matter, wish to consider corrective action before the end of this year, based on a conservative view of the grant date, to avoid the possibility that future events may prevent them from correcting at a later date. Any such corrective action should, however, also be evaluated as to its implications for corporate securities and accounting purposes.

Corporations should expect options and SARs to be scrutinized by the IRS for backdating. The IRS has currently targeted the area of backdated options for enforcement and it is our understanding that companies are now beginning to get IDRs which request information with regard to such things as whether the company has conducted any internal investigations on backdating.

Finally, a company analyzing its option or SAR program in this regard should also consider options or SARs it may have issued in exchange for stock rights granted by an acquired company and the nature of the option/SAR program maintained by the target.

Conclusion

Any corporation that may have discounted options or SARs should consider whether corrective action should be taken to avoid adverse tax consequences for corporate insiders holding such stock rights. Corporations that are adversely affected by IRS Notice 2006-79 should realize that such corrective action must be taken on or before December 31.

For additional information, please contact any of the following lawyers:

Jeanette Dayan, jdayan@milchev.com, 202-626-6037

Elizabeth F. Drake, edrake@milchev.com, 202-626-5838

Marianna G. Dyson, mdyson@milchev.com, 202-626-5867

Michael M. Lloyd, mlloyd@milchev.com, 202-626-1589

C. Frederick Oliphant, foliphant@milchev.com, 202-626-5834

Anthony G. Provenzano, aprovenzano@milchev.com, 202-626-1463

Gary G. Quintiere, gquintiere@milchev.com, 202-626-1491

Lee H. Spence, lspence@milchev.com, 202-626-5965

Adrian L. Morchower

Related Files
Related Links

The information contained in this newsletter is not intended as legal advice or as an opinion on specific facts. This information is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. For more information about these issues, please contact the author(s) of this newsletter or your existing Miller & Chevalier lawyer contact. The invitation to contact the firm and its lawyers is not to be construed as a solicitation for legal work. Any new lawyer-client relationship will be confirmed in writing.

This newsletter is protected by copyright laws and treaties. You may make a single copy for personal use. You may make copies for others, but not for commercial purposes. If you give a copy to anyone else, it must be in its original, unmodified form, and must include all attributions of authorship, copyright notices and republication notices. Except as described above, it is unlawful to copy, republish, redistribute, and/or alter this newsletter without prior written consent of the copyright holder.