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Author Topic: Restricted Stock Units (RSUs)  (Read 858 times)
 
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« on: March 10, 2016, 03:50:58 PM »

According to the March 15, 2016 Agenda Minutes of the C&R Committee, amendments to the USRP will be proposed to exclude Restricted Stock Units (RSU) as part of the January 1, 2017 Regulatory Filing to take effect with respect to policies with anniversary rating dates on or after January 1, 2018.   

RSUs are becoming an increasingly frequent form of compensation in certain industries in California.  Although the USRP contains provisions directing that some specific forms of equity compensation are excluded from reportable payroll, equity compensation in the form of RSUs is not specifically excluded in the USRP.  Other jurisdictions currently do not have rules that specifically address RSUs.

RSUs are not a reliable proxy for exposure for the policy in effect at the time of vesting as they are:

  • paid based on a structured agreement that usually spans multiple policy periods and
  • subject to fluctuations in valuation that are not directly controlled by the employer. As such,
    these forms of compensation do not directly correlate to exposure based on the employee’s work
    performed during the policy period in which the award vests.

RSUs are a type of equity compensation that has recently become popular to attract and retain employees, especially at start-up and technology companies in California. An RSU is a grant valued in terms of company stock, but company stock is not issued at the time of the grant. RSUs are a structured agreement to issue shares of stock to the employee at one or more points in the future upon the satisfaction of vesting requirements. After the recipient satisfies the vesting requirement, the company distributes shares or the cash equivalent of the number of shares used to value the unit. Most vesting requirements are time-based for the purpose of retaining employees. However, vesting requirements may also be defined in terms of company or individual performance. RSUs are currently included as reportable payroll/remuneration in California at the time the stock units vest, as there is no USRP provision specifically directing that RSUs be treated otherwise.

Prior to 2007, start-up and technology companies frequently used stock options as a tool to recruit and retain staff. Stock options are awarded as an option for the employee to purchase stock in the company at a specified price at a future date. Stock options have value to the extent that the option price is lower than the market price for the stock. Stock options can become worthless if the stock’s market price falls below the option price; these are often described as “underwater” stock options. Many employers, particularly those in technology-related industries, have shifted from stock options to RSUs.

There are limitations set by the Internal Revenue Service with regard to how the option price is set when stock options are issued; an option price that is too low relative to the stock’s current market price will result in taxes due when the option is issued. Until 2005, companies were able to set the stock purchase price for an option as low as 1/10 of the price per share most recently paid by outside investors without being taxed at the time of issuance. Section 409A, added to the Internal Revenue Code effective January 1, 2005, resulted in more conservative differentials between the option price and the most recent market valuation, such that options prices are required to be at least approximately 1/3 of the most recent market price to avoid incurring taxes at time of issuance.4 Although Section 409A imposed new restrictions on stock options, stock options continue to provide an attractive incentive to employees, unless outside investors have recently paid an above market price to acquire shares in the company.

RSUs became popular with many technology and start-up employers around 2007 as they avoid many of the issues that exist with stock options. RSUs are a documented agreement to issue shares of Common Stock to the employee at a future date, subject to the employee satisfying vesting requirements. RSU vesting schedules are typically5 multi-year agreements that may include numerous vesting dates. RSUs do not trigger taxation at time of issuance, but they are taxed as income when they vest.

Unlike stock options, which are granted as an option for the employee to purchase stock in the company at a specified price at a future date, RSUs do not require any optional purchase by the employee; they are simply awarded subject to vesting requirements. As such, a smaller number of RSUs may provide a similar value to the employee compared to a larger number of stock options; this ultimately permits the employer to issue fewer shares of stock, reducing per share earnings dilution. While stock options can become worthless if the stock’s market price falls below the option price, RSUs will always have some value unless the company stock itself has no value; RSUs cannot be “underwater”.

RSUs are not the same as restricted stock, in which actual shares of stock are reserved for the employee subject to vesting. With restricted stock, the stock must exist at the time the grant is issued, and the restricted shares may begin accruing dividends as of the award date. The shares of restricted stock havea known value at the time the grant is issued, and the employee has legal title to the stock, subject to the employer’s contractual right to repurchase, from the award date until the time of vesting. The issuance of the restricted shares can dilute the earnings per share for the company while the shares await vesting. Restricted stock will be addressed in Phase 2 of this study.

RSUs are not a form of bonus, which are specifically included as payroll/remuneration. Some bonuses are paid in company stock. Unlike a stock bonus, with RSUs, the employee does not instantly receive the stock as an awarded bonus but instead may receive stock according to a multi-year vesting plan and distribution schedule. Unlike a stock bonus where the employer is able to pay a bonus with a known cash value, RSUs are not assigned a fair market value until they vest and so their eventual value at vesting is unknown when the grant is awarded. Upon vesting, they are considered income for tax purposes and a portion of the shares may be withheld by the employer to pay income taxes. However, the employer has no control as to what the value of the RSUs will be when they vest, and whatever value they have to the employee upon vesting is not directly correlated to the work the employee performed during the then current policy period due to the multi-year vesting schedule. For this reason, RSUs are not a strong proxy for the insurer’s exposure in the year they vest and may in fact result in a sharp increase in payroll with no corresponding increase in loss exposure if the RSUs have a high value that is not necessarily related to an employee’s work in the current policy period.

In reviewing the Appendix II entry for employer contribution to a profit sharing stock purchase plan or fund that is held by the employer until the employee’s termination, the entry notes that such payments are not included as payroll/remuneration. In a stock purchase plan, employees contribute to the plan through payroll deductions, which accumulate until the stock purchase date. At the purchase date, the company uses the accumulated funds to purchase shares in the company on behalf of the participating employees, at a discounted price that is typically 10 to 15% below market price. The amount of the discount represents the employer’s contribution, which is excluded from reported payroll. Stock purchase plans are dissimilar from RSUs as RSUs do not include an employee contribution; the entire value is provided by the employer. Like RSUs, these contribution payments are distributed to the employee at a point in time that does not directly correlate to when they were earned or awarded, and could result in a sharp increase in payroll with no corresponding increase in loss exposure and fluctuation in year-to-year reported payrolls.

Appendix II also directs that stock options are not included as payroll/remuneration. As detailed above, RSUs have grown in popularity largely as an alternative to stock options, as both function as a financial incentive that is separate from an employee’s regular payroll earnings. To the extent that employers adopt RSUs to replace stock options as incentive equity-based compensation, the exclusion of RSUs from payroll/remuneration should not significantly erode or reduce reportable payroll/remuneration.

4 Private companies that do not have an established market price are required to obtain independent current valuation appraisals when issuing stock options, referred to as 409A appraisals.
5 Some RSU agreements include provisions for immediate or “cliff” vesting upon the occurrence of a specific event, such as the sale
of the company.

Based on its review of the characteristics of RSUs as equity-based incentive compensation, WCIRB staff makes the following conclusions:

1. RSUs are not a good proxy for a workers’ compensation insurer’s exposure as they are typically multi-year agreements and, at the time of vesting, have no direct correlation to operations performed by the employee during the then current policy period.
2. Employers cannot directly control the eventual value of the RSU stock at the time it vests. As a result, there is little potential for manipulation of reportable remuneration if RSUs are excluded from reportable payroll/remuneration.
3. RSUs share key characteristics with other forms of compensation including profit sharing stock purchase plans, stock options and retroactive wages awarded for time worked during a prior policy period that are currently excluded from reportable payroll/remuneration.
4. The inclusion of potentially large amounts of payroll for statistical reporting purposes as a result of including RSU amounts can result in volatility in reported payrolls from year to year without similar shifts in underlying loss exposure.
5. The exact impact of removing RSUs from reported payroll/remuneration cannot be established as these amounts have not been separately reported. However, an informal survey of certain large technology firms suggests that for certain classifications, the impact of excluding RSUs from reportable payroll may be significant.
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