The SEC’s Guidance on Spring-Loaded Equity Awards
June 23, 2022
Late last year, the SEC issued Staff Accounting Bulletin No. 120 on how to account for spring-loaded equity awards. Recently, I recorded a podcast with Takis Makridis of Equity Methods to discuss the SEC’s guidance and how companies might want to modify their grant procedures in light of it.
Here is a summary of what I learned from our conversation.
What Is Spring-Loading?
Takis explains that the term “spring-loading” refers to issuing an equity grant shortly before an announcement of material nonpublic information that causes the company’s stock price to suddenly increase. He gives a hypothetical example of a company that issues a stock option to an executive the day before it announces a major new strategic partnership. The announcement causes the company’s stock price to increase by 150%, so that the executive’s newly granted stock option is suddenly worth quite a bit more than just one day earlier, when it was granted.
Why Does the SEC Care About Spring-Loading?
This might seem like a victimless crime. In our example, the shares underlying the stock option are either treasury shares or authorized but unissued shares that the company wasn’t doing anything with anyway. It’s not like an investor was duped into selling stock at a low price. If anything, the company simply cheated itself out of some additional cash that it could have eventually received if it had just waited a day to grant the option.
Takis points out that, in his example, the company has engaged in self-dealing by taking advantage of its insider information to issue a more lucrative grant to the executive. One thing that Takis finds interesting about the SEC’s guidance is that they argue that a spring-loaded grant violates the economic principles underpinning ASC 718.
In SAB 120, the SEC posits that the entire premise of ASC 718 Is that objective market prices are used for valuation purposes and that market prices are presumed to be unbiased; the fair market value reflects the price a willing buyer would pay to a willing seller if neither party has any private information about the security being sold. In a spring-loaded grant, the company has information about the value of the underlying stock that isn’t yet reflected in stock’s trading values; this creates a bias in the valuation of the spring-loaded grant.
What Does SAB 120 Require?
Takis describes SAB 120 as a technical accounting standard, not a governance standard. It doesn’t prohibit spring-loading or even express an opinion on it; instead, the bulletin provides guidance on how companies need to address the bias that the SEC has identified as existing in the valuation. Companies must mitigate that bias, as Takis says, “by deploying a model to update the market price to reflect the anticipated impact of the private information that is about to be released.
In Takis’s example of an option issued just before a major partnership is announced, the company would use a mathematical model to estimate the impact the announcement will have on the company’s stock price and incorporate that estimate into the fair value of the option.
What Is the Practical Impact?
As Takis and I discuss during the podcast, the practical impact is that spring-loaded options will be more expensive. Takis discusses the types of models that can be used to estimate the effect of an announcement on a company’s stock price and their limitations, but the upshot is that the valuation of the grant is likely to be higher as a result of the anticipated announcement.
This is even more of a concern if the company isn’t aware that they are spring-loading at the time that the grant is issued. During the podcast, Takis and I reminisce about the back-dating scandal and how most companies that were caught up in it were not aware that they were doing anything wrong at the time and, in fact, many backdated grants were merely the result of administrative errors. Similarly, spring-loading may also be a result of poor communication or a lack of awareness of the technical accounting requirements.
I imagine that, in many cases, the way this will go is:
- Step 1: The company issues a grant just before making a material public announcement. Maybe the grant is in anticipation of the announcement or maybe it is entirely unrelated: maybe the compensation committee isn’t even aware that the announcement is happening at the time the grant is approved.
- Step 2: The news is announced.
- Step 3: The auditors review the company’s financials and identify the grant issued just before the announcement as spring-loaded. They require the company to recalculate the fair value of the grant using a model that estimates the effect of the announcement, which results in a higher valuation.
And let’s say that this company, like virtually all public companies, uses a value-based approach to size grants—that is, it divides the aggregate target grant value by its per-share grant value to determine the number of shares that will be granted. In step 1, when the comp committee was sizing the grant, it thought the fair value was lower than the auditors have now determined it to be. Not only is the expense higher on a per-share basis, but the grant is larger than it would have been if the company had used the higher value to size the grant. This could significantly increase the expense the company recognizes for the grant.
No Take-Backs in ASC 718
Unfortunately, once a grant is issued, there’s no way to cancel it and reverse the expense for it unless it is forfeited due to failure to fulfill service or performance-based vesting conditions. Even when the grant turns out to be considerably more expensive than was expected at the time of grant, it may not be possible to walk back the transaction. Given the implications to the executive who received the grant, many companies may not want to rescind the grant anyway.
Consequently, companies should implement processes now to prevent grants from being unwittingly issued prior to announcements of material nonpublic information, so that the company can make informed decisions with respect to these grants.
Takis suggests having an “all-clear” process that includes checking with various functions involved in the dissemination of news—e.g., finance, legal, investor relations—before issuing grants. If an announcement is planned for just after a grant, one solution is to delay either the grant or the announcement. Another solution might be to move the grant back to put a little more space between it and the announcement.
Be sure to listen to the full podcast, “The SEC’s Guidance on Spring-Loaded Equity Awards,’ for more thoughts from Takis around grant procedures, and check out his feature article, “Examining the SEC’s New Guidance on Spring-Loaded Grants” in the Winter 2022 NASPP Advisor newsletter.