As I mentioned in my blog on Tuesday, we are starting to see some movement towards repeal or revision of at least parts of the Dodd-Frank Act. The Administration’s executive order isn’t the only action that has been taken; here are a couple of other developments:
CEO Pay Ratio—The SEC Weighs In
On Monday, February 6, Acting SEC Chair Michael Piwowar issued a statement on the CEO pay ratio disclosure. Piwowar requests comments on “unexpected challenges that issuers have experienced as they prepare for compliance with the rule and whether relief is needed,” and encourages detailed comments to be submitted within 45 days. Piwowar also notes that he has directed the SEC staff to “reconsider the implementation of the rule based on any comments submitted and to determine as promptly as possible whether additional guidance or relief may be appropriate.”
While that’s pretty vague, is does indicate that, in addition to the Secretary of the Treasury and the Financial Stability Oversight Council, the SEC is also looking at the CEO pay ratio rule. Even so, it’s hard to say what this means. As we all know, and as an article in the Wall Street Journal notes (“GOP-Led SEC Considers Easing Pay-Gap Disclosure Rule of Dodd-Frank“), it is difficult for the SEC to move quickly on matters like this:
Republicans on the SEC could be stymied by the commission’s own procedures on the pay-ratio rule because undoing a regulation is handled by an often lengthy process that is similar to creating one. It also is difficult for the SEC to delay it outright, because of the commission’s depleted ranks. There are just two sitting commissioners—Mr. Piwowar and Kara Stein, a Democrat—meaning the SEC is politically deadlocked on most matters. Ms. Stein on Monday signaled opposition to efforts to ease the pay rule. “It’s problematic for a chair to create uncertainty about which laws will be enforced,” she said.
And Then There’s Congress
An article in Bloomberg/BNA reports that the Financial Choice Act is likely to be reintroduced into Congress this year (“Dodd-Frank Rollback Bill Expected in February, Duffy Says“). Originally introduced last year, this bill would repeal or restrict major parts of the Dodd-Frank Act, including reducing the frequency of Say-on-Pay votes, limiting application of the clawback provisions, and repealing the CEO pay ratio and hedging disclosures. Jenn Namazi blogged on the Act last year (see “Post Election: Things to Watch – Part I” and “Part 2“).
The Financial Choice Act is bigger than Dodd-Frank. The bill would also require a joint resolution of Congress before any “major” rulemaking by the SEC and a number of other agencies could go into effect. Mark Borges notes in his blog on CompensationStandards.com (“Acting SEC Chair Weighs in on CEO Pay Ratio Rule“) that the bill is expected to require the major proxy advisory firms to register with the SEC and, among other things, disclose potential conflicts of interest.
Poll: What Are You Doing?
It’s hard to know what to do in response to all this. Preparing for the CEO pay ratio disclosure requires a lot of time and resources, which most on the corporate side would view as wasted if the disclosure is eliminated. But if the disclosure isn’t eliminated, stalling preparations now could result in an implementation time crunch.
In his blog on CompensationStandards.com (“As Predicted—Hitting the Pause Button on the CEO Pay Ratio Rule“), Mike Melbinger says: “Postponement and revision of the rule seems likely. Now might be a good time to stop spending time and money on this calculation.” Take our poll to tell us what your company is doing (click here if the poll doesn’t display below).
ISS 2017 Equity Compensation Plan FAQ notes that where companies want ISS to include performance awards in their burn rate when the awards are earned, ISS now requires specific disclosures with respect to the performance awards.
A Quick Primer on ISS, Burn Rates, and Performance Awards
ISS includes performance awards in a company’s burn rate when the awards are earned, if the company includes this information in the disclosures related to its stock plan. If this information isn’t disclosed, ISS includes the performance awards in the burn rate calculation when they are granted.
The problem with including the performance awards when they are granted is that ISS doesn’t reduce the burn rate for subsequent forfeitures (due to either termination of employment or failure to meet the performance goals). Consequently, it is generally preferable to have performance awards included in the burn rate when they are earned. This will result in a more accurate (and possibly lower) burn rate, because only the shares that are actually earned and paid out will be included in the calculation.
What’s Changed?
In the past, ISS simply required companies to clearly and consistently disclose how many shares were granted and earned under performance awards, without defining what the disclosure should have looked like. In its 2017 Equity Compensation Plans FAQ, however, ISS has stipulated the following requirements for the disclosure:
Table format
Separate from the disclosure for time-based awards
Aggregate of all performance awards granted to all employees (providing the disclosure only for awards held by NEOs is insufficient)
Covering three years
Included every year going forward, even if the plan will not be acted on in a particular year
Included even if no performance awards were granted or earned in a particular year
ISS has also said that they generally won’t calculate the number of shares earned under performance awards, even if it would be possible for them to do this from information presented in narrative format.
The FAQs include a sample disclosure that looks remarkably like the old roll-forward tables companies used to include for all of their stock compensation under the original FAS 123.
Is This Legally Required?
The disclosure isn’t legally required or required under ASC 718. But if you want ISS to include your performance awards in your burn rate when they are earned, rather than when they are granted, the disclosure is necessary.
As most of my readers know, the FASB has amended ASC 718 to expand the exception to liability treatment that applies to shares withheld to cover taxes to include withholding up to the maximum individual tax rate. This has led many companies to consider changing their tax withholding practices for stock compensation.
Plan Amendment Likely Necessary
As noted in my blog entry “Getting Ready for the New Share Withholding” (May 5, 2016), companies that are interested in taking advantage of the expanded exception face an obstacle in that virtually all stock plans include a prohibition on using shares to cover taxes in excess of the minimally required statutory withholding. Where companies want to allow shares to be withheld for tax payments in excess of this amount, the plan must first be amended to allow this.
Shareholder Approval Not Necessary
In the aforementioned blog entry, I had noted that it wasn’t clear if shareholder approval would be required for the plan amendment, particularly if the shares withheld will be recycled back into the plan. I have good news on this question: both the NYSE and Nasdaq have amended their shareholder approval FAQs to clarify that this amendment does not require shareholder approval, even if the shares will be recycled.
Nasdaq (ID number 1269, it should be the last question on the second page. Or do a keyword search for the word “withholding” and the relevant FAQ should come right up.)
For a while, there was still a question as to whether the NYSE required shareholder approval when shares withheld from restricted stock awards would be recycled. In late December, John Roe of ISS arranged for the two of us to meet with John Carey, the Senior Director at NYSE Regulation, to get clarification on this. Just prior to our meeting, the NYSE updated their FAQs to clarify that shareholder approval is not required even in the case of share withholding for restricted stock awards, even when the shares will be recycled.
ISS Still Not a Fan of Share Recycling
It should come as no surprise that, where the withheld shares will be recycled, ISS isn’t a fan of amendments to allow shares to be withheld for excess tax payments. Now that it’s clear shareholder approval isn’t required for the amendment, this likely isn’t a significant concern for most companies, unless they are submitting their plan for shareholder approval for some other reason. It isn’t a deal-breaker, but it could enter into ISS’s qualitative assessment of the plan. This would particularly be an issue if ISS’s recommendation is tied to more than the plan’s EPSC score.
Not a Modification for Accounting Purposes
There also has been some question as to whether the amendment would be considered a modification for accounting purposes if applied to outstanding awards. Based on the FASB’s recent exposure draft to amend the definition of a modification under ASC 718 (see “ASC 718 Gets Even Simpler,” November 22, 2016), the FASB doesn’t seem to think modification accounting is necessary. The comment period on the exposure draft ended on January 6. There was little opposition to the FASB’s position: only 14 comment letters were received, one letter clearly opposed the change, 12 supported the change, and one was “not opposed” but not enthusiastic. Given that response, hopefully the FASB will finalize the proposed update quickly so that this question is settled.
The full results from the 2016 Domestic Stock Plan Design Survey, which the NASPP co-sponsors with Deloitte Consulting LLP, are now available. Companies that participated in the survey (and service providers who weren’t eligible to participate) have access to the full results. And all NASPP members can hear highlights from the survey results by listening to the archive of the webcast “Top Trends in Equity Plan Design,” which we presented in early November.
For today’s blog entry, I highlight ten data points from the survey results that I think are worth noting:
Full Value Awards Still Rising. This survey saw yet another increase in the usage of full value awards at all employee levels. Overall, companies granting time-based restricted stock or units increased to 89% of respondents in 2016 (up from 81% in 2013). Most full value awards are now in the form of units; use of restricted stock has been declining over the past several survey cycles.
Performance Awards Are for Execs. We are continuing to see a lot of growth in the usage of performance awards for high-ranking employees. Companies granting performance awards to CEOs and NEOs increased to 80% in 2016 (up from 70% in 2013) and companies granting to other senior management increased to 69% (from 58% in 2013). But for middle management and below, use of performance award largely stagnated.
Stock Options Are Still in Decline. Usage of stock options dropped slightly at all employee levels and overall to 51% of respondents (down from 54% in 2013).
TSR Is Hot. As a performance metric, TSR has been on an upwards trajectory for the last several survey cycles. In 2016, 52% of respondents report using this metric (up from 43% in 2013). This is first time in the history of the NASPP’s survey that a single performance metric has been used by more than half of the respondents.
The Typical TSR Award. Most companies that grant TSR awards, use relative performance (92% of respondents that grant TSR awards), pay out the awards even when TSR is negative if the company outperformed its peers (81%), and cap the payout (69%).
Clawbacks on the Rise. Not surprisingly, implementation of clawback provisions is also increasing, with 68% of respondents indicating that their grants are subject to one (up from 60% in 2013). Enforcement of clawbacks remains spotty, however: 5% of respondents haven’t enforced their clawback for any violations, 8% have enforced it for only some violations, and only 3% of respondents have enforced their clawback for all violations (84% of respondents haven’t had a violation occur).
Dividend Trends. Payment of dividend equivalents in RSUs is increasing: 78% of respondents in 2016, up from 71% in 2013, 64% in 2010, and 61% in 2007. Payment of dividends on restricted stock increased slightly (75% of respondents, up from 73% in 2013) but the overall trend over the past four surveys (going back to 2007) appears to be a slight decline. For both restricted stock and RSUs, companies are moving away from paying dividends/equivalents on a current basis and are instead paying them out with the underlying award.
Payouts to Retirees Are Common. Around two-thirds of companies provide some type of automated accelerated or continued vesting upon retirement (60% of respondents for stock grants/awards; 68% for performance awards, and 60% for stock options). This is up slightly in all cases from 2013.
Post-Vesting Holding Periods are Still Catching On. This was the first year that we asked about post-vesting holding periods: usage is relatively low, with only 18% of companies implementing them for stock grants/awards and only 13% for performance awards.
ISOs, Your Days May be Numbered. Of the respondents that grant stock options, only 18% grant ISOs. This works out to about 10% of the total survey respondents, down from 62% back in 2000. In fact, to further demonstrate the amount by which option usage has declined, let me point out that the percentage of respondents granting stock options in 2016 (51%) is less than the percentage of respondents granting ISOs in 2000 (and 100% of respondents granted options in 2000—an achievement no other award has accomplished).
Next year, we will conduct the Domestic Stock Plan Administration Survey, which covers administration and communication of stock plans, ESPPs, insider trading compliance, stock ownership guidelines, and outside director plans. Look for the survey announcement in March and make sure you participate to have access to the full results!
In my blog entry this week titled “Other ISS Policy Amendments,” I said that ISS no longer permits the 5% carve-out with respect to minimum vesting requirements. This statement was not correct. ISS will still permit up to 5% of shares granted under a stock plan to vest quicker than required under the plan’s minimum vesting requirements. I apologize for my error and any confusion it created; I have corrected my original entry.
On November 29, I discussed ISS’s amendments related to dividends paid on awards (ISS Targets Dividends on Unvested Awards), but that’s not the only amendment to their 2017 Proxy Voting Guidelines that impacts stock compensation programs. For today’s blog entry, I discuss the other amendments.
Minimum Vesting Requirements
The plan must specify a minimum vesting period of one year for all awards to receive full points for this test under the Equity Plan Scorecard. In addition, no points will be earned if the plan allows individual award agreements to reduce or eliminate this vesting requirement (note, however, that ISS still permits an exception for up to 5% of shares awarded).
Anyone who listened to my podcast “Five Things Barbara Baksa Learned About the ISS Equity Plan Scorecard” knows that I’m not a fan of this test in the EPSC because I’m convinced it is just a compliance disaster waiting to happen. And now that the plan can’t allow any exceptions to it all, I like it even less.
Plan Amendments
Although ISS didn’t deem this change significant enough to include it in the Executive Summary, the policy with respect to how plan amendments are evaluated has also been updated. For most types of substantive amendments (i.e., amendments that aren’t purely administrative or that aren’t solely for purposes of Section 162(m)), the plan will be reevaluated under the EPSC and ISS will assess the amendments on a qualitative basis.
It isn’t clear to me why the EPSC isn’t enough by itself (since it would be enough for a new plan). Apparently ISS just doesn’t like some stuff that companies do with their equity plans and they want to be able to recommend that shareholders vote against amendments that would add those features to your plan, even if they would be allowed under the EPSC.
Where private companies are submitting a plan to shareholders for the first time, the plan will have to pass the EPSC even if no new shares are being requested (e.g., if the plan is submitted solely for Section 162(m) purposes) and ISS will make a qualitative assessment of any amendments.
The practice of paying dividends (or dividend equivalents, in the case of units) on unvested awards has been declining since we first started tracking it in 2007. No one likes the practice, other than companies and the employees who benefit from it. Investors certainly aren’t a fan, FASB imposes some onerous accounting requirements on it, and even the IRS has taken issue with the practice. Now, ISS’s 2017 Equity Plan Scorecard deducts points for this.
What’s the Big Deal?
The main criticism of paying dividends on unvested awards is philosophical: if dividends are paid out before an award vests, employees have arguably received compensation they aren’t entitled to. And, if the awards are subsequently forfeited, no one makes the employees pay back the dividends; they are allowed to keep the dividends on shares that they ultimately didn’t earn. Here are a few of the consequences of this practice:
Implicates the dreaded two-class method of reporting earnings-per-share, something few people, if any, even understand (I’ll admit it—I am not one of the few) (see “Applying the Two-Class EPS Method to Share-Based Payments,” by KPMG)
When the awards are forfeited, any dividends paid prior to vesting that aren’t also forfeited are treated as compensation expense (normally, dividends do not increase the expense associated with an award)
If paid on performance awards, the dividends cannot be considered performance-based compensation for purposes of Section 162(m) unless they are subject to vesting contingent on performance goals (see “IRS Clarifies Treatment of Dividends Under Section 162(m)“)
ISS Gets into the Game
One of ISS’s changes to its 2017 Corporate Governance Policy is to add paying dividends on unvested awards to the Plan Features pillar of its Equity Plan Scorecard. Plans will receive full points for this test only if they prohibit paying dividends prior to vesting for all awards offered under the plan. If the plan is silent or includes the prohibition for some awards but not others, the plan receives no points for this test.
It is permissible for dividends to accrue on awards prior to vesting, so long as the dividends are still subject to forfeiture in the event that the underlying award is forfeited.
The Data
This handy interactive infographic shows how payment of dividends on unvested awards has declined since 2007 (click on the years to see the data change):
Perhaps one day, paying dividends on unvested awards will go the way of reloads and pyramid exercises: mythic transactions rarely, if ever, seen in the wild.
– Barbara
* Data referenced in this blog, including the infographic, are from the Domestic Stock Plan Design Survey (years 2007, 2010, 2103, and 2016), co-sponsored by the NASPP and Deloitte Consulting LLP.
Every year, ISS conducts a survey in advance of updating its corporate governance policy. The survey is open not only to ISS clients and institutional investors but also to entities that are often the subject of ISS recommendations, including both companies and corporate directors, as well as other market participants, such as those that advise companies. There are a couple of questions in this year’s survey that caught my eye.
Frequency of Say-on-Pay Votes
Although most companies currently hold Say-on-Pay votes every year, the SEC’s final regulations allow these votes to be held every one, two, or three years, at the election of shareholders. The “Say-on-Pay frequency vote” must be held at least once every six years. In 2017, for the first time since Say-on-Pay went into effect, most companies will once again give shareholders an opportunity to vote on how often their Say-on-Pay vote should be held.
In anticipation of this, ISS has included a couple of questions on the frequency of Say-on-Pay votes in this year’s survey. Currently, ISS’s policy recommends an annual Say-on-Pay vote. The survey contemplates a different recommendation, possibly one that is dependent on company circumstances, such as company size, performance, problematic pay practices, and/or past Say-on-Pay vote results.
P4P Analysis
As part of its evaluation of CEO pay, ISS performs a “Pay-for-Performance Evaluation.” This consists of a quantitative analysis in which the company’s TSR performance is compared to the CEO’s pay and both metrics are ranked against the company’s peers. If the company performs poorly in the quantitative analysis, the next step is a qualitative analysis, in which ISS looks at the company’s specific pay practices.
The survey focuses on the quantitative analysis, asking if this analysis should be based on other metrics, in addition to TSR, and, if yes, what other metrics should be included.
In the past decade, we’ve seen a significant increase in the use of TSR targets in performance awards. In the NASPP/Deloitte Consulting 2013 Domestic Stock Plan Design Survey, use of TSR had increased to 43% of respondents, up 48% from the 2010 survey. I expect usage will be even higher in this year’s survey—possibly nearing or exceeding 50% of respondents. No other metric comes close, in terms of prevalence.
But, TSR is not without its critics. For example, see the article we just posted by Brett Herand of Pearl Meyer, “Re-Evaluating Total Shareholder Return as an Incentive.” It is interesting to see that the TSR backlash has reached enough of crescendo that ISS is considering changing its policy.
Survey Closes August 30
If you want to participate in ISS’s survey, you don’t have much time. The survey closes on August 30.
Today’s CompensationStandards.com blog points readers to a handy chart of “Problematic Pay Practices – as Identified by ISS” published by ExecutiveLoyalty.org. Since there are several that stem from equity compensation practices, I’ll recap some of them.
Avoid These Practices or Risk a Negative ISS Vote
While there were several compensation practices identified, only some of them apply to equity compensation. They include:
Repricing or replacing of underwater stock options/stock appreciation rights without prior shareholder approval (including cash buyouts, option exchanges, and certain voluntary surrender of underwater options where shares surrendered may subsequently be re-granted).
Stock plans with a liberal CIC definition (e.g. low % or occurrence before CIC closing) coupled with single trigger vesting upon the CIC “are likely to receive a negative recommendation” (FAQ #63).
Equity plans or arrangements that include a liberal CIC definition (such as a very low buyout threshold or a CIC occurring upon shareholder approval of a transaction, rather than its consummation), coupled with a provision for automatic full vesting upon a CIC, are likely to receive a negative recommendation. [FAQ 59]
Excessive reimbursement of income taxes on executive perquisites or other payments (e.g., related to personal use of corporate aircraft, executive life insurance, bonus, restricted stock vesting, secular trusts, etc; see also excise tax gross-ups above.
I don’t think any of these come as a particularly big surprise – but it’s helpful to see the most likely hot button practices wrapped up into a handy chart for reference. As ExecutiveLoyalty.org points out, “on at least an annual basis, those who make executive compensation decisions for public companies should “score” their practices against ISS and other policy guidelines.”
You may know that one of the (many) mantras of the stock plan administrator is something like “know the terms of your stock plan.” If there was a list of top 10 phrases of advice for a stock plan administrator, I’m pretty sure that understanding all of the various nuances of your company’s stock plan(s) would be there. Interestingly, when many of us think of plan terms, we’re thinking of the really important details, like the number of shares, limits on shares, handling of terminations, death and disability. You get the picture. I’m betting that I’m in the majority (not the minority) in having read a stock plan or two and skimmed over the language that seems fairly standard. Especially the wording that seems to be pretty similar in every stock plan, or, what I call “legal stuff” that doesn’t translate to outright administration responsibilities. Language that is just there. Well, as it turns out, that language is there for a reason and the phrasing of some of those terms could be way more important than one might think.
Waxing Philosophical?
I’m going to start using the word “purpose” now, as in understanding the purpose of your stock plans. I’m not really waxing philosophical, though. If you look at your stock plan, chances are the very first thing you see is a section on the “purpose” of the plan. And it usually goes something like:
“The purpose of this Plan is to provide incentives to attract, retain and motivate eligible persons whose present and potential contributions are important to the success of the Company, and any Parents and Subsidiaries that exist now or in the future, by offering them an opportunity to participate in the Company’s future performance through the grant of Awards.“
The above is a copy and paste from a real stock plan, available publicly online, that will remain nameless. I think you get the picture, and I’m betting if you look at your own plan’s “purpose,” it will read fairly similar.
So why all this chatter about the purpose of a stock plan?
Intent Does Matter
A recent blog by California attorney Keith Bishop recounts a recent 9th Circuit Court of Appeals ruling involving – you guessed it – the purpose of a stock plan. The plan involved in the case was a stock rights plan, but in terms of plan terms the one in question for this matter is similar to what you’d find in an equity incentive plan. The specifics of the appeals case are described by Attorney Bishop as follows:
Most equity award plans that I come across include a statement of the plan’s purposes. I haven’t tended to give these provisions a whole lot of thought, but an opinion issued yesterday by the Ninth Circuit Court of Appeal makes it clear that a plan’s purpose clause can be very important indeed. The case arose from the retirement of the plaintiff, a Mr. Foster Rich, from Booz Allen Hamilton, Inc. (BAH). While working at BAH, Mr. Rich participated in the company’s stock rights plan (SRP) pursuant to which he was granted the right to purchase BAH shares. When Mr. Rich retired from BAH, he had accumulated 30,500 shares. BAH then exercised its right to repurchase those shares and paid Mr. Rich $4,507,900, or $147.80 per share. That is a lot of money, but a little over a year later BAH sold a portion of its business to The Carlyle Group and holders of BAH stock received $763 per share. Because Mr. Rich was no longer a BAH shareholder, he did not receive any compensation from that transaction. Presumably, Mr. Rich would have received $23,271,500 had his shares not been repurchased. It seems that while Mr. Rich became wealthy under the SRP, he didn’t become nearly as wealthy as others.
Mr. Rich sued alleging breach of contract and Employee Retirement Income Security Act (“ERISA”) claims.
The 9th Circuit did not agree with Mr. Rich and upheld that the plan was not subject to ERISA (more details can be read in that blog). In arriving at their conclusion, they turned to the “purpose” of the plan as defined by the plan, and corroborating actions and communications within the company that further supported the stated purpose. That plan’s purpose was defined as “to provide incentives for [BAH] Officers to continue to serve as employees of the Company and its subsidiaries.” Sound familiar? That’s not too far off from the Equity Incentive Plan purpose language above, right? It appears that, in this case, it was the plan’s own language that played a significant role in helping the 9th Circuit decide to uphold that the plan was not subject to ERISA (and therefore the former employee was not entitled to further gain from the shares post repurchase).
Bishop suggests that this case may be something for companies to consider when responding to item 1(a) on the Form S-8. The choice of words there could be an important factor in helping to clearly define the true intended purpose of a stock plan (“Briefly state the general nature and purpose of the plan, its duration, and any provisions for its modification, earlier termination or extension to the extent that they affect the participants.”) and their corresponding entitlements. This is something for all stock plan drafters to consider. Certainly for those involved in drafting new plans or the S-8 process – even if it’s just reviewing the documents, it’s something to raise as a point of discussion. While your stock plan may not be subject to an ERISA-based challenge, there could certainly be other challenges that arise. That’s why having a clear and solid intention behind all that plan language, supported by administration practices that reiterate and corroborate those intentions, really does matter. It turns out that those many pages of plan terms are important after all.