United States: C-Suite Compensation Center: Tip Of The Week: 4 Ideas To Ease Tax Obligations When Equity Awards Vest During A Blackout Period

All publicly-traded issuers have (or should have) a blackout policy that prohibits a designated individual from engaging in open-market transactions whenever such individual possesses material non-public information. But what if the issuer is always (or near always) in a blackout period? How does the issuer satisfy its income tax withholding obligation if the individual cannot finance the obligation through other means (e.g., family money, borrowings, etc.) and the individual is prohibited from financing the obligation by selling shares in the open market? Answers to these questions are discussed in this Tip of the Week (presented in NO particular order, and not intended as an exhaustive list).

Idea No. 1 – Contractually Provide for an Automatic Extension of the Vesting Period

  • Contractually require a continuation of the vesting schedule anytime the equity award would vest during a blackout period. Such contractual provision could be inserted into the equity award agreement, could be triggered automatically and without discretion, and the portion of the award (or whole award) subject to extended vesting could automatically vest on the day immediately following the last day of the blackout period.
  • The current protections of Section 83 are not likely enough. As background, a substantial risk of forfeiture is presumed to exist under Section 83 whenever a sale of the equity award would subject a Section 16 insider to short-swing transaction liability under Section 16(b). Though such automatic extension of the vesting schedule for tax purposes is helpful, such is not likely a solution in all instances because an issuer’s insider trading policy could be designed to be broader than the requirements of Section 16(b) (e.g., the insider trading policy could apply to more individuals than just Section 16 insiders, and could prohibit more transaction than the transactions otherwise prohibited by Section 16(b)).
  • A downside to this Idea No. 1 is that the individual has a real risk of forfeiture during the extended vesting period, a risk that was not otherwise part of the initial design. As a result, some individuals may prefer to avoid this Idea No. 1, especially individuals working for issuers that have never-ending blackout periods (i.e., the risk of forfeiture would likewise be never-ending).

Idea No. 2 – Implement a Net Withholding (Issuer Financed)

  • The Compensation Committee of the issuer’s Board of Directors approves, on an individual-by-individual basis, a net withholding whereby the issuer holds back the number of shares having a fair market value equal to the withholding obligation, and the individual receives the after-net shares. Such does not involve an open-market transaction and therefore would not be prohibited by Rule 10b-5 and should not be prohibited by the issuer’s insider trading policy (but beware, some insider trading policies are drafted extremely broad, and as a result, the insider trading policy should always be reviewed before implementing this Idea No. 2). With this Idea No. 2, the individual should receive the same economic benefit that he or she would have received with a broker-assisted sale in the open market (though the individual would not have any broker fees).
  • The following design issues should be considered prior to implementing this Idea No. 2: (i) will the netted out shares revert back to, and replenish, the share reserve of the equity incentive plan; (ii) does the issuer have sufficient cash flow to remit monies to the U.S. Treasury; (iii) will net withholding design as chosen by the issuer satisfy Rule 16b-3 (which exempts grants to Section 16 insiders from the short-swing transaction rules of Section 16(b)), especially given recent plaintiff activity in the area; and (iv) will the withholding rate be the minimum statutory rate or the maximum individual statutory rate, and if the latter, (x) will an amendment to the equity plan be required, (y) will stockholder approval be required under NYSE and NASDAQ listing rules, and (z) how will the issuer implement the aggregate method of withholding in order to effectuate a withholding rate that is higher than the supplemental rate.
  • A downside of this Idea No. 2 is that the issuer is financing the withholding obligation (i.e., the issuer will have to dig into its pockets in order to satisfy the required remittance to the U.S. Treasury).

Idea No. 3 – Incorporate a 10b5-1 Net Withholding Provision (Market Financed)

  • A 10b5-1 compliant trading plan could be entered into for the sole purpose of satisfying tax withholding obligations during blackout periods. Such would provide for the individual to effectuate a sale of shares in the open market to the minimum extent necessary to offset his or her income tax withholding obligations. And if a full 10b5-1 trading plan is not desired, then a 10b5-1 compliant provision could be inserted into the tax withholding section of the award agreement, thus accomplishing the same result but with no formalized trading plan.
  • A benefit of this Idea No. 3 is that the withholding obligation is financed by the open market, which when compared to Idea No. 2, can be an attractive benefit for issuers with low cash reserves. But keep in mind that to the extent the “next day deposit” rule is triggered (requiring the issuer to deposit withholding taxes with the U.S. Treasury by the end the next business day) and the equity award covers restricted stock, care should be taken to ensure that any timing disparity between the next day deposit rule and the issuer later receiving the open market transaction proceeds is not deemed an “advance” in violation of Section 402 of SOX (which prohibits personal loans from an issuer to any of its directors or executive officers).
  • A downside of this Idea No. 3 can occur if a Section 16 insider is conducting open market purchases of the issuer’s stock. In such instance, issuers should proceed carefully so that Section 16 insiders are not subject to disgorgement of profits under the short-swing profit rule of Section 16(b).

Idea No. 4 – Streamline Grant Practices and Plan for Vesting to Occur During an Open Window

  • Though there are no guarantees that a blackout period will not apply, Idea No. 4 is to design the equity awards so that vesting coincides within a short window immediately following the issuer’s annual stockholders meeting and/or immediately following the release of quarterly earnings.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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