Avery Marz

Stock options can be an important component of total rewards packages. For private companies, equity grants can be used to attract and retain qualified employees, consultants and directors by offering the potential for significant appreciation in the value of their awards and to align the interests of the company’s service providers with those of its shareholders and investors. Equity grants can also improve service provider productivity, resulting in increased company value, and preserve capital by paying less in cash compensation. Ensuring a stock option process is correct from the start is simpler — and cheaper — than fixing mistakes later. Adopting any equity compensation plan, including a stock option plan, is subject to applicable state laws and a company’s foundational documents, e.g., the corporate charter and bylaws. Typically, a company’s board of directors is empowered to adopt a stock option plan, and a plan is deemed adopted when it is approved by the board of directors, unless the board’s approval is subject to the occurrence of a subsequent event. For more on delegating grantmaking authority under an equity compensation plan, see our previous blog post. The Two Categories of Stock Options: ISOs and NQSOs Stock options fall into two categories: incentive stock options (ISOs) and nonqualified stock options (NQSOs). ISOs provide employees with more favorable tax treatment than NQSOs. An individual who exercises an NQSO must pay ordinary income taxes on the excess of the fair market value of the underlying shares on exercise over the exercise price (the spread). However, ISOs are not subject to ordinary income taxes if the shares are held for both (1) one year from the date of exercise and (2) two years from the grant date. An employee incurs no income tax at the grant or upon the exercise of an ISO (although the spread is a tax adjustment item for purposes of calculating alternative minimum tax), and the profit (if any) made on the sale of the shares is taxed as a long-term capital gain. As with ISOs, there is no tax at the grant of an NQSO. However, when an NQSO is exercised, ordinary income is recognized in an amount equal to the spread. When the shares are subsequently sold, there is a capital gain or loss on the difference between the sale price and the sum of the exercise price paid, plus the ordinary income recognized on exercise. Whether it is a long-term or short-term gain or loss depends on how long the shares are held. What Conditions Must a Plan Meet for ISO Grants? In order to be treated as an ISO under Section 422 of the Internal Revenue Code, and to therefore be subject to favorable tax treatment, the plan under which the ISO is granted must meet the following conditions. (Note: The terms of the ISO itself must also meet additional requirements.) Conditions: The plan must designate the maximum aggregate number of shares that may be issued under the plan through ISOs. A plan that merely provides that the number of shares that may be issued as ISOs under the plan may not exceed a stated percentage of the shares outstanding at the time of each offering or grant under such plan does not satisfy this requirement. The plan must also specify the employees or class of employees who are eligible to participate in the plan. The shareholders of the company must approve the stock option plan within 12 months before or after the date the plan is adopted. Shareholder approval must comply with all applicable provisions of the corporate charter, bylaws and applicable state law(s) prescribing the method and degree of stockholder approval required for the issuance of corporate stock or options. If state law does not prescribe a method and degree of stockholder approval in such cases, an equity plan that purports to include ISOs must be approved by either:A majority of the votes cast at a duly held stockholders’ meeting at which a quorum representing a majority of all outstanding voting stock is present and voting (either in person or by proxy). A method and degree adequate under state law for actions requiring stockholder approval. If any of the above conditions are not satisfied with respect to the plan, then any options granted pursuant to such plan will be treated as NQSOs.

A recent decision by the Delaware Supreme Court emphasizes the importance of clearly written notice provisions in a contract and strict compliance with them, including any timing requirements and provisions requiring the disclosure of information and documents as a condition to a valid notice. What the Chancery Court Found In Thompson Street Capital Partners IV v. Sonova United States Hearing Instruments, Sonova United States Hearing Instruments LLC acquired audiology practices operated by Alpaca Group Holdings LLC pursuant to a merger agreement entered into by, among others, Alpaca, Sonova and Thompson Street Capital Partners IV LP, the latter of which served as the representative of former members of Alpaca. One business day before the survival period for submitting certain claims for indemnification under the merger agreement expired, Sonova delivered a notice (claim notice) to Thompson, as members’ representative, in which Sonova claimed indemnification for breaches of certain representations and warranties under the merger agreement based upon alleged improper billing practices of Alpaca, its affiliates and the audiology practices. The claim notice stated that Sonova became aware of certain billing practices of Alpaca and its affiliates that Sonova believed were not in compliance with applicable laws and/or third-party payor reimbursement rules or other requirements, and as a result of such billing practices, Sonova believed Alpaca and its affiliates billed and received payment or reimbursement to which they are not entitled, which constituted the breach of certain representations and warranties under the merger agreement. The claim notice also stated that Sonova’s investigation and analysis was continuing, and that it would supplement the claim notice as it learned additional information. The claim notice alleged that, while the aggregate amount of damages was not known or estimable with certainty, such damages exceeded the funds that were deposited and held in escrow to provide a source of funds for indemnification claims, and directed the escrow agent to reserve the full amount of the escrow. Thompson filed a complaint in the Delaware Court of Chancery, seeking an order declaring that Sonova’s claim notice did not comply with contractual requirements under the merger agreement because, among other things: (1) it was not delivered within 30 days of Sonova becoming aware of the claim as required by the merger agreement; and (2) it did not include the specific information required under the merger agreement, including a description of the claim in reasonable detail and “all available material written evidence thereof.” Thompson sought a mandatory injunction requiring Sonova to execute a joint instruction letter directing the escrow agent to release the funds in escrow to Thompson in its capacity as members’ representative. Sonova moved to dismiss the action, arguing that: the merger agreement required only that it serve a written claim notice on or before the survival date in order to preserve a claim for indemnification and prevent the release of the escrowed funds and did not contemplate the level of detail that Thompson was seeking; the claim notice was timely; and Thompson did not plead any specific prejudice or harm due to the timing of claim notice. The Chancery Court granted Sonova’s motion to dismiss the action, finding that Sonova’s claim notice was valid for stopping the release of the escrowed funds. Thompson appealed to the Delaware Supreme Court. What the Supreme Court Found On appeal, the state Supreme Court reversed the Court of Chancery’s dismissal of the action and remanded the action for further development of certain points. Failure to Provide All Required Information in Notice The Supreme Court held that it is reasonably conceivable that Sonova failed to comply with the requirement in the merger agreement that Sonova include copies of all available material written evidence of its claim, noting the complaint alleged that although Sonova supposedly spent months investigating and analyzing these matters, Sonova’s claim notice failed to include any materials or evidence supporting Sonova’s claim, let alone copies of “all available material written evidence thereof” as required by the merger agreement. Failure to Comply with Timing Requirement The court also held that it is reasonably conceivable that Sonova violated the provision in the merger agreement requiring Sonova to provide notice of its claim within the specified time period. The court found that Thompson adequately pleaded that (1) Sonova failed to provide notice of its claim within the required time period and (2) the delay actually and materially prejudices the merger party, to the extent sufficient to survive a motion to dismiss. The court noted that Thompson’s complaint alleged that Sonova had been aware of the facts underlying the claim since long before the date it delivered the claim notice, as Sonova representatives confirmed in various communications with Alpaca’s former CEO and CFO before the merger agreement closed, as well as in communications with a continuing employee of Sonova following the closing. The court also noted that Thompson pleaded that by disregarding the claim deadline Sonova caused the kind of material prejudice that deadline was put in place to avoid, including by: (1) increasing the risk of excess damages by disregarding contractual and statutory refund/repayment periods; (2) negating the parties’ ability to negotiate with applicable third-party payors in good faith and in a timely manner where due credit would be given; and (3) potentially implicating a greater period of noncompliance in any final damages. Waiver/Forfeiture of Sonova’s Ability to Claim Indemnification Thompson argued that Sonova’s failure to comply with each of the requirements in the merger agreement applicable to asserting a claim for indemnification resulted in an enforceable waiver/forfeiture of Sonova’s ability to seek indemnification. In its analysis, the court reviewed a number of Delaware cases that it found distinguishable from this case and noted that if the language of a contract does not clearly provide for forfeiture, a court will construe the contract to avoid causing one. In this case, the court found that the merger agreement provides that Sonova shall have no right to recover any amounts pursuant to the agreement unless Sonova notifies the members’ representative in writing of such claim on or before the survival date. The court held that such language unambiguously expressed a condition precedent capable of triggering a forfeiture due to Sonova’s noncompliance with notice requirements. The court remanded the action for further proceedings consistent with its opinion, including whether the forfeiture from noncompliance with the condition precedent can be excused based upon questions of materiality and disproportionate forfeiture that are insufficiently developed in the record.

In the dynamic landscape of employee compensation, companies may reevaluate and adjust the vesting schedules of stock options for various reasons, such as recognizing employee commitment and adapting to shifts in the market or employee performance. For example, changes to a vesting schedule might include changes to time-based or performance-based vesting conditions. However, making changes to a vesting schedule of a stock option involves legal and tax issues that employers should consider. A “modification” under the U.S. Internal Revenue Code of 1986, as amended (Tax Code), is any change in the terms of the option, plan or governing agreement that provides the option holder with additional benefits, regardless of whether they benefit from the change. A modification of a stock option is treated as a grant of a new option. This means that if an incentive stock option (ISO) is “in the money,” it becomes a non-qualified stock option (NSO) or must be repriced at the fair market value at the time of the modification to maintain ISO status. When an ISO becomes an NSO, it loses potential favorable tax treatment — generally, deferral of any income tax on exercise until the ISO shares are sold and long-term capital gain treatment on the sale proceeds if the ISO holding periods are met. (Note that while ISOs are not subject to ordinary income tax on exercise, the spread between the exercise price and the fair market value of the stock at exercise is subject to the alternative minimum tax on exercise.) Unlike ISOs, when an optionee exercises an NSO, the optionee recognizes ordinary income at the time of exercise in an amount equal to the spread between the exercise price and fair market value on the date of exercise. In general, changes to vesting schedules are not considered modifications under the Tax Code. However, changes to the vesting schedule of an ISO may be considered a modification if the option is exercisable before fully vesting (so called “early-exercise options”). A key tax implication for ISOs is that an optionee can only hold up to $100,000 worth of ISOs that first become exercisable in a given calendar year. Any options in excess of this limit are treated as NSOs. If ISOs are not immediately exercisable, the option first becomes exercisable when it vests. Thus, changes to the vesting schedule could impact the $100,000 limit. Board approval may be required to change the vesting schedule of an ISO. Optionee consent is necessary if the change negatively affects the optionee (such as by changing an ISO to an NSO). As long as an NSO is exempt from Tax Code Section 409A, a company can change the vesting of the option. Options that are granted with an exercise price below fair market value are subject to Section 409A, meaning that they can only be exercised on the occurrence of certain permissible payment events. Because the chief purpose of a stock option is to give an optionee the ability to exercise the option whenever the optionee chooses (and when the option is in the money), it is extremely uncommon to subject a stock option to Section 409A. As with modifications to ISOs, board approval may be required to change the vesting schedule of an NSO, and optionee consent is necessary if the change negatively affects the optionee.

Reporting requirements established by Pennsylvania’s Act 122 of 2022 began this year, mandating that most domestic and foreign business filing associations file with the Pennsylvania Department of State an annual report detailing certain information about the association. The new reporting obligation replaces the previous decennial report and contains substantially the same information. What Entities Fall Under Act 122? Beginning in calendar year 2025, entities required to file an annual report include: Domestic filing entities, including Pennsylvania business and nonprofit corporations, limited liability companies (LLCs), limited partnerships (LPs) and business trusts. Domestic limited liability (general) partnerships (LLPs). Domestic electing partnerships. Registered foreign associations. What Information Should Be Reported? The annual report requires business entities to provide the following information to the Pennsylvania Department of State: Entity name. Jurisdiction of formation. Registered office address. Principal office address. Name of at least one governor (director, member, partner, etc., depending on the type of association). Names and titles of the principal officers, if any. Entity number issued by the Pennsylvania Department of State. When Is the Report Due? The filing deadlines are based on the type of entity: Corporations (business and nonprofit, domestic and foreign registered): June 30. LLCs (domestic and foreign registered): September 30. Other domestic filing entities or foreign registered filing associations: December 31. How Should the Report Be Filed? The current filing fee is $7 for business corporations, LLCs, LPs and LLPs and certain other entities noted above. There is no fee for nonprofit corporations and LPs or LLCs with a not-for-profit purpose. Penalties for failure to file annual reports will not be imposed on associations until the end of the 2026 calendar year. Beginning in 2027, failure to file six months after the due date of the annual report will subject associations to administrative dissolution, termination or cancellation, which could result in the loss of protection for the entity’s name. The Department of State will notify entities via email (if provided) and postcard before the deadlines. Be sure your email is up to date on the Department of State site. In addition, the department website provides user-friendly instructions and a form of the annual report. The report (DSCB:15-146) should be filed online. For a more detailed guide, visit the Commonwealth of Pennsylvania’s Annual Reports in Pennsylvania site.

A federal judge recently granted preliminary approval to a multibillion-dollar settlement of three athlete-compensation antitrust cases against the National Collegiate Athletic Association (NCAA), Atlantic Coast Conference, Big Ten Conference, Big 12 Conference, Pac-12 Conference and Southeastern Conference. The proposed settlement, filed with the U.S. District Court for the Northern District of California, brings a closer resolution to the three class-action lawsuits. If finalized, student-athletes would be prohibited from bringing legal action against the NCAA for potential antitrust violations, and they must abandon their pending lawsuits in the following cases: House v. NCAA, Hubbard v. NCAA and Carter v. NCAA. A New Financial Model The decision moves the NCAA and the conferences closer to funding a nearly $2.8 billion damages pool (over a span of 10 years) to compensate current and former student-athletes. This would set the stage for a fundamental change in college sports. Division I schools would be allowed to start paying athletes directly for use of their name, image and likeness (NIL), subject to a per-school cap that would increase over time. If eligible, current and former student-athletes received notification starting on October 18, and those covered under the settlement agreement can opt out or reject by January 31, 2025. Certain athletes have already objected to the proposed settlement and filed an opposition to the preliminary approval. In addition, the proposed settlement would clear the way for schools to inaugurate a new financial model in which revenue is shared between schools and athletes. Future benefits include athletic compensation through revenue-sharing, which would permit colleges to spend about $22 million annually on paying athletes with no guidelines for how the money can or cannot be spent. The revenue model allows schools to provide up to 22% of the average athletic media, ticket and sponsorship revenue to student-athletes starting in the 2025-26 academic year. In addition, third parties may continue to enter into NIL agreements with student-athletes. Employment Status However, even if finalized, the pending settlement does not resolve ongoing efforts, mainly by the National Labor Relations Board (NLRB) and plaintiffs lawyers, to designate student-athletes as employees under state and federal labor and employment laws. College conferences or institutions should examine whether student-athletes might be deemed employees under the federal Fair Labor Standards Act (FLSA) such that the athletes would be entitled to a minimum wage and overtime compensation. It is important to point out, however, that the legal landscape regarding the status of student-athletes is uncertain at this point and is rapidly evolving. In a pivotal decision issued several months ago by the U.S. Court of Appeals for the Third Circuit, the court did not definitively rule whether student-athletes are employees. Instead, the court in Johnson v. NCAA indicated that student-athletes might be deemed employees depending on the economic realities of the situation. The court articulated a four-part “economic reality” test to determine whether an athlete is an employee. The test considers whether: (1) the student-athlete performs services for another party (i.e., the university); (2) such activity is for the benefit of the university; (3) the student-athlete services are performed under the university’s supervision and control; and (4) the work is being performed in return for express or implied compensation or other in-kind benefits. The FLSA requires that each athlete’s employment status be evaluated on a case-by-case basis. Title IX and Walk-Ons Another unresolved issue is how universities will comply with Title IX when creating revenue-sharing models. Title IX, among other things, prohibits discrimination based on sex in educational settings. The statute’s protections may be the sole means for guaranteeing that women would be compensated fairly. The primary concern is how universities will create an equitable distribution of payments between men’s and women’s teams when male-dominated sports generate most of the revenue. Institutions are responsible for creating their own revenue model, which will require compliance with Title IX, careful management of the NIL marketplace, understanding of market needs and providing transparency in their operations. It is also uncertain how the proposed settlement will affect “walk-on” athletes. The prospective settlement emphasizes that full scholarships should be awarded for all roster spots. However, an unintended consequence of limited roster spots may be that athletic programs are less inclined to maintain non-scholarship sports or to accept walk-ons. The federal court’s preliminary approval of the settlement agreement is a significant step forward in addressing student-athlete compensation. However, many issues remain unresolved, which will drive continued litigation and may foreshadow the need for federal legislation.