As I write this blog, the buzz is escalating around the imminent IPO of social media site Twitter. I don’t think there’s been this much anticipation for an IPO since Facebook joined the ranks of public companies last year. It’s like the perfect storm of variables – stock compensation, hot IPO, and the prospect of significant wealth. Yet, with every party there are “party poopers”, and the Twitter party is no different. That’s why I wasn’t entirely surprised when Senators Levin and McCain tried to crash the party yesterday with a joint statement pushing once again to eliminate the corporate tax deductions on stock compensation.
What is it this time?
It’s likely the Senators are following the lead of Citizens for Tax Justice (a left-leaning tax activist and research group), who earlier this week released results of an analysis of 11 public companies and Twitter, suggesting that the cumulative corporate tax deductions in the coming years for these 12 companies would be in the billions of dollars. So what is new and different in the latest argument that companies are somehow avoiding paying taxes on stock compensation and that this “loophole” should be avoided? Well, not much. There have been many NASPP Blogs on this topic in the past, so I’ll let you catch up on the nuances of the corporate tax deduction through those. The latest justification the Senators offer for ending this perfectly reasonable deduction appears to be that “…given the deficit and damaging sequester cuts facing this country, this corporate stock option tax deduction is the kind of tax loophole that ought to be closed.” Huh? Now this is the solution to a slew of other fiscal issues?
Another Battle in a Long War…
Senator Levin has been waging this battle for years, so it seems every time there is a new opportunity, he’ll raise the issue again, with a new twist. The reality is, and this is often overlooked in media analysis of the Senators’ calls to action, for every dollar of corporate tax deduction taken for stock compensation transactions, there is a dollar that is taxable income to an employee. Companies are not “avoiding” paying tax – the tax is being paid by the employee. Another tidbit I’ll point out is that starting January 1, 2013, the maximum individual tax rate was increased to 39.6% – higher than the highest corporate rate of 35%. So by taxing the individual rather than corporations on significant stock compensation gains, the IRS actually is likely to fare better. For example, if Mark Zuckerberg of Facebook makes $1 billion in stock compensation gains he would theoretically be taxed at 39.6% on the vast majority of his gains. Facebook would get a corresponding $1 billion tax deduction, reducing the company’s taxable income (which, let’s hypothetically say is taxed at 35%). I’m simplifying this – but you get the gist.
How Does Financial Reporting Factor In?
Another argument the Senators are raising (and not for the first time) is that stock compensation tax deductions should not exceed the amount of accounting expense recorded by the company in its financial statements. To that I say “who cares?”. Accounting and tax are two completely different animals, with completely different intents. It’s reasonable and common for the two to be misaligned.
Moving On…
I’m guessing that this latest effort by the two Senators will be short lived, just as in prior instances. Let’s hope so, or I’ll have to invest in a larger bandwagon and bigger megaphone, because I vehemently disagree with Senators Levin and McCain on this issue. I’m also getting kind of tired of the party crashing. Can’t we just bask in the enjoyment of another successful stock compensation IPO without the grumbling about corporate tax deductions? It’s time to move on.
I realize the title of my blog is somewhat broad – I mean, I’m guessing that highly paid CEOs have a lot in common (a nice office, fancy cars, access to private jets, world travel…). Alright, daydreaming aside, I’ll kill the suspense and answer my own question. In today’s blog I’m angling for an answer along the lines of “at least $95M each in income last year from stock compensation”.
With a rallying stock market, a legendary IPO and other favorable factors, the 10 most highly paid CEOs in 2012 (based on a recent poll by GMI Ratings – a corporate governance rating group) all earned in excess of $100M. The top two in that group earned in excess of a billion dollars. “Ah, so what?”, I thought. Then I looked a little closer and realized that that largest cash bonus in that group was $9.5M. The landslide majority of that compensation all came from stock compensation – both restricted stock and stock options.
It’s been a banner couple of years for executive pay. Once again, equity compensation appears to be squarely on top of the executive compensation pie. Of course the concerns about disproportionate gains (executives who are winning big while shareholders still are not) have surfaced, too. I’m going to avoid that discussion today, but if you’re interested in more on that topic, see Broc Romanek’s recent blog. Remember, the GMI Ratings information reflects 2012 compensation. With the stock market soaring, it seems that 2013 may even outpace 2012 in terms of realized gains on stock compensation.
When I start to see such record gains from stock compensation, and the corresponding publicity, I think about several things that stock administrators should consider:
Prepare for trading activity. As year-end draws near and the stock market is going gangbusters, this seems to be the perfect combination for increased trading activity from executives. Even those with 10b5-1 plans may still lead to increased activity – if the 10b5-1 plan was based on a series of limit orders, those limits may execute quickly in an up market. Tax and financial advisers may also encourage executives to liquidate some of their position for one reason or another. This means there could be a surge in executives looking to trade in the coming weeks (requiring availability for pre-clearance procedures, and assurance the executive knows who to contact to execute the transaction).
Consider whether there will be say-on-pay considerations for your upcoming proxy season. Is your company up for a say-on-pay vote this coming proxy season? With record executive compensation, there is bound to be scrutiny as to how those gains compare to shareholder returns. This opens the window to more of a microscope when the say-on-pay filter is applied. Even if you don’t get overly involved in the proxy preparation, given that a huge portion of executive compensation may have come from stock option or restricted stock transactions, you may need to be more involved in providing information for the disclosures. Now, for those who yawn at the mention of say-on-pay, let me just go tangential for a second to say that as of last week, there were 64 companies so far this year with a failed say-on-pay vote – already exceeding the 61 failures in all of 2012. So this is not an area where bygones have become bygones.
Is it time to beef up year-end communications? Have you been considering sprucing up the old examples you use in your year-end communications? With an up stock market, I’m guessing the equity compensation windfalls may not be limited to just executives. With more employees cashing in on market gains, they are bound to be more interested in your year-end communications. Now’s the time to consider enhancing those communications with more detail and timely examples in order to proactively address employee questions. Remember, this is the first year some of those quirky taxes (like the additional medicare withholding rate) kick in, so employees may not be fully aware of how they may be or have been affected by these changes.
Who doesn’t love a good stock market rally? As keepers of the stock plans, this is what we hope for when we issue those grants and/or awards. Try to keep that in mind during those times when volume of transactions is up, and more year-end preparation is needed.
Let me start this week’s blog with a big disclaimer – I’m not a lawyer, so everything I say here is purely from my own head and is definitely not legal advice. Okay, that all said – I’ve always got my ear to the ground to see what’s going on in the courts relative to equity compensation. This week I noticed a wee court case that made the news related to stock options. There are some interesting takeaways that could certainly be discussed with counsel, so I figured they’re worth a mention.
A Stock Option, A Termination and a Non-Compete
Many of us are familiar with references to non-compete agreements that are often included in stock option agreements. This topic became front and center in a recent New York appeals case (Lenel Systems Intl. v. Smith). In short, an employee was granted stock options as part of his employment with the company. The option agreement contained a clause referencing a requirement to not compete. The agreement did not explicitly state that the agreement could be terminated if the non-compete was violated, but it did say that the employee’s agreement to not compete was consideration for the options. Fast forward – the employee left the company, and subsequently violated his non-compete agreement. Since the company did not have the ability to outright terminate the former employee’s stock options, they did the next best thing: they sought to rescind the agreement.
A recent Herman law blog summarized the court’s reaction to this approach as follows:
“The court summarized that rescission is an equitable remedy that allows a court to declare a contract void from its inception. As a general rule, rescission of a contract is permitted where there is a breach of contract that is material and willful, or so substantial and fundamental “as to strongly tend to defeat the object of the parties in making the contract.” The court rejected the defendant’s argument that an express forfeiture clause in the option agreement was required in order for option to be subject to rescission. Instead, the court reasoned that the noncompetition covenant was the sole consideration for the option agreement, and when the defendant chose to compete with Lenel “in violation of the only material condition of the agreements,” he would give up his right to the stock options promised in exchange.
In is also worth noting that two of the appellate judges dissented from this decision, arguing that the consideration for the option consisted of two parts, one being the compliance with the covenant during the term of employment and the other part for the post-termination period. The dissent reasoned that since the defendant did comply with the covenant during his six years of employment with Lenel, it cannot be said that he did not provide any consideration for the option, thereby reducing the argument in favor of rescission.”
Although the company won their appeal (and was permitted to use rescission as an appropriate recourse for the employee’s violation of the non-compete), it wasn’t entirely a slam dunk. For one thing, two judges dissented and raised some interesting points – questioning whether in six years of employment the employee did not provide any other type of consideration for the option. This thought didn’t prevail amongst the appellate judges, but hmm…something to think about.
One message that seems clear to me is that perhaps companies should check on those clauses in the option agreement that refer to non-compete. Is the course of action fully defined? Or is it vague? While the company came out on top in its quest to rescind the option agreement, there certainly was a lot of time, money and effort spent on this pursuit. It lends thought to whether it would be easier to revisit grant agreement language to clarify whether the agreement can be terminated in this type of situation.
I’m not suggesting that everyone immediately line up, option agreement in hand, to ask their lawyers. But this is a situation where having some clearer language in the agreement could have achieved this result much more expeditiously. I’m just saying. If your company is drafting new grant agreements, or revisiting option terms, this may be a question to bring to the table.
Across my desk this week came the latest report from Equilar, an executive compensation data firm, on equity trends. In their 2013 Equity Trends Report, key findings included upticks in the use of restricted stock and performance shares, and a slight downturn in the use of stock options. I’ll highlight a few of the observations in today’s blog.
Trending Now
The Equilar report analyzed the equity practices in S&P 1500 companies that are publicly traded and have at least 6 years of disclosures (resulting in a pool of 1,327 companies). Some of the notable findings include:
Restricted stock awards are at an all-time high, with 92.8% of the companies issuing restricted stock in 2012 (compared to about 80% back in 2007). I couldn’t find any breakdown in the report between the use of RSAs vs. RSUs – so for purposes of this analysis the term “restricted stock” appears to encompass both types.
Stock options continue to decline in use. Equilar reports that over the past 6 reporting years (2007-2012), the number of companies reporting that they grant stock options has decreased to 65.2% from 78.5%. The size of the median stock option grant has also decreased for three straight years in a row, continuing a trend we’ve seen over the last decade (only varied by a blip in 2008 and 2009 when companies increased grants to compensate for market conditions). Although there has been a continued downward trend in this area, I personally believe that stock options will continue be mainstream – I don’t see them just riding off into the sunset – at least not in the near term.
Performance shares keep rising in popularity. This has been an ongoing trend, so no big surprise here. The report indicates that 61.8% of the S&P 1500 CEOs received performance grants in 2012, compared to 55.8% in 2011. I expect we’ll continue to see upward mobility in those numbers, year over year.
The Equilar report does cover additional topics of interest, such as trends in dilution and volatility rates. You can access the full report on Equilar’s website. This report affirms some of the trends we’ve observed, and we expect these trends will continue to gain upward (or downward, in the case of some of the stock option trends) momentum in the coming months and years.
Just before the turning of the New Year, the New York Times printed an article about the potential for large cash windfalls to CEOs who received mega-sized stock option grants during the lowest points of the stock market downturn in 2008 and 2009. Judging from the number of Google Alerts that subsequently came to my inbox on this topic, it seems the article stirred some strong opinions, particularly about the corresponding potential corporate tax deductions.
High Value Non Qualified Stock Option Exercise = Hefty Corporate Tax Deduction
In summary, during the lowest points of stock market performance, many companies issued larger-than-usual stock option grants to their executives. Now, with the market on the rebound, and barring a relapse, many of these grants are well in-the-money and primed to generate huge windfalls of cash for the executives upon exercise. Hand in hand with large cash gains for the executive would be a hefty tax deduction for the company. Estimates run in the billions in terms of shares granted and potential dollars in gains resulting from the grants in question. According to the article, “of the billions of shares worth of options issued after the crisis, only about 11 million have thus far been exercised, according to data compiled by InsiderScore, a consulting firm that compiles regulatory filings on insider stock sales.” This seems to indicate that most of the potential windfall is still on paper, and there may be many significant stock option exercises to come.
What’s the Buzz?
Critics of the stock option tax deduction provisions within the Internal Revenue Code are already vocalizing dissent over the possibility that many companies may drastically reduce, or altogether eliminate, their tax liability due to the large sized deductions that would accompany such significant executive gains. Barbara blogged about a similar concept back in September. As I thought about this possibility, it occurred to me that this is not the only time in history that large windfalls equaled large deductions. In fact, anytime there is an uptick in a company’s stock and a stock option appreciates, there is value. This could be in parallel with market conditions, or simply because a company is performing well, or both. When that value is recognized in the form of an exercise of a non-qualified stock option, the company receives a corresponding tax deduction. Since executives are usually the employees with the largest stock grants, it’s likely that the largest corporate tax deductions typically originate from executive transactions. This isn’t a new trend.
Déjà Vu
I’m thinking back to the 1990s up through 2000 when the stock market was bullish, and feeling like I’ve been here before. Which prompts me to say “so what?” Now, before I get dozens of emails correcting me on statement, the “what” that is different in this situation is that it seems many of the stock options granted in 2008 and 2009 were particularly oversized, seemingly because of the state of the economy and miserable market conditions. In addition, many of those grants were free of performance conditions, which means that the potential windfall in many cases may be a pure reflection of a market rebound, and has nothing to do with the executive or company’s performance. That thought has stirred some buzz, and it seems likely to continue as more paper gains translate into real cash through exercises. It seems that time is upon us, or not too far into the future. This will be a topic that is bound to generate some buzz in the coming months. I wonder if Senator Levin will use this as yet another opportunity to try and get his bill (limiting stock option tax deductions to the expense recognized for them) through Congress. It seems like 2012 may be a year of epic stock option gains; we’ll just have to wait and see.
Are you staying current with international developments that may impact your company’s equity compensation program? You will find many essential tools in the NASPP Global Stock Plans portal to keep up-to-date. If you haven’t browsed through the portal recently, you really need to check out our latest feature; the Stock Plan Compliance Evaluation tool.
The Stock Plan Compliance Evaluation tool is available only to NASPP members. To access, click on the link that is under the Country Guides on the NASPP Global Stock Plans portal. This evaluation tool, provided by GlobalSharePlans, is a fantastic interactive tool that you can use to evaluate your international stock plans. By choosing your countries of interest, you can get an instant overview of the potential issues to be aware of. If you are seeking greater detail, head to the “Plan design by country” drop-down and run a personalized healthcheck on your plans by including applicable details. The Stock Plan Compliance Evaluation tool may be available this year only, so take advantage now!
We also continue to get regular updates to our Country Guides, Alerts, Articles, and Quarterly Updates. If you don’t already, sign up now to receive country alerts. You can subscribe to receive alerts for just the countries your company does business in, or all countries on the list! And, here’s a tip you may not be aware of: you can search the archive for alerts on a particular topic, or find a summary of individual country alerts in each Country Guide link. Here is an alert that recently caught my eye:
Korea: The Korean government recently updated its position on the deductibility of employee stock options costs to a Korean subsidiary or branch. The Korean subsidiary or branch will now be able to deduct the costs associated with employee stock options issued by a foreign parent company as long as the subsidiary incurred the costs directly or through a recharge agreement. Because of this new position, when the Korean subsidiary or branch bares the cost of employee stock options, the employee’s stock option income will be subject to income tax and social security tax withholding. Additionally, the Korean government clarified that in many cases, the income assessed and subsequent tax withholding on income from stock options earned by mobile employees will be calculated pro-rata for the time spent in Korea.
Our Global Stock Plans portal Task Force Members regularly contribute in-depth articles and quarterly newsletters. Valerie Diamond and Barbara Klementz from Baker & McKenzie recently contributed the “Top 10 Things You Need to Know for Option Exchanges Involving International Employees”. A great reminder included in this valuable list is that there are countries where the employee and/or the local entity have had to pay taxes on the options at grant. Additionally, it is likely that neither the employee nor the local entity may be able to obtain a refund or tax credit and will owe taxes again at grant for the new option.
Don’t miss out on the latest developments; be sure to put a regular review of the NASPP Global Stock Plans portal on your schedule!