If you ever want to see a benefits lawyer get nervous, start talking about corporate intent.  Yes, the company intended to grant options at an earlier and lower exercise price, and yes it may have made promises to the individuals who would receive the awards; everybody seems to be in agreement. But there may be inadequate documentation, or worse, none at all, and the tax implications have to be considered. The foundation for any equity grant will be corporate action, and the experienced perspective is that if there is doubt about the corporate action, it will be hard to defend.

The Incentive Stock Option (“ISO”) regulations and the Code Section 409A regulations (“Section 409A”) both provide guidance on when an equity grant is actually made for the purposes of those Code Sections. For ISOs, the “date or time when the granting corporation completes the corporate action” constituting an offer under the terms of a statutory option which is not considered complete until the maximum number of shares and the minimum price are fixed or determinable. For Section 409A, the date when the “granting corporation completes the corporate action” necessary to create a legally binding right to the option which is not complete until the date on which the maximum number of shares and the minimum exercise price are fixed or determinable, and the class of underlying stock and the identity of the service provider are designated. Obviously, the regulations have similarities, but the common and essential element is the requirement for a corporate action.

Corporations can act (i) pursuant to a meeting of the directors which requires notice and a minimum number of directors to be present for a quorum (generally, meetings can be held telephonically), with action typically by a majority vote, or (ii) by written consent to an action which must be unanimous for all directors on the board and which will be effective when all the directors have consented. We can remember the backdating scandals of the 2000s and the issues that came up when companies treated a unanimous written consent as being effective prior to the date when the last director signed the consent, and that led to quite a few restatements.

So why do we care, and why is this a hot button issue for diligence in every financing or acquisition to do a “tie-back” of the outstanding options to a board action and then check for exercise prices of no less than fair market value on the date of grant?  If an option is not granted validly pursuant to a completed board action, it has several liability risks: (i) there are accounting accuracy problems, (ii) there could be claims from service providers who thought that they were granted options when the board failed to act or did not act effectively, and (iii) the option may be a “discount” stock option under Section 409A if the date of grant and exercise price of no less than fair market value on the date or grant are not correct, potentially resulting in income tax (and wage taxes for employees) on the spread in the year of vesting (whether or not exercised) plus an additional tax of 20% on the amount included in income, as well as company reporting and withholding obligations. It  is obvious that both the optionee and the company are not going to be pleased with this result.

Economic alternatives to provide value for a delta between a former lower exercise price without a proper board action and the current increased fair market value for a new award include full value equity awards (RSUs, restricted stock) and cash bonuses (usually linked to liquidity like a change of control event).