Last week, the SEC announced the adoption of Staff Accounting Bulletin No. 120 (SAB 120), which provides guidance for companies as to how they should recognize and disclose the cost of providing “spring-loaded” awards to executives. As defined in SAB 120, a spring-loaded award refers to a “share-based payment award granted when a company is in possession of material nonpublic information to which the market is likely to react positively when the information is announced.” Such awards include all instruments, including share options and restricted stock units. Consistent with the SEC’s focus on gatekeepers, the new guidance sends a warning to compensation committees and audit committees, stating “non-routine spring-loaded grants merit particular scrutiny by those charged with compensation and financial reporting governance.”
In addition to providing interpretive guidance around spring-loaded awards, SAB 120 also rescinds SAB Topic 14.A (because it is no longer relevant as a result of 2018 accounting standards updates) and amends SAB Topics 5 and 14 (to conform references to the latest guidance in Accounting Standards Codification 718, Compensation–Stock Compensation (ASC 718)).
ASC 718 governs the accounting for stock-based compensation. Under ASC 718, the “measurement objective for equity instruments awarded to grantees is to estimate at the grant date the fair value of the equity instruments the entity is obligated to issue when grantees have delivered the good or rendered the service and satisfied any other conditions necessary to earn the right to benefit from the instruments.” SEC Chair Gary Gensler echoed this basic principle in commenting on SAB 120, noting that “[i]t is important that companies’ accounting and disclosures reflect the economics and terms of these compensation arrangements.”
To achieve ASC 718’s measurement objective, the standard starts with the premise that “observable market prices of identical or similar equity or liability instruments in active markets are the best evidence of fair value and, if available, should be used as the basis for the measurement for equity and liability instruments awarded in a share-based payment transaction.” (emphasis added) However, if such inputs are not available, the standard allows for the use of valuation techniques or models that comply with the measurement objective. To do this, management generally needs to develop three estimates: (1) the expected volatility of its company’s share price; (2) the expected term of the option (if applicable), considering both the contractual term of the option and the effects of grantees’ expected exercise and post-vesting termination behavior; and (3) the determination of the current price of the underlying share. SAB 120 implores companies to scrutinize the impact of material non-public information and primarily adds illustrative guidance in regards to the first and third prongs, as summarized below.
Companies estimate expected volatility based on assumptions about expected volatility that participants in the marketplace likely would use to determine an exchange price. ASC 718 does not specify a particular approach that must be followed. Topic 14.D sets forth a number of considerations when evaluating historical and implied volatility. SAB 120 adds to those considerations the need to apply careful consideration around “whether material non-public information is currently available (or would be available) to the issuer that would be considered by a marketplace participant in estimating the expected volatility,” which should be considered in both a historical volatility and implied volatility context. To illustrate the point, SAB 120 describes a scenario involving entry into a material transaction that has not been announced as such an event that might impact expected volatility. Of course, the concept of material non-public information extends well beyond more clearly identifiable M&A events, thus making these considerations potentially more challenging to apply, both from the perspective of ensuring that all such material non-public information is shared with accountants likely preparing these calculations and preparing assumptions about marketplace participants’ reactions. Post-disclosure market reactions offer a reasonable barometer for checking these assumptions, though it is possible that such data points may be unavailable by the time a periodic report is filed for a financial reporting period.
Current Price of Underlying Share
Adding a new subsection to SAB Topic 14.D., SAB 120 sets forth specific guidance for estimating the current price of the underlying share. When an observable market price is unavailable for a share option or similar instrument with the same or similar terms and conditions, companies must estimate the fair value of such instrument, considering a number of factors, including the current price of the underlying share. In this regard, the SEC staff believes consideration should be given to whether observable market prices of underlying shares should be adjusted, such as “when the observable market price does not reflect certain material non-public information known to the company but unavailable to marketplace participants at the time the market price is observed.” Whether to make, and the magnitude of, such adjustments “requires significant judgment.”
For a “routine annual grant to employees that is not designed to be spring-loaded,” the SEC staff believes that the observable market price of the underlying share on the date of grant is a “reasonable and supportable estimate.” SAB 120 does not address circumstances when a company makes arguably routine annual grants in different months from year to year.
Regarding spring-loaded awards, the SEC staff believes “companies should carefully consider whether an adjustment to the observable market price is required, for example, when share-based payments arrangements are entered into in contemplation of or shortly before a planned release of material non-public information, and such information is expected to result in a material increase in share price.” In this regard, the SEC staff takes the position that a “material increase” in the market price of a security upon release of the information indicates that market participants would have considered adjusting the observable market price on a date shortly preceding the release of such information.
To illustrate, SAB 120 describes a company that awards non-routine share options after entering into a material contract but before such material contract is announced to the market. The share price is expected to increase significantly following announcement of the contract. In such a scenario, “the closing share price [on the date of grant before announcement of the material contract] would not be a reasonable and supportable estimate and, without an adjustment the valuation of the award would not meet the fair value measurement objective of FASB ASC Topic 718 . . . .”
From a governance perspective, SAB 120 reminds companies of “the importance of strong corporate governance and controls in granting share options, as well as the requirements to maintain effective internal control over financial reporting and disclosure controls and procedures.” In this regard, SAB 120 suggests that prior to making a spring-loaded award, companies should consider whether the award is consistent with the company’s policies and procedures, including its compensation plan approved by shareholders, other governance policies, and legal requirements.
From a disclosure perspective, FASB ASC 718 requires companies to disclose sufficient information to enable users of the financial statements to understand the nature and terms of share-based payment arrangements that existed during the period and the potential effects of such arrangements on shareholders. This includes providing a description of the method used and significant assumptions used to estimate the fair value of awards under share-based payment arrangements. SAB 120 articulates a number of expected financial statement footnote disclosures on top of the ASC 718 requirements in the spring-loaded award context:
- How the company determined the current price of shares underlying share options for purposes of determining the grant-date fair value of its share options in accordance with FASB ASC Topic 718.
- The company’s accounting policy related to 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.
- The characteristics of the share options, including their spring-loaded nature, if such options differ to such an extent from the company’s other share-based payment arrangements. Spring-loaded awards may also need to be disclosed separately from other share-based payment arrangements to best describe the company’s use of share-based compensation.
Additionally, SAB 120 notes that companies “should consider the applicability of MD&A and other disclosure requirements, including those related to liquidity and capital resources, results of operations, critical accounting estimates, executive compensation, and transactions with related persons.” In particular, companies should keep in mind the SEC’s 2006 guidance that a company’s Compensation Discission and Analysis section must disclose if the company has, or expects to have, “a program, plan or practice to select option grant dates for executive officers in coordination with the release of material non-public information.”