Just a quick update that on April 8, 2020, Institutional Shareholder Services (“ISS“) published policy guidance reflecting certain adjustments due to the impact of the COVID-19 pandemic.  The guidance addresses how ISS’s benchmark and voting policies may be applied in this new area of uncertainty.  In many cases, the guidance merely reiterates that ISS will respond to corporate actions on a case-by-case basis.  To address the topic, we published a client alert entitled “ISS Issues COVID-19 Guidance on Benchmark and Voting Policies.”

On a separate note, two of my partners (Steven Haas and Allen Goolsby) authored a client alert entitled “Should the Board Create a Special Committee to Oversee the Response to the Pandemic.”  I found it interesting from a compensation perspective, and I am sharing for that reason.

Join us on April 9, 2020 from 10:00 am to 11:00 am Central for our FREE monthly webinar on “Executive Compensation Considerations in Light of Market Volatility, Stock Prices and the Unknown,” where we will discuss compensatory issues to consider as a result of failed (or failing) performance-based compensation metrics and lost value to the issuer’s long-term shareholders, including:

  • Considerations with respect to annual incentives for 2020;
  • Thoughts with respect to outstanding performance-based equity awards where the performance conditions are not likely to be attained, including a discussion of what to do with long-term equity awards that were granted in 2018 and 2019;
  • Action items with respect to upcoming 2020 equity incentive grants;
  • How to deal with large stock awards resulting from value-based grants of equity (e.g., a grant equal to 40% of the executive’s base salary);
  • Design and governance considerations when an executive desires to reduce his or her base salary in exchange for equity grants;
  • Using a stock-price forfeiture as a design to avoid future underwater stock options;
  • Re-thinking equity plan share pool constraints and individual per grant limitations; and
  • How to structure the cancellation of Rule 10b5-1 trading plans so as to avoid negative shareholder optics.

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.

EXECUTIVE SUMMARY

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.

To help issuers prepare for the upcoming proxy season, and as a follow-up to our prior post entitled “Compensation Considerations for the 2020 Proxy Season,” we are hosting a FREE webinar entitled “Upcoming Proxy Season: Compensatory Thoughts from ISS (an Annual Program)” on Thursday, January 16, 2020 from 10:00 am to 11:00 am Central [Register here].  The purpose of this webinar is to discuss compensatory thoughts and trends of institutional shareholder advisory services such as ISS, including:

  • New compensation pronouncements and positions of ISS since the 2019 proxy season;
  • Compensatory thoughts where issuers should focus their attention due to continued focus by ISS;
  • The impact the foregoing is likely to have (or could have) on current compensation designs; and
  • Our overall thoughts and suggestions.

See you soon!

This is a just a quick note that proposed Treasury regulations were issued under Section 162(m) that reverses a series of private letter rulings previously granted to UPREITs.  Under the proposed Treasury regulations, the $1mm deduction limitation under Section 162(m) would apply with respect to compensation that a publicly-traded REIT’s covered employee receives from an operating partnership for services he or she provided on behalf of such operating partnership.  The proposed Treasury regulation is applied by potentially disallowing a REIT’s distributive share of any compensation deduction arising from compensation the covered employee received from the REIT’s operating partnership.  As a result, at least from a Section 162(m) perspective, compensation paid to a covered employee by an operating partnership should now be vetted and analyzed at the REIT level.

A more detailed analysis of the proposed Treasury regulations was drafted over the holidays by my partners Kendal A. Sibley and George C. Howell, III in the attached Client Alert entitled “Unexpected Provision in Proposed Section 162(m) Regulations May Affect Compensation Deductibility for UPREITs.”

Other aspects of the proposed Treasury regulations will be set forth in upcoming posts!

The purpose of this Post is to help issuers prepare for the upcoming 2020 proxy season by providing a non-exhaustive list of certain compensatory issues/topics to consider.  To that end (listed in no particular order):

ADOPT AN ANNUAL GRANT POLICY

  • Background.  It is common for Compensation Committees to initially denominate an equity award as a dollar amount, and then convert such dollar amount into a number of shares immediately prior to the date the equity is granted (e.g., executive is to receive a number of shares equal to 20% of his/her base salary).  This approach could create unfavorable shareholder optics if, for example, a U.S.-wide economic downturn were to cause the stock price of the issuer to decline.  In such a situation, the  equity grant to a key employee would cover a larger number of shares than it would have covered had there been no economic slide.  The result is that a plaintiff-orientated shareholder could allege that the executives were timing the market by granting an equity award with an artificially high number of shares.
  • Solution to Consider.  If the issuer had an annual grant policy, then such could act as an affirmative defense to any allegation that the issuer was timing the market.

CONSIDER A STOCK-PRICE FORFEITURE PROVISION TO AVOID THE DRAG OF UNDERWATER STOCK OPTIONS

  • Problem with Underwater Stock Options.  The concept of an “underwater stock option” occurs when the exercise price of an option is greater than the fair market value of the underlying stock.  In such a situation, the stock option is considered outstanding for purposes of the issuer’s burn rate calculation even though the stock option might not be serving its purpose from the perspective of the optionee.  And repricing the underwater stock option is not likely a viable solution because a repricing would likely trigger the SEC’s tender offer rules if a value-for-value exchange were sought by the issuer (i.e., a value-for-value exchange is typically sought in order to negate incremental compensation expense for accounting purposes).
  • Possible Going Forward Solution Is to Implement a Stock-Price Forfeiture within the Granting Documentation.  The foregoing issues could be avoided if the stock option had a stock-price forfeiture provision contained within the forfeiture provisions of the stock option documents (e.g., if the stock price falls to a certain price, then the stock option is automatically forfeited).  A stock-price forfeiture provision could avoid the time and expense associated with repricing underwater stock options because the issuer could simply grant new stock options in normal course following the stock-price forfeiture provision being triggered (but make sure such does not trigger the cancellation/regrant provisions of NYSE and NASDAQ listing rules because, if such is triggered, the forfeiture followed by a regrant could be deemed a repricing subject to shareholder approval).
  • More Information.  For more information, please see our prior Post “Tip of the Week: Could a Stock-Price Forfeiture Provision Eliminate the Existence of Substantially Underwater Stock Options”.

SEPARATE NON-EMPLOYEE DIRECTOR EQUITY PLAN – 5% MINIMUM 1 YEAR VESTING CARVE-OUT

  •  Alleviate Stress on the 5% Carve-Out to the Minimum 1-Year Vesting Requirement.  For issuers trying to curry points under ISS’s Equity Plan Scorecard, the “plan features” pillar has a requirement that, in order to get full points, the equity incentive plan must have a 1-year minimum vesting schedule for all equity awards (though a 5% carve-out exists such that 5% of the equity plan’s share reserve does not have to be subject to a 1-year minimum vesting schedule).
  • Separate Non-Employee Director Equity Plan.  There are two data points to keep in mind: first, it is common for non-employee directors to be granted fully vested stock awards in situations where they are compensated in arrears for services previously rendered, and second, the concept of an Equity Plan Scorecard does not apply to a non-employee director equity plan (i.e., no need to satisfy a 1-year minimum vesting requirement).  Therefore, having a separate equity plan for non-employee directors could relieve the stress on the 5% carve-out, thus allowing the issuer to preserve the 5% carve-out for other purposes such as new hires.

SEPARATE NON-EMPLOYEE DIRECTOR EQUITY PLAN – STOCKHOLDER APPROVED DIRECTOR COMPENSATION

  • Consideration.  Consider whether all or some of a non-employee directors’ compensation should be approved by the shareholders (e.g., annual fees, compensation caps/limits, fixed formulas, etc.) in order to help protect the decisions of the non-employee directors with respect to their own compensation.  For more information, see “Discuss Director Compensation During the Fall 2018 Board Meetings“.

DIRECTOR COMPENSATION

  • More Robust Narrative Disclosure Preceding the Director Compensation Table.  Consider having substantially more robust narrative disclosure proceeding the non-employee director compensation table of the proxy statement.  To that end, discussions with the Compensation Committee should include:
    • What is the philosophy associated with non-employee director compensation,
    • How is pay assessed,
    • What is the frequency of the assessment, and
    • What is the process associated with any benchmarking of non-employee director compensation.

CONSIDER INCREASING THE DEDUCTIBILITY OF COMPENSATION

  • Background.  The Tax Cuts and Jobs Act of 2017 eliminated the performance-based exception to the $1mm deduction limit and expanded the definition of “who” is subject to the $1mm deduction limit.  This means that, starting January 1, 2018, all compensation paid to a “covered employee” that exceeds $1mm will not be deductible.  And too, remember that covered employee status was expanded and now includes the CEO, the CFO and the next 3 most highly compensated executive officers who are disclosed in the company’s Summary Compensation Table.  Finally, the new rules require that once an executive is a covered employee, he/she will ALWAYS remain a covered employee.
  • Increase Compensatory Deductions by Limiting “Executive Officer” Status.  Only an “executive officer” is eligible to be an officer disclosed in the Summary Compensation Table.  So one way to mitigate “covered employee” status is for the Board to revisit which individuals are “executive officers” of the issuer (i.e., if the individual is not an executive officer, then he/she could never be a named executive officer on the Summary Compensation Table, and therefore, such individual could never be a covered employee that is subject to the $1mm deduction limitation).
  • Other Ideas to Increase Compensatory Deductions.  Other ideas consider with respect to covered employees include:
    • Implement a deferral program with future annual payouts to be less than $1mm.
    • Replace the standard 3- and 4-year vesting schedules with a longer schedule (not likely practical).
    • Move lump-sum severance obligations to installment payouts (e.g., only $1mm of a $4mm lump sum payout would be deductible if paid to a covered employee, but if the payout was structured over three years, then $3mm of the $4mm would be deductible).

INCREASE NET WITHHOLDING

  • Background.  Many equity plans have a provision that limits the net withholding rate to the minimum statutory rate (i.e., the supplemental rate of 22%).  Such was previously required in order to avoid liability classification for accounting purposes.  However, the Financial Accounting Standards Board changed the rule a few years ago and now allow net withholding to occur at the highest federal tax rate without triggering liability classification for accounting purposes.
  • Consider Whether to Amend the Equity Plan.  Consider whether to amend the equity incentive plan to allow for a higher net withholding rate.  Such amendment might require shareholder approval (depending upon the design of the amendment), but the upside is that any equity plan with liberal recycling provisions should enjoy a longer life expectancy associated with the share reserve.
  • More Information.  For more information, please see our prior Post “Tip of the Week: 4 Ideas to Ease Tax Obligations When Equity Awards Vest During a Blackout Period.”

*      *     *     *     *

If an issuer is looking for a primer or introductory course on Employee Stock Purchase Plans (“ESPPs“), then check out the detailed slide deck that our David Branham put together for our monthly webinar series.  The slide deck is entitled Employee Stock Purchase Plans – The Introductory Course (November 2019 Webinar) and covers the following:

  • Requirements under the tax law,
  • Must have document requirements,
  • Tax consequences to employees and to employers,
  • Compliance requirements with respect to federal securities laws, and
  • International workforce considerations.

The slide deck is detailed and contains more information than is otherwise typical of an “introductory” course.  It could be a useful starting point for issuers who are considering whether to implement an ESPP this upcoming proxy season.

It is common for a key employee to be offered an opportunity to purchase equity of the employer.  Often the key employee can personally finance such purchase.   And sometimes the employer will help the key employee finance the purchase by providing him or her with a loan equal to the purchase price.  The purpose of this Tip of the Week is to remind readers that a substantial part of the loan should be recourse.

  • Risk Associated with 100% Non-Recourse Note – Key Employee Received an Option.   If the loan is 100% non-recourse (meaning the key employee has no personal assets at risk other than the underlying equity securing the loan), then the IRS could take the position that: (i) NO transfer of property occurred at the time of purchase, (ii) at the time of purchase the key employee only received an option (i.e., the key employee has optionality because he or she can walk away from the loan with no personal risk),  and (iii) the tax transfer actually occurred later in time when the loan was repaid by the key employee.  If such IRS position were successful and the fair market value of the underlying equity increased from the date the equity was purchased until the date the loan was repaid, then the key employee would have compensatory ordinary income equal to the spread between the purchase price and the fair market value of the underlying stock when the loan was repaid.  The employer would have a corresponding withholding obligation.
  • Applicable Rules.  The Treasury Regulations provide that if the amount paid for the equity is an indebtedness secured by the transferred property, and there is no personal liability to pay “all or a substantial part of such indebtedness,” then such transaction could be in substance the same as the grant of an option and taxed accordingly.  See Treas. Reg. Section 1.83-3(a)(2).  This Treasury Regulation further provides that the determination of the substance of the transaction will be based upon all the facts and circumstances.
  • Only a “Substantial Part” is Required to be Recourse, the Test Is Not “Substantially All.”  According to a plain reading of Treas. Reg. Section 1.83-3(a)(2), only a “substantial part” is required to have personal liability.  What is a “substantial part”?  90% recourse?  75% recourse?  50% recourse?  If 30% of the loan was recourse, could that percentage be considered a “substantial part” of the whole (i.e., keeping in mind that “substantial” is different and can be less than a “significant” standard)?

The Internal Revenue Code and Treasury Regulations do not provide how much of the loan must be recourse in order to satisfy the “substantial part” test.  But a conservative approach, assuming there are supporting facts, is that at least 50% of the loan must be recourse in order to avoid the IRS successfully treating the purchase as the receipt of an option.

Compensation governance is a front-and-center topic with a continued focus on stock ownership and clawback policies (in part due to the voting guidelines of institutional investors, proxy advisory firms and the Dodd-Frank Act).  At 10:00 am Central on Thursday, October 10, 2019, in a webinar entitled “Stock Ownership Policies & Clawback Policies: Design Pointers,” our Emily Cabrera will be providing a complete overview of stock ownership policies and clawback policies, including a deep dive into their related design choices, prevalence, best practices and disclosure considerations.  And as always, our monthly webinar programs are FREE.  Just click on the title to sign up!

The purpose of this post is to discuss whether incentive stock option (“ISO”) awards should be designed to destroy ISO treatment with respect to terminated employees, thereby preserving the compensatory deduction to the corporation and increasing shareholder value.

Continue Reading Game of Inches: An Idea to Increase Shareholder Value by Destroying ISO Status for Terminated Employees