By James B. Bristol

The 2008 proxy season has been completed for most companies, although fiscal year issuers are still conducting annual meetings. If you are a publicly traded company, your proxy was no doubt reviewed by Institutional Shareholder Services (ISS), which is owned by Risk Metrics. ISS reviews more than 38,000 proxies each year, and its influence with proxy voting is significant. Some institutional shareholders engage ISS to actually vote their proxies, based solely on ISS’s recommendations. Glass, Lewis & Company is another proxy and shareholder advisory service that reviews most proxies. Glass Lewis, however, seems to have only a fraction of the institutional business of ISS and does not seem to match ISS in influence.
Many companies have hired ISS to review their stock plan proposals under the ISSue Compass model to ensure that ISS will issue a favorable recommendation when it reviews the proxy. To mitigate the possibility of conflicts of interest, ISS has a “Chinese Wall” that separates the corporate services group who reviews your proxy under ISSue Compass and the proxy review group. We have seen, unfortunately, recent cases where the corporate services group gives a green light under ISSue Compass, but the proxy review team (on the other side of the wall) recommends no. These are some possible responses to a no recommendation from ISS:

1. Do nothing and hope that your proposal passes anyway. This strategy has worked for companies with no significant institutional shareholders, or with a large block of stock represented on the board. Some institutionals may not place significant weight on ISS recommendations, though this group seems smaller than it was. A good proxy solicitor can help you assess the leanings of your institutional shareholders. For many companies, doing nothing might not be the best option.
2. Call your larger institutionals and explain the reasons for your proposal. Shareholders usually appreciate being called and may go along with conditions. In a stock incentive plan proposal, for example, you may be asked to formally restrict option repricing.
3. Contact ISS to change the proposal in a way that will allow it to pass under their metrics. We’ve seen several examples where a stock incentive plan failed due to the company’s average “burn rate” (i.e., the rate that stock awards are granted). ISS generally will change to a “yes” if the company formally limits the burn rate to its industry average and files an 8-K or 14A proxy amendment.
4. Use your proxy solicitor service to solicit votes from non-institutional shareholders. Many of these shares may go unvoted. We have it on good authority that this can work.

We have found that these options, particularly 2 and 3, work best if your proxy solicitor and legal counsel work together to identify what will be persuasive and then communicate that to your shareholders and/or ISS. In one recent case where ISS had initially made an adverse recommendation on a stock plan proposal, we were able to help ISS find an error in the assumptions used in the burn rate analysis. They were happy to correct their analysis and promptly issued a reversal notice. Maybe ISS isn’t so bad after all.

By James Bristol

Two proxy seasons have now come and gone since the SEC introduced new compensation disclosure rules, including the requirement of a compensation discussion and analysis (CD&A). Our bulletin summarizes our general observation of this process. Notwithstanding this regulatory effort to curb abuses, executive compensation continues to grab news headlines. For example, a recent article in USA Today shouts “CEO Pay Climbs Despite Companies’ Struggles.” This article ranks the top ten paid CEOs in 2007, beginning at $34.1 million for Occidental Petroleum all the way up to $83.1 for Merrill Lynch. These numbers include cash and the value of non-cash items (such as stock options) disclosed in annual reports and proxies.

The news stories all focus on companies in the Fortune 100 or 250. What is reported there has very little or nothing to do with the world of compensation in smaller companies. Typical pay for CEOs of small-cap and mid-cap companies is a small fraction of those pay levels. Indeed, some small-cap companies would consider the CEO compensation at large-cap firm to be a worthy annual revenue goal.

The compensation buzz is similar to the effect of Sarbanes-Oxley on smaller companies. The rules are pretty much one-size-fits-all, whether the company has $100 million or $150 billion in revenue. For the smaller company, the cost and complexity of compliance is out of proportion – and the worst part of it. Many executive perks that are common in larger companies, such as supplemental retirement plans and corporate jets, are hard to find in a smaller company. CEOs in most companies are paid modestly in comparison to their colleagues in the Fortune 500. Yet the ferocity of the disclosure rules falls on all equally.

Many companies have previously enjoyed a fairly informal compensation process. This is to be expected when the CEO is a founder and the board members are from the venture capital firms that initially invested in the enterprise. The new disclosure rules have forced development of formal compensation processes, as well as discovery and articulation of past compensation decisions. Our perspective is that mid-cap and smaller companies were generally not doing the sorts of things that were targeted in the SEC’s compensation disclosure rules. This is borne out by the results. For smaller companies, very little in the way of “hidden” compensation has come to light under CD&A and new compensation disclosures.

Note: this experience could be relevant to those who are urging adoption of shareholder approval of executive pay, or “say on pay.” While the shareholders of Merrill Lynch may have views about paying their CEO $83 million, it seems unlikely that the shareholders of a mid-cap company are going to focus as much on the $3 million paid to its CEO.
 

By James Bristol

For several years companies have employed a number of tools to measure compensation paid to executives. These include benchmarking, performance measures and goals, internal pay equity, stock ownership and retention guidelines and accumulated wealth analysis. Compensation is analyzed with these tools in order to assure that amounts paid to executives are reasonable and appropriate. These terms are described as follows:

• Benchmarking. This is the most common measurement used to support a particular level of executive pay as “reasonable.” Benchmarking is a comparison of a company’s pay practices with those of its competitors or peers in the industry.
• Performance Measures and Goals. Closely related to compliance with Internal Revenue Code section 162(m). Usually applied to incentive pay to make payment conditional on the achievement of financial budgets.
• Internal Pay Equity. This is a comparison between the pay of the CEO with other top managers. Reasonableness is based on CEO pay not exceeding a pre-set multiple of pay to others.
• Stock Ownership and Retention. Companies may require executives to acquire and maintain ownership of a minimum level of stock. The minimum may be set as a percentage of salary. The purpose is to align the financial interests of officers and stockholders.
• Accumulated Wealth Analysis. This involves an assessment of an executive’s financial position and accumulated stock holdings. This can inform the compensation committee as to the personal impact of compensation decisions and the appropriate mix of compensation components (e.g., stock, salary, long-term incentives).

There has been a lot of press on the efficacy of these tools used by corporate America. For some (but not all), the process has done little to police “runaway” executive pay. Risk Metrics (formerly Institutional Shareholder Services or ISS), has undertaken a compensation analysis project that resulted in a white paper as well as tools for measuring these effectiveness of these compensation considerations. This report is available at www.riskmetrics.com/compensation (users must create a free login ID). For cash compensation, Risk Metrics says the focus should be on appropriate benchmarks for base pay and the performance hurdles for bonus or incentive pay. For equity pay, attention should be given to comparing new grants with an executive’s current holdings, and whether or not equity awards are actually aligning the interests of executives with stockholders. With regard to other forms of pay, such as SERPs, perquisites and severance, attention should be given to the liability that is being created. Moreover, the integrity of the pay-setting process seems to be impugned with generous benefits that are not performance-based, according to Risk Metrics..

One of the more interesting features of this report is a tool for evaluating the peer group companies that are included in benchmarking. Risk Metrics warns that compensation “distortions” often occur when the peer group is not appropriately assembled. The measuring tool is intended to help a company avoid such distortions. It includes an assessment of the homogeneity of companies in the selected peer group, the disparity of pay between similar and dissimilar companies and the ranking or relative position of the company with regard to the size of companies in the peer group. The Risk Metrics website includes a demonstration that has values assigned for larger U.S. companies and gives the user an opportunity to build a peer group from the database.

One can wonder if this is an entrepreneurial effort by Risk Metrics. The premise of the white paper seems to be that the current state of compensation analysis is not getting the job done. The paper recites some well-known anecdotes of executive pay “excesses,” arguing that the benchmarks relied on to justify such pay were inappropriate. For now, this report is advisory and Risk Metrics seeks feedback. Some who have worked with Risk Metrics for a few years may worry that this is a testing stage for a product that will be added to the suite of proxy review services offered to institutional investors and companies seeking stockholder approval in the proxy process.

By James Bristol

As reported in recent postings [April 24 and May 19], executive pay has entered the political debate in this presidential election year. New sounds bites have been recorded from a June 10th speech by Senator John McCain in Washington to the National Federation of Independent Business (NFIB), an organization that supports small businesses. The speech included a call to federal prosecutors to crack down on abuses and advocated “say on pay” legislation, i.e., that all aspects of executive pay be subject to approval by shareholders. McCain said, "Something is seriously wrong when the American people are left to bear the consequences of reckless corporate conduct while the offenders themselves are packed off with another $40 million or $50 million for the road."

Senators Obama and Clinton have either introduced or supported legislation that would require say on pay and impose new limits on executive pay. McCain’s comments indicate his position has less emphasis on congressional action. Regardless of who wins the election in November, however, it seems that executive pay will be on the radar screen in Washington for a while.

This political development may be echoing a trend in the world economy. Say on pay is the law in other countries, like the United Kingdom and Australia. As we’ve recently posted, however, the concept gets less traction in shareholder meetings. To date, only eight US companies have agreed to follow the say on pay path: Tech Data, MBIA, Par Pharmaceuticals, Littlefield, Risk Metrics, Verizon and Blockbuster. Shareholder support in 2008 was down from 2007, however.

Why is shareholder review of executive pay failing to garner the attention that shareholder activists – and perhaps presidential candidates – are expecting? Risk Metrics (corporate parent of ISS) organized a roundtable discussion in April to address this and related issues. The attendees noted that say on pay generally is perceived as positive in other markets but has not resulted in pay declines or measurable improvements in pay for performance. Shareholder advisory votes may have forced boards to consider the business rationale for their pay practices. On the other hand, there is concern that annual advisory pay votes would require investors to expend more resources to analyze compensation and could stifle boards' creativity in crafting performance-driven programs.

Others in the industry have voiced similar concerns. There is concern that shareholders would not be well equipped to analyze the details of executive compensation. This could give a board an out. Rather than be burdened with weighing difficult and competing considerations, they can be absolved from fiduciary obligations by throwing a proposal on the proxy and watching shareholders provide a rubber stamp approval. If mandatory shareholder review of compensation becomes law, the clear winner would be proxy advisory firms.

By James Bristol

Representatives from the IRS and the Treasury Department have been making rounds in recent weeks to talk about compliance with section 409A of the Internal Revenue Code transitional guidance. The presentations have been conversational in tone and have included deep drilling on technical niceties that make for dense reading. The following notes include information provided by Treasury in May to the AICPA National Conference on Employee Benefit Plans in Las Vegas and the ABA Section of Taxation conference in Washington, D.C.

Who Bears The Penalty? 409A compliance rests on the shoulders of the employer. The penalty for 409A errors falls, however, on the employee. In many cases, there is a 20 percent additional tax on top of immediate taxation of amounts that were intended to be deferred. The employer gets a tax deduction (hardly a penalty). It is odd that the penalty for noncompliance falls on those who may have no role in achieving compliance.

Transition Election. 409A generally does not permit acceleration of a distribution. A participant may extend the deferral date in some circumstances. Until the end of 2008, however, participants can change a previous distribution election. For example, if a plan provides for ten-year installment payments at age 65, a new election could be permitted for a lump sum payment on termination of employment. This is known at the IRS as a “19C” election.

Dividend Equivalents on Stock Options.  Generally not allowed. Typically, these give the employee a cash payment on option exercise. In 409A, this has the effect of lowering the exercise price, making the option exercise price less than market value on the grant date. It seems to make no difference if dividends are paid periodically, upon vesting or upon exercise.

Grandfathered Deferrals.  Amounts deferred before 2004 are not subject to section 409A but are grandfathered under prior deferred compensation rules. Grandfathering is lost if there is a material modification of the agreement. There appear to be many opportunities to materially modify an agreement. For example, making the transition distribution election described above is a material modification.

Plan Documents.  409A requires a written plan document that includes certain specified language. The plan document need not be a single piece of paper. For example, a deferral agreement coupled with one or more “plan” documents will be considered a single plan and will be taken together to determine if the plan contains the language needed for 409A compliance.

409A Correction Program.  IRS Notice 2007-100 provides a limited correction program for inadvertent operational failures. A permanent and more extensive program is possible/likely in the near future.

Restricted Stock and 409A.  Section 409A does not apply to compensation that is taxed under section 83 of the Internal Revenue Code. So, what happens when there is a compensation deferral election and the form of payment is restricted stock? Answer: since the restricted stock payment is taxed under section 83, the deferral election to receive restricted stock is not subject to 409A. This is also true if the employee can elect among two or more forms of payment that are subject to section 83. There is not yet an IRS position on whether the employee can elect to get cash or restricted stock. One Treasury official stated that it was a close call, but that his personal opinion was that the choice between cash and restricted stock should not trigger 409A.

Two Years/Two Times Pay Exception.  Generally, deferred compensation payments to “key employees” cannot begin prior to six months following separation from service. There are a few exceptions to this rule, including a payment that is no more than two times annual salary and paid within two years of separation. Apparently, the IRS was focused on early retirement windows. While acknowledging that this could be used for a payment under an individual separation agreement, the IRS reiterated that this exception only applies to funds that would not otherwise be payable under any other program.

Toggling.  It is okay to for distributions to be triggered by different events, but the triggers can’t be subject to timing manipulation. For example, it is okay for a plan to provide payment upon the separation from service, age 65 or a change in control—whichever comes first. Impermissible “toggling” would occur if an employee could choose among these events. The IRS is making a point that toggling can occur in less obvious circumstances, such as a choice between payment at age 55 with 10 years of service or at age 65 with five years of service.

By James Bristol

As we recently reported, executive compensation has hit the campaign trail in this presidential election season. The drum beat continues. Senator Hillary Rodham Clinton (D-NY) recently introduced the Corporate Executive Compensation Accountability and Transparency Act (S. 2866). It includes the following:

• Mandate “say on pay” advisory vote for shareholders. This mirrors the bill that was passed in the House in 2007.
• No more than $1 million of compensation could be deferred in a year under section 409A of the Internal Revenue Code (notice the echo of section 162(m)).
• If a company is required to restate its financial statements as a result of misconduct, the CEO and CFO would be required to pay to the company any gains on equity compensation, bonuses and incentive compensation.

The bill also requires disclosures on compensation consultant engagements that are aimed at potential conflicts of interest. This has been a hot topic for Rep. Charlie Rangel (D-NY), chair of the House Committee on Oversight and Government Reform.

This and Senator Obama’s recent remarks on say on pay legislation indicate what types of reforms are in store next year for executive compensation, particularly if a Democrat wins the election.

Say on Pay Update

Meanwhile, the pressure from shareholder proposals to adopt say on pay seems to be waning, if only slightly. As a reminder, “say on pay” provides shareholders with a vote (usually advisory, not binding) on executive compensation proposals. Last year, many such shareholder proposals garnered significant support. Several companies saw the writing on the wall and voluntarily adopted an advisory vote procedure. Aflac’s proposal from management garnered more than 90 percent of the vote.

The number of say on pay proposals this proxy season was down, however. Approval of such proposals – 21 vs. more than 50 in 2007 - was also lower than last year. This seems to have come as a surprise to say on pay advocates. Shareholder proposals were approved for Apple and Lexmark, but rejected in financial services companies (with significant subprime mortgage exposure), including Citigroup and Merrill Lynch where there was well-publicized “outrage” at executive pay received by executives who presided over significant losses. There was also a well-publicized hearing in front of Charlie Rangel. Still, the shareholders balked.

Speculation

Regardless of the headlines that have been blaring “runaway” pay for some executives, the issue does not seem to have a simple or obvious solution. The risk for CEOs is immense and shareholder pressure to perform is unrelenting. Finding an experienced and capable manager who will actually take the risk is daunting. It is easy for everyone to agree that a successful manager deserves significant rewards and an unsuccessful manager does not. Yet there are many devils in the details that seem inappropriate for shareholder micromanagement. With respect to congressional oversight, such as sections 409A, 280G and 162(m) of the Internal Revenue Code, it seems that further measures from the federal government will only create more work for tax advisors to … uhm … find creative solutions for compliance with statutory limitations.

By James Bristol

A congressional hearing doesn’t seem to be the end of the political discourse on executive pay. The April 14th edition of the Wall Street Journal (“Candidates Target Executive Pay” April 14, 2008) includes sound bites from the three leading presidential campaigns. Republican Senator McCain has called executive payouts at Bear Stearns and Countrywide “outrageous” and “unconscionable” and urges the private-sector solutions to restrain “corporate greed.” Democratic candidate Barack Obama is stumping for mandatory shareholder approval of executive pay, which is commonly known as “say on pay.” Presumably, the Senator is referring to bills pending in the Senate and House that are both entitled “Shareholder Vote on Executive Compensation Act.”

Currently, shareholders must authorize equity incentive programs for officers and directors of NYSE and Nasdaq companies. Shareholders also must authorize performance compensation programs that are intended to qualify as “performance based compensation” under section 162(m) of the Internal Revenue Code. Once authorized, the compensation committee sets the actual awards under these programs, as well as base pay and some fringe programs. Under most of the say on pay proposals, shareholders would have an opportunity to vote on compensation awards that are made by the compensation committee. Institutional Shareholder Services (ISS), a firm that advises institutional shareholders on proxy voting, includes recommendations on say on pay as a “best practice.” ISS’ 2008 policy guidelines include the following for say on pay proposals from management:

1. Maintain linkage between pay and performance. Consideration is given to mix between fixed and variable pay, performance goals and equity based plan costs.
2. Avoid arrangements that risk pay for failure, e.g., indefinite terms on employment contracts, excessive severance and guaranteed compensation.
3. Performance metrics that are relevant to business strategy, peer groups included, alignment of performance and pay trends over time, and disparity of pay between CEO and other executive officers.
4. Balance of fixed and variable pay and “excessive” pay practices, i.e., perks, severance, SERPs and equity burn rates.
5. Quality of compensation discussion and analysis and board responsiveness to investor input.

Whether or not Congress makes say on pay the law, several companies are voluntarily adopting some type of say on pay program, including such notables as Aflac, Blockbuster, and Verizon Communications. Perhaps this is the type of private-sector solution encouraged by Sen. McCain. Many other companies are considering similar proposals.

By James Bristol

Challenge to forfeiture in voluntary executive stock purchase plan

The New Jersey Supreme Court is considering a challenge to a Smith Barney stock purchase plan. This type of plan is used frequently for executive equity participation. It is unlike the typical employee stock purchase plan that is permitted under section 423 of the Internal Revenue Code because of these features:

• Executives could elect to buy Smith Barney common stock at a 25 percent discount through a salary deferral agreement.
• The shares were “restricted stock” and subject to forfeiture if the executive resigned or was fired with cause within two years.
• Executives were shareholders and could vote and receive dividends.
• Upon forfeiture, the executives lost the entire value of the stock, including the purchase price paid out of the salary deferral.

Two executives who voluntarily elected to participate in the plan left Smith Barney to join competing brokerage firms. One used 5 percent of his compensation to buy restricted stock and the other contributed 20 percent of pay. All of the non-vested stock was forfeited when they left. Federal and state securities laws included exemptions for this type of plan. Tax laws made provisions for deducting the purchase price paid on forfeited stock.

Like all other states, New Jersey has a law that protects employees from forfeiting wages. Laws like this were adopted to protect basic wages in situations where protect workers have uneven bargaining power. The two brokers at Smith Barney claimed that the stock forfeiture violated New Jersey’s version of this law.

The brokers were hardly the victims of sharp practices that the law was intended to protect. Indeed, Smith Barney implemented the plan as a type of “handcuffs” to try to slow defections by brokers that were (and still are) common. Nonetheless, the trial judge ruled that this was a forfeiture of wages in violation of the statute. An appellate court ruling (here) overturned the trial judge and found that executives should be free to enter into these kinds of agreements. The appellate decision turned on the sophistication of the brokers and their informed decision to accept the risks and rewards of the plan.

Similar stock purchase plans have been upheld in other states. The 25 percent discount and two- year vesting provisions are typical. Most of the executive plans we have seen, however, refund the purchase price in the event of a forfeiture. Regardless of how the supreme court ultimately rules on New Jersey law, this case provides helpful reminders:

1. Be careful when providing stock incentives to employees who may not fully appreciate the risks and rewards.
2. The law abhors a forfeiture. Be careful in structuring vesting clauses, particularly with non-executives.
   

By James Bristol

By all accounts, the March 7th hearing of the Committee on Oversight and Government Reform on CEO pay (discussed in our last entry) was something less than the public spectacle that the same committee provided last month on the use of steroids in professional baseball.

Testimony on the state of the mortgage crisis and executive pay came from academics, corporate governance advocates, and the executives and board members from Countrywide, Merrill Lynch and Citigroup. The questioning was relatively light and fell along party lines. Many Committee members were absent for the Friday hearing, as Friday is typically a travel day for those going to their home districts.

Rep. Elijah Cummings, noting that some of his constituents are losing their houses, asked Angelo Mozilo why he had urged Countrywide to pay taxes on his wife’s travel on the company’s private jet.  Mozilo responded, “It sounds out of whack today because it is out of whack, but in 2006, the company was doing great.” Mozilo apologized for his sharp tone in an internal e-mail message that was revealed, admitting, “I’m an emotional person.”

On the other side, Rep. Tom Davis drew analogies to pay in the sports and entertainment world, noting that no one expected Ben Affleck and Jennifer Lopez to give back their money for their roles in the disastrous movie Gigli. The reputations of the three CEOs, who represent classic American success stories, seem intact. The search will need to continue if Congress wants to find suitable scapegoats for the mortgage crisis.

Stock Option Backdating – Conviction for Brocade HR Chief

As we recently noted, Gregory Reyes, former CEO of Brocade Corporation, was sentenced to 21 months in prison and ordered to pay $15 million for his role in a stock option backdating scheme. The former HR director of Brocade, Stephanie Jensen, was sentenced on Wednesday to four months in prison and a fine of $1.25 million for her collaboration. Mr. Reyes and Ms. Jensen are the first two executives prosecuted for stock option backdating.

Obviously, this demonstrates that the HR director cannot use a rubber stamp in the compensation process. But where does one draw the line? HR directors are often obliged to follow the orders of the CEO. Becoming insubordinate is not criminal but can easily result in economic uncertainty for the HR person who doesn’t follow orders. It is difficult to imagine that Ms. Jensen at that time could have appreciated that the technical niceties of option grant procedures could ever amount to securities fraud, or that she had an obligation to stand up to her boss. Fortunately for Mr. Reyes and Ms. Jensen, backdating did not invoke the outrage and stiff sentences that are customary in other types of securities fraud, such as insider trading (see, e.g., Michael Milliken’s ten year conviction).

CEOs Appear Before Congress

By James Bristol

Headlines continue to blare bad news on mortgage foreclosures, sub-prime and other risky lending practices, etc. Now the heat is on those who presided over multi-billion dollar shareholder losses. The House Committee of Oversight and Government Reform interviewed the CEOs of Countrywide, Merrill Lynch and Citigroup. The advance memo (available here) indicated just how difficult the trip would be for CEOs Angelo Mozilo, Stanley O’Neal and Charles Prince.

The memo included three separate case studies comparing compensation and performance. It claims that the three CEOs were paid $460 million between 2001 and 2006 when the mortgage business was booming. When their firms lost $20 billion in the last six months of 2007, however, they were paid handsomely. Much of this was on account of the severance payments required or negotiated under their employment contracts.

Henry Waxman, chair of the committee, has targeted executive pay in the past. Late last year he held hearings in an attempt to portray compensation consulting firms as laden with conflicts of interest when they provide advice on executive pay while also receiving lucrative consulting contracts for other work. This new round of hearings will ring that bell again.

As outlined in our last entry, Congress and the regulators have been increasing their scrutiny of executive pay practices, as have activist shareholders. One wonders if Congress really has the appetite to enter the fray of writing executive employment contracts, or if it will exercise the judgment to let shareholders decide how to evaluate their boards and executives.

We think that it has always made sense to align the financial interests of executives and shareholders. There is ample justification for offering meaningful severance and change in control protection as a tool to recruit capable CEOs. Chairman Waxman, however, would likely say that executives can accumulate significant wealth for work well done, but that severance and change in control protection can get distorted over time.

One can assume that the IRS was aware of the research of the house staffers to prepare for this hearing. It seems fair to speculate that there was collaboration in developing policy when the IRS issued Revenue Ruling 2008-13 two weeks ago. As described in our bulletin and last entry on this topic, the IRS changed a long-standing position and denied deductibility of performance pay when the agreement allows the possibility of golden parachutes like those paid to Messrs. Mozilo, O’Neal and Prince.
 

By James Bristol

Now that the IRS has clarified that its new position on 162(m) performance-based compensation is prospective and provided a transition period, we have a moment to wonder why the IRS changed its mind. In case you missed the discussion, our bulletin on Revenue Ruling 2008-13 is available here. The ruling changed a technical IRS point on performance-based pay that had been affirmed as recently as 2006.

This ruling looks like a tax on golden parachutes that are paid when an executive is performing poorly. Ken Griffin, the IRS agent who signed the revenue ruling, suggested in public comments that termination without cause or for good reason is in reality being forced out for having done a bad job. One can understand this view by reading recent headlines in business publications. There are many notable situations where fired executives land softly, even if not on their feet. One of the best known is Disney’s separation payment to Michael Ovid after 11 months of poor (disastrous?) performance. Mr. Ovid got payments and continuation of stock options worth more than $100 million. More recently, Stan O’Neal was forced out as CEO of Merrill Lynch following a one-quarter loss of more than $2 billion. His fall from grace was cushioned by severance of more than $160 million. Perhaps the new ruling merely expresses a tax policy that huge payments to poor performers are unreasonable and not deductible.

While the change to 162(m) is fairly technical, it is symbolic of the new world of scrutiny on executive pay practices. One should add it to the list of what we have seen since the demise of Enron, WorldCom and others where executives allegedly abused the system. These include:

• Sarbanes-Oxley and other corporate governance rules
• Delaware court’s ruling in Disney raising the bar of fiduciary obligations in approving executive pay
• Section 409A of the Internal Revenue Code
• Tightened 280G regulations for golden parachute taxes on change in control payments
• Financial Accounting Standards Board adoption of FAS No. 123R
• SEC investigations and Department of Justice prosecutions for stock option backdating
• SEC Form 4 reporting required in 2 business days for stock transactions
• SEC proxy disclosure rules requiring detailed compensation discussion and analysis
• Scrutiny from Institutional Shareholder Services (ISS) and other “activist” shareholders
• Bills in Congress that would extend the effect of 162(m) or otherwise limit deductibility of payments to executives

Viewed with this history, one gets the sense that extraordinary rewards for poor performance will be scrutinized more and more.

By James Bristol

IRS Revenue Ruling 2008-13 (available here), issued on Feb. 21, 2008, could disqualify many payments that were intended to be performance-based compensation under 162(m). This ruling follows on the heels of a January ruling (PLR 200804004) that modified a long-standing IRS position on permissible performance award provisions. It affirms that the IRS is embracing a new position and provides transitional relief. The relief applies to employment agreements entered into before Feb. 21, 2008 and for awards with performance periods that begin before Jan. 1, 2009.

For more information, please see the Waller Lansden bulletin at this link.

By James Bristol

The IRS has been peppered with inquiries since releasing PLR 200804004. Numerous law firm memos have been posted to announce the change discussed in our last entry, telling the IRS that this ruling reaches very different conclusions than a ruling as recent as 2006. That ruling OK’d a performance program guaranteeing payment upon death, disability, change in control, termination without cause/good reason and – even – retirement.

Ken Griffin, the agent who signed the new PLR, participated in a Valentine’s Day webcast discussing the new ruling. Mr. Griffin would give few specifics, but he did say the following:

• The IRS has heard the concerns over loud and clear. There is right now a draft of a guidance document from the IRS on Griffin’s desk for expedited release.
• The 2008 ruling was fully vetted at the executive level. Most PLRs are not reviewed outside of the IRS branch. This ruling represents the IRS’ collective thinking.
• The IRS views without cause/good reason termination events as qualitatively different than death, disability or change in control. While all are involuntary, a person could be fired without cause who is not performing well. This possibility of poor performance seemed inconsistent with the concept of performance-based compensation.
• Retirement is a voluntary event and inconsistent with the death, disability and change in control exceptions.
• The IRS did not consider the accounting consequences of this ruling under FIN 48.

The Accounting Angle

This change in the IRS position certainly signals prospective changes in practice. Presumably, awards made in prior years that are consistent with the 1999 and 2006 rulings should be safe from a tax audit. Those who live in accounting-land are sounding the alarm, however, due to the peculiar standards of FIN 48. In short, the new ruling means that any company that relied on the 2006 or 1999 rulings no longer have substantial authority for those positions. FIN 48 requires disclosure of tax positions for which there is not substantial authority. This could result in reporting lost tax benefits that would reduce earnings per share.

Mr. Griffin indicated in his somewhat vague remarks that the IRS is cognizant of this dilemma and considering the broader impact of the ruling as they craft guidance. This conundrum may inspire the IRS to issue a notice that limits application of the 2008 ruling to future awards.

Relief Requested – 96 Law Firms and Others

This letter urging transitional relief was submitted to the IRS on February 13th by two past chairs of the American Bar Association Tax Section. The 96 law firm group is circulating a draft letter today to be submitted to the IRS as soon as possible.

By James Bristol

Section 162(m) of the Internal Revenue Code limits deductibility for compensation paid to top executive officers over $1 million annually. This limit does not apply to “performance-based compensation.” Nearly all publicly traded companies rely on this exception to preserve deductibility of compensation items like cash bonuses, restricted stock, stock options, etc.

To qualify as performance-based, the payment or vesting of the award must be conditioned on the achievement of performance goals. Also, payment must be uncertain at the time the award is made. Whether or not there is “uncertainty” is a facts and circumstances test. IRS regulations expressly permit an award to provide payment on death, disability or change in control.

The new IRS ruling (PLR 200804004) changes what practitioners thought was “uncertainty.” The agreement in question provided that payment would be made regardless of the performance goals if the executive’s employment was terminated without “cause” or upon resignation for “good reason.” The IRS suggested that only death, disability or change in control were conditions that satisfied the uncertainty requirement. This made the arrangement fail to be performance-based pay under section 162(m).

This changes the IRS’s position in prior letter rulings. While the bad news of the letter ruling only applies to the one taxpayer, it is a shift in the IRS’s long-standing position.

For now, all publicly traded companies should review performance-based awards that are being made for 2007, as many companies are going through the award process right now.  Any agreements that are in place with a similar cause/good reason termination should be reviewed with counsel and possibly revised with the consent of the award recipient.

96 Law Firms Request Transition Relief?

A move is already under way from the 96 law firms that spearheaded the 409A relief effort. The in-box was full this morning from the east coast law firms in the group asking for consensus. The in-box continued to fill throughout the day as law firms in the later time zones logged in. It appears that the IRS will be asked to provide transition relief to give companies time to review and modify their existing agreements. Some firms are asking the group to tell the IRS that they were wrong in this letter ruling and should go back to their prior position.

Updates will be provided as information becomes available.

By James Bristol

For companies that are acquired in an all-cash merger, it is not unusual to “cash out” some or all employee stock options. This works well when options are all “in the money.” The option holders receive the intrinsic value of the options, which is the spread between the exercise price and the merger value for the company’s stock. The situation is more difficult when options are underwater or “out-of-the-money,” i.e., the exercise price is greater than the merger value. Some have argued that underwater options are worth $0, since they have no intrinsic value. Therefore, the argument goes, an acquirer should be able to cancel underwater options with or without the consent of the holder.

Most stock option plans make provisions for change in control transactions. It is common for options to become fully vested. Many plans provide for assumption of options and stock incentives by the surviving entity. Some plans specify that the compensation committee can adjust or cancel options in connection with change in control transactions.

In Lillis v. AT&T, the Delaware Chancery Court ruled unilateral cancellation of underwater options violated the rights of the option holders. The language of the option plan stated that in the event of a merger, options “shall be appropriately adjusted . . . provided that each Participant’s economic position with respect to the Award shall not, as result of such adjustment, be worse than it had been immediately prior to such event.” Even though the options were underwater and had $0 intrinsic value, they are deemed to have “fair value” that can be measured under Black-Scholes or some other method. This value is calculated and reported on a company’s financial statement in accordance with FAS 123R.
The court awarded the option holders the Black-Scholes value immediately prior to the merger. The language in the option plan was not unique. Chances are, similar fact patterns will emerge in a lot of cash mergers where there are under-water options. The lesson is that unilateral cancellation of options for no consideration can be costly.

Careful plan drafting can help, but it is difficult to anticipate every possible outcome in advance. It seems that in the Lillis case the plan language could have been interpreted to permit cancellation of underwater options. If possible, it is always best to try to get agreement from option holders as to how they will be treated in the merger. Some holders may be asked to rollover some or all of their options into the new company. Another approach is to offer option holders cash for all options, both in the money and underwater, equal to the intrinsic value of the in the money options. For those who have only underwater options, some form of consideration may be needed to support cancellation.

By James Bristol

Section 409A has ushered in a new era for companies that issue stock incentive awards. The IRS wandered into new territory – territory off the reservation? – in deciding that stock options could be “deferred compensation” under 409A. Long-standing IRS regulations have provided that tax would occur on the exercise of stock options (with one very rare exception). To avoid 409A, an option (or phantom stock or stock appreciation right) must be issued with an exercise price that is at least 100% of fair market value.

Most companies we have seen over the years always issued options at fair market value. So, on first blush, making this mandatory shouldn’t be a big deal for most companies. Here’s the rub:

1. The bar has been raised much higher for demonstrating fair market value. Mere “good faith” of the board is no longer sufficient.
2. Stock option “backdating” now applies to privately held companies. It is a 409A problem if the exercise price is lower than market value by the time that all corporate formalities are completed for granting the option.

Fair market value – the price that would be paid by a willing buyer to a willing seller – is not an exact science. It is a price range rather than a specific number. Short of hiring an appraisal firm, a company can prepare a written valuation report internally if it is reasonably done in good faith and covers all relevant factors, including:

• Value of assets (tangible and intangible)
• Present value of future cash flows
• Value of similar companies that are publicly traded
• Company’s net worth
• Economic outlook of the industry
• Company’s position in the industry
• Stock transactions with third parties (at arms-length)
• Minority and marketability discounts

The weight to be given to any factor depends on the company, industry and circumstances of the marketplace. This process is similar to what is employed by a professional appraisal firm. Start-up companies (i.e., less than ten years in business) that follow this process get a presumption of reasonableness under 409A. The good news is that this process is reasonable and is consistent with good corporate governance practices.

The bad news is that this is a significant increase in analysis and documentation from what companies are accustomed to undertaking. Before section 409A, board members could determine value under any reasonable method as long as it was done in good faith.

The other bad news is the increased scrutiny on the timing of option grants and corporate formalities. Stock option “backdating” is often a failure to properly document the necessary corporate action. A letter to an officer promising a stock option award might be enough to create a legally binding contract. Much more is needed, however, to validly issue equity securities.  (More to come in future posts). Publicly traded companies have been getting used to heightened scrutiny on such formalities for several years.

Section 409A does not apply to stock awards such as restricted stock.

By James Bristol

In the first criminal prosecution involving stock option backdating, Gregory L. Reyes, former CEO of Brocade Corporation, was sentenced to 21 months in prison and has to pay $15 million.

After the backdating came to light, Brocade was obliged to restate earnings for the period from 1999 to 2004. Hundreds of millions of dollars of profit were wiped out. Brocade’s stock was, for a time, on a meteoric rise. It reached highs over $130 in 2000 but fell precipitously in 2001. Brocade now trades under $10 per share. Many tech stocks have experienced a similar fate without undergoing an earnings restatement. It is difficult to determine how much of this demise is due to the restated earnings.

Judge Charles Bryer said, “This offense is about honesty,” in his comments during the sentencing. “Every time Gregory Reyes falsified documents, repeatedly, over a three-year period, he was lying. That is the core of the defendant’s criminal conduct.” Reyes expressed sincere apologies and struggled to keep his composure. He struck a moment of poignant irony when he said, “If I could turn back the clock, I would.”

The act of “lying” was to file financial statements that did not include a compensation expense for stock options that would have been required under the accounting standards that applied at that time. The expenses were phantom accounting charges. In other words, no one diverted real dollars away from Brocade.

Although Reyes is appealing his conviction, additional prosecutions will undoubtedly follow.
Scores of investigations have been conducted by the Department of Justice and the Securities and Exchange Commission. We’ll be watching.

By James Bristol

Recently, a federal jury convicted Gregory L. Reyes, former CEO of Brocade Corporation, of crimes related to stock option back-dating (see August blog and bulletin). Sentencing is scheduled for January 16th.

Ten years is the prison term calculated by the federal prosecutor under federal sentencing guidelines. That is a long sentence for a crime that stems from complicated accounting practices that have been hotly debated for years. Fortunately for Mr. Reyes, the judge’s view seems to be that 21 months is the maximum sentence that can be imposed.

The prosecution argued at trial that Reyes deserved to be convicted because he had personally deceived Brocade’s finance department. An employee even testified for the prosecution, saying she was unaware the employee stock grants had been backdated. Reyes requested a new trial because this employee had recanted her testimony and admitted that she knew about the backdating practice.

The judge denied the motion, finding there was already evidence of others in the company with knowledge of the practice – including the finance department? While Reyes wasn’t the only one involved in the scheme and didn’t deceive the entire finance department, he is the one heading to prison.

IRS Bringing The Party To Privately Held Companies?
 
The next back-dating wave may be in the form of Internal Revenue Service audits of both publicly traded and privately held companies. Based on informal discussions we’ve had with agents in the field, some in the IRS believe that back-dating was wide-spread and prevalent, and private companies will be targeted. Unlike the SEC, the IRS is not looking so much at earnings reports provided to investors. Instead, a back-dated stock option can become “deferred compensation” under section 409A of the Internal Revenue Code. The executive holding the option is subject to ordinary income tax as soon as the option is vested, whether or not it has been exercised. A 20 percent excise tax can be added under 409A.

By James Bristol

Executive compensation practices at not-for-profits has been in the spotlight – much like executive pay has been scrutinized in the for-profit world. There have been headline-grabbing stories of executives at some of the most respected charities taking home millions. The increased scrutiny is coming from the IRS, Congress, state attorneys general and other watchdogs.

Excessive pay to executives of a 501(c)(3) or 501(c)(4) entity will result in an excise tax on the executive and, possibly, the board that approved an “excess benefit transaction.” These taxes were adopted in 1996 as “intermediate sanctions” to discourage lavish compensation practices by individuals without necessarily yanking the tax-exempt status. Since then, the IRS has been developing strategies for creating transparency and improving compliance. Beginning in 2009, there will be a new Form 990 that will require far more disclosure on compensation practices than before. Not-for-profits will need to demonstrate that their compensation practices are reasonable.

These transparency requirements are coming at the same time that the SEC has overhauled executive compensation disclosure for reporting companies. In the for-profit sector, companies must provide shareholders with a compensation discussion and analysis (CD&A) that displays executive pay in dazzling detail. Compliance with Form 990 may not be as paper- and lawyer-intensive as CD&A but the purpose is the same: transparency.

Essentially, a board needs to show that it relies on independent sources for determining compensation. Best practices developing in this area include:

• Independent compensation committee with charter or bylaws that outline role and procedures – members should be free of conflicts of interest
• Well-articulated compensation philosophy that defines marketplace “peer group” for talent and links compensation, as appropriate, to performance, strategy, values and mission
• Committee advisors are hired by and report to committee
• Periodic education for committee on relevant market practices and compliance requirements
• Address each component of compensation (base salary, incentives, retirement, etc.) and total compensation in linking with peers and market practices

These practices are similar to what publicly traded companies have been doing in recent years. Obviously, not all nonprofits have the financial resources – or the financial risk – to justify committing to practices that mirror corporate boardrooms on Wall Street. As the financial magnitude increases, however, the risks are elevated and more thorough attention is warranted.

By James Bristol

Many of our conversations with clients on compensation planning or most any other topic leads to the ever-popular question: “What are other companies doing these days?” Here is how some practices have changed for stock options these days:

The Days Just Before These Days –

Equity compensation awards were predominantly stock options until three or four years ago. The reason was simple. Options provide an incentive based on shareholder return, the company received cash on exercise and the charge to earnings was $0. In comparison, cash compensation costs real money and reduces reported earnings per share. Restricted stock, stock appreciation rights and other forms of stock-based pay all created an expense that reduced earnings per share. Beginning in the mid-90s, however, the enforcement of the equity pay accounting standard – APB No. 25 – tightened. To get the $0 charge to earnings, companies had to limit the methods for payment of the option exercise price.  These were the most popular:

• Cash
• Through a broker-assisted trade
• Delivery of “mature” shares (i.e., shares held six months), though newly issued shares could be retained by the company to cover tax-withholding

There were other requirements for getting $0 compensation expense. The exercise price had to be 100% of the stock’s market value on the grant date and all terms of the option had to be “fixed” on the date of grant. Option pyramiding and discounted option grants were legally permissible, but would result in a charge to earnings under APB No. 25.

The primary financial statement bite was that outstanding options, even those that were deeply under water, had to be counted when diluted earnings per share were calculated.

These Days –

Beginning in 2006, Financial Accounting Standard No. 123R replaced APB No. 25. One goal of FAS 123R was to level the treatment of equity awards by eliminating artificial accounting advantages of one form over another. A compensation expense is charged on the “fair value” of all equity awards. Many companies rely on the Black-Scholes method of determining fair value, although other methods are permissible.

Since stock options are no longer free, and the strict rules from APB No. 25 have been replaced, companies are now doing some things differently:

• Stock options are still prevalent but other forms of equity compensation are becoming popular, including:
  – Stock appreciation rights (SARs) settled in stock
  – Restricted stock
  – Restricted stock units (RSUs)
  – Performance shares that provide stock upon achievement of financial performance goals
• Better paper trails are kept for equity awards.
  – Stock options (and SARs) must still be issued at 100% of market value (or greater) due to section 409A of the Internal Revenue Code.
  – “Back-dating” allegations can be overcome with compensation committee records that establish grant date, number of shares, and identity of award recipients.
• Stock options can be exercised through cashless methods, including “pyramiding” or share “netting”
  – The restrictions on methods of exercise were due to APB No. 25, and are no longer applicable
  – Allowing cashless exercise reduces shareholder dilution, keeps reduces broker trades on the market
• Financial performance goals are being added as a vesting condition
  – Common to provide some awards with time vesting and others with performance vesting

If minimizing shareholder dilution is a primary goal, stock appreciation rights (SARs) settled in stock can be very attractive. SARs operate much like a cashless exercise of an option. If the market value of the company goes up after the grant date, the holder gets shares of stock equal to the appreciation in value from the date of grant.

What to do with options from the old days –

For companies concerned with shareholder dilution, there is an opportunity to modify outstanding awards. Stock options that are exercised through a broker-assisted trade increase dilution and may flood the market with shares. This is counter-intuitive for companies that are engaged in stock buy-back programs. There is some concern that a broker-assisted trade by an executive may violate the loan prohibitions under Sarbanes-Oxley. Options can be amended to permit cashless exercise. Essentially, the amendment permits the option holder to pay the exercise price by surrendering a portion of the shares that could otherwise be purchased for cash under the option. As with an SAR, the option holder receives only the net number of profit shares.

By James Bristol

Our recent entries have discussed the delivery of a half loaf of Section 409A relief from the IRS. IRS Notice 2007-86 (read it here) essentially extends the deadline for compliance with the final regulations until January 1, 2009. There are some details that we are discussing in a bulletin – it will soon be available on our website: www.wallerlaw.com.

The odyssey of a nation of taxpayers obtaining needed tax relief is chronicled in our 409A posts. Many cynics said it couldn’t be done. To the contrary, the IRS appears to have taken seriously the pleas from the legal community. This was a case of lawyers in real life (96 of them) talking to the legion of lawyers employed by the bureaucracy. There were other pleas, as well. In the preamble to the Notice, the IRS said:

“Commentators stated that although the Notice 2007-78 transition relief was helpful, the transition relief in that notice did not adequately address the need for additional time for service recipients and service providers to analyze all of their plans and make informed and reasoned decisions regarding the changes that would be necessary to bring existing arrangements into compliance with the final regulations. This notice addresses these concerns ….”

The notice is masterful in preserving the familiar style of IRS prose. It is not, however, a time machine that takes us back to the world before section 409A was enacted. Many companies will need to make drastic changes in order to comply by the new deadline. Those who are urging repeal of 409A argue that the efforts required to comply with a new set of rules are simply too drastic and out of proportion with the virtues contained within the new law.

By James Bristol

Speaking at a conference for executive compensation practitioners last week, Alan Tawshunsky, the deputy associate chief counsel for employee benefits at the IRS, indicated that the IRS is working on at least two Section 409A matters.

1. A voluntary program for correcting 409A errors is being developed on the fast track. This program was announced in Notice 2007-78. Tawshunsky indicated that the program should be ready in the near future.
2. A further extension to the effective date of the 409A final regulations is under serious consideration. In other words, the IRS is taking seriously the extension request made by 96 law firms and the American Bar Association, as discussed in our October 5 blog entry.

Whatever the outcome of the 96 firm petition for an extension, it seems inevitable that mistakes will occur in 409A administration. Most of the tax penalties fall on the directors, employees and consultants who happen to be paid under a program that technically satisfies the broad term “deferred compensation.” Particularly onerous is the provision for a 20 percent excise tax on payments made to “key employees” within six months of termination of employment. We are very curious about the type of relief that will be offered in the new IRS correction program.

By James Bristol

See our August 29 and September 12 entries on the petition by 92 law firms for an extension to the effective date of the 409A final regulations and the granting of partial relief.

The initial glee over the relief given by the IRS was short lived. Most in the legal community have concluded that IRS Notice 2007-78 delivers no more than half a loaf. The 92 law firms decided to make another run. The IRS explained on the phone that their intention was to provide meaningful relief. So a week after 2007-78 was issued, representatives of the legal community and industry groups traveled to Washington to explain why the relief was something less than “meaningful.” According to participants in the conference, some at the IRS were not sympathetic, explaining that deadlines are always