The Stock Options Book

Excerpts

From Chapter 3, "Tax Treatment of Incentive Stock Options" (footnotes omitted)

If an ISO is modified only with respect to a portion of the optioned shares, or if the modification is solely for the purpose of increasing the number of shares under option, only the portion of the ISO relating to such shares will be deemed modified for these purposes. The affected options will be considered to be newly granted options. If a company inadvertently modifies its ISOs, it can undo the modification without disqualifying the option as long as the modification is reversed by the earlier of the last day of the calendar year when the change was made or the date of exercise of the option.

If an ISO exercisable at $1 per share is amended at a time when the underlying stock has a value of $5 per share, the option exercise price will have to be increased to at least $5 per share to maintain the ISO status of the option. If the exercise price is not adjusted, the option will be treated as a discounted NSO that is subject to retroactive taxes and penalties under Section 409A from the original grant date. Taxes and penalties under Section 409A are due in the year the option vests. Even if the stock price has dropped, the modification may raise Section 409A issues, as discussed in section 9.5.3.

Under the ISO rules, if an ISO is modified, the grant date is deemed to be the date of the modification rather than the date of the original grant. This will mean that the optionee’s statutory holding period must be extended for an additional two years. Note that even if the modification occurs in a down market without repricing (because the exercise price is greater than current fair market value), the statutory holding period will re-start on the date of the modification.

A change in option terms by virtue of a “corporate transaction” will not be treated as a modification for these purposes. “Corporate transactions” include mergers, consolidations, reorganizations, and liquidations; changes in the corporate name; and other changes as may be prescribed by the Internal Revenue commissioner. Stock splits and stock dividends are not modifications so long as they are proportionate and do not result in more than minor changes to the value of the awards. For example, if a company conducts a 2-for-1 stock split in which every share become two shares, each of which is worth half of the pre-split share price, then outstanding option grants could be adjusted accordingly—the size of each outstanding grant could double and the exercise price could be halved without jeopardizing the ISO treatment or requiring remeasurement of the $100,000 limit.

From Chapter 6, "Trends in Equity Compensation: An Overview" (footnotes omitted)

In this context, a clawback is a contractual or statutory right to recover realized equity compensation upon the occurrence of certain events. The Sarbanes-Oxley Act of 2002 authorizes SEC enforcement of forfeiture of compensation by the CEO and CFO in the event of certain securities law violations (e.g., those giving rise to financial restatements, such as backdating). The Dodd-Frank Act included a provision requiring companies to adopt written clawback policies that set forth their authority to claw back compensation. In late October 2022, the SEC finalized clawback rules, and the national securities exchanges subsequently issued listing standards that were implemented in 2023. The new rules set forth when compensation must be clawed back and who it must be clawed back from.

Under the rules, current and former Section 16 officers are subject to clawback of their incentive compensation when grant or vesting is based on stock price or other financial reporting metrics. This includes performance-vested equity compensation received in the three years leading up to a restatement that results from noncompliance with SEC rules. The error can be either a material error or one that would become material if not corrected.

Because the Dodd-Frank Act does not require that compensation be clawed back solely from those who were involved in the financial misstatements, it potentially has a much broader application than the earlier Sarbanes-Oxley provision. In 2016, the Ninth Circuit Court of Appeals took a broader view of the clawback provisions of the Sarbanes-Oxley Act when it upheld the SEC’s argument that Sarbanes-Oxley allows clawbacks from CEOs and CFOs who have certified false and misleading financial statements that are later restated—even if the restatement was not caused by the misconduct of the CEO or CFO.

The SEC rules, as well as the rules adopted by the national securities exchanges, require companies to adopt and disclose policies for clawing back incentive compensation from current and former executive (Section 16) officers when material noncompliance with financial reporting requirements leads to financial restatements. The amounts to be clawed back include incentive compensation tied to accounting-related metrics, stock price, or total shareholder return (TSR). Clawbacks are not limited to those who participated in the actions that led to the restatement. The recoverable amount is the amount of incentive-based compensation received that is in excess of the amount that would otherwise have been received if calculated based on the restated metric.

The clawback provisions must apply to incentive compensation received in the three years preceding the date on which the company is required to prepare the restatement.

Under the rules, companies are required to file their clawback policies as exhibits to their annual reports. They are also required to disclose in their annual reports and in any proxy statement that requires executive compensation disclosures whether a restatement requiring recovery of incentive-based compensation was completed during that fiscal year as well as the existence of any outstanding balance of excess incentive-based compensation from a prior restatement.

The rule applies to listed companies, including emerging growth companies, smaller reporting companies, and foreign private issuers. Listed companies that fail to adopt and disclose clawback policies will be subject to delisting.