What to Do About Post-Dated Terminations

In today’s blog, I take a look at an issue that plagues most stock plan administration departments: late notification of terminations. It’s a fairly common scenario that can cause numerous problems:
 

• Additional shares may have vested after the employee terminated but before you were notified of the termination and the shares may have already been exercised or released to the now former employee.
• The notification may be so late that you don’t receive it until after the post-termination exercise period should have ended, again allowing the former employee to exercise shares he or she isn’t entitled to.
• The notification may be delayed past the end of the fiscal period, making the stock plan activity and expense reported for that period incorrect. Once the termination is entered into your database, with the correct termination date, it creates discrepancies between your beginning and ending balances for the fiscal periods the termination and notification span.

What Should You Do?

If the former employee hasn’t received shares that he or she wasn’t entitled to, the solution is generally to enter it into the database just as you would have if you had received the notice on time, making a note of it in your records so you can account for any discrepancies the cancellation subsequently causes in reports.

Recovering Shares a Former Employee Wasn’t Entitled To

Where the former employee has received shares that he or she wasn’t entitled to, either through an option exercise or release of award shares, the ideal solution is to rescind the transaction and recover the shares from the employee. If the shares haven’t been sold yet, unwinding the transaction is relatively straightforward; the company simply requires the employee to surrender the shares.

If the shares have already been sold, unwinding the transaction is more challenging. If the error is caught quickly enough, the broker would be instructed to “bust” the trade. What this means is that the broker buys the shares back on behalf of the employee so that they can be surrendered to the company and the employee is required to return the sale proceeds.

When trades are busted, it is unusual for the broker to be able to repurchase the shares at the exact price the employee sold them for. If the broker has to pay more for the shares, the broker is typically going to look to the company to make up the shortfall. Some companies might charge the shortfall to the employee (who presumably should have known that he/she wasn’t entitled to the shares). Where a payroll department is repeatedly remiss in reporting terminations, shortfalls on busted trades might be charged to the department.  

What About Letting the Former Employee Keep the Shares?

It may be tempting to just look the other way–what’s a few shares, after all? But chances are, this won’t be an isolated occurrence; in my experience, even the most well-run stock plan administration departments must address this issue occasionally. How you handle one termination can set a dangerous precedent. In addition, these transactions are easily auditable and, given how common a problem this is, there’s a good chance your audit team will look for them.

More significantly, you, your manager, or even the company’s general counsel, may not have the authority to let it go. Allowing the former employee to keep the shares he or she wasn’t entitled to is tantamount to modifying the award. Generally, modifications of vesting provisions must be approved by the compensation committee, the board of directors, or at least a member of the board. Even under Delaware law, where authority to approve grants can be delegated to an officer who is not a board member, the same flexibility doesn’t apply to vesting provisions; those still must be approved by a board member.

Companies are most likely to allow employees to keep the shares if the number involved is de minimis, there are mitigating factors, or unwinding the transaction is too much of a challenge (e.g., perhaps due to the amount of time that has elapsed). Even if the shares involved are de minimis, the decision should be referred to the compensation committee for approval.

What Are the Accounting Consequences?

Where the decision to allow a former employee to keep the shares is duly approved, it should be accounted for as a modification. It is essentially an acceleration of vesting, so the company will recognize incremental cost equal to the current fair value of the additional shares the employee received (the company would still reverse any previously recognized expense associated with the unvested portion of the award as it existed before the modification)—see my blog entry “Accounting for Acceleration of Vesting Upon Termination.”

For a few missed terminations here or there, the accounting consequences most likely aren’t material. But if this is a regular pattern, the expenses could start to add up.

Addressing the Larger Problem

In addition to addressing the situation at hand, it’s smart to determine the cause of the late notification and take steps to prevent it from happening in the future. If you have a specific payroll group that is an ongoing transgressor, schedule a meeting to discuss the problem and come up with a resolution that works for everyone.