Last month the SEC issued a no-action letter to a financial services firm that sheds light on the scope of the prohibition under Section 402 of the Sarbanes-Oxley Act of 2002 which makes it unlawful for an issuer to “extend or maintain credit, to arrange for the extension of credit, or to renew an extension of credit, in the form of a personal loan to or for any director or any executive officer . . . of that issuer.”
Historically, the SEC appears to have been reluctant to issue formal guidance respecting the parameters of the loan prohibition under Section 402. Common arrangements left in limbo by this lack of regulatory guidance extend to personal use of company credit cards, personal use of company cars, travel-related advances, and broker-assisted option exercises.
The SEC’s no-action letter was issued to RingsEnd Partners, a financial services firm. The letter addresses a program established to facilitate the payment of taxes associated with the grant of restricted stock awards. Under this program, recipients of restricted stock awards make a qualifying election to be taxed on those shares at the time of grant (a so-called 83(b) election) and then transfer those shares to a trust administered by an independent trustee who is directed to borrow funds from an independent bank through non-recourse loans sufficient in amount to pay the tax liability incurred as a result of the stock awards. Through this mechanism, recipients of these awards can retain ownership of all shares granted to them rather than sacrificing a number of those shares necessary to pay applicable tax obligations. To facilitate utilization of the program, however, an employer is involved in a variety of administrative actions necessary to maintain the program, including delivering the share awards to the trust, providing information to the lending institution and delivering prospectuses and registration statements covering the shares to the trustee. All administrative costs associated with administering the trust are borne by those recipients electing to participate in the trust.
The SEC concluded that employers whose employees where involved in this program would not by their administrative activities be deemed to be in violation of the prohibitions of Section 402. The conclusions reached by the SEC in this case would appear to be very instructive in reaching conclusions about the permissibility of other more common practices that would appear to involve arrangements that are no more administratively intensive, such as broker-assisted option exercises.
In this recently reported case, one Dr. Sutardja, a recipient of an allegedly discounted option, sued to recover 409A taxes imposed by the IRS. The case does not decide whether the option was discounted, but Dr. Sutardja argued that his option, even if discounted, shouldn’t be subject to 409A.
Essentially, he tried to argue that (1) the grant of the discounted option is not a taxable event, (2) stock options aren’t “deferred compensation,” (3) he didn’t have a legally binding right until he exercised the option, or (4) 409A couldn’t apply to the discounted option. Those familiar with 409A will sigh upon reading the list since clearly none of these arguments holds any water. Discounted options are subject to 409A and must have fixed dates for exercise and payment.
The interesting part of the case, though, was the government arguing that Dr. Sutardja did not have a legally binding right to the supposedly discounted option until it vested. This is an interesting argument for the government to make because the 409A regulations themselves say:
A service provider does not have a legally binding right to compensation to the extent that compensation may be reduced unilaterally or eliminated by the service recipient or other person after the services creating the right to the compensation have been performed. … For this purpose, compensation is not considered subject to unilateral reduction or elimination merely because it may be reduced or eliminated by operation of the objective terms of the plan, such as the application of a nondiscretionary, objective provision creating a substantial risk of forfeiture. 26 C.F.R. 1.409A-(b)(1)
Generally speaking, before an option vests, it is subject to a substantial risk of forfeiture. This means the opportunity to buy stock could be lost if the recipient leaves employment or service with the granting company before it vests. Applying that analysis to the above language, the legally binding right to an option is created when it’s granted, not when it vests.
In the end, the argument doesn’t amount to much because any portion of the option that vested after December 31, 2004 is still subject to 409A and its stringent taxes. However, the case is interesting in that it shows that the IRS has begun enforcing 409A. It will also be interesting to see if the government’s argument in this case is used against it in future cases.
It’s that time of year again! Time to ensure year-end executive compensation deadlines are satisfied and time to plan ahead for 2013. Below is a checklist of selected executive compensation topics designed to help employers with this process.
I. 2012 Year-End Compliance and Deadlines
□ Section 409A – Amendment Deadline for Payments Triggered by Date Employee Signs a Release
It is fairly common for an employer to condition eligibility for severance pay on the release of all employment claims by the employee. Many of these arrangements include impermissible employee discretion in violation of Section 409A of the Internal Revenue Code because the employee can accelerate or delay the receipt of severance pay by deciding when to sign and submit the release. IRS Notice 2010-6 (as modified by IRS Notice 2010-80), includes transition relief until December 31, 2012 to make corrective amendments to plans and agreements.
Generally, the arrangement may be amended to either (1) include a fixed payment date following termination, subject to an enforceable release (without regard to when the release is signed), or (2) provide for payment during a specified period and if the period spans two years, payment will always occur in the second year. We recommend employers review existing employment, severance, change in control and similar arrangements to ensure compliance with this payment timing requirement. The December 31, 2012 deadline for corrective amendments is fast approaching.
□ Compensation Deferral Elections
Compensation deferral elections for amounts otherwise payable in 2013 must generally be documented and irrevocable no later than December 31, 2012. The remainder of 2012 is sure to pass quickly, especially with the added distractions of the elections and tax law uncertainty. Employers should consider additional communications to ensure the deadline is not overlooked. (It’s also a good time to confirm 409A compliance generally, as we have discussed previously.)
□ Payroll Deduction True-Up for Fringe Benefits and Other Compensation
Some employers utilize a rule for administrative convenience that permits income and employment tax withholding on certain items of compensation to be made at the end of the year (i.e., imputed income on after-tax long-term disability premiums). Employers should ensure that all payroll deductions for taxable compensation for the year are taken into consideration.
□ Annual Compensation Risk Assessment for SEC Reporting Companies
Beginning with the 2010 proxy season, companies have been required to perform a risk assessment of their compensation policies and practices. The purpose of the assessment is to evaluate compensation-related risk-taking incentives. Where a company determines that its employee compensation program includes “risky” pay policies and practices, it must include disclosures (including mitigating practices). In recent addresses, representatives of the SEC have included a “reminder” to public companies that the compensation risk assessment must be performed annually.
□ Compensation Consultant Conflict of Interest Assessment for SEC Reporting Companies
Beginning with the 2013 proxy season, the Dodd-Frank Act requires a company to disclose whether the work of its compensation consultant has raised any conflict of interest. The assessment should consider six specified factors outlined in the rules. The purpose of the assessment is to determine whether the work of the consultant raised a conflict of interest. If the company determines a conflict of interest was raised, the company must disclose the nature of the conflict and how the conflict is being addressed.
II. 2013 Planning
□ Section 162(m) Employer Compensation Deduction Limit
Section 162(m) of the Internal Revenue Code limits the deduction for a publicly-held corporation to $1 million for each covered employee (typically the chief executive officer and four most highly compensated officers, other than the CEO and CFO). This deduction limit does not apply to “qualified performance-based compensation.” To qualify for the exception, the compensation must be payable solely on account of the attainment of one or more pre-established performance goals and other technical requirements must be satisfied. Employers should review their plan design and administrative practices to ensure compliance with the technical requirements. For example: (1) review the timing of prior shareholder approval to determine whether new shareholder approval must be obtained in 2013, (2) confirm that the compensation committee is comprised solely of two or more “outside directors,” and (3) ensure that the committee timely establishes the performance goals for the new performance period, and pre-certifies the level of achievement of the performance goals at the end of each performance period. A few other technical requirements to note include:
- If the company issues restricted stock and restricted stock units (RSUs) that are designed to qualify as performance-based compensation, any related dividends and dividend equivalents must separately satisfy the performance-based compensation requirements (i.e., must be contingent on achievement of the performance goals).
- It is common for a shareholder-approved equity plan to include a per-employee share limit for a stated period for awards granted under the plan. It is important for the company to keep track of this limit to ensure actual awards do not exceed this cap.
New for 2013 – Deduction Limit for Health Insurance Providers and Related Entities
A new provision enacted under the Health Care Reform law takes effect on January 1, 2013. New Section 162(m)(6) of the Internal Revenue Code limits the deduction covered health insurance providers (and their related entities) may take for compensation paid to certain employees in excess of $500,000. There is no performance-based compensation exception to this limit.
□ Monitor Tax Law Changes
There are a number of tax law changes scheduled to occur beginning in 2013 that will impact required income and employment tax withholding for many forms of executive and equity compensation. Congress could act to extend some tax rate cuts beyond 2012. We recommend employers monitor tax law developments and be prepared to make changes to current payroll reporting processes. Below are some of these changes:
Employment Taxes. On October 16, 2012, the Social Security Administration announced employment tax rates for 2013. The taxable wage base for earnings subject to the Social Security tax for 2013 is $113,700, up from $110,100 in 2012. In addition to an increase in the Social Security taxable wage base, the tax withholding rate is scheduled to return to 6.2% (the temporary 4.2% reduced rate is scheduled to expire at the end of 2012). The Medicare tax also applies and the required withholding rate is an additional 1.45% with no wage limit. Starting in 2013, an additional Medicare tax of 0.9% applies to earnings from wages and other taxable compensation over a threshold amount (i.e., $200,000-$250,000 based on filing status).
Supplemental Wage Withholding. The supplemental wage withholding rate is used by employers for income tax withholding on bonus, commissions, severance payments, equity awards and other special payments. The supplemental wage withholding rate for 2012 is 25% or a mandatory 35% once aggregate supplemental wages exceed $1 million for the year. Due to the scheduled expiration of the Bush-era tax cuts, the 2013 rates are scheduled to increase to 28% and 39.6% for aggregate amounts in excess of $1 million.
□ Proxy Statement Preparation for SEC Reporting Companies
With the implementation of Say on Pay, proxy statement disclosures serve as a key investor communication tool to help explain the company’s compensation program and how it ties to company performance. Now is the time to improve disclosures and implement best practices for the upcoming proxy season. Below are some areas for consideration:
On October 16, 2012, Institutional Shareholder Services (ISS) issued for comment several proposed proxy voting policy changes. The following would affect U.S. public companies:
Current Policy: Recommend vote against or withhold votes from the entire board (except new nominees, who are considered case-by-case) if the board failed to act on a shareholder proposal that received the support of either (i) a majority of shares outstanding in the previous year; or (ii) a majority of shares cast in the last year and one of the two previous years.
Proposed Policy: Recommend votes against or withhold votes from the entire board (with new nominees considered case-by-case) if it fails to act on any proposal that received the support of a majority of shares cast in the previous year.
The proposed change is intended to increase board accountability. ISS is specifically seeking feedback as to whether there are specific circumstances where a board should not implement a majority-supported proposal that receives support from a majority of votes cast for one year.
Say-on-Pay Peer Group
Current Policy: ISS’s pay-for-performance analysis includes an initial quantitative screening of a company’s pay and performance relative to a group of companies reasonably similar in industry profile, size and market capitalization selected by ISS based on the company’s Standard & Poor’s Global Industry Classification (GICS).
Proposed Policy: For purposes of the quantitative portion of the pay-for-performance analysis the peer group will continue to be selected from the company’s GICS industry group but will also incorporate information from the company’s self-selected benchmarking peers. When identifying peers, ISS will afford a higher priority to peers that maintain the company near the median of the peer group, are in the company’s own selected peer group and that have selected the company as a peer.
The change is likely a direct response to criticism from companies that the ISS-selected peer groups are not comparable and in many cases do not take into account multiple business lines. ISS is specifically requesting comments on whether there are additional or alternative ways that ISS should use the company’s self-selected peer group, what size range (revenue/assets) should be used for peer group determination and what other factors should be considered in constructing the peer group for pay-for-performance evaluation.
Say-on-Pay Realizable Pay Analysis
Current Policy: If the quantitative pay-for-performance screening demonstrates unsatisfactory long-term pay for performance alignment or misaligned pay, ISS will consider grant-date pay levels or compensation amounts required to be disclosed in the SEC summary compensation table to determine how various pay elements may work to encourage or to undermine long-term value creation and alignment with shareholder interests.
Proposed Policy: Rather than focusing solely on grant-date pay levels, the qualitative analysis for large-cap companies may include a comparison of realizable pay to grant-date pay. Realizable pay will consist of relevant cash and equity-based grants and awards made during the specific performance period being measured, based on equity award values for actual earned awards or target values for ongoing awards based on the stock price at the end of the performance measurement period.
In its recent annual survey, 50% of investors indicated that they consider both granted and realized/realizable pay as an appropriate way to measure pay-for-performance alignment. ISS has requested comments as to how to define realizable pay, whether stock options should be considered based on intrinsic value or Black-Scholes value and under what rationale and what should be an appropriate measurement period for realizable pay. (more…)
In a decision released on June 29, the Delaware Chancery Court (a trial court) in Seinfeld v. Slager (no, not that Seinfeld) allowed an allegation of corporate waste to survive a motion to dismiss. The allegation: that directors wasted corporate assets by granting themselves restricted stock units in an excessive amount. The case is significant in part because the court is widely regarded as a leading court on corporate governance issues.
This case is interesting because, most often, compensation of non-employee directors is protected under the “business judgment rule” that basically prevents courts from second-guessing the decisions of a board of directors. However, the business judgment rule is generally not available for transactions where directors have a financial interest that could reasonably compromise their independent judgment. In asserting the protection of the business judgment rule, the directors argued that the stock plan under which the awards were granted was stockholder approved and provided a maximum number of 1,250,000 shares that could be subject to an award to any eligible recipient in a year.
This stockholder approval, the defendant directors argued, cleansed their self-interestedness because they were merely implementing the terms of a stockholder-approved plan. In essence, the directors argued that any grants below the stockholder-approved cap were not self-interested because the directors were acting within parameters approved by stockholders. However, the court said, “Though stockholders approved this plan, there must be some meaningful limit imposed by the stockholders on the Board for the plan to be consecrated by [prior case law] and receive the blessing of the business judgment rule [as a result of stockholder approval].” (emphasis in original). With a stock value of $24.79 per share, the maximum meant that each director could receive tens of millions of dollars of compensation and the court did not find that limit to be meaningful enough to survive a motion to dismiss.
Depending on how this litigation progresses through the trial and appellate levels, companies may want to consider including hard-wired grants or maximum share limits, or reevaluating any limits they already have, going forward. If a maximum number of shares or maximum dollar value that non-employee directors can receive in a given year is in the plan, it should be sufficiently tailored so as not to create the ability to grant excessive director compensation. Additionally, if a plan has a maximum number of shares, that number may need to be revisited (and reduced) as the company’s stock price increases.
Every 409A attorney knows the look. It’s a look that is dripping with the 409A attorney’s constant companion – incredulity. “Surely,” the client says, “IRS doesn’t care about [insert one of the myriad 409A issues that the IRS actually, for some esoteric reason, cares about].” In many ways, the job of the 409A attorney is that of knowing confidant – “I know! Isn’t it crazy! I can’t fathom why the IRS cares. But they do.”
There are a lot of misconceptions out there about how this section of the tax code works and to whom it applies. While we cannot possibly address every misconception, below is a list of the more common ones we encounter.
I thought 409A only applied to public companies. While wrong, this one is probably the most difficult because it has a kernel of truth. All of the 409A rules apply to all companies, except one. 409A does require a 6-month delay for severance paid to public company executives. However, aside from this one rule, all of 409A’s other rules apply to every company.
But it doesn’t apply to partnerships or LLCs. Wrong, although again a kernel of truth. Every company, regardless of form, is subject to 409A. However, the IRS hasn’t yet released promised guidance regarding partnerships or LLCs, most of the 409A rules (like the option rules) apply by analogy.
But I can still change how something is paid on a change of control. Maybe, but maybe not. If a payment is subject to 409A, there are severe restrictions on how it can be modified, even on a change of control. Even payments not subject to 409A by themselves can, inadvertently, be made subject to 409A if the payment terms are modified. There is some latitude to terminate and liquidate plans in connection with a change in control, but – word to the wise – these termination payments are very tricky to implement and require a pretty comprehensive review of all plans in place following the change in control.
409A only affects executives. Nope. Any time “deferred compensation” is implicated, 409A applies, even to rank and file. In fact, 409A can have adverse effects for a mind boggling array of employees, including innocuous arrangements like school-year teacher reimbursement programs!
And the definition of deferred compensation is broad, including such items as severance agreements or plans or even bonuses, if paid beyond the short-term deferral period. As a practical matter, many rank and file severance and bonus plans qualify for exemptions that make them not subject to 409A’s restrictions on time and form of payment, but it’s still worth reviewing them to make sure.
Okay then, it only applies to employees, right? Wrong again. Directors and other independent contractors are subject to 409A’s grip. There are some exemptions, but, again, they are difficult to implement.
What’s the company’s tax burden if we screw up? This question itself is not a misconception, but the unstated assumption – that it’s the company’s liability – is. The penalties fall entirely on the employee, director, or contractor.
But put yourself in the shoes of an executive who, unexpectedly, gets hit with a 409A penalty. The executive may argue that the employer designed the plan and the employer administered the plan. The executive’s role was to work, possibly even contribute his or her own money to the plan, and reap the benefit down the road. The IRS rules say that something got messed up and the executive owes substantial additional taxes – perhaps even before payment is made from the plan – through no fault of the executive.
What’s the first thing the executive does? Turn to the employer and loudly proclaim, “Make me whole.”
In addition, employers can also have additional direct withholding and reporting penalties. Depending upon culpability, those penalties can be very large.
The bottom line is that 409A potentially applies to anyone who hires anyone else to do anything for them – and does not pay them immediately.
The IRS has released proposed regulations under Section 83 of the Internal Revenue Code to refine the concept of what constitutes a substantial risk of forfeiture for the purpose of narrowing the scope of the concept.
The proposed regulations are in response to case law, tracing back as far as 1986, which the IRS claims has created confusion over the appropriate elements of what may constitute a substantial risk of forfeiture.
In the proposed regulations, the IRS clarifies that a substantial risk of forfeiture may be established only through (1) a service condition or (2) a condition related to the purpose of the transfer, such as a performance condition relating to the services provided by a service provider. In addition, the proposed regulations further clarify that in determining whether a substantial forfeiture exists based on a condition is related to the purpose of the transfer, both the likelihood that the forfeiture event will occur and the likelihood that the forfeiture will be enforced must be considered.
The IRS emphasizes in the proposed regulations that transfer restrictions do not create a substantial risk of forfeiture, such as lock-up agreements or restrictions related to insider trading. However, the IRS acknowledges that the statutory exception related to potential short-swing profits liability under Section 16(b) of the Securities Exchange Act does delay taxation under Section 83.
The IRS appears to be laying the groundwork for the anticipated issuance of new regulations under Section 457 of the Internal Revenue Code, which incorporates the same concept of a substantial risk of forfeiture. While we are not aware of any statements by IRS officials to that effect, it is one possible explanation why the IRS did not address an issue from 1986 until now.
The proposed regulations, if finalized, will apply to transfers of property occurring on and after January 1, 2013.
On May 18th, two famous, photogenic Olympians found themselves almost $300 million richer. A banner day for anyone, and yet they may have felt at least a twinge of regret. Why? They contend that 409A should have made them much richer, to the tune of as much as $1.2 billion.
At this point, Hollywood has made the story almost old-hat. In December 2002, then Harvard students Tyler and Cameron Winklevoss had an idea. They would develop a web site that connected Harvard students. If successful, they would expand the concept to other campuses. In November of 2003, after several false starts, the Winklevoss twins retained the services of a young, talented programmer to implement their vision. Three months later, without the knowledge of the Winklevoss twins, Mark Zuckerberg gave birth to Facebook. After a successful run at Harvard, the social networking site spread to other campuses, and then took over the world.
In 2004, the Winklevoss twins (and their company ConnectU) filed suit against Facebook, claiming that Mark Zuckerberg had copied their social networking ideas and source code and used them to create Facebook. In 2008, the parties settled, reportedly for $65 million – $20 million in cash and a specified number of shares of Facebook. The problem was the valuation of Facebook stock at the time of the settlement.
Around the time of the settlement, Microsoft made an investment in Facebook. This investment valued Facebook at $15 billion. The Winklevoss twins apparently used this valuation, with a per share price of $35.90, when determining that the number of shares provided as part of the settlement.
How does 409A come in to this story? Like many illiquid startup firms, Facebook made substantial option grants to its employees. For an option to be exempt from Code Section 409A, the option must be granted with an exercise price no less than the fair market value of the underlying stock on the date of grant. Most private start-up companies, particularly ones growing very quickly, regularly engage experienced valuation firm to establish the Company’s fair market value for 409A option grant purposes. Facebook was no exception. In fact, Facebook had come up with an $8.88 per share 409A valuation shortly before the settlement.
After learning of the 409A valuation, the Winklevoss twins sought to invalidate the settlement agreement. Among other things, the twins argued that Facebook’s failure to disclose the $8.88 409A valuation constituted fraud. Had Facebook disclosed the 409A valuation and had that valuation been used in the settlement, the twins would have ended up with more than four times the number of shares they actually received.
Ultimately, the twins lost their appeal to invalidate the settlement, which, after Facebook’s recent IPO, left them with stock purportedly worth around $300 million. Had they used the 409A valuation at settlement, however, their settlement stock could have been worth as much as $1.2 billion.
What’s the moral of this story? Private company stock valuations are inherently speculative, and can be appropriated for purposes other than that for which they are intended. For private companies that issue stock options, 409A can create a paper trail of valuations that can at least raise issues for potential investors, employees, and litigants. Prudence may dictate that companies clearly qualify the limited purpose for which a 409A valuation is obtained (i.e., compliance with 409A). Further, it may be advisable to include confidentiality provisions in stock option agreements and to take such other measures as are necessary to keep private company 409A valuations … well, private.
This post is the fifth and final post in our BenefitsBryanCave.com series on five common Code Section 409A design errors and corrections. Go here, here, here, and here to see the first four posts in that series.
Code Section 409A abhors discretion. One concern with discretion is that it could lead to the type of opportunistic employee action or employer/employee collusion that hurt creditors and employees during the Enron and WorldCom scandals.
Another concern is that discretion could be used opportunistically to affect the taxation of deferred compensation. Consider an employment agreement with a lump-sum payment due at any time within thirteen months following a change in control, as determined in the employer’s discretion. This provision would permit the employer to pick the calendar year of the payment. Because non-qualified payments are generally taxable to the recipient when paid, this type of provision would allow a company to essentially pick the year in which the employee is taxed on the payment. In this situation, the IRS would be concerned that the plan participant (who often has great influence with the company) would collude with the company so that the resulting payment was of most tax benefit to the participant.
Code Section 409A addresses this problem by restricting the timing of a deferred compensation payments following a triggering event to a single taxable year, a period that begins and ends in the same taxable year, or a period of up to 90 days that could potentially span two taxable years. If the “up to 90 day period” approach is taken, Code Section 409A also requires that the service provider not have the right to designate the taxable year of the payment. Most plans provide for payments within a 90 day period following the appropriate Code Section 409A triggering event.
Plans are occasionally drafted using a payment period longer than 90 days. Fortunately, the IRS allows correction of these over-long payment periods. The correction is to amend the plan to either remove the over-long payment period from the plan or to provide for an appropriate period of time for the payment. This amendment can even occur within a reasonable amount of time following the Code Section 409A triggering event, but penalties would apply. As always, certain correction documents must be filed with the IRS.
Code Section 409A is, in part, a response to perceived deferred compensation abuses at companies like Enron and WorldCom. The story of Code Section 409A’s six month delay provision is inextricably tied to the Enron and WorldCom bankruptcies.
Under established IRS tax principles, participants’ rights under a non-qualified plan can be no greater than the claims of a general creditor. Because deferred compensation plans often pay out upon termination of employment, a plan participant with knowledge of a likely future bankruptcy could potentially terminate employment and take a non-qualified plan distribution to the detriment of the company’s creditors (a number or Enron executives with advance knowledge of Enron’s accounting irregularities did just this). This opportunistic cash out is obviously unfair to the company’s creditors. In addition, the cash out only helps hasten the likely bankruptcy because non-qualified plan payments come from the general assets of the company.
How did Congress solve this problem? By requiring that a payment of deferred compensation to any of the most highly compensated employees of public companies (called “specified employees”) be delayed at least six months if the payment is due to a separation from service. The thought was that for public companies (like Enron and WorldCom), plan participants would not have enough time to opportunistically terminate employment and receive payout if the payouts were delayed at least six months following termination.
Code Section 409A requires that the six month delay for specified employees of public companies be codified in the relevant plan document. Generally, plans are drafted so that payments due upon separation from service are delayed the required six months, but only if the terminating employee is a specified employee at the time of termination, and only to the extent such payments are “deferred compensation” within the meaning of Code Section 409A.
What should you do if you work for a public corporation and your high-level employment and severance agreements do not contain the required six month delay language? (more…)