Tender Offer Rules
3.1. Application of the Tender Offer Rules
US tender offer rules are generally implicated when the holder of a security is required to make an investment decision with respect to the purchase, modification, or exchange of that security. One might question why a unilateral reduction in the exercise price of an option would implicate the tender offer rules since there is no investment decision involved by the option holder. Indeed, many equity incentive plans permit a unilateral reduction in the exercise price of outstanding options, subject to shareholder approval, without obtaining the consent of option holders on the basis that such a change is beneficial to them. In reality, however, the likelihood of a domestic company being able to conduct a repricing without implicating the tender offer rules is minimal for the reasons set forth below.
Because of the influence of proxy advisors and institutional shareholders, most option repricings involve a value-for-value exchange consisting of more than a mere reduction in exercise price. A value-for-value exchange requires a decision by option holders to accept fewer options or to exchange existing options for restricted stock or RSUs. This is an investment decision requiring the solicitation and consent of individual option holders.
A reduction in the exercise price of an incentive stock option (“ISO”) would be considered a “modification” akin to a new grant under applicable tax laws. The new grant of an ISO restarts the holding periods required for beneficial tax treatment of shares purchased upon exercise of the ISO. The holding periods require that the stock purchased under an ISO be held for at least two years following the grant date and one year following the exercise date of the option. The resulting investment decision makes it difficult in practice to effect a repricing that includes ISOs without seeking the consent of ISO holders, since they must decide if the benefits of the repricing outweigh the burdens of the new holding periods.
The SEC staff has suggested that a limited option repricing/exchange with a small number of executive officers would not be a tender offer. In such an instance, the staff position is that an exchange offer to a small group is generally seen as equivalent to individually negotiated offers, and thus not a tender offer. Such an offer, in many respects, would be similar to a private placement. The SEC staff believes that the more sophisticated the option holders, the more the repricing/exchange looks like a series of negotiated transactions. However, the SEC staff has not provided guidance on a specific number of offerees, so this remains a facts-and-circumstances analysis based on both the number of participants and their positions and sophistication.
Not all equity incentive plans involve issuing ISOs, and thus the attendant ISO-related complexities will not always apply. As a result, foreign private issuers and domestic companies that have not granted ISOs and are simply reducing the exercise price of outstanding options unilaterally may also be able to avoid the application of the US tender offer rules. Foreign private issuers are discussed in more detail below.
3.2. Requirements of the US Tender Offer Rules
The SEC views a repricing of options that requires the consent of the option holders as a “self-tender offer” by the issuer of the options. Self-tender offers by companies with a class of securities registered under the Exchange Act are governed by Rule 13e-4 thereunder, which contains a series of rules designed to protect the interests of the targets of the tender offer. While Rule 13e-4 applies only to public companies, Regulation 14E applies to all tender offers. Regulation 14E is a set of rules prohibiting certain practices in connection with tender offers and requiring, among other things, that a tender offer remain open for at least twenty business days.
In March 2001, the SEC issued an exemptive order providing relief from certain tender offer rules that the SEC considered onerous and unnecessary in the context of an option repricing. Specifically, the SEC provided relief from complying with Rule 13e-4(f)(8)(i) (the “all holders” rule) and Rule 13e-4(f)(8)(ii) (the “best price” rule). As a result of this relief, issuers are permitted to reprice/exchange options for only certain selected employees. Among other things, this exception allows issuers to exclude directors and officers from repricings. Furthermore, issuers are not required to provide each option holder with the highest consideration provided to other option holders.
3.3. Pre-commencement Offers
The tender offer rules regulate the communications that a company may make in connection with a tender offer. These rules apply to communications made before the launch of a tender offer and while it is pending. Pursuant to these rules, a company may publicly distribute information concerning a contemplated repricing before it formally launches the related tender offer, provided that the distributed information does not contain a transmittal form for tendering options or a statement of how such form may be obtained. Two common examples of company communications that fall within these rules are the proxy statement seeking shareholder approval for a repricing and communications between the company and its employees at the time that proxy statement is filed with the SEC. Each such communication is required to be filed with the SEC under cover of a Schedule TO with the appropriate box checked to indicate that the content of the filing includes pre-commencement written communications.
3.4. Tender Offer Documentation
An issuer conducting an option exchange will be required to prepare the following documents as exhibits to a Schedule TO Tender Offer Statement:
- the offer to exchange, which is the document pursuant to which the offer is made to the company’s option holders and which must contain the information required to be included therein under the tender offer rules;
- the letter of transmittal, which is used by the option holders to tender their securities in the tender offer; and
- other ancillary documents, such as the forms of communication with option holders that the company intends to use and letters for use by option holders to withdraw a prior election to participate.
The offer to exchange is the primary disclosure document for the repricing offer and, in addition to the information required to be included by Schedule TO, focuses on informing security holders about the benefits and risks associated with the repricing offer. The offer to exchange is required to contain a “summary term sheet” that provides general information—often in the form of frequently asked questions—regarding the repricing offer, including its purpose, eligibility of participation, duration, and how to participate. It is also common practice for a company to include risk factors disclosing economic, tax, and other risks associated with the exchange offer. The most comprehensive section of the offer to exchange is the section describing the terms of the offer, including the purpose, background, material terms and conditions, eligibility to participate, duration, information on the stock or other applicable units, interest of directors and officers with respect to the applicable units or transaction, procedures for participation, tax consequences, legal matters, fees, and other information material to the decision of a security holder when determining whether or not to participate in such offer.
The offer to exchange, taken as a whole, should provide comprehensive information regarding the securities currently held and those being offered in the exchange—including the difference in the rights and potential values of each. The disclosure of the rights and value of the securities is often supplemented by a presentation of the market price of the underlying stock to which the options pertain, including historical price ranges and fluctuations, such as the quarterly highs and lows for the previous three years. The offer to exchange may also contain hypothetical scenarios showing the potential value risks/benefits of participating in the exchange offer. These hypothetical scenarios illustrate the approximate value of the securities held and those offered in the exchange at a certain point in the future, assuming a range of different prices for the underlying stock. If the repricing is part of an overall shift in a company’s compensation plan, the company should include a brief explanation of its new compensation policy.
3.5. Launch of the Repricing Offer
The offer to exchange is transmitted to employees after the Schedule TO has been filed with the SEC. While the offer is pending, the Schedule TO and all of the exhibits thereto (principally the offer to exchange) may be reviewed by the SEC staff, who may provide comments to the company, usually within five to seven days of the filing. The SEC’s comments must be addressed by the company to the satisfaction of the SEC, which usually requires the filing of an amendment to the Schedule TO, including amendments to the offer to exchange. Generally, no distribution of such amendment (or any amendments to the offer to exchange) will be required. This review usually does not delay the tender offer and generally will not add to the period that it must remain open.
Under the tender offer rules, the tender offer must remain open for a minimum of twenty business days from the date that it is first published or disseminated. For the reasons noted below, most option repricing exchange offers are open for less than thirty calendar days. If the consideration offered or the percentage of securities sought is increased or decreased, the offer must remain open for at least ten business days from the date such increase or decrease is first published or disseminated. The SEC also takes the position that if certain material changes are made to the offer (e.g., the waiver of a condition), the tender offer must remain open for at least five business days thereafter. At the conclusion of the exchange period, the repriced options, restricted stock or RSUs will be issued pursuant to the exemption from registration provided by Section 3(a)(9) of the Securities Act of 1933, as amended (the “Securities Act”) for the exchange of securities issued by the same issuer for no consideration.
3.6. Conclusion of the Repricing Offer
The company is required to file a final amendment to the Schedule TO setting forth the number of option holders who accepted the offer to exchange.
Certain Other Considerations
4.1. Tax Issues
Incentive Stock Options. If the repricing offer is open for thirty days or more with respect to options intended to qualify for ISO treatment under US tax laws, those ISOs are considered newly granted on the date the offer was made, whether or not the option holder accepts the offer. If the period is for less than thirty days, then only ISO holders who accept the offer will be deemed to receive a new grant of ISOs.As discussed above, the consequence of a new grant of ISOs is restarting the holding period required to obtain beneficial tax treatment for shares purchased upon exercise of the ISO. As a result of these requirements, repricing offers involving ISO holders should generally be open for no more than thirty days.
To qualify for ISO treatment, the maximum fair market value of stock with respect to which ISOs granted to an employee may first become exercisable in any one year is US $100,000. For purposes of applying this dollar limitation, all ISOs granted to the employee are taken into account; the stock is valued when the option is granted, and ISOs are taken into account in the order in which they were granted. Whenever an ISO is canceled pursuant to a repricing, any options and shares scheduled to become first exercisable in the calendar year of the cancellation would continue to count against the US $100,000 limit for that year. To the extent that the new ISO becomes exercisable in the same calendar year as the cancellation, the canceled options and shares (referenced in the immediately preceding sentence) reduce the number of shares that can receive ISO treatment (because the latest grants are the first to be disqualified). Where the new ISO does not start vesting until the next calendar year, however, this will not be a concern.
Section 409A Compliance. If the repricing occurs with respect to nonqualified stock options (i.e., options that are not ISOs), such options need to be structured so as to be exempt from (or in compliance with) Section 409A of the Code. Section 409A comprehensively codifies the federal income taxation of nonqualified deferred compensation. Section 409A generally provides that unless a “nonqualified deferred compensation plan” complies with various rules regarding the timing of deferrals and distributions, all amounts deferred under the plan for the current year and all previous years become immediately taxable, and subject to a 20% penalty tax and additional interest, to the extent the compensation is not subject to a “substantial risk of forfeiture” and has not previously been included in gross income. Nonqualified stock options are usually structured to be exempt from Section 409A. One of the conditions for this exemption is that the option have an exercise price at least equal to the fair market value of the underlying stock on the option grant date. A reduction in the option exercise price that is not below the fair market of the underlying stock value on the date of the repricing should not cause the option to become subject to Section 409A. Instead, such repricing of an underwater option is treated as the award of a new stock option that is exempt from Section 409A. While foreign private issuers may enjoy certain relief from the US tender offer rules as described below, there is no similar relief from US tax considerations for US taxpayers. This is most important where foreign private issuers’ home country rules allow for the grant of options with exercise prices below fair market value. In such case, care should be taken to ensure that grantees who are US taxpayers receive awards that comply with Section 409A.
4.2. Plan Grant Limitation
It should also be noted that a repriced option will count against any per-person grant limitations (typically an annual limit on the maximum number of shares which may be granted to an individual) in the applicable equity plan.
4.3. Accounting Treatment
Accounting considerations are a significant factor in structuring a repricing. Before the adoption of ASC 718 in 2005, companies often structured repricings with a six-month hiatus between the cancellation of underwater options and the grant of replacement options. The purpose of this structure was to avoid the impact of variable mark-to-market charges. Under ASC 718, however, the charge for the new options is not only fixed upfront but is for only the incremental value, if any, of the new options over the canceled options. As discussed above, in a value-for-value exchange, a fewer number of options or shares of restricted stock or RSUs will usually be granted in consideration for the surrendered options. As a result, the issuance of the new options or other securities can be a neutral event from an accounting expense perspective.
4.4. Section 16
The replacement of an outstanding option with a new option having a different exercise price and a different expiration date involves a disposition of the outstanding option and an acquisition of the replacement option, both of which are subject to reporting under Section 16(a). However, the disposition of the outstanding option will be exempt from short-swing profit liability under Section 16(b) pursuant to Rule 16b-3(e) if the terms of the exchange are approved in advance by the issuer’s board of directors, a committee of two or more nonemployee directors, or the issuer’s shareholders. It is generally not a problem to satisfy these requirements. Similarly, the grant of the replacement option or other securities is subject to reporting but will be exempt from short-swing profit liability pursuant to Rule 16b-3(d) if the grant was approved in advance by the board of directors or a committee composed solely of two or more nonemployee directors, or was approved in advance or ratified by the issuer’s shareholders no later than the date of the issuer’s next annual meeting, or is held for at least six months.
Foreign Private Issuers
5.1. Relief from Shareholder Approval Requirement
Both the NYSE and Nasdaq provide foreign private issuers with relief from the requirement of stockholder approval for a material revision to an equity compensation plan by allowing them instead to follow their applicable home-country practices. As a result, if the home-country practices of a foreign private issuer do not require shareholder approval for a repricing, the foreign private issuer is not required to seek shareholder approval under NYSE or Nasdaq rules.
Both the NYSE and Nasdaq require an issuer following its home-country practices to disclose in its annual report on Form 20-F an explanation of the significant ways in which its home-country practices differ from those applicable to a US domestic company.Alternatively, companies listed on the NYSE may disclose such home-country practices on the issuer’s website, in which case the issuer must provide in its annual report the web address where the information can be obtained. Under Nasdaq rules, the issuer is required to submit to Nasdaq a written statement from independent counsel in its home country certifying that the issuer’s practices are not prohibited by the home country’s laws.
Many foreign private issuers disclose that they will follow their home-country practices with respect to a range of corporate governance matters, including the requirement of shareholder approval for the adoption or any material revision to an equity compensation plan. These companies are not subject to the requirement under NYSE or Nasdaq rules of obtaining shareholder approval for a repricing. Companies that have not provided such disclosure and wish to avoid the shareholder approval requirements when undertaking a repricing will need to consider carefully their historic disclosure and whether such an opt-out poses any risk of a claim from shareholders.
5.2. Relief from US Tender Offer Rules
Foreign private issuers also have significant relief from the application of US tender offer rules if US option holders hold 10% or less of the company’s outstanding options. Under the exemption, assuming the issuer’s actions in the United States still constitute a tender offer, the issuer would be required to take the following steps:
- file with the SEC under the cover of a Form CB a copy of the informational documents that it sends to its option holders. This informational document would be governed by the laws of the issuer’s home country and would generally consist of a letter to each option holder explaining why the repricing is taking place, the choices each option holder has, and the implications of each of the choices provided;
- appoint an agent for service of process in the United States by filing a Form F-X with the SEC; and
- provide each US option holder with terms that are at least as favorable as those terms offered to option holders in the issuer’s home country.
A more limited exemption to the US tender offer rules also exists for foreign private issuers where US investors hold 40% or less of the options that are subject to the repricing. Under this exception, both US and non-US security holders must receive identical consideration. The minimal relief is intended merely to minimize the conflicts between US tender offer rules and foreign regulatory requirements and provides little actual relief in the context of an option repricing.
There have been surprisingly few deviations from the repricing approaches described above. In the past, Microsoft and Google used different and more innovative methods to address the issue of underwater employee stock options, thereby providing an alternative to a traditional repricing. To date, other companies have not followed suit, but it is possible that others will consider these approaches in the future.
In 2007, Google implemented a program that afforded its option holders (excluding directors and officers) the ability to transfer outstanding options to a financial institution through a competitive online bidding process managed by Morgan Stanley. The bidding process effectively created a secondary market in which employees can view what certain designated financial institutions and institutional investors are willing to pay for vested options. The value of the options is therefore a combination of their intrinsic value (i.e., any spread) at the time of sale plus the “time value” of the remaining period during which the options can be exercised (limited to a maximum of two years in the hands of the purchaser). As a result of this “combined” value, Google believed that underwater options would still retain some value. This belief is supported by the fact that in-the-money options were sold at a premium to their intrinsic value.
Google’s equity incentive plan was drafted sufficiently broadly to enable options to be transferable without the need for Google shareholder approval to amend the plan. Many other companies’ plans would likely limit transferability of options to family members. Accordingly, most companies seeking to implement a similar transferable option program will likely need to obtain shareholder approval to do so. Note that ISOs become nonqualified stock options if transferred. The only options Google granted following its IPO were nonqualified stock options and, accordingly, the issue of losing ISO status did not arise. Finally, notwithstanding the benefits that Google’s transferable option program offers, it did not prevent the company from effecting a one-for-one option exchange and incurring a related stock-based compensation expense of US $460 million over the life of the new options.
In 2003, Microsoft implemented a program that afforded employees holding underwater stock options a one-time opportunity to transfer their options to JPMorgan in exchange for cash. The program was implemented at the same time that Microsoft started granting restricted stock instead of options, and it was open on a voluntary basis to all holders of vested and unvested options with an exercise price of US $33 or more (at the time of the implementation of the program, the company’s stock traded at US $26.50). Employees were given a one-month election period to participate in the program, and once an employee chose to participate, all of that employee’s eligible options were required to be tendered. Employees who transferred options were given a cash payment in installments, dependent upon their continued service with Microsoft.
The methods used by Google and Microsoft require consideration of tax and accounting implications and required the filing of a registration statement under the Securities Act in connection with short sales made by the purchasers of the options to hedge their exposure. To date, these methods have not been adopted by other companies, and it is to be expected that most companies will continue to conduct more conventional repricings to address underwater options.
The current market realignment has not yet continued for long enough to generally justify a significant number of repricings. Trends over the last decade have shown a tendency to avoid repricing when possible. Continued examples of market resilience and feasibility of alternative compensation practices have subsided the widespread occurrence of repricings. Nevertheless, while underwater option repricings may not rise to the levels following the financial crisis of 2008, companies will likely always require the ability to reprice underwater options upon certain market fluctuation or individual corporate circumstances, especially those that last for longer periods in tight labor markets.