NCEO s CEP Exam Preparation Course Spring 2018 Level 3 Core Topic: Equity Plan Design, Analysis & Administration

Transcription

1 NCEO s CEP Exam Preparation Course Spring 2018 Level 3 Core Topic: Equity Plan Design, Analysis & Administration Presented by Mary Lee, CPA, CEP, Stripe Moderated by Achaessa James, CEP, NCEO Streaming audio is available through your computer or, dial and use access code

2 Participating in a Webinar By Internet Chat Go to the chat box in the lower left of your screen and type in a question. The moderator will pose your question at an appropriate point in the Webinar. Welcome. I m Achaessa James with the NCEO. Before we begin, our webhost has a couple of features that I want to bring to your attention. Because the system is streaming audio, all participants are automatically muted. So if you d like to ask a question or make a comment, you can type it into the chat box on the lefthand side of the screen and the moderator will read it into the recording. We encourage you to ask questions with this format it is the only way we know if you re understanding the information. Another quirk is that you may notice that a few of the slides are a bit distorted, like the slide title will break or the reading reference on the left side will scrunch up. I ve worked with the slides a dozen times and can t get them to not distort but don t worry, the PDFs are all clean and not scrunched up. And speaking of pdfs, when I finalize and post the recording of this session I ll also be posting the pdf slides with the narrative notes because they were so popular in the spring. And just a reminder that we ll be breaking the webinars at logical breaking points, about every 30 minutes or so, to make numerous smaller recordings instead of one long recording. At those points, I ll stop the recording and re start it and I ll announce that that s what I m going to do it s a quick 1 minute process, so nothing inconvenient. I m going to start the recording now and then we ll get going for real. 2

3 NCEO s CEP Exam Preparation Course Spring 2018 Level 3 Core Topic: Equity Plan Design, Analysis & Administration Presented by Mary Lee, CPA, CEP, Stripe Moderated by Achaessa James, CEP, NCEO 3

4 Mary Lee, CPA, CEP Mary Lee heads all things equity at Stripe. She has a degree in marketing and certificate in bean counting. She s found the perfect combination of spreadsheets, people and numbers in equity. She has years of experience making equity easy for companies to administer and employees to understand. My name is Achaessa James. I am the Product Manager for equity compensation products here at the NCEO including the CEP Exam Prep Course and I will be your presenter for today s session. Assisting me today is Sarah Roberts of Stock & Option Solutions. Sarah and I are both CEPs and between the two of us we have about 35 years of experience in the equity compensation industry. Thank you, Sarah, and welcome. NEXT SLIDE 4

5 IMPORTANT REMINDER 3 Watch the Exam Tips recorded webinar if you have any questions about how to study using the CEPI binder materials The Reading List IS NOT a complete listing of the topics you need to study (it only goes down two outline levels) Refer frequently to the Exam Topics Outline (the Syllabus ) to see all topics (there are often three to four outline levels) Download the new L Suggested Best Reading Resource By Topic document So with our topic focused format this year, we ll cover all the general course review statistics in the Exam Tips webinar which was recorded last week. The only reminder I want to give here is that on the reading list appears to be straightforward, turns out to be more complex when you look at the Exam Topics Outline. Always remember, the Reading List only goes down two outline levels, but there are often 3 or 4 levels on the Exam Topics Outline. Also, new for 2018, I ve prepared a Suggested Best Reading Resource by Topic document for each of the three study levels. You ll find that in the Supplemental Documents section for your study level. This new resource replaces my usual year over year comparison of your Detailed Reading List. It lists what our subject matter experts consider to be the best reading resource for each Syllabus line item topic and also highlights any newly assigned reading for this year. NEXT PAGE 5

6 Level 3 Administration New Assignments 4 NEW SUBTOPICS Characteristics of Equity Awards > Performance Awards > Administration Processes External Considerations > Plan Features > Dilution > Plan Features > Repricing > Plan Features > Value Transfer Governing Docs > Plan Provisions > Amendments > Plan Provisions > Repricing Programs > Plan Provisions > Severance Limitations in the Document Planning > Acceptance Requirements > International > Exchange Controls > Understanding When Plan Provisions Govern There are no new top level topics for Level 3 Administration, just new subtopics in Characteristics of Equity Awards, External Considerations, Governing Docs, and Planning. So now let s get into the study content of the webinar. It s all yours, Mary NEXT SLIDE 6

7 5 Reference: GPS: Performance Awards section 4 General Administration Characteristics Performance Award Administration Processes Flexibility of administration system to accommodate customized performance metrics Manual workarounds may be required Consider financial reporting implications Internal controls are key Key questions include How performance goals are determined How to record expense and track award When the performance period ends and how the system handles flexible performance periods How performance is certified When the service period ends and how the system handles prorated payouts Is vesting automatic or must it be done manually Payout processes for deferrals, dividend equivalents, etc. See Exhibit 4 1 for Internal Controls and Tests See Exhibit 4 2 for Common Questions on administrative functionality of the system 923 Characteristics > Performance Awards > Administration Processes In today s webinar, we will cover the new assignments in the order listed, starting with Characteristics of Equity Awards. As with the previous Level 3 webinars, we will only be covering new subtopic assignments and critical reviews. Starting with performance award administration processes, it s basically the same as any other award the awards must be properly approved by the board or compensation committee, the award must be properly communicated to the award recipient, etc. The main differences occur when you start taking into account the variability of the award terms and how those will be administered. You ll need to understand the flexibility and limitations of the administration system to handle customized performance metrics and sometimes you may have to do manual workarounds. If workarounds are required, you will have to be in close communication with your company s stakeholders in charge of financial reporting to understand the potential implications of such manual workarounds and, equally important, will be internal controls to ensure that the manual workarounds are properly handling the expensing, vesting, tracking, etc. Key questions that you ll need to answer are listed here on this slide 8 and you ll want to tab out Exhibits 4 1 and 4 2 in this GPS publication so that you can easily refer to them during the exam. 7

8 External Considerations new subtopics & best reading 6 External Considerations > Plan Features > Dilution best reading Selected Issues section 9.3.2, Equity Alternatives sections and > Repricing best reading The Stock Options Book section > Value Transfer best reading Selected Issues section External considerations > plan features > dilution 128 External considerations > plan features > repricing 747 External considerations > plan features > value transfer Next we re going to look at the three External Considerations subtopics under Plan Features dilution, repricing, and value transfer. I recommend Selective Issues section on dilution, The Stock Options Book section on repricing programs, and Selected Issues section on value transfer. Let s look at each of these, starting with Dilution. NEXT SLIDE

9 External Considerations Dilution & Repricing 7 Reference: Selected Issues section When offering a repricing for underwater options, why would a company that has been scrutinized for granting practices opt to offer employees restricted stock in exchange for their options rather than a new grant of stock options? a. There are accounting advantages under ASC 718 for the cancellation of a grant and regrant of a new award. b. Employees must pay for restricted stock at grant, which results in immediate cash flow to the company. c. Restricted stock provides employees with a low risk opportunity for equity interest in the company. d. Offering an exchange for restricted stock is less dilutive and can be more acceptable to shareholders. 746 External considerations > plan features > dilution 128 External considerations > plan features > repricing PRESENTER Let s start this section with a question and then look at the assigned reading. ACHAESSA READS QUESTION. Rather than wait for your answers, we re going to look at the assigned reading for the answer to this question. NEXT SLIDE 9

10 External Considerations Dilution 8 Reference: Equity Alternatives sections and Shareholders don t like dilution Full-value awards are more dilutive Cash-settled awards have zero dilution Actual dilution is different than diluted EPS Comparative dilution of award types on a one-for-one basis (most to least): 1. Stock-settled, full-value awards based on value of underlying stock plus appreciation over vesting period (Phantom Stock) 2. Restricted stock, RSUs 3. ESPPs 4. Options 5. Stock-settled Stock Appreciation Rights 6. Cash-settled awards - zero dilution (RSUs, SARs, Phantom Stock) 746 External considerations > plan features > dilution The quick and dirty answer is dilution is bad and shareholders don t like it. Dilution to existing shareholders occurs whenever the company issues new shares and, within the context of equity compensation, whenever the company sets aside authorized but unissued shares for issuance through an equity compensation plan. Dilution is what makes shareholders so reluctant to authorize equity compensation plans, evergreen provisions, and increases to the plan reserve pool. Every time something dilutes a shareholders ownership it means that shareholder has less relative power and less relative value in the company. This slide 11 lists the various types of awards from the most dilutive to the least dilutive. However, in practice, award types covered by items 1 and 2 are not generally issued on a one for one basis in comparison to the remaining types of awards, meaning that because award types 1 and 2 are full value awards, grants for these types of awards are for fewer shares of stock than options and the other types of awards. So, viewed as a component within an overall equity compensation program, a company s issuance of full value awards could actually be less dilutive than purchases under a heavily discounted ESPP, for example. This is especially true when calculating Diluted Earnings Per Share, which counts all stocksettled awards as if they were fully exercised. NEXT SLIDE 10

11 External Considerations Repricing 9 Reference: Selected Issues section 7.2.2, The Stock Options Book section Institutional Shareholders and Proxy Advisors No approval of plans that permit repricing without shareholder vote Generally viewed as favorable repricing terms and circumstances by advisors: Officers and board members do not participate Stock decline mirrors market/industry declines in timing and magnitude Repricing is value neutral or value creative for shareholders, with very conservative assumptions Management and the board make a cogent case for the repricing 128 External considerations > plan features > repricing We re going to keep the discussion on shareholder concerns about repricing brief because we just covered this at length in the Level 3 Securities webinar yesterday and it has the same assigned reading. Basically, neither securities laws, nor Exchange rules require shareholder approval for a repricing. Nevertheless, because an option repricing gives the option holders a benefit that is not available to shareholders in general, proxy advisors will recommend that shareholders vote against any equity compensation plan that allows a future repricing without shareholder approval. This slide 12 lists the types of considerations that make repricing offers palatable enough for shareholders to give their approval. Recommendations by advisors vary, but they are all relatively similar to this list and the one that is on the top of every advisor s list is that executives and directors do not participate in the repricing. This is because the officers and board members can be seen as having been responsible for the poor performance of the stock and allowing them to participate in the repricing would, in effect, be failing to hold them accountable for their failed management of the company. It s also important that shareholders be able to look at the company s stock volatility and a

12 comparative volatility analysis within the company s market or industry and see that the company s performance tracks industry performance. This is an indicator that the company s decline in stock price may be due to external factors and not be totally due to mismanagement or a product failure. The repricing should also be value neutral or value creative from an accounting perspective and that calculation should be arrived at using very conservative assumptions. And, finally, management and the board should make a very clear and convincing discussion of the rationale behind the repricing, the alternatives investigated, and reasons for settling on the repricing as presented to the shareholders in the proxy statement. SLIDE

13 External Considerations Dilution & Repricing 10 Reference: Selected Issues section When offering a repricing for underwater options, why would a company that has been scrutinized for granting practices opt to offer employees restricted stock in exchange for their options rather than a new grant of stock options? a. There are accounting advantages under ASC 718 for the cancellation of a grant and regrant of a new award. b. Employees must pay for restricted stock at grant, which results in immediate cash flow to the company. c. Restricted stock provides employees with a low risk opportunity for equity interest in the company. d. Offering an exchange for restricted stock is less dilutive and can be more acceptable to shareholders. 136 External considerations > plan features > dilution 128 External considerations > plan features > repricing Getting back to our question, we now know that one benefit of replacing options with restricted stock is that restricted stock ordinarily has no purchase or exercise price and provides immediate value to the recipient. Consequently, the exchange ratio will generally result in less dilution to existing stockholders than an option for option exchange. Because of the reduced dilution, shareholders may be more inclined to vote favorably for such an exchange offer. NEXT SLIDE 12

14 11 External Considerations Value Transfer Reference: Selected Issues section External considerations > plan features > value transfer Value Transfer, within the context of equity compensation plans, is a binomial option pricing model calculation devised by proxy advisors to measure the amount of shareholder equity flowing out of the company to the plan participants. This goes back to the shareholders dislike of dilution and because of the catchy name you can probably expect an exam question on Shareholder Value Transfer. ISS, the proxy advisor service that devised the Shareholder Value Transfer model, sets allowable caps for each company by comparing top performing companies within industry groups and then doing regression analyses on each group to identify variables related shareholder value transfer and arrive at a benchmark. The benchmark number is then adjusted to reach a company specific allowable cap, below which the company s calculated SVT must fall to be acceptable to the proxy advisors and, by extension, to the shareholders. There is a single paragraph in Selected Issues section that details the types of data looked at in establishing the allowable cap. NEXT SLIDE

15 Governing & Supporting Documents new subtopics & best reading 12 Governing & Supporting Docs > Plan Provisions > Amendments best reading Selected Issues section 4.2.1, 4.4.4, Equity Alternatives section > Repricing Programs best reading Selected Issues section 7.1, The Stock Options Book section 9.6 > Severance Limitations in the Document best reading The Stock Options Book section Docs > Plan > Amendments 250 Docs > Plan > Repricing Programs 237 Docs > Plan > Severance Limitations in Docs Next we re going to look at the three Governing & Supporting Documents subtopics under Plan Provisions amendments, repricing programs, and severance and the related limitations in the documents. I recommend Selective Issues section and on amendments, Selected Issues section 7.1 on repricing programs, and The Stock Options Book section on severance. Let s look at each of these, starting with amendments. NEXT SLIDE

16 Documents Amendments 13 Reference: Selected Issues in Equity Compensation section 4.2.1, Plan generally gives board broad authority to amend plan documents NYSE/NASDAQ require shareholder approval of material amendments to plan Proxy advisors require shareholder approval provisions even when not statutorily required Common amendments/provisions that require shareholder approval: Increase in share reserve pool Adding a new form of acceptable payment Repricing Evergreen provisions Amendments for which shareholder approval is recommended: Any amendment which provides an additional benefit to optionholders 152 Docs > Plan > Amendments None of the assigned reading speaks specifically to the amendment of governing and supporting documents, so this slide 16 simply reiterates some general knowledge and some key points about amendments that we ve covered in the other level 3 webinars. The Plan generally provides the board with broad authority to amend the plan and its supporting documents, and usually accompanies that authorization with a statement about obtaining shareholder approval when required. As you ll recall from the Level 3 Securities Law webinar, the New York Stock Exchange and NASDAQ both require shareholder approval of material amendments to the plan. The exchange rules specifically do not require shareholder approval of a repricing where the originally approved plan already allows a repricing, however, you ll also recall that proxy advisors will recommend that shareholders vote no on any plan that does not require a shareholder vote at the time of repricing. Common amendments that require shareholder approval are an increase in the share reserve pool, adding a new form of acceptable payment for exercises, repricing offers, and annual approval of evergreen provisions in plans that have a term longer than 10 years. 15

17 A good rule of thumb is that shareholder approval should be sought by the company for any amendment which provides an additional benefit to equity award holders. NEXT SLIDE

18 Documents Repricing Programs 14 Reference: Selected Issues sections 7.1, 7.2.2, The Stock Options Book section 9.6 If the original plan includes a repricing provision, shareholder approval is not statutorily required Proxy advisors still recommend shareholder approval at the time of the repricing If the original plan does not include a repricing provision, it is considered a material modification and shareholder approval is required by the NYSE Unless the cancelation and exchange is pursuant to a merger, acquisition, spinoff or similar corporate transaction Exchange may include revised terms Extended vesting period Blackout period on vested shares Section 162(m) says both original and replacement award are counted against $1m limit 250 Docs > Plan > Repricing Programs We ve already had an extended discussion on repricing programs, shareholder approval, and the tender offer process in the Level 3 securities law webinar, so we won t cover that ground again. Apart from the shareholder approval requirements and the timing and communications restrictions on making a tender offer, an administrator will have to have a complete understanding of any change in terms for the replacement awards. Such changes commonly include an extension of the original vesting period and a blackout period for exercising already vested shares. It is the administrator s job to integrate these changes into the award database, either on a group basis or an individual award basis. And, finally, it will be the highly valued plan administrator that reminds the CFO before the repricing happens that for Section 162(m) purposes a repricing of executive options means that both the original option and the replacement option will be counted against the annual $1 million cap on the executive compensation tax deduction. NEXT SLIDE 16

19 15 Documents Severance Limitations Reference: The Stock Options Book section Docs > Plan > Severance Limitations in Docs The title of this last subtopic Severance Limitations is very specific, so I m guessing that you might expect a question on the exam. This insert shows the entire paragraph of reading pertinent to this subtopic. The important points are that, when designing a severance package, you must always check the language of the plan and the language of the affected award before any changes are made because if the language of the plan is too restrictive the plan may need to be amended to accommodate the proposed offer. I wonder, though, whether such an amendment would be seen as offering a new benefit to the award recipient to such a degree that it would be a material modification and require shareholder approval. NEXT SLIDE 17

20 NCEO s CEP Exam Preparation Course Spring 2018 Level 3 Core Topic: Equity Plan Design, Analysis & Administration Presented by Mary Lee, CPA, CEP, Stripe Moderated by Achaessa James, CEP, NCEO Welcome to the National Center for Employee Ownership s CEP Exam Prep Course series. Today we re covering Level 3 Equity Plan Design, Analysis & Administration. This is part 2 of the recorded webinar. 18

21 Planning new subtopics & best reading 16 Planning > Acceptance Requirements The Stock Options Book section > International > Exchange Controls best reading Equity Alternatives section > Understanding When Plan Provisions Govern best reading The Stock Options Book sections 4.1.2, Planning > Acceptance Requirements 707 Planning > International > Exchange Controls 244 Planning > Understanding when plan provisions govern Next we re going to look at the three new Planning subtopics acceptance requirements, international exchange controls, and understanding when plan provisions govern. I recommend The Stock Options Book section on acceptance requirements, Equity Alternatives section on exchange controls, and The Stock Options Book sections 4.1.2, and 14.3 on understanding when plan provisions govern. Let s look at each of these, starting with acceptance requirements. Next we re going to look at the Planning core topic. We ll start with the Acceptance Requirements subtopic and work our way down. NEXT SLIDE

22 Planning Acceptance Requirements 17 Reference: The Stock Options Book section Grant is a contract Is it unilaterial? Or Are terms negotiable by participant? Affirmative acceptance Provides acknowledgement of receipt Reduces risk of litigation by optionee over terms of award Can be required as a prerequisite to exercise Can be used to delay vesting or payment until received Failure to accept may result in rejection of grant Distribution methods and signature Hardcopy Electronic , company HR website, plan administration platform ordinary course of business 230 Planning > Acceptance Requirements As you have previously learned, an equity compensation award agreement is a contract and is governed by contract law. The controversy with grant agreements is whether or not the company needs to have a written acceptance from the award recipient for it to be a binding contract as to both parties. Aside from best practices, the key to answering that question for purposes of statutory compliance lies in whether the terms of the award are negotiable by the recipient. If the terms are negotiable by the participant, then the contract cannot be finalized until the recipient agrees to the terms by signing the contract. It s as easy as that. Nevertheless, best practices are to require an affirmative acceptance even when the terms are non negotiable. The benefits of an affirmative acceptance requirement are numerous. It provides an acknowledgement of receipt from the award recipient, it reduces the risk of litigation because the recipient will be less able to argue that he or she was relying on promises or offers made external to the award, and the company can make affirmative acceptance a gating action in the award process, making it a prerequisite to exercise, vesting, or settlement, and in some cases, such as restricted stock awards that do not require an exercise, the failure to make an affirmative acceptance can result in the rejection of the award. 20

23 There are many methods available for distributing award documents and securing the recipient s affirmative acceptance, including real paper copies and ink, circulation and acknowledgement by , distribution and acknowledgement on the company s HR website, or within the plan administration platform. Whether or not electronic distribution is appropriate for the particular workforce is generally determined by whether or not the recipients use or the internet in the ordinary course of business, and when they do not, hardcopy distribution and signature is usually called for. NEXT SLIDE

24 Planning Currency Exchange Controls 18 Reference: Equity Alternatives section Foreign governments control the entry of foreign currency into the country and the exit of domestic currency from the country Currency Exchange Controls may include Limitations on the amount of funds leaving the country Limitations on the amount of funds that can leave the country over a specific amount of time Disallowance or requirement of the use of payroll deductions to pay for exercise or purchase Stock ownership limitations may also be imposed Prohibition of purchasing stock in foreign companies Shareholder reporting of vested shares Repatriation of funds upon sale of shares (whether shares were originally paid for or granted without payment) 707 Planning > International > Exchange Controls Now, looking at currency exchange controls. When employees in international locations are required to pay for restricted stock or the exercise of options, the local foreign government will often regulate the movement of currency in that transaction. Common limitations include the value of currency that can leave the country, the value of currency that can leave the country over a specified period of time, the disallowance of or requirement of the use of payroll deductions to pay for the exercise or purchase of shares. The country may also impose limitations on the ownership of stock. Sometimes the purchase is completely prohibited. And, even if payment is not required by the employee some foreign jurisdictions require that the new shareholder may have to report the grant and/or vesting of the shares, and sometimes the funds generated upon the sale of the shares must be returned to the foreign country, even if the shares were not initially paid for by the award recipient. NEXT SLIDE 21

25 19 Reference: The Stock Options Book section 4.1.1, see Exhibit 4 1 Basic Plan Features and 4 2 Policies Outside of the Plan Planning Understanding When Plan Provisions Govern Statutory authority always prevails over internal company policy Company policy can be more restrictive, but not less restrictive External authority Statutory and regulatory authorities change constantly Write plan documents for broadest permissible interpretation Internal policy Refer to sources by policy title or description and as in effect from time to time, but do not incorporate in plan documents Allows for later amendment of policies Authority among plan and grant documents unless it is inconsistent with (or in conflict with) the terms of the plan 244 Planning > When Plan Provisions Govern It should be obvious to point out that statutory and legal authority will always govern over internal company policy, though, in most cases, company policy can be more restrictive than statute and still be compliant. However, as we have seen, the rules regulating equity compensation plans are complex and subject to frequent change for legal and political reasons. Response to changes in such external authorities will be facilitated by designing the plan documents so that it can be interpreted using the broadest permissible parameters permitted under current law. This is especially important when designing an omnibus plan that allows for a variety of award types, not all of which are bound by the same statutory requirements. A good example of this is setting a 90 day post termination exercise period in an omnibus plan because it is a requirement for tax qualified options, even though non statutory awards can have more liberal exercise periods. Of equal importance is how the plan designers incorporate internal policy into the plan, such as fair market methodology, performance matrices, human resources policies on leaves of absence and change in status. Where plan administration is dependent upon internal policy, it is best to refer to such policies by as in effect from time to time without incorporating them specifically into the 22

26 plan. In this way the company retains the ability to amend the policy documents in the future without having to amend the plan. And then, finally, remember that an equity incentive grant is a contract between the company and the recipient, the company must assure that, between the plan and the grant documents, the hierarchy of authority is clear. The complete contract is made up of the individual notice of grant, exercise documents, and the plan itself. The plan will set out the generic default terms under which individual grants can be made. The grant document will set forth the individual award terms, and should incorporate the plan by reference, including a statement that the grant document controls unless it is inconsistent with or in conflict with the terms of the plan. Exhibits 4 1 and 4 2 to section 4 of The Stock Options Book are good summaries of basic plan features and applicable company policies and their purposes in plan design. Now let s do some essential review. NEXT SLIDE

27 Understanding Transactional Functions 20 Reference: GPS: Performance Awards section 7.4 General Administration Textbook citation verified 2017 Syllabus xref verified ) Transactional Functions Even though there aren t any new subtopics in the Understanding of Transactional Functions core topic, the newly assigned reading in the GPS Performance Award publication section 7.4 focuses on the mechanics of tax withholding for performance stock options. When a Performance Stock Option is exercised, withholding can be paid either directly by cash, by a net exercise where the company retains enough of the shares to pay for the taxes, or in a same day sale or sell to cover purchase. NEXT SLIDE 23

28 Understanding Transactional Functions 21 Reference: The Stock Options Book section 7.2 Net exercise Similar to same day sales except that the company itself, not the broker, withholds the shares to cover the exercise price. The company withholds the number of shares with a value equal to the full exercise price. The optionee receives the balance of the shares and pays ordinary income tax on the full spread at exercise. Withholding taxes may be Paid by additional share withholding by the company and the company pays the withholding in cash Paid by check by optionee Paid by optionee selling shares on the open market 266 Understanding Transactional Functions > Exercising Methods > Net Exercise Continuing on with understanding transactional functions, a net exercise is similar to a same day sale except that the transaction does not go through a broker and, instead, the company handles the share withholding. The company withholds the number of shares with a value equal to the full exercise and the optionee receives the remainder of the shares, but pays ordinary income taxes on the full spread of all the exercised shares. Withholding taxes can also be paid by the company withholding additional shares and then generating the cash to cover the taxes, or the optionee can pay the taxes by check, or the company can require the optionee to sell some of the exercised shares on the open market to generate the cash required for the tax withholding. As mentioned before, when using the net exercise method, it is important to check share counting procedures to ensure that net shares are properly counted under the pool. And, finally, even though net exercise, stock swap and employer loans were topics assigned under your Level 2 studies, the new Level 3 assignment of sections 7.2, 7.3 and 7.4 of The Stock Options Book tells me that the CEPI wants you to have a deeper understanding of those sections, so you should read those three sections closely. 24

29 Characteristics Phantom Stock 22 Reference: Equity Alternatives section Full value award based on value of underlying stock plus appreciation over vesting period Usually does not require payment of exercise or purchase price at settlement Deferred compensation under Section 409A A short term deferral is exempt from 409A Payout taxed as ordinary income if compliant with or exempt from Section 409A; if not, recipient pays 20% penalty plus interest May settle in cash or stock Accounting treatment is similar to SAR Eligible for employer tax deduction for amount of reported compensation If awards are broad based, may fall under ERISA 660 Characteristics > Phantom Stock > Features Now let s do some essential review on phantom stock, stock appreciation rights, performance awards and dividend equivalent rights. A phantom stock award is analogous to a restricted stock award, but does not grant actual shares. Rather, it is a full value award based on the value of the underlying stock that also appreciates over time as if it were stock, so it provides the recipient with the benefit of the value of the stock and the appreciation in value until settlement, and also usually carries the right to receive or be credited for any dividend equivalents until vesting. A phantom stock award does not usually require a capital investment by the award recipient in the form of an exercise or purchase price and for that reason the award is generally subject to deferred compensation rules under Section 409A of the Internal Revenue Code. Phantom stock awards may be exempt from 409A if the payout is made shortly after vesting. This short term deferral provision requires that payment of the award be made within the later of two and one half months after the end of the employer s fiscal year or the calendar year in which the award vests, and the award terms do not require payment on a date or event that could potentially occur after that two and a half month period. 25

30 Section of the Equity Alternatives textbook states that the plan need not state a specific date for payment within the 2.5 month period, but, rather, it must specifically NOT include terms which would allow for a payment after the 2.5 month period, and gives the example of a plan that provides for a lump sum payment upon separation of service where because the stated event, the separation from service, could hypothetically happen after the 2.5 month period, the award fails to qualify for the short term exemption even if the payout is actually made before the 2.5 months elapses. Otherwise the award is subject to 409A and will incur penalties and interest if the award is not found to be compliant with or exempt from the statute s operation. A phantom stock award may settle in cash or stock, the accounting treatment is similar to a stock appreciation right, which is discussed in detail in the Level 3 accounting webinar, and the amount reported to the recipient as compensation can be claimed as a tax deduction by the employer. If the company has a history of granting phantom stock awards to a broad employee base, the plan will have to be carefully structured so as not to be considered a retirement plan and fall under ERISA, which regulates such plans. NEXT SLIDE

31 Characteristics Tandem SAR 23 Reference: The Stock Options Book section Tandem award = Stock Appreciation Right component issued in conjunction with associated equivalent option component Exercise of one award component cancels out the other Tandem ISO/SAR is permissible provision for ISO rules Tandem ISO/SAR gives optionee determination at exercise as to whether to exercise SAR for cash or ISO for stock If settled for cash, gain is immediately taxable at the time of settlement If settled in stock, the shares will carry the same preferential ISO tax treatment, even though the SAR would not have been eligible for that treatment 118 Characteristics > SARs > Basics A Tandem award is characterized by the issuance of two dependent awards, often a Stock Appreciation Right component and an equivalent option component. Under this arrangement, exercise of one component cancels out the other component. When the option component is a tax qualified ISO, SARs are permissible and if settled in stock carry the same preferential tax treatment and holding periods as the ISOs. NEXT SLIDE 26

32 Characteristics Performance Awards General 24 Recruit / attract Reward / motivate Retain Reference: Equity Alternatives section Characteristics > Performance Awards > General Understanding As mentioned earlier, clearly defining the purpose of an award and the objectives of the plan in the planning stages will be the key to determining what types of awards will be issued under the plan and the terms and conditions of those awards. As pointed out in this inset, performance plans are generally not the proper tool for recruiting or attracting new employees, but are well structured for rewarding and motivating existing employees and ensuring long term loyalty of executives and highperformers. NEXT SLIDE 27

33 Documents Dividend Equivalent Rights 25 Reference: GPS: RS section 5, review controls on page 34 Dividend Equivalent Rights: The right for an unvested equity award to receive an amount equivalent to dividends declared on company stock Usually payable on full value stock based awards such as RSUs and phantom stock Payable upon declaration in cash or deferred until vesting and settled in cash or stock Key dates: Declaration date. The date the Board announces a that dividend will be paid, an exchange will be made, a transaction will occur. Record date. The date the company identifies eligible shares and shareholders based on company records. This date is the cutoff for who gets the benefit/right and who does not only those who are shareholders on this date qualify even though the transaction date is later. Transaction date. The date the company delivers the payment, performs the exchange, closes the transaction, etc. 172 Docs > Plan > Dividends & DERS A dividend equivalent right is the right for an unvested equity award to receive an amount equivalent to a declared dividend on company stock. Dividend equivalent rights are not a required award element and are not actual dividends but are simply structured to mirror dividends paid on unvested restricted stock. When they are included in an award, dividend equivalents are usually payable on full value stock based awards such as restricted stock units and phantom stock. Like dividends, DERs can be payable in cash at the time the dividend is declared or they can be deferred and settled later in stock or in cash. It is most common for dividend equivalent rights to be treated as a deferred payment as if the dividend was reinvested in stock, or deferred until the underlying award vests. When the deferred dividend is paid in stock on vest date, the conversion of cash to shares is based on the fair market value of stock on the date of vest. As an administrator, you will be most concerned with the implementation of the dividend program, which revolves around three key dates. The declaration date is the date that the board of directors announces that a dividend will be paid. You should remember the term Record Date from your earlier studies on shareholder 28

34 voting. The record date is the date the company identifies which shareholders will be eligible to receive the dividend or equivalent based on the company s records. The record date is the metaphoric line in the sand, that says, shares owned on or before this date are eligible to participate in whatever action is being contemplated, like voting or receiving a dividend, and shares purchased after this date are not eligible. The payment date, or transaction date, is the date the company actually delivers the payment on the eligible shares. As an administrator it will be important for you to understand the difference between eligible shares and eligible shareholders because even though a shareholder may be eligible to receive the dividend based upon stock owned at the time of the record date, that person s holdings may change between the record date and the payment date. The shares owned by the shareholder on the record date are the eligible shares. Any shares purchased after the record date but before the payment date are not eligible shares and will not receive the declared dividend. Likewise, any awards that are eligible to receive dividend equivalents will have the same eligibility cutoff. You will want to read Question 21 in section 5.3 of the GPS: RS publication and familiarize yourself with the sample controls listed in the GPS: RS publication on page 34. NEXT SLIDE

35 26 Reference: Selected Issues sections 4.2, 4.4.4, External Considerations # of Securities Issued Type of award Tax qualified awards. Full value awards. Appreciation awards. Number of securities granted. Purpose of award recruiting, reward, retention Target recipient directors and officers, executives and management, staff, advisors and consultants Industry practices Number of securities issued. Cash settled Stock settled Depends upon exercise method Stock used to pay tax withholding Rounding issues External Considerations > Plan Features Another important point that your prior studies have touched upon is share counting and calculating plan reserves. This takes on greater importance in Level 3 because of the goal of testing your professional discretion. As we ve already discussed, tax qualified awards, such as ISOs and ESPPs, require the company to state the maximum number of shares that can be issued under the plan at the time the plan is initially adopted and approved by shareholders. If the plan is an omnibus plan that allows for a variety of award types, the company will also need to take into consideration whether the awards are full value awards or appreciation awards when determining the number of shares that will be set aside in the reserve pool and whether the reserve will be a fungible share pool that reduces the reserve by a greater than 1 for 1 ratio for full value awards. In addition, the company will have to consider the purpose of the award and the target recipient as well as industry practices in order to determine the appropriate number of securities to be granted. And, then, finally, at the time of settlement or exercise the administrator will have to calculate the number of securities to be issued. When an award is cash settled, no securities will be issued. When an award is stock settled, the number of securities will often 29

36 depend upon the exercise method. If the exercise is done by payment of cash, then the notice of exercise will state the number of shares to be issued. If the exercise is accomplished by a cashless exercise, net exercise, pyramid exercise, or other stock for stock method, or if shares will be used to pay for withholding taxes, then the number of shares actually issued will be fewer than the number of shares exercised. Also note that for purposes of share counting if outstanding shares are used to exercise an option, only the net number of shares issued to the optionee after the exercise is subtracted from the share reserve pool (The Stock Options Book section 3.2, pg 27). And, finally, if an exercise results in fractional shares, best practice is always to round down the number of shares to the nearest whole share, and pay the fractional share in cash. NEXT SLIDE

37 Level 3 Administration New Assignments 27 Characteristics of Equity Awards External Considerations Governing & Supporting Documents Planning Understanding of Transactional Functions And that concludes our coverage of the new Level 3 assignments and essential reviews for the Equity Plan Design, Analysis and Administration core topic. But since Administration is such a large part of the Level 3 exam, and since it s likely that many of those questions will be complex or analytical questions on Level 2 topics, we re next going to cover some of those types of questions and give you some tips on how to prepare for this portion of your test. NEXT SLIDE 30

38 28 Equity Plan Design, Analysis, and Administration Bonus 1 Question Your Company has just rolled out a new IRC 423 ESPP. The board has made it clear that the plan is meant to augment the total compensation package for nonofficers. Which of the desired features below would be prohibited? a. Individual limit of 400 shares per offering b. Exclude all executives in the company who make more than $200K c. Allow part time employees who work 8 hours a month d. Allow employees to write a check to the company for additional shares, up to one week prior to the purchase date 31

39 29 Reference: Selected Issues section Equity Plan Design, Analysis, and Administration Bonus 1 Question Your Company has just rolled out a new IRC 423 ESPP. The board has made it clear that the plan is meant to augment the total compensation package for non officers. Which of the desired features below would be prohibited? a. Exclude all Section 16 officers b. Exclude all EXECUTIVES in the company who make more than $200K (cannot exclude a class of employees only restrictions that apply to entire employee population) c. Allow part time employees who work 8 hours a month d. Allow employees to write a check to the company for additional shares, up to one week prior to the purchase date 220 Characteristics > ESPP > General Understanding Answer b. is the correct answer the company would be prohibited from excluding all executives who make more than $200,000 per year. Now I know many of you are thinking, but IRC 423 allows for the exclusion of all employees that earn in excess of $200,000, so how can that be prohibited? It s because the company can t exclude a specific class of employees, as in answer b. which seeks to exclude only executives in the company who earn more than $200k. Just as all benefits must be equally available to all employees, so must all limitations set by the company be equally applied to all eligible plan participants. The only exception to excluding a specific class of employees is that the company is allowed to exclude all Section 16 officers, regardless of their compensation. 32

40 30 Equity Plan Design, Analysis, and Administration Bonus 2 Question Refer to the XYZ EIP Document. On 3/31/2012 Joe Jones receives a 100 share RSU grant. On 6/30/2012 Joe receives an additional 325 share RSU grant. Prior to any vesting event the company performs a 1:3 reverse split. How many RSU shares does Joe have after the split and what happened to the fractional shares? a , fractions cashed out on final vesting date b. 141, fractions cashed out during split processing c. 142, fractions rounded up during split processing d. 141, fractions rounded down during split processing 33

41 31 Reference: XYZ EIP Plan, RSU Agreement, Section 4, Page 2 Equity Plan Design, Analysis, and Administration Bonus 2 Question Refer to the XYZ EIP Document. On 3/31/2012 Joe Jones receives a 100 share RSU grant. On 6/30/2012 Joe receives an additional 325 share RSU grant. Prior to any vesting event the company performs a 1:3 reverse split. How many RSU shares does Joe have after the split and what happened to the fractional shares? a , fractions cashed out on final vesting date b. 141, fractions cashed out during split processing c. 142, fractions rounded up during split processing d. 141, fractions rounded down during split processing 220 Characteristics > ESPP > General Understanding Per section 4 of the XYZ EIP RSU agreement, all fractional shares are cashed out on the final vesting date. This is a good example of where you put your professional practice aside and answer according to the terms of the sample plan. 34

42 32 Equity Plan Design, Analysis, and Administration Bonus 3 Question Refer to the XYZ EIP Document. The company grants 100,000 ISOs, 34,000 RSUs, 20,000 cashsettled SARs, and Performance Shares Units with a 17,777 base and a potential of 2 times that amount. The entire ISO grant vests, 50% of the SARs are cancelled. 25% of the RSUs are cancelled and the PSUs are paid out at 125% of the base. How many shares does the company have left in its initial allocation? a. 4,828,419 b. 4,818,418 c. 4,831,168 d. 4,844,273 Go to polling question #1 to answer 35

43 33 Equity Plan Design, Analysis, and Administration Bonus 3 Question Refer to the XYZ EIP Document. Reference: XYZ EIP, Main Plan Doc, Sections 4.1 and 4.2, Page 8 The company grants 100,000 ISOs, 34,000 RSUs, 20,000 cashsettled SARs and Performance Shares Units, with a 17,777 base and a potential of 2 times that amount. The entire ISO grant vests, 50% of the SARs are cancelled. 25% of the RSUs are cancelled and the PSUs are paid out at 125% of the base. How many shares does the company have left in its initial allocation? a. 4,828,419 b. 4,818,418 c. 4,831,168 d. 4,844,273 Math on next slide 151 Governing Docs > Plan Provisions > Administration The correct answer is 4,818,419 shares. Let s just move on to the math slide. 36

44 34 Reference: XYZ EIP, Main Plan Doc, sections 4.1 and 4.2, page 8; Notice of Stock Option Grant and Notice of Restricted Stock Unit Grant, pages 29 & 35 Equity Plan Design, Analysis, and Administration Bonus 3 Explanation Explanation: Granted 100,000 ISOs, 34,000 RSUs, 20,000 cash settled SARs, and 20,000 Performance Shares Units with a 17,777 base and a potential of 2 times that amount. Settled The entire ISO grant vests, half the SARs are forfeit and half reduce the pool 1:1 even though they re cash settled. Released 25% of the RSUs are cancelled and PSUs are paid out at 125% of the base and, because they are full value awards RSUs and PSUs will reduce the pool 1.5 shares for every 1 share released The math: 100,000 ISOs fully vested 10,000 SARs pay out 38,250 RSUs are released (34,000 x 1.5 x 75%) 33, PSUs are released (17,777 x 1.5 x 125%) Total awards 181,581.9 rounded up to 181,582 Reserve pool 5,000, ,582 = 4,818, Governing Docs > Plan Provisions > Administration This question wants you to know the different reduction rates from the share pool based on the award type. So let s just walk through it: ISOs are predictably a 1 for 1 reduction to the pool. SARs, even though they are cash settled, are also a 1 for 1 reduction to the pool. And because RSUs and PSUs are full value awards, they will reduce the pool by 1.5 shares for every 1 share issued. So the math shows those calculations and then you ll also have to know that the two available grant agreements say that if the vesting schedule would result in a fraction, that fraction shall be rounded to the nearest whole Share. and that s why we round up the aggregate total awards. You can find these pool reduction rules in the XYZ Plan Summary in the Supplemental Materials section of the website, but you can also simply print out this slide as an easy reminder. 37

45 35 Equity Plan Design, Analysis, and Administration Bonus 4 Question Refer to the XYZ EIP Document. An XYZ Corporation employee takes a promotion that makes her an employee of a subsidiary of XYZ; XYZ is the majority shareholder of the subsidiary. At the time of her promotion, XYZ Corporation is in the process of purchasing the 51% of the subsidiary that it does not yet own. What happens to the ISOs and NSOs she holds under the XYZ Corporation Equity Incentive Plan? a. All ISOs retain their status and continue to vest on schedule along with the NSOs, all awards will expire on their original expiration date. b. Unvested ISOs convert to NSOs and NSOs continue to vest on schedule, three months after the promotion vested unexercised ISOs convert to vested NSOs. c. NSOs continue to vest on schedule; unvested ISOs are forfeit at the time of promotion, unexercised ISOs are canceled three months after the promotion. d. Vesting on both ISOs and NSOs ceases upon the change in jobs; unexercised NSOs and ISOs will be canceled three months after the promotion. 38

46 36 Reference: XYZ EIP sections 2.1, 2.11, and 6.8; XYZ Corporation Stock Option Agreement section 2; and The Stock Options Book appendix 2, Code Sections 424(e) and (f) Equity Plan Design, Analysis, and Administration Bonus 4 Explanation 41 Explanation: The correct answer is b. Unvested ISOs convert to NSOs and NSOs continue to vest on schedule, three months after the promotion vested unexercised ISOs convert to vested NSOs. The Equity Incentive Plan specifies that a transfer to an Affiliate controlled by XYZ Corporation does not constitute a termination of service, which means that all awards continue in full effect. Even so, under the plan's definition of "affiliate," in Plan section 2.1, if the award is an ISO then the subsidiary must meet the Internal Revenue Code Section 424 definition of "affiliate." The Code considers a company to be an affiliate for ISO purposes only if the parent company owns at least 50% of the voting stock at the time of grant. Thus, under the XYZ Corporation plan, the employee can be considered to be transferring to an Affiliate for the purposes of her NSOs, but not for her ISOs because XYZ company only owns 49% of the subsidiary even though it is the majority shareholder so XYZ controls the subsidiary from the Plan perspective, but not from the IRC perspective. In that circumstance, the unvested ISOs will convert to NSOs at the time of promotion and the employee will have three months in which to exercise the vested ISOs before they also convert to NSOs. 151 Governing Docs > Plan Provisions > Administration Even though the EIP says that a transfer to an affiliate company controlled by XYZ is NOT a termination of service, if the award is an ISO then the affiliate entity must also meet the definition of IRC 424. That section of the Internal Revenue Code says that for ISO purposes the parent company must own at least 50% of the voting stock at the time of grant. In the fact scenario, XYZ only currently owns 49% of the affiliate company so the company doesn t meet the Internal Revenue Code ownership requirements for retaining the ISO status. So in this fact scenario unvested ISOs will immediately convert to NSOs at the time of promotion. The vested ISOs will retain their ISO status for three months before they also convert to NSOs if they re not exercised. 39

47 37 Equity Plan Design, Analysis, and Administration Bonus 5 Question A publicly held company is planning to grant restricted stock awards to all full time employees. Which of the following should be a plan design concern? a. Avoiding having awards vest during predictable blackout periods. b. Providing employees with 83(b) election forms. c. Ensuring that any elections for deferral of payment comply with Section 409A. d. Arranging to issue the underlying shares from the share pool at vesting. 40

48 38 Equity Plan Design, Analysis, and Administration Bonus 5 Question A publicly held company is planning to grant restricted stock awards to all full time employees. Which of the following should be a plan design concern? Reference: Equity Alternatives section 3.2 and Table 3 1 a. Avoiding having awards vest during predictable blackout periods. b. Providing employees with 83(b) election forms. c. Ensuring that any elections for deferral of payment comply with Section 409A. d. Arranging to issue the underlying shares from the share pool at vesting. 151 Governing Docs > Plan Provisions > Administration Answer a. is the correct answer. Avoiding vesting during blackout periods is important because the employees wouldn t be able to sell stock required to meet the tax liability triggered by the vesting event. Answers b and c are incorrect because 83(b) elections and 409A deferrals are, technically, the responsibility of the employee (even though many companies assist their employees with these matters), and answer d is incorrect because it s immaterial. Issuing shares from the share pool at vesting applies to all types of awards, not just RSAs, and the shares will automatically come out of the share pool when issued through a plan that s the whole point of having a plan and share pool. And that s the end of our coverage for Level 3 Administration. 41

49 Notes on the Administration Questions 39 Know the plans cold! Print out the Plan summaries from the Prep Course website Try printing them at 75% and writing tons of notes in the margins. Try setting them up in your stock admin software and printing the plan setup reports that you are used to seeing. This may help with common features. This may help you remember critical outliers in the feature set (things your system canʼt handle well). Most people lose their way in the plans. Level 3 questions are very specific and generally refer to the odd or esoteric features of the plan. Know where every interesting feature is and understand it. Now let s close with some exam pointers. The first tip is know the XYZ Plans cold. This means not just the employee stock purchase plan and the equity incentive plan but also the ancillary documents that are provided along with the plan documents in your exam binder. The XYZ ESPP has no changes since last year, but the Equity Incentive Plan was updated on four very important points: The board adoption, shareholder approval dates were updated to 2012, and amendment date to 2017, which pushes the ten year plan expiration date to And paragraph 2 of the Restricted Stock Unit Agreement has been updated to change allowable value of shares withheld for payment of tax withholding from the minimum statutory rate to the maximum individual statutory tax rate in the applicable jurisdiction. 42

50 Questions? Achaessa James, CEP National Center for Employee Ownership 1629 Telegraph Ave., Suite 200 Oakland, CA