For today’s blog entry I have a couple of recent developments that don’t really warrant a blog entry of their own.
T+2: It’s Happening
The SEC has adopted an amendment to the Settlement Cycle Rule (Rule 15c6-1(a) of the Exchange Act) to move to T+2. The new settlement cycle will commence on September 5 (the day after Labor Day). I already blogged about this—twice—so I don’t really have any more to say on the topic (see “T+2: What’s It to You” and “Progress Towards T+2“). We hosted a great webcast on it in April (“Be Prepared for T+2“); if you aren’t up to date on this development, be sure to check it out.
FASB Issues Modification Accounting ASU
Yesterday the FASB issued ASU 2017-09 (not to be confused with ASU 2016-09—right, no one is going to get these confused), which redefines when modification accounting is required under ASC 718.
All companies have to adopt the ASU by their first fiscal year beginning after December 15, 2017. Early adoption is permitted. Once adopted the ASU applies prospectively. Unlike with ASU 2016-09, if ASU 2017-09 (yep, not confusing at all) is adopted in an interim period, prior interim periods in the same year are not adjusted.
Riddle me this: when is a benefit not a benefit? The answer: when that benefit results in a change to the terms and conditions of an ISO. Making changes to ISO can have the unfortunate effect of disqualifying the options from ISO treatment, which might make the optionees less than enthusiastic about the new “benefit.”
The Uber Case
This was highlighted in a recent class-action lawsuit brought by an Uber employee (McElrath v. Uber Technologies). McElrath, an employee of Uber and the plaintiff in the suit, was promised an ISO that vested over four years in his offer letter. But, when the ISO was granted, the vesting schedule was shortened to just six months. This caused a much greater portion of the ISO to exceed the $100,000 limitation. The plaintiff contends that Uber changed the vesting schedule to ensure a corporate tax deduction for the option.
There could be any number of legitimate reasons for Uber to grant the options with a shorter vesting schedule than stated in the offer letter. Additionally, shorter vesting periods certainly offer benefits to employees. I suspect that many companies consider acceleration of vesting to be a change they can make without an award holder’s consent. But this illustrates that, when it comes to ISOs, it is important to consider the tax consequences to the optionee before making any changes.
Modifications, Too
The Uber case doesn’t involve a modification, just a discrepancy between what was granted and what was promised in the offer letter. But this concept also applies any time an ISO is modified. Any change that confers additional benefits on the optionee (other than acceleration of exercisability and conversion of the option in the event of a change-in-control) is consider to be the cancellation of the existing ISO and the grant of a new option. If the new option doesn’t meet all of the ISO requirements (option price at least equal to the current FMV, granted to an employee, $100,000 limitation, etc.), the option is disqualified from ISO treatment.
And, while acceleration of exercisability (which most practitioners interpret to mean vesting) doesn’t result in a new grant, there is still the pesky $100,000 limitation to worry about. In many cases, acceleration of exercisability will cause an ISO to exceed this limitation.
Where a modification disqualifies all or a portion of an option from ISO treatment, it is important to consider whether it is necessary for the optionee to consent to the modification. Most option agreements stipulate that any changes that adversely impact the optionee cannot be executed without the optionee’s consent. Keep this in mind the next time your compensation committee has a bright idea about making existing ISOs better.
Last week, I blogged about the FASB’s recent update to ASC 718, which clarifies when modification accounting is required for amendments to outstanding awards. The genesis for this update is the amendments companies are making to their share withholding provisions in light of ASU 2016-09. So the question is: will the update be final in time for companies to rely on it for their share withholding amendments?
Timing of Share Withholding Amendments
Calendar-year public companies have to adopt ASU 2016-09 by this quarter and presumably will want to amend the share withholding provisions in their plan at the same time or shortly thereafter. Unfortunately, the update on modification accounting (which doesn’t have an official number yet) won’t be issued until April, at the earliest.
Consider Waiting
One obvious alternative is to wait until the update is issued to amend plans and award agreements. But companies with major vesting events happening before then may want to amend their plans and awards sooner.
Hope for the Best
Once the update is issued, companies can adopt it early. The update clearly won’t be issued in time for it to be adopted in calendar Q1, but companies should be able to adopt it in calendar Q2. When companies adopted ASU 2016-09 in an interim period, they were required to apply it to prior interim periods in the same year. We don’t know for sure that this requirement will apply to the update on modification accounting, but it seems reasonable to assume that it will (it applies to many, if not all, ASUs issued lately by the FASB).
Thus, if calendar-year companies amend their awards in Q1 and account for the amendments as modifications, it’s possible that early adopting the modification accounting update would allow them to reverse that treatment.
Maybe Auditors Won’t Make Companies Wait for the Update
Lastly, my understanding is that—even without the FASB’s update—some auditors don’t think amending a share withholding provision requires modification treatment. The few comment letters that opposed the update did so on the basis that it is unnecessary because this conclusion can already be reached under the current standard.
The FASB’s recent vote on the update (which was unanimous with respect to the question of when modification accounting should be required) provides a clear indication of the board’s attitude. Given that, perhaps the actual issuance of the final update is a mere formality and most (maybe all) auditors will come to the conclusion that modification accounting isn’t required for share withholding amendments even without the final update. But I wouldn’t assume this without discussing it with your auditors.
In late February, the FASB met to review the comments received on the exposure draft of the proposed update to modification accounting under ASC 718 (see “ASC 718 Gets Even Simpler“) and voted to go ahead with the changes.
What’s Changing
The update clarifies that when the terms of an award are amended, modification accounting is required only if the amendment causes one of the following things to change:
The current fair value of the award
The vesting provisions
The equity/liability status of the award
The Comment Letters
The FASB received only 15 comment letters on the exposure draft and 12 of those were in support or it. The three letters that opposed the proposal did so at least in part because they felt that the above conclusion can already be drawn from the current standard. (Although, board member James Kroeker noted that one of the firms that opposed the proposal had previously contacted the FASB with technical inquiries as to what types of amendments require modification and had suggested that the FASB issue the update because they felt that there is diversity in practice. Go figure—perhaps the people writing the letters don’t communicate with the people actually doing the work.)
The FASB’s Decision
The FASB voted to go ahead with the proposed update, with only a few clarifications:
The determination of whether the fair value has changed should be consistent with the approach used to determine incremental cost for modifications. In general, this is determined on an award basis (rather than a per-share basis or an aggregate basis for all awards modified at one time).
The disclosures related to material modifications are required even if the amendment doesn’t trigger modification accounting.
Not So Fast; This Isn’t Final Yet
The FASB staff still has to draft the final language of the update and the FASB has to approve it. The staff anticipates issuing the final update in April 2017. Public companies will have to adopt it by the start of their first fiscal year beginning after December 15, 2017. Early adoption is permitted, but not before the official ASU is issued.
Could I Possibly Use the Word Modification More in One Blog Entry?
I doubt it. Here is this blog entry in a nutshell: As a result of technical questions that arose in the context of the prior modification to ASC 718, the FASB voted to go forward with a proposed modification to ASC 718 to stipulate that award modifications are subject to modification accounting only when the fair value, vesting conditions, or status of awards are modified, but the FASB had a few modifications to the proposed modification. The next time the FASB decides to update ASC 718, I hope the change doesn’t have anything to do with award modifications.
It will come as no surprise to any of you that accounting for modifications under ASC 718 is complicated. In the aftermath of the issuance of ASU 2016-09, the FASB has received a number of questions about whether amending a stock plan or award to allow shares to be withheld for more than the minimum statutorily required tax payment would trigger modification accounting under ASC 718. It probably seems crazy to you that we even have to consider this question and I guess it also seemed that way to the FASB, because they’ve issued an exposure draft to amend ASC 718 to clarify that this sort of change isn’t a modification.
ASC 718 currently says that any change whatsoever to an award is considered an modification and goes on to define four types of modifications: probable-to-probable, probable-to-improbable, improbable-to-probable, and improbable-to-improbable. The accounting treatment varies based on which type of modification you are dealing with and for some types of modifications, a new valuation of the award is required even if the value of the award isn’t changed as a result of the modification. Hence, the concern about the amendments relating to share withholding, even though these amendments arguably don’t materially increase the value of an award to the award holder.
So the FASB has proposed an amendment to ASC 718 that would clarify that not every change to the terms and conditions of an award requires modification treatment. Instead, a change to the terms and conditions of an award would require modification treatment only if at least one of the following conditions is met:
The fair value of the award is changed as a result of the amendment. For purposes of determining if there is a change in fair value, the fair value of the award immediately following the amendment would be compared to the fair value immediately beforehand (rather than to the grant date fair value). Generally, there would be no change in fair value if the amendment does not impact any of the inputs necessary to determine the award fair value.
The amendment modifies the vesting conditions of the award.
The amendment causes the classification of the award to change (from equity to liability or vice versa).
Amending a plan or award to allow additional shares to be withhold for taxes would not meet any of the about conditions (provided the share withholding is still limited to the maximum individual tax rate in the applicable jurisdiction) and, thus, under the proposed amendment, there would be no question that this is a modification. Even without the proposed amendment to ASC 718, I believe that many practitioners would not treat this as a modification.
Comments may be submitted on the exposure draft until January 6, 2017. The update would be applied prospectively only, thus the accounting treatment for any prior modifications of awards would not change. The exposure draft does not specify an effective date.
Earlier this summer, Apple announced that CEO Tim Cook’s previously granted RSU for 1 million shares will be modified to vest contingent on relative TSR–per his own request. In today’s blog entry, I take a look at this development.
The Modification
Cook’s award was granted in 2011 and originally vested as to 500,000 shares in August 2016 and another 500,000 shares in August 2021. I’m sure you can guess what I thought of the original award, based on my prior entries covering Apple and mega grants (“Steve Jobs’ Affinity for Mega Grants,” April 28, 2009, and “And Another Thing,” May 5, 2009).
As modified, 100,000 shares still vest in August 2016 and 2021, regardless of performance. The remaining shares vests in increments of 80,000 per year, from 2012 to 2021, with the vesting in years 2014 to 2021 subject to a relative TSR goal (a small portion of the shares vesting in 2013 is also subject to a relative TSR goal). The TSR goal is applicable to 50% of each 80,000-share vesting tranche–so 40,000 shares vest every year regardless of Apple’s TSR and another 40,000 shares vest if specified TSR thresholds are achieved.
Why Do This?
What’s most interesting about this story is that the award was modified at the request of Cook. Past examples of companies modifying awards to vest contingent on performance conditions have been executed under threat of a failed Say-on-Pay or stock plan proposal or in response to a failed Say-on-Pay vote (“Eleven and Counting,” May 3, 2011). So why would Cook voluntary ask for his award to be modified? The stated reason (Apples’ Form 8-K, June 21, 2013) is that Apple is going to be granting performance awards to executives in the future and Cook wants to lead by example. Which could be true, but I’m a skeptic, especially when it comes to grants of stock currently worth close to $500 million. So I wondered, was the real reason:
To demonstrate confidence in Apple’s products and performance
To make other CEOs look bad
Because Cook is worried he won’t perform well if not properly motivated
Because Cook really wants his personal wealth to be better aligned with Apple’s shareholders’ wealth
After gestating on this question for a while, my suspicion is that it was a preemptive strike. In the 8-K announcing the change, Apple says:
“In outreach discussions this year with many of our largest shareholders, we heard that they believe it is appropriate to attach performance criteria to a portion of our future executive stock awards that have been entirely time-based (i.e., vesting for continued service) in the past.”
I think that Cook saw awards held by other CEO’s modified in response to shareholder pressure and thought it might be smart to get out ahead of any demands for the same thing from Apple’s shareholders. This way, he has more control over the modifications and was able to ensure that over 50% of the award still vests based solely on the passage of time.
More on Say-on-Pay and Performance Awards
Tune in tomorrow for the NASPP’s webcast “Performance Equity Design in Light of Say-on-Pay,” which will take a look at the pressure to grant performance awards that has resulted from Say-on-Pay votes and how this is changing long-term incentive programs.
One of the most common types of “unplanned” modifications I see in my consulting work, which we will cover in our presentation, is that of vesting modifications.
The text of the ASC 718 standard says this about modification accounting: Modifications of Awards of Equity Instruments
51. A modification of the terms or conditions of an equity award shall be treated as an exchange of the original award for a new award. …In substance, the entity repurchases the original instrument by issuing a new instrument of equal or greater value, incurring additional compensation cost for any incremental value. The effects of a modification shall be measured as follows:
a. Incremental compensation cost shall be measured as the excess, if any, of the fair value of the modified award determined in accordance with the provisions of this Statement over the fair value of the original award immediately before its terms are modified, measured based on the share price and other pertinent factors at that date. … b. Total recognized compensation cost for an equity award shall at least equal the fair value of the award at the grant date unless at the date of the modification the performance or service conditions of the original award are not expected to be satisfied. Thus, the total compensation cost measured at the date of a modification shall be (1) the portion of the grant-date fair value of the original award for which the requisite service is expected to be rendered (or has already been rendered) at that date plus (2) the incremental cost resulting from the modification.
But then the examples in ASC 718-20-55-111 through ASC 718-20-55-118 go on to delineate four, count them four, different types of vesting modifications, with two different treatments:
Type I: Probable to Probable: Recognize fair value of original award + incremental expense, if any.
Type II: Probable to Improbable: Recognize fair value of original award + incremental expense, if any.
Type III: Improbable to Probable: New fair value only. Reverse expense for any unvested shares.
Type IV: Improbable to Improbable: New fair value only. Reverse expense for any unvested shares.
Type II and Type IV are incredibly uncommon, but we DO see a good number of Type I and Type III. Type I are often triggered by option exchanges, or any modification to already vested shares, like an extension of exercise grace period at termination. Type III modifications are also quite common at the time of termination when unvested shares are accelerated.
How do you handle the modifications? First, decide if they are Type I or Type III. If the shares are vested, chances are good you are dealing with a Type I. If the shares would have been cancelled if not for the termination, then chances are good you have a Type III. If a Type I, perform two fair value calculations: one before the change, and one after, and compare the expense to determine your incremental expense. If a Type III, you need only one fair value calculation, using the attributes of the grant after the modification. Calculate how much expense has already been booked for the unvested shares in the grant and true up (or down) to the new fair value.
There is good news about most modifications, especially those at the time of termination: they are generally fairly simple one-time calculations where all the expense is booked immediately. Once and done. The bad news is that most systems have limited support for modification accounting and the inputs can be quite tricky. What is the expected term of an underwater option before it is exchanged for a new option? Is it the remaining expected term from the original grant date fair value? The remaining contractual life? An expected term calculated by a Monte Carlo simulation? Each company must decide for itself. A few examples in the standard seem to point to remaining contractual term, but the Monte Carlo simulation approach seems to fly past audit as well. No two audit firms, or audit partners, seem to have the same opinions.
Join me and my talented co-panelists in New Orleans as we wrestle modification accounting to the ground and give you a solid understanding of the required treatment and some varying interpretations. Laissez Les Bon Temps Roulez!
Say-on-Pay vote failures have picked up, with more failures last week than any other week so far this proxy season. Today I provide an update on the latest Say-on-Pay stats and comment on a couple of companies that recently modified options granted to their CEOs in response to shareholder feedback related to their Say-on-Pay votes.
Say-on-Pay: The Latest Data Broc Romanek and Mark Borges have been keeping track of Say-on-Pay votes in their respective blogs on TheCorporateCounsel.net and CompensationStandards.com. Last week, Navigant Consulting, Cogent Communications, MDC Holdings, and Janus Capital were the eighth, ninth, tenth, and eleventh companies to report that their Say-on-Pay proposals failed.
Say-on-Pay Frequency
Say-on-Pay Frequency votes seem to be primarily ending up in the annual camp; if my math is correct, of the companies that have held and reported votes thus far, 72% have reported that shareholders prefer annual votes. Many companies have put forth a recommendation for an annual vote, rather than risk the embarrassment of shareholders voting against managements’ recommendation.
Even so, a triennial vote is a possible outcome–Mark Borges reports that, of the 235 companies where the board has recommended a triennial vote (and the companies have reported vote results), only 43% have reported that shareholders indicated a preference for annual votes. Fascinatingly, at one company (Qualstar), management recommended an annual vote but shareholders preferred a triennial vote.
Options Modified in Response to Shareholder Feedback
I think it is also notable that, in the last two weeks, two companies, GE and Lockheed Martin, announced modifications to options held by their CEOs. The modifications added performance targets to options that were previously only service-based. In both cases, the modified options now vest based on two independent performance goals (50% of the options vest when one goal is met and 50% vest when the other goal is met). In Lockheed’s case, one goal is based on cash from operations and the other is based on ROIC. For GE, one goal is also based on cash-flow, but the other goal is tied to relative TSR–which adds a market condition to an option that was previously only service-based. I’m very intrigued by the accounting implications–or possible lack thereof–of these modifications and I hope to look at them at length in an upcoming issue of The Corporate Executive.
According to SEC filings submitted by both companies, the options were modified in response to conversations they had with shareholders (and ISS, we imagine). It seems likely that the modifications were necessary to ensure passage of their Say-on-Pay votes and are illustrative of the level of power Say-on-Pay has given shareholders.
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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.
Register for 19th Annual NASPP Conference (November 1-4 in San Francisco). Don’t wait; the early-bird rate is only available until May 13.
Attend your local NASPP chapter meetings in San Diego and Wisconsin. Robyn Shutak, the NASPP’s Education Director, will be at the San Diego meeting–be sure to say hello!
Last week I explored the connection between the affirmative defense provided under Rule 10b5-1(c) and appropriate timing of Rule 10b5-1 trading plans. The same interpretive guidance that got me thinking about creating 10b5-1 trading plans also clarified some issues around the modification or termination of trades under existing Rule 10b5-1 trading plans.
Modifying a Transaction
Any investor may have situations where they want to change their trading behavior based solely on circumstances that are not connected to insider information, including your company’s own insiders. For example, an insider may have an existing plan that includes the sale of 20,000 shares, intending to use the cash generated from the sale to cover a balloon payment that is due on his or her mortgage. If the stock price drops unexpectedly before the trade takes place, the insider may wish to increase the number of shares being sold under the trading plan. In fact, the SEC does say that modifications made “in good faith” may be acceptable.
However, modifications of trades under a Rule 10b5-1 trading plan are not a good practice for insiders. The interpretive guidance from the SEC makes it very clear why. In response to question 120.16, the SEC clarifies that the modification of a trade is the same as terminating the existing trade and entering into a new plan for that trade. Since the modified transaction is considered to be under a new trading plan, the new plan is subject to the same requirements in order to qualify for the affirmative defense under Rule 10b5-1(c), the insider should not be in possession of material nonpublic information at the time of the modification.
One Transaction, One Plan
What’s more, in response to question 120.19 the SEC clarifies that the termination of one or more transactions within a plan is the same as terminating the entire plan and entering into a new plan for all transactions under the plan. Therefore, at the point of the termination of one transaction, all the remaining transactions must still meet the requirements of Rule 10b5-1(c) in order to rely on the affirmative defense. Because this is virtually impossible for your company’s insiders during a closed window, it’s a good idea to require pre-clearance for both modifications and terminations of trades within a plan to ensure that the “new” trading plan created by the modification or termination of a trade still falls within the parameters of your insider trading policy.
Terminating the Entire Plan
So, what about the termination of an entire plan? In isolation, there isn’t necessarily an issue with terminating an entire plan. However, in most cases, an insider terminating a plan will want to enter into a new one. This is where the concept of “good faith” comes into play. In addition to not being in possession of material nonpublic information at the creation of a Rule 10b5-1 trading plan, the insider may not enter into a plan that is “part of a plan or scheme to evade” the prohibitions under Rule 10b5-1(c). Therefore, what happens after the termination of a Rule 10b5-1 trading plan will be key to determining if the termination of the plan was in good faith. In real terms, that means that the insider will want to avoid any appearance that the plan was terminated based on inside information.
As an example, let’s assume that an insider has an existing Rule 10b5-1 trading plan that includes a market sale of 10,000 shares. At some point prior to the sale, that insider learns about an upcoming acquisition that is anticipated to greatly increase the value of the company’s stock. In response to this knowledge, the insider terminates the existing plan and enters into a new plan in the next open trading window, after the acquisition has been disclosed or completed and when the company share price has gone up. The new plan has all the appearances of meeting the requirements for a Rule 10b5-1 trading plan. However, in this case the old plan wasn’t terminated in good faith, and the affirmative defense of Rule 10b5-1(c) may not be available.
Cooling Off Period
One of the reasons that a “cooling off” period between the creation of a Rule 10b5-1 trading plan and the first trade under that plan is highly recommended is to maintain the appearance of good faith. So, what about a situation where an insider wishes to terminate an existing plan and enter into a new one for the purposes of adding a new transaction to the plan and one or more of the original transactions is set to take place almost immediately? Obviously, each situation needs to be analyzed individually, but in most cases this shouldn’t cause an issue with complying with Rule 10b5-1(c). Even though each of the transactions within the new plan, including those carried over from the old plan, are subject to the prohibitions under Rule 10b5-1(c), your company should be able to take the position that trades carried forward unmodified from an old plan are considered to be made in good faith.
You can find more information on Rule 10b5-1 trading plans on our Rule 10b5-1 portal.