Revisiting the Termination & Change-In-Control Disclosure

In the third installment of Infinite Equity’s Five Practical Improvements for Modernizing Executive Compensation Disclosure, we review potential revisions to Item 402(j) of Regulation S-K: Potential payments upon termination or change-in-control.

Background

Item 402(j) of Regulation S-K requires that companies describe, explain, and estimate the specific payments that a Named Executive Officer would receive in connection with any type of termination event from the company, including (but not limited to) resignation, retirement, termination with/without cause, and a change-in-control of the company.

In practice, this disclosure is placed near the end of related executive compensation tables in the proxy statement. (Before the more recent implementations of the CEO Pay Ratio and Pay Versus Performance, it was often the final executive compensation disclosure reported in the proxy statement.) The disclosure is inclusive of a short narrative segment, followed by at least one detailed table and supporting footnotes.  Some disclosures can take up multiple pages, with several tables and accompanying narrative/footnotes.

Two important details within the rule and SEC guidance are that:

• Instruction 1. to Item 402(j) requires that companies base these disclosures assuming the hypothetical event occurred on the last day of the fiscal year using the closing market price per share of the company’s stock as of that date.
• SEC CD&I Question 126.01 notes that if options are accelerated upon a termination or change-in-control, the “spread” or the difference between the stock price and the strike price of the option should be used to calculate the value of the award. 

Challenges with the Current Rule

The current rule has several limitations which can imply false levels of precision within the disclosed payout estimates – meaningfully limiting their value.  The calculations of these estimates also create added complexity for companies depending on the nature of their compensation agreements. These limitations include:

• The requirement that the estimates disclosed are as what is known about the company’s stock and compensation agreements as of fiscal year end:
  • In the case of a company’s stock price, this assumption may be reasonable for some types of routine terminations like retirement or resignation, but it is not reasonable for a change-in-control. On a change-in-control, a company’s stock price often changes significantly upon the announcement of the transaction, causing the final severance payout to be materially higher than what is reported in the disclosure currently.

• In the case of a company’s compensation agreements, the rule assumes that compensation provisions in place as of the end of the year will be the same as compensation provisions provided when a termination or change-in-control occurs. This is often not the case, with award agreements and compensation terms being changed as a part of an executive’s resignation or within the negotiations related to a change-in-control of the company.

• The complexity of some of the calculations required by the rule to develop these estimates, particularly for equity-based compensation. For example, due to the potential for excise taxes on a change-in-control imposed by Section 280G of the Internal Revenue Code, many companies add a provision to their compensation agreements to provide for a “cut back” of an executive’s severance to avoid this excise tax if the cut back is more favorable to the executive. Many companies feel obliged by the current rules to include these sorts of adjustments within their estimates, significantly increasing the time and expense needed to determine estimated values, without necessarily increasing the estimate’s accuracy.

These limitations, both independently and combined, limit the value of the estimated payouts provided by this disclosure. When these approximations are disclosed alongside detailed discussions of the precise terms of the compensation agreements in place as of the fiscal year end, it can cause the reader to believe that these estimates are reasonably close to what the executive might receive on termination when that may not be the case.

Suggested Revisions

To address these false precision and calculation complexity concerns, we first should acknowledge that any estimate of termination values – particularly in the case of a change-in-control – that simply assume what is known as of the end of the fiscal year will likely be incorrect. This is not to say that the idea of providing investors an estimated value of the termination agreements does not have merit, but that such regimented calculations of these values may not be necessary.

We suggest two changes to the current rules:

• Relax quantifications of termination values to allow companies to more generally approximate the value of equity awards in termination scenarios. The expectations set within the item 402(j) and CD&I Question 126.01 could both be amended to allow the company to choose their own methodology to estimate the values in the table, so long it is a reasonable approximation of the terms of the severance agreement as of the fiscal year end. Whatever method used to estimate the award value would need to be described via footnote.

Some examples:

• If outstanding equity awards were to accelerate vesting on a change-in-control, a company could disclose:
  • The outstanding equity fair value disclosed in the revised outstanding equity table 
  • The current intrinsic value similar to how these values are currently quantified
  • Adding a premium to the fiscal year-end share price before calculating one of these values
  • Any other methodology a company thinks best reflects the value provided
• Nuances like 280G considerations could be ignored at the company’s discretion for purposes of the figures disclosed. 

• Allow for links to the descriptions of termination scenarios to the relevant documents filed with the SEC that explain the severance treatment being applied with a brief description of any assumptions, like those contemplated above. Allowing the reader to find these details elsewhere reduces the length of the disclosure while also ensuring that the precise terms of the termination can be found without relying on a summary.

For more information on Infinite Equity’s suggested amendments to the current executive compensation disclosure landscape, refer to the rest of our materials on our website, www.InfiniteEquity.com