On November 24, 2021, the SEC released Staff Accounting Bulletin No. 120, or SAB 120. The SAB addresses the valuation of share-based compensation (SBC) awards issued shortly before the planned release of positive material non-public information (MNPI).

These situations, called spring-loaded grants, are the inverse of the backdating drama that plagued the early 2000s. Back then, companies were called out for tethering awards to the lowest historical strike price they could find. With spring-loaded awards, companies look forward to find a pop they can hitch an award to. The SEC is flagging the latter as a financial reporting issue in which the failure to properly identify a spring-loaded grant and consider it in the valuation may result in a misstatement of compensation cost.

Although the thrust of SAB 120 is to address spring-loaded grants, it applies to all situations—intentional and unintentional—where a grant precedes the release of MNPI. Robust governance protocols and planned granting schedules should make spring-loaded situations rare. Nonetheless, if one arises, the solutions are murky.

In this article, we discuss the context of spring-loaded grants, the scope of SAB 120, how companies can avoid or remedy these situations, and considerations as you formulate a plan in response to the new SAB. If you’re already familiar with aspects of the topic, you can jump straight to a specific section.

Section 1: Overview of Spring-Loaded Granting

Section 2: Scope of SAB 120

Section 3: Solutions and Best Practices to Mitigate Risk

Section 4: Implementation Considerations

Section 1: Overview of Spring-Loaded Granting

Let’s start by looking at how a spring-loaded grant works and what the SEC is advising companies to do in valuing one.

Simple illustration of a spring-loaded grant

Suppose a company is preparing to release positive MNPI and is also coordinating an SBC grant. Ordinarily, and as per ASC 718-10-55-27, the valuation of that SBC award would reference the market price of the underlying share on the date of grant.

Now suppose the SBC grant is staged for a Tuesday, and the next morning the company intends to release positive material non-public information. Then the valuation of that grant would be predicated on an artificially deflated share price insofar as the observable market price at grant doesn’t embed the positive news management is preparing to release. For instance, suppose Tuesday’s closing price is $80 and the news released on Wednesday takes the share price to $100. According to SAB 120, this mismatch clashes with the fair value objective of ASC 718 and results in the valuation being biased due to its omission of the positive MNPI.

The SAB embraces a flavor of market efficiency called semi-strong efficiency, which posits that markets are well-priced and security prices embed all available public information. Therefore, security prices follow a random walk and move in response to the release of private news. ASC 718 requires that a valuation reflect how a marketplace participant would price the instrument and is free of bias (ASC 718-55-13). Awarding and valuing an instrument in reference to a security price that omits known MNPI inserts a bias.

Valuation treatment of a spring-loaded grant

SAB 120 instructs companies to adjust their valuation methodology to omit the bias stemming from using a share price that doesn’t embed positive MNPI. Continuing with the same example where a grant is being made at $80 and the positive MNPI will boost the share price to $100, the company would use the higher share price of $100 in its fair value measurement technique. It should also consider the impact on stock price volatility that the MNPI will have. Collectively, these adjustments aim to remove the bias.

In blog posts like this, we can use simple examples and stated facts that cause the numbers to foot. In the real world, we need to formulate assumptions and use tools in financial economics to fill in the gaps. Indeed, the task in SAB 120 is to estimate ex ante how the market will respond to the MNPI. SAB 120 states that

Company D would disclose in a footnote to its financial statements how it determined the current price of shares underlying share options for purposes of determining the grant-date fair value of its share options in accordance with FASB ASC Topic 718. For example, the staff would expect Company D to disclose its accounting policy related to how it identifies when an adjustment to the closing price is required, how it determined the amount of the adjustment to the closing share price, and any significant assumptions used to determine such adjustment, if material.

We’re concerned that this will cause an already assumption-rich process to kick into overdrive. As we discuss later, a more practical solution may often be to simply delay the grant.

What if delaying isn’t possible? The SAB instructs companies to adjust both the current share price and the stock price volatility assumption. Some accounting firms suggest engaging a third-party valuation specialist (e.g., a firm like ours). In academic circles, one common method to model a share price adjustment is to create an event study to measure the empirical effect of similar situations. Another approach is to model the impact of the news release on earnings and draw inferences from the modeled price-to-earnings (PE) ratio.

With respect to adjusting the volatility assumption, an analysis of prior news releases may also be appropriate. If some leakage of the news occurred prior to the grant date, this may merit a greater reliance on implied volatility.

Still, we’re skeptical that fancy techniques like these are better than deferring the grant timing to bypass the issue altogether. One approach some have voiced is to simply take the stock price after the MNPI release and adjust the valuation retrospectively. But that has its own complications, not least of which is that the valuation should be made as of the grant date and not factor in any subsequent information.

If using targeted adjustments to the current share price and volatility assumption, the SAB requires disclosure of the critical assumptions. It also suggests that the terms of such an award may be unique enough to merit standalone disclosure apart from other equity awards issued.

Back to top

Section 2: Scope of SAB 120

SAB 120 is clearly focused on non-routine grants that are opportunistically linked to planned releases of MNPI. However, its literal reach is broad and not only limited to non-routine grants, even though these are most likely to trigger a spring-loaded issue. Although SAB 120 is unlikely to apply in normal situations, it certainly can and that’s an argument for proactively reassessing existing processes and governance protocols. We’ll get into some specific best practices, but before we do that, let’s look at the scope of the SEC’s guidance.

Does SAB 120 apply only to ad hoc and non-routine granting?

No. As noted, SAB 120 applies to both non-routine and routine (pre-scheduled) granting. Nonetheless, the context of the SAB is substantially focused on non-routine grants that are linked to a subsequent planned release of positive MNPI. The operative text is:

…when share-based payments arrangements are entered into in contemplation of or shortly before a planned release of material non-public information, and such information is expected to result in a material increase in share price. [emphasis added]

The “or” clause splits the sentence into two flavors. The first is a situation where the equity award is intentionally sequenced to immediately precede a planned release of MNPI (“in contemplation of”). The second is a more generic case in which the equity award simply happens to precede the release of planned MNPI. We think the former scenario is the one that creates the most risk and worry to the SEC. The SEC goes on to write that “non-routine spring-loaded grants merit particular scrutiny by those charged with compensation and financial reporting governance.”

But annual grants or otherwise routine issuances are still subject to the rule. These are simply less likely to trigger the spring-loaded provisions in SAB 120 given the role of existing governance practices and protocols. However, the SEC’s bar for triggering a spring-loaded grant situation is simply whether there’s a planned release of MNPI shortly after the issuance of SBC awards, regardless of whether the organization was actively trying to spring-load the grant:

Additionally, when a company has a planned release of material non-public information within a short period of time after the measurement date of a share-based payment, the staff believes a material increase in the market price of the company’s shares upon release of such information indicates marketplace participants would have considered an adjustment to the observable market price on the measurement date to determine the current price of the underlying share.

A key term in the above statement is the word planned. Note that “planned” modifies the release of MNPI and not the issuance of an SBC award. In other words, the company doesn’t need to be trying to spring-load the grant in order to trigger the provisions in SAB 120. On the other hand, if positive MNPI is released but not planned, then this shouldn’t create a spring-loaded situation. For example, if a company issues SBC awards and a few days later benefits from a court ruling that favorably resolves open litigation, this outcome wasn’t planned—it simply happened.

Nevertheless, litigators are likely to be running data screens and looking for fact patterns where a share price pop occurs shortly after a grant. Whether the MNPI release was planned or unplanned can’t be part of their screening process—it’s an empirical reality uncovered in legal discovery. That’s why tight controls, internal processes, and documentation are essential.

Are there contexts outside of new grant issuances to be concerned with?

Yes. Remember that a modification is functionally a new grant, so it also applies. The measurement of incremental cost in a modification is tethered to the facts and circumstances on the modification date, which means that any planned release of MNPI shortly after the modification date would trigger a spring-loaded grant situation.

In fact, we think it’s more likely that a company could get itself into a spring-loaded bind when modifying awards since modifications are usually ad hoc and may be a response to an external event that involves MNPI.

Does SAB 120 apply only to options or to all share-based compensation awards?

It applies to everything. The framing of the SAB is focused on options, but we think the principles apply to all award types. The fundamental principle behind SAB 120 is that companies shouldn’t issue underpriced equity because they’re sitting on positive MNPI. If they do issue underpriced equity, then the reported fair values are biased and the financials pertaining to ASC 718 compliance are misstated.

That risk also applies to time-based and performance-based RSUs. It especially applies to performance-based awards with a market condition, since these follow a fair value measurement process similar to stock options. But any share-based compensation award can be deemed spring-loaded if it’s issued prior to the release of planned and positive MNPI.

The use of an averaging period on a total shareholder return (TSR) award can automatically address the risk, but only if the averaging period looks forward instead of backward. Coincidentally, this has emerged as one of many practical techniques to neutralize the impact of realized returns on TSR valuation.

Back to top

Section 3: Solutions and Best Practices to Mitigate Risk

We think spring-loaded grant situations will be rare. But when they do occur, they’ll be hard to resolve. In particular (and as we discuss in the next section), we’re concerned about the imprecision in suitable adjustment techniques and the negative effect any such techniques may have on SBC award recipients.

Therefore, in no particular order, here are some best practices that may help you mitigate the occurrence of a spring-loaded situation:

• Publish a grant calendar that shows the timing of the annual grant and off-cycle new hire awards. Most annual grants occur shortly after the annual earnings release. Fast-growing technology firms may issue new hire grants as frequently as monthly, but most do so quarterly. Document all this and make sure all stakeholder functions are aligned.

• Develop an “all-clear” signoff process for every grant issuance that includes legal and finance. At any given time, someone in your organization is sitting on MNPI. But the SEC’s standard in SAB 120 is a planned release of MNPI. An all-clear signoff process asks Legal and Finance whether they’re about to release MNPI and ensures the timing and sequencing of the grant and MNPI release are appropriately determined.

• Establish decision rules on how to adapt granting decisions if an upcoming grant might intersect with the planned release of MNPI. SAB 120 discusses techniques to adjust the current share price and volatility to embed the impact of the MNPI. As noted, we think it’s often simpler to delay the grant so that it occurs shortly after the MNPI is released. If you do, though, think carefully about how long it will take the market to digest the information so that the stock price stabilizes and you aren’t granting midway into a roller coaster ride (see the Kodak case below).

• Educate your board to avoid cowboy grants. Even in mature public companies, it’s not unheard of for CFOs to discover that the compensation committee had met earlier and approved a handful of large grants. If the CFO is preparing to release MNPI, this scenario forces their hand because the grant is done and that bell can’t be un-rung.

• Understand and socialize how the accounting grant date is solidified. It’s easy to misinterpret the measurement date on an SBC award, effectively assuming that the grant date falls after the MNPI when actually your accounting team is using a grant date that precedes MNPI. For instance, the grant date is generally the date when the compensation committee approves the grant recommendation, not when the communication rollout occurs.

• Track the share price during the weeks following a grant. If the share price spikes shortly after a grant has taken place, it will trigger a red flag even if you’ve checked the right boxes. Identify and look into these cases before you receive an inquiry from a party like the SEC. If an error was made and the grant looks like it was spring-loaded, take corrective action preemptively.

Newly public companies without well-established granting practices are at the highest risk of inadvertently creating a spring-loaded situation. Given the difficulty of working through a spring-loaded situation after it’s occurred, take measures to improve granting protocols before you need them. And if you have comprehensive protocols already, adopting some or all of the above enhancements can go a long way toward further de-risking.

Back to top

Section 4: Implementation Considerations

We appreciate SAB 120 as an effort to identify situations where SBC award valuations may suffer from bias. However, this relatively short SAB introduces valuation concepts that are particularly murky to apply in practice. In this section, we’ll look at some of the implementation challenges. We’ll focus on the bigger picture rather than the nitty-gritty of adapting the valuation process to a spring-loaded situation. (Email us if you’d like to delve into the actual valuation mechanics.)

Let’s begin with a case study that highlights the limitations of existing solutions.

Case study: Eastman Kodak

Eastman Kodak is the poster child for spring-loaded granting. The Wall Street Journal covered this story extensively in this article and this article, along with this more recent one on spring-loaded awards.

On July 27, 2020, Kodak made option grants one day prior to officially announcing a $765 million loan from the government to produce drugs at some of its factories. That day, the stock price closed at $2.62. The next day, after the news was officially released, the stock closed at $7.94. And on July 29, the stock price closed at $33.20. Although there had also been some leakage leading up to the official announcement, the pop was clearly on July 28 and again on the 29^th.

Had SAB 120 existed then, its framework would assert that options granted and valued using a current price of $2.62 are potentially biased in light of the planned release of positive MNPI the very next day. The SAB would suggest that Kodak either hold off on the grant or adjust the current share price and volatility in their valuation technique to reflect the impact of this MNPI. (A cursory reading of Kodak’s 10-K suggests certain adjustments were indeed made.)

Let’s look at some other parts of the fact pattern. The stock price didn’t stay above $30 for long. By August 7, the stock dipped down to $15 and never again rose above $15. The stock has always been volatile, but it wasn’t until October that it seemed to regain some semblance of stability. As we’ve mentioned a few times, our preferred solution for avoiding a spring-loaded grant situation is to simply defer the grant until after the planned MNPI release. But this case study suggests even that solution is risky because the market may take some time to digest the news. Imagine if Kodak had waited a few days and issued options with a strike price of $33.20—they’d have avoided a spring-loaded situation but ended up sitting on a pile of underwater options.

The SEC initiated an investigation into the matter. Kodak commented that none of the executives exercised their options or sold stock. Further, Kodak disclosed that the grant was scheduled to precede the loan announcement to shield executives from having their equity stakes diluted if convertible debt holders activated their conversion features upon loan issuance. That of course wouldn’t have been a suitable defense against SAB 120. But it does show that Kodak was trying to solve other problems during this sequence of events.

Let’s again suppose SAB 120 did exist when Kodak was taking the government loan, and let’s further suppose that deferring the grant date was not an option. As such, Kodak would need to adjust the current market price and volatility estimate used in measuring the fair value of the grants. We referenced the use of tools in financial economics, such as event studies using similar historical information releases or cash flow modeling that looks at PE ratios.

Suppose Kodak had estimated a market price of $60 using one or more of those techniques. Perhaps the SEC and Kodak’s auditors would approve of each technique, but this would create a massive deadweight loss to the recipients if their option grant quantities were calibrated using the accounting value. In other words, this would yield a higher valuation and, in turn, fewer options granted—which means a lower realizable pay to the recipient. That’s fine if the estimations become reality, but in Kodak’s case the stock price never hit $60 and it didn’t even stay at $30.

This illustrates the possibility that compliance with the spirit of SAB 120 can harm award recipients in other ways given the interdependence between accounting values, proxy disclosure, and award grant size calibration.

How much time between a grant issuance and planned release of MNPI is enough?

SAB 120 defines a spring-loaded situation as one in which the planned release of MNPI occurs a “short period of time after the measurement date of a share-based payment.” However, it doesn’t define a “short period of time.” Later in the SAB, the SEC uses an example involving a hypothetical company. The company enters into a material client contract after market close, awards options to its executives that evening, and then announces the contract the next morning (i.e., everything takes place within a 12-hour window).

We interpret the SAB as being principles-based and not rules-based. Therefore, there won’t be any bright line standards demarcating an appropriate distance between an SBC award and subsequent release of MNPI.  Literature argues the market is swift and decisive in embedding new information into security prices. A common case study looks at how quickly the market responded in figuring out which entity was at fault when the Challenger space shuttle crashed (even though a panel of experts took months to officially sort out the details).[1]

Conceptually, a one-week period seems to be plenty of demarcation for normal MNPI releases. An informal safe harbor of two weeks could emerge by appealing to the Item 402(x) disclosure the SEC has recently proposed, provided it goes into effect as proposed (discussed next). Our hope is for a formal safe harbor that is shorter than two weeks (e.g., three days), but this seems unlikely. This may be why the SEC kept their guidance to instructing companies to adjust the share price and volatility to reflect the planned release of MNPI, instead of mechanically trying to separate the two events by an arbitrarily imposed amount of time.

How does the SEC’s proposed Item 402(x) addition relate to SAB 120?

Shortly after the release of SAB 120, the SEC announced and proposed amendments to the Section 10b5-1 rules and disclosure provisions under Reg S-K (among other things). Of interest here is the proposed addition of an Item 402(x) disclosure that would require a tabular disclosure to identify specially timed grants. Here’s the relevant excerpt from the proposed rule:

Under the proposal, to identify if any such timed options are granted, a new paragraph (x) would be added to Item 402 of Regulation S-K that would require tabular disclosure of each option award (including the number of securities underlying the award, the date of grant, the grant date fair value, and the option’s exercise price) granted within 14 calendar days before or after the filing of a periodic report, an issuer share repurchase, or the filing or furnishing of a current report on Form 8-K that contains material nonpublic information; the market price of the underlying securities the trading day before disclosure of the material nonpublic information; and the market price of the underlying securities the trading day after disclosure of the material nonpublic information.⁷⁵

⁷⁵ Under the proposed rule, disclosure would also be required of the grant date fair value of each equity award computed in accordance with FASB ASC Topic 718.

Mechanically, the way you’d comply is to first identify the dates of all periodic reports, share repurchases, and 8-Ks. After that, check for and disclose any stock option grants within a 14-day window of any of these events. Notably, the proposed disclosure addresses stock options (and option-like instruments) only, whereas we read SAB 120 to encompass all award types.

Complying with the proposed tabular disclosure seems straightforward enough, but we’re concerned that it creates undue risk. An erratic stock price movement within that 14-day window could draw considerable attention even though there’s arguably a massive difference between a stock price movement two days after a grant and eight days after a grant.

Our suggestion earlier was to simply defer a grant date to avoid proximity with any planned MNPI release. But delaying a grant, especially a broad-based one, by two weeks is an administrative mess. It may also not be feasible to find a perfect date if the trigger is a 14-day look-back and look-forward provision. The SEC’s rules are not final and we expect significant commentary and potential revision.

Should the strike price also be adjusted in a spring-loaded grant situation?

The backdating scandal of the early 2000s was linked to artificially deflated strike prices on options. Companies intentionally or unintentionally tied the strike price to a date when the share price was depressed, thereby catapulting those options into the money. Spring-loaded granting is the flip side: Rather than looking back and rewriting the strike price to a historical low, you’re tethering the grant to a date right before a known spike is about to occur.

But unlike the backdating literature, SAB 120 never mentions the strike price, only the current market price and volatility estimate used in an option-pricing model. This begs the question: In a spring-loaded situation, should the company also adjust the strike price on the option to reflect the expected current market price being used for valuation purposes?

Coming back to our simplified example in which the stock price is $80 on a Tuesday and jumps to $100 the next day when MNPI is released, should the company write the option contract with a $100 strike price? We don’t think so. Section 409A is a tax rule by the IRS and except when explicitly stated, IRS rules don’t necessarily intersect with GAAP. Unless the IRS provides new guidance to the contrary, their focus is the observed market price—in our example, that’s the $80 figure. In other words, in a spring-loaded situation, there’s a divergence between the IRS lens and the GAAP lens wherein the IRS is not expecting any set of adjustments to be applied to the observed market price.

Let’s trace it one step further. Suppose the company in our example adjusted the strike price upward to $100. Then, the company would value the award for GAAP purposes as an at-the-money grant and the IRS would view it as a premium-priced option since their lens is trained on the observed market price. Let’s further suppose that the MNPI is released and the stock price barely makes it to $84, suggesting the $100 estimate was wildly optimistic. Now the company is stuck explaining to the executive why she was granted a premium-priced option.

What should the disclosure include?

Another reason we prefer deferring the grant, instead of adjusting the current market price and volatility in the valuation, is the corresponding disclosure required. Deferring the grant until after the MNPI release eliminates a spring-loaded situation. Adjusting the share price and volatility in the valuation of the SBC award accommodates a spring-loaded situation and requires disclosure.

Any such disclosure would be sensitive. The assumptions underpinning the adjustment approach would be subject to scrutiny. Even the best assumptions made with the best intentions may undershoot or overshoot what actually happens. This could lead to an award that’s either substantially underpriced or overpriced relative to the actual pop in the stock price. In the former case, critics could argue the company failed to adequately incorporate the effect of the MNPI; in the latter case, disclosed proxy values are inflated, increasing the probability of a pay-for-performance disconnect.

Nevertheless, if you find yourself in a spring-loaded situation, the SEC instructs that the methodology for adjusting the share price and volatility be disclosed. This involves referencing the conceptual framework used to model the expected impact of the MNPI on both the share price and volatility. The SEC also hints that altogether separate disclosure of the spring-loaded grants is appropriate when the differences are sizable relative to normal awards.

How do you know the MNPI is positive MNPI?

The SAB is written in the context of positive MNPI, which the definition of spring-loading hinges on. We’re worried that in the real world it’s not always clear whether information is unequivocally positive. Some information is, such as in the Kodak case study, but even then it wasn’t clear how positive it really was.

Remember that markets move based on expectations, wherein good information might not be good enough if the market was already expecting it. It’s not always obvious what the market expects. The textbook example is when a company meets or barely exceeds its earnings estimate and is nonetheless punished—which suggests the market had already raised its expectations and was disappointed with the so-called earnings beat.

Let’s think about another case. Consider a company that settles a lawsuit with a competitor but the settlement is for a larger amount than the market expected or there are terms to the settlement that may damage the brand. It’s unclear whether the market will cheer (the lawsuit is over, eliminating left-tail risk) or boo (the terms of the settlement missed expectations).

Most often, we expect that companies will be able to anticipate whether the MNPI is positive or negative, but they’ll struggle to quantify how much the market will move. We think this is a serious implementation challenge that touches on the themes raised thus far.

What prompted the release of SAB 120?

As far as we know, this topic first came up in academia. One widely-cited study was released as a working paper in 2014 and published in 2018.[2]

The paper makes some debatable assumptions about CEO intentions and their proclivity toward opportunistically timing good news and bad news. The paper is also based on data from January 2007 to December 2011. Not only did this mark the beginning of a period of steep decline in option grants, but it also spanned the Great Recession—perhaps not the most generalizable timeframe.

We would feel more comfortable if the analysis were refreshed with current data so that it’s robust to contemporary equity award designs (e.g., the use of PSUs over options), present-day granting practices, and a more stable time period. Indeed, the authors’ closing recommendation is to use an average stock price as the basis of a grant. That’s precisely what virtually all TSR granters now do (i.e., set the beginning TSR price equal to a 20 or 30-day average). Equity compensation granting practices are anything but static and have changed tremendously since 2007.

That’s not to say every idea in this paper made its way into the SAB. For instance, the authors argue that spring-loaded grants (and their close cousins, the bullet-dodging grants) are an artifact of scheduled granting times because CEOs can opportunistically time information releases. However, the SEC in SAB 120 is much more concerned with the opposite scenario involving non-routine grant events.

Back to top

Conclusion

SAB 120 is going to be tricky because it should affect relatively few companies yet will create considerable complexity for those that do find themselves in a spring-loaded situation.

If the SEC’s proposed Item 402(x) tabular disclosure does go into effect as drafted, this may unintentionally broaden the reach of SAB 120 and create an implicit two-week demarcation that increases the number of cases that could be flagged as spring-loaded. A two-week boundary also makes it considerably harder to delay the grant without creating other operational frictions. Of course, this is only an issue if there does happen to be a pop in the share price shortly after the grant.

At a minimum, the onset of SAB 120 underscores the importance of robust granting practices and protocols, such as prescheduled dates and approval processes. Cross-functional “all-clear” signoff processes to check for any planned release of MNPI become crucial. Just as we saw with the backdating woes of the early 2000s, many problems arise simply due to immature controls.

The decision of what to do in a spring-loaded case isn’t straightforward. While we favor the simplicity of deferring the grant, a broad-based grant isn’t exactly easy to defer—especially if the proposed Item 402(x) table implicitly draws a two-week demarcation period. On the other hand, the proposed Item 402(x) disclosure only applies to stock options and is just that—a disclosure, not an admission of wrongdoing or anything of the sort. To that end, familiarizing yourself with the issues in advance will enable more agile decision-making in the moment.

As always, we’re happy to be of support on this or any other topical issue.

[1] Michael Maloney and Harold Mulherin, “The Complexity of Price Discovery in an Efficient Market: The Stock Market Reaction to the Challenger Crash,” Journal of Corporate Finance, 2003, Volume 9, Issue 4, 453-479. doi: 10.1016/S0929-1199(02)00055-X.

[2] R. Daines, G. McQueen, and R. Schonlau, “Right on Schedule: CEO Option Grants and Opportunism,” Journal of Financial and Quantitative Analysis, 2018, 53(3), 1025-1058. doi:10.1017/S0022109017001259.