SEC Issues Guidance On Spring-Loaded Compensation Awards
Posted by Securities Attorney Laura Anthony | January 17, 2022

On November 29, 2021, the SEC issued accounting guidance on the recognition and disclosure of “spring-loaded awards” made to executives.  A spring-loaded award is a share-based compensation arrangement 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.  The SEC new guidance and scrutiny is not unexpected following the re-opening of the comment period on proposed rules on listing standards for the recovery of erroneously awarded executive compensation (“Clawback Rules”) (see HERE) and proposed new rules on share repurchase programs and stock trading plans (blogs coming soon on each of these).

According to the new SEC accounting bulletin prepared by the SEC’s Office of the Chief Accountant and the Division of Corporation Finance, non-routine spring-loaded grants merit particular scrutiny by those responsible for compensation and financial reporting governance at public companies.  In particular, it is the SEC’s view that a company should not grant spring-loaded awards under the mistaken belief that the accounting for the award, including compensation cost, does not have to include the additional value conveyed to the recipient from the anticipated announcement of material information.

SEC Accounting Bulletin No. 120

As an attorney, I do delve into the technicalities of accounting standards but rather keep my information high level.  The new SEC Accounting Bulletin No. 120 is meant to align guidance related to the accounting treatment of spring-loaded compensation awards with existing GAAP principals, including those reflected in FASB Topic 718.  FASB ASC Topic 718 is based on the underlying accounting principle that compensation cost resulting from share-based payment transactions be recognized in financial statements at fair value.  Topic 718 addresses a wide range of share-based compensation arrangements including share options, restricted share plans, performance-based awards, share appreciation rights, and employee share purchase plans.

In presenting the new guidance, the SEC noted that it is observed numerous instances where companies have granted share-based compensation while in possession of positive material non-public information.  When companies are in possession of positive material non-public information, the staff believes these companies should consider whether 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 share-based payment award are appropriate when applying a fair-value-based measurement method to estimate the cost of its share-based payment transactions.

The bulletin includes interpretive guidance related to the transition from nonpublic to public status, valuation methods (including assumptions such as expected volatility, expected term, and current price of the underlying share, particularly when valuing spring-loaded awards), the accounting for certain redeemable financial instruments issued under share-based payment arrangements, the classification of compensation expense, and capitalization of compensation cost related to share-based payment arrangements. The guidance includes specific examples, and as usual, reminds companies of their corporate governance and disclosure obligations, as well as the need to maintain effective internal controls.

The new guidance applies to all share based compensation, whether granted to employees or non-employees.

                Transition from Nonpublic to Public Status

The SEC bulletin sets forth a set of facts and then four sample questions and interpretations based on those facts.  The fact scenario involves a private company that files a registration statement with the SEC and which had been issuing stock compensation based on intrinsic value.  The SEC considers the company to be public upon first filing a registration statement as opposed to upon the closing of the public offering.

The first question focuses on accounting for share options that were granted, while private, but for which services (vesting) will not occur until the company is public.  In that case, the company could continue to value the options as it did as a non-public company unless the options are subsequently modified, repurchased or cancelled.

The second question focuses on the accounting of fully vested awards that have not been settled.  In that case, the company would increase its liability for the award for the difference between the previous intrinsic value and the new fair value as accounted for as a public company.  The third question confirms that a company may not retrospectively apply the fair value-based method to an award granted before becoming public.  Finally, the fourth question reminds the company that it should clearly describe in MD&A the change in accounting policy that will be required by Topic 718 in subsequent periods and the reasonably likely material future effects.

Valuation Methods

Again, the SEC bulletin sets forth a set of facts and then four sample questions and interpretations based on those facts.  Topic 718 indicates that the measurement objective for equity instruments awarded to grantees is to estimate the fair value at the grant date the company is obligated to issue the award when the grantees have delivered the good or rendered the service and satisfied any other conditions necessary to earn the right to benefit from the instruments.  Observable market prices of identical or similar equity or liability instruments in active markets are the best evidence of fair value and, if available, should be used as the basis for the measurement for equity and liability instruments awarded in a share-based transaction.  If observable market prices of identical or similar equity or liability instruments are not available, Topic 718 provides various valuation options.

This section is especially interesting because it considers when a valuation estimate can be considered misleading when the fair value does not correspond to the value ultimately realized by the grantees who received the share options.  Although estimates by nature are difficult, the estimate of fair value should reflect the assumptions marketplace participants would use in determining how much to pay for an instrument on the fair value measurement date.  As long as the original valuation is made in good faith, based on reasonable market information, later changes would not call into question the original valuation.

As long as all the principals in Topic 718 are applied, the SEC will decide which of those allowed valuations are better or worse than another.  Here, the emphasis is on all the principles which includes that a valuation technique or model (i) is applied in a manner consistent with the fair value measurement objective and other requirements Topic 718, (ii) is based on established principles of financial economic theory and generally applied in that field and (iii) reflects all substantive characteristics of the instrument (except for those explicitly excluded by Topic 718).  Moreover, valuation techniques can change over time as long as they continue to comply with all the rules.

Although valuations do not have to be completed by outside third parties, they must be completed by a person with the requisite expertise.

Assumptions in Valuation Methods

Fair value determinations must consider (i) the expected volatility of its company’s share price; (ii) the expected term of the option, taking into account both the contractual term of the option and the effects of grantees’ expected exercise and post-vesting termination behavior; and (iii) the determination of the current price of the underlying share.  The Black-Scholes-Merton framework is often used to determine fair value.

Volatility is a measure of the amount by which a financial variable, such as share price, has fluctuated (historical volatility) or is expected to fluctuate (expected volatility) during a period. Option-pricing models require an estimate of expected volatility as an assumption because an option’s value is dependent on potential share returns over the option’s term. The higher the volatility, the more the returns on the share can be expected to vary — up or down. Because an option’s value is unaffected by expected negative returns on the shares, other things being equal, an option on a share with higher volatility is worth more than an option on a share with lower volatility.

Topic 718 does not specify a particular method of estimating expected volatility, but it does provide a list of factors entities should consider in estimating expected volatility.  Factors consider both historical volatility and expected or implied future volatility.  Companies that have appropriate traded financial instruments from which they can derive an implied volatility should generally consider this measure and may even consider it exclusively.

In computing historical volatility, companies should consider the length of the option.  Longer term options are less likely to have the same volatility as longer historical periods. Companies should use consistent regular intervals for price observations, which could include daily, weekly or monthly reviews, based on reasonable facts and circumstances.  The SEC bulletin lists certain circumstances in which it believes it would be acceptable for a company to rely exclusively on historical volatility.

In computing expected future volatility, the objective is to ascertain the assumptions that marketplace participants would likely use in determining an exchange price for an option.  Future events could range widely but may include mergers and acquisitions, material transactions, changes in business models or changes in key executives.

In computing implied volatility, a company should consider: (i) the volume of market activity of the underlying shares and traded options; (ii) the ability to synchronize the variables used to derive implied volatility (i.e., trading prices measured at the same point in time and if no active trading market, at the point in time closest to the grant date); (iii) the similarity of the exercise prices of the traded options to the exercise price of the newly-granted share options (at or near the money options); (iv) the similarity of the length of the term of the traded and newly-granted share options; and (v) consideration of material non-public information.  The SEC bulletin lists certain circumstances in which it believes it would be acceptable for a company to rely exclusively on implied volatility.

Where a company has recently gone public and does not a trading history upon which it can base estimates, it can base its estimates on similar entities.  Similar entities would be those in the same industry, stage of life cycle, size and financial leverage.  A company can look to industry sector indexes to find comparables but should not use the index itself.

Regardless of methods used, a company must disclose the expected volatility and method used to estimate it.  Disclosure would be appropriate in the financial statement footnotes and under critical accounting estimates in its MD&A.  Moreover, if the volatility could have a material impact on the future business of the company, additional disclosure may be required in the general MD&A discussion.

As mentioned, in determining fair value, a company must also consider the expected term of the option.  Generally, if an option is tradeable, it is sold rather than exercised.  Likewise, if it is not tradeable, it must be exercised or allowed to expire.  Tradeable options have a higher fair value.  The new SEC bulletin provides guidance on determining expected term of an option which includes a consideration of the contractual term, but also tradeability (and therefore hedgeability) and likelihood of early exercise.    Expected term can never be shorter than the vesting period of an option.  Also, Topic 718 requires that a company aggregate individual awards into groups with respect to exercise and post-vesting employment termination behaviors for the purpose of determining expected term.

Current Price and Spring-Loaded Grants

Assumptions used to estimate the fair value of equity and liability instruments granted in share-based payment transactions shall be determined in a consistent manner from period to period. For example, an entity might use the closing share price or the share price at another specified time as the current share price on the grant date in estimating fair value, but whichever method is selected, it shall be used consistently.

A consistently applied method to determine the current price of the underlying share should include consideration of whether adjustments to observable market prices (e.g., the closing share price or the share price at another specified time) are required such as for material non-public information.  Determining whether an adjustment to the observable market price is necessary, and if so, the magnitude of any adjustment, requires significant judgment. Companies should carefully consider whether an adjustment to the observable market price is required, for example, when share-based payments arrangements are entered into in contemplation of or shortly before a planned release of material non-public information, and such information is expected to result in a material increase in share price.  Non-routine spring-loaded grants merit particular scrutiny by those charged with compensation and financial reporting governance.

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