We are frequently asked by clients about the rules that apply to the treatment of equity awards in the context of a
When a company engages in a reduction in force, or RIF, the company usually seeks to
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Generally, the underlying equity plan gives the corporate board wide latitude in setting, or modifying, the terms of equity award agreements so that the employer may have a good amount of flexibility to change the post-termination exercise period. However, this is not always the case, so the first step is to always check the equity plan and award agreements to see what can be done without, or with, the employee option holder's consent.
Equity awards usually include a fixed post-termination exercise period after a regular individual termination without cause, including death, but do not provide any special treatment if the termination is part of a reduction in force. Extending this post-termination exercise period in a RIF can improve relationships with departing employees and could be consideration for a release of claims.
Suppose the award is a stock option and provides that the award must be exercised within 90 days after termination of employment. The company could do nothing, and continue to apply that restriction even in the case of a reduction in force. For private company stock, doing nothing requires the employee to decide whether to purchase the stock (exercise the option), typically with no available market or prospects to resell the stock in the future, or forfeit the stock options (even if vested). But suppose the company wants to extend the effective life of the award — what then?
If the award is an "incentive stock option ("ISO"), the United States tax code (the "Code") requires exercise of the ISO within three months after termination of employment (with an exception for death) — one of the few fixed rules that we were alluding to that are applicable to a situation such as a reduction in force. But the Code does not require cancellation of the option if not exercised within that period; instead the Code provides that exercise after that three-month period changes the tax treatment from an ISO to an ordinary nonqualified option ("NQO"); in fact, that three-month post-termination exercise period is frequently used for NQOs.
While an employee may plan how to handle such a short post-termination exercise period, a reduction in force is frequently a surprise for which employees could not plan in advance. For that reason, an extension of the post-termination exercise period can be a valuable benefit offered as part of a reduction in force. Accordingly, the employer might decide to extend the exercise period as part of the consideration for a release of claims.
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It is often the case that the equity plan limits the duration of an equity award to 10 years from the date of grant, and frequently the case that the grant award itself limits the duration to a shorter period, e.g., five years. The Code generally permits extension of the duration of the award up to the full duration permitted under the equity plan (but not to exceed 10 years) without adverse tax consequences, so a kindly employer (or as additional consideration for a release) might decide to extend the duration of awards to employees adversely affected by the reduction in force. However, the employer should consider whether there may be consequences under the accounting rules in connection with making such extensions.
What if there were "vesting" conditions limiting the exercise of the option, whether the conditions are length of service, performance or a combination? The employer could decide to waive or reduce such hurdles in connection with the reduction in force, e.g., it is not the employees' fault that they did not complete the length of service required to make the option (fully) exercisable. This type of waiver (or service credit) of vesting terms could be accomplished by separate notice, or added to the terms of the severance program. Again, there might be accounting considerations in case of such a waiver.
Note that many private companies granting equity awards include provision for rights of first refusal, right of repurchase and "drag-along" (or perhaps tag-along) rights. In the case of a corporate transaction, these rights assist in protecting the company following exercise of the equity award. We would expect that in extending an exercise period or waiving any vesting conditions, the company would continue to maintain those types of provisions for the applicable award.
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Our point is that the employer has almost complete flexibility in what it decides to do about equity awards in the context of a reduction in force, but it does take some planning about how to obtain approvals/consents and implement/communicate the changes in what is sometimes a very fast-paced situation. Further, although the discussion above focuses on stock options, the same facets generally apply in the context of other forms of equity awards, but possibly with other factors applying, e.g., did the grantees make "83(b) elections" with respect to restricted stock? Are the awards subject to Code Section 409A or exempt therefrom?
Keep in mind that any special treatment of equity awards outside of that contained in the award documents (especially if serving as consideration for a release of claims) should be added to the terms of the severance program, in which case that additional benefit may become part of a "welfare" benefit plan covered by the Employee Retirement Income Security Act ("ERISA"). Under ERISA, the benefits are required to be in a plan document and described in the welfare benefit plan's summary plan description.
Employers who have granted equity awards to their employees, and who are contemplating a reduction in force, should consult with both their labor and employment counsel (who typically advise on a reduction in force) and their benefits counsel (who can advise on the implications for equity awards).
