ICS CLIENT BULLETIN | DECEMBER 2021
Accounting for Spring-loaded Compensation
This memo is part of ISS Corporate Solutions’ (ICS) Client Bulletin series designed to keep you abreast of the latest trends and developments affecting governance and sustainability at corporations.
The Securities and Exchange Commission (SEC) issued a Staff Legal Bulletin (SLB) the week of November 29th that clarifies prior advice to companies about accounting for ‘spring-loaded,’ stock-based compensation, which is defined as share-based awards made while a company is in possession of material, non-public information. So that relevant staff interpretations are consistent with the latest U.S. generally accepted accounting principles (U.S. GAAP) as issued by the Financial Accounting Standards Board (FASB), the SLB rescinded and conformed parts of earlier guidance. The relevant part of the Accounting Standards Codification (ASC) is FASB ASC Topic 718, which addresses the valuation of all stock-based pay, not just that which might be considered spring-loaded.
Like Topic 718, the SLB also deals with all types of stock-based pay. For example, a question is asked: what should happen to the valuation of stock options granted to executives of a private company once it goes public? In this instance, the answer is: nothing. Likewise, the SLB asks: should a company consider an additional discount for non-hedgability and non-transferability of stock-based pay? Again, the answer is: no.
On spring-loaded stock pay, fundamentally, the SLB says that companies should consider whether adjustments to the current share price or to the expected volatility of the share price are appropriate when calculating the fair-value of the award. The SLB includes many examples, including awards to employees and non-employees, that allow issuers to see in practice how to approach stock award valuation. In more detail, when a company is in possession of material, non-public information, the SLB reiterates that the implied volatility of the stock price should a reflect the company’s expectations of future volatility, using the same factors as it would in a normal fair value calculation, including the following:
- Historical volatility;
- Amount of historical data;
- Frequency of price observations;
- Consideration of future events; or
- Exclusion of periods of historical data (e.g., where volatility was outside the normal range)
At the same time, however, companies should consider whether a price adjustment to the actual market price is required if awards are made shortly before a planned release of material, non-public information; particularly if it is anticipated that its publication will increase the share price. If such a material increase does occur, this is a clear indication, says the SLB, that the company should have considered an adjustment to market price on the date of the award, in order to determine the ‘real’ share price, as if the information had been absorbed by the market.
The SLB gives an example where a company enters into a material contract with a customer after the market has closed. Subsequently, but before the market opens the next day, one-off stock option awards are made to executives as a reward for signing the contract. The company expects news of the contract to materially increase its stock price. But it typically uses closing grant date share price when estimating the grant-date fair value of share options.
In commenting on this hypothesis, the SLB first encourages companies to determine whether such awards are consistent with their own stock plan policies and governance – many equity compensation plans contain clauses that prevent companies from making stock awards while in possession of material information – as well as ensuring that the awards comply with any state or federal legal requirements.
If the company makes no adjustment, SEC staff would not agree that the closing share price is “a reasonable and supportable estimate and… would not meet the fair value measurement objective of FASB ASC Topic 718,” because the closing share price does not reflect the market’s reaction to signing the contract.
In addition to recommending an adjustment, the SLB outlines the kinds of disclosures that should be made about the award, including a “description of the method used and significant assumptions used to estimate the fair value of awards under share-based payment arrangements.” More specifically, the company should disclose in a footnote: “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.”
Such information should, it suggests, be made separately from other fair-value based assumptions to allow investors to understand fully what specific actions were taken in relation to the spring-loaded awards.
As in other SLBs, SEC staff uses the bulletins to offer interpretive guidance, not rules, and the guidance does not carry the stamp of official approval. For this reason, the guidance expects readers to interpret it within a reasonable range of conduct; and it does not imply a single conclusion or methodology, but a whole range of potential methodologies that a company might use to base its valuation decisions on. ISS Corporate Solutions staff can offer advice and help as to how to interpret this latest SEC guidance.
Head of ISS Corporate Solutions
ISS Corporate Solutions