My FREE webinar for the month of February is entitled "Avoid Mistakes: Lessons Learned from Last Proxy Season." It is at 10:00 am Central this Wednesday (February 13, 2013), and you can sign up or learn more about the series here (where the schedule for the remainder of the calendar year is set forth): http://www.winstead.com/AboutWinstead/ContinuingEducationWebinarSeries/CompensationBenefits Hope you can attend!
The purpose of this post is to consider whether implementation of a stock-price forfeiture within a stock option award agreement could be used to increase the life expectancy of the equity plan's share reserve.
Explanation of the Problem
The problem arises whenever a company has, or expects to have due to volatile stock prices, outstanding stock options that are underwater (i.e., a stock option where the exercise price is greater than the fair market value of the underlying common stock). If the company desires to reprice such underwater stock options, then the Schedule TO rules would have to be followed unless:
- The repricing is conducted on an individually negotiated basis and limited to a small number of key executives (see March 21, 2001 Exemptive Order); or
- The repricing is conducted on a unilateral basis (i.e., without optionee consent), the goal being to negate the Schedule TO rules because there would be no "offer" under applicable securities rules (i.e.., absent an offer, the optionee would not make an investment decision, and absent an investment decision, no Schedule TO should be triggered).
Noteworthy is that incremental compensation cost will likely be incurred in the unilateral repricing situation because, with a unilateral repricing, a value-for-value exchange is not possible.
Possible Solution to Consider
One solution is to draft the stock option award agreement to provide that the stock option will be automatically and immediately forfeited if the fair market value of the underlying stock falls below the exercise price by a certain dollar threshold. For example, a stock option with an exercise price of $2.25 could provide in the award agreement that it will be automatically forfeited if the fair market value of the underlying stock is ever at or below $1.95. The benefits of a stock-price forfeiture provision could include:
- The forfeited shares could return to and replenish the share reserve of the equity plan;
- Avoidance of the time and expense associated with repricing underwater stock options and complying with the SEC's tender offer rules; and
- Possibly avoiding shareholder issues that are typically associated with repricings and tender offers of underwater stock options.
Risks to Consider
For companies considering whether to implement a stock price forfeiture, the following issues should be considered (not an exhaustive list):
- Whether the trigger of a stock price forfeiture, even if implemented at a time when the stock option is granted at the money, would be deemed a "cancellation" under NYSE and NASDAQ listing rules, thus being deemed a "repricing" subject to shareholder approval under such rules;
- Depending upon the above answer, whether the terms of the equity plan would require shareholder approval to implement a stock price forfeiture;
- Whether the terms of the equity plan would allow the forfeited shares to return to and replenish the share reserve under the equity plan; and
- Whether the implementation of a stock price forfeiture at the date of grant would cause beneficial or adverse accounting consequences for the company.
Just another idea to consider that could increase the life expectancy of an equity plan's share reserve!
The purpose of this post is to remind issuers that inducement grants do not require shareholder approval, so if they are used correctly, they can help to increase the life expectancy of the equity plan's share reserve.
Shareholder approval of inducement grants to new hires is NOT required according to applicable NYSE and NASDAQ listing rules. To qualify as an inducement grant:
- The grant of equity must act as a material inducement to the person being hired as an employee (or such person being rehired following a bona fide period of interruption of employment); and
- Promptly following the grant of an inducement award, the issuer must disclose in a press release the material terms of the award, including the identity of the recipients and the number of shares involved.
Since grants of equity are often larger in the context of hiring an executive officer, the use of inducement awards can help an issuer prolong the life of the share reserve under the equity incentive plan. Thus, the "ask" to shareholders to increase the share reserve could happen less frequently.
Form of Award
Since inducement grants would be outside the equity incentive plan, the form of the award would typically be a stand-alone agreement. However, an inducement "plan" could also be used, and is more common in M&A situations where the target's employees will be offered equity of the acquiror.
Inducement grants would not be covered by the equity plan's Form S-8, therefore, consideration must be given to whether registration of the underlying shares is desired. If the inducement grant covers restricted stock, registration may not be required under the "bonus stock exemption" (certain restricted stock is treated as registered if certain conditions are satisfied). See SEC Release No. 33-6188 and Release No. 33-6281, and a series of No-Action letters. But even then, if the grant is to an "affiliate," registration is still likely desired so that the affiliate does not have to comply with Rule 144.
It is a new year and we are beginning the 4th year of our monthly webinar program. On this Wednesday, January 9, 2013, our monthly FREE webinar series will kick off with a session on "How to Increase the Life Expectancy of an Equity Plan's Share Reserve." Again, the webinar is FREE and will provide CLE, CPE and HRCI credits. For more information and to register: Click Here. Happy New Years!!
This is just a short follow-up to the below post. Pursuant to the Senate version of the Jumpstart Our Business Startups Act (approved by the House of Representatives yesterday), the investor threshold (referenced in the below post) will be increased from 500 to 2,000 in many instances (assuming the President signs the legislation into law, which he is expected to do soon).
The purpose of this post is to describe how stock options and restricted stock units ("RSUs") are counted when analyzing the SEC registration mandate for privately-held issuers with 500 or more holders of a class of equity securities and assets in excess of $10mm. The following is a quick analysis and compilation of the applicable legal support.
- Stock Options. Stock Options are treated as a separate class of equity securities for purposes of the 500 limit. See Section 3(a)(11) and Rule 3a11-1; and Section 12(g)(5) (defining "class" to include "all securities of an issuer which are of a substantially similar character and the holders of which enjoy substantially similar rights and privileges."). This means a company could have 499 shareholders and 499 option holders (PROVIDED NO OPTIONEES EXERCISE) without triggering the foregoing registration requirement. Stated another way, this means an issuer with 500 or more option holders and more than $10mm in assets is required to register that class of options under the Exchange Act UNLESS AN EXEMPTION APPLIES. See Release No 34-56887.
- Exemption for Retirement-Type of Plans. An exemption from the 500 limit for certain employee compensation plans (such as retirement plans) is contained in Rule 12h-1(a). This means the securities held by such plans are NOT counted towards the applicable 500 limit.
- Exemption for Certain Stock Options. Effective December 7, 2007, the SEC adopted an exemption from the above registration requirement for certain compensatory stock options. See Release No. 34-56887 (provided the conditions and limitations contained therein are satisfied). This means stock options that comply with the requirements and mandates set forth under Release No. 34-56887 are NOT counted towards the applicable 500 limit. Keep in mind there are certain disclosure requirements that must be contained within the granting documentation in order to gain protection under Release No. 34-56887. Another important note to keep in mind is that the exemption does not apply to the class of securities underlying stock options to the extent such are exercised. Therefore, if a privately-held issuer has a shareholder count close to the 500 limit, it may want to consider adding exercise pre-conditions to ensure such stock options cannot be exercised until a liquidity event (e.g., the stock option cannot be exercised until the earlier of an IPO or a change-in-control).
- Application to RSUs. On February 13, 2012, the SEC essentially incorporated the above analysis and applied it to stock and cash-settled RSUs. See SEC No-Action Letter. Private issuers should be able to rely upon this SEC no-action letter because the relief was addressed to a law firm in response to their request (Requesting Letter Found Here); whereas previous SEC no-action letters on the topic were provided to specific issuers. See No-Action Relief to Twitter on August 23, 2011 (SEC Response Found Here and Requesting Letter Found Here), and Facebook on October 13, 2008 (SEC Response Found Here and Requesting Letter Found Here).
- Increase in 500 Limit? There is a bill in the House to increase the above shareholder limit from 500 to 1,000. The status of this bill is uncertain at this time.
The above is not a frequent topic in the life of most private issuers, but when the topic does arise, it is usually a topic of high importance.
According to the SEC's Dodd-Frank rule-making schedule, proposed rules addressing clawbacks will be issued within the January-July 2012 time frame, and final rules will be adopted within the July-December 2012 time frame. Assuming this time line remains unchanged, a current question is whether some form of clawback policy should be initiated by companies prior to the SEC's issuance of proposed/final rules. Here are my thoughts:
As background, Dodd-Frank requires national securities exchanges to implement clawback policies (a.k.a., recoupment policies) that are more expansive than current requirements under Section 304 of SOX. Under Dodd-Frank:
- The clawback policy must be triggered any time the company prepares an accounting restatement resulting from "material" noncompliance with any financial reporting requirement (in contrast, Section 304 applies only when a financial restatement is "required" and is the result of "misconduct").
- Once the clawback policy is triggered, it would apply to all incentive-based compensation paid to current and former executive officers (in contrast, Section 304 applies only to the CEO and CFO).
- The look back period for which incentive-based compensation is subject to clawback is the three-year period preceding the date of restatement (in contrast, the look back period under Section 304 is twelve months).
- The amount subject to the clawback is the difference between the amount paid and the amount that should have been paid under the accounting restatement.
Issue to Consider until Final Rules are Adopted
Ensuring compliance with the Dodd-Frank clawback requirements is an issue between the company and the applicable exchange (e.g., NYSE), therefore, problems could arise with executives who have contractual rights. For example, assume a fact pattern where the executive has contractual rights to a benefit that, if paid, would jeopardize the company's listing with NYSE because such payment would violate the Dodd-Frank clawback requirements. If this fact pattern were to arise, it would create a tug-a-war for the company (i.e., complying with the listing requirements on the one hand, and complying with the executive's contractual rights on the other hand). However, this issue could be resolved in a simple manner if a contractual arrangement with the executive mandated compliance with the company's Dodd-Frank policy.
Resolutions for the Gap Period
The above issue will resolve itself once proposed and final rules are adopted. Until then (i.e., the gap period), a company could take the following actions:
- Do nothing by adopting a wait and see approach. This may be acceptable if the executives and the board of directors have a warm relationship. However, if a tug-a-war arises during the gap period . . . .
- Adopt a short policy that is expected to be amended in a more robust manner once final rules are adopted. I am in favor of this approach.
- In conjunction with the above bullet, have executives sign a contractual arrangement under which each executive agrees (as to all then existing and future arrangements) to comply with the Dodd-Frank clawback requirements (when effective) and any clawback policy adopted by the company as such is amended from time to time. I am in favor of this approach because it is easy and can be accomplished with a one-page document (including signature blocks!!).
- Adopt a formal and robust clawback policy. I am less in favor of this approach since proposed rules have not been issued.
An example of a simple policy (referenced in the above second bullet) was adopted by Tractor Supply Company around May 3, 2011, that provides:
"Tractor Supply Company shall seek to recover incentive compensation paid to any executive as required by the provisions of the [Dodd-Frank Act] or any other 'clawback' provision required by law or the listing standards of the NASDAQ Global Select Market."
That policy, if used in conjunction with one-page arrangements that contractually bind the executives, is simple, easy to implement and should protect companies during the gap period. I am a big fan!
The purpose of this Post is to address some of the common issues that members of a Boards of Directors should consider when negotiating employment agreements with named executive officers.
Consider defining the term "cause" to include a substantial under-performance of the executive (e.g., failure to achieve minimum financial goals for two consecutive fiscal years).
Additionally, consider the Board's use of after-acquired evidence to determine whether the executive terminated employment for "cause." It could be that evidence supporting a termination of employment for cause is not found until after the executive has terminated employment for a reason other than cause. Without an after-acquired evidence clause, the Board will not likely be able to change the characterization of the executive's prior termination of employment (and therefore the Company may remain contractually liable for associated severance pay benefits). But if instead an after-acquired evidence clause were contained within the employment agreement, the Board could recharacterize and deem the executive's prior termination as one for cause (thus likely negating associated severance pay benefits).
Defining "Change in Control"
Ensure that the definition of "change in control" requires consummation of the transaction. There are a few public examples where the term change in control was triggered upon execution of the underlying transaction document. If such were the facts and the underlying transaction was not consummated (i.e., a failed deal), then the Board might see the makings of a shareholder derivative lawsuit, especially if the payouts to the executives were rich.
Implement Robust Clawback Provisions
Consider adding clawback provisions in addition to those required under Section 304 of SOX and the Dodd-Frank Act. For example, consider adding a clawback for any breach of post-employment restrictive covenants (e.g., violation of a non-compete clause). Additionally, but related, consider adding a clause that if the non-compete provision is ever judicially or administratively ruled to be unenforceable, then the executive must forfeit certain portions of his or her severance pay (including a return of any gains on equity awards that the executive sold after his or her termination of employment).
Require Automatic Resignation from the Board
It is surprising to me how many employment agreements I review that do not require the automatic resignation from the Board (and other Company-related entities) upon the termination of the executive's employment with the Company. Failure to implement such a provisions provides the departing executive with "some" leverage at the time of his or her termination and, in instances where the executive does not resign from the Board, could be politically awkward until his or her term on the Board is complete.
Remember that Severance Pay Should be Bridge Pay, Nothing More
In setting the amount of any severance pay, keep in mind that severance pay packages should be designed to act as a bridge between jobs. Therefore, consider limiting the amount of severance pay packages to 6 months base salary and bonus (or upward to 1 year base salary and bonus). Additionally, consider whether it makes sense to offset the amount of any future severance pay by the amount of any income the executive earns from his or her new employer.
Design the Timing of Severance Pay as Salary Continuation
Absent a change in control of the Company, consider designing severance pay to take the form of salary continuation (as opposed to a lump sum payment). Salary continuation is more friendly to the Board's position because it allows the Board to hold purse strings as a mechanism to enforce any post-employment restrictive covenants such as a non-compete clause. However, the foregoing might not make sense if the executive's employment is being terminated in conjunction with a change in control.
Use Double Triggers for Change in Control Transactions (Try to Avoid Single Triggers)
Single trigger vesting events (i.e., accelerated vesting upon a change in control) are viewed disfavorably by institutional shareholder advisory services such as ISS. For this reason consider using only double triggers (i.e., accelerated vesting only if there is both a change in control and a termination of the executive's employment).
Implement Non-Competes to Avoid Use of a 280G Tax Gross-Up
As background, executives generally prefer a tax gross-up for any change in control payments that would be subject to Section 280G of the Internal Revenue Code (absent a tax gross-up, the executive could be subject to a 20% excise tax on change in control payments). However, tax gross-ups are highly disfavored by institutional shareholder advisory services.
Consider negating the need for any 280G tax gross-up by implementing a non-compete provision, the related compensation to which could act to reduce golden parachute payments subject to the 280G excise tax. Keep in mind that the reduction is not on a dollar-for-dollar basis with the separation pay, rather, the reduction is generally based on the difference between the enterprise value of the company with and without the non-compete. Thus, the value of the non-compete and the value of the 280G reduction could be a lot more than the severance pay directly associated with the non-compete (thus acting to also reduce other compensation subject to 280G, such as the present value of of equity awards that accelerate vesting upon the change in control).
To close, my experience is that Boards carefully consider the terms of executive employment agreements. Hopefully the above is helpful with that endeavor.
We now have our first failed say-on-pay proposal for this proxy season. Discussed below, this failure raises the issue of whether companies should affirmatively disclose controversial pay practices or compensation issues within their proxy statements. Minimally, the issue should be considered.
Generally, institutional shareholder advisory services such as ISS will only look to the "four corners" of the proxy statement in making its recommendation (i.e., it will not look at other filings of the issuer). This means that if a company has a controversial pay practice or compensation issue, it should consider affirmatively explaining such issue in its proxy statement in the hopes of avoiding a possible negative recommendation from ISS (and applicable others).
First Failed Say-on-Pay Proposal of this Proxy Season
On January 28, 2011, Jacobs Engineering Group Inc. filed a Form 8-K (Found Here) showing that their advisory say-on-pay vote resulted in a majority voting "against" the proposal. This is the first failed proposal for this proxy season.
It seems a cause for the failure related to a one-time grant of restricted stock to its executive officers. The proxy statement contained little discussion about the grants. Though I did not check, it can be inferred that ISS (or other service) recommended a "no" vote because the company later made an effort to explain the grants by filing additional materials to its proxy statement. (Found Here)
Some Examples of Companies Providing Affirmative Disclosure
A few examples of companies providing affirmative disclosure of controversial pay practices or issues within their proxy statements are as follows:
- FedEx Corporation explained in their proxy statement filed on August 16, 2010, why tax reimbursements associated with their executive officers' receipt of restricted stock was appropriate even though the company generally discontinued tax gross-ups. (Found Here)
- Level 3 Communications, Inc. discussed its rationale for single trigger vesting and 280G gross-up provisions in its proxy statement filed on April 2, 2010. (Found Here)
- Saks Incorporated addressed its rationale for severance arrangements with its executive officers in its proxy statement filed on May 7, 2010. (Found Here)
- Intel Corporation addressed overhang and burn rate issues in its proxy statement filed on April 3, 2009. (Found Here)
To close, companies should at least consider providing affirmative disclosure.
Issuers who hold their annual shareholders meeting after January 21, 2011, will have to implement say-on-pay as part of their proxy process. At this first annual meeting, shareholders must also decide on the frequency of the say-on-pay vote, such frequency also becoming known as "say-when-on-pay." The purpose of this Post is to discuss issues that should be considered when implementing say-when-on-pay.
Addressing the frequency of say-on-pay, issuers must offer shareholders the following four choices: annual, biennial, triennial and abstention. Thereafter, the vote on frequency must be held by a separate resolution no less than once every six years.
Worth noting is that a majority of the issuers who have filed proxy statements this season have recommended triennial say-when-on-pay.
Some Reasons to Adopt an Annual Vote
- There is a belief that annual votes will become routine, similar to annual ratification of an issuer's outside auditors. Those following this thought believe that the scrutiny associated with an annual vote will eventually be less than the scrutiny associated with a biennial or triennial vote.
- Another thought is that shareholder dissatisfaction is likely to be expressed in the say-on-pay process as opposed to utilizing withhold/no votes on compensation committee members. Thus, as the thought goes, compensation committee members are more protected with annual say-on-pay.
- ISS recommends annual voting.
- There is real time disclosure and shareholder feedback associated with annual voting.
- For those issuers with poor pay practices, annual voting may be preferred so that the taint associated with a no vote does not last for two or three years (as it would if biennial or triennial voting were implemented).
Some Reasons to Adopt a Biennial or Triennial Vote
- A biennial or triennial vote helps shareholders evaluate the long-term effects of an issuer's multi-year compensation structures. In contrast, an annual vote encourages short-term thinking and focuses on interim results, such as a decrease in stock price.
- Preparing for and implementing say-on-pay on an annual basis may be costly and mis-directs the attention of management.
- Assuming shareholders express negative thoughts during the say-on-pay process, the compensation committee may need to time implement changes to various compensation policies and procedures.
- Some investors prefer a voting frequency that is longer than annual voting (e.g., the United Brotherhood of Carpenters prefers triennial voting).
- Certain registered institutional investment managers may find that annual reporting to the SEC on how they voted is too burdensome for every portfolio company.
Recommendation from the Issuer
Issuers have the opportunity in their proxy statement to recommend a voting frequency. The following are some examples of recent examples (and links to their proxy statements) where issuers have recommended a frequency vote or have affirmatively abstained from such recommendation (or you can go here where I have cut and paste the applicable language into this PDF):
- Annual vote recommendation filed by Navistar International Corporation in its proxy statement on January 14, 2011.
- Biennial vote recommendation filed by Fair Isaac Corporation in its proxy statement on December 27, 2010.
- Triennial vote recommendation filed by Tyco International Ltd. in its proxy statement on January 14, 2011.
- Affirmative abstention from any recommendation filed by Jack In The Box, Inc. in its proxy statement on January 13, 2011.
Any Worries with Recommending other than an Annual Vote?
For issuers who prefer other than an annual vote but are worried that such a recommendation may not succeed, consider offering an olive branch such as:
- A written commitment in the recommendation that the issuer will resubmit its say-when-on pay the following year if the biennial or triennial recommendation does not receive the affirmative vote of a majority of the shareholders.
- A written commitment in the recommendation that the issuer will resubmit the say-when-on-pay proposal at such biennial or triennial vote.
As a concluding thought, for those of you who are responsible for implementing say-on-pay and say-when-on-pay internally at the issuer, do not forget to set internal expectations as to what is an acceptable percentage of "no" votes. It may be that your team thinks 10% or 20% "no" votes is acceptable, whereas your compensation committee may find such percentage appalling (or vice versa).