In thinking back through some of my past blog entries, I notice several have focused on failures in internal controls. In recent months I’ve covered lapses in keeping tabs on plan limits and the SEC’s interest in late Section 16 filings, among others. As administrators, the concept of an audit is a daily process component. In theory pretty much everything that happens from a process standpoint is (or should be) audited. There is a lot of checking and balancing. I can’t possibly cover all of the audit spectrum in one blog, but for today I will cover 5 of them that, in my mind, can prevent many headaches down the road.
Audit, Defined
Audit: “a careful check or review of something” (Merriam-Webster).
I think many times the word “audit” signifies something big in our heads. Like when the auditor comes and performs an extensive or extended review of a process. For today’s purposes, let’s just assume that an audit is simply a careful review of something. It could be big or small, quick or more prolonged. That’s really it, though. All of the audits I’m going to suggest can be performed relatively quickly, with lots of bang for the time invested. A few minutes now can save hours of headaches later on. The headaches I’m talking about include disclosing control failures internally and publicly, increased shareholder scrutiny and litigation, unwinding grants, purchases or awards, and more.
3 Areas of Audit
1. Review Plan Limits. In my blog “Share Limit Lessons the Hard Way – Part II” (January 15, 2015), I covered some examples of control failures and the resulting repercussions in this area. Your stock plan could have several different limitations on shares or other provisions, often easily identified by the use of the words “minimum” or “maximum”. Common plan limits include the total number of shares issued under the plan, a cap on the quantity of shares that can be issued to an individual – over the life of the plan or within a specified time period (or both), a minimum required vesting period (for example, awards that must have a minimum of a one-year vesting period), and share ratios (fungible or flexible ratios). The easiest way to monitor these limits is to maintain a list of all the “limits” specified under the plan and review them regularly. Educate those involved in the grant process about share limits so that any potential for exceeding them can be headed off before the grant is made. This type of audit should be performed at least quarterly, with interim reviews performed when there is significant related activity, such as a large grant.
2. Compare Plan Activity to the Form S-8. This sounds straightforward, but I have seen this time and time again. The company files an S-8 to register shares to be issued from the plan, and then the balance registered is never compared to actual plan activity. It sometimes feels more like an item to be checked off a to-do list at plan inception, rather than an area of ongoing review. Problems can occur when the company ends up issuing more shares from the plan than are registered on the S-8. How does this happen? There are a number of possibilities – among them are adding new shares to the plan, and not counting the re-issuance of forfeited shares. To recap, the S-8 does not register the plan itself with the SEC, but is for the offer and sale of the securities under the plan. In tracking shares issued under the plan against the number of shares recorded on the S-8, there are a number of factors to consider – like how forfeitures of restricted stock (and subsequent re-grants of those shares) will impact the number of shares remaining for issuance. Subscribers to The Corporate Counsel may benefit from reviewing the article “Form S-8: Share Counting, Fee Calculations, and Other Tricks of the Trade.” It’s time to dust off the Form S-8 filings and review them against shares issued from the corresponding stock plans.
3. Monitor Section 16 Transactions. I’ve talked before about the SEC’s recent interest in Section 16 reporting violations (see “Section 16 Reporting: Low Hanging Fruit for SEC“, November 6, 2014). Because of the short time frame to disclose most Section 16 reportable transactions to the SEC, many companies have controls designed to monitor daily activity from the stock plans. However, common causes of reporting violations include out of box transactions and corrections that fail to be reported. This is an area of audit that will require some creativity to fully embrace. How do you proactively audit for things that are not in the company’s control, for example a situation where an officer ceases to be trustee of the family’s trust (releasing him from beneficial ownership of the shares)? Another opportunity for a “miss” in reporting is adding or removing executives and directors to/from the list of those obligated to comply with Section 16 reporting. This is an area where auditing may involve the contributions of many. It may take you away from your traditional view of an “audit”. In monitoring Section 16 activity, building relationships is an essential component. You’ll want to be proactive in building relationships with your compliance officer and other executives who may regularly interact with board members and can inquire about ongoing activity. You’ll want to build an alliance with the trusted advisors who assist your Section 16 reporting persons in managing their finances/portfolio/estate. The reporting person may forget to tell you about something, but it may be the professional advisor that tips you off to a change that warrants reporting. This doesn’t replace other forms of trying to monitor activity – like proactively inquiring to brokers and asking Section 16 officers/directors about activity. If you’ve had reporting failures in the past couple of years, it’s time to examine the controls to make sure you have enough of the right audit steps in place. Think outside of the box.
There are probably a hundred audits that can encompass stock plan activity and their related disclosure/compliance requirements. We have only tackled three in today’s blog. None of these are grossly time consuming and could work in your favor, heading off potentially messy situations down the road. If there’s one thing to remember, “audit” doesn’t have to mean an all encompassing days long event. It can be as simple as a quick inquiry, review, or analysis designed to stay ahead of the curve in managing your stock plans. Implement these (and more) audits, and you’ll thank yourself later!
Deadline Extended: Global Equity Incentives Survey! We’ve extended the deadline to participate in the NASPP’s 2015 edition of our Global Equity Incentives Survey (co-sponsored with PwC) until April 15! Don’t miss out–issuers have to participate to have access to the full survey results. Register to participate today!
Andrea Best on Why Business Is Personal
Check out the latest Career Corner blog by Andrea Best of SOS, “A Case for Making Business Personal,” on why it’s not only okay but a good idea to be friendly with your professional colleagues.
NASPP To Do List
Here’s your NASPP To Do List for the week:
It’s no April Fool’s joke—on March 31, the IRS and Treasury issued final regulations under Section 162(m). The final regs are largely the same as the proposed regs that were issued back in 2011 (don’t believe me—check out the redline I created); so much so that I considered just copying my blog entry on the proposed regs and changing the word “proposed” to “final” throughout. But I’m not the sort of person that takes short-cuts like that, so I’ve written a whole new blog for you.
For more information on the final regs, check on the NASPP alert, which includes several law-firm memos.
The IRS Says “We Told You So”
The final regulations implement the clarification in the proposed regs that, for options and SARs to be exempt from the deduction limit under Section 162(m), the plan must specify a limit on the maximum number of shares that can be granted to an individual employee over a specified time period. It is not sufficient for the plan to merely limit the aggregate number of shares that can be granted, even though this creates a de facto per-person limit; the plan must separately state a per person limit (although the separately stated per-person limit could be equal to the aggregate number of shares that can be issued under the plan). One small change in the final regs was to clarify that the limit doesn’t have to be specific to options/SARs; a limit on all types of awards to individual employees is sufficient.
When the proposed regs came out, I was surprised that the IRS felt the need to issue regs clarifying this. This had always been my understanding of Section 162(m) and, as far as I know, the understanding of most, if not all, tax practitioners. In his sessions over the years at the NASPP Conference, IRS representative Stephen Tackney has said that everyone always agrees on the rules until some company gets dinged on audit for not complying with them—then all of a sudden the rules aren’t so clear. I expect that a situation like this drove the need for the clarification.
In the preamble to the final regs, the IRS is very clear that this is merely a “clarification” and that companies should have been doing this all along, even going so far as to quote from the preamble to the 1993 regs. Given that the IRS feels like this was clear all the way back in 1993, the effective date for this portion of the final regs is retroactive to June 24, 2011, when the proposed regs were issued (and I guess maybe we are lucky they didn’t make it effective as of 1993). Hopefully, you took the proposed regs to heart and made sure all your option/SAR plans include a per-person limit. If you didn’t, it looks like any options/SARs you’ve granted since then may not be fully deductible under Section 162(m).
Why Doesn’t the IRS Like RSUs?
Newly public companies enjoy the benefit of a transitional period before they have to fully comply with Section 162(m). The definition of this period is one of the most ridiculously complex things I’ve ever read and it’s not the point of the new regs, so I’m not going to try to explain it here. Suffice it to say that it works out to be more or less three years for most companies.
During the transitional period, awards granted under plans that were implemented prior to the IPO are not subject to the deduction limit. Even better, the deduction limit doesn’t apply to options, SARs, and restricted stock granted under those plans during this period, even if the awards are settled after the period has elapsed. It’s essentially a free pass for options, SARs, and restricted stock granted during the transition period. The proposed regs and the final regs clarify that this free pass doesn’t apply to RSUs. For RSUs to be exempt from the deduction limit, they must be settled during the transition period. This provides a fairly strong incentive for newly public companies to grant restricted stock, rather than RSUs, to executives that are likely to be covered by Section 162(m).
I am surprised by this. I thought that some very reasonable arguments had been made for treating RSUs the same as options, SARs, and restricted stock and that the IRS might be willing to reverse the position taken in the proposed regs. (In fact, private letter rulings had sometimes taken the reverse position). I think the IRS felt that because RSUs are essentially a form of non-qualified deferred comp, providing a broad exemption for them might lead to abuse and practices that are beyond the intent of the exemption.
This portion of the regs is effective for RSUs granted after April 1, 2015.
I think it’s safe to say that if you work in this industry, you’re familiar with the concept of insider trading. What do we know? You can’t trade in a company’s stock based on material non-public information. If you do, the Securities and Exchange Commission (“SEC”) could hunt you down and make your life very, very miserable. Isn’t that what time and experience have taught us? In the past, I’ve blogged about the SEC’s renewed and aggressive interest in pursuing a variety of insider trading violations (see Husbands and Wives Insider Trading and “There’s a Reason They Call it “Insider” Trading). With more sophisticated technology and monitoring mechanisms, even the smallest trades are not below the line of scrutiny, and it’s an area where I’ve been advocating the use of caution for a while now. However, what was left unsaid in those many recounts of insider trading crackdowns was the fact that although there have been prosecutions and penalties and repercussions for trading based on material non-public information, there isn’t actually a federal law that specifically makes insider trading illegal. Now, that tide may be changing, with multiple bills in pending in Congress that intend to create a federal statute to address this legislative hole. In today’s blog I’ll catch you up on what’s happening on that front.
How Can That Be?
I already know what you are thinking: “Huh? Insider trading is illegal.” I mean, isn’t that why we’ve seen dozens of successful prosecutions in the last few years? You know what I’m talking about – and we’ve seen it all. CEOs, hedge fund managers, employees who accidentally passed on inside information to their wives, friends having brunch together and sharing small talk about their jobs. I think the variety of circumstances is broad, with one commonality: the SEC has been successful in working with the Justice Department to bring charges, obtain convictions and levy penalties. Jail time has been a very real outcome in some of these cases. So how could this all happen if insider trading is NOT illegal? Well, technically it’s not. And, although the SEC has been successful in pursuing these cases, they have had to use loopholes to do so – relying on general antitrust laws and decades of case law (and, I’m not a lawyer, but I’m told that case law is subject to interpretation by individual judges, so the application of that could vary widely). The bottom line is there isn’t a statute that specifically addresses insider trading, which leads to potential ambiguity and inconsistencies in the courts.
Why the Interest Now?
We’ve established that there are no clear federal insider trading laws on the books, but what’s the sudden interest in creating one? The initial catalyst was a landmark ruling (December 2014) by the Second U.S. Circuit Court of Appeals (U.S. v. Newman) that overturned two “key” insider trading convictions, dealing a blow to the Justice Department and the SEC. At the time, the Wall Street Journal summarized the situation as follows: “…a federal appeals court overturned two insider-trading convictions and ruled it isn’t always illegal to buy or sell stocks using inside information.
The ruling raised the bar for prosecutors on a crime that is already hard to prove, and it will likely limit the types of cases the government can pursue.
Specifically, the three-judge panel of the Second U.S. Circuit Court of Appeals said prosecutors must prove traders knew that the person who provided an inside tip gained some sort of tangible reward for doing so. The judges also said it may be legal to trade on inside information, even if it gives an investor an unfair advantage in the markets, as long as the tipper didn’t commit an illegal breach of his or her duty.”
What’s the Fallout?
The Newman decision has created a still ongoing fallout, making it more challenging for the SEC and Justice Department to pursue insider trading cases. As a result, some pending cases have been dropped, others who were successfully convicted are now seeking review of their cases, and Congress is taking action to statutorily define insider trading and also to reverse the requirement under the appellate decision that:
“the tippee know both that the tipper breached a duty of confidentiality and
the tipper received a personal benefit of “some consequence.”
What’s Happening in Congress?
There are currently three bills pending in Congress that seek to define insider trading. The National Law Review describes them as follows:
“Two bills introduced by Democrats have been pending without bipartisan support and have stalled. The broadest of these is the Stop Illegal Insider Trading Act, which was introduced by Sen. Jack Reed (D – RI) and Sen. Robert Menendez (D – NJ). The Stop Illegal Insider Trading Act would make it illegal to trade on “material information” that the person “knows or has reason to know” is not publicly available – excluding information a person developed from publicly available sources.
The second bill is the Ban Insider Trading Act of 2015, which was introduced by Rep. Stephen Lynch (D – MA), and would redefine “material” nonpublic information as information that would likely affect the stock’s price if it were made public.
Most recently, Rep. Jim Himes (D – CT) and Rep. Steven Woman (R – AK), introduced the first bill with bipartisan support, which would ban trading based on material, nonpublic information that the person knew or recklessly disregarded was wrongfully obtained.”
What’s Next?
It’s not clear what the outcome of any of these efforts will be, but what we do know is that the fallout from the Newman decision has caused a ruckus, and there is more pressure than ever to find a consistent way for the courts to define insider trading. It’s quite possible that any new legislation in this area will trigger a need to revamp the insider trading policy, educate employees and possibly adjust some practices and procedures. We’ll keep you informed on any new developments in this area.