Spring-Loaded Equity Awards are Back on the SEC’s Agenda

Maj Vaseghi, Lori Goodman, and Pamela Marcogliese are partners at Freshfields Bruckhaus Deringer LLP. This post is based on a Freshfields memorandum by Ms. Vaseghi, Ms. Goodman, Ms. Marcogliese, Elizabeth K. Bieber, and Andrew Herman. Related research from the Program on Corporate Governance includes Stealth Compensation Via Retirement Benefits by Lucian Bebchuk and Jesse M. Fried.

On November 29, 2021 the United States Securities and Exchange Commission (the “SEC”) issued new guidance under Staff Accounting Bulletin No. 120 (the “Bulletin”) on estimating the fair value of share-based compensation under Accounting Standards Codification (“ASC”) Topic 718, Compensation—Stock Compensation (“Topic 718”) that leaves some key questions unanswered and that we expect will significantly curtail, if not eliminate, the granting of so-called “spring-loaded” equity awards. The new guidance comes on the heels of reports on “spring-loaded” stock options granted to senior executives prior to the announcement of significant positive news. The Bulletin notes that “[t]he staff has observed numerous instances where companies have granted share-based compensation while in possession of positive material non-public information, including share-based payment transactions that are commonly referred to as being “spring-loaded.”’

The Bulletin relates to estimating the accounting fair value of equity grants that are made in contemplation of, or shortly before, a planned release of positive material non-public information, such as an earnings release in which the company discloses it significantly outperformed guidance and analyst expectations or a transaction, where the information is expected to result in a material increase in share price (i.e., “spring-loaded” equity awards). Under the SEC’s guidance, when determining the fair value of any “spring-loaded” equity awards for accounting purposes under ASC Topic 718, companies will be required to consider the expected increase to the current share price and the expected volatility in share price following the disclosure of such information.

The Bulletin notes that companies that have traditionally valued stock-based awards based on the share price on the date of the grant, without taking into account any prospective share price increases expected in the near-future following the grant, should take into account these expected price increases when valuing “spring-loaded” equity awards. Companies should also disclose how they identified if an increase in the “observable market price” was taken into account and the quantum of such adjustment in its publicly filed financial statements. The SEC expects that companies will disclose information on “spring-loaded” awards independently from their disclosure of other share-based awards .

The Bulletin provides as an example a public company that entered into a material contract with a customer after market close. Subsequent to entering into the contract but before the market opens the next trading day, the company grants stock options to its executives. The company expects the share price to increase significantly once the announcement of the contract is made the next day. In this case the SEC expects the company 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” and “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.” [Emphasis added] The SEC continues, that in this case, using the closing share price on the date of grant, without an adjustment to reflect the impact of the new material contract with a customer, “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.” [Emphasis added]

What Are the Implications of the SEC’s Guidance?

While historically “spring-loaded” stock options awards have been the primary focus of scrutiny and have, under Delaware law, implicated directors’ fiduciary duties, the SEC’s guidance broadly applies to any share-based payments and would include other award types such as restricted stock and restricted stock units. While the Bulletin provides that non-routine grants merit particular scrutiny, we note that the Bulletin suggests that the guidance will similarly apply to grants made in a company’s normal grant cycle that are close in time to a market price moving announcement.

The guidance leaves a number of unanswered questions, including:

  • The methodology companies should use to determine the appropriate valuation of “spring-loaded” awards and what would be considered a reasonable adjustment to the valuation; and
  • If the new guidance will apply to awards that have already been granted, including, for example, during the current quarter of the effective date of the Bulletin, or will only apply to awards granted following the effective date of the Bulletin.

Given the difficulty and other implications in applying the SEC’s guidance, we expect that it will result in significantly curtailing, if not eliminating, “spring-loaded” awards. The implications of the Bulletin will go beyond accounting treatment, especially with respect to stock option grants. A company that increases the accounting fair value of a stock option grant based on future expected movement in the stock price, will need to think hard about also increasing the option exercise price of that award as the underlying stockholder approved equity plan that the awards are issued under generally require that stock option exercise prices be at least equal to the fair market value of stock on the date of grant.

In light of this SEC renewed focus in this area and guidance, companies will need to reassess their equity award grant practices so that grants are not made shortly before planned releases of positive material non-public information.

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