he SEC's recent Rule 10b5-1 rulemaking has drawn attention to its efforts to crack down on illegal trading by corporate insiders. (See our related post here.) But less attention has been paid to part of the rulemaking that will likely impact every public company's option grant practices.
Newly adopted Item 402(x)(2) of Regulation S-K imposes a significant new executive compensation disclosure requirement on public companies. Under new Item 402(x)(2), companies must disclose in their annual reports, on a grant-by-grant basis for the CEO and each other named executive officer, every option, stock appreciation right or similar award that is granted shortly before or after the disclosure of material nonpublic information. (The rule generally does not apply to other awards, such as restricted stock awards, that do not have an exercise price.) The relevant disclosure period starts four business days before the filing or furnishing of any Form 10-K, Form 10-Q or Form 8-K and ends one business day after the filing date (for a total period of six business days, including the filing date). Technically, the new rule does not apply to a Form 8-K that does not disclose material nonpublic information, but we expect that most companies will presume, at least initially, that the information in each Form 8-K is material and nonpublic for this purpose.
The SEC's purpose behind this new disclosure requirement is to give companies another reason not to "spring-load" stock options. A company spring-loads a stock option by granting that option before the announcement of material positive news, thereby fixing the exercise price before an anticipated jump in the stock price. This new disclosure requirement builds on the position the SEC staff took in Staff Legal Bulletin No. 120, which indicated that grant-date fair values of spring-loaded options may not comply with generally accepted accounting principles if they are not adjusted to reflect the impact of material nonpublic information. If the threat of a possible restatement were not enough, the new disclosure requirement may help to draw a map for a potential SEC enforcement action or shareholder lawsuit.
Companies must present the new disclosures in a table, which will include the grant date, the number of options, the exercise price, the grant-date fair value and, most significantly, the percentage increase in the closing price of the underlying shares between the trading day immediately before the disclosure of the material nonpublic information and the trading day beginning immediately after that disclosure. This last requirement will highlight the degree to which the options may have been spring-loaded, and the disclosure of large percentage increases may draw the attention of both regulators and shareholders.
We expect that most companies will seek to minimize any disclosures under new Item 402(x)(2), and an additional new disclosure requirement will encourage them to do that: Item 401(x)(1).
Newly adopted Item 401(x)(1) requires companies to disclose their "policies and practices" regarding the timing of awards of stock options in relation to the disclosure of material nonpublic information, and whether and how they take material nonpublic information into account when making such awards. Few companies will be eager to state or imply that they are not thoughtful about the timing of stock option grants, so we expect that more companies will migrate to a practice of structuring option grants to occur at least two business days after each annual or quarterly filing in order not to trigger the new disclosure requirements under Item 402(x)(2). This practice should generally mitigate potential allegations of spring-loading. However, companies that possess material nonpublic information that is not ripe for disclosure when they file their annual or quarterly reports (such as a potential material transaction still under negotiation) will have to take additional steps to avoid triggering the new tabular disclosure requirement.
The new rule leaves numerous unanswered questions. Item 402(x)(2) does not expressly apply to the filing of amendments to the underlying forms, nor does it expressly apply to proxy statements, even those that are intended to satisfy the requirements of Part III of Form 10-K. Curiously, the final rule does not address press releases, which often generate significant movements in stock prices and could similarly implicate potential spring-loading.
The new requirements also do not address "bullet-dodging," another concern the SEC staff expressed in the rulemaking release. Bullet-dodging is the practice of deferring a stock option grant until after the disclosure of material unfavorable news so that the exercise price will be fixed only after the stock price has dropped. The staff may be caught by the conundrum that a common practice for avoiding spring-loading – i.e., following a routine of deferring the grant date until after full disclosure – can result in bullet-dodging when the market reacts negatively to an announcement.
These new disclosure requirements do not apply to foreign private issuers. For domestic issuers that are not smaller reporting companies, the new rules apply to the Form 10-K that covers the first full fiscal period that begins on or after April 1, 2023 (i.e., for calendar year companies, the Form 10-K covering 2024 that will be filed in 2025). For smaller reporting companies, the new rules apply to the Form 10-K that covers the first full fiscal period that begins on or after October 1, 2023 (i.e., for calendar year companies, also the Form 10-K covering 2024).
While the transition period affords companies some time to modify their option granting practices, companies will adapt in different ways, with some opting for rigid policies and others seeking to retain maximum flexibility. Please reach out to your Foley Hoag attorney if you need help designing a solution that works for your company.
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