Under New 409A Transition Guidance, Certain Discounted Options Require Action by December 31, 2006

Many public companies are in the early stages of determining whether they may have any option timing issues with respect to the grant of outstanding options. The transitional guidance issued yesterday under Section 409A of the Internal Revenue Code of 1986, as amended, places a premium on an issuer making such determinations (and taking action if necessary) by December 31, 2006 with respect to outstanding options held by persons who were the company’s “insiders” under Section 16 of the Securities Exchange Act at the time the options were granted.

Section 409A and the available guidance thereunder provide that options issued with an exercise price less than the fair market value of the underlying shares on the date of grant of the option are subject to Section 409A unless such options are grandfathered, i.e., the options were vested as of December 31, 2004 and were not modified thereafter. Proposed regulations issued under Section 409A provided a variety of permissible steps an issuer could take to modify such discounted options in 2006 to avoid liability under Section 409A. In general, if an option is not modified or replaced in a timely manner, the option will become subject to Section 409A, potentially subjecting the director or executive to an additional tax of 20%, interest and penalties. If a discounted option is exercised prior to its replacement or modification, the proposed regulations provide that the option generally will be subject to Section 409A.

Notice 2006-79, issued by the Treasury Department and the Internal Revenue Service on October 4, 2006, generally extends much of the transition guidance included in the proposed regulations under Section 409A. To avoid Section 409A penalties, on or before Dec 31, 2007 (extended from Dec 31, 2006 except with respect to “backdated options” as discussed below), a discounted option must either be replaced by an option with an exercise price equal to the fair market value of the underlying shares on the date that the discounted option was granted in retroactive compliance with an exception from Section 409A or be modified to comply with Section 409A, e.g., by making the option exercisable at a fixed time.

The Notice expressly excludes “backdated options” from the extended transition relief; the time to replace or modify these options remains the earlier of exercise or December 31, 2006. “Backdated options” are defined in the Notice as options or other stock rights that were granted: (1) by an issuer which had publicly registered equity at grant, and (2) to persons who were the issuer’s “insiders” within the meaning of Section 16 at grant (i.e., directors or executive officers), and, with respect to which the:

As a result, issuers with “backdated options” that wish to take advantage of the transitional relief must do so by December 31, 2006, not December 31, 2007.

The ability to compensate the optionholder for the loss of the discount by making an immediate cash payment equal to the discount in the year of replacement expired on December 31, 2005. Thus, any compensation for replacing an option in 2006 or 2007 should not be paid until after December 31, 2006 or 2007, respectively.

If an optionholder is given a choice to exchange a discounted option for a replacement option or cash, the applicable rules under state and federal securities laws respecting tender offers should be considered, particularly if a broad-based group of employees is involved.

Note that the Treasury Department and the IRS have not clarified how to determine the grant date of an option in the context of Section 409A and whether it will be tied to the determination for accounting purposes.

Please call any of your regular contacts at the firm or any of our partners and counsel listed under Employee Benefits in the Our Practice section of our web site if you have any questions about these matters.