Equity Plan Share Reserves: How to Increase Its Life Expectancy: Executive Compensation Practical Pointers

Efforts to conserve an equity plan’s share reserve should begin the day the issuer’s stockholders approve the plan (or share increase), and should continue going forward. Issuers that do not make such efforts tend to face problems relating to dwindling share reserves, including moving to cash-based programs, hiring proxy solicitation firms to garner stockholder support for share increases, and overcoming possible negative reactions from ISS.

The following are some ideas an issuer could use to extend the life of its plan share reserve:1

  • Grant awards that are settled in cash – Depending on the terms of the plan, a cash-settled award may not draw from the share reserve.2 An alternative would be settling a portion of the award in shares (e.g., up to target), with any achievement above that settled in cash.
  • Grant full value awards like restricted stock or RSUs – Such grants provide greater value to the holder than options or SARs, the latter providing incentive only to the extent the share price exceeds the exercise/strike price, but draw from the share reserve the same as full value awards.3
  • Permit net-exercise of stock options – Depending on the terms of the plan, the shares subject to the option that are netted in a net-exercise may not draw from the share reserve. Also, a net-exercise could be helpful to a Section 16 insider to avoid a blackout (i.e., no open market transaction occurs with a net-exercise).4
  • Amend the plan to permit maximum withholding – A recent change in accounting rules provides that maximum withholding will not result in liability accounting treatment. Depending on the terms of the plan, withholding of shares to cover taxes may not draw from the share reserve.
  • Grant stock-settled SARs rather than options – A stock-settled SAR will provide the same economic result as a net-exercised option, but since a SAR is settled in shares with respect to only the excess over the strike price, fewer shares are burned than with a net-exercised option.
  • Use inducement awards for new executive-level hires and certain M&A events – The award must be a material inducement to getting the executive/employee to accept the position. If properly structured, these awards can be made outside of the plan and do not require stockholder approval under NYSE or NASDAQ rules.5
  • Implement an ESOP or ESPP – ESOPs, which are subject to ERISA, do not require stockholder approval under NYSE or NASDAQ rules. Depending upon the structure of an ESPP, stockholder approval may be required.6

1. Some of these methods involve liberal share counting, which is disfavored by ISS.

2. Liability classification would apply for accounting purposes and settlement in cash will not count towards satisfying any share ownership requirements.

3. This method will not work if the plan contains fungible share counting provisions.

4. However, a net-exercise of an incentive stock option could jeopardize the ISO’s favorable tax treatment.

5. Without stockholder approval, such awards could not qualify for deduction under Section 162(m), if applicable.

6. Broad participation requirements may apply.

This post was written by Matthew B. Grunert  & Carolyn A. Exnicios of Andrews Kurth Kenyon LLP.,© 2017
For more legal analysis go to The National Law Forum 

Will Auditors Influence How Executives Are Paid?

Recently The National Law Review published an article by Andrew C. Liazos of McDermott Will & Emery regarding Executive Pay:

PCAOB proposals would have auditors reading the employment and compensation contracts of corporate leaders and, possibly, forcing changes to comp programs due to unacceptable risks of material restatement.

Unfortunately, the PCAOB is suggesting that auditors also evaluate whether the design of an executive-compensation program could itself lead to excessive risk taking. Here’s what one of the board members, Steven Harris, had to say about this matter:

“Equity-based compensation arrangements may also provide strong incentives for excessive risk-taking by executives. Studies have shown that these arrangements can position executive officers to benefit from the upside of high-risk investments, while largely insulating them from the downside risks. In addition, excessive risk taking generally is viewed as one of the contributing factors to the recent financial crisis. For example, ‘The Financial Crisis Inquiry Report’ concluded that ‘Executive and employee compensation systems at these institutions disproportionately rewarded short-term risk taking.’ The Board’s proposals would require auditors to focus on the potential opportunities and motivations for executive officers to exaggerate gains, or minimize losses, and to consider any effect compensation incentives might have on the reliability of the financial statements.” (Emphasis added)

That type of statement raises the possibility that an auditor might view the structure of an executive-compensation program to be so problematic that, when coupled with other factors, the auditor may be unable to issue an unqualified opinion. This risk (i.e., not receiving an unqualified opinion on financial statements) could give the auditor significant influence over executive-compensation decisions.

What’s particularly interesting about the timing of the PCAOB release is that its focus on executive compensation is happening when shareholders now have a “say on pay” under Dodd-Frank and there is an increasing focus on “pay for performance.” As discussed in my January column, ISS, the leading shareholder advisory service, recently revamped its guidelines for making recommendations on executive compensation by focusing on total shareholder return (TSR) as compared with peer companies, and it’s reasonable to expect that issuers will start to use TSR performance goals. One can only imagine the reaction of compensation committees if their decisions to restructure executive pay in response to shareholders were to be second-guessed by auditors, particularly in light of the current lawsuits regarding failed say-on-pay votes.

The PCAOB is moving quickly on this change. While the proposed amendments require SEC approval, the PCAOB anticipates that these changes would be effective for audits of financial statements for companies with fiscal years beginning on or after December 15, 2012.

© 2012 McDermott Will & Emery