The question of mid-offering period changes to employee stock purchase plans (ESPPs) has been coming up with unusual frequency, in some cases due to stock price volatility causing an earlier-than-expected shortage of shares and in others due to companies desiring to quickly make their plans more competitive in the ongoing battle for talent.
Impact of a Modification of a Section 423 ESPP Option
But a mid-offering change to the terms of a Code Section 423 ESPP raises special modification issues, on top of the usual factors that need to be considered when making a change to an outstanding equity award, such as employee consent, Board/Committee approval process and accounting expense impact. This is because a modification of a Code Section 423 option is treated as creating a new grant date under Code Section 424.
Under most ESPPs, the first day of an offering period is intended to be the grant date for Section 423 purposes. As a result, the setting of a new grant date mid-offering is problematic, particularly for plans with a “look-back” pricing mechanism, where the purchase price is based on the lower of the discounted value of the stock at the start and end of the offering period. In particular, an ESPP change that modifies outstanding options will cause:
- the grant date prong of a look-back pricing formula to be determined based on the higher of (i) the value of the stock on the original offering period start date and (ii) the value of the stock on the modification date (resulting in a higher purchase price if the stock price is rising);
- the $25,000 limit on the value of stock that may be purchased per calendar year to be recalculated for the offering based on the value of the stock on the modification date (instead of on the first day of the offering); and
- the grant date component of the holding period for a qualifying disposition to commence on the modification date, rather than on the original offering period start date (so that the holding period becomes two years from the modification date and one year from the purchase of shares).
What is a “Modification” for Section 423 Purposes?
Under the Code Section 424 regulations, a “modification” is any change in the terms of an option that gives the option holder additional benefits, regardless of whether the option holder benefits from the change. The regulations include the following (non-exhaustive) examples of changes that will be treated as a modification:
- an extension of the period during which an option can be exercised;
- a change providing an alternative to the exercise of the option (such as a stock appreciation right);
- a change providing an additional benefit upon exercise of the option (such as a cash bonus);
- a change providing more favorable terms for payment for the stock (such as the right to tender previously acquired stock);
- a change made in an attempt to qualify the option as an ISO or Section 423 option; or
- a change that gives the company discretion to provide the option holder with an additional benefit in the future, with the exercise of any such discretion being an additional modification.
As the IRS has noted in informal discussions, under the Section 424 regulations that took effect in 2004, the bar for a modification to a qualified option is very low, giving companies limited ability to introduce ESPP enhancements other than at the beginning of an offering period. For example, the following changes would likely be treated as modifications if applied to outstanding ESPP options:
- extending an ESPP offering period;
- allowing employees to pay for stock through a means other than the standard payroll deductions (e.g., through a lump sum catch-up contribution);
- allowing employees to increase their contribution rate mid-offering;
- correcting the offering terms to meet Section 423 requirements; or
- adding a cash-out feature to avoid the purchase of shares and give the participant the cash value of the ESPP discount.
It is worth noting that mid-offering changes are sometimes needed to comply with laws, particularly foreign laws when an ESPP is offered globally. For example, (i) some countries require ESPP contributions to be held in a separate bank account or trust account and not as part of the company’s general funds, (ii) changes to the Class Order securities exemption in Australia suggest that participants must be permitted to withdraw from an ESPP and receive a refund of accumulated contributions at any time up to the purchase date, and (iii) some companies offering ESPP in Russia considered using a cash-out feature to settle options outstanding at the time of the invasion of Ukraine. To the extent that an ESPP is amended mid-offering to make any of these participant-friendly changes, it would likely modify outstanding options, and if employees in the applicable countries were participating in the same Section 423 offering as U.S. employees, the changes would impact the U.S. participants’ options in a potentially adverse manner under Section 423.
Finally, falling stock prices can cause companies to burn through their equity plan share reserves more quickly than anticipated. Where this causes an ESPP to run out of shares mid-offering, companies typically consider infusing the ongoing offering with additional shares upon shareholder approval of an amended ESPP during the offering. As confirmed in recent discussions with the IRS, this type of mid-offering infusion generally creates a unique type of modification, whereby the original offering date would remain the grant date for the number of shares purchasable prior to shareholder approval , but the grant date for the additional shares purchasable following shareholder approval would be the date of the shareholder meeting – resulting in two grant dates for shares purchased in a single ESPP offering, with all of the resulting complexities including potentially different purchase prices under a look-back plan, different $25,000 limits and different holding periods for determining a qualifying disposition.
In view of how easy it is to modify an option for Section 423 purposes, companies should carefully consider any potential change to a Section 423 ESPP and whether it needs to be applied mid-offering (while also considering the accounting expense and other consequences of any such change). Further, this should serve as a reminder to companies offering global ESPPs that they need to have their plan administrator approve “separate offerings” for Section 423 purposes prior to offering the plan so that non-U.S. employees are not participating in the same offering as U.S. employees and therefore any changes that may need to be made for non-U.S. purposes will not trigger a Section 423 modification of any U.S. options.
 References to the “Code” mean the Internal Revenue Code of 1986, as amended.
 Note that the Section 424 regulations apply to both Code Section 423 options and incentive stock options (ISOs) under Code Section 422.