Highlights from the 23rd Annual NASPP Conference
Equity Methods was a sponsor of the NASPP Conference, held in San Diego in late October. As usual, it was a lively, insight-filled event. Here are some of our takeaways for this year.
Plan Design and Redesign
Fight Club: When Plan Design and Administration Collide
Arthur Meyers (Choate Hall & Stewart), Jillian Forusz (Adobe Systems), Kelly Geerts (E*Trade Finanical) and Thomas Welk (Cooley LLP) weighed the pros and cons of a number of plan design trends. One of the trends is to add complex features to so-called “Cadillac” ESPPs. Examples of these include longer offerings, resets and rollovers, and multiple changes during an offering period. These features can help to further incentivize, provide larger discounts, and retain employees. But they also can result in more complex administration, accounting, and difficulty explaining to plan participants.
Other topics included extensions of post-termination exercise periods and equity compensation choice. The first prevents employees from staying at a job waiting for a liquidation event or stock price increase, but can also be a significant modification expense and may not be available within standard reporting systems. As for equity compensation choice, while it allows employees and directors to choose the awards that suit their needs, it requires significant effort to educate participants, compile proxy disclosures, and design a balanced set of options for participants.
Why Auditors and the SEC Ask the Questions That They Do
Our president and CEO Takis Makridis delivered this session with Mark Barton (FASB), Nancy Dartez (Vital Therapies), and Ken Stoler (PWC). First was an introduction of the key players in the accounting ecosystem: regulators, SEC, PCAOB, and auditors. Next was an examination of each player’s role, with perspectives from issuers and consultants. The overall theme was to encourage better ways of working with them.
One interesting question is why the PCAOB matters to issuers, given that the PCAOB mainly oversees the audit firms. The answer is that so many new requirements from audit teams stem from PCAOB requirements imposed on them. So understanding the evolutions in the PCAOB’s guidance and protocols helps issuers understand and anticipate their auditors’ needs.
The audit process includes planning and scoping, substantive and controls testing, and completion when an opinion is rendered. The types of proof requested will vary based on whether the auditor is testing the system of internal control over financial reporting or the financial results. The panelists debated the merits of certain auditors valuing controls that prevent problems from occurring more than controls that alert preparers of an actual problem. Variance analysis has emerged as an important control.
Under SOX, the SEC is required to review every public company at least once every three years. The SEC’s main scrutiny tends to be registration statements as companies IPO. Common SEC comment letter questions pertain to fair value measurement methodology, earnings per share, and disclosure ambiguity. When dealing with an SEC comment letter, companies are best served by getting on a call with the SEC, remaining cordial throughout, and responding in “plain English.”
A copy of the presentation can be found here.
FAS 123(R) 10 Years After: Impact and Practical Implications
Mark Barton (FASB), along with Don Delves, Paula Todd, and Stephen Zwicker (all from Towers Watson) discussed FAS 123(R)’s implications for equity compensation programs.
Before FAS 123(R), companies could decide whether to expense an option award. Guess what? No expenses were booked before FAS 123(R) and options were granted to employees for free. During that time, executive and CEO pay increased significantly, mostly in the form of stock options. When FAS 123(R) came out, options unsurprisingly went into decline. Today, many organizations grant them to higher level employees only. Restricted stock and performance awards have become more prevalent, with companies granting a more balanced mix of long term incentive awards. Total shareholder return (TSR) is now a more common performance measure than internal metrics such as EPS and revenue.
ASC 718 in Motion: The FASB’s Amendments
In June 2015, FASB issued an exposure draft that aims to make ASC 718 clearer and less costly for public and private companies. Takis Makridis of Equity Methods joined Mark Barton (FASB), Paul Bailey (Red Hat), and AmyLynn Flood (PWC) to discuss the proposed changes.
One of the changes would allow companies to preserve equity treatment for awards that withheld tax less than or equal to the maximum statutory rate. Although the exposure draft doesn’t make this clear, the intent is to apply the rule by jurisdiction, which is simpler than applying it by employee.
Controversially, FASB has also proposed to remove the APIC pool and run tax windfalls and shortfalls through the income statement. Changing this will introduce income volatility for companies while requiring them to forecast out excess tax benefit/deficiency when calculating the estimated effective tax rate. A possible solution is to remove the APIC pool but allow everything to go through equity.
The FASB also proposed giving companies a choice as to whether they apply a forfeiture rate. While appealing to small and private companies, the election may not be helpful to larger companies because it will insert more budget-to-actual variability. Be aware that once the policy is elected, future switches will be considered a change of accounting policy.
Tour De Monte Carlo: Bringing Clarity to the “Black Box”
Josh Schaeffer, PhD, who leads our complex securities valuation practice, served on this panel with Phil Drake, PhD (Arizona State University), Scott Sweeney (Novatel Wireless), and Zachary Biddle (EY). They discussed the use of Monte Carlo simulations to value TSR and other complex award types.
Monte Carlo simulations are a unique challenge for companies and their auditors. While it’s possible to check the math on calculations such as forfeiture rate or even plug the inputs into a Black-Scholes model, Monte Carlo simulations are not directly testable in this way. Instead, issuers have to use common sense checks, and auditors must build corroborative models to validate the findings of external specialists.
Given so many moving parts, it’s important to select a provider with industry experience, a good reputation, and verified expertise in Monte Carlo-based valuations. The right provider can easily explain considerations such as a change in value from the previous year, and seamlessly resolve differences between preparer and auditor.
A copy of the presentation is here.
Administration and Best Practices in Equity Compensation
Hot Topics: 50 Practical Nuggets in 75 Minutes
This session was presented by five panelists: Amy Wood (Cooley LLP), Kyoko Takahashi Lin (Davis Polk), Bob Lamm (Gunster), Stacy Ingram (Home Depot), and Wendy Davis (Jones Day). Each offered 10 practical tips on executive compensation. Here are our favorites:
- Communicate ahead so there are no surprises.
- Get compensation consultants involved early in the compensation discussion and analysis (CD&A) drafting process.
- Do consider disclosure requirements for executive compensation design, but don’t let them scare you into making a suboptimal decision.
- To avoid unfair comparisons, consider excluding board of directors skill metrics.
- Know the limits of your knowledge.
- Have an outside consultant look over the plan and the market.
- Maintain the latest updates of ISS and Glass Lewis guidance.
- Read the full ISS and Glass Lewis guidance to understand opportunities for both improvement and potential misunderstanding.
- Make sure every sentence in the proxy is true and informative.
- Do use graphs, but in moderation.
- Find someone who knows the CD&A inside and out to proofread it.
- Find someone not directly involved with the CD&A to proofread it.
Maximizing Corporate Tax and Income Benefits for Global & Mobile Workforces
Raenelle James, CPA (Equity Methods), Ellie Kehmeier (Steele Consulting), and Marlene Zobayan (Rutlen Associates) shared their perspective on employee mobility, primarily as it effects international recharging.
Recharging equity is not the same as direct tracing. Direct tracing is the process of pushing down expense to different levels of the organization (i.e., a book activity), whereas recharging involves the subsidiary paying the parent cash for equity granted to their employees. The key differentiating factor between a recharge and direct tracing is that with a recharge program cash changes hands.
There are a myriad of benefits to recharging, but the predominant one is the cash that you can bring back into the US on a tax-free basis. However, there are several reasons why companies opt not to recharge. First, there may be an unintended consequence from transfer pricing provisions. Additionally, country-specific tax law may make recharging ineffective or overly complicated. The panelists closed by sharing a few case studies to illustrate the country-specific nuances.
A copy of this presentation can be found here.
Devil in the Details: Realities of Implementing Performance Awards
There’s a long list of items to consider when granting a performance award. How to set and measure the measure performance goals? What is the impact to financial and tax reporting? What happens with mobility between groups? What about recipient education? Lisa Klevence (Plan Management Corp.), Jeanne Strand (Kymeta Corporation), and Elena Thomas (Plan Management Corp.) discussed ways to answer those questions from administration, accounting, and employee communication perspectives.
While expense is based on the current estimation of the future payout, EPS is based on the current measurement assuming the performance period ends on the reporting date. It’s also important to understand the accounting grant date of the performance awards. If performance metrics are not set at the time of grant, the award does not have a grant date, meaning there is no financial reporting or proxy impact.
When granting performance awards, be sure to:
- Consider all possible payout scenarios and their impact on administration, financial reporting, and the incentive you plan to get.
- Know any limitations of your administration and accounting tools.
- Involve the auditors and accounting team early to understand the implications on financial reporting.
- Communicate the performance programs early and often so participants know how their awards fit in the overall compensation structure.
Navigating ISS & Glass Lewis
Presenters Amy Bilbija (Evercore Partners), Carol Bowie (ISS), Bob McCormick (Glass Lewis), and Ning Chiu (Davis Polk) revealed best practices for working with ISS and Glass Lewis to obtain a positive recommendation for company equity plans.
Tips include avoiding actions that would guarantee rejection, such as a prior repricing without shareholder approval. It’s also possible to trigger an automatic approval, so long as the company is only amending a previously approved plan for Section 162 (m) compliance. However, there’s more ambiguity when it comes to the development of award terms, such as:
- Minimum vesting requirements in the plan versus in the awards. There is a preference for this, but it may cause friction with external hires.
- Vesting in change in control. Is it okay to trigger all award vesting on any change in control? Or should there be pro-rata vesting or a requirement that the holder lose their job?
- Changing non-GAAP measures from year to year. Advisors are on the lookout for companies who report negative earnings, but allow awards to fully vest due to adjustments.
Particularly interesting was a discussion of what to do if a negative recommendation is coming. First, companies can make sure all the data used by the advisors is correct. Second, companies can sometimes modify the plan to improve the score. Unfortunately, because negative recommendations are rarely due to a single issue, this could result in substantial plan changes, and the advisors will not inform the company in advance if these changes are insufficient.
Finally, the whole panel agreed on a pet peeve: companies that fail to tell a cohesive story in their CD&A section. Instead, they use unnecessary charts to break up rambling text. A vastly better approach would be for companies to have someone outside of the process read the proxy for clarity.
M&A & Equity Plans: Hot Topics
Amit Banker (E&Y) and William Murphy (E&Y) debated the equity considerations for each party involved with an M&A transaction (including mergers, acquisitions, spinoffs, IPOs, and Inversions). In an M&A event, a whole range of treatments are possible, including assumption, substitution, cancellation, or cash out. Each situation is unique. The most important issues are related but not limited to NEO compensation, stock plan administration, payroll process, design aspects, and—last but not least—accounting implications.
In an M&A transaction, timing for tax deductions is governed by principles under sections 83, 162, and 404(a)(5). Whether it’s preferable to take the deduction either pre- or post-spin depends on the companies’ tax profiles and the type of transaction.
In a spinoff transaction, equity can be split under the concentration or basket method. Under the concentration method (what we call the “employment method” at Equity Methods), employees are awarded equity in the company employing them. Otherwise, the equity can be split under the basket method (what we call the “shareholder method” at Equity Methods), where the parent award is divided into an adjusted parent award and a spinoff company award.
IPO and inversion/diversion transactions also have their issues. These include being able to grant on the IPO date to motivate the workforce and dealing with the downstream administration and accounting implications.