– Peter Hursh, Managing Director, ECG Advisors, LLC
Recently, there was a blog about why companies should not issue restricted stock. While I am not a tax attorney, here is my understanding of at least four reasons why restricted stock makes sense.
1. Restricted stock gets capital gains treatment, either from the date of the 83(b) election, however infrequent, or from the date of vesting. RSUs never get capital gains treatment; they are always subject to ordinary income tax. For most executives, the federal capital gains tax is 15% through 2010, and then 20%. The highest marginal federal income tax rate is 35%.
2. Restricted shares are protected from creditors in bankruptcy. RSUs, which are nothing more than deferred compensation that tracks the performance of the company’s stock, are not protected from creditors in bankruptcy.
3. The recipient of restricted stock has the flexibility to sell his or her shares, once vested, even while he or she continues to be employed by the company or serve as a director. RSUs are often not available to cash-in until the individual terminates employment with the company.
4. The section 83(b) election should not be dismissed out of hand. The executive who truly believes in his or her company will make the election, locking in capital gains treatment from the date of grant. If the executive thinks that the stock price will go through the roof, then he or she can be a big winner. Moreover, the election sends a very strong message to shareholders abut the alignment of the executive’s interests with theirs.
By the way, the dividends and voting rights on restricted stock do not have to commence on the date of grant. The dividends can be held until vesting occurs, and the voting rights can be barred until vesting.
– Gregory Schick, Partner, Sheppard Mullin Richter & Hampton LLP, San Francisco
Yes, sadly this is yet another blog posting dealing with that infernal Internal Revenue Code Section 409A. But, my musings here are not about the intricacies of 409A and the various tax issues it presents or even the fact that the year-end compliance deadline is now less than 150 days away! Rather my focus is on whether this pervasive tax statute also has the power to complicate securities law compliance as well.
Private Company Valuation and Discounted Stock Options
As most practitioners know, 409A does not look too kindly on employee stock options that were issued at a discount from the grant date share fair market value. Whereas a typical vanilla flavored stock option is exempt from 409A, a discounted option is not. And, if a discounted option’s exercise periods are not sufficiently constrained (e.g., by limiting exercisability to a 409A permitted event) then such a discounted option could likely violate 409A.
As most of us know, this treatment has caused quite a stir with privately held companies since the determination of the fair market value of their shares cannot be gleaned simply by looking at trading prices posted on-line or in the morning newspaper as is the case for public companies. Indeed, the 409A final regulations recognize this and provide elaborate discussion (along with some guidance and safe harbor presumptions) on how private companies should determine the fair market value of their shares.
Since most stock options are generally intended to be granted with an exercise price equal to the grant date fair market value, the fear of course is that a defective undervaluing of the shares means that the company could have inadvertently awarded discounted options which then could cause a 409A violation.
Apart from altering their future option grant and share valuation practices, many private companies and their counsel/accountants have had to scurry around examining historical option grants to uncover whether they had outstanding discounted options due to low and indefensible valuations. The existing 409A guidance discusses various techniques for correcting discounted stock options. The most obvious method is to simply increase the exercise price of the discounted option up to the corrected, higher grant date fair market value. And, a number of companies have opted to follow this path.
Rule 701 Numerical Limits and Consequences of Repricing Stock Options
The potential securities law compliance issue that is the source of my musings relates to Rule 701 of the Securities Act of 1933. Rule 701 is the easiest and primary way that companies obtain exemption from the registration requirements of the Act with respect to their compensatory stock options. Rule 701 imposes numerical limitations on the magnitude of equity securities that can be issued in reliance on Rule 701 in a twelve month period.
In particular, the aggregate sales price or amount of securities sold in a twelve month period cannot exceed the greater of: (i) $1 million, (ii) 15% of total assets or (iii) 15% of outstanding securities. Moreover, if relying on either (ii) or (iii) and the aggregate sales price of Rule 701-issued securities exceeds $5 million, then Rule 701 requires that additional disclosures (in essence, a prospectus) be provided to grantees. Such additional disclosures need to have been provided to grantees before they exercised their Rule 701 options and acquired shares.
The sales price for stock options awarded for purposes of these numerical tests is computed at the time of option grant and is calculated by multiplying the number of option shares by the per share exercise price. The SEC’s April 1999 adopting release of amendments to Rule 701 provides that “In the event that exercise prices are later changed or repriced, a recalculation will have to be made under Rule 701.”
Normally, such a recalculation would be performed (with favorable results) when there is an option repricing to lower the exercise price to equal a share fair market value that has declined since the grant date. But, what about if the option is repriced upwards in order to accommodate 409A? Presumably, options whose exercise price is increased to avoid being treated as a discounted option under 409A must also be recalculated for purposes of Rule 701 using the higher option exercise price. Would the recalculation be retroactively performed for the period when the initial grant was made or would the value of the amended option be included in Rule 701 numerical analysis as of the date of the amendment?
In either case, the effect of such an upward adjustment could result in the aggregate sales price exceeding the $1 million and/or total assets thresholds of Rule 701 whereas computations applying the pre-adjusted exercise prices did not. And, perhaps even more troubling, if the Rule 701 $5 million threshold was breached as a result of the recalculation, it could be problematic or even impossible for the company to comply with the additional disclosure requirements imposed by Rule 701 since it is quite possible that some grantees may have already exercised their stock options absent the benefit of the requisite additional disclosure.
Private companies that have increased their option exercise prices in order to comply with 409A may want to also re-examine their compliance with the numerical limitations of Rule 701 particularly if they are considering going public or being acquired since their historical securities law compliance will come under closer scrutiny. While it is possible that the company may be able to avail itself of another exemption under the Act (e.g., Regulation D for certain qualifying option grants), will these recurring 409A-related headaches never end?
I think Frank Glassner’s recent post only tells one side of the independence story – the one that boutique consultants want to be told. But it fails to note that the majority of the Fortune1000 companies (61% in 2007, according to the Equilar data) continue to use full-service consulting firms in some capacity for advice on executive pay either in addition to or in lieu of a firm that consults only on executive compensation.
In virtually all cases, these companies have carefully examined the “consultant independence” issue and concluded that the depth and breadth of resources and expertise offered by full-service firms can’t be replicated in most cases by smaller, so-called independent firms. They have concluded that any potential conflicts of interest in the full-service firms can be effectively and appropriately managed. Many have speculated that even greater potential conflicts could result from smaller firm’s dependence on business from any particular client.
A more balanced perspective can be found in several recent academic studies that squarely rebut the notion that potential conflicts of interest at the leading full-service consulting firms play any meaningful role in the escalation of executive pay. Unlike the Waxman Committee’s highly partisan December 2007 majority report on the consultant independence issue, these more recent studies by researchers at The Wharton School, the University of Southern California and Stanford bring more rigor and objectivity to the analysis of consultants’ influence on executive pay decision-making.
Among other areas, the researchers examined the potential conflicts of interest inherent in all advisory firms, full-service and boutique (e.g., the need to sell repeat business as well as to cross-sell other services), and concluded that potential consultant conflicts play no significant role in companies’ decisions about executive pay.
No credible evidence suggests that full-service executive pay consultants are any less objective than the “independent” boutiques. Ultimately, the real issue is not pay consultants’ perceived “independence,” but the objectivity and overall value of their advice.
Here’s a summary of the academic studies as well as Towers Perrin’s views about consultant independence.
As the Presidential election nears, it’s interesting to see articles about CEO pay in places you normally wouldn’t expect them. For example, the Christian Science Monitor ran this article yesterday entitled “How Long Will Politicians Look the Other Way on CEO Pay?”.
A few weeks ago, Financial Week magazine reported that the Congressional crackdown on executive compensation consultants with conflicts of interest has rapidly changed the industry landscape.
Many of the country’s largest companies are now rushing to hire independent consulting firms that specialize exclusively in executive compensation, instead of retaining large consulting firms that provide other, often far more lucrative, consulting services, such as human resources, actuarial, healthcare, pension and benefits plan administration, in addition to dispensing advice on executive pay. Many of those firms provide insurance products to, and receive commissions from, the very companies to whom they are providing compensation consulting services. Some are even owned by the insurance companies themselves.
The extent of the change is stark. According to a recent Equilar analysis of Fortune 1000 proxy filings, 39% of compensation committees now rely on independent consultants for advice on executive pay, compared with barely 30% in 2007. The remaining compensation consulting arrangements are with “full-service” firms.
Similarly, many other corporations are disclosing lengthy details concerning their relationships with their existing compensation consultants, in hopes of quashing concerns about possible conflicts of interest that sometimes arise when a consulting firm provides multiple types of consulting services outside the executive pay arena.
These changes are taking place at a time when both presidential candidates, lawmakers, and shareholder activists have been trumpeting the potential of very real conflicts to arise if an executive compensation consultant’s firm performs non-related work for the same client.
Congressional Interest
Indeed, the Congressional Committee on Oversight and Government Reform, under the leadership of Rep. Henry Waxman (D-Calif.), released a highly critical report at the end of 2007, revealing that 113 of Fortune 250 companies retained “conflicted consultants”—consultants that received, for example, $200,000 to provide advice on executive pay, and yet more than $2 million to provide consulting services in other areas. In the Committee’s well publicized hearings last December, Rep. Waxman declared, “In effect, the consultants are being asked to evaluate the worth of the executives who hire them, and then pay their consulting firms millions of dollars”. The system is intrinsically flawed.
The Committee found that:
– Human resources consulting firm conflicts of interest are pervasive;
– The fees earned by human resources consulting firms for providing services other than executive compensation consulting services (e.g., benefits, pension actuarial, healthcare, insurance, etc.) often far exceed those earned for advising on executive compensation;
– Some human resources consulting firms received over $11 million dollars in 2006 to provide services other than executive compensation consulting – in some cases, 50 to 70 times more than the client company paid the human resources consulting firm for executive pay consulting; and
– Most of the companies scrutinized by the Committee did not disclose their human resources consulting firm’s conflicts of interest.
According to the Committee, there appears to be a direct correlation between the extent of the human resources consulting firm’s conflict of interest and the level of CEO pay within the client company.
It is no wonder many companies are going above and beyond to avoid even the hint of such a conflict. Financial Week reported that corporations such as Safeway and Verizon, for instance, have changed their compensation consultants to independent firms over the past year, pointed out Paul Hodgson, senior research associate at the Corporate Library. “It’s a clear-cut way to send a message that you’re intent on being conflict-free,” Mr. Hodgson said. “It’s an easy solution to something that could be a potentially sticky problem.”
“It’s an emerging trend to use an independent adviser in this role,” said Melissa Plaisance, senior vice president of finance and investor relations at Safeway, which generated more than $42 billion in revenue last year. “We felt it was just an additional step in maintaining a strong governance program.”
The Trend in Practice
Because of this, independent executive compensation consulting firms will continue to be in greater demand for their services. For instance, Pfizer, whose board has used an independent compensation consultant since 2003, goes so far as to name its consultant as a specific adviser in its proxy—while also itemizing each of the 14 responsibilities he is charged with in his role, as well as the specific projects he worked on for the company last year.
Pfizer also volunteered to disclose the fees paid to their executive pay consultant for these services. In 2007, the pharmaceutical company paid $150,901 for consulting with its board on executive compensation issues, plus a fee of less than $5,000 for an executive compensation survey.
Pfizer is hardly alone in deciding to disclose information about fees paid to executive compensation consultants. While only a small portion of companies actually offer this level of disclosure— only about 3% of companies revealed these fees in their proxies earlier this year—that’s triple the percentage of companies that did so in their 2007 proxy filings, according to the Equilar proxy analysis. (The average fee for these services was $161,691 last year, a 33% increase from the average fee of $121,183 one year prior.)
Such disclosures appear to be even more detailed if a human resources consulting firm also provides other advisory services to a company. Consider Time Warner, which in its proxy filing earlier this year offered a seven-paragraph, 700-plus word description of the role of its compensation consultant, Towers Perrin, which it attempted to characterize as “independent”. The company notes that its compensation committee has used the firm as its independent executive compensation consultant since 2002, outlines the work it did for the committee in 2007, and also reveals the fees Time Warner paid for Towers Perrin executive compensation consulting services: $250,368 in 2007 and $263,885 in 2006.
However, in the same section of the proxy, Time Warner notes that Towers Perrin also provides the company with consulting and actuarial services for its retirement plans, as well as consulting on its health and welfare programs for employees, and consulting on human resources systems. For these services, Time Warner disclosed that it paid Towers Perrin roughly $2 million in aggregate fees for each of the last two years. None of these fees, however, impact the compensation advice Towers Perrin provides to Time Warner, it states in the proxy, adding that the team of compensation consultants do not work on any other consulting assignments for the company, and, they attempt to explain, that their own pay has nothing to do with any of these other arrangements.
Our Views
Compensation Design Group has always supported the Committee’s conflict of interest views on human resources consulting firms that really do have entangled business relationships.
We also believe that public company shareholders and board members deserve higher standards of disclosure to verify the independence of the executive compensation advice that their companies receive from their consulting firms. This disclosure will assist in curing the terribly negative views that shareholders, employees, the media, and the American public have on executive pay.
The Securities and Exchange Commission will likely require further disclosure on compensation consultant independence. Current SEC rules do not require tabular disclosure of fees for services provided by human resources consulting firms. This only fuels the flames of public perception as well that the executive compensation consulting profession is not helping with, and perhaps even exacerbating problems with executive pay.
Diversified human resources consulting firms, often owned by insurance providers or public companies themselves, in fact have significant economic incentives to provide ancillary services, frequently far more financially lucrative than the executive compensation consulting services they provide. The executive compensation consultants of these firms do, however, have the ear of the board and senior management. That coupled with cross selling of ancillary services, along with the realization of significant fees, creates a recipe for the disaster of independence and objectivity.
Was it just me or did others laugh out loud while reading the closed captioning during yesterday’s SEC webcast on the technologically brilliant new IDEA? (See Broc’s blog to learn what the SEC’s IDEA is about.)
Chairman Cox was talking away while typing on the computer to show how IDEA will work and the closed captions were wild. Apparently the “reporter” was from Mars or just couldn’t read his lips while he was concentrating on the keyboard. Or (assuming the reporter is a computer) maybe the SEC should earmark some of the technology funding to an upgrade on voice recognition. I’m betting there were some hearing impaired listeners scratching their heads!
I was perusing the NASPP’s very helpful new “Domestic Stock Plan Design and Administration Survey” the other day. I was surprised to see how many companies are still issuing restricted stock (as opposed to restricted stock units). I frankly cannot think of any good reasons to keep issuing restricted stock, but of course some of you may wish to correct my thinking on this.
Historical Practice
In the old (pre-FAS123R) days, companies traditionally issued stock options as their primary equity vehicle under their long term incentive plan, with restricted stock grants to a few key executives.
Current Trends
With the advent of FAS123R, grants of full value awards (restricted stock or restricted stock units (RSUs)) have grown in prevalence for a variety of reasons, including share conservation, ease of administration (i.e., no Black-Scholes value issues), retention value in a flat or down market, high employee perceived value as compared with Black-Scholes value of options, etc. The survey confirms this.
So, as companies expand the use of full value awards, it initially made sense to look at making restricted stock grants (based on the historical practice) to a broader group of employees. However, the form of grant suitable to a handful of key executives based in the U.S. is, in my view, unsuitable for broader award groups, particularly if the group includes non-U.S. award recipients.
Key Features of Restricted Stock/RSUs
Restricted stock for this purpose means shares actually issued at grant, with full voting and dividend rights, but subject to a forfeiture back to the company if the employee leaves before the specified vesting period. So, the shares are issued, but placed in escrow or otherwise “restricted” so that the forfeiture provisions can be applied upon a termination of employment. Although dividends on such shares are real dividends from a corporate perspective, they are not dividends from a tax perspective, but rather are compensation in the hands of employee, subject to income and FICA/FUTA taxes and withholding.
The grant of restricted stock is eligible for a so called section 83(b) election allowing the employee to be taxed upfront at grant (otherwise tax is at vesting). So, the company needs to communicate with the award recipients the pros and cons of section 83(b) elections, provide forms, etc. This is all compressed, in that any section 83(b) election must be made within 30 days of grant.
My experience is that essentially no one at a public company makes a section 83(b) election on restricted stock, so the availability of this election is more of a curse than a benefit for restricted stock.
RSUs are, of course, economically equivalent to restricted stock (assuming dividend equivalents are provided on the RSUs), but the shares are not typically issued until vesting. Tax rules are almost identical (although RSUs are technically taxed under constructive receipt principles, so release is the income tax event rather than vesting, but these are typically the same). No actual dividends are paid during the vesting period (since no shares have actually been issued), but dividend equivalents can be paid or (better yet, in my view) accumulated as notionally reinvested into shares and paid only at vesting along with the underlying shares.
Pros and Cons of Restricted Stock/RSUs
The accounting treatment for restricted stock and RSUs is essentially identical, with relatively minor differences too complicated to discuss here. So, why are RSUs superior to restricted stock?
First, companies do not need to worry about section 83(b) elections, communicating the pros and cons of this to a broad range of employees and hearing the complaints when an employee makes a bad choice or files his/her form a day late. Second, since the shares are not issued until vesting/release, there is no need to deal with the hassles of recovering forfeited shares. Third, net share withholding (the method of withholding which most companies choose for broad based RSU grants) is certainly no more difficult to deal with than withholding with respect to restricted shares which have already been issued.
Finally, restricted stock issued outside the U.S. is typically taxed at grant (with no election) in many countries, including many key European countries, which presents adverse tax consequences to the employee and withholding challenges for the employer. I am aware that restricted stock is not subject to the section 409A rules whereas RSUs may be. However, if RSUs are designed properly (e.g., paid out at vesting) or in accordance with a fixed payment schedule, the section 409A problems are manageable.
So, for my part, issue RSUs and forget about restricted stock.
– Why has Moody’s issued this new report?
– How can better disclosure of performance metrics targets enhance a creditworthiness evaluation?
– What type of peer group benchmarking disclosure is Moody’s looking for?
– How about for payments following a change in control?
Absolute performance goals are specific targets against which future performance is measured. Typically linked to the company’s business strategy; they are relatively easy to measure and communicate; are consistent with shareholder expectations of typical practices; and give plan participants a strong sense of control and influence. For example, a company might set an absolute goal of $1B in revenue from a starting point of $900M, with achievement based on actual revenue at the conclusion of the performance period. The downside is that absolute goals rely heavily on effective planning and forecasting and also may create an incentive for executives to set lower goals to increase their chances of a payout.
In contrast, relative performance goals measure company performance against a group of peers or a company index. For example, a performance-based LTIP might require performance in the first quartile relative to a group of 20 peer group companies, based on revenue growth for the performance period. Such comparative performance assessments tend to be motivational in both good years and bad, with the greater likelihood of payouts even in a down year likely to aid retention. While suited to longer performance periods, relative metrics are more sensitive to changes in the composition of the comparator group or the alignment of different companies’ fiscal year-end. Relative measures also can be more difficult to communicate to a broad-based population, while outcomes may be inconsistent with investor expectations, the company’s cash flow or its ability to pay out the awards.
Generally speaking, companies that are facing significant change and prefer a performance-based LTIP with a one-year performance period would be better off using absolute metrics, while a similar company facing significant change that is measuring results over two to three years may prefer relative performance measures.
– Ed Hauder, Senior Attorney and Consultant, Exequity, LLP
As the clamor for better corporate governance at U.S. companies continues and activist shareholders push companies to revisit their severance plan designs and equity compensation practices, a note of caution is in order. While more companies embrace lower severance multiples (2x for top executives and 1.5x and less for lower-level executives) and adopt performance-based equity programs (in whole or part), these changes may interact in ways that are not always obvious at first glance.
For example, these trends when coupled with investor concern over gross-ups, could lead a company to also adopt a policy of no gross-ups for its executives. Companies need to be vigilant and fully review the possible consequences of such design changes, and not just leave things to what folks intuitively believe should be “ok” in order to avoid unintended consequences of their compensation design changes.
Example
For example, I just finished up some modeling under Section 280G of the Internal Revenue Code for a company that has adopted a more shareholder-friendly severance policy using the lower multiples mentioned above. The company also has adopted a change to its long-term equity incentive program so that half of the LTI value is delivered by stock options (time-based vesting) and half by performance shares (performance-based vesting) – both have their vesting accelerated upon a change in control. Currently, the company does not have gross-ups for all of its executives (but does have them for several newly-hired executives).
Section 280G Modeling: The Surprising Results
When modeling out the impact of Section 280G on this company’s executives, a surprising result occurred. For quite a few of the executives, even though they received only 1.5x their base salary and annual target bonus, they ended up being “over” the Section 280G cap (or “parachute limit”) or very close to it. Once an individual executive’s severance amount plus other applicable payments contingent upon a change in control exceed the Section 280G cap (generally, 3x the “base amount”), all amounts in excess of the “base amount” (generally, the average of the past 5 years’ W-2 income – from Box 1) become subject to a 20% excise tax under Section 4999.
Well, you might think, that is ok. After all, the executives obviously will receive quite a bit in severance (1.5x of base salary plus bonus) so they can afford to give-up some of that in order to come-in under the Section 280G cap. In some cases they could; in others, while they could, it would represent more than half of the cash severance payment they would have to forego; and, for others, even if they gave up their entire cash severance amount, they still would exceed the Section 280G cap and the only way they could come under the cap would be by giving up some of their equity awards.
What Caused These Results?
The cash severance amount intuitively seems reasonable. Also, the LTI grants were lower than market median and half were delivered as performance shares. So what happened to cause the severance amounts to these executives to come close to or exceed the Section 280G cap? In a nutshell, it was due to the change in their LTI program in which they switched from an all-stock option program to a half stock option, half performance share program. If the company had simply maintained an all stock option program, perhaps only one executive would have exceeded the Section 280G cap (and that was a newly hired executive who was given a 110% alternate cap gross-up – see below for an explanation of “alternate gross-ups”).
Why Did Switch in LTI program Cause This Result?
The reason is in how the Section 280G regulations handle equity awards based on whether their vesting is strictly time-based or has a performance-based aspect to it. In the former case, time-vested awards only have an incremental amount included in the Section 280G calculation – determined based on the amount of time by which the award’s vesting is accelerated. Whereas for performance-based awards, the full amount gets included (full spread for performance-based options and full value of performance shares at deal close).
Consequences
If the company does nothing, then its severance program may not end up producing the results it wants – making the executives indifferent to whether a transaction that is in the best interests of the company and shareholders occurs. If the company goes ahead and grants a standard full gross-up, it likely would be pilloried in the press.
So what to do? Here is where the Board and Compensation Committee need to take ownership and decide what is in the best interests of the company and its shareholders. First off, they should commit to monitoring the potential expense of any solution they implement (preferably on an annual basis as part of their Tally Sheets). Second, they need to balance the objectives of the severance program with shareholder concerns on severance multiples, gross-ups and using performance-based awards. If a company simply adopts all the current practices being proposed without thinking about how they will actually interact, and reviewing the likely consequences of such interaction, it could be in for a surprise.
In the above example, the company adopted lower severance multiples and adopted performance-based equity awards. If it also then blindly adopts the position of some activist shareholders to avoid any gross-ups entirely, the interests of the company and shareholders could actually be hurt, because it could cause the severance plan to fail in its primary purpose.
One possible solution that balances ensuring the goals of the severance program are met with shareholder concern on “excessive compensation” might be to adopt a gross-up provision that only is triggered if the after-tax benefit to an executive exceeds some threshold as compared to the after-tax benefit to the executive with the gross-up applying. Such a provision is generally referred to as an alternate gross-up and a typical threshold is 110% of the after-tax benefit without the gross-up in order for the gross-up provision to be triggered. If the after-tax benefit doesn’t exceed such threshold, then the executive’s compensation is cut back so that it falls under the Section 280G cap and the executive avoids the 20% excise tax.
The Bottom Line
As companies seek to adopt more progressive corporate governance policies and take actions to re-design their compensation plans and programs, they need to stop and review the practical consequences of their actions to determine the possible impact relative to the underlying purpose for having particular compensation plans and programs. It might be a little extra work, but it helps avoid unwanted surprises and unintended consequences later.