(This Item Posted April 2001)

Prepared by: Jeffrey R. Capwell

McGuireWoods LLP

Charlotte, North Carolina

As stock prices began to slide last year, particularly in the high-technology sector, some companies allowed their executives to rescind stock option exercises that had occurred earlier in the year. Under a typical stock option rescission, the executive would return to the company all shares that he received when he exercised the option, plus any dividends that had been paid on the shares since exercise. The executive then would receive back from the company the amount he paid to exercise the option, and a new option identical to the option that he had exercised (i.e., an option for the same number of shares and at the same exercise price).

These transactions were tax motivated. The intent was cancel the prior option exercise for income tax purposes (or alternative minimum tax purposes in the case of incentive stock options) and treat the exercise as if it had never occurred. The companies that permitted rescissions took the position that the rescission eliminated any income tax or alternative minimum tax consequences for the employee and cancelled any income tax deduction that the company could have claimed on the exercise

The Securities and Exchange Commission (the "SEC") became concerned earlier this year with how rescissions should be treated for financial accounting purposes. The SEC has announced a position that will have adverse accounting consequences for companies that permit rescissions. Under the new announcement, stock option rescissions like the one described above must be treated as a grant to the executive of a right to put his shares back to the company at a price other than their fair market value. Providing the executive with such a put right causes the reinstated option to be subject to "variable" accounting treatment. Under variable accounting, the difference between the exercise price of the reinstated option and the value of the underlying shares is periodically determined until expiration or forfeiture of the reinstated option, or the end of the tax year in which the reinstated option is exercised. Increases in that difference must be periodically charged against the company’s earnings.

Despite this unfavorable position, the SEC will allow rescission transactions that occurred before January 1, 2001 to be accounted for under more favorable "fixed" accounting rules. The SEC will permit the compensation expense for rescissions prior to January 1, 2001 to be limited to the difference between the fair market value of the shares returned to the company and the sum of (1) the repaid exercise price, (2) the difference between the exercise price and fair market value of the shares under the new option, and (3) the tax deduction that the company relinquished due to the rescission. Only this fixed amount must be charged to the company’s earnings.

The SEC further announced that companies that permitted rescissions must disclose those rescissions in the stock option footnotes of their financial statements, and must separately identify the initial grant and the rescission in the company’s statement of changes in stockholders’ equity. In addition, companies must reflect the original option exercise as having had a dilutive effect on its earnings per share calculation until the rescission occurred. Finally, the SEC cautioned that the income tax deduction that a company lost under a nonqualified stock option by agreeing to rescind may have an adverse cash impact that would require disclosure in the Management Discussion and Analysis section of the company’s annual report.