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

I spent a fair amount of time this proxy season advising public companies on nuances associated with net-exercised stock options and/or stock-settled stock appreciation rights ("SARs").  The purpose of this Post is to highlight some advantages and disadvantages of these types of awards.

Background

In the stock option context, a net-exercise is similar to a broker-assisted cashless exercise except in the former there is no open market transaction.  Instead, a portion of the exercised shares equal in fair market value to the exercise price is tendered to the company in lieu of paying the exercise price in cash.  For example, assume a holder is granted a stock option to acquire 8 shares of stock with an exercise price of $1.00 per share (its then fair market value).  Assume further that at the time of exercise the fair market value of the underlying stock is $4.00 per share.  In this example, a net exercise means the holder would tender 2 of the 8 shares of common stock to the company in exchange for paying the exercise price of $8.00.  Immediately thereafter the holder would own 6 shares of common stock having a then fair market value of $24.00.

Stock-settled SARs generally provide the holder with a number of shares of stock equal in fair market value to the accumulated appreciation in the underlying stock from its fair market value at the date of grant; however, unlike net-exercised stock options, no shares are tendered to the company with stock-settled SARs.  Using the above example, the accumulated appreciation of the underlying stock from the date of grant would also provide the holder with 6 shares of common stock (i.e., $24.00 of accumulated appreciation divided by $4.00 per share). 

Advantages 

Compared to stock options utilizing a cashless exercise feature, the advantages of using net-exercised stock options and/or stock-settled SARs generally include:

• Assuming the plan document contains appropriate share counting provisions, the life expectancy of the share reserve under the plan should be longer because a lesser number of shares are issued.  This could lessen the frequency within which shareholders are asked to increase the plan's share reserve.
• Reduced shareholder dilution because only the net shares are considered issued and outstanding.
• The holder receives the same economic benefit as stock options with a cashless exercise feature. 
• Broker fees associated with cashless exercises are avoided.
• There could be less problems associated with insider trading blackout periods since net-exercises and/or stock-settled SARs do not use open market transactions.
• More favorable treatment in calculating basic earnings per share.  

Disadvantages 

Compared to stock options utilizing a cashless exercise feature, the disadvantages of using net-exercised stock options and/or stock-settled SARs generally include:

• Company may have decreased cash flow because no monies are paid to the company in conjunction with an exercise.
• The holder may be unable to obtain favorable incentive stock option treatment.
• Depending on the underlying facts, it may become more burdensome for the company to satisfy its withholding obligation.
• Shareholder advisory services such as RiskMetrics Group might assign a higher cost to the awards than it would traditional stock options. 

Given that many of the disadvantages could be lessened with careful planning, companies should consider whether it makes sense to utilize net-exercised stock options and/or stock-settled SARs.  At least don't wait until next proxy season!!

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The purpose of this Post is to highlight issues that compensation committee members should consider when designing an effective "clawback policy" for compensation paid to certain executive officers.

Background

A clawback policy (also known as a "recoupment policy") generally refers to a company's ability to recover compensation it paid to an employee (or former employee) due to a specific triggering event.  Effective clawback policies can provide positive CD&A disclosure, are generally considered shareholder friendly by shareholder advisory services such as RiskMetrics, and can help negate "materiality" under the new SEC risk assessment disclosure rules (Prior Post).

Section 304 of SOX May Not Be Sufficient

Under Section 304 of the Sarbanes-Oxley Act of 2002 ("Section 304"), the CEO and CFO of a public company are required to reimburse the company for certain cash and equity compensation received (and any profit realized) during the 12-month period following the company's first issuance or filing of erroneous financial statements.  However, Section 304 has a number of deficiencies, including:

• Only the CEO and CFO are covered. 
• Clawbacks are mandated only when the company is "required" to restate its financial statements (it is not always clear whether a restatement is required, e.g., consider whether a restatement to follow advice of a new accounting firm would be considered voluntary or required).
• Clawbacks are triggered only as the result of "misconduct," which is not defined.
• Only the SEC can bring an action against the CEO and/or CFO (i.e., private plaintiffs such as a company or its shareholders cannot bring a claim under Section 304 against the CEO and/or CFO).

In light of these possible deficiencies, compensation committees should consider implementing a more robust clawback policy.

Issues to Consider When Designing a Clawback Policy

The following are a few issues compensation committees should consider when designing a clawback policy:

• Which employees should be subject to the clawback policy?  Minimally, it should include one or more employees who have influence on critical business issues.  For example, the policy could be designed to cover: (i) the CEO and CFO (comparable to Section 304), (ii) all named executive officers (though this could become burdensome if NEOs change from year to year under the new SEC disclosure rules), (iii) all Section 16 officers, or (iv) all executive officers.
• Should it cover current and/or former employees?
• Which events should trigger a clawback (e.g., restated financial statements, fraud, misconduct, negligence, poor performance, and/or violation of non-competes or other restrictive covenants)?
• Should the policy require the executive to have some culpability or should the culpability of a subordinate be sufficient?
• What compensation should be subject to clawback (e.g., cash payments, equity, etc.)?  Should it include profit (e.g., recover any profit arising from sale of stock options)?
• Who should be responsible for enforcement (e.g., a risk assessment officer, the compensation committee, the full board of directors)? 

To conclude, increased compensation governance standards, public outrage over perceived compensation abuses and prospective say-on-pay mandates are just a few of the reasons compensation committees should discuss implementing or bolstering clawback policies prior to their upcoming annual meeting.

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