POWER WORD PLAY (A Term, Word, or Concept an Executive Ought to Know): UNIT APPRECIATION RIGHTS

BY G. A. FINCH

Unit Appreciation Rights (for limited liability companies and known as Stock Appreciation Rights for corporations) are a form of executive compensation tied to the performance of a set amount of units or shares within a set time period.  They could include only compensation tied to the amount of increase in the value of equity,  or compensation that comprises both such increase and the original value of the equity.

The compensation may be cash payments or equity equivalent based on the original full value of a number of units that an executive holds and/or any increase in value (the difference between the price of the units at the time of grant and the price of the units upon exercisability). When an executive exercises his right, a company’s Unit Appreciation Rights Plan may allow the company to pay in cash or real common equity of the company or a combination thereof.

The units granted under Unit Appreciation Rights are not real units of ownership in a company entity, but rather are hypothetical “Phantom Units”. The company will grant an executive a number of units, e.g. 3,000 which will have an initial price per Phantom Unit, e.g. $30.00. The units will vest after a set period, e.g. two years after the date of grant while the executive is still employed. After vesting and before any expiration date, the Unit Appreciation Right becomes exercisable by the executive either in partial amounts or in the full amount depending on the terms and conditions of the company’s Unit Appreciation Rights Plan. If not exercised during the executive’s lifetime and assuming that an expiration date has not occurred, then any person empowered under the deceased executive’s estate ordinarily could exercise the Unit Appreciation Right.

POWER WORD PLAY (A Term, Word, or Concept an Executive Ought to Know): VESTING

BY G. A. FINCH

 

As the saying goes, the only dumb question is the unasked question. Sometimes employees and sophisticated executives are unsure about the concept of “vesting.” The terms “vest” and “vested” are part and parcel of any employee benefits system. It pertains to when an employee’s right to a benefit becomes ripe and irrevocable.

 
For example, “vest” is a term that is used in describing and accessing employee benefits like retirement payments or grants of stock to employees.

 
Vesting is the time when specified benefits provided to an employee become certain and complete and are no longer contingent on the employee continuing to work for the employer.  When vested, the entitlement to the benefit becomes an absolute right.  Obviously, this right to a benefit may not mean much if the employer  becomes insolvent.

 
When an executive leaves his employment for any reason, he must scrutinize his benefits materials, employment contract, if any, and his separation agreement, if any, to ascertain what benefits to which he is entitle and which benefits have vested. If the benefits materials are dense and confusing, then he should consult his benefits or human resources department to ensure his understanding. If the employee has engaged an attorney to represent him in his separation, the attorney may also help the employee to evaluate what benefits have or have not vested.

SAY ON PAY: DODD-FRANK ACT

The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) had a recent first anniversary (it became law on July 21, 2010).  The legislation responded to the financial meltdown that occurred toward the end of the last decade and contains the greatest federal legislative financial reforms since the Great Depression of the 1930s.

Dodd-Frank covers a lot of ground.  Noteworthy for executives of public companies are its provisions concerning shareholders’ approval of executive compensation.

At least once every three years, Dodd-Frank gives shareholders the right to an advisory vote on the compensation of “named executive officers,” who are the principal executive officer, the principal financial officer and the three most highly compensated executive officers other than the principal executive officer and principal financial officer.  This vote on executive compensation is commonly called “Say on Pay.”

At least once every six years, Dodd-Frank also authorizes shareholders to have an advisory vote to determine the frequency of shareholders’ vote on executive compensation of a public company, i.e. whether the Say-on-Pay vote should take place every one, two or three years.

Finally, Dodd-Frank provides shareholders an advisory vote on all severance compensation paid to named executive officers (the top five executives mentioned above) upon an acquisition, merger, consolidation or a proposed sale or disposition of all or  substantially all the assets of a public company.  In other words, this is Dodd-Frank’s provision for shareholder approval of so-called “Golden Parachute” compensation.  Dodd-Frank specifically requires the vote on this shareholders’ resolution to approve Golden-Parachute compensation to be separate from any shareholder vote to approve an acquisition, merger, consolidation, etc.

As a result of Dodd-Frank, corporate board compensation committees must be much more rigorous in setting and justifying the compensation paid to the top executives of their respective companies.

DO YOU KNOW ABOUT RESTRICTED STOCK AND AN IRS SECTION 83(b) ELECTION?

We have noted in other blog articles how “restricted stock” is a widely used form of executive compensation.  Restricted stock is a grant of stock that vests over time and may or may not be tied to performance measures like year-end profitability. Restricted stock is frequently tied to length of time working for an employer.   A typical grant provides that the shares will vest at the end of a fixed period, e.g., five years from the date of grant, if the executive remains employed by the company.

Any Executive who is eligible to receive restricted stock ought to know about the availability of an Internal Revenue Code Section 83(b) election.  Not knowing about a Section 83(b) election could result in serious tax consequences to the Executive.

An Executive who is about to receive restricted stock should immediately consult a tax accountant or tax attorney.

I asked my law firm tax partners, Richard Sawdey and Richard Harbaugh, to give me an updated primer on Section 83(b) and they contributed substantially to this post.  Here is a snapshot of Section 83(b) and why it is so important.

When a company transfers restricted stock to an Executive in connection with employment, Section 83 provides that the Executive will recognize ordinary income in an amount equal to the excess of the fair market value of the stock as of the date when they are no longer subject to a real risk of forfeiture over the amount, if any, paid for the stock.

In the example we are discussing, the Executive’s restricted shares are subject to a substantial risk of forfeiture until the five-year vesting period has expired.  Thus, under Section 83, the fair market value of the stock at the end of the five-year period will be the amount of taxable income resulting from the grant.

Section 83(b) permits the executive to make an election, instead, to include the fair market value of the shares in income in the year in which the award was made.  If this election is made, the amount of income is determined based on the then value of the shares without regard to the possible forfeiture of the shares.

A major caveat is that the Executive must make the election within 30 days of the Executive’s receiving the stock.  The election form must be sent to the IRS office with which the Executive files his personal income tax return.  Also, the election form should be sent by certified mail (return receipt requested) to ensure the executive has a record that the IRS has received it.

A Section 83(b) election requires careful consideration of the possible benefits and risks.  The possible benefit is a saving of income taxes if the value of the shares at the end of the five-year vesting period is higher than their value at the time of grant.  The Executive will have shielded from ordinary income tax rates the entire amount of the appreciation during the vesting period.  Upon a later sale of the shares, the appreciation that took place during the vesting period will instead be taxed as capital gain.

However, the election also carries significant risks.  If the Executive’s employment is terminated  during the vesting period and a Section 83(b) election was made, the Executive will forfeit the shares but will not be entitled to a deduction for the income taxes paid in the year of the grant. Thus, taxes will have been paid on shares that never will be received.

If the Executive believes the stock will rise in value, believes there is little risk of forfeiture of the stock, and knows that the income that will be reported upon election will be modest, then there may be a strong case to make the Section 83(b) election.

In the context of a restricted stock grant with a five-year vesting period, in our example, the safest, lowest risk course is to forgo a Section 83(b) election and recognize the income in the year when the grant vests.  The Executive knows in that case that he is paying tax on stock that he owns and that he has avoided the out-of-pocket tax cost that could have resulted had he paid the income tax when he received the stock followed by forfeiture of the very same stock.

Again, the Executive should immediately consult with a tax accountant or tax attorney to analyze the Executive’s particular employment situation and stock restrictions to determine whether a Section 83(b) election makes sense and to accomplish the election in a timely fashion when the election is warranted.

CONTINUED RISE IN PERFORMANCE-BASED EXECUTIVE COMPENSATION

Pay-for-performance-executive compensation has increased.

According to the 09 May 2011 Wall Street Journal, “Of the 350 companies in [The Wall Street Journal/Hay Group compensation] survey, 238 gave the CEO some form of performance-based award last year, up from 204 the prior year.”

As a result of the Dodd-Frank legislation, shareholders in public companies exert more influence on executive pay with increasing emphasis on applying performance metrics to executive compensation.  Because of more scrutiny and assertive critics, board of directors’ compensation committees are endeavoring to get executive compensation packages just right.  A  CEO just showing up to work and looking presidential will not impress prudent compensation committees. Any instinctive good will and generosity that compensation committee members may have toward a CEO will be overridden by their need to protect their own reputations as objective, clear-eyed stewards of the shareholders’ interests.

Commonsense should have dictated that executive pay for performance ought to have been commonplace all along.

Copyright © 2011 by G. A. Finch, All rights reserved.