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Holding Periods: A Better Alternative to Clawbacks?

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July 13, 2021 | Barbara Baksa

Holding Periods: A Better Alternative to Clawbacks?

A recent article in the Harvard Business Review, “Why Executive Compensation Clawbacks Don’t Work,” by Sanjai Bhagat and Charles M. Elson, looks at two problems with clawback provisions and suggests using holding periods as an alternative.

How Do Clawbacks Typically Work?

A clawback provision is designed to enable the company to recover amounts paid to employees, typically executives, in certain circumstances, usually situations in which the individual’s behavior in some way warrants a demand that the compensation be repaid.

In the NASPP/Deloitte Consulting Domestic Stock Plan Design Survey, the percentage of respondents reporting that equity grants are subject to a clawback provision has increased from 32% in 2010 to 72% in 2019. There are many different events that can trigger clawbacks (the survey tracks 12 different triggers, plus the ubiquitous “other” category), but the top five most common triggers are:

  • Financial restatement due to fraud or misconduct (90% of respondents)
  • Ethical misconduct/fraud/intentional misconduct (68%)
  • Financial restatement due to inadvertent error (41%)
  • Inappropriate use of trade secrets/breach of confidentiality (41%)
  • Violation of non-compete agreement (39%)

When it comes to equity awards, the most common repercussion when a clawback is triggered is to require executives to return performance shares that have been earned (78% of respondents to the NASPP/Deloitte 2019 survey). Just under 70% of survey respondents require executives to return the gain realized on previously exercised options and/or forfeit vested options and awards. It is also common for bonuses and cash compensation to be subject to clawbacks, but our survey only covers equity awards, so I don’t have data on cash compensation.

Possession Is Nine-Tenths of the Law

The problem with clawback provisions is that they are often difficult to enforce. In many cases, executives balk at having to return the compensation and expensive litigation is required to pursue enforcement.

With regards to pursuing legal claims to enforce a clawback, Bhagat and Elson note the following:

[T]he legal requirement for recovering monies already paid to an executive typically involve the notion of “cause” — unless convicted of a crime, an executive will argue the company has no legal right to reclaim the cash.

Getting a judgement against an executive is only half the battle. A second challenge to enforcing clawbacks is that oftentimes, at the time the clawback is triggered, the stock has been sold, the money has been spent, and there’s nothing left to recover. In the words of Bhagat and Elson:

[O]nce the money is out the door, the burden is on the party without the cash to get it back. And, in many circumstances, the money may be spent and basically unrecoverable.

Holding Periods Might Offer a Solution

Bhagat and Elson suggest requiring executives to hold stock acquired under restricted stock awards until six to 12 months after their last day of employment with the company and prohibiting options from being exercised until that time as well. They note that:

This would prevent executives from capturing the financial gains from questionable decisions or actions before the longer-term costs of those decisions or actions became apparent. And from the company’s perspective, it is clearly easier to simply withhold the stock or options than to attempt to recover cash paid out. Of course, an aggrieved executive can still sue the company, but then the burden would be on the plaintiff to prove their case.

Easier to Do with RSUs, than Restricted Stock or Options

Although Bhagat and Elson refer specifically to restricted stock and options, imposing a hold-thru-retirement requirement may be easier with RSUs because the arrangement could be structured to defer taxation for federal income tax purposes until the shares can be sold. (FICA will still be due in the year of vest and the deferral would need to comply with Section 409A.)

Restricted stock will be taxed at vest for both FICA and FIT purposes, even if the shares are subject to a holding requirement. Bhagat and Elson suggest that executives might be allowed to sell some of their stock, so perhaps shares could be sold or withheld to cover the tax liability.

Prohibiting exercise of stock options until the option holder terminates employment is likely untenable unless the holder is virtually assured of terminating within the traditional ten-year option term. Otherwise, the option would have to be granted with a significantly longer term (or without a term). This, combined with the prohibition on exercise, would significantly increase the expected life of the option and materially increase its fair value.

Bhagat and Elson note that imposing a holding period is not without cost to the company, but they are referring to the fact that the holding periods make the grants less attractive to executives and thus it might be necessary to increase the size of the grants. If the materially higher fair value is combined with a larger grant, the result would be quite a bit more expensive for the company.

Thus, to make this idea work with stock options, exercise would likely have to be permitted upon vesting, with the shares acquired upon exercise subject to the holding requirement. If the option is an NSO, taxation for FICA and FIT purposes occurs upon exercise (any attempt to defer taxation beyond exercise is a violation of Section 409A).

Granting the option in the form of an ISO would delay taxation for FIT purposes (and eliminate FICA taxation altogether); moreover, by the time the executive terminates and can sell the shares acquired upon exercise, the ISO holding period may have elapsed, converting the taxable income to a long-term capital gain. But, alas, granting ISOs is not a panacea. The $100,000 limit caps the size of the option and executives would still have to contend with the AMT implications of any exercises.

Reduced Fair Value

When shares underlying restricted stock and units are subject to a post-vest holding period or when shares acquired upon exercise of a stock option are subject to a post-exercise holding period, an illiquidity discount can be applied to the fair value of the grant. See Aon’s article “Maximize Your Investment in Equity Compensation and be a Good Corporate Citizen at the Same Time.”

If the shares acquired under equity grants cannot be sold for six to 12 months after termination of employment, this requirement could translate to a reduction in fair value, which could offset the increased size of the grant necessary to compensate executives for the restrictions.

I realize that it sounds like this contradicts what I just said about the increased fair value of stock options. It’s a matter of when the option can be exercised. If the option can’t be exercised until after termination of employment, that will increase the expected life of the option, possibly quite significantly. In addition, an illiquidity discount will only be available if the shares acquired under the option cannot be immediately sold.

Conversely, if the option can be exercised as soon as it vests, but the shares acquired upon exercise cannot be sold for a period of time after exercise, an illiquidity discount may be available. Of course, like many aspects of stock compensation, it’s complicated. If the hold-thru-retirement requirement causes executives to delay exercising because they know they can’t sell the stock right away, this will increase the expected life of the option, increasing its fair value, and may also reduce the length of the holding period, shrinking the illiquidity discount.

- Barbara

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