SEC Issues SAB No. 120 Regarding “Spring-Loaded” Awards

Cydney S. Posner is special counsel at Cooley LLP. This post is based on her Cooley memorandum. Related research from the Program on Corporate Governance includes Stealth Compensation Via Retirement Benefits by Lucian Bebchuk and Jesse M. Fried.

[On Nov. 29, 2021], the staff of the SEC’s Office of the Chief Accountant and Corp Fin released Staff Accounting Bulletin No. 120, which provides guidance about proper recognition and disclosure of compensation cost for “spring-loaded” awards made to executives. According to the SEC press release, “[s]pring-loaded awards are share-based compensation arrangements where a company grants stock options or other awards shortly before it announces market-moving information such as an earnings release with better-than-expected results or the disclosure of a significant transaction.” When these grants are not routine, according to the staff, they “merit particular scrutiny.” Notably, the staff advises that, in measuring compensation actually paid to executives, companies “must consider the impact that the material nonpublic information will have upon release. In other words, companies should not grant spring-loaded awards under any mistaken belief that they do not have to reflect any of the additional value conveyed to the recipients from the anticipated announcement of material information when recognizing compensation cost for the awards.”

More specifically, the staff adds new guidance (and rescinds other guidance) to help companies estimate the fair value of share-based payment transactions under Topic 718 with respect to the determination of the current price of the underlying shares and the estimation of the expected price volatility when the company grants awards that are “spring-loaded.” When companies grant awards while in possession of positive MNPI, the staff believes that companies estimating fair value should consider making adjustments to the current price of the underlying share or the expected volatility of the price of the underlying share for the expected term of the award.

According to the WSJ, the new “guidance follows events involving Eastman Kodak Co.’s stock last year. Rochester, N.Y.-based Kodak’s stock surged in July 2020 to its highest level in six years shortly after the company and a federal agency announced the company was set to receive a $765 million loan to help make drugs to protect against coronavirus. Kodak handed out options to executives the day before the loan was officially announced. Those options, some of which vested the day they were granted, soared in value with the stock.” The WSJ reports that one executive “stood to reap more than $95 million from the stock increase if he had exercised options at then-current prices,” although he did not in fact exercise at the time. The company has not been charged with any violations.

With regard to estimating expected volatility, the objective “is to ascertain the assumptions that marketplace participants would likely use in determining an exchange price for an option.” For example, if the company has recently announced a merger that “would change its business risk in the future, then it should consider the impact of the merger in estimating the expected volatility if it reasonably believes a marketplace participant would also consider this event.” Likewise, companies will need to carefully consider whether MNPI “is currently available (or would be available) to the issuer that would be considered by a marketplace participant in estimating the expected volatility.” If the company has entered into an undisclosed material transaction prior to the company’s grant of equity, depending on the facts, the company could conclude that the event should be taken into account in estimating the expected volatility.

The staff expects that the company would, at a minimum, disclose in a footnote to its financials how it determined the expected volatility assumption, including how it determined any significant adjustments to historical volatility. In addition, companies also need to consider disclosure as critical accounting estimates in MD&A (Reg S-K Item 303(b)(3)) to the extent that “consideration of future events in estimating expected volatility…resulted in an estimate that involves a significant level of estimation uncertainty and has had or is reasonably likely to have a material impact on the financial condition or results of operations of the company.”

With regard to market price, while an observable market price on the grant date is usually considered to be a reasonable estimate of the current price of the underlying shares of a routine annual grant to employees that is “not designed to be spring-loaded,” the market price may require adjustment when grants are made

“in contemplation of or shortly before a planned release of [MNPI], and such information is expected to result in a material increase in share price. The staff believes that non-routine spring-loaded grants merit particular scrutiny by those charged with compensation and financial reporting governance. Additionally, when a company has a planned release of [MNPI] within a short period of time after the measurement date of a share-based payment, the staff believes a material increase in the market price of the company’s shares upon release of such information indicates marketplace participants would have considered an adjustment to the observable market price on the measurement date to determine the current price of the underlying share.”

The SAB provides as an example a public company that has entered into a material contract with a customer after market close and, after signing the deal but before disclosure the next day, the company awards options to its executives that are non-routine and approved by the board in contemplation of the material contract. The deal is expected to make the share price pop significantly once announced. The company’s policy is to consistently use the closing share price on the day of the grant as the current share price in estimating the grant-date fair value of options.

First, the staff delivers a reminder that, in this circumstance, companies are expected to “consider whether such awards are consistent with its policies and procedures, including the terms of the compensation plan approved by shareholders, other governance policies, and legal requirements. The staff reminds companies of the importance of strong corporate governance and controls in granting share options, as well as the requirements to maintain effective internal control over financial reporting and disclosure controls and procedures.” Second, the staff believes that, without an adjustment to the closing share price to reflect the impact of the new material contract, “the closing share price would not be a reasonable and supportable estimate and, without an adjustment the valuation of the award would not meet the fair value measurement objective of FASB ASC Topic 718 because the closing share price would not reflect a price that is unbiased for marketplace participants at the time of the grant.” [Emphasis added.]

In addition, the staff would expect the company to disclose in its footnotes, at a minimum, how it determined the current price of shares underlying options for purposes of determining the grant-date fair value, including “its accounting policy related to how it identifies when an adjustment to the closing price is required, how it determined the amount of the adjustment to the closing share price, and any significant assumptions used to determine such adjustment, if material.” The company should also consider if the characteristics of these spring-loaded options differ from the company’s other options to an extent that would require separate disclosure regarding these options to allow investors to understand the company’s use of share-based compensation. The staff also advises that the company “should consider the applicability of MD&A and other disclosure requirements, including those related to liquidity and capital resources, results of operations, critical accounting estimates, executive compensation, and transactions with related persons.”

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