Creates Trap for Unwary and Will Require Process Changes at Most Companies

In a recent conference call, the Financial Accounting Standards Board (FASB) asserted that in order for a company to fix the "expense" amount of an equity award under FAS 123 and FAS 123(R), it is not enough for the Board of Directors or Compensation Committee to merely approve the equity awards. Instead, the date for fixing the expense (what FASB refers to as the "measurement date") does not occur until the terms of the award actually have been communicated to employees. Historically, many companies have treated the date that the Compensation Committee approves an equity grant as the effective date of the award, provided recipients were notified of the awards shortly thereafter.

The position expressed by the FASB staff on the conference call (and later confirmed by a FASB spokesman) is based upon language in FAS 123 and FAS 123(R) (the accounting standards for equity instruments), each of which contains a requirement that "the employer and the employee have a mutual understanding of the key terms and conditions of an award." FAS 123(R) applies to most public companies as of the first annual reporting period beginning after June 15, 2005, and to non-public companies as of the first annual reporting period beginning after December 15, 2005, although many companies have already adopted the new accounting standard.

Some commentators have expressed hope for either a reversal by the full FASB of the informal FASB staff position or an SEC "clarification." However, absent such relief, the new FASB staff position will require companies that are now or will soon become subject to FAS 123(R) to review their existing processes for granting equity awards to employees, perhaps by implementing alternatives such as the following:

  • Prepare summaries of award documents in advance and then use email or a website to communicate Board or Compensation Committee actions regarding equity grants on the day such actions are taken.
  • Prepare the actual award documents in advance and distribute them on the date the Board or Compensation Committee takes action.
  • Have the Compensation Committee or Board make the equity awards as of a future date (with the exercise price of options determined on that date) that provides the company with sufficient time to communicate the terms of the awards to employees.

What seems increasingly unworkable is to simply continue the current practices of communicating awards to employees. In many cases, those historical practices – when combined with the FASB’s staff position – will require the company to keep track of the exact date each employee was informed of the award, which in turn will cause many different measurement dates for each group of awards approved by the Board or Compensation Committee. (In this regard, the FASB staff reportedly did suggest that if a company determines that the difference in its stock price between the Board approval date and the date the award was communicated to substantially all employees was immaterial, it could use the average stock price for that period in computing the compensation expense.)

The approach of immediately communicating stock option grants may also help to avoid any potential problems under the new nonqualified deferred compensation rules set forth in Code section 409A. Under those rules, a stock option granted at fair market value is exempt from those new rules, but a discount stock option is not. If there is a delay in communicating the stock option award, and the company’s stock price increases during the interim, granting a stock option with a stock price keyed to the date the Board approved the award could raise questions as to whether the option is a discount stock option. (For stock options that are intended to be incentive stock options under the Code, there is a similar concern that a perceived discount from fair market value may cause those options to fail to qualify as incentive stock options and instead be treated as nonqualified stock options.) Compliance with the new FASB staff position might also help ensure compliance with plan documents that prohibit the issuance of stock options at a discount. In many cases, Board or Compensation Committee action will be enough to establish a "grant" of an equity award for tax purposes if there is a legally enforceable obligation under state law. However, clients may want to revisit the terms of their plans (and the associated administrative rules) to see if they need to be revised to clarify when a grant occurs, particularly if the employer will not otherwise be changing its grant procedures in light of the new FASB staff position.

If a company takes the approach of providing award recipients with a preliminary or summary communication via email or similar electronic media, it is unclear precisely what details of the awards must be communicated to employee on that day (i.e., what are the "key terms and conditions of an award.") An email describing the number of options or shares awarded to the participant, the strike price, vesting period and term should be sufficient (particularly if the email references that an actual award agreement – in the form of the company’s model award previously filed on an 8-K – will follow.) We de not believe the employee should have to acknowledge receipt of the communication.

Companies will need to work with their outside auditors for specific methods that will satisfy their auditors. However, in the near term, companies would probably benefit from erring on the side of providing employees more information rather than less as auditors appear to be struggling with precisely how complete the communication to employees needs to be in order to fix the measurement date.

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