Back in December I reported on a shareholder who was sending demand letters to companies alleging that share withholding transactions aren’t exempt from Section 16(b) unless the transaction is automatic, i.e., insiders have no choice in how to pay their taxes (“Shareholder Challenging 16(b) Status of Share Withholding“). I have a few updates on this development.
The Bad News
Back in December, it was just one shareholder but now there at least two more shareholders that are issuing demand letters like this. Also, we’ve now progressed beyond demand letters, with several companies now in litigation over this.
Both Good and Bad News
As noted in the March 2017 issue of Section 16 Updates, the shareholders have submitted demand letters to around 70 companies. One bit of good news is that in most cases, the amount of the alleged short-swing profits has been small, so payments to the shareholders have also been small.
But this is also bad news because it means that most companies would prefer to settle rather than pursuing costly litigation, which is necessary to get clarification on this matter from the courts. As noted in Section 16 Updates:
A clear ruling on the issue is much needed, given the chilling effect that the shareholders’ demand letters have had on the grant and exercise of elective stock withholding rights and the burden that re-approvals have imposed on compensation committees.
The court dismissed the complaint for failure to state a claim, holding in a one-page order that “the transactions in question are compensation related and are designed to be exempt under” Rule 16b-3(e). While a lengthier discussion of the issue might have been more helpful in resolving other pending cases, the court’s holding is nevertheless important because it clearly rejects the plaintiff’s argument that Rule 16b-3 exempts withholding transactions only if they are “automatic.” Moreover, the court allowed reliance on the exemption even where the decision to withhold shares was made by the issuer (i.e., employees) rather than the insider or the compensation committee. The case therefore provides reason to believe that courts will reach a similar result regarding all forms of stock withholding so long as withholding was authorized by the compensation committee as part of the initial equity award.
I’m sure this is a topic that Alan will be discussing in his session “Section 16 & Insider Considerations in Today’s Market” at the 25th Annual NASPP Conference—don’t miss it!
Do your award agreements include the phrase “vesting commencement date” or a similar phrase? A recent lawsuit against Tesla hinges on what it means for vesting to “commence.”
The Lawsuit Against Tesla
A group of former Tesla employees have brought a lawsuit against Tesla, claiming that they should have been able to exercise their options at the time of their termination of employment, even though they had not yet fulfilled the one year of service required for the grants to begin vesting. At the heart of the lawsuit is the language in Tesla’s employment agreement, which states that vesting commences on the first day of employment. The employees have interpreted this to mean that the options were immediately vested at grant.
What Part of “One Year After” Don’t You Understand?
The whole claim seems rather disingenuous to me. As explained in The Recorder (“Trial Opens Over Tesla Options,” March 1, 2016):
The entire dispute turns on a single sentence in Tesla’s employment agreement letter, stating that employee stock options “will vest commencing upon your first day of employment.” But parenthetically added in the employment agreement is the following: “1/4th of the shares vest one year after the vesting commencement date, and 1/48th of the shares vest monthly thereafter over the next three years.”
Given the parenthetical, it seems hard to believe that anyone was really confused about when the options vested.
Key Takeaways
The problem with a lawsuit like this, however, is that no matter how disingenuous it might seem, it won’t go away by itself. Responding to a lawsuit often involves a lot of time, resources, and legal fees. It’s worthwhile to take some precautions to mitigate the company’s risk:
Make sure the language in your employment and grant agreements is clear. Avoid terms that are ambiguous, if possible. If you can’t avoid them, make sure they are clearly defined.
Take off your equity compensation hat once in a while. While a term like “vesting commencement date” might seem obvious to you, it might not be so clear to someone who doesn’t have a background in equity compensation. Plaintiffs’ attorneys are great at exploiting ambiguities.
Keep a record of all information communicated to employees about their awards. In a case like this, educational materials that further clarify how awards vest, possibly with examples, can help bolster the company’s defense.
Does your company issue grants to outside directors out of the same plan that you issue grants to executives and other employees? If do you, does the plan expressly limit the number of shares that can be granted to directors over a specified period of time?
If it doesn’t, you aren’t alone. According to the NASPP/Deloitte Consulting 2014 Domestic Stock Plan Administration Survey, 77% of respondents’ plans don’t include a limit on grants to outside directors. But a recent spate of litigation, including a lawsuit that Facebook recently agreed to settle, suggest that maybe companies should rethink this practice.
What Litigation?
The lawsuits cover a range of issues related to stock and executive compensation. Some suits allege excessive compensation and some allege deficiencies over stock plan disclosures or proxy disclosures. In addition to Facebook, companies that have been targeted in these suits include Republic Services, Citrix Systems, Goldman Sachs, Cheniere Energy, and Unilife. One common denominator in all of these suits, however, is that the plaintiffs allege that because the company’s outside directors can receive unlimited awards under the plans, they aren’t disinterested administrators of the plan.
Why Is Disinterested Administration Important to these Lawsuits?
These lawsuits are all “derivative” actions (which are lawsuits brought by a shareholder on behalf of the corporation, usually alleging that management is doing something that is to the detriment of the corporation). In a derivative lawsuit, the plaintiff has to meet a “demand” requirement for the suit to proceed. Demand means that the plaintiff asked the company to investigate the matter and the company either refused to investigate or the shareholder doesn’t agree with the outcome of the investigation. In a lot of cases, these suits never get past the demand stage.
But, there is an exception to the demand requirement in lawsuits over stock compensation plans. Can you guess what it is? Yep, that’s right, the demand requirement is excused if a majority of the directors administering the plan lack independence. Plaintiffs are claiming that directors who can receive unlimited awards under a plan aren’t disinterested.
What Happened with Facebook?
Well, first of all, once a suit gets past the demand stage, it gets expensive. So the first thing is that Facebook had to spend a bunch of money on their own lawyers. That, in and of itself, is reason enough to want to keep any of these suits from getting past the demand stage.
The settlement Facebook agreed to includes the following provisions:
Corporate governance reforms, including (A) an annual review of all compensation (cash and equity) paid to outside directors, (B) engage a compensation consultant to advise the company on this review and on future compensation to be paid to outside directors, and (C) use the results of the review to make recommendations to the board on future compensation to outside directors.
Submit the 2013 grants to outside directors to shareholder vote (these grants were the subject of the lawsuit). Hopefully the shareholders approve them–I’m not sure what happens if they don’t (but I’m pretty sure it would make a good blog entry).
Submit an annual compensation program for directors to shareholders for approval. The program has to include specific amounts for equity grants and has to delineate annual retainer fees. As far as I can tell, this is a one-time requirement, for Facebook’s 2016 meeting; if I understand the settlement correctly, the board is allowed to make changes to the program in the future, commensurate with the results of the annual review required under #1 above.
Pay an award of attorneys’ fees and expenses to plaintiff’s counsel not to exceed $525,000 (this is, of course, in addition to whatever Facebook has paid to its own counsel).
A Simple Fix
The simple fix to avoid all of this is to have a limit on the awards that can be issued to outside directors in your plan. If your company is submitting a stock plan to shareholder vote this year, it is worth considering adding a limit like this to your plan.
Thanks to Mike Melbinger of Winston & Strawn for providing a handy summary of the Facebook settlement, as well as a number of the other lawsuits, in his blog on CompensationStandards.com (see “Follow-Up on Facebook Litigation Settlement,” January 29, 2016).
It’s once again proxy season and many companies will be asking their shareholders to vote on proposals relating to their stock plan. Most of these proposals probably add more shares to the plan, but there are a number of other plan amendments companies might seek shareholder approval for, including:
To add a new type of award that can be granted under the plan
To change the employees eligible to participate in the plan
To increase the limit on the number of shares that can be granted to one employee or some other plan limit
To extend the term of the plan
In some cases, companies aren’t making any changes at all to the plan, but are merely seeking shareholder approval to preserve the plan’s exempt status under Section 162(m) (where a plan doesn’t state the specific performance conditions that awards will be subject to, the plan has to be approved by shareholders every five years).
To Bundle or Not Bundle
It is not unusual for a company to have two or more changes to their stock plan that they are asking shareholders to approve. Where this is the case, the company can bundle all the changes into one proposal or can present each change as a separate proposal subject to a separate vote.
Bundling presents shareholders with an all-or-nothing proposition; they either approve all the changes or they approve none of them. It seems to me that this could go either way for the company. If shareholders are a little opposed to some of the changes but mostly supportive, they might overlook their niggling doubts and vote for the proposal. On the other hand, if shareholders strongly oppose one of the changes, they might vote against the entire proposal and the company doesn’t get any of the changes that it wanted.
Shareholders Wanting Their Cake and Eating It Too
Mike notes in his blog that there have been some recent lawsuits alleging improper bundling of changes (and expresses hope that the SEC’s new CDI will help resolve/prevent these suits), particularly where one of the changes is beneficial to shareholders. This is interesting to me because my guess is that where a company bundles a shareholder-friendly change with another change, the shareholder-friendly change is probably included solely to pave the way for shareholders to approve the other change.
For example, a company might bundle a proposal allocating new shares to the plan with an amendment to restrict the company from repricing options without shareholder approval. The repricing restriction is likely included because the company has received negative feedback from shareholders on this issue (repricing without shareholder approval is considered a poor compensation practice by ISS) and is afraid the share allocation won’t be approved without it. The two proposals have a symbiotic relationship: the company isn’t willing to agree to the repricing amendment unless shareholders agree to the share allocation. Forcing companies to unbundle the two amendments means the company could end up having to implement the shareholder-friendly amending without getting the other change that it wanted.
A Poll
I conclude this blog with a short poll on how you are handling your shareholder proposals this year.
For today’s entry, I have several follow-up items relating to a few of my recent blog entries.
Your Favorite Words 10 pts. to Sheila Jan of Life Technologies for accepting my challenge in “Holiday Fun” (December 18, 2012) and submitting her own favorite word with an example of how it might be used at a holiday gathering. Sheila’s submission:
Tranche: I’m going to help myself to a second tranche of the mashed potatoes!
A Little More on Excess Withholding Susan Eichen of Mercer reminded me that allowing employees to use share withholding to cover more than just the statutorily minimum required tax payment will trigger liability treatment under ASC 718, even if the proscribed W-4 procedures are followed (see my blog entry from last week, “Supplemental Withholding“). If the difficulty of the W-4 withholding process wasn’t enough, this makes one more reason to prohibit excess withholding for restricted stock and units (for NQSOs, where shares are generally sold on the open market, rather than withheld, to cover taxes, this is less of a concern).
Proposed Regs on New Medicare Tax The IRS has issued proposed regs on withholding the additional 0.9% Medicare tax that applies to wages in excess of $200,000 for individuals/$250,000 if married filing jointly. No surprises here, the procedures are as I described them back in August (“The Supreme Court and Stock Compensation“):
The company withholds the additional 0.9% tax on any wages in excess of $200,000 that are subject to Medicare, regardless of the employee’s filing status or wages paid to his/her spouse.
Any overpayments or underpayments as a result of the employee’s filing status/spousal income will be sorted out on the employee’s tax return. The company has no obligations here.
Employees can’t request that the company withhold additional Medicare tax (for example, if they have received wages of less than $200,000 but know that their wages, when combined with their spouse’s wages, will exceed $250,000). In this case, employees should submit a new Form W-4 to increase their withholding for federal income tax purposes. This will then offset the deficit in Medicare withholding when they file their tax returns.
Follow-up on Lawsuits Targeting Stock Plan Proposals On November 6 (“Martha Steward and Your Proxy Statement“), I blogged about a new type of shareholder lawsuit that seeks to extract plaintiffs’ attorney fees from companies by alleging that the disclosures in connection with their stock plan proposals (e.g., adopting a new stock plan or allocating shares to an existing plan) are inadequate. There now have been over 30 of these suits filed, with no end in sight as proxy season ramps up. We’ve posted a new alert, “Shareholder Lawsuits Target Stock Plan Proposals,” that collects several law firm memos on the suits as well as a interesting commentary on them from Stanford (“Shareholder Lawsuits: Where Is the Line Between Legitimate and Frivolous?“). It’s worth your time to catch up on this issue.
By now, you are probably finishing off any remaining leftovers from Thanksgiving. On that theme, I have a few leftover items for the blog and now seems like a good time to use them up. Sort of like making a casserole out of turkey, mashed potatoes and stuffing, but not quite as tasty.
Update on Proxy Disclosure Lawsuits On November 6, I blogged about plaintiffs’ attorneys that are now bringing lawsuits alleging that companies’ disclosures related to their stock plan or Say-on-Pay proposals are inadequate (“Martha Stewart and Your Proxy Statement“). The lawsuits seek an injunction to delay the shareholder votes on these proposals (which, in effect, delays the annual meetings); companies targeted by these attorneys are faced with settling and paying out plaintiffs’ attorney fees in the six figures (up to $625K) to avoid a delay.
Last week, Mike Melbinger provided an update on this issue in his Compensation Blog on CompensationStandards.com. To date, 20 companies have been targeted and at least six have settled, meaning that they agreed to make additional disclosures and pay fees to the plaintiffs’ attorneys. At least one company (Brocade Communications) also had to delay the vote on their stock plan proposal (although they did hold their annual meeting on time). At least three companies (Clorox, Globecomm Systems, and Hain Celestial) got courts to reject the injunction. And Microsoft got the law firm that filed the complaint (Faruqi & Faruqi, which has initiated most of these suits) to withdraw it. The article “Insight: Lawyers Gain from Say-on-Pay” Suits Targeting U.S. Firms,” published by Reuters on November 30, has a good summary of the various suits.
This is an opportunity for you, as a stock plan administrator, to demonstrate the value that you bring to the table. Make sure that your legal department is aware of the potential for these lawsuits, so that if your company is targeted, they aren’t caught offguard. You also might want to forward the memo we’ve posted from Orrick to legal (“New Wave of Proxy Statement Injunctive Lawsuits: How to Win & Prevent Them“), which include thoughts on strengthening your disclosure so they will be more likely to withstand one of these lawsuits.
IFRS: Hot or Not? An article published on November 13 in Accounting Today (“SEC Still Has Reservations about IFRS” by Michael Cohn) reports on comments by SEC officials at FEI’s 31st Annual Current Financial Reporting Issues conference on where the SEC stands on IFRS. The upshot is that SEC researchers have identified a number of concerns with adopting IFRS in the US and that the SEC is still taking a wait and see approach. Some of the areas the researchers looked at were the cost of conversion, whether or not IFRS makes sense for US capital markets, the interpretative process, the impact on private companies, investor understanding, and what our exit strategy might be if the US adopts IFRS and it backfires. Based on this report, I’d say we still have a long ways to go before we are under IFRS (or some sort of equivalent) here in the US.
Of course, things may change now that there will be a new chair at the SEC.
Even the SEC Makes Mistakes The next time someone finds a typo in something you’ve written, you can point out that you are in good company. In his blog for Allen Matkins, Keith Bishop notes a number of errors on the Form 10-K posted to the SEC website (“The SEC’s Form 10-K: ‘In Endless Error Hurled,'” April 11, 2012), including cites to regulations that don’t exist and outdated instructions. I feel a lot better now about the myriad typos I’m sure can be found in my blogs. If the SEC isn’t perfect, how can the rest of us be expected to be error-free?
More Than You Ever Want to Know About Stock-for-Stock Exercises I spent an hour or so today drafting a 1,200-word essay in response to a question in the NASPP Discussion Forum about stock-for-stock exercises. I’m so pleased with my response that I wish I had another use for it. But I don’t, so I’m mentioning it here in the hopes that a few more people will read it. If you want to understand what a tax-free exchange of property is (and what it isn’t), check out Topic #7391.
Shout-Out Finally, a shout-out to Sara Spengler at Facebook for suggesting the Thanksgiving tie-in for today’s blog entry.
If you are an issuer that will be submitting a request for additional shares for your stock plan to a shareholder vote in the upcoming proxy season, you need to read this blog. I’m filing this under “don’t say I didn’t warn you.”
What Does Martha Stewart Have to Do With This?
A while back, a short blurb about Martha Stewart Living Omnimedia caught my eye and I put it in my back pocket for a future blog entry if I ever figured out what the heck it was about. The blurb appeared in Mark Borges’ proxy disclosure blog on CompensationStandards.com:
Martha Stewart Living Omnimedia Inc. was the target of a shareholder class action lawsuit alleging that the company’s disclosure in connection with a proposal to increase the share reserve of its omnibus stock plan was inadequate.
This intrigued me because:
In my other, non-stock compensation life, I secretly want to be Martha Stewart (but with better hair and no insider trading scandal), so I’m fascinated by anything involving her. (Don’t scoff–I’m very crafty! I make all my own window treatments, can refinish a dining room table, and can whip up some pretty tasty jams and jellies.)
It involved the company’s stock plan, which falls squarely into the category of “things I care a lot about.”
Now, thanks to Mike Melbinger’s Oct 26 blog entry on CompensationStandards.com, I’ve finally figured out the implications of the lawsuit and determined that, if you are an issuer, it should be something you care a lot about as well.
Lawsuit Over Stock Plan Disclosures Could Delay Shareholders Meeting
There have now been several similar lawsuits filed. The lawsuits allege that the company’s disclosures relating to stock plan or Say-on-Pay proposals are inadequate and seek to delay the shareholders meeting. As Mike explains it:
[Companies] are forced to decide between (a) paying the class action lawyers hundreds of thousands of dollars of attorneys’ fees and issuing enhanced disclosures or (b) fighting the matter through a preliminary injunction hearing, which may have the effect of delaying [their] shareholder meeting (and create additional legal fees).
One company has already paid $625K to plaintiff attorneys to settle a similar lawsuit and, while they didn’t have to delay their entire annual meeting, they still had to delay the vote on their stock plan and file a supplement to their proxy statement with additional disclosures about the plan.
What Can You Do?
Mike asks “Does that sound like Armageddon?” and I’d say that it sure sounds like that me. Mike says that it is too soon to panic but suggests taking extra care in drafting your disclosures relating to any stock plan proposals and your Say-on-Pay propoals. A recent memo we posted from Orrick has suggestions for fortifying both types of disclosures against attack. Here are their suggestions for disclosures relating to any stock plan proposals:
Disclose the number of shares currently available for issuance under the stock plan and explain why the existing share reserve is insufficient to meet future needs. Consider citing your current burn rate and anticipated shares needed for new grants over the next year.
Explain how the remaining shares in the reserve and the new shares will be used and how long the new share reserve is expected to last.
Describe how you determined the number of shares you are requesting approval of.