In the past few years there has been an uptick in stockholder derivative litigation related to equity compensation granted to named executive officers that exceed the plan share limits. The claims against the companies include breach of fiduciary duty, waste of corporate assets, unjust enrichment and false or misleading disclosures. At the core of these claims is Section 162(m) of the Internal Revenue Code. Section 162(m) limits to $1 million the compensation expense deduction a publicly-traded company can take with respect to compensation of certain named executive officers or "covered employees." Excluded from the Section 162(m) deduction limitation is compensation that qualifies as "performance-based," which includes stockholder approval requirements.

A stock option by its nature is performance-based, as the optionee generally receives a benefit only if the value of the stock at the time of exercise exceeds the exercise price. In addition to other requirements, Section 162(m) qualifies stock options1 granted under a plan as "performance-based" if (i) the governing plan sets forth the maximum number of shares subject to stock options that may be awarded to an individual over a set period of time, (ii) the exercise price of the stock options are made at or above the stock's fair market value on the grant date, and (iii) the company's stockholders approve the plan. For other types of awards, the stockholders must approve the maximum amount that can be paid to an individual either through a fixed amount or a formula that allows a stockholder to calculate the maximum amount. Typically, a plan will set forth a maximum number of shares or value of shares that may be granted as a performance-based full-value award, for example, restricted stock units or restricted stock upon which vesting is conditioned upon the achievement of performance goals.

It is best practices for a company to avoid compromising the qualification of equity compensation as "performance-based" by taking preventative measures. For example, a company may have its stockholder services department calculate the maximum amount of shares that may be granted, under a stock option or full-value award, to any individual in advance of a meeting of the board of directors or compensation committee in which equity awards are to be approved. If a company finds that it has granted an equity award in excess of the Section 162(m) limits, the company should be able to correct the grant prior to payment, and preserve the grant's status as "performance-based,"2 as follows:

  • Obtain Stockholder Approval: the company may seek stockholder approval of the award prior to payment; however, seeking stockholder approval from a timing or cost perspective may be impractical.
  • Cancel Excess Shares Subject to the Award: the company may cancel an award made in excess of the limits; provided that (a) the award is not a stock option, and (b) the awardee consents to the cancelation.
  • Cancel the Award and Re-Grant Under a Separate Equity Plan: the Section 162(m) Treasury regulations provide that an option that is canceled "continues to be counted against the maximum number of shares for which options may be granted." Thus, the cancelation of all or a portion of the stock option award will not preserve its performance-based qualification. The new stock option award would have to be granted under a separate stockholder approved plan within the limits of such separate plan.

A cancellation and re-grant of a stock option is not without challenges. The company may not wish to tackle the complexities of re-granting a stock option at the original exercise price, if the stock price has increased, as the re-grant would be considered a discounted stock option and subject to Section 409A of the Internal Revenue Code. Nevertheless, unless the plan has a provision invalidating an excess grant, the cancellation of the stock option is an adverse action requiring the consent of the optionee. If the stock price has decreased, the company would be prudent to re-grant the stock option at the original exercise price as a re-grant at a lower price may be deemed a repricing, which would require stockholder approval under certain listing rules.

A company should be aware that a grant in excess of the plan limits will not always create a tax issue. For example, a company's principal financial officer is not currently considered a "covered employee" subject to the Section 162(m) limitation, so an excess grant to such an officer may be deductible even though his or her compensation is in excess of $1 million. Also, whether or not an award is deductible may not matter to a company that is currently operating at a loss.

We recommend that companies conduct an internal audit of their equity plans in advance of receiving a demand letter from, or notice of a lawsuit filed by, a stockholder. We at King & Spalding are ready to assist you.