Remediation Center: Stock Option Strike Prices Under 409A

At the request of subscribers, Compliance Week offers a Remediation Center, in which readers can submit questions—anonymously—to securities and accounting experts. Compliance Week's editors will review all questions and then submit them—confidentially, of course—to specialists who can address the issues. The questions and responses will then be reprinted in a future edition of Compliance Week. Below is one of the Q&As; ask your own questions by clicking here.

QUESTION

If a company uses the average price of its stock over the 10-day period prior to the grant date to determine the strike price for stock options granted, is this method permissible under Section 409A of the Internal Revenue Code?

The option agreement specifically requires this method of determining the strike price and is used consistently by our company. We have reviewed past grants and have determined that for some awards, the strike price is lower than the fair market value of the stock on the grant date. Does this create an issue even though the method is required by the option agreement? Are there any potential Section 409A issues?

ANSWER

Awards of stock options with a strike price at or greater than the fair market value of a company's common stock on the grant date are not subject to Section 409A and final regulations. Generally, the final 409A regulations provide that the strike price for an option award must not be less than the fair market value of a share of the company's common stock on the grant date. Further, the final regulations provide that the commitment for granting a stock option award with a strike price based on an average of the company's common stock over a certain specified period must be irrevocable before the commencement of the averaging period.

The intent of the rule is to prevent a company from manipulating the strike price. Under the final 409A regulations, if a company wants to use an averaging method for determining the strike price for an option award prior to the commencement of the averaging period, the company must designate the individual who will receive the award of stock options, the number of shares covered by the option award, and the method for determining the strike price for the award. If these requirements are met, there will not be a violation of Section 409A simply because the strike price (as determined using the averaging method) is less than the fair market value of the company's common stock on the grant date.

Based on the final 409A regulations, if the company wants to continue to establish the strike price for option awards by using the average price of the company's common stock over the 10-day period before the grant date, the terms of the award must be irrevocably determined before the averaging period begins. (For example, before the beginning of the averaging period, the company must irrevocably determine the individual entitled to the award and the number of shares covered by the award.)

Because of the complex nature of the rules, an example is probably in order. Using the facts described above, if the company wants to use the average price of the company's common stock over the 10-day period before the grant date to determine the strike price, the company should first establish a grant date. For purposes of this discussion, let's use a grant date of Monday, Jan. 1 and assume that the 10-day averaging period means 10 business days and not 10 calendar days. The decision to award the stock options with a grant date of Jan. 1 must be made before the 10-day averaging period begins. So, the commitment to make the award on Jan. 1 must be irrevocably made before Dec. 18, the first day of the 10-day averaging period). If the commitment to grant the award is made prior to this date, the fact that the strike price has a value less than the fair market value on Jan. 1 will not be a violation of Section 409A.

Whether the stock option plan or the award agreement specifically outlines the method for establishing the strike price is not determinative. The determinative factor is the timing of the commitment of granting an award. If the commitment to grant an award is made after the averaging period begins, the method for determining the strike price will not be in compliance with Section 409A. If the commitment to grant an award is made before the averaging period starts, the method for determining the strike price will comply with Section 409A.

In summary, a company may use an averaging period for establishing the strike price for an award of stock options if the commitment to make such an award is irrevocably made prior to the start of the averaging period.

Please be aware that Section 409A is complex and because of its recent enactment, guidance is very limited. To improve compliance with Section 409A, please contact your executive compensation legal counsel.