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Many publicly traded companies use stock options to attract, motivate, compensate and retain employees. In the past several years, companies have expanded the use of stock options and other equity incentives beyond only senior management to include a much broader range of employees. In a bull market, the incentives that stock options provide employees can be enormous. Those incentives largely evaporate, however, when markets experience significant declines, such as those that have been experienced over the past 18 months. Typically, stock options are granted with a fixed exercise price equal to the trading price of the underlying stock at the time the options are granted. Because many companies granted their employees options when the market price for their stock was much higher, the significant and broad-based decline in the trading levels for many issuers’ stock has resulted in many of these employees holding options that are “out-of-the-money” (i.e., the exercise price of the option is higher than the market price of the underlying stock). Since these options may be viewed as virtually “worthless” to employees, they no longer serve the employer’s motivational purposes. As a result, many issuers have implemented option repricing or option exchange programs. These programs put the employees back in the position of being able to benefit from increases in their employer’s stock price (hopefully, a result of their hard work). They are, however, fraught with potential problems for issuers. PROBLEM WITH OPTION REPRICING In the past, companies could simply reprice their employees’ out-of-the- money options by lowering the exercise price to the current market price for its stock without any financial impact associated with such repricings. Unfortunately, the adoption of Financial Accounting Standards Board Interpretation No. 44, Accounting for Certain Transactions Involving Stock Compensation (interpreting APB Opinion No. 25, Accounting for Stock Issued to Employees) (“FASB Interpretation No. 44″), significantly changed the treatment of fixed stock option repricings. FASB Interpretation No. 44 requires companies to apply the variable accounting rules to otherwise fixed employee stock options that are modified to reduce the exercise price of the options granted to their employee; treating these repriced employee stock options as variable as opposed to fixed. Under variable accounting rules, a company that reprices its options must expense any appreciation in the repriced options until the options are fixed, exercised or expired. This differs significantly from the treatment that stock options receive under the fixed accounting rules. Under the fixed accounting rules, because the exercise price is at the current market price at the time the stock options are granted and the number of exercisable shares is known at the time the stock options are granted, the options have no intrinsic value on the date of the grant and no compensation cost is recognized by the employer. ‘SIX-PLUS-ONE’ OPTION EXCHANGE PROGRAMS In light of the adoption of FASB Interpretation No. 44, many companies choose not to reprice the exercise price of their employee stock options, but instead choose to exchange the out-of-the-money options for new options. However, simply exchanging these options does not necessarily avoid variable accounting treatment of the new options. If the new options are granted within six months of the cancellation of the original options, they will be subject to variable accounting under FASB Interpretation No. 44. In an attempt to avoid this result, many issuers choose to implement an option exchange program where the employee option holders forfeit their “out-of-the-money” options and, six months and one day later, options are granted with an exercise price equal to the market price of the underlying stock at the time of the new grant. These programs are also referred to as “six-plus-one” option plans. Sprint Corp. was one of the first major companies to implement a “six-plus-one” option exchange program in the fall of 2000. Since then, many more employers, including Amazon.com Inc. and Nortel Networks Corp., have followed Sprint’s lead with their own six-plus-one option exchange programs in an effort to continue providing their employees with equity growth incentives despite current market conditions. OPTION EXCHANGE PROGRAMS AND SEC TENDER OFFER RULES Another issue that arises under option exchange programs is whether the offer to exchange outstanding stock options constitutes an “issuer tender offer” under the rules promulgated by the Securities and Exchange Commission pursuant to the Securities Exchange Act of 1934. If so, the offer is subject to the filing, disclosure, dissemination, best price, all holders and antifraud provisions of Rule 13e-4. Rule 13e-4 applies to any company that has equity securities registered pursuant to � 12 of the Exchange Act, or that is required to file period reports with the SEC pursuant to � 15(d) of the Exchange Act in connection with a “tender offer” for any of its own securities, whether or not these securities are registered under the Exchange Act. The purpose of Rule 13e-4 is to ensure that security holders have adequate information about the tender offer to make a decision of whether to participate in the tender offer. The rule also serves to prevent fraudulent, deceptive or manipulative practices in connection with the issuer tender offer. The SEC has not specifically defined the term “tender offer,” nor is there a definition under the Exchange Act. However, there may be circumstances where an option exchange program falls outside the scope of Rule 13e-4, depending on how the option exchange is structured. Some factors that are considered in determining whether an option exchange program is considered a “tender offer” include: � active and widespread solicitation of public shareholders; � whether solicitation is made for a substantial percentage of the issuer’s securities; � the price of the offer; � whether the offer is contingent on certain conditions and for a limited period; and � whether the offeree is subject to pressure to sell his or her securities. In the event that an option exchange program is deemed to be a tender offer, it will be subject to the tender offer rules, including Rule 13e-4 and the filing and disclosure (Schedule TO) requirements thereunder. HANDLING OPTION EXCHANGE TENDER OFFERS Because many companies have broad-based incentive stock option programs, their option exchanges are not limited to executive officer and directors but are instead open to a large number of employees. Many issuers have taken the position that such broad-based stock option exchange programs qualify tender offers. In an “Update to the Current Issues and Rulemaking Projects” outline issued March 21, 2001 (the “update”), and an accompanying exemptive order, the SEC has taken the position that unlike option repricings, the option holders in broad-based option exchange programs must make individual investment decisions, and that “the decision to accept the [option exchange] offer is not merely a compensation decision.” Accordingly, these exchange offers are subject to the issuer tender offer rule, Rule 13e-4 under the Exchange Act, if the issuer has a class of equity securities registered under � 12 or is required to file reports under � 15(d) of the Exchange Act. Although the SEC has not defined what a “broad-based” option exchange program entails, many companies that institute such programs where there are many eligible employee participants have taken the position that their option exchange programs constitute “issuer tender offers” subject to the requirements of Rule 13e-4. In many instances, employers want the ability to treat option holders differently to accomplish their compensation objectives (i.e., giving executive officers a lower exercise price to provide an added incentive). In addition to the general filing and disclosure requirements of Rule 13e-4, that rule requires issuers to (i) extend the offer to all security holders of the subject class of securities (i.e., the option holders — the “all holders” rule) and (ii) offer the highest consideration to any security holder that is offered to any other security holder (the “best price” rule). If a company chooses to treat its executive officers or other key employees differently to achieve its compensation objectives, it would not be able to comply with Rule 13e-4′s all-holders-and-best-price rules. Because the SEC believes that option exchanges (in the compensation context) “do not present the same concerns caused by discriminatory treatment among security holders that [the all holders and best price] rules were intended to address[,]” the SEC’s Exemptive Order exempts option exchange offers from Rules 13e-4(f)(8)(i) and (ii), the all-holders-and-best-price rules, respectively, if the following conditions are met: � the issuer is eligible to use Form S-8, the options subject to the exchange offer were issued under an employee benefit plan as defined in Rule 405 of the Securities Act, and the securities offered in the exchange offer will be issued under such an employee benefit plan; � the exchange offer is conducted for compensatory purposes; � the issuer discloses the offer to purchase the essential features and significance of the exchange offer, including risks that option holders should consider in deciding whether to accept the offer; and � the issuer otherwise complies with Rule 13e-4. Of course, issuers are still subject to the filing, disclosure and antifraud provisions of the Exchange Act and the rules thereunder. Due to the potential costs associated with option repricings and option exchange programs, companies may also wish to consider issuing additional new options to employees or canceling the options and issuing restricted stock to employees subject to a vesting schedule to provide their employees with out-of-the-money options. Regardless of the course of action a company chooses to provide its employees with the incentive of equity growth, in addition to the legal and accounting considerations, companies should also consider: � The likelihood of growth in the company’s stock price in the near future; � The time to implement a program; � The administrative, legal and financial cost of the alternatives; � Investors’ perception of the company’s course of action; � Employees’ perception; and � Alternative noncash performance incentives. Kevin Lau is an associate in Haddonfield, N.J.-based Archer & Greiner‘s Computer & High Technology and Intellectual Property Practice Groups. His practice focuses on representing emerging growth companies in the areas of corporate formation and governance, corporate finance and private securities transactions.

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