The last couple of weeks have been fun but it’s time to get back to serious stuff.  Last week, my Google alert for stock options exploded with articles on Barnes & Noble’s snafu relating to an option granted to their CEO. One day’s alert had three articles on this topic, with more articles in subsequent alerts. For today’s blog entry, I offer my take on the blunder.

Oops–Can We Have That Grant Back?
Back in early December 2011, Barnes & Noble’s compensation committee decided to grant the CEO an option to purchase 1,000,000 shares. Unfortunately, no one noticed that a grant of this size exceeded the plan’s limitation on the number of shares that can be granted to an individual. The error wasn’t discovered until somewhere around six months later (the amended Form 4 correcting the original report of the grant was filed on June 28, so I’d guess they discovered the error towards the end of June).

Barnes & Noble really had no choice but to rescind the portion of the grant that exceeded the limitation (500,000 shares), as if it had never been granted. The grant wasn’t valid under the terms of the plan and, as an NYSE-traded company, Barnes & Noble can’t make grants outside of its shareholder approved plans (unless the grants themselves are approved by shareholders). They are now asking shareholders to approve an amendment to the plan that will increase the individual limit; if passed, another option to purchase 500,000 shares will be granted to the CEO at the then-current FMV.

What the Heck?

This individual limit is required for options granted under the plan to be considered performance-based compensation under Section 162(m). If your company is public, you probably have a limit like this stated in your plan. If you don’t know what it is, now would be a good time to dig out your plan and look it up. 10 pts to anyone who already knows what the limit in their plan is without peeking. You might also want to verify whether the limit is adjusted for stock splits.

Last year, the IRS issued proposed regs to clarify that just stating a maximum number of shares available for grant under the plan isn’t sufficient to satisfy this requirement (even though this does effectively limit how many shares can be granted to an individual). The plan must have a separately stated individual limit (see the NASPP alert, “Proposed Regulations Under Section 162(m),” July 2011).

Shouldn’t Someone Have Noticed?

It seems like this error should have been caught sooner. Ideally, stock plan administration would be informed of any grant recommendations to be submitted to the compensation committee for approval in advance, so that they can review the grants to for problems like this (and also so they can get a head start on the Form 4 filing, if they are responsible for it).

I understand that this doesn’t always happen–sometimes stock plan administration is the last to know about new grants to executives. But they should be informed of the grants shortly after approval, so that the grants can be entered into the administrative system and properly accounted for. Part of this process should include reviewing all grants to ensure that the plan limit isn’t exceeded. Remember that this isn’t an individual grant limit; it’s a limit on the cumulative number of shares that can be granted to an individual over a period of time. Even a relatively modest grant could be the fabled straw that breaks the camel’s back, if an individual has previously received an excessive number of grants or excessively large grants. Having an appropriate control procedure in place here can allow stock plan administration to raise the red flag before the grants are publicly reported and a media circus ensues.

Don’t Do That

Diligent readers of my blog already know my opinion of mega grants like this (see “And Another Thing,” May 5, 2009). Running afoul of the individual grant limit in your plan is just one other reason to avoid them.

More Section 162(m) Traps for the Unwary

For more Section 162(m) gotchas, don’t miss the session “Section 162(m): Keeping Your Executive Compensation Deductions Safe from the Tax Man,” at the 20th Annual NASPP Conference.