Compensation Committee Corner : Executive Compensation Lawyer & Attorney : Winstead Law Firm : Director Liability, Employee Benefit Arrangements

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.

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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:

Background

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!

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