Yes, sadly this is yet another blog posting dealing with that infernal Internal Revenue Code Section 409A. But, my musings here are not about the intricacies of 409A and the various tax issues it presents or even the fact that the year-end compliance deadline is now less than 125 days away! Rather my focus is on whether this pervasive tax statute also has the power to complicate securities law compliance as well.

Private Company Valuation and Discounted Stock Options

As most practitioners know, 409A does not look too kindly on employee stock options that were issued at a discount from the grant date share fair market value. Whereas a typical vanilla flavored stock option is exempt from 409A, a discounted option is not. And, if a discounted option’s exercise periods are not sufficiently constrained (e.g., by limiting exercisability to a 409A permitted event) then such a discounted option could likely violate 409A.

As most of us know, this treatment has caused quite a stir with privately held companies since the determination of the fair market value of their shares cannot be gleaned simply by looking at trading prices posted on-line or in the morning newspaper as is the case for public companies. Indeed, the 409A final regulations recognize this and provide elaborate discussion (along with some guidance and safe harbor presumptions) on how private companies should determine the fair market value of their shares.

Since most stock options are generally intended to be granted with an exercise price equal to the grant date fair market value, the fear of course is that a defective undervaluing of the shares means that the company could have inadvertently awarded discounted options which then could cause a 409A violation.

Apart from altering their future option grant and share valuation practices, many private companies and their counsel/accountants have had to scurry around examining historical option grants to uncover whether they had outstanding discounted options due to low and indefensible valuations. The existing 409A guidance discusses various techniques for correcting discounted stock options. The most obvious method is to simply increase the exercise price of the discounted option up to the corrected, higher grant date fair market value. And, a number of companies have opted to follow this path.

Rule 701 Numerical Limits and Consequences of Repricing Stock Options

The potential securities law compliance issue that is the source of my musings relates to Rule 701 of the Securities Act of 1933. Rule 701 is the easiest and primary way that companies obtain exemption from the registration requirements of the Act with respect to their compensatory stock options. Rule 701 imposes numerical limitations on the magnitude of equity securities that can be issued in reliance on Rule 701 in a twelve month period.

In particular, the aggregate sales price or amount of securities sold in a twelve month period cannot exceed the greater of: (i) $1 million, (ii) 15% of total assets or (iii) 15% of outstanding securities. Moreover, if relying on either (ii) or (iii) and the aggregate sales price of Rule 701-issued securities exceeds $5 million, then Rule 701 requires that additional disclosures (in essence, a prospectus) be provided to grantees. Such additional disclosures need to have been provided to grantees before they exercised their Rule 701 options and acquired shares.

The sales price for stock options awarded for purposes of these numerical tests is computed at the time of option grant and is calculated by multiplying the number of option shares by the per share exercise price. The SEC’s April 1999 adopting release of amendments to Rule 701 provides that "In the event that exercise prices are later changed or repriced, a recalculation will have to be made under Rule 701".

Normally, such a recalculation would be performed (with favorable results) when there is an option repricing to lower the exercise price to equal a share fair market value that has declined since the grant date. But, what about if the option is repriced upwards in order to accommodate 409A? Presumably, options whose exercise price is increased to avoid being treated as a discounted option under 409A must also be recalculated for purposes of Rule 701 using the higher option exercise price. Would the recalculation be retroactively performed for the period when the initial grant was made or would the value of the amended option be included in Rule 701 numerical analysis as of the date of the amendment?

In either case, the effect of such an upward adjustment could result in the aggregate sales price exceeding the $1 million and/or total assets thresholds of Rule 701 whereas computations applying the pre-adjusted exercise prices did not. And, perhaps even more troubling, if the Rule 701 $5 million threshold was breached as a result of the recalculation, it could be problematic or even impossible for the company to comply with the additional disclosure requirements imposed by Rule 701 since it is quite possible that some grantees may have already exercised their stock options absent the benefit of the requisite additional disclosure.

Private companies that have increased their option exercise prices in order to comply with 409A may want to also re-examine their compliance with the numerical limitations of Rule 701 particularly if they are considering going public or being acquired since their historical securities law compliance will come under closer scrutiny. While it is possible that the company may be able to avail itself of another exemption under the Act (e.g., Regulation D for certain qualifying option grants), will these recurring 409A-related headaches never end?

For further information, please contact Gregory C. Schick at (415) 774-2988.