How does your company approach the issue of in-the-money options that are nearing their expiration date? This has always been a potential issue for terminated employees whose vested shares are no longer exercisable for the full term of the option. We now also see more companies with options that are actually nearing full term, especially when the options have remained underwater for an extended period of time.
Communications
The first decision on expiring options is whether or not the company will endeavor to notify participants of the impending expiration. At face value, this appears to be a fantastic idea, but there are still issues to consider. Ideally, these communications would be automated to some degree to avoid the administrative burden of manual distribution.
Identifying the grants and employees who should receive a notice regarding expiring in-the-money options may not be easy. Even if your stock plan administration software has a report that generates a list, you could be faced with a daily verification depending on the vesting schedules for your employee options. Most brokers have the ability to alert employees of upcoming option expirations through the employee accounts and some may even be able to send out automated email notification.
Another important consideration is how to ensure that the communication is universal. It is reasonable to exclude specific groups of employees (e.g., employees holding underwater options), but it is important that the exclusion is consistent to avoid even the appearance of discrimination. When considering the timing of communications, keep your termination parameters and typical administrative delays in processing terminations in mind. As with any communication, you run the risk of an employee relying on the notification, not receiving it due to an administrative anomaly, and find yourself in the middle of a lawsuit.
Automatic Exercise
More brokers are now willing and able to support a company’s policy to have expiring in-the-money options automatically exercised on the day before they expire. Automatic exercise has existed for many years for publicly traded options, so it’s not a stretch to apply the same logic to an employee plan. However, there are more considerations for employee stock options.
Exercise Type
When instituting an automatic exercise policy, careful consideration should be given to how the employee will pay the exercise price and tax withholding associated with the transaction. It is possible to initiate a same-day sale on an expiring option on behalf of the employee providing you have the appropriate permissions to do so and your broker is willing to execute the transaction. However, my opinion is that the best fit for an automatic exercise is some form on net share settlement. The key advantage is that employees would simply receive the net shares in their account, which could be held or sold at their discretion. You won’t have to ensure that brokerage accounts are open and unrestricted and you don’t have to worry about coordinating a market transaction. Regardless of the exercise type you choose, there should be a way for employees to opt out of the automatic exercise.
How Much is Enough?
Another consideration for automatic exercise is just how in the money options need to be for an exercise, especially if you are doing a net share settlement. Even with a sell-to-cover transaction, it is better if the employee receives more than a fraction of a share in value for the transaction. For non-qualified stock options, you have to account for not only the exercise price, but also the tax withholding, which could dramatically reduce the value returned to the employee. Although in general some value is better than nothing, there are many situations where the exercise of an option that is barely in the money could actually do more harm than good. If you set a minimum value, be sure that it can be consistently administered and is clearly communicated to employees.
Documentation
If you are instituting a new automatic exercise policy, confirm with your legal team on how to handle both existing options and new grants. Does your plan accommodate and will your company feel comfortable simply making it a policy and notifying employees, or will you need to have some kind of agreement from employees. For future grants, will you need to include specific language for an automatic exercise in the grant agreement?
Early Bird Special for the 19th Annual NASPP Conference
Speaking of expiring options, don’t miss out on your option to register for the 19th Annual NASPP Conference at a reduced price! Now through May 13th, NASPP members will receive a special discount on Conference registrations. Register today!
We are about half-way through the first tax year in which employers have known the income reporting, tax withholding, and valuation requirements for employees in India. Last year (2009/2010) was quite a scramble, with retroactive updates and guidance being provided late into 2009.
Valuations
One issue that companies continue to work with is the calculation of FMV, as a Category 1 Merchant Banker valuation is still required for companies not listed on a recognized exchange (Neither NASDAQ nor NYSE are recognized exchanges.). There were several months where it was unclear whether or not Merchant Banker valuations would be required. If your company reported and withheld based on the market value of your stock during the 2009/2010 tax year, you should have adjusted your reporting at this point.
Frequency
When it comes to Merchant Banker valuations, frequency is still a key consideration (and one that will remain so long as these valuations are required). The regulations state that valuations are only required every 180 days, so it is possible to only value your company’s shares two times a year. However, this may not right for your company, especially if the trading value of the shares has decreased significantly since the most recent valuation.
Double Standard
The difference between the Merchant Banker valuation and the trading value of the stock will remain an ongoing issue regardless of how often your company has a valuation performed. If your stock plan administration software does not permit more than one FMV on a trading date, you may have to provide custom employee communications to accommodate the FMV that was used to calculate income.
Australia
Reporting Obligations
Generally speaking, most options and RSU grants in Australia awarded after July 1, 2009 are taxable at vest. There is no withholding obligation for employers, but there is a reporting obligation of Employee Share Scheme (ESS) statements to both the employee and the Australian Tax Office (ATO). They are not unlike the U.S. Section 6039 information statements in theory; presumably they will help employees better understand how to complete their own tax returns and will help the tax authorities determine if income is being properly reported on tax returns, which they will be auditing (See this alert from Deloitte.)
Valuation
For RSUs, the trading value of the shares at vest may be the FMV for income calculation. However, options are considered an “unlisted right” and might require a valuation method (e.g.; Black Scholes) to determine the market value of the shares on date of the taxable event.
30 Day Rule
One tricky piece of determining the FMV on the taxable date in Australia is the 30 day rule. If an employee sells shares from an RSU vest or option exercise within 30 days of the original taxable event date, then the sale date might be considered the taxable event, provided the company is aware of the sale.
Employees
Individual tax returns for the 2009/2010 tax year are due by October 31, 2010. Employees may still be trying to understand the ESS statements provided to them by the company.
Taking Action
Many companies appear to have moved away from granting options in Australia as a result of the reporting obligations. We completed a Quick Survey on this in September; only 20% of respondents were continuing to grant options in Australia, 38% were not granting options to begin with, and a significant 42% were moving to share grants (like RSUs) or some type of cash compensation.
What do you do when someone has inadvertently been omitted from the grant approval process? You really can’t just slip the grant into the approval documentation, fully disclosed or clandestinely, and write it off to an “administrative error.” The bad news is that each situation has the potential to be unique, which makes it unlikely that you can create a standard response to a missed grant. For this reason, your grant policy probably can’t (even shouldn’t) attempt to address every potential circumstance surrounding a missed grant. The good news is that you can prepare yourself to evaluate the responses available to you in the event you do find a missed grant. These are my top five considerations:
Vesting
If a grant is left out of the approval process and needs to be approved at a later date, you need to know if the delay in approval will impact vesting. If your plan or grant policy already bases the vesting off a date other than the approval date or is flexible on the issue, it is possible that the grant can maintain the intended vesting dates.
Approval
It’s important to have a solid understanding of your plan and approval process under any circumstance, but when it comes to a missed grant, there are additional considerations. If the delayed approval will result in a grant that is different from your typical grants either in size or vesting schedule, you need to know who has the authority to approve the grant. If standard grants are approved by an officer, such as the CEO, it’s likely that a modification to standard terms will cause the grant to fall outside the parameters of the officer’s approval authority and may need to be referred to the compensation committee for approval.
Stock Price
If the grant in question is an option, then the stock price has likely moved on since the original approval date. If the price has dropped, it is easy to sell your employee on a grant of equal size and vesting with a better exercise price, but it may not be advisable to provide a disproportionately advantageous position to just one employee. Provided your plan permits it, it is possible to approve the option with the intended (i.e., higher) grant price.
If the stock price has increased, you have the opposite issue to contend with–the employee really shouldn’t be penalized for an administrative error. However, approving the grant at the lower exercise price would most likely result in a discounted option, making it subject to 409A. You can, however, develop a policy on how the company may compensate for this change in FMV such as increasing the number of shares or providing a cash payment to make up the difference.
If an RSU has slipped through the cracks in your approval process, making up for lost time can be less of a burden provided you have the flexibility in your plan to keep the intended vesting schedule. But, make sure that if your grant policy doesn’t lock in grant size based on the date of approval (e.g.; a value of $1,000 based on the FVM on date of approval).
Timing
Ideally, you never have to deal with a missed grant. Hopefully, if you do encounter one, the error is discovered virtually immediately. However, it is a good idea to think about what the company can do if a significant amount of time has passed between the date the grant should have been approved and the discovery.
One possible issue is vesting; if the grant should have already vested by the time the error is discovered. Like compensating for a higher exercise price, the company could choose to increase the number of shares or provide a cash payment to compensate for a missed sale opportunity. This is risky business because you are using counterfactual history–there is no way to know at what point the employee would have sold the shares.
Another issue comes up for companies that use a “total rewards” type compensation standard and one or more annual grants have been approved before the original missed grant is discovered. In a total rewards model, annual grant size would typically be based on a target total equity value or total compensation level. If the missed grant is not included in the calculations, then an annual grant approved after the error is likely to be larger to accommodate the value “missing” from that employee’s total equity value or compensation level.
Communication
Regardless of the circumstances leading up to a missed grant, communication is going to be key. No matter how you cut it, employees don’t appreciate being left out and bristle at the idea of being penalized for an administrative error, whether that idea is well-founded or not. This might sound a little like running a customer service call center, but it’s not a bad idea to have some apology verbiage ready that can fit most administrative issues; something that can help to reassure the employee that the company will “make it right” without actually obligating the company to provide recompense it isn’t prepared or able to accommodate. Whatever your response is to a missed grant, keep the employee abreast of the process as much as possible. Also, it’s probably best to avoid detailing the circumstances of the oversight even if you are trying to reassure the employee.