Diversification Alternatives regarding Employer Stock
Note: See Law360 for a comprehensive article on this topic
2018.07.11 Diversification from Employer Stock: It's Not Always a Bad Practice. There have been recent thought-provoking commentaries (noted below) about the risks that can come when executives feel over-invested in employer stock, whether due to actual share ownership or the added stake provided through equity-based awards such as stock options, restricted stock, RSUs, and phantom stock. Diversification programs may seem contrary to aligning executive interests with those of shareholders, but they may be sensible in situations such as the following:
(a) Stock Awards Settled on Termination of Employment. Absent a diversification program, an executive may need to resign in order to convert restricted stock units or stock-based deferred compensation into a different investment. Code Section 409A regulations permit diversification without the need for a termination of employment.
(b) Overexposure to Employer Stock Could Create Warp Executive Decisions. The warnings have come in 2018 from the New York Times ("You've Got Lots of Company Stock. Now What?") and Forbes ("Equity Compensation is Great. But Is It Leaving Your Investments Overexposed?"). For executives who feel over-invested in employer stock, there are two natural responses: pursue a less risky business strategy in order to protect against loss, or pursue an exit strategy such as a company sale in order to maximize or lock-in value. Termination of employment is, of course, another exit strategy. But hedging is not usually viable or advisable, because that is both a widely-criticized practice and because a public company that allows hedging would need to publicly disclose that (per Section 955 of the Dodd-Frank Act and SEC rules). For a company that desires sustained long-term growth, it may make sense to allow executives to diversify their risk through a well-informed strategy framed by the company. There are many possible avenues for this, with trading windows and a 10b5-1 plan being two common solutions.
(c) Employer Stock is Not a Magic Elixir. It is unquestionably a best practice to make stock awards because they promise to align the financial interests of executives with those of shareholders. Too much employer stock may however create winners and losers not due to executive merit, but due to the vagaries of the stock market or of particular industries. Employers and their compensation committees should consider balancing stock awards with long-term deferred compensation that is credited based on corporate performance -- such as earnings -- and that has a future value determined by a measure other than stock price. There are many possibilities for sound approaches to deferred compensation (including its use as an incentive to protect trade secrets and to assure the honoring of post-employment covenants such as noncompetes). It takes some thought. But the exercise should be a win-win for companies and executives.
Conclusion. In widely-reported remarks, SEC Commissioner Jackson recently called on corporate boards and their counsel to focus on how stock buybacks affect long-term corporate performance and the link between pay and performance. He advises that "Corporate boards and executives should be working on [creating long-term sustainable value], not cashing in on short-term financial engineering." Diversification programs involving employer stock can serve valid, long-term corporate purposes if properly designed. This may seem like a formidable challenge, but executive compensation has become a high stakes corporate exercise that promises to reward those who are smart and forward-looking.
Copyright © Joseph Poerio. All rights reserved.