Companies that sponsor equity compensation plans often face volatility in the price of the company’s stock. This volatility, especially declines in price, can put unexpected pressure on the adequacy of the plan’s share reserve and upend established award practices. Indeed, this prospect can cause companies to envy the lovelorn man in the song I Can’t Get Started With You who sold short in 1929. But unlike the lovelorn man in that song, companies can get started with approaches to address this prospect. This article discusses those approaches.
The effects of price volatility often turn on how the plan limits awards to participants individually and in the aggregate. Plans may place an annual limit on individual awards, especially on awards to nonemployee directors. The annual limit is often expressed as a dollar amount, and occasionally as a limit on the number of shares. In addition, the plan may place an annual limit on the aggregate amount of all awards, which may be expressed as a dollar amount, a number of shares, or a percentage of common shares outstanding. Most importantly, the plan will place a limit on the aggregate number of shares subject to all awards during the term of the plan, otherwise known as the share reserve.
Use of a dollar amount provides consistent grant date value by adjusting the number of shares on the grant date to match the dollar amount, and consistent proxy disclosure regardless of fluctuations in stock price. It is often used by established companies with less stock price volatility. However, when a plan limits awards by dollar amount, and the company’s stock price declines, the decline results in a larger number of shares per grant. The increase in the number of shares per grant can put pressure on the plan’s annual individual and aggregate limits and the share reserve. Furthermore, if the company has experienced reduced cash flow, it may shift from annual or long-term cash bonuses to equity compensation. In these situations, the plan’s share reserve will be depleted more rapidly, and the plan’s burn rate and level of shareholder dilution will increase.
For example, if the company’s stock price declines by 25%, the number of shares needed to deliver the same dollar value as before the decline increases by 33.3%. If the company’s stock price declines by 50%, the number of shares need to deliver the same dollar value as before the decline increases by 100%.
Companies facing stock price volatility should consider approaches to reduce the rate of depletion of the share reserve, otherwise known as the plan’s burn rate. When a plan limits awards by a dollar amount and the company’s stock price declines so that the number of shares per grant increases, the company may wish to stanch this increase by amending the plan to limit awards by the number of shares. This approach is often used by companies that have recently gone public. It provides a lower burn rate and less dilution of shareholders, and can head off claims by proxy advisors and institutional shareholders of an undeserved economic windfall for directors and executives. When the company wishes to amend the plan to limit awards by the number of shares, under the NYSE and NASDAQ listing rules as long as the amendment does not increase the share reserve, the amendment is not a material revision to the plan that requires shareholder approval.
Another approach is to set a floor below which the price per share value used to determine the number of shares in an award will not fall. The floor will apply regardless of the share’s market value. A variation on this approach is to use the same price used for a prior grant made in a less volatile market when stock prices were higher. Since these approaches reduce the number of shares available per grant, they have employee retention risk.
When the plan places an annual limit on the aggregate amount of all individual awards expressed as a percentage of common shares outstanding, this approach provides a more predictable burn rate and dilution of shareholders. It is often used by private companies and companies that have recently gone public.
When a plan limits annual awards by dollar amount, the company has to consider how to determine the annual dollar limit. One method is the value under Financial Accounting Standards Board Accounting Standards Codification Topic 718. Another method is the fair market value on the grant date, such as the closing price. However, when shares are subject to substantial volatility, use of a single day spot price can reflect a major price fluctuation. One way to avoid this result is for the plan to use a thirty to sixty day trailing average of closing prices, which smooths out the effect of volatility. When a plan does not use a trailing average to determine award limits and the company wishes to amend the plan to provide for its use, under the NYSE and NASDAQ listing rules the amendment is not a material revision to the plan that requires shareholder approval.
If after taking any of the foregoing approaches the company faces the prospect of depleting the share reserve and being unable to make ordinary course annual awards, the company will need to increase the share reserve. Under the NYSE and NASDAQ listing rules, a material increase in the share reserve is a material revision to the plan that requires shareholder approval. In determining the number of additional shares to request approval for, the company should take into account the decline in stock price and any shift from cash compensation to equity compensation. It should also assess the risk that if its stock price recovers as part of a sector or other macroeconomic recovery, proxy advisors and institutional shareholders will view the awards as an undeserved economic windfall for directors and executives, rather than an appropriate reward for company or individual performance.
Pending shareholder approval, to avoid fully depleting the share reserve a company should consider the following five approaches to making annual awards. First, the company can adopt an across-the-board reduction in the number of shares to be used for awards. This approach has employee retention risk.
Second, the company can make larger awards to key executives, and either forego awards to employees below a certain level or limit awards to those employees to a specified percentage of the employee population. This approach has employee retention risk for the adversely affected employee population.
Variations on this approach are the grant of awards only to employees below the executive level; the grant to employees, especially those below the executive level, of the right to select their mix of awards, e.g., 50% options and 50% restricted stock units; and a partial grant of awards before the annual meeting and the remainder after shareholder approval is obtained at the annual meeting.
With these approaches, the company often uses restricted stock units for a greater portion of annual awards. Unlike options, restricted stock units do not require stock price appreciation to provide intrinsic value and therefore provide value in declining markets. Furthermore, restricted stock units require fewer shares than options to deliver the same dollar grant value as options, and therefore are less dilutive of shareholders than options. Finally, when a plan provides for restricted stock, under the NYSE and NASDAQ listing rules amendment of the plan to provide for restricted stock units is not a material revision to the plan that requires shareholder approval.
Third, a company can make cash-settled awards of phantom stock or stock appreciation rights outside of a shareholder-approved plan. The disadvantage of cash-settled awards is that they are treated as liability awards subject to variable or mark-to-market accounting. Under the NYSE and NASDAQ listing rules, shareholder approval for cash-settled awards is not required.
Fourth, a company can make inducement awards for newly hired employees. Under the NYSE and NASDAQ listing rules, inducement awards do not require shareholder approval or count against share limits on individual awards or the share reserve. To make inducement awards, a company can use a separate share pool under an existing equity compensation plan, adopt a separate equity compensation plan limited to inducement awards, or make inducement awards outside of an equity compensation plan. The company should understand that proxy advisors consider inducement awards when assessing plan cost, burn rate, and overhang. Proxy advisors also treat inducement awards as outstanding awards when determining the number of shares available for future equity plan proposals.
Fifth, subject to the NYSE and NASDAQ listing rules, a company can create a legally binding right of a promise to grant awards after the annual meeting contingent on shareholder approval to increase the share reserve. With this approach, the company must safely navigate the notoriously complex rules of Section 409A of the Internal Revenue Code for nonqualified plans of deferred compensation, and its regulatory exemptions for options, stock appreciation rights, and restricted stock.
The exemptions for options and stock appreciation rights allow employees to exercise these stock rights at any time after vesting free from the shackles of the Section 409A limitations on the permissible exercise times and events. To come within these exemptions, the exercise price must be equal to or greater than the fair market value of the stock on the date of grant of the option or stock appreciation right. Therefore, correctly determining the date of grant is essential to ensure that the exercise price satisfies this requirement.
The date of grant is the date when the granting corporation completes the corporate action necessary to create a legally binding right constituting the option or stock appreciation right. The corporate action is not complete until the date on which the maximum number of shares that can be purchased and the minimum exercise price are fixed or determinable, and the class of underlying stock and the identity of the employee are designated.
Ordinarily, if the corporate action provides for an immediate offer of stock for sale to an employee, or provides for a particular date on which such offer is to be made, the date of grant is the date of such corporate action if the offer is to be made immediately, or the date provided as the date of the offer.
If the company imposes a condition on the grant of an option or stock appreciation right, such condition generally will be given effect. However, if the grant of an option or stock appreciation right is subject to shareholder approval, the date of grant is determined as if the option or stock appreciation right had not been subject to shareholder approval.
When a company promises to grant options or stock appreciation rights after the annual meeting contingent on shareholder approval to increase the share reserve, and the promise does not provide an exercise right or establish a fixed or determinable exercise price, a grant does not occur. The promise is not a legally binding right constituting an option or stock appreciation right. In addition, the shareholder approval is to increase the share reserve for all future grants, and not for the grant of any option or stock appreciation right to any employee. The grant occurs when the company issues the option or stock appreciation right after shareholder approval is obtained. To come within the exemption from Section 409A, the exercise price must be equal to or greater than the fair market value of the stock on that grant date.
For restricted stock, the Section 409A regulations focus on whether there is a legally binding right to receive nonvested or vested property in a future taxable year. There is a two-step analysis. First, whether there is a legally binding right to compensation, which here is the restricted stock. Second, whether the legally binding right to compensation is a deferral of compensation.
A legally binding right to compensation generally means a contractual right, regardless of whether the right is conditional or contingent, that is enforceable under the law governing the contract. It also includes an enforceable right created by governing law, such as a statute. For example, an agreement to pay an employee a bonus equal to a percentage of the amount that the employer receives on sale of a property is a legally binding right to compensation. The requirement that the property be sold is a condition to the right to the payment, but the right to payment is a legally binding right created when the parties enter into the agreement.
There is a deferral of compensation when an employee has a legally binding right during a taxable year to compensation that is or may be payable to, or on behalf of, the employee in a later taxable year. A legally binding right to an amount that will be excluded from income when and if received is not a deferral of compensation unless the employee has received the right in exchange for, or has the right to exchange for, an amount that will be includible in income.
The Section 409A regulations provide specific rules for whether a legally binding right to receive property in a future taxable year is a deferral of compensation. A legally binding right to receive property in a future taxable year in which the property will be substantially nonvested under Treasury Regulation Section 1.83-3(b) at the time of transfer will not provide for the deferral of compensation. However, a legally binding right to receive property in a future taxable year in which the property will be substantially vested under Treasury Regulation Section 1.83-3(b) at the time of transfer may provide for the deferral of compensation.
In the case of an award of nonvested shares, since the creation of the legally binding right to the transfer of the shares is not a deferral of compensation, the legally binding right can provide for the transfer within thirty days of shareholder approval regardless of whether shareholder approval occurs in the same taxable year as the creation of the legally binding right or in the following taxable year.
In the case of an award of vested shares, the creation of the legally binding right to the transfer of the shares is a deferral of compensation. Accordingly, the company should ensure that the legally binding right satisfies the requirements of Section 409A or an exemption thereto. There are three potential scenarios. First, the company creates a legally binding right before the annual meeting to transfer vested shares once shareholder approval is obtained at the meeting, and the annual meeting and transfers must occur in the same taxable year as the creation of the legally binding right. Under this scenario, there is no plan for the deferral of compensation.
Second, the company creates a legally binding right before the annual meeting to transfer vested shares once shareholder approval is obtained at the meeting, and the annual meeting and transfers must occur no later than the end of the short-term deferral period ending on March 15 of the following taxable year. Under this scenario, the legally binding right is a short-term deferral exempt from Section 409A.
Third, the company creates a legally binding right before the annual meeting to transfer vested shares once shareholder approval is obtained at the meeting, and the annual meeting and transfers can occur after the end of the short-term deferral period ending on March 15 of the following taxable year. Under this scenario, the arrangement is a plan of deferred compensation subject to Section 409A. As a result, the transfer of the vested shares must satisfy the permissible distribution event of payment at a specified time or fixed schedule.
Under the rule for payment at a specified time or fixed schedule, in the absence of a vesting event the amount of a payment cannot be based all or in part on the occurrence of an event. Since shareholder approval to increase the share reserve may come within this prohibition, the legally binding right should not provide for the transfer of shares at a time determined by reference to the date of shareholder approval. Rather, the legally binding right should provide for the transfer of shares on a specified date without reference to the date of shareholder approval. For example, if the company creates a legally binding right in December, and the annual meeting takes place in April in the following taxable year, the legally binding right should provide for the transfer of the vested shares in June.
Alternatively, the legally binding right can provide that the employee must be employed on the date of shareholder approval, and the transfer of the vested shares must occur within thirty days thereafter. This arrangement will be a short-term deferral exempt from Section 409A.
For the creation of a legally binding right to the grant of restricted stock units contingent on shareholder approval to increase the share reserve, the creation of the legally binding right will not be a plan of deferred compensation. Restricted stock units are unfunded promises subject to vesting conditions to make future distributions of shares or cash equal to the value of the shares. The units are most often structured to provide that once they vest, distributions are made within the short-term deferral period so that the units come within the short-term deferral exemption. Alternatively, the units are structured to provide that once they vest, distributions are made on one or more Section 409A permissible distribution times and events so that the units comply with Section 409A.
The grant of an unfunded restricted stock unit is not a taxable event. Accordingly, the creation of a legally binding right to the grant of an unfunded and unvested restricted stock unit contingent on shareholder approval to increase the plan reserve is not a deferral of compensation. The company can create a legally binding right before the annual meeting to grant a restricted stock unit once shareholder approval is obtained at the meeting. The legally binding right can provide for the grant within thirty days of shareholder approval regardless of whether the annual meeting occurs in the same taxable year as the creation of the legally binding right or in the following taxable year before or after March 15. Once the company grants the restricted stock unit that entitles the employee to distribution of stock or cash, the grant must satisfy the requirements of Section 409A or an exemption thereto.
