Latham & Watkins Benefits & Compensation Practice

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1 Number October 2008 Client Alert Latham & Watkins Benefits & Compensation Practice Underwater Options in the UK Can We Throw Them a Lifeline? Companies incorporated in the United Kingdom which are listed face a number of difficulties in dealing with underwater stock options. Introduction Over the past few months, the world has seen major stock markets drop significantly, some by more than 50 percent. Inevitably, this will mean that many stock options that were granted to employees and executives over the last few years will now be underwater, i.e., the price at which an employee has to pay to exercise the stock option will be more than the market value of the share. Consequently, it will be cheaper for the employee to buy shares in the market rather than through exercising the stock options. Also, over the last few years, we have seen the proportion of performancerelated pay (specifically stock options) to fixed pay has increased significantly. The result is that many employees and executives will, unless there is a dramatic improvement in the performance of the stock markets, earn materially less than they had anticipated. The knock-on effect may well be that the two key benefits of having a stock option plan for a company, namely to incentivise employees to work hard, and to act as a retention mechanism, whereby the employees will extract more value from the stock options the longer they remain with the company, are no longer provided by that stock option plan. As a result, companies will need to consider what steps, if any, they can take to re-incentivise employees. This Client Alert looks at the ways in which companies can deal with underwater options and also the restrictions that may well be placed on companies looking to re-price or re-grant existing stock options. In addition, this Client Alert considers what other forms of share-based incentives there might be which are less prone to the uncertainties of stock market performance. Whilst the Client Alert focuses on the issues for listed companies, many of the points are also relevant to private companies. What Can a Company Do to Deal with Underwater Options? Do nothing Stock options are granted to employees in order to align the interests of employees more closely with those of the shareholders. Consequently, the argument goes that if shareholders are suffering from a low share price, so should the employees. This is particularly the case if the reason for the low share price can be attributed to the actions of the executives, for example, the strategy they have put in place for the company. Latham & Watkins operates as a limited liability partnership worldwide with affiliated limited liability partnerships conducting the practice in the United Kingdom, France and Italy. Under New York s Code of Professional Responsibility, portions of this communication contain attorney advertising. Prior results do not guarantee a similar outcome. Results depend upon a variety of factors unique to each representation. Please direct all inquiries regarding our conduct under New York s Disciplinary Rules to Latham & Watkins LLP, 885 Third Avenue, New York, NY , Phone: Copyright 2008 Latham & Watkins. All Rights Reserved.

2 Certainly, in most instances, companies will face criticism from their shareholders if they attempt to re-price underwater options or replace them with a re-grant of stock options that are in the money. However, where the low share price has come about as a result of a general market collapse shareholders may be more understanding. If there is a significant risk to the company that executives may leave because their share-based compensation has become worthless, shareholders may well agree to some form of new incentivisation plan which is in intended to maintain a stable workforce. Do nothing, but make up for it in the next annual option grant Companies often make annual grants of options. The ABI 1 guidelines for listed companies recommend this approach, partly to avoid all options becoming underwater. Therefore, the company could simply make an increased grant of options to employees at the time of its next grant cycle. 2 If the share price is still low, then these options will be granted with a low exercise price (usually exercise price is required to be equal to market value of the shares on grant) and therefore a bigger upside if the share price increases. As share options are designed to be long term incentive, provided an employee stays with the company it is likely that the underwater options will be in the money in the future, assuming the stock market recovers. However, if the options are designed as a short term incentive tool, for example, linked to a planned takeover or merger, waiting for the next annual option grant will not solve the problem of underwater options. Grant of replacement options Broadly, there are two ways to replace underwater options. The first is simply to re-price the options, i.e., change the exercise price by lowering it to current market value; alternatively, the employees could surrender the existing options in return for a re-grant of new options at a reduced exercise price. Generally speaking, re-pricing of options is unusual. Firstly, if the company is listed in the United Kingdom, the company is likely to follow the institutional guidelines on executive pay, for example those published by the ABI. The ABI guidelines state very clearly that the re-pricing of options is not appropriate. The listing rules apply to companies incorporated in the United Kingdom which are listed on the London Stock Exchange. Listing Rule provides that, without shareholder consent, a listed company must not grant options with an exercise price that is less than the market value of a share on the date when the exercise price is determined. The re-pricing of options is likely to breach this rule. Finally, most option plans do not allow the exercise price to be amended except following a variation of the company s share capital, for example, a rights issue. If options are tax approved/qualified, HM Revenue & Customs will not allow re-pricing. The surrender of underwater options and the re-grant of new options with a lower exercise price is perhaps easier to achieve, although again may make shareholders unhappy. Unlike re-pricing, the share option rules are less likely to require amendment because the company will be cancelling the existing options. However, the new options will have to be granted under the same plan rules. 4 Therefore, if the plan rules require vesting over a period of not less than three years from grant, it will not be possible for the new options to mirror fully the options that they replace without amending the rules to shorten the vesting period. Listing Rule should not be relevant to a re-grant, provided the new options are not being granted with an exercise price below market value at the time the option is granted. However, a company would need to consider whether it needed shareholder consent to cancel existing options and make a re-grant. Assuming the company will not exceed shareholderapproved limits to employee share plans, shareholder consent may not

3 be required. However, this is not to say that the shareholders will not be uncomfortable with such a strategy. The surrender and re-grant of options will have to be disclosed in the Directors Remuneration Report and this will be the subject of a vote by the shareholders. Although the vote is non-binding, listed companies do not generally ignore these votes due to the large amount of adverse publicity they generate in the financial press. Consequently, if a company is considering going down this route, it is advisable that it enters into full consultation in advance with its shareholders to obtain their buy-in. It may be possible to make the re-grant more attractive to shareholders if the exercise price is set above market value on date of grant. In that way, a hurdle has to be jumped before the options deliver value. Not surprisingly, the ABI guidelines do not approve of the surrender and regrant of options. Replace options with different share-based incentive plan Given that options may no longer be a popular form of incentive as they are susceptible to going underwater, companies may prefer to cancel underwater options and replace them with another form of share-based incentive. A popular alternative might be to grant free shares to employees (where vesting is subject to performance criteria) under a Long Term Incentive Plan (LTIP). In the US, these plans are commonly called Restricted Stock Plans (RSU Plans). Replacing options with an LTIP should not fall foul of Listing Rule However, shareholder consent may well be required for the introduction of a new type of share incentive plan. Companies incorporated in the United Kingdom and listed on the London Stock Exchange will require shareholder consent. If the company is not subject to the Listing Rules, then shareholder consent to the introduction of a new plan may not be required provided that the grant of LTIP rights will not exceed shareholder approved limits to employee participation in the share plans. Other alternatives Given that underwater options are hopefully a short-term problem, an alternative to re-pricing, surrendering or re-granting of options might be to provide cash or even share-based bonuses in the short-term. These could be tied to performance so that the arrangements would provide both an incentive for the executive to remain in place but also deliver value for the shareholders. Again, this is an issue that should be discussed with shareholders in advance as, certainly for listed companies, it will have to be fully disclosed in the Directors Remuneration report. We understand that some US companies have introduced option trading programs whereby employees with underwater options are able to sell them to a buyer (who presumably expects to realise value from the options in the long-term). This is unlikely to work in the United Kingdom as almost all options are non-transferable. Alternative Arrangement That Avoid the Risks of Going Underwater As a result of stock market crashes earlier in this decade and changes to certain accounting rules in relation to options, many companies have moved away from granting options and instead are granting rights to free shares under Long Term Incentive Plans. Under an LTIP, an employee is given the right to a grant of free shares if, over the performance period, the company meets certain performance targets. The performance period is usually no less than three years (following the ABI guidelines) and the performance targets usually require the performance of the company to be matched against the performance of similarly placed companies. The benefit of an LTIP grant over options is that, because there is no exercise price, the LTIP can never be underwater. However, unlike options, LTIPs only vest if performance conditions are met. Although much depends upon the particular

4 performance conditions, if they peg the company to the performance of other similar companies, the performance conditions may still be met in a general stock market crash rather than where the company itself is doing badly when compared to its comparator groups. Another alternative form of share-based incentivisation is to grant restricted shares to employees. This type of plan actually gives the employee ownership of the shares on date of grant although their rights are restricted so that the shares cannot be sold or transferred and are usually subject to a risk of forfeiture in certain circumstances. Restricted share plans are usually not appropriate for listed companies but may be useful for private companies and they also offer certain tax advantages. Endnotes 1 The ABI guidelines primarily apply to companies listed on the London Stock Exchange. However, they are advisory only. Obviously, if a company has shareholder consent to its proposed actions then it should not be a problem to breach the ABI guidelines. 2 The ABI guidelines recommend that companies do not grant annual option awards that exceed one year s base pay unless they are linked to high levels of performance. 3 This Listing Rule only applies to a company incorporated in the UK which is listed on the London Stock Exchange. 4 Shareholder consent is usually required to introduce a new share option plan or materially amend existing rules. Conclusion Therefore, companies incorporated in the United Kingdom which are listed face a number of difficulties in dealing with underwater stock options. However, certainly with shareholder approval it may be possible to introduce alternative arrangements that provide short-term incentives to the employees until the stock markets recover. Private companies, or companies not governed by the Listing Rules and other codes of best practice (such as the ABI guide to executive remuneration) will find it easier to deal with underwater options, but in practice are still likely to require shareholder buy-in.

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