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Stock Option Strike Prices Under 409A

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Remediation Center: Stock Option Strike Prices Under 409A

By Compliance Week — September 11, 2007

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.

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




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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.




Compliance Week can be found at http://www.complianceweek.com. Call (888) 519-9200 for more information.
                                       ABOUT THE EXPERT
              S. Tony Ling is a partner in Jenner & Block’s Chicago office. He is a
              member of the Firm’s Employee Benefits and Executive Compensation and
              ERISA Litigation Practices, and he serves on the subcommittee of the
              Firm’s Diversity Committee. Mr. Ling counsels clients on all aspects of
    Ling      employee benefits and executive compensation. He has much transactional
 experience, advising clients on employee benefit and executive compensation aspects
 of business transactions, including the allocation of pension and retiree medical
 liabilities and assets, severance issues, post-closing transition issues with respect to
 retirement and health and welfare programs, stock option conversions, golden
 parachutes, reductions in force, and withdrawal liability. Mr. Ling also counsels clients
 on a full spectrum of ERISA and employee benefit matters.

 Mr. Ling is a member of the American Bar Association, Illinois State Bar Association,
 Asian American Bar Association of Chicago, Chinese American Bar Association of
 Chicago, and National Asian Pacific American Bar Association. He is also a board
 member of the Chicago Dragons Athletic Association.

 Mr. Ling earned his J.D. degree from the Indiana University School of Law, cum
 Laude, in 1996 and his B.A. in Chemistry from Northwestern University in 1993. He is
 a member of the bar of Illinois and Indiana.




Compliance Week provides general information only and does not constitute legal or
financial guidance or advice.




Compliance Week can be found at http://www.complianceweek.com. Call (888) 519-9200 for more information.

				
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