Client Alert

Financial Accounting Standards Board Statement No. 123 (revised 2004), Share-Based Payment ("FAS 123(R)"), requires the "fair value" expensing of share-based awards, such as stock options, restricted stock, and restricted stock units settled only in stock. If such awards are modified after grant, a company may incur an additional accounting charge equal to the difference between the fair value of the awards prior to the modification and the fair value of the awards after the modification. Several major accounting firms have recently interpreted FAS 123(R) as providing that a modification will occur -- potentially causing additional compensation expense -- if an anti-dilution provision allows discretionary adjustments of share-based awards in the event of certain corporate restructurings, such as stock dividends, stock splits, and spin-offs. Companies should review the terms of their equity plans and award agreements as soon as possible to determine whether they will be affected by this new interpretation.

The text of FAS 123(R) governing modification of share-based awards provides that addition of an anti-dilution provision in contemplation of a corporate restructuring likely will result in additional compensation expense. On the other hand, addition of an anti-dilution provision where no corporate restructuring is contemplated generally will not result in additional compensation expense.

As noted above, several accounting firms have now determined that discretionary anti-dilution provisions will result in additional compensation expense. However, mandatory anti-dilution provisions -- which require adjustments in a corporate restructuring -- likely will not result in additional compensation expense.

From these principles, the addition of a mandatory anti-dilution provision when a corporate restructuring is not contemplated would allow a company to protect the value of awards for plan participants, while likely avoiding significant, additional compensation expense. The following issues should be considered when analyzing whether to add such a provision or to change a discretionary provision to a mandatory one: 

• The extent to which the addition or change will constitute a modification for purposes of Code Section 409A (governing all nonqualified deferred compensation arrangements) or Code Section 422 (governing incentive stock options). This must be determined based on the terms of the plan and awards. 
• The possibility that addition or change of an anti-dilution provision will necessitate shareholder approval. Based on NYSE and NASDAQ guidelines for shareholder approval of equity compensation plans, it does not appear that shareholder approval generally will be required. 
• The effect on older equity plans under which there may be outstanding awards, even though the company does not currently grant awards under such plans. These outstanding awards should not be overlooked in reviewing a company’s anti-dilution provisions. 
• The contractual rights to which plan participants will be entitled under a mandatory anti-dilution provision in the event of a corporate restructuring. Companies should weigh the potential compensation expense in the event of a corporate restructuring against the desire to maintain discretion to adjust awards. 
• The exact wording of an anti-dilution provision. It appears that in many cases no additional compensation expense will result if a company retains discretion over the exact form of adjustment that is made, provided that adjustment is mandatory. In other words, a Board can likely retain discretion to determine the exact adjustment that is made, provided that some kind of adjustment is required.

Of course, any contemplated changes to a plan or agreement should be reviewed by the company’s accountants to ensure that the desired accounting treatment is obtained.