So often, executives receive a large
portion of their compensation in
stock options, restricted stock or performance stock units, tying their overall compensation package back to the
growth of the company and the value provided to shareholders. They often seek
diversification strategies based upon their
risk tolerance and investment objectives.
But as insiders, or being perceived as
insiders, they’re limited on when they can
sell company shares.
Usually, executives can only trade when
they are not in possession of material non-public information. This is generally presumed to be during an open trading window, which is set by companies and most
often occurs for a short period after earnings release. These windows are narrow
and can close unpredictably when the
executive insider comes into the possession of material nonpublic information.
The executive is caught in a bit of a
conundrum: While stock sales of key
executives tend to be negatively perceived, a concentrated position in their
company stock exposes them to market-and company-specific risk. As a result of
all these factors, the executive’s ability to
sell stock in the most optimal manner is
quite limited.
“SEC Rule 10b5-1 plans are a potential
solution,” explained Richard K. McDonnell
Jr., CPA, a senior manager in the tax
department at Burr Pilger Mayer. “They
also allow for an affirmative defense
against potential claims of insider trading.”
Smart Business received more insight
into these plans from McDonnell.
How do SEC Rule 10b5-1 plans work?
These plans allow executive insiders to
complete an agreement between a broker-dealer and the executive, approved
by the issuer’s corporate counsel, to sell
shares in a preset manner throughout the
year.
Corporate executives can generally use
the plans for the sale of actual company
shares, to allow for the exercise of their
company stock options and the immediate sale of the shares received, as well as
the sale of their restricted stock or shares warded through performance
share plans.
For example, let’s say that the executive has different lots of stock options at
different grant prices and expiration
dates. We would review the grants with
the executive and complete the planning.
The executive’s decisions would then be
incorporated by the broker-dealer into a
SEC Rule 10b5-1 plan for the executive’s
and corporate counsel’s sign off. For
example, the executive only has two
years to exercise one lot of stock options
prior to expiration of 20,000 shares. The
grant price is $10 and the market is $40;
the executive thinks that the stock
should go up to $45 over the year or so.
The executive could set up his plan to
exercise 3,000 shares a month, as long as
the current market is over $40. On the
next lot, with approximately the same
parameters, the executive could set the
exercise price at $45 for the full lot. For a
lot that has a few years until expiration,
consideration for the exercise price
might be at $60 because the executive
thinks, and the market shows, that over
the next few years the value might reach
$60 but not much more than that. If the price hits currently, the executive can
capitalize. On the whole, the planning is
quite flexible and can be customized to
fit both the executive’s needs and selling
decisions.
How do the plans apply to restricted stock
grants?
These plans are extremely important for
use with restricted stock grants, whose
restriction may lapse during a blackout
window. In that case, the executive would
receive the stock and the Form W-2 compensation without the ability to sell the
stock until the next open window. This
could be detrimental if the stock drops in
value between the date of the lapse in
restriction when the compensation element is determined and the actual sale of
the stock.
So we could set up a plan during an
open window that would enable the executive to sell these shares the day the
restriction lapses. Once the plan is drawn
up with a broker-dealer and approved by
corporate counsel, when the restriction
lapses, the executive would be able to sell
the shares at the current market value,
equal to the compensation element.
Are there any other considerations?
Most companies will only allow SEC Rule
10b5-1 plans to be implemented during
open window periods and, of course, when
the executive does not have knowledge of
any material nonpublic information.
The most important item to remember is
that the modification or termination of the
plan may weaken or lose the benefit of the
affirmative defense against insider trading.
If the executive completes his or her stock
option planning and diversification strategy
in conjunction with the SEC Rule 10b5-1
plan, it is very important that he or she stay
the course for the length of the particular
plan, which typically runs for one year.
RICHARD K. MCDONNELL JR., CPA, is a senior manager in the tax department at Burr Pilger Mayer. Reach him at (650) 855-6880
or [email protected].
