article is reprinted with permission from the
March 30, 1995
New York Law Journal.
© 1995 NLP IP Company.
The FASB Stock-Based Compensation Project
By Joseph E. Bachelder.
TODAY'S COLUMN DISCUSSES the latest development in the Financial Accounting Standards Board (FASB) project on accounting for stock compensation. It also discusses issues involved in determining whether severance arrangements may be subject to the Employee Retirement Income Security Act of 1974 (ERISA), as reviewed in a recent decision by the Ninth Circuit.
The FASB has announced another major step -- perhaps the final one -- in its stock-based compensation project. 1 At its March 8 meeting, the FASB indicated it expects to release a final accounting standard in mid-summer, requiring extensive footnote disclosure with respect to stock options and other stock awards, including the pro forma net income and earnings per share resulting from treatment of the value of such awards as an expense. There will be no new "Exposure Draft" circulated for public comment.
On June 30, 1993, as the culmination of its long-term project on accounting for stock awards, the FASB issued for comment an Exposure Draft that included a proposed charge against earnings for the "fair value" of stock option grants determined as of the date of grant. The proposal represented a substantial change from current Accounting Principles Board (APB) Opnion No. 25 (1972), under which no charge against earnings is required for most stock option grants.
The Exposure Draft resulted in substantial opposition from major U.S. corporations and many smaller corporations, especially technology-based companies that have long use options as an important part of their compensation. The Big 6 accounting firms, as well as many other accounting firms, joined in the opposition. The FASB received hundreds of letters urging it not to adopt the proposal, and many people criticized the proposal at public hearings held by the FASB.
In May 1994, the U.S. Senate adopted a sense-of-the-Senate resolution against the proposal by a vote of 88-9. In addition, a bill was introduced in both houses of Congress that would effectively overrule the proposal if adopted, 2 and another bill was introduced in the Senate that would require the SEC to approve any new or amended financial accounting standard adopted by the FASB. 3
Opponents attacked many aspects of the FASB proposal, but the main argument was that nontransferable employee stock options are not susceptible to meaningful valuation at the time of grant and that models developed for the purpose of valuing publicly traded short-term options are not helpful in this regard. Many critics were also concerned that if the proposal were adopted many small and medium-size technology-based companies would have to curtail their use of stock options to attract key executives. Other arguments included the substantial burden that complying with the proposal would impose on companies and the lack of comparability among companies since small changes in assumptions could result in large differences in the value of option grants.
In the face of this opposition, on Dec. 14, 1994, the FASB decided not to proceed with the proposed requirements that the "fair value" of stock option grants be charged against earnings. Instead, the FASB voted to "encourage" companies to voluntarily take such a charge as originally provided in the Exposure Draft. Despite the FASB's encouragement, it is expected that very few companies will elect to adopt the new accounting method and take a charge against earnings. 4
On March 8, as noted above, the FASB decided that it was not necessary to issue for public comment a new Exposure Draft embodying the modified proposal requiring footnote disclosure. Instead, the FASB intends to distribute a draft final standard in early April to the members of the FASB's Task Force on Stock Compensation for their comments and to adopt the final standard by mid-summer.
At the same meeting, it was decided that the new rule would not affect 1995 financial statements but would be effective beginning with the 1996 financial statements. However, stock grants made in both 1995 and 1996 would be required to be included in the 1996 financial statements. (References to 1995 and 1996 include fiscal years beginning after Dec. 15, 1994, and Dec. 15, 1995, respectively.)
Assembling the Data
The FASB's revised proposal creates several concerns, some of which are similar to the concerns raised by the original proposal.
First, the assembly of the data required for the footnote disclosure is likely to be an onerous task, and the required text may be complicated and very lengthy. Based on the Exposure Draft and decisions made by the FASB since the date of the Exposure Draft, it appears that the footnote would have to include the following information as to stock options:
* A description of the plan or plans, including the general terms of the awards, such as vesting requirements, maximum term of options granted and the maximum number of shares authorized under the plan.
* The number and weighted-average exercise prices of options outstanding at the beginning and end of the year and the number of options that are exercisable at those dates and the number of options granted, exercised, forfeited or expired during the year. Also, the range of exercise prices and the weighted-average remaining contractual life as of the end of the year must be disclosed. If the range of exercise prices is wide (i.e., the highest exercise price exceeds 120 percent of the lowest exercise price), information about outstanding and exercisable options should be disclosed by groups of ranges.
* The weighted-average fair values of options granted during the year at the dates granted. If the exercise prices of some options differ from the market price of the stock on the grant date, weighted-average exercise prices and fair values of options must be disclosed separately for options whose exercises price (i) equals, (ii) exceeds, or (iii) is less than the market price of the stock on the date of grant.
* A description of the method and significant assumptions used to estimate the fair value of options, including the risk-free interest rate, expected volatility, expected dividend yield and the expected lives of the options. It may also be necessary to disclose an estimate of forfeitures during the vesting period.
* Pro forma net income and earnings per share based on treating the fair value of the option grants as a charge against earnings over the relevant vesting periods.
* The terms of significant modifications to outstanding option grants.
A company that has not only a stock option plan, but also other forms of stock-related plans such as a restricted stock plan or a performance-share plan, must provide some of the foregoing information separately for each such stock-related plan. For example, the key terms of each such plan would have to be provided, as well as certain other information about each plan.
Second, if business publications choose to publish the pro forma net income and earnings per share from the footnote disclosure as part of their reports on quarterly and year-end results, companies will be perceived by some as having lower earnings as a result of stock option grants, the same result the business community sought to avoid in opposing the FASB's original proposal. It may be anticipated that business publications like The Wall Street Journal, Business Week and Forbes, which have special issues each year covering executive compensation, will emphasize the impact on pro forma earnings for those companies that have substantial stock option programs.
Finally, there is a concern that once the disclosure approach is in effect the FASB would not find it difficult to move from the requirement of footnote disclosure to the original proposed requirement that companies charge option grants against earnings. In a letter dated Dec. 14, 1994, to the FASB Task Force on Accounting for Stock-based Compensation, signed by Joseph V. Anania, task force chairman, and Diana W. Willis, project management, the FASB expressly denied such an intention. It also stated:
Moreover, once the Board issues a final Statement that permits continuation of accounting under Opinion 25, the stock compensation issue will be removed from the Board's agenda. It would only be added to a future agenda by a formal vote of the Board after consultation with constituents. Given what we perceive as the desire for closure on this diverse issue by most of the Board's constituents, we think it unlikely that either they or we will want to reopen it in the near future.
Even if one accepts this statement as an accurate reflection of the FASB's current intent, the fact is that the make-up of the FASB will change. Further, the passage of time may dilute the vigor of organized corporate opposition, expecially as corporations become accustomed to footnote disclosure, and the political strength in Congress of the opponents of the original FASB proposal. (Many commentators have expressed doubt as to the wisdom of congressional interference.) Thus, publication of the proposed final standard by the FASB this summer may prove to be an intermediate step toward requiring a charge against yearnings as proposed in the summer of 1993.
In a recent decision, Delaye v. Agripac Inc., 5 the Court of Appeals for the ninth Circuit addressed the frequently recurring, troublesome issue of when a severance arrangement constitutes a plan covered by ERISA. 6 Before the discussion of that case, note will be made of the statutory basis for the issue of and a key Supreme Court decision.
A severance arrangement may be subject to ERISA as an "employee welfare benefit plan," one of the two types of employee benefit plans recognized by ERISA (the other being an "employee pension benefits plan"). 7 ERISA defines an "employee welfare benefit plan" as "any plan, fund or program . . . established or maintained by an employer or by an employee organization" that provides certain benefits, including severance pay. 8 Neither the statute nor the regulations explicitly define the terms "plan, fund or program."
In 1987, the U.S. Supreme Court, in Fort Halifax Packing Co. v. Coyne, 9 identified several elements that typically make up an employee benefit plan:
An employer that makes a commitment systematically to pay certain benefits undertakes a host of obligations, such as [(O)] determining the eligibility of claimants, [(ii)] calculating benefit levels, [(iii)] making disbursements, [(iv)] monitoring the availability of funds for benefit payments, and [(v)] keeping appropriate records in order to comply with applicable reporting requirements. 10 (Numbers added for emphasis.)
If such characteristics are present, the Supreme Court went on to note:
the most efficient way to meet these responsibilities is to establish a uniform administrative scheme, which provides a set of standard procedures to guide processing of claims and disbursement of benefits. Such a system is difficult to achieve, however, if a benefit plan is subject to differing regulatory requirements in differing States. 11
The Supreme Court concluded that a "uniform administrative scheme" is a prerequisite for a benefits arrangement to become a "plan" subject to ERISA. Even if the several individual elements 9as enumerated in the above quotation from the Court's opinion) are present in an employee benefit arrangement, the arrangement will not be subject to ERISA unless these elements are of sufficient substance to require a "uniform administrative scheme."
The Fort Halifax case involved a Maine statute that required companies, in the event of certain plant closings, to make one-time lump-sum severance payments to certain employees. The Court held that such an arrangement was not a "plan" because
[the] requirement of a one-time, lump-sum payment triggered by a single event requires no administrative scheme whatsoever to meet the employer's obligation. The employee assumes no responsibility to pay benefits on a regular basis, and thus faces no periodic demands on its assets that crete a need for financial coordination and control. Rather, the employer's obligation is predicated on the occurrence of a single contingency that may never materialize. . . . To do little more than write a check hardly constitutes the operation of a benefit plan. Once this single even is over, the employer has no further responsibility. 12
Thus, the Supreme Court indicted that unless a plan is to be administered on an ongoing basis it is not a plan subject to ERISA. The correctness of the Court's reasoning and the wisdom of its conclusion is subject to question. As stated by Justice Byron White, dissenting in the 5-4 decision:
[It] is incredible to believe that Congress intended that the broad preemption provision contained in ERISA would depend upon the extent to which an employer exercised administrative foresight in preparing for the eventual payment of employee benefits. 13
As evidenced by numerous cases addressing the issue since Fort Halifax, the answer to whether "a uniform administrative scheme" exists in a particular case is very difficult to predict. If reflects the old adage, "beauty is in the eye of the beholder." One recent example is Ninth Circuit decision in Delaye v. Agripac Inc.
In the Delaye case, an executive entered into an employment agreement to serve as Agripac's president and chief executive office. The agreement to serve as Agripac's president and provided that if the CEO were terminated for cause he would receive only his salary earned up to the date of termination, but if he were terminated without cause, he would receive (i) 12 to 24 fixed monthly payments, based on a set formula, (ii) accrued vacation benefits and (iii) accident, health, life and disability insurance coverage until his monthly payments stopped or he became reemployed. Approximately one year later, Agripac terminated the CEO, allegedly for cause. The CEO, asserting that he was terminated without cause, sued Agripac in the federal district court for Oregon, alleging that Agripac violated ERISA by denying him the severance benefits to which he was entitled under his employment agreement.
The district court, focusing on whether an agreement with a single employee could be an "employee welfare benefit plan" under ERISA, found that the employment agreement was such a plan and awarded the CEO severance benefits. 14 On appeal, the Court of Appeals for the Ninth Circuit stated that it did not consider it necessary to reach the one-person plan issue. The court stated that the issue before it was whether the severance provisions in the CEO's contract constituted an employee benefit plan subject ERISA.
In analyzing this issue, the Ninth Court stated that it was guided by Fort Halifax and that "a relatively simple test has emerged to determine whether a plan is covered by ERISA: Does the benefit package implicate an ongoing administrative scheme?" 15 The Court held that the CEO's employment contract was not an "ERISA plan" because the severance provisions in the agreement contemplated a "straightforward computation of a one-time obligation," and sending him a check once a month, as "specified in the employment contract, [, did] not rise to the level of an ongoing administrative scheme." 16 Accordingly, the court dismissed the appeal because the plaintiff's claim of breach of the employment contract did not present a federal question.
The Ninth Circuit, in reaching its decision found no plan where elements were present that one typically would associate with an employee benefit plan -- discretion as to eligibility for benefits, payment over an extended period (two years) and obvious need for funds over the period to pay those benefits. The court, as noted above, explicitly stated that it was not basing its decision on the fact that only one person was involved in the severance arrangement.
Whether or not they use the rubric, "uniform administrative scheme," the Supreme Court and the Ninth Circuit (and other courts as well) are simply deciding whether there is such substance to the severance arrangement before the court that, in the curt's opinion, ERISA should apply. The complexity of the arrangement and, despite the uncertainty created by Delaye, the circumstances that payments are made over a meaningful period of time appear to influence the courts. 17.
Like it or not, the Supreme Court, the Ninth Circuit and other courts using the "administrative scheme" nomenclature have opened the door to forum shopping on issues involving severance arrangements. Perhaps Justice White was correct in observing at the end of his dissent (joined in by three other Justices) in Fort Halifax that
[the] Court's "administrative-scheme" rationale provides States with a means of circumventing congressional intent, clearly expressed in §1144, to preempt all state laws that relate to employee benefit plans. 18
Justice White might have extended his observation to any litigant better off in respect of a severance arrangement under state law than under ERISA.
1 For earlier discussions of the FASB's stock-based compensation project, see this column, New York Law Journal, March 29, 1993; June 30, 1993; June 30, 1994; Aug. 31, 1994, and Nov. 29, 1994.
2 Equity Expansion Act of 1993, S. 1175, H.R. 2759, 103d Cong., 1st Sess. (1993).
3 S. 2525, 103d Cong., 2d Sess. (1994).
4 Some companies that have performance-based options may decide to elect the new method. Under APB No. 25 there is a charge against earnings for performance-based options equal to the difference between the exercise price and the market price on the date the performance criteria are met. Since the charge at the time may be substantially greater than the grant-date value to be used under the new method, such companies may find the new method advantageous. On the other hand, companies must use the same method for all grants. If the company also uses regular stock options, the possible reduction in the charge for performance-based options resulting from using the new method may not offset the charge for the regular options under the new method. Also, once a company chooses to use the new method, it may, depending on the provisions of the final standard, be difficult or impossible for the company to return in a subsequent year to using APB No. 25.
5 39 F3d 235 (9th Cir. 1994), petition for cert. filed, 63 USLW 3599 (U.S. Feb. 6, 1995) (No. 94-1336).
6 29 USC §1001 et seq.
7 ERISA defines the term "employee benefit plan" as being an "employee welfare benefit plan" or an "employee pension benefit plan" or one that is a combination of both. 29 USC §1002(3). The term "employee welfare benefit plan" is defined in 29 USC §1002(1) and the term "employee pension benefit plan" is defined in 29 USC §1002(2).
8 29 USC §1002(1). A severance plan generally is treated as an employee welfare benefit plan. See 29 USC §1002(2)(B) and 29 CFR §2510.3-2(b).
9 482 U.S. 1 (1987).
10 Id. at 9.
12 Id. at 12.
13 Id. at 23.
14 Whether an arrangement for one person constitutes a plan subject to ERISA is an unsettled issue. A recent court decision noting the status of the issue and citing early Department of Labor rulings is Williams v. Wright, 927 F2d 1540 (11th Cir. 1991).
15 Delaye v. Agripac Inc., 39 F3d 235, 237 (9th Cir. 1994).
17 In a recent decision, the Court of Appeals for the Second Circuit held that a severance payment that could be made over a 60-day period was not an employee benefit plan under ERISA. James v. Fleet/Norstar Financial Group Inc., 992 F2d 463 (2d Cir. 1993).
18 482 U.S. at 26.