These 3 Audits Can Prevent Headaches

In thinking back through some of my past blog entries, I notice several have focused on failures in internal controls. In recent months I've covered lapses in keeping tabs on plan limits and the SEC's interest in late Section 16 filings, among others. As administrators, the concept of an audit is a daily process component. In theory pretty much everything that happens from a process standpoint is (or should be) audited. There is a lot of checking and balancing. I can't possibly cover all of the audit spectrum in one blog, but for today I will cover 5 of them that, in my mind, can prevent many headaches down the road.

Audit, Defined

Audit: "a careful check or review of something" (Merriam-Webster).

I think many times the word "audit" signifies something big in our heads. Like when the auditor comes and performs an extensive or extended review of a process. For today's purposes, let's just assume that an audit is simply a careful review of something. It could be big or small, quick or more prolonged. That's really it, though. All of the audits I'm going to suggest can be performed relatively quickly, with lots of bang for the time invested. A few minutes now can save hours of headaches later on. The headaches I'm talking about include disclosing control failures internally and publicly, increased shareholder scrutiny and litigation, unwinding grants, purchases or awards, and more.

3 Areas of Audit

1. Review Plan Limits. In my blog "Share Limit Lessons the Hard Way - Part II" (January 15, 2015), I covered some examples of control failures and the resulting repercussions in this area. Your stock plan could have several different limitations on shares or other provisions, often easily identified by the use of the words "minimum" or "maximum". Common plan limits include the total number of shares issued under the plan, a cap on the quantity of shares that can be issued to an individual - over the life of the plan or within a specified time period (or both), a minimum required vesting period (for example, awards that must have a minimum of a one-year vesting period), and share ratios (fungible or flexible ratios). The easiest way to monitor these limits is to maintain a list of all the "limits" specified under the plan and review them regularly. Educate those involved in the grant process about share limits so that any potential for exceeding them can be headed off before the grant is made. This type of audit should be performed at least quarterly, with interim reviews performed when there is significant related activity, such as a large grant.

2. Compare Plan Activity to the Form S-8. This sounds straightforward, but I have seen this time and time again. The company files an S-8 to register shares to be issued from the plan, and then the balance registered is never compared to actual plan activity. It sometimes feels more like an item to be checked off a to-do list at plan inception, rather than an area of ongoing review. Problems can occur when the company ends up issuing more shares from the plan than are registered on the S-8. How does this happen? There are a number of possibilities - among them are adding new shares to the plan, and not counting the re-issuance of forfeited shares. To recap, the S-8 does not register the plan itself with the SEC, but is for the offer and sale of the securities under the plan. In tracking shares issued under the plan against the number of shares recorded on the S-8, there are a number of factors to consider - like how forfeitures of restricted stock (and subsequent re-grants of those shares) will impact the number of shares remaining for issuance. Subscribers to The Corporate Counsel may benefit from reviewing the article "Form S-8: Share Counting, Fee Calculations, and Other Tricks of the Trade." It's time to dust off the Form S-8 filings and review them against shares issued from the corresponding stock plans.

3. Monitor Section 16 Transactions. I've talked before about the SEC's recent interest in Section 16 reporting violations (see "Section 16 Reporting: Low Hanging Fruit for SEC", November 6, 2014). Because of the short time frame to disclose most Section 16 reportable transactions to the SEC, many companies have controls designed to monitor daily activity from the stock plans. However, common causes of reporting violations include out of box transactions and corrections that fail to be reported. This is an area of audit that will require some creativity to fully embrace. How do you proactively audit for things that are not in the company's control, for example a situation where an officer ceases to be trustee of the family's trust (releasing him from beneficial ownership of the shares)? Another opportunity for a "miss" in reporting is adding or removing executives and directors to/from the list of those obligated to comply with Section 16 reporting. This is an area where auditing may involve the contributions of many. It may take you away from your traditional view of an "audit". In monitoring Section 16 activity, building relationships is an essential component. You'll want to be proactive in building relationships with your compliance officer and other executives who may regularly interact with board members and can inquire about ongoing activity. You'll want to build an alliance with the trusted advisors who assist your Section 16 reporting persons in managing their finances/portfolio/estate. The reporting person may forget to tell you about something, but it may be the professional advisor that tips you off to a change that warrants reporting. This doesn't replace other forms of trying to monitor activity - like proactively inquiring to brokers and asking Section 16 officers/directors about activity. If you've had reporting failures in the past couple of years, it's time to examine the controls to make sure you have enough of the right audit steps in place. Think outside of the box.

There are probably a hundred audits that can encompass stock plan activity and their related disclosure/compliance requirements. We have only tackled three in today's blog. None of these are grossly time consuming and could work in your favor, heading off potentially messy situations down the road. If there's one thing to remember, "audit" doesn't have to mean an all encompassing days long event. It can be as simple as a quick inquiry, review, or analysis designed to stay ahead of the curve in managing your stock plans. Implement these (and more) audits, and you'll thank yourself later!