Failure to Account for Risk in Reporting Equity Awards
The values of equity awards as reported in proxy statements, based on so-called "date of grant" values, do not adequately take into account the risks associated with such awards at the time of grant.1 For example, if a named executive officer receives a dollar of salary and a "dollar's worth" of restricted stock, these two "dollars" are treated as equivalent for purposes of the Summary Compensation Table. (The Summary Compensation Table is the table in the proxy statement that sets out total compensation, including amounts involved in different categories of pay making up total compensation, for each named executive officer.)
Risk factors noted below that are associated with equity awards are not generally taken into account in reporting equity awards in the Summary Compensation Table. (Footnote 2 provides a summary of how equity award values are reported in the Summary Compensation Table.)2 This means that the two "dollars" are treated as equivalent values in the computation of total compensation, as reported in the Summary Compensation Table, notwithstanding risk factors accompanying an equity award.
The significance of this problem was underscored by the Securities and Exchange Commission's publication on Sept. 18, 2013, of proposed regulations on the "CEO Pay Ratio" required under Dodd-Frank Section 953(b).3 Dodd-Frank Section 953(b) requires issuers to report a ratio involving total pay of the CEO and median total pay of all other employees.4 The calculation of the CEO Pay Ratio is tied to pay as reported in the Summary Compensation Table and, hence, likewise does not adequately reflect risk associated with a major portion of CEO pay. This is discussed further below.
Market Risk During Period of Non-Transferability. Most equity awards vest gradually over several years. Some "cliff" vest, meaning no vesting until a future date when the entire award vests all at once. During the period of vesting, whatever it is, the executive does not have the right to transfer the award.5 As a result, executives are subject to the risk of a drop in the market price of the stock during the period they must hold the award. While the opportunity for gain also exists, in the absence of discretion as to when and if to sell, the holder (the executive) faces a risk of loss that he or she could avoid if the equity were transferable.
Most executives have a substantial portion of their wealth tied up in the employer. Unlike most investors in the stock market, the typical executive is not very diversified in his or her portfolio (i.e., the executive's equity portfolio is principally committed to equity of the employer). This magnifies the market risk associated with a period of non-transferability because so much of the executive's wealth is tied up in the equity of the employer.6
Forfeiture Due to Termination of Employment. The possibility of forfeiture due to termination of employment significantly reduces the value of an equity award from what it would be if granted outright.
Following are different types of terminations that may occur before an equity award vests:7
a. by the employer: for cause; without cause;
b. by the executive: for good reason; without good reason;
c. due to disability;
d. due to death.