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Three Keys to a Good Equity Compensation Plan

Having worked with a number of companies and equity compensation plans over the decades, I paused the other day to reflect on what makes for a “good” plan in my experience. In thinking this through I think there are three keys which help make an equity plan “good”:

  • Compliance
  • Best Practices
  • Flexibility

Compliance

Seems simple, but a good equity plan ensures that it complies with all the applicable rules. These rules include the Securities and Exchange Commission rules, the listing exchange (NYSE/NASDAQ) rules, the tax rules, and accounting rules.

Best Practices

A good plan reflects the current thinking of what constitutes “best practice” with respect to an equity plan. For example, today’s good plans typically have a minimum vesting period for awards, have some form of double-trigger protection for change-in-control, and are likely to place a limit on the number of shares that can be granted as full value awards (stock-settled awards other than stock options or stock appreciation rights).

Flexibility

Good equity plans also manage to balance compliance and best practices with flexibility, so that the plan itself does not unintentionally box the company into a particular action but instead enables the company to determine what is to occur, i.e., maintaining the most flexibility while still being in compliance with applicable rules and following best practices. Flexibility itself often is not fully understood until an unforeseen event occurs and the equity plan is put to the test.

Conclusion

I listed the keys for a good plan in order of their applicability. In order to have a viable equity plan, it has to comply with the applicable rules, i.e., compliance. To have a better equity plan, it should reflect current best practices in its provisions (vesting, CIC, award limits, share limits, etc.). Finally, to be a good plan, an equity plan needs to have sufficient flexibility to allow the company to address issues that arise, even if not expected.

In my experience, the hardest thing for an equity plan to do is to incorporate adequate flexibility and reflect current best practices. Sometimes, compliance can be a stretch, but that is a baseline which needs to be met and most plans do an adequate job of following the applicable rules. Many plans also do a relatively good job of incorporating best practices at the time they are adopted. The toughest thing is drafting an equity plan to ensure there will be sufficient flexibility.

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New Video Podcast!

I am happy to announce that on May 2, 2018, my new video podcast, The EC Minute, launched.  The first three episodes are all live now. New episodes will be posted weekly. You can see the video podcast episodes at:

The EC Minute

The first three episodes take a look at Say-on-Pay, with a focus on S&P 500 companies.

 

If you have an idea or suggestion for a topic for The EC Minute, just let me know by using my contact form:

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CEO Pay Ratio-How is it Expressed? 1 to ###

As companies begin to file proxy statements that detail their Pay Ratio disclosure under Item 402(u) of Regulation S-K, a quick recap of the final rule and what it requires might help companies.

Item 402(u) states:

“(u) Pay ratio disclosure.—

(1) Disclose:

(i) The median of the annual total compensation of all employees of the registrant, except the PEO of the registrant [A];

(ii) The annual total compensation of the PEO of the registrant [B]; and

(iii) The ratio of the amount in paragraph (u)(1)(i) [A] of this Item to the amount in paragraph (u)(1)(ii) [B] of this Item. For purposes of the ratio required by this paragraph (u)(1)(iii), the amount in paragraph (u)(1)(i) of this Item shall equal one, or, alternatively, the ratio may be expressed narratively as the multiple that the amount in paragraph (u)(1)(ii) of this Item bears to the amount in paragraph (u)(1)(i) of this Item.”

[Bracketed, bold text and emphasis added. Note that final rule calls for a ratio of A to B.]

Now, up in the commentary section of the adopting release for the final Pay Ratio DIsclosure Rule, the SEC described the required disclosure a bit differently:

“c. Final Rule

After considering the comments, we are adopting the final rule as proposed. The final rule adds new paragraph (u) to Item 402 and requires disclosure of:

(A) the median of the annual total compensation of all employees of the registrant (except the registrant’s PEO);

(B) the annual total compensation of the registrant’s PEO; and

(C) the ratio of the amount in (B) to the amount in (A), presented as a ratio in which the amount in (A) equals one, or, alternatively, expressed narratively in terms of the multiple that the amount in (B) bears to the amount in (A).”

[Emphasis added.]

The ratio required in the commentary section is B to A, while the ratio actually required by the language set out in the final rule is A to B.

A bit of a disconnect, right?  So the language in the commentary that suggests that the ratio can be expressed as ### to 1 does not appear to be applicable to the final rule that the SEC adopted. The clear language of the final rule requires the ratio to be expressed as 1 to ### if a number/ratio or narratively as, “the CEO’s annual total compensation is ### times that of the median of the annual total compensation of all employees other than the CEO.”

So take a minute to review your proposed Pay Ratio Disclosure to ensure it complies with how Item 402(u)(1)(iii) is actually written, i.e., that it requires the ratio of the median of the annual total compensation of all employees other than the PEO/CEO (equal to 1) to the annual total compensation of the PEO/CEO, 1 to ###.

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Warning: Section 162(m) Language and Incentive Plans

Just a quick word of warning to executive compensation professionals to take a long, hard look at both short-term incentive and long-term/equity incentive plans (and their associated proxy proposals ) that include Section 162(m) language. The reason is not so much the question of whether such Section 162(m) language is still needed (it might be if your company is putting forward a plan amendment and there are outstanding awards that may qualify for the Section 162(m) transition relief under the Tax Cuts and Jobs Act), but rather what justifications are given for seeking shareholder approval of the proposed plan.

If the proxy proposal indicates that one reason for requesting shareholder approval due to qualifying compensation paid under the plan under Section 162(m), then the plaintiff’s bar is ready to file suit.  I have been working with one company that filed its proxy early in 2018 and was requesting shareholder approval for both its annual and equity plans.  The company was on a fiscal year and the changes in Section 162(m) wrought by the Tax Cuts and Jobs Act will not fully apply until later in calendar 2018–after the company’s annual meeting. But, the proposals did not indicate this and the plaintiff claimed that the disclosures were misleading and sought an injunction.

So, practitioners should carefully evaluate the rationale given for seeking shareholder approval of any incentive plan being proposed in a company’s proxy statement.  If Section 162(m) is mentioned, then be sure to address the changes wrought by the Tax Cuts and Jobs Act and explain how the changes will impact the plan and awards under the plan going forward, as well as why shareholder approval would be needed in light of the changes to Section 162(m).

Finally, if the proposal is for a completely new plan, and there is no possibility that any of the Section 162(m) transition relief will apply to awards under the proposed plan, you may be tempted to eliminate all references to Section 162(m). Of course, even though certain elements of equity plans are no longer needed by Section 162(m), ISS has already said that it will be reviewing the elements included in plan documents. So it may not make complete sense right now to eliminate things like annual (or other period) limits on awards, especially to directors, or a list of potential performance metrics, and other elements that used to be included solely for Section 162(m) compliance reasons.

As they always said in Hill Street Blues, “Let’s be careful out there.”

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