September 5, 2008

The Other Side(s) of the FAS 5 Coin: The Auditor and Investor Viewpoints

A few weeks ago, I blogged about how lawyers were not happy about the FASB’s proposal to reform FAS 5. Now that the comment period has expired, the views of the auditors and investors are available – some of which side with lawyers (and management) and most of which that don’t. For example, ran this article that summarized some of the objections.

Former SEC Chief Accountant Lynn Turner tells me: “The comments from the investor community are solidly in the camp favoring complete and timely information on loss contingencies. Now it is the unenviable task of the FASB to decide which camp they are in as their proposed statement was strongly supported by investors, and is consistent with their own conceptual framework. The question is whether the FASB will now water down what they have proposed.

As several of the investor comment letters note, it appears some companies are not currently complying with the current standards which raise the question of where is the enforcement. This issue also highlights that is probably not correct to say that there is an “expectation gap” difference between companies and their auditors and those in the investment community, as much as there is an out right ideological difference on what management of companies should have to report and disclose to the owners of the business.

And in the past, when on statements addressing such issues as off balance sheet SPEs, derivatives (No. 133), stock options (No. 123) and leasing, and the FASB chose to give companies what they asked for, it always seemed to come back to kick them on the backside when those standards had significant shortcomings or outright failures as a result of the compromises made.”

Here are other notable comments and analysis:

CFA Institute

Deloitte & Touche



BDO Seidman

Grant Thornton

AICPA’s Accounting Standards Executive Committee

AICPA’s Private Companies Section



Investors Technical Advisory Committee

John Feeney’s “ Blog”

Francine McKenna’s “Re: The Auditors” Blog

The Intersection of Rule 701 and Section 409A

Getting lots of great feedback on the new “The Advisors’ Blog” on, with new content from the 30-plus experts being posted daily. Yesterday, Gregory Schick of Sheppard Mullin blogged a great piece on the intersection of Rule 701 and Section 409A. Below is an excerpt from that blog:

The potential securities law compliance issue that is the source of my musings relates to Rule 701 of the Securities Act of 1933. Rule 701 is the easiest and primary way that companies obtain exemption from the registration requirements of the Act with respect to their compensatory stock options. Rule 701 imposes numerical limitations on the magnitude of equity securities that can be issued in reliance on Rule 701 in a twelve month period.

In particular, the aggregate sales price or amount of securities sold in a twelve month period cannot exceed the greater of: (i) $1 million, (ii) 15% of total assets or (iii) 15% of outstanding securities. Moreover, if relying on either (ii) or (iii) and the aggregate sales price of Rule 701-issued securities exceeds $5 million, then Rule 701 requires that additional disclosures (in essence, a prospectus) be provided to grantees. Such additional disclosures need to have been provided to grantees before they exercised their Rule 701 options and acquired shares.

The sales price for stock options awarded for purposes of these numerical tests is computed at the time of option grant and is calculated by multiplying the number of option shares by the per share exercise price. The SEC’s April 1999 adopting release of amendments to Rule 701 provides that “In the event that exercise prices are later changed or repriced, a recalculation will have to be made under Rule 701.”

Normally, such a recalculation would be performed (with favorable results) when there is an option repricing to lower the exercise price to equal a share fair market value that has declined since the grant date. But, what about if the option is repriced upwards in order to accommodate 409A? Presumably, options whose exercise price is increased to avoid being treated as a discounted option under 409A must also be recalculated for purposes of Rule 701 using the higher option exercise price. Would the recalculation be retroactively performed for the period when the initial grant was made or would the value of the amended option be included in Rule 701 numerical analysis as of the date of the amendment?

In either case, the effect of such an upward adjustment could result in the aggregate sales price exceeding the $1 million and/or total assets thresholds of Rule 701 whereas computations applying the pre-adjusted exercise prices did not. And, perhaps even more troubling, if the Rule 701 $5 million threshold was breached as a result of the recalculation, it could be problematic or even impossible for the company to comply with the additional disclosure requirements imposed by Rule 701 since it is quite possible that some grantees may have already exercised their stock options absent the benefit of the requisite additional disclosure.

Private companies that have increased their option exercise prices in order to comply with 409A may want to also re-examine their compliance with the numerical limitations of Rule 701 particularly if they are considering going public or being acquired since their historical securities law compliance will come under closer scrutiny. While it is possible that the company may be able to avail itself of another exemption under the Act (e.g., Regulation D for certain qualifying option grants), will these recurring 409A-related headaches never end?

The Battle Over Online Ratings

A while back, I blogged about the initial unhappiness over Avvo’s rating system – that service has evolved since then and seems to be doing well with consumers (and the litigation has been dropped). Now, the “Wired GC” Blog describes the latest dust-up regarding ratings involving TheFunded, a site that purports to offer information on VC firms and deal terms from anonymous entrepreneurs. This dispute involves anonymous online feedback…

– Broc Romanek