Last week I provided an overview of how the Hart-Scott-Rodino Act applies to stock compensation (“The $16K Per Day Mistake,” February 19, 2013). This week I answer some of your burning follow-up questions about the HSR Act.
How Do the “Size of Party” Thresholds Apply to Executives?
You will recall that when an individual engages in an acquisition that causes his/her company stock holdings to be somewhere between $70.9 million and $283.6 million, the acquisition is only reportable if one party to the transaction has annual net sales or assets exceeding $14.2 million and the other has annual net sales or assets exceeding $141.8 million.
But how do these thresholds apply to a human being? That is a good question. The executive is usually going to the be smaller party and the company is usually going to be the larger party, so the $14.2 million threshold is probably the operable number to worry about for the individual.
My understanding–which I would describe as “sketchy, at best”–is that unless the individual happens to have financial statements (unlikely), he/she creates a pro forma balance sheet to determine his/her assets. The net annual sales test typically wouldn’t apply, but it can sometimes and includes certain types of investment income or revenues of entities that the individual owns. And, some assets don’t count for purposes of the assets test. As I explained last week, I think the key take-away here is that if an individual’s stock holdings exceed $70.9 million, it’s time to get the lawyers involved and let them figure this out.
Can Stock Price Appreciation Cause an Executive to Be Subject to the HSR Act?
No, an executive will not become subject to the HSR Act merely because the value of his/her stock holdings increase above the threshold; only an acquisition of stock triggers the filing requirements.
For example, say that an executive owns company stock worth $60 million. Now let’s say the stock price subsequently increases so that the executive’s holdings ultimately have a value in excess of $70.9 million. The increase in value would not trigger the HSR Act filing requirements. But, now the executive’s holdings are above that minimum $70.9 million threshold, so any acquisitions the executive makes from here on out have the potential to trigger the filing requirements (unless, of course, the value of the executive’s stock declines below $70.9 million or the size of party thresholds aren’t met).
Which Stock Plan Transactions Could Trigger HSR Act Filings?
Any stock plan transaction in which executives are acquiring common stock or other voting securities, regardless of whether or not the executive voluntarily engages in the transactions. Typically this would include the following transactions:
Exercise, but not grant, of employee stock options
Grant of restricted stock
Settlement, but not grant, of RSUs
Exercise of SARs that are settled in stock
Purchase of stock under an ESPP
Acquisition of stock under a dividend reinvestment program (but not acquisition of dividend equivalent rights–those would not result in an acquisition of voting stock until settled)
Can the Company Pay the Filing Fees?
As I noted last week, the HSR Act filing fees are substantial, starting at $45,000. This is an individual obligation, so the fees apply to the executive. If the company reimburses the executive for the fees, that should be disclosed in the Summary Compensation Table.
We recently posted an alert about the filing thresholds under the Hart-Scott-Rodino Act increasing. The alert reminded me that this is a topic I’ve been meaning to blog about for a while now.
The HSR Act
The Hart-Scott-Rodino Antitrust Improvement Act was enacted to provide the Federal Trade Commission and the Department of Justice with advance notice of large mergers and acquisitions by requiring the entities involved in the transaction to file reports with the FTC and the DOJ.
What does this have to do with stock compensation? I’m glad you asked! It turns out that the HSR Act applies to individuals as well as corporations. If an individual’s holdings in a company’s stock exceed the filing thresholds, that individual is responsible for making the required filings with the FTC and the DOJ.
The Filing Thresholds
Any acquisition that does not cause an individual’s holdings to exceed more than $70.9 million is exempt from the filing requirement.
Any acquisition that causes an individual’s holdings to exceed $283.6 million triggers the filing requirements.
Stuck in the Middle With You
Transactions that cause an individual’s holdings to fall somewhere in between these two thresholds trigger the filing requirements only if the smaller party in the transaction has annual net sales/assets exceeding $14.2 million AND the larger party has annual net sales/assets exceeding $141.8 million.
If you aren’t confused about this, you are probably a lawyer that specializes in antitrust laws. The rest of you are likely wondering how these “size of party” thresholds apply when individuals are acquiring company stock. I’ll provide some more information on this next week. For now, however, I think the key takeaway is that if an executive at your company is in danger of acquiring more than $70.9 million in company stock, it’s time to get the lawyers involved so they can figure all this out.
Thresholds Increase Annually
The size of transaction and the size of party thresholds increase every year (they just increased as of February 11 of this year).
Filing Requirements and Penalties
The filings must be completed before the acquisition is closed. In the context of a merger, there is typically an extended period between when the parties agree to the deal and when it closes, providing time to complete these filings. Where an individual becomes subject to the filing requirements as a result of an acquisition of stock through, say, the company’s stock compensation program, there may not be as much time to make the filing. Thus, monitoring executive’s stock ownership levels with respect to the minimum filing threshold should, at a minimum, be part of your annual procedures. Where executives are close to the threshold, this should be verified before every transaction.
There are some steep fees that go along with the filings–the minimum filing fee is $45,000. But the penalty for not making the filings can be up to $16,000 per day–three days late and the penalty could already exceed the filing fees. We are aware of an executive that was fined $500,000 for failure to comply with the HSR Act. Luckily, according to an O’Melveny & Myers memo, first-time offenders are rarely fined, provided that the error was inadvertent and the filings are completed as soon as the error is identified.
Stay Tuned
Next week I’ll discuss more specifically how the HSR act applies to stock compensation. If you just can’t wait ’til then, see the NASPP’s new HSR Act Portal for more information.
Risky Behavior and Stock Options The study, which is summarized in the article “The Making of a Daredevil CEO: Why Stock Options Lead to More Risk Taking,” published by Knowledge@Wharton, looked at companies that had recently experienced an increased risk and evaluated which companies took steps to mitigate that risk based on the percentage of their managers’ compensation that is in stock options and the in-the-moneyness of the options.
The researchers found that firms where managers held more stock options took fewer mitigating actions. They felt that this is because once stock options are underwater, the value of the options can’t get any lower. When you think about it, with full value awards, there’s always upside potential but there’s also always downside potential–until the company is just about out of business, the value of the stock can always drop further. But once an option is underwater, it doesn’t matter how low the stock price drops, the option can’t be worth any less. As a result, managers in the study that held more options were less incented to take actions to keep the stock price steady.
Risk and In-the-Moneyness
Interestingly, and in line with this theory, the study also found that when managers’ had in-the-money options they took more mitigating action than when their options were underwater. If there was some spread in the options, the managers were motivated to preserve that spread and thus took action to keep the stock price from dropping. But where there was no spread, the managers were more incented to take risks (presumably in the hopes that the risks would pay off and the stock price would increase).
This is all very interesting; I’ve often wondered (probably here in this blog even) why the media and investors have a bias for full value awards over stock options–I think this is the first plausible explanation I’ve heard for that bias. But here in the NASPP Blog, we view studies like this with a healthy level of skepticism–it’s odd but I’ve never seen a study that didn’t prove the researchers’ initial hypothesis–so I wouldn’t scrap your option plan in favor of full value awards just yet (if you haven’t already done so).
A Nail in the Coffin for Premium-Price Options
I’ve never been a fan of premium-priced options because the reduction in expense is less than the premium, which, to my mind, makes them an inefficient form of compensation. I prefer discounted options, which provide a benefit that exceeds the additional expense to the company.
If this study can be believed, premium options would also discourage executives from taking steps to mitigate risk (whereas discounted options would presumably have the opposite impact). Maybe regulators and investors need to reconsider their bias against discounted options (although, in the case of the IRS, this bias may have less to do with concerns about risk taking and more to do with tax revenue–see my March 16, 2010 blog, “Discounted Stock Options: Inherently Evil or Smart Strategy“).
NASPP “To Do” List We have so much going on here at the NASPP that it can be hard to keep track of it all, so I keep an ongoing “to do” list for you here in my blog.
The SEC plans to address the clawbacks in Section 954 of the Dodd-Frank Act between August and December of this year. Many companies appear to be waiting to make final decisions on how to apply the clawback requirements until the SEC completes the proposed rules. (There is more information on creating a clawback policy in the NASPP blog entry, Clawbacks and Executive Compensation.)
Under the Dodd-Frank Act, companies risk delisting if they do not adopt a clawback policy that complies with Section 954 (which is now Section 10D of the Exchange Act). Some of the more difficult aspects of compliance may be in the clawback period (there is a three-year look-back), the potential for little or no company discretion in enforcing the policy, the fact that the executive does not need to be at fault or have contributed to a financial restatement and the actual calculation of compensation that must be recouped.
SEC Enforcement
In 2009, the SEC brought the first enforcement action based solely on SOX clawback provisions. There has been an increase since that case of suits involving clawbacks initiated by the SEC. Last month Beazer CEO, Ian McCarthy, agreed to pay back $6.5 million in compensation under the SEC action against him. (It may not be a coincidence, then, that Beazer’s shareholders voted against pay packages for company executives this year).
Enforcement Snags
The legal aspect of actually recouping compensation under a clawback provision or policy is complex. In the Unites States, enforcement is subject to state wage laws and may or may not be feasible. Presumably, the federal regulations from Dodd-Frank will trump state law, but that is yet another detail to be worked out. Another difficulty for companies to overcome is with respect to di minimis recoupment amounts or clawbacks that would require unreasonable efforts, such as situations where the individual does not have the finances available to repay the compensation.
International Considerations
International considerations for clawbacks are covered in this great matrix from Baker & McKenzie, which differentiates between Dodd-Frank, noncompete, and nonsolicitation clawback practices. In some countries like Canada, Germany, and Mexico, the provisions of Dodd-Frank are likely to be enforceable. However, in many countries like Australia, Japan, Spain, such policies most likely would not be enforceable, particularly if there isn’t an issue of misconduct or individual culpability. There are even situations like in Ireland or the UK where the provisions are likely to be enforceable as long as they were included in the original agreement, which could be a problem for existing equity compensation.
One of the fundamental principles behind deferring payout on awards is the desire to lessen the potential time gap between the point at which an executive is rewarded for his or her policies and the point at which the company realizes the consequences or benefits of those same decisions. The deferral is one way to help keep executives focused on the long-term impact of business strategy.
Advantages
As Barbara pointed out in her August 17th blog entry, deferring the payout of shares can be particularly useful when used in conjunction with a clawback provision or to supplement the company’s ownership guidelines. A deferral may also be valuable for performance awards if there is the possibility of a future negative adjustment exists.
With clawbacks and potential negative adjustments on performance award payouts, it can be very difficult to recover shares or income after the fact, even with carefully constructed provisions. If the company must take back vested shares, it is obviously easier to do if the shares have not been disposed of, yet.
Depending on the parameters of a company’s holding requirements or ownership guidelines, it may be advantageous to an executive subject to these policies to also be subject to deferral on certain grants. The deferral may effectively delay the income event out to a point that either coincides with or is closer to the point at which the executive can dispose of the shares.
Considerations
Of course, any deferral program should be compliant with 409A. However, because there is no deferral election, designing within the parameters of 409A is easier. Another consideration is whether or not the deferral would require, or even be best suited for, a non-qualified deferred compensation program into which the vested shares may be deposited. Visit our Section 409A portal or Bruce Brumerg’s new site, www.myNQDC.com, for more on this issue.
In conjunction with 409A compliance, the general timing of the deferral is a key issue. On one hand, the deferral should be far enough into the future to align the executive’s risk on that potential income with the company’s risk. However, executives are making policy that could impact the company far into the future; there is little incentive for income that is delayed indefinitely. A compromise must be reached to find an appropriate period of time that is effective as a risk-mitigation technique that does not negate the incentivizing power of the reward.
Taxation
Some RSU programs permit participants to elect to defer the payout of shares to a future date, presumably a time when the participant’s tax bracket is lower than in the year of the original vest. 409A has made elective deferral programs more cumbersome, but they do still exist. A non-elective deferral does not give the participant control over whether or not receipt of the vested shares is deferred. As our panelists in the Conference session “Risk Mitigation for Stock Compensation” pointed out, we are at a point when income tax rates are likely to increase in the near future, which makes deferring income less appealing right now. A company implementing a required deferral of RSU or performance shares should carefully consider how to communicate the program’s goals and application to executives or other employees who will be subject to the deferral.
On a more practical administrative level, deferral of the share payout only defers the income tax withholding requirement. FICA withholding, along with the associated FUTA contribution, are due at the vest date.
Quick Survey on 6039 Returns and Information Statements
Take our quick survey on filing Forms 3921 and 3922 to report ISO and ESPP transactions to the IRS and on distributing the associated information statements to plan participants. Find out how other companies are planning to comply with these new requirements.