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The Employee Ownership Update

Corey Rosen

March 1, 2001

(Corey Rosen)

SEC Says Option Grant Rescissions Require Variable Accounting

The Securities and Exchange Commission has issued new guidance stating that if a company allows employees with options to turn in shares obtained through the exercise of stock options in exchange for new options, then this will trigger variable accounting procedures. For the rescission to be effective, the shares have be turned in during the same tax year the employee exercised the option.

The policy of allowing "rescissions" on options is controversial. It's easiest to understand how a rescission works through an example. Assume Bill gets an option at $20 per share in 1995. In January 2000, he exercises the option. The share price is now $45. It doesn't matter whether the option is an incentive stock option (ISO) or non-qualified option. An incentive option will become a non-qualified option if the employee turns in the shares because they will not have been held long enough to qualify as an ISO. By December, the share price has tumbled to $15. The company allows Bill to turn in the shares and get new options with the same price and terms as the old ones. The price Bill paid to exercise the options is returned to him, and Bill returns any dividends paid during the period he held the shares. From an income tax standpoint, the argument is that nothing has happened -- the old options have been canceled, the employee has no tax due, and the company does not get a tax deduction.

The SEC has issued guidance on rescissions saying that the practice creates a variable accounting requirement, meaning that, unlike with conventional stock option practices, the cost of option must be reflected on the company financial statements. The SEC has allowed a transition period, however, saying that the treatment will apply only to rescissions granted after January 1, 2001.

For rescissions prior to 2001, the company must record a charge to earnings equal to any tax deduction it lost as a result of the rescission (the $25 spread between the $20 exercise price and the $45 share price, in our example), plus any additional cost represented by the excess of the share price over the option price at the time of the rescission (in this example). It is not clear whether the company will still have to take a charge to earnings for lost deductions under the new procedures as well.

For rescissions after January 1, 2001, the company must use "marked-to-market" variable accounting, meaning it records an expense each quarter representing the current difference between the option price ($20) and the market price of the shares, a process that can result in a substantial accounting charge. This goes on until the options are no longer in effect, either because they have been exercised, they have lapsed, or are forfeited. In addition, the company has to disclose the terms of the rescission in its financial statements. In its stockholder equity section, the company must show the initial exercise and subsequent rescission. Rescinded shares must be included in the calculation of "basic" earnings per share while the shares are outstanding, and any cash flow results need to be discussed in management's "discussion and analysis."

It is not known just how common the rescission practice has become, but it has generated considerable controversy about whether it is just another way to eliminate the risk associated with options, one that could, in some cases, cost a company valuable tax deductions. The SEC's guidance is apparently at odds with FASB staff recommendations, and FASB has not yet issued any guidance of its own on the subject other than to release the SEC guidance.

Labor Department Issues Guidance on Plan Expense Policy

Some expenses of ERISA plans, including ESOPs and 401(k) plans, can be paid for by the plan. In Advisory Opinion 2001-01A, the Pension Welfare Benefit Administration (PWBA) has issued new guidance on when the plan can pay for various tax qualification and other plan functions.

Expenses related to so-called "settlor" functions cannot be paid for by the plan. Settlor functions are those relating to the establishment, termination, or design of the plan, except to the extent changes in plan rules or operations are mandated by changes in law and/or regulations or by requirements of anti-discrimination testing. Changes in the plan that are optional, such as changing the vesting schedule in an ESOP to extend the repurchase obligation period, would not be plan expenses. On the other hand, required administrative filings (including letters of determination) and expenses relating to the ongoing operation of the plan under its current terms would be allowed plan expenses.

For more detail, go here on BNA's site for a full text of the opinion.

Section 423 Plan That Has a First Refusal Right Qualifies as ERISA Plan

A company's Section 423 employee stock purchase plan allows employees to purchase shares at a 15% discount at either the end or the beginning of its offering period. Once employees have purchased the shares, they must provide the employer notification of their intent to sell the stock if the sale is to occur within two years after the grant of the right to purchase or one year after exercise. The company then has 10 days to repurchase the shares at the lower of the price at which they bought them or the current market price. If the repurchase occurs, the deduction to the employer, and the taxable amount to the employee, are determined by the actual price paid for the shares.

In Private Letter Ruling 200102042, the IRS ruled that this plan would qualify under Section 423 of the Internal Revenue Code.

NASDAQ and NYSE Shareholder Approval Rules Pending

Under pressure from the SEC, the NYSE and the NASDAQ are considering changes in their current rules for shareholder approval of option grants. On both exchanges, current rules provide exemptions form shareholder approval for plans that are broad-based, defined by the NYSE as plans in which a majority of the options are issued to non-exempt employees and in which a majority of full-time non-exempt employees are eligible to participate. NASDAQ has a similar exemption, but simply states that the plan must cover a majority of employees.

The proposed NYSE rules, which NADAQ is considering as well, would require shareholder approval of any plan in which officers and directors participate and the proposed dilution (measured in terms of currently outstanding options and options that have been authorized but not issued) is 10% or more of the existing authorized dilution under the plan. However, options issued in conjunction with acquisitions of other companies or to new employees would not be counted.

Netherlands Passes New Options Law

Under a new law passed in the Netherlands, previously one of the most option-unfriendly tax jursidictions, employees can choose to have their options taxed on grant or on the spread at exercise. Employees and the employer must notify the tax auhtority at the time the option is granted which approach will be used. It cannot be subsequently changed.

BLS to Expand Study of Option Incidence

The Bureau of Labor Statistics has started to ask employers if they offer stock options in its annual survey of medium to large-sized employers. The data will provide another useful tool in estimating he total number of employees eligible to receive options, and will be part of a lager BLS effort to gauge the impact of options on employee compensation.

SEC Issues Proposed Equity Compensation Plan Rules

The SEC is proposing regulations for public companies that would require at least annual disclosure about the total number of securities that have "been authorized for issuance under equity compensation plans in effect as of the end of the last completed fiscal year, whether or not the plans have been approved by security holders." The disclosure would be in a table in the company's proxy statement if there is a request for plan approval, and/or in the company's annual report of 10-K filing if no proxy statement is been filed.

The proposal would require identifying each equity compensation plan in effect as of the end of the last completed fiscal year. It would have to include:

This information would be provided whether the equity compensation plan was previously approved or not, but the disclosure would have to identify which plans were approved and which were not. Plans would also have to be briefly described. Comments on this proposed rule are being solicited. To see the entire proposal and to submit comments, go to the SEC's page on the topic.

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