Two Step's Private Company Equity Management Blog

Cooley Godward Kronish LLP issued an alert on Sept. 25, 2007 that does a nice job of answering certain anticipated questions, such as:

• What does Notice 2007-78 do?
• Does it delay the effective date of the final regulations under Section 409A until January 1, 2009?
• May we delay providing a designated time and form of payment under our non-qualified deferred compensation plan until December 31, 2008?
• If our non-qualified deferred compensation plan contains a distribution event that is not permitted under Section 409A (e.g., a "haircut” provision), must we amend the plan to remove that provision on or before December 31, 2007?
• If our non-qualified deferred compensation plan provides a409A-compliant time and form of payment of deferred compensation, may we amend the plan to add or remove a time or form of payment after December 31, 2007?
• Does Notice 2007-78 extend the period during which we may take such actions?
• May we amend our executive’s employment contract to revise the "good reason” definition giving rise to separation pay in order to take advantage of the short-term deferral exception and the double pay exception to Section 409A?
• If we want to amend our non-qualified deferred compensation plan to designate each payment in a series of installment payments as a "separate payment,” may we do so by December 31, 2008?
• What actions should we take before the end of 2007?

To highlight three areas covered by the Cooley Alert that may require action prior to Dec. 31, 2007:

1. Although Notice 2007-78 provides employers with additional time to come into documentary compliance with Section 409A, employers must determine whether their deferred compensation plans and arrangements contain a compliant time and form of payment. If any plan or arrangement does not contain a compliant time and form of payment, then the plan or arrangement must be amended before January 1, 2008.
2. Employers should examine their past stock option grant practices to determine whether any stock options were granted with an exercise price at less than the fair market value of the underlying stock on the date of grant. If any options were granted with an exercise price less than the fair market value of the stock on the date of grant, then the employer has until December 31, 2007 to fix those discounted options.
3. If employers wish to permit deferred compensation plan participants to modify their elections for distributions scheduled to occur after 2007,then the employer must provide the participants with that right, and participants must make their elections, before January 1, 2008.

Click here to read the full alert including answers to the above questions.

The article discussed the federal trial court decision in First Marblehead Corp. v. House.  The court held that “…. the terms of the instrument approved by the company’s board of directors granting the option must control, despite any conflicting terms in the memorandum or worksheet provided to the executive.” By way of background from the Utz article:

… the executive had previously received a two-page memorandum setting forth the principal terms of the grant, which had indicated only that the options “must be exercised within 10 years of the date of grant.” There had been no mention in the memorandum of any three-month deadline for exercise following termination of employment.

… the executive never saw the specific grant of incentive stock options nor the complete plan document prior to his leaving the company. The executive contended that he believed he could exercise his stock options at any time within the 10-year period. He indicated that no one at the company ever told him anything about time limits for exercise upon termination of employment (and the employee did not inquire about any such limits).

The court rejected the executive’s breach of contract argument that the written terms of the grant, and in particular the three-month deadline for exercise following termination, did not apply because the memorandum the executive received stated that the options had a 10-year duration.

Utz states that the lessons are: “… recipients of stock option grants should … carefully read the terms of their grants and the terms of the underlying stock option plan document … [for employers] stock option plan documents and grants should be written carefully and precisely ...”

From our perspective at Two Step, this case reiterates the important lesson that has been most recently illustrated in the stock option backdating scandals which is that stock option documentation must be carefully managed and retained.  It will be required in any dispute like the First Marblehead case, in any investigation like the recent backdating scandals, or by auditors during their annual audit of compensation expense.

At least in this case, there was no dispute over the facts or the existence of each document.  In most cases, there is a tangled web of documents that relate to the board grants, the plan documents, the employee’s agreements, and the exercise documents.  Sometimes there are inconsistencies that make it even more challenging.  And even if not, think about the time spent trying to find all the documents related to a particular stock option.  How many Board minutes would have to be searched?

All documents need to be easily accessible and stored in a manner that connects all the pieces. It’s worth the time and effort to upload all the documents into a consolidated online system that can be searched and can connect each person’s name to all the related documents.  The archaic methods of using three ring binders and file folders has not proven for most companies to be a solid plan that will prepare a company for future unforeseen events. 

One of the leading global accounting, tax and business advisory organizations, Grant Thornton LLP, recently reported that some of the implementation issues technology company executives continue to face include “methods for valuing stock options, applying an accurate forfeiture rate assumption to compensation cost, and reconciling the effect of 123(R) on income taxes.” 

Grant Thornton LLP surveyed finance and accounting executives at 104technology companies (75% were public) on how technology companies are using and accounting for stock-based compensation.  Here are some of their findings:

• 85% report that the overall process of option valuation is significantly more complex than it was before Statement 123(R).
• 76% say they are outsourcing option valuation as a result of this increased complexity and scrutiny.
• 59% of companies report an increased involvement of their compensation committee in designing their compensation programs.
• 58% indicate that reconciling the tax benefit for awards that were partially or fully vested upon adoption of 123(R) is challenging or burdensome.
• 56% find the grant-by-grant reconciliation of the option exercise tax benefit to be challenging and burdensome.
• 35% reported granting restricted stock in the first year post-adoption of 123(R).

If you would like to learn some practical tips on how the FAS 123Rvaluation and expensing rules apply to non-public companies, you can download Two Step’s
on-demand webinar “Straight Talk on FAS 123R Compliance: 5 Things Your Auditors Will Want to Know.”

Leading industry experts Peter Suzman of FAS123 Solutions, LLC and Brock Benson of iComp LLC joined Two Step to present this webinar to help make the audit process easier for non-public companies.  During the presentation, we discuss key issues facing chief financial officers including the pros and cons of the Black-Scholes formula, how to determine key valuation inputs, use of forfeiture rates, and managing the related corporate governance documentation.

If you’re struggling with FAS 123R, take an hour to watch the webinar or download the related white paper: A Five Step Framework to Create Auditable Stock Option Records and Comply with FAS 123R. You can download them anytime and of course they’re free.