The SEC announced the adoption of its new pay versus performance rules, or Item 402(v) on August 25, 2022. A detailed summary of the new rules can be found within our Alert found here.
As a reminder, the new rules require all outstanding and unvested awards to be re-valued as of the end of the fiscal year and awards that vest during the fiscal year to be valued on their vest date. As of this writing, the guidance is still very new, and there may be areas in which we need clarification from the SEC. (Updates based on new guidance from the SEC in the Compliance & Disclosure Interpretations as of 9/27/2023.)
One such area is with respect to the timing of the final valuation date, and the technical terminology of “vesting date”. The intent of this short Alert is to clarify Infinite Equity’s opinion of the terminology and our firm’s interpretation. We have summarized examples of 2 common scenarios in which the final re-valuation and measurement date may not be the explicit Vest Date. Instead, it will be important to monitor the Requisite Service Period as described in ASC718.
Example 1: Retirement Eligibility – Company ABC has retirement eligibility rules such that individuals who are 65 years old are allowed to continue to hold their unvested equity after retirement/termination. On 12/31/2021, when the stock price is $20, Company ABC granted 50,000 time based Restricted Shares which cliff vest in 1 year (12/31/2022) to an individual who meets the retirement eligibility criteria. Since the award holder can hold the awards post-retirement, the awards are non-forfeitable, and the vesting restrictions are non-substantive. Under ASC718, the “requisite service period” for an award granted to a participant who is retirement eligible as of the date of grant begins and ends on the Grant Date. As a result, the full accounting expense will be recognized immediately, however the individual has an implied holding period for 1 year. Company ABC recognizes an illiquidity discount and determines the fair value to be $18.19 per share. For purposes of Item 402(v) and disclosures for Compensation Actually Paid, Company ABC will accrue the entire $909,296 (50,000 shares x $18.19) in the year of Grant. There is no further need to revalue the award, as the retirement eligible executive has an “unconditional right” to the award.
Update as of 9/27/2023: This treatment has been confirmed in Question 128D.18 from the SEC in the C&DI’s released on 9/27/2023.
Example 2: Market Conditions with Derived Service Periods – Company ABC granted 50,000 performance shares on 1/1/2022 when the stock price was $20. The performance shares have an explicit service period of 1 year, and also requires the stock price to achieve a hurdle of $30 within the next 4 years. Company ABC determines a fair value on grant date of $12. From the valuation model, Company ABC calculates the “derived service period” (the median of the successful price paths) to be 1.50 years or on 6/30/23. The performance shares’ requisite service period is the 1.50 year derived service period. Under ASC718, Company ABC amortizes the $600,000 (50,000 units x $12 fair value) from the Grant Date until the end of the requisite service period of 6/30/2023. Company ABC achieves the $30 hurdle on 12/31/2023 and the awards are earned on that date. For purposes of Item 402(v) and disclosures for Compensation Actually Paid, Company ABC is required to re-value the awards as of 12/31/2022. As of 12/31/2022, the stock price is $25, and the new fair value is $21. Company ABC recognizes $1,050,000 (50,000 x $21) into Compensation Actually Paid for 2022. There is no need for a revised derived service period. (Note that the new fair value is not used for the income statement or ASC718 expense recognition, but only for the executive compensation disclosures of 402(v)). As of 60/30/2023, the aware is “vested” for accounting purposes under ASC718, and the full expense has been recognized. However, the executive does not have an “unconditional right” to the award at the end of the derived service period, and it must continued to be remeasured for purposes of Item 402(v). On 12/31/2023, after achieving the stock price hurdle of $30, the award vests, and the executive has an “unconditional right” to the award. The Compensation Actually Paid is $1,500,000 (50,000 x $30). Since Company ABC has already recognized $1,050,000 of this value into Compensation Actually Paid in the 2022 Proxy, they only need to recognize the incremental growth for 2023 of $450,000 ($1,500,000 – $1,050,000). No further re-valuations or changes in recognition need to occur thereafter.
The two (2) aforementioned unique examples illustrate separate and distinct final measurement dates. The former, Example 1, applies the “Requisite Service Period”, from ASC718 as the final measurement date. While the latter example continues to be remeasured after the Requisite Service Period until the ultimate vesting date.
The guiding principle that we have followed in determining this treatment comes from Page 48 of Item 402(v), which determines that “an executive does not have an unconditional right to an equity award before vesting”. In the case of Example 1, we believe the Retirement Eligible employee has an “unconditional right”, while in Example 2 the individual does not (as the market condition has yet to be satisfied).
With the complexity of explicit service periods, implied service periods from performance conditions, derived service periods from market conditions and the potential interdependency between them, Infinite Equity believes that the final measurement date for executives should be thoughtful and in consideration of all facts and circumstances.
Infinite Equity continues to examine the new pay for performance rules and how they will impact both the executive and equity compensation community. For more information on the new pay for performance regulations or assistance navigating these changes, reach out to us at Infinite Equity for help.
