Release No. 33-8732A Release No. 34-54302A Release No. IC-27444A

Securities and Exchange Commission

Executive Compensation and Related Person Disclosure
Section II.A.

II. Executive and Director Compensation Disclosure

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A. Options Disclosure

1. Background

Many companies use stock options to compensate their employees, including executives. In a simple stock option, a company may grant an employee the right to purchase a specified number of shares of the companys stock at a specific price, called the exercise price and usually set as the market price of the companys stock on the grant date. While some options require no future service from the employee, most include vesting provisions, such that the employee does not earn the option unless he remains employed by the company for a specified period of service. Often a company will grant a specific number of options that will then vest proportionately in staggered increments over a set time period. For example, if the grant vests at a rate of 20% per year for five years, the option for the last 20% is earned by the employees provision of five years of services. Most options become exercisable upon vesting and remain exercisable until their stated expiration. Generally, upon termination of the employment relationship, however, an employee loses unvested options, and has a limited term (e.g., 90 days) to exercise vested options.⁶¹

Options have most often been issued "at-the-money" i.e., with an exercise price equal to the market price of the underlying stock at the date of grant but may also be issued either in-the-money i.e., with an exercise price below the market price of the underlying stock at the date of grant or "out-of-the-money" i.e., with an exercise price above the market price of the underlying stock at the date of grant. An option holder benefits only when the companys stock price is above the exercise price when the employee exercises the option. Hence, setting a lower exercise price increases the value of the option.

As some commentators have observed, using options for compensation purposes may have advantages. These commentators point out that, unlike salary and bonus compensation, stock option compensation does not require the payment of cash by the company, and therefore can be particularly attractive to companies for which cash is a scarce resource. Stock option compensation may also provide an incentive for employees to work to increase the companys stock price. Additionally, some companies may be able to use stock option compensation to help retain employees, because an employee with unvested in-the-money options forfeits their potential value if he leaves the companys employ.

At the same time, other commentators stress that option compensation is not without costs and disadvantages. Options granted to employees, if ultimately exercised with the resulting issuance of the underlying stock, give rise to a dilution of the interests in the company held by existing stockholders. Options that are not in-the-money may not provide a retention benefit, and some managers believe that options that fall out-of-the-money (or are underwater) not only fail to motivate employees but, in fact, can result in poor employee morale and resultant turnover, especially at companies where option compensation is an important component of total compensation. In addition, options with shorter vesting periods or longer term options approaching their vesting dates may provide incentives to employees to focus on increasing the companys stock price in the short term rather than working toward achieving longer term business goals and objectives that would enable the company to achieve and sustain future success.

The Commission does not seek to encourage or discourage the use of stock options or any other particular form of executive compensation. The federal securities laws, however, do require full and fair disclosure of compensation information to the extent material or required by Commission rule.

2. Required Option Disclosures

The Commission acknowledged the importance to investors of proper disclosure of executives option compensation throughout the Proposing Release. The existing body of rules regarding disclosure of executive stock option grants, however, has not previously contained a line-item requirement with respect to information regarding programs, plans or practices concerning the selection of stock option grant dates or exercise prices.⁶² The disclosure we proposed in January, along with related disclosure we also adopt today, should provide investors with more information about option compensation.⁶³ We have summarized below the various provisions of the rules that we adopt today that relate to options disclosure.⁶⁴

a. Tabular Disclosures

The following disclosures are required in the tables we adopt today. These provisions are discussed in more detail later in the section relating to each particular table.

• As proposed and adopted, grants of stock options will be disclosed in the Summary Compensation Table at their fair value on the date of grant, as determined under FAS 123R. By basing the executive compensation disclosure on the full grant date fair value computed in accordance with FAS 123R, companies will give shareholders an accurate picture of the value of options at the time they are actually granted to the highest-paid executive officers.⁶⁵
• A separate table including disclosure of equity awards, the Grants of Plan-Based Awards Table, requires disclosure of the grant date as determined pursuant to FAS 123R.⁶⁶ The grant date is generally considered the day the decision is made to award the option as long as recipients of the award are notified promptly. Even if the options exercise price is set based on trading prices as of an earlier date or dates, the grant date does not change.
• If the exercise price is less than the closing market price of the underlying security on the date of the grant, a separate, adjoining column would have to be added to this table showing that market price on the date of the grant.⁶⁷
• If the grant date is different from the date the compensation committee or full board of directors takes action or is deemed to take action to grant an option, a separate, adjoining column would have to be added to this table showing the date the compensation committee or full board of directors took action or was deemed to take action to grant the option.⁶⁸

Further, if the exercise or base price of an option grant is not the closing market price per share on the grant date, we require a description of the methodology for determining the exercise or base price.⁶⁹

b. Compensation Discussion and Analysis

Companies will also be required to address matters relating to executives option compensation in the new Compensation Discussion and Analysis section, particularly as they relate to the timing and pricing of stock option grants. Without being an exhaustive list, several of the examples provided in Item 402(b)(2) illustrate how these types of issues and questions might be covered in a companys disclosure. For example, Item 402(b)(2)(iv) shows that how the determination is made as to when awards are granted could be required disclosure. This example was included in part to note that material information to be disclosed under Compensation Discussion and Analysis may include the reasons a company selects particular grant dates for awards, such as for stock options. Similarly, other examples we provide in Item 402(b)(2) illustrate how the material information to be disclosed under Compensation Discussion and Analysis might need to include the methods a company uses to select the terms of awards, such as the exercise prices of stock options.

i. Timing of Option Grants

We understand that some companies grant options in coordination with the release of material non-public information. If the company had since the beginning of the last fiscal year, or intends to have during the current fiscal year, a program, plan or practice to select option grant dates for executive officers in coordination with the release of material non-public information, the company should disclose that in the Compensation Discussion and Analysis section. For example, a company may grant awards of stock options while it knows of material non-public information that is likely to result in an increase in its stock price, such as immediately prior to a significant positive earnings or product development announcement. Such timing could occur in at least two ways:

• The company grants options just prior to the release of material non-public information that is likely to result in an increase in its stock price (whether the date of that release of material non-public information is a regular date or otherwise pre-announced, or not); or
• The company chooses to delay the release of material non-public information that is likely to result in an increase in its stock price until after a stock option grant date.

Although the facts would be slightly different, a company also may coordinate its grant of stock options with the release of negative material non-public information. Again, such timing could occur in at least two ways:

• The company delays granting options until after the release of material non-public information that is likely to result in a decrease in its stock price; or
• The company chooses to release material non-public information that is likely to result in a decrease in its stock price prior to an upcoming stock option grant.

The Commission does not express a view as to whether or not a company may or may not have valid and sufficient reasons for such timing of option grants, consistent with a companys own business purposes. Some commentators have expressed the view that following these practices may enable a company to receive more benefit from the incentive or retention effect of options because recipients may value options granted in this manner more highly or because doing so provides an immediate incentive for employee retention because an employee who leaves the company forfeits the potential value of unvested, in-the-money options. Other commentators believe that timing option grants in connection with the release of material non-public information may unfairly benefit executives and employees.

Regardless of the reasons a company or its board may have, the Commission believes that in many circumstances the existence of a program, plan or practice to time the grant of stock options to executives in coordination with material non-public information would be material to investors and thus should be fully disclosed in keeping with the rules we adopt today. Consistent with principles-based disclosure, companies should consider their own facts and circumstances and include all relevant material information in their corresponding disclosures.⁷⁰ If the company has such a program, plan or practice, the company should disclose that the board of directors or compensation committee may grant options at times when the board or committee is in possession of material non-public information. Companies might also need to consider disclosure about how the board or compensation committee takes such information into account when determining whether and in what amount to make those grants.

Although it is not an exhaustive list, there are some elements and questions about option timing to which we believe a company should pay particular attention when drafting the appropriate corresponding disclosure.

• Does a company have any program, plan or practice to time option grants to its executives in coordination with the release of material non-public information?
• How does any program, plan or practice to time option grants to executives fit in the context of the companys program, plan or practice, if any, with regard to option grants to employees more generally?
• What was the role of the compensation committee in approving and administering such a program, plan or practice? How did the board or compensation committee take such information into account when determining whether and in what amount to make those grants? Did the compensation committee delegate any aspect of the actual administration of a program, plan or practice to any other persons?
• What was the role of executive officers in the companys program, plan or practice of option timing?
• Does the company set the grant date of its stock option grants to new executives in coordination with the release of material non-public information?
• Does a company plan to time, or has it timed, its release of material non-public information for the purpose of affecting the value of executive compensation?

Disclosure would also be required where a company has not previously disclosed a program, plan or practice of timing option grants, but has adopted such a program, plan or practice or has made one or more decisions since the beginning of the past fiscal year to time option grants.

ii. Determination of Exercise Price

Separate from these timing issues, some companies may have a program, plan or practice of awarding options and setting the exercise price based on the stocks price on a date other than the actual grant date. Such a program, plan or practice would also require disclosure, including, as appropriate, in the tables described in II.A.2.a above and in the Compensation Discussion and Analysis section. Again, as with the timing matters discussed above, companies should consider their own facts and circumstances and include all relevant material information in their corresponding disclosures.

Similar to such a practice of setting the exercise price based on a date other than the actual grant date, some companies have provisions in their option plans or have followed practices for determining the exercise price by using formulas based on average prices (or lowest prices) of the companys stock in a period preceding, surrounding or following the grant date. In some cases these provisions may increase the likelihood that recipients will be granted in-the-money options. As these provisions or practices relate to a material term of a stock option grant, they should be discussed in the Compensation Discussion and Analysis section.

⁶¹ More complex stock options can include provisions that alter the terms of the instrument based on whether performance or other targets are met.

⁶² Our existing rules for companies disclosure do prohibit material misrepresentations of option grant dates, as well as any resulting material misstatements of affected financial statements. Companies are also required under our existing rules to disclose any material information that may be necessary to make their other disclosures, in the light of the circumstances under which they are made, not misleading. See, e.g., Rule 12b-20 under the Exchange Act [17 CFR 240.12b-20].

⁶³ We note that Exchange Act Rule 16a-3 [17 CFR 240.16a-3] sets forth the general reporting requirements under Exchange Act Section 16(a). Prior to August 2002, a number of transactions between an issuer and its officers or directors such as the granting of options were required to be disclosed following the end of the fiscal year in which the transaction took place although individuals could disclose those transactions earlier if they chose to. In implementing Section 403(a) of the Sarbanes-Oxley Act of 2002, in August 2002, the Commission required immediate disclosure of these transactions for the first time. As a result, since August 2002, grants, awards and other acquisitions of equity-based securities from the issuer, including those pursuant to employee benefit plans (which were previously reportable on an annual basis on Form 5) have been required to be reported by officers and directors on Form 4 within two business days. Ownership Reports and Trading by Officers, Directors and Principal Security Holders, Release No. 34-46421 (Aug. 27, 2002) [56 FR 56461] at Section II.B.

⁶⁴ We also note that under our rules regarding disclosure of director compensation, the concerns and considerations for disclosure of option timing or dating practices in the executive compensation realm would also apply when the recipients of the stock option grants are directors of the company.

⁶⁵ Item 402(c)(2)(vi).

⁶⁶ Item 402(d)(2)(ii) and Item 402(a)(6)(iv).

⁶⁷ Item 402(d)(2)(vii).

⁶⁸ Item 402(d)(2)(ii).

⁶⁹ Instruction 3 to Item 402(d).

⁷⁰ Relevant material information might include disclosure in response to the examples in Item 402(b)(2) in the Compensation Discussion and Analysis section, discussed below.