Lululemon, an athletic apparel company, recently received some attention from the media because one of their shareholders (a pension fund) is suing them over an increase to their bonus program that their compensation committee approved just before the company announced a $60 million recall. Emily Cervino of Fidelity forwarded an article (“C-Suite Addiction to Stock Options No Bonus for Shareholders“) on the development to me because she knows of my penchant for both stylish workout gear and stock compensation. It’s rare that I get to combine the two interests.
Arrrggh!
The author of the article uses the Lululemon story as a jumping off point to lambast stock options, eventually making the statement that “While stock options are a no-lose proposition for those who get them, they are a no-win situation for existing shareholders.” Which is ridiculous.
For one thing, as far as I can tell, the suit against Lululemon has nothing to do with stock options. The investors are suing over an increase to the executives’ bonus program, not stock options (the reporter’s tenuous connection is that sometimes incentive compensation takes the form of stock options). Moreover, stock options most certainly aren’t a “no lose” deal for employees, any more than they are a “no-win” proposition for shareholders.
In fact, grants of stock options, rather than cash bonuses, might have been a more palatable solution for shareholders in this case. Unlike bonus plans, stock option payouts are non-discretionary. Either the stock price appreciates or it doesn’t. The compensation committee can’t decide to just pay out more under the options (setting aside the possibility of repricing). And if the company announces a major recall just after options are granted, presumably the company’s stock price will decline and the options will be worthless. If the options aren’t worthless, the stock price didn’t decline and investors haven’t lost money as a result of the recall.
Even if we allow the possibility of repricing, most public companies can’t do that without shareholder approval. Bonus plans, however, can typically be changed with just compensation committee approval (unless the plan is intended to qualify as performance based compensation under Section 162(m)).
What Do Responsible Stock Options Look Like?
The conclusion of the article asks readers to comment on how stock options can be structured to reward workers and protect investors, which got me thinking about what responsible options look like for executives. Here are some of the components that I think make for an option program that aligns with shareholder interests:
No mega grants. Small options granted frequently; never more than a single year’s worth of shares in one grant.
Appropriately sized options for everyone, execs included. When granting to execs, the size of grants should be determined based on option fair value, consideration of several possible payout scenarios, and consideration of the amount of wealth the executive has already accumulated through the company’s compensation programs. I know this thought makes me a communist, but really, how much money does one person need?
No flipping for executives. Require executives to fund exercises through netting, sell-to-cover, cash, or other payment methods that don’t require a sale and implement a holding period on the shares issued to the executive. I’m fine with allowing the rank-and-file to flip, however.
Reasonable caps on the option gain for everyone, execs and rank-and-file. You should really be doing this for full value awards as well. It’s a smart way to reduce plan expense with minimal to no impact on perceived value.
Appropriate clawback policies on shares/gain for execs.
No single-trigger vesting acceleration on a change-in-control (for everyone, both execs and the rank-and-file).
No repricing of options held by executives. Only shareholder approved, value-for-value repricing for the rank-and-file, preferably in lieu of that year’s annual grants, with renewed/extended vesting, and cancelled shares that aren’t regranted are retired (rather than returned to the plan).
I often hear that liberal share counting–i.e., allowing shares tendered to the company for net exercises and tax withholding–is a deal-breaker with ISS. Turns out, this isn’t always the case. For full value awards, allowing shares tendered for taxes to return to the plan is okay. Moreover, if you don’t have a flexible share reserve (or a cap on the number of shares that can be issued as full value awards), liberal share counting is also okay.
This is because the only impact of a liberal share counting provision is that ISS will treat all options and SARs as full value awards in their shareholder value transfer analysis. But full value awards are already treated as full value awards in that analysis, so there’s no reason not to use liberal share counting for these awards. And without a flexible share reserve or a cap on the number of shares that can be issued as full value awards, ISS assumes that all shares under the plan will be issued as full value awards.
Black-Out Periods and Post-Exercise Grace Periods
It is possible for stock plans to provide that, where a black-out period occurs during the post-termination exercise period for stock options, the exercise period is automatically extended. This ensures that all former employees have the same amount of time to exercise their options without having to modify the options (and perhaps take an accounting hit) at the time of termination. I imagine it also might head off lawsuits that might be filed if former employees aren’t able to exercise due to a company-imposed blackout. (Of course, in no event, should the extension allow the option to be exercised beyond the original contractual term of the option.)
Shareholder Voting Bias
One consideration in the decision to amend vs. adopt a new plan is that shareholders might have a slight bias for new plans. Just a slight bias–when considering this decision, W.W. Grainger was advised that approval rates for new plans were maybe 1% to 2% higher than for plan amendments–but still, every little advantage helps.
Majority for NYSE Companies
For stock plan proposals, NYSE companies need a majority not just of the votes cast but of their total votes outstanding. That’s a much higher bar to acheive and, since brokers can’t vote on stock plan proposals without receiving direction from shareholders, could be a challenge for companies with high levels of lackadaisical shareholders, e.g., retail investors and probably even employees. When stock plan proposals are in your proxy statement, make sure employees are aware of them and vote.
You’re Not Getting Away With Anything
You may have some older plans with a lot of unused shares still available for grant–maybe even an non-shareholder approved plan that you slipped in before Nasdaq and the NSYE tightened up those requirements–and you (or your execs) may think those plans are flying below the radar. Not so. Your shareholders, particularly institutional investors, and their advisors, are aware of those plans (after all, you are disclosing these plans under Item 201(d) in the proxy statement) and these plans are likely to impact how shareholders will vote on current stock plan proposals. If you aren’t using these plans, maybe it’s time to get rid of them.
The Early-Bird Gets the Vote
You might have been thinking that this webcast was timed oddly–really too late to do anything about stock plan proposals for this year’s proxy season. But, in fact, the webcast was timed just about right for getting started on next year’s proposals. If you expect to go out to shareholders with a proposal that is significant enough that it warrants consideration of amending an existing plan vs. adopting a new plan, you want to start that process about a year ahead of time. Even better would be to start two years ahead of time and get the proposal into your proxy statement a year early, so you have another chance if the proposal fails.
These were just a tiny portion of the many great practical tips presented during the webcast. If you missed it, the audio archive is now available and the transcript will be posted in a couple of weeks.
Online Financial Reporting Course–Only a Few Days Left for Early-Bird Rate There are only a few days left to receive the early-bird rate for the NASPP’s newest online program, “Financial Reporting for Equity Compensation.” This multi-webcast course will help you become literate in all aspects of stock plan accounting, including the practical considerations and technical aspects of the underlying principles. Register by this Friday, April 29, for the early-bird rate.
2011 Domestic Stock Plan Administration Survey The NASPP is excited to announce the launch of our 2011 Domestic Stock Plan Administration Survey, covering administration and communication of stock plans, ESPPs, insider trading compliance, outside director plans, and ownership guidelines. You must participate in the survey to receive the full survey results. Register to complete the survey today–you only have until May 20 to complete it.
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.
Register for the NASPP’s newest online course, “Financial Reporting for Equity Compensation.” Don’t wait; the early-bird rate is only available until this Friday, April 29.
FAS 123(R) (Now ASC 718) eliminated the adverse accounting consequences associated with net exercise that existed under APB 25, making it more feasible for companies to implement net exercise.
What exactly is a net exercise?
The concept of net exercise isn’t unfamiliar. Many companies already employ share withholding on restricted stock or even have a stock-settled SAR program. Like share withholding on restricted stock, a net exercise means that the employee tenders shares back to the company to cover his or her obligations from a transaction. Like a stock-settled SAR, the employee capitalizes on the appreciation in stock price without an output of cash for the exercise price and without a sale of shares.
In a net exercise, when a participant wants to exercise in-the-money shares, the company holds onto enough shares from the exercise to cover the exercise price and delivers the net amount remaining to the employee. For example, if an employee exercises 100 shares of an NQSO with an exercise price of $5.00 at a time when the current FMV is $10.00, then the company retains 50 shares and delivers 50 shares to the employee. Depending on the plan parameters, the shares tendered to the company may return to the stock plan or may be retired. Either way, the exercise does not result in a market sale. The company may also set up the net exercise program to include share withholding to cover the employee tax obligation.
When is net exercise a good fit?
There are many advantages to implementing a net exercise program. If those advantages are important to your company, then net exercise may be a good fit. If your company is concerned about dilution or wants to promote share ownership (especially if your executives are subject to holding or ownership requirements) then net exercise may be particularly appealing. For our top ten advantages of net exercise, check out the March-April 2008 issue of the Stock Plan Advisor.
One truly great aspect of net exercise is that it doesn’t require the company to grant new equity vehicles. Depending on how your company’s stock plan is structured, it may be possible to implement a net exercise program on existing option grants, in which case the company can realize the benefits of net exercise immediately. In fact, even if your plan doesn’t already include net exercises, it may even be possible to add net exercise without the need to obtain shareholder approval.
Net exercise is particularly useful with regards to your executives and Section 16 insiders. For one, because there isn’t a market sale of shares, no Form 144 needs to be filed for a net exercise (only on any subsequent sale). Additionally, the net exercise method provides Section 16 insiders a way to fund their exercise without risking short-swing profit recovery issues that must be considered with a came-day sale. Net exercise is also a particularly effective way to help your executives comply with company share holding or ownership requirements.
A really cool way to take advantage of net exercise is to implement a policy to process a net exercise on in-the-money options that are about to expire. This allows the company to obtain the tax deduction on options that have already been expense, prevents the participant from losing out on option shares they have earned, and doesn’t require brokers to impose a sale of shares that hasn’t been initiated by the account holder.
Issues to Consider
If you are contemplating whether net exercise is right for your company, there are several important issues to consider. Most importantly, take a good look at the goals of your equity compensation program and see if the benefits of net exercise facilitate those goals. If you really want to capitalize on the advantages of net exercise, you may decide to mandate net exercise for all or a portion of your employees.
Then, conduct a careful review of your plan document and grant agreements. In your plan document, check to see what exercise methods are permitted, any requirements around modifications to the plan, and if you have any pesky outdated language regarding the use of “immature” shares. You’ll also want to know if any of your grant agreements limit the methods of exercise that may be used.
The issue of incentive stock options and net exercise is murky. A conservative view is that the use of net exercise ISOs disqualifies the entire grant from preferential tax treatment; while the most aggressive argument is that the shares tendered in a net exercise were never issued, preserving the ISO status of both the delivered shares and the remaining unexercised shares. If you do not wish to exclude ISO grants from your net exercise program, then you’ll need to consult closely with your legal counsel and auditors to determine what your company’s position is.
Finally, your international employee population must also be considered. There may be jurisdictions in which net exercise is either prohibited or where the challenges outweigh the benefits. Before implementing net exercise outside the United States, consult with your advisors.
If you’re looking for more information on net exercise, refer to our practice alert on the benefits of net exercise, this handy net exercise comparison chart, or the session and materials from last year’s Conference session “The Roadmap: How–and Why–to Implement Net Exercises”. You can access the session on our 2009 Conference Materials page in the Plan Design and Redesign section (and don’t forget that you can purchase access if you weren’t able to attend last year).
NASPP Conference 2010
Speaking of our Conference, be sure to get your speaking proposals in for the NASPP Conference this year! You can submit your proposal HERE. If you are wondering how to put together a winning proposal, check out our Top Ten Tips For Creating A Successful Proposal.