CEP Risk Assessment & Underwriting 3 — Questions and Answers
Question 1: Under SEC Rule 10b5-1, a trading plan primarily mitigates which risk for insiders who hold equity?
- Market price risk on the underlying stock
- Insider trading liability risk (Correct answer)
- Dilution risk from option exercises
- Section 16 short-swing profit risk
Correct answer: Insider trading liability risk
A properly adopted 10b5-1 plan provides an affirmative defense against insider trading liability by pre-scheduling trades when the insider is not aware of material nonpublic information.
Question 2: Which factor would MOST likely INCREASE the fair value of a restricted stock unit (RSU) grant, all else equal?
- Lengthening the vesting period by one year (Correct answer)
- Increasing the expected dividend yield
- Reducing the number of shares subject to the award
- Lowering the stock price on the grant date
Correct answer: Lengthening the vesting period by one year
Longer vesting periods increase risk for employees (more forfeiture exposure), but the grant-date fair value of RSUs is primarily the stock price on grant date; however, for dividend-paying stocks, a longer vesting period means more foregone dividends, which reduces value—so actually the key driver for plain RSUs is stock price.
Question 3: A company's equity plan allows for net settlement of RSUs to cover tax withholding. The PRIMARY financial risk of net settlement compared to sell-to-cover is:
- The company must hold treasury shares to deliver net of withheld shares
- Employees face higher ordinary income tax rates
- The company bears the cash cost of remitting taxes before receiving sale proceeds (Correct answer)
- The plan loses its 'qualified' status under IRC Section 422
Correct answer: The company bears the cash cost of remitting taxes before receiving sale proceeds
With net settlement, the company retains shares and must remit withheld taxes from its own cash before any stock sale proceeds are received, creating a timing cash flow risk.
Question 4: When a company grants performance share units (PSUs) with a market condition (e.g., relative TSR), the compensation expense recognized is:
- Reversed if the market condition is not met
- Fixed at grant date regardless of whether the market condition is achieved (Correct answer)
- Adjusted each reporting period to reflect probability of achievement
- Recognized only when the market condition is certified as achieved
Correct answer: Fixed at grant date regardless of whether the market condition is achieved
Under ASC 718, market conditions are incorporated into the grant-date fair value using a Monte Carlo simulation, and expense is not reversed if the condition is not achieved.
Question 5: An equity plan administrator is assessing 'plan dilution risk.' Which metric directly measures this risk?
- Overhang percentage (shares reserved divided by total shares outstanding) (Correct answer)
- Weighted average exercise price of outstanding options
- Total compensation expense recognized under ASC 718
- Number of participants enrolled in the ESPP
Correct answer: Overhang percentage (shares reserved divided by total shares outstanding)
Overhang percentage measures the potential dilutive impact of all outstanding and reserved equity awards relative to total shares outstanding.
Question 6: Which of the following represents a 'clawback' risk for a CEP professional managing an executive equity plan?
- The risk that vested awards lose market value before exercise
- The risk that previously paid compensation must be recouped due to a financial restatement (Correct answer)
- The risk that the board reduces the equity plan's share reserve
- The risk that performance targets are reset after a merger
Correct answer: The risk that previously paid compensation must be recouped due to a financial restatement
Under Dodd-Frank and SEC Rule 10D-1, listed companies must recover incentive-based compensation from executives if there is an accounting restatement that reduces the amount they would have received.
Question 7: A company is going through an IPO and wants to assess underwriting risk for its equity compensation pool. Which is the MOST critical consideration?
- Whether outstanding options have a cashless exercise feature
- The lock-up period for employee shares and its impact on post-IPO trading volume (Correct answer)
- Whether the ESPP meets IRS Section 423 qualified plan requirements
- The grant date fair value of all awards issued in the prior fiscal year
Correct answer: The lock-up period for employee shares and its impact on post-IPO trading volume
Lock-up expirations create a known future event where large volumes of employee shares may enter the market, which underwriters must model as a risk to post-IPO price stability.
CEP Risk Assessment & Underwriting 3
Under SEC Rule 10b5-1, a trading plan primarily mitigates which risk for insiders who hold equity?