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The Employee Ownership Update

Corey Rosen

January 15, 2009

(Corey Rosen)

Stock Drop Cases Increasing Again, But Most Aren't Making Progress

In the wake of the market collapse, a number of lawsuits are being filed by participants arguing that fiduciaries of their 401(k) plans or, less often, ESOPs should have removed company stock as an investment option and/or notified employees of impending financial problems. A number of recent court rulings, however, have given fiduciaries considerable leeway under the Moench doctrine, which states that unless the company is in imminent danger of collapse, the fiduciaries should not be held responsible provided the plan documents state that employer stock is one of the investment options or, as in an ESOP, is the sole option. Courts have come to more mixed conclusions on the issue of whether financial information should be disclosed to participants before it is disclosed to the market (this would apply only where employees are making an investment choice involving employer stock).

The new cases are likely to be even harder for plaintiffs to win because judges may be more sympathetic to the notion that few people anticipated what happened in the markets. So unless there was fraud (as at Enron and others) or an intentional effort to induce employees to buy stock when company fortunes were doubtful, plaintiffs would have to convince courts that fiduciaries should be smarter than the markets, even on a daily basis.

Over the now eight-year history of these cases, very few have actually had final rulings, but a number have been settled, mostly for amounts that were under $1,000 per participant.

FAS 123(R) Option Assumptions: The 2007 Results

Watson Wyatt recently completed its second annual analysis of stock option valuation assumptions and results under Statement of Financial Accounting Standards (FAS) 123(R). From 2006 to 2007, the percentage of companies disclosing option fair values decreased from 74% to 73%, and the number disclosing stock compensation expense increased from 93% to 94%. Median stock compensation expense increased by 9% in 2007. The analysis is available at this link.

Recoverability of Equity-Based Compensation Deferred Tax Assets

As the stock market slides, more stock options and related deferred compensation instruments are underwater, and the related deferred tax assets may no longer be recoverable, according to an article in the Journal of Accountancy.

In addition to recognizing an expense for equity compensation awards, companies also recognize the tax benefit they reap from awards. They receive tax deductions for amounts that employees must recognize as ordinary income. For equity compensation awards that are not tax-qualified-meaning for everything except ISOs and Section 423 ESPPs-companies estimate ultimate tax deduction based on the accounting expense recognized for the arrangement under FAS 123(R) and, as the arrangement vests, record tax savings based on this estimate, reducing their reported tax expense during that period.

If, at the time of exercise, the company's actual deduction is bigger than the original estimated amount, the company records the difference (called a "windfall") on its balance sheet as additional paid-in capital. Any windfall amounts are used as credits to cushion any subsequent shortfalls by forming a "pool." However, this pool can never fall below zero.

If the company's actual tax deduction is less than the amount it originally estimated, as it most likely is for many companies whose options are now underwater, it will incur a shortfall for the difference. If the company does not have sufficient amounts in the pool to offset the shortfall, then the difference between the estimate and the actual tax deduction is recorded as additional tax expense on the company's income statement.

The journal article points out that the balance sheets and tax footnotes of many entities highlight the magnitude of these equity-based compensation deferred tax assets and encourages companies to monitor their plans quarterly for events that trigger the fixing of the corporate tax deduction and affect the recoverability of the related tax asset. When and how they are written off, the article says, could have a significant impact on the income statement. The article is available at this link.

NCEO Volunteer Opportunities

There are a number of ways people can help the NCEO accomplish its mission of providing good information on broad-based employee ownership. These include helping find audiences for speakers we can arrange (such as trade associations or local business groups), getting your trade publication or local newspaper to write about employee ownership companies, writing articles for our Journal of Employee Ownership Law and Finance, helping with research projects (or contributing to help fund them), or, for employee ownership companies, speaking at NCEO meetings and Webinars.

For a full list, go to this link (this is in the members' area of our site; if you are not a member, contact me at

Great Game of Business Conference Set for May 6-8 in St. Louis

The annual Gathering of the Games meeting organized by the Great Game of Business is set for May 6-8 in St. Louis. The meeting is co-sponsored by the NCEO each year. The conference provides detailed, hands-on sessions on how to share financial information, teach business literacy, and get employees involved in using the numbers. Many of the companies have employee ownership plans. If your company practices open-book management, or is thinking about it, the gathering is an essential event and a very good investment. For details, go to this link.

Author biography and other columns in this series

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