Many publicly-traded issuers in today’s environment have outstanding equity awards with performance goals that are unlikely to be achieved. In response, Compensation Committees of such issuers will need to strike a balance between incentivizing/retaining executives and dealing with the stark reality that shareholders have lost substantial value. To that end, Compensation Committees are likely to discuss whether it makes sense to revise performance metrics for outstanding equity awards. The purpose of this Post is to highlight that revising performance metrics of outstanding equity awards can trigger the SEC’s tender offer rules if not done correctly.
With respect to outstanding performance-based equity awards, and from a contractual perspective within the award agreement, participant consent may be required in order for a Compensation Committee to replace ill-performing performance criteria with new performance criteria (e.g., swap out EPS with relative TSR). Seeking such consent may inadvertently trigger the SEC’s tender offer rules. However, if the Compensation Committee can effectuate such amendment in a unilateral manner without participant consent, then the issuer could avoid the tender offer rules on the basis that the participant had no choice and made no investment decision. Alternatives 1, 2 and 3 in the far below portions of this e-mail are just three of the many viable alternatives that could be used by Compensation Committees to operationally revise ill-performing performance metrics without triggering the SEC’s tender offer rules.
BACKGROUND – APPLICATION OF THE SEC’s TENDER OFFER RULES
- GENERALLY. Generally, the SEC’s tender offer rules under Rule 13e-4 of the Securities Exchange Act of 1934 should be analyzed whenever a holder of a security is required to make an investment decision with respect to the purchase, modification or exchange of that security. These tender offer rules were front and center during previous financial downturns (e.g., beginning around 2001 and again around 2008) when issuers were making offers (or thinking of making offers) to employees to reprice their underwater stock options. During those times the SEC’s tender offer rules had to be analyzed and were often triggered because the proposed amendment to the terms of the outstanding stock option created an investment decision by the employee (i.e., an investment decision is triggered due to the employee having a choice between two alternatives, even if the alternatives are only slightly different). To be clear, unilateral repricings without optionee consent do not trigger the SEC’s tender offer rules, but such a repricing creates incremental compensation expense from an accounting perspective (measured by the difference between the fair value of the option immediately prior and after the repricing). As a result, issuers sought to neutralize incremental compensation cost by effectuating the repricing pursuant to a value-for-value exchange. The value-for-value exchange would replace the underwater stock options with securities of an equal fair value (typically determined pursuant to a Black-Scholes formula) pursuant to either: (i) a lesser number of shares being subject to the repriced stock option or (ii) a grant of restricted stock or restricted stock units. The result of a value-for-value exchange is that the issuer has to solicit consent from the optionee and the optionee has to make an investment decision. Thus, the SEC’s tender offer rules were triggered.
- RAMIFICATIONS OF TRIGGERING THE SEC’s TENDER OFFER RULES. On March 21, 2001, the Division of Corporation Finance issued an exemptive order (the “Exemptive Order”) under the Exchange Act for exchange offers conducted solely for a compensatory purpose. See SEC Exemptive Order. The purpose of the Exemptive Order was to relax the tender offer rules under Rule 13e-4 of the Exchange Act when triggered solely for compensatory purposes, and to grant an exemption from Rule 13e-4(f)(8)(i) (the “all holders” rule) and Rule 13e-4(f)(8)(ii) (the “best price” rule) for repricings that meet certain criteria. Assuming such criteria were satisfied, compliance with the relaxed tender offer rules under the Exemptive Order would still require the issuer to (among other requirements):
- Announce the offer by issuing a press release describing the terms of the transaction;
- File with the SEC a Schedule TO and mail an offer to purchase (along with ancillary documents) to security holders;
- Keep the offer open for at least 20 business days;
- Upon expiration of the offer, issue a press release announcing the preliminary results; and
- Provide employees with withdrawal rights that do not expire until the expiration of the offer and at any time within 40 business days from the commencement date.
- HISTORICAL METHODS TO AVOID THE SEC’s TENDER OFFER RULES. There were only two ways to avoid the SEC’s tender offer rules with respect to repricing underwater stock options, such being: (i) implement only a unilateral repricing without optionee consent (thus no investment decision), or (ii) reprice on an individually negotiated basis but only with respect to a small number of key executives. As to (i), such would trigger incremental compensation cost and was often avoided. As to (ii), the Exemptive Order provided that an exchange to a limited number of executives or senior officers of the issuer would not trigger the SEC’s tender offer rules, though the Exemptive Order did not provide guidance on what would be the appropriate maximum number of executives or senior officers.
- APPLICATION OF THE SEC TENDER OFFER RULES TO RSAs, RSUs, PSAs AND PSUs. Relaxation of the SEC’s tender offer rules pursuant to the Exemptive Order was specific to stock options, however, we think the Exemptive Order could also apply to resetting/amending performance criteria of outstanding restricted stock awards, stock-settled restricted stock units, performance-based stock awards and stock-settled performance-based stock units so long as there is ONLY a compensatory purpose. That said, this issue is not settled in the law and advice from one law firm to another may vary.
ALTERNATIVES TO AVOID THE SEC’s TENDER OFFER RULES
The following Alternatives 1, 2 and 3 are just three of the many viable alternatives that could be used by Compensation Committees to operationally revise ill-performing performance metrics without triggering the SEC’s tender offer rules.
- ALTERNATIVE 1 – LEAVE OUTSTANDING AWARD AND GRANT NEW PERFORMANCE-BASED EQUITY AWARD. This Alternative 1 would not trigger the SEC’s tender offer rules, however, it could substantially increase the strain on the available shares that remain for grant under the issuer’s equity incentive plan. This is a fact specific analysis, but many issuers have substantially constrained share pools under their equity plan. These issuers need to conserve shares because they typically are not in a position to seek shareholder approval to increase the share pool size.
- ALTERNATIVE 2 – DO NOTHING NOW, AND LATER APPLY POSITIVE DISCRETION TO WAIVE THE PERFORMANCE CONDITION. The optics of this Alternative 2 can be shaped if the issuer implements a robust shareholder outreach program prior to the next proxy meeting. As background, with the elimination of the performance-based exception to the $1mm deduction limit under Section 162(m), many issuers now allow for positive discretion within their performance-based equity incentive program, and as a result, the Compensation Committee could have the authority to later waive any portion or all of the pre-existing performance conditions. The ability to execute this Alternative 2 is based on facts and circumstances, that is, the equity plan and award agreement will have to be reviewed to determine whether the Compensation Committee has the authority to exercise positive discretion. And the SEC’s tender offer rules would not be triggered in this Alternative 2 because such positive discretion can be implemented unilaterally without participant consent (thus, no investment decision by the participant). That said, this Alternative 2 might not be enough to incent and retain the participant since he or she would have no contractual rights that positive discretion will be used in the future.
- ALTERNATIVE 3 – LAYER THE NEW PERFORMANCE SCHEDULE ON THE EXISTING AWARD, AND REQUIRE THAT THE EXECUTIVE RECEIVES THE “GREATER OF”. The optics of this Alternative 3 can be shaped if the issuer implements a robust shareholder outreach program prior to the next proxy meeting. The idea of this Alternative 3 is that the executive would receive the greater of the number of shares that would vest based on either the pre-existing performance schedule or the new performance schedule. Since the participant’s rights would not be impaired in implementing this Alternative 3, participant consent would generally not be required. As a result the SEC’s tender offer rules would not be triggered and the outstanding performance award continues to have performance metrics.
To close, the above is not legal advice and intentionally does not address the accounting or institutional shareholder implications of revising performance metrics of outstanding equity awards.