Legal Updates

4/25/2007

Section 409A Countdown to Full Compliance - Installment No. 2: Stock Plans

For additional information, see our other Section 409A news items.

Section 409A’s Impact on Stock Plans

Section 409A has a significant impact on the design and operation of equity-based incentive compensation plans of both public and private companies. All compensation plans that use stock or stock equivalents should be reviewed to ensure there are no plan document defects that could result in Section 409A violations. All companies should also review their equity-award granting practices to ensure that their equity-based award programs are operating in compliance with Section 409A.

STOCK OPTIONS AND STOCK APPRECIATION RIGHTS

Incentive stock options that qualify under Section 422 of the Internal Revenue Code are not subject to Section 409A. Nonstatutory stock options (i.e., any options other than incentive stock options) and stock appreciation rights (collectively, “stock rights”) are subject to Section 409A unless an exemption applies. While in theory it is possible to structure stock rights to comply with Section 409A, in practice, if a stock right is subject to Section 409A then it will almost always violate Section 409A, because the holder is free to exercise the stock right at any time. Thus, most stock rights will need to be structured to be exempt from Section 409A.

The only available exemption for stock rights is the “fair market value” exemption. A stock right will generally qualify for this exemption if (i) the exercise price of the stock right is not less than 100% of the fair market value of the underlying stock, (ii) the fair market value is determined on the date of grant, (iii) the underlying stock is stock of the service recipient (employer), and (iv) the stock right is not impermissibly modified or extended after the date of grant. Stock rights that provide for any additional deferral feature (other than the deferral of the potential spread value) do not qualify for this exemption. The four basic requirements for qualifying for this exemption are discussed in turn below.

Requirements Affecting Public and Private Companies Alike

• Fair Market Value: Stock rights are exempt from Section 409A only if granted with an exercise price not less than 100% of the fair market value of the underlying stock on the date of grant. For public companies, valuation is generally not an issue. It is important to note, however, that if a public company decides to base the fair market value of a stock right on the company’s average stock prices on an exchange within a designated period prior to or following the date of grant (not to exceed 30 days in either case), it must specify the period in advance, pre-identify all grantees and the amounts of all grants and pre-commit to making the grants prior to the start of the designated period. Valuation issues for private companies are more significant and are discussed in greater detail below.

• Date of Grant: Stock rights may fail to be valued at 100% of their fair market value if they are granted effective as of a date that is different from their actual date of grant. Section 409A defines the “date of grant” as the date on which the issuer completes the corporate action constituting a legally binding right of the stock right with respect to the grantee. If the grant is intended to occur immediately following the corporate action, the grantee must be notified of the award within a reasonable period after the corporate action.

• Service Recipient Stock: A stock right is only exempt from Section 409A if at the time of grant it is granted on “service recipient stock.” The definition of service recipient stock has two elements: the type of stock on which stock rights may be granted, and the entity on whose stock the stock rights may be granted.

For the type of stock, service-recipient stock generally includes any class of common stock (the chosen class is not required to have the highest aggregate value of all classes) and stock that is preferred only as to liquidation (not dividend) rights.

As to the entity, service-recipient stock only includes the stock of the grantee’s employer or a corporation that is a “higher-tier” corporation with respect to the employer. A “higher-tier” corporation is any corporation that is a 50%-or-more shareholder of the grantee’s employer or is in a chain of corporations ending with the grantee’s employer, where each corporation in the chain owns at least 50% of the corporation immediately beneath it. It is important to note that service-recipient stock does not include stock of any subsidiary of the grantee’s employer, or of any entity that is a brother-sister corporation of the grantee’s employer at the time of grant. The final 409A regulations allow a 20% threshold to be substituted for the 50% threshold discussed above generally if there is a legitimate business purpose for the substitution.

• Modifications and Extensions of Options/SARs After the Date of Grant: A stock right that is initially exempt from Section 409A as of its date of grant may still end up violating Section 409A if the stock right is ever impermissibly modified or extended after its date of grant. A modification is generally any change to the terms of the stock right that results in a direct or indirect reduction in the exercise price, whether or not the benefit from the change is in fact realized by the grantee. A modification generally does not include any acceleration of the vesting terms of a stock right. It is also not a modification of a stock right to assume or substitute the stock right as part of a corporate merger or other similar transaction generally as long as the assumption or substitution results in the stock rights possessing the same aggregate spread value and each stock right possessing the same individual ratio of exercise price to share value immediately after the transaction as immediately before the transaction. The final regulations have generally relaxed the requirements relating to stock right extensions. Under the final regulations it is generally only considered an impermissible extension of a stock right if the exercise period is extended beyond the lesser of the original option term or ten years from the date of grant.

Valuation Requirements Affecting Private Companies

Section 409A provides detailed standards for valuing stock that is not readily tradable on an established securities market. The general standard is that the stock be valued based on the “reasonable application of a reasonable valuation method.” This is stricter than the “good faith” standard that applies for purposes of incentive stock option awards. A stock value that is determined in “good faith” may nevertheless violate Section 409A if the valuation method is objectively unreasonable or is applied unreasonably.

The final regulations emphasize that private companies are not required to use an independent appraiser to determine their stock value for purposes of granting stock rights. However, as a practical matter, unless a private company that does not use an independent appraiser can show that it has considered all of the factors that the final regulations consider relevant for valuation purposes, there is a risk that the valuation method will be deemed insufficiently “reasonable.” The factors that are to be considered for valuation purposes under the final regulations include:

• The value of a company’s tangible and intangible assets

• The present value of anticipated future cash-flows

• The market value of stock in similar corporations engaged in similar businesses

• Any recent arm’s length transactions involving the sale of the company’s stock

• Control premiums or discounts for lack of marketability

• Valuation methods used by the company for any other purposes

• Any other information material to the value of the company

Valuations become “stale” and are no longer considered reasonable after the earlier of 12 months or the occurrence of an event (such as the resolution of material litigation involving the company) that materially affects the value of the company.

The final regulations also provide three “safe harbor” valuation methods which are presumed to be reasonable, unless the IRS can demonstrate that the method was grossly unreasonable in light of a company’s situation. The three safe harbor methods are:

• Valuation by an independent appraiser that meets the requirements for valuation of company stock held in an employee stock ownership plan;

• Valuation based on a formula, such as a multiple of book value or corporate earnings, that constitutes a “nonlapse restriction” for Code section 83 purposes. The same formula must apply for purposes of all transactions (compensatory and noncompensatory) with the company or any 10% shareholder of the company (other than arm’s length transactions involving the sale of substantially all the company’s stock to an unrelated purchaser);

• Valuation of illiquid stock of a start-up corporation by a qualified valuation expert

Different valuation methods can be used to determine the exercise price on the one hand and fair market value at the time of exercise or repurchase price on the other, provided the method, once designated, can not be changed retroactively. In addition, if the company’s stock becomes publicly traded after the date of grant but before the date of exercise or repurchase, the valuation must be based on the market price of the stock at the time of exercise or repurchase.

RESTRICTED STOCK & RESTRICTED STOCK UNITS

Restricted Stock. Restricted stock awards are generally exempt from Section 409A. However, an arrangement under which dividends are payable on restricted stock during the restriction period is potentially subject to Section 409A. To avoid Section 409A, the dividends must be paid to the restricted shareholder at the same time as dividends are paid to other shareholders of record, or the dividend arrangement must be structured to take advantage of the short-term deferral exception (for example, by providing that the dividends are accumulated and subjected to the same restrictions as apply to the underlying restricted shares).

Restricted Stock Units: Restricted stock units, whether payable in cash or in stock, are subject to Section 409A unless an exemption applies. In practice, many restricted stock units are structured or can be structured to be paid out at the same time that vesting occurs. In general this allows restricted stock units to qualify for the short-term deferral exemption. However, restricted stock units whose vesting (but not whose payment) is accelerated due to events during the restriction period that are within the control of the grantee (such as retirement or other voluntary terminations of service) or can be accelerated in the discretion of the employer may fail to qualify for the short-term deferral exemption. In that event, the restricted stock units would need to be structured to comply with Section 409A.

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