SEC Targets Spring-Loaded Equity Awards

The SEC has issued new guidance on how companies need to value spring-loaded equity grants. Here’s what you need to know.

What Is Spring Loading?

Spring-loading is granting equity awards in advance of a public announcement that the company expects will cause its stock price to increase, such as earnings results that exceed expectations, plans to acquire another company, or a material new contract or customer acquisition.

Can You Give Me an Example?

I sure can! Last year, Kodak issued options to purchase 1.75 million shares to its CEO—some of which were immediately vested—just one day before it announced a major government contract. After the announcement, Kodak’s stock price surged from $2.62 to as high as $60, settling around $24 per share, and the CEO’s options had increased in value to $50 million. Various sources have speculated that these grants were a significant impetus for the SEC’s guidance.

Seems Like a Good Deal—What’s the Problem?

By granting options or awards in advance of such announcements, the grant occurs before the company’s stock price increases in response to the announcement. This results in a lower grant date fair value than if the company waited until after the announcement to complete the grant and, in the case of stock options, results in a lower exercise price.

Because most companies use a value-based approach to determine grant size, the lower per-share fair value also likely means that the grants are larger than they would be if the company had waited until after the announcement to issue the grants. Then, when the announcement is made and the stock price gets a boost, employees are nicely in-the-money with grants that are worth more than the company is expensing for them.

Win-win, right? Well, not from everyone’s perspective. Detractors of spring-loading argue that it is an unfair use of information, misleading to investors, unethical, and possibly even illegal. In its press release for the new guidance, the SEC states:

Companies should not grant spring-loaded awards under any mistaken belief that they do not have to reflect any of the additional value conveyed to the recipients from the anticipated announcement of material information when recognizing compensation cost for the awards.

What Is the SEC Doing About It? 

The SEC has weighed in on how spring-loaded grants should be accounted for.  Staff Accounting Bulletin No. 120 issued by the SEC in November 2021, instructs public companies that issue grants in contemplation of or shortly before the release of material nonpublic information to consider whether the following adjustments are necessary when determining the grant fair value for ASC 718 purposes:

• Adjustments to the current fair market value of the company’s stock
• Adjustments to the expected volatility assumption

SAB 120 notes that non-routine grants merit particular scrutiny.

Thus, when public companies issue grants in anticipation of the release of public announcements that are expected to cause their stock price to appreciate, it may be necessary for companies to estimate the effect of the planned announcements and incorporate this into the grants’ fair values for ASC 718 purposes. This is especially a concern if the grants are not made in accordance with an established grant pattern.

Plus, Disclosures for Spring-Loaded Grants

In addition to the fair value considerations, SAB 120 notes that the SEC staff expects the following disclosures, at a minimum, with respect to spring-loaded grants:

• How the company determines when an adjustment to fair value is necessary for the grants
• How the amount of the adjustment is determined
• Any significant assumptions used to determine the adjustment

Most interesting (well, to me, at least), the bulletin suggests that the characteristics of spring-loaded grants may differ sufficiently from the company’s other grants that separate disclosure is required for the spring-loaded grants. This would really emphasize them for investors.

Finally, the bulletin directs companies to 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.”

Routine vs. Nonroutine Grants

One thing I find interesting is that the SEC differentiates between routine and nonroutine grants, with the implication being that adjustments to the grant fair value may not be necessary for routine grants:

The staff believes that an observable market price on the grant date is generally a reasonable and supportable estimate of the current price of the underlying share…when estimating the grant-date fair value of a routine annual grant to employees that is not designed to be spring-loaded.

Does the nonroutine character of a grant make it more valuable in light of a subsequent run-up in the stock price? Is a routine grant issued in contemplation of a positive announcement worth less than a nonroutine grant?

Setting my philosophical questions aside, this clearly implies that establishing a pattern of issuing grants at specific times could help companies avoid the fair value adjustments and disclosures required under SAB 120.  Many companies already have a process under which RSU awards are granted on a specific day of each month or quarter; we now might see even more companies adopt this process for not only RSUs but other types of equity awards as well. [Here’s a tip: if you are implementing this process for the first time, pick a date in the middle of the month.]

Adjustments to Fair Value—Not a DIY Project?

For companies that issue spring-loaded grants, one challenge will be determining how to adjust the fair market value and expected volatility assumptions. While the company might believe the impending announcement will increase the stock price, determining by just how much is another matter.

EY has written the most helpful summary of SAB 120 that I’ve found thus far. In their summary, the firm notes that:

Companies that issue spring-loaded awards may want to consider engaging a third-party valuation specialist to assist in the calculation of any adjustment.

Modifications, Too?

EY also notes that, although award modifications aren’t addressed in SAB 120, it is possible that the same guidance may need to be applied to modifications that are adopted in contemplation of an announcement that will result in a boost to the company’s stock price.