– Broc Romanek, CompensationStandards.com

As the Presidential election nears, it’s interesting to see articles about CEO pay in places you normally wouldn’t expect them. For example, the Christian Science Monitor ran this article yesterday entitled “How Long Will Politicians Look the Other Way on CEO Pay?”.

– Frank Glassner, Compensation Design Group

A few weeks ago, Financial Week magazine reported that the Congressional crackdown on executive compensation consultants with conflicts of interest has rapidly changed the industry landscape.

Many of the country’s largest companies are now rushing to hire independent consulting firms that specialize exclusively in executive compensation, instead of retaining large consulting firms that provide other, often far more lucrative, consulting services, such as human resources, actuarial, healthcare, pension and benefits plan administration, in addition to dispensing advice on executive pay. Many of those firms provide insurance products to, and receive commissions from, the very companies to whom they are providing compensation consulting services. Some are even owned by the insurance companies themselves.

The extent of the change is stark. According to a recent Equilar analysis of Fortune 1000 proxy filings, 39% of compensation committees now rely on independent consultants for advice on executive pay, compared with barely 30% in 2007. The remaining compensation consulting arrangements are with “full-service” firms.

Similarly, many other corporations are disclosing lengthy details concerning their relationships with their existing compensation consultants, in hopes of quashing concerns about possible conflicts of interest that sometimes arise when a consulting firm provides multiple types of consulting services outside the executive pay arena.

These changes are taking place at a time when both presidential candidates, lawmakers, and shareholder activists have been trumpeting the potential of very real conflicts to arise if an executive compensation consultant’s firm performs non-related work for the same client.

Congressional Interest

Indeed, the Congressional Committee on Oversight and Government Reform, under the leadership of Rep. Henry Waxman (D-Calif.), released a highly critical report at the end of 2007, revealing that 113 of Fortune 250 companies retained “conflicted consultants”—consultants that received, for example, $200,000 to provide advice on executive pay, and yet more than $2 million to provide consulting services in other areas. In the Committee’s well publicized hearings last December, Rep. Waxman declared, “In effect, the consultants are being asked to evaluate the worth of the executives who hire them, and then pay their consulting firms millions of dollars”. The system is intrinsically flawed.

The Committee found that:

– Human resources consulting firm conflicts of interest are pervasive;

– The fees earned by human resources consulting firms for providing services other than executive compensation consulting services (e.g., benefits, pension actuarial, healthcare, insurance, etc.) often far exceed those earned for advising on executive compensation;

– Some human resources consulting firms received over $11 million dollars in 2006 to provide services other than executive compensation consulting – in some cases, 50 to 70 times more than the client company paid the human resources consulting firm for executive pay consulting; and

– Most of the companies scrutinized by the Committee did not disclose their human resources consulting firm’s conflicts of interest.

According to the Committee, there appears to be a direct correlation between the extent of the human resources consulting firm’s conflict of interest and the level of CEO pay within the client company.

It is no wonder many companies are going above and beyond to avoid even the hint of such a conflict. Financial Week reported that corporations such as Safeway and Verizon, for instance, have changed their compensation consultants to independent firms over the past year, pointed out Paul Hodgson, senior research associate at the Corporate Library. “It’s a clear-cut way to send a message that you’re intent on being conflict-free,” Mr. Hodgson said. “It’s an easy solution to something that could be a potentially sticky problem.”

“It’s an emerging trend to use an independent adviser in this role,” said Melissa Plaisance, senior vice president of finance and investor relations at Safeway, which generated more than $42 billion in revenue last year. “We felt it was just an additional step in maintaining a strong governance program.”

The Trend in Practice

Because of this, independent executive compensation consulting firms will continue to be in greater demand for their services. For instance, Pfizer, whose board has used an independent compensation consultant since 2003, goes so far as to name its consultant as a specific adviser in its proxy—while also itemizing each of the 14 responsibilities he is charged with in his role, as well as the specific projects he worked on for the company last year.

Pfizer also volunteered to disclose the fees paid to their executive pay consultant for these services. In 2007, the pharmaceutical company paid $150,901 for consulting with its board on executive compensation issues, plus a fee of less than $5,000 for an executive compensation survey.

Pfizer is hardly alone in deciding to disclose information about fees paid to executive compensation consultants. While only a small portion of companies actually offer this level of disclosure— only about 3% of companies revealed these fees in their proxies earlier this year—that’s triple the percentage of companies that did so in their 2007 proxy filings, according to the Equilar proxy analysis. (The average fee for these services was $161,691 last year, a 33% increase from the average fee of $121,183 one year prior.)

Such disclosures appear to be even more detailed if a human resources consulting firm also provides other advisory services to a company. Consider Time Warner, which in its proxy filing earlier this year offered a seven-paragraph, 700-plus word description of the role of its compensation consultant, Towers Perrin, which it attempted to characterize as “independent”. The company notes that its compensation committee has used the firm as its independent executive compensation consultant since 2002, outlines the work it did for the committee in 2007, and also reveals the fees Time Warner paid for Towers Perrin executive compensation consulting services: $250,368 in 2007 and $263,885 in 2006.

However, in the same section of the proxy, Time Warner notes that Towers Perrin also provides the company with consulting and actuarial services for its retirement plans, as well as consulting on its health and welfare programs for employees, and consulting on human resources systems. For these services, Time Warner disclosed that it paid Towers Perrin roughly $2 million in aggregate fees for each of the last two years. None of these fees, however, impact the compensation advice Towers Perrin provides to Time Warner, it states in the proxy, adding that the team of compensation consultants do not work on any other consulting assignments for the company, and, they attempt to explain, that their own pay has nothing to do with any of these other arrangements.

Our Views

Compensation Design Group has always supported the Committee’s conflict of interest views on human resources consulting firms that really do have entangled business relationships.

We also believe that public company shareholders and board members deserve higher standards of disclosure to verify the independence of the executive compensation advice that their companies receive from their consulting firms. This disclosure will assist in curing the terribly negative views that shareholders, employees, the media, and the American public have on executive pay.

The Securities and Exchange Commission will likely require further disclosure on compensation consultant independence. Current SEC rules do not require tabular disclosure of fees for services provided by human resources consulting firms. This only fuels the flames of public perception as well that the executive compensation consulting profession is not helping with, and perhaps even exacerbating problems with executive pay.

Diversified human resources consulting firms, often owned by insurance providers or public companies themselves, in fact have significant economic incentives to provide ancillary services, frequently far more financially lucrative than the executive compensation consulting services they provide. The executive compensation consultants of these firms do, however, have the ear of the board and senior management. That coupled with cross selling of ancillary services, along with the realization of significant fees, creates a recipe for the disaster of independence and objectivity.

– Laura Thatcher, Alston & Bird

Was it just me or did others laugh out loud while reading the closed captioning during yesterday’s SEC webcast on the technologically brilliant new IDEA? (See Broc’s blog to learn what the SEC’s IDEA is about.)

Chairman Cox was talking away while typing on the computer to show how IDEA will work and the closed captions were wild. Apparently the “reporter” was from Mars or just couldn’t read his lips while he was concentrating on the keyboard. Or (assuming the reporter is a computer) maybe the SEC should earmark some of the technology funding to an upgrade on voice recognition. I’m betting there were some hearing impaired listeners scratching their heads!

– Ed Burmeister, Baker & McKenzie

I was perusing the NASPP’s very helpful new “Domestic Stock Plan Design and Administration Survey” the other day. I was surprised to see how many companies are still issuing restricted stock (as opposed to restricted stock units). I frankly cannot think of any good reasons to keep issuing restricted stock, but of course some of you may wish to correct my thinking on this.

Historical Practice

In the old (pre-FAS123R) days, companies traditionally issued stock options as their primary equity vehicle under their long term incentive plan, with restricted stock grants to a few key executives.

Current Trends

With the advent of FAS123R, grants of full value awards (restricted stock or restricted stock units (RSUs)) have grown in prevalence for a variety of reasons, including share conservation, ease of administration (i.e., no Black-Scholes value issues), retention value in a flat or down market, high employee perceived value as compared with Black-Scholes value of options, etc. The survey confirms this.

So, as companies expand the use of full value awards, it initially made sense to look at making restricted stock grants (based on the historical practice) to a broader group of employees. However, the form of grant suitable to a handful of key executives based in the U.S. is, in my view, unsuitable for broader award groups, particularly if the group includes non-U.S. award recipients.

Key Features of Restricted Stock/RSUs

Restricted stock for this purpose means shares actually issued at grant, with full voting and dividend rights, but subject to a forfeiture back to the company if the employee leaves before the specified vesting period. So, the shares are issued, but placed in escrow or otherwise “restricted” so that the forfeiture provisions can be applied upon a termination of employment. Although dividends on such shares are real dividends from a corporate perspective, they are not dividends from a tax perspective, but rather are compensation in the hands of employee, subject to income and FICA/FUTA taxes and withholding.

The grant of restricted stock is eligible for a so called section 83(b) election allowing the employee to be taxed upfront at grant (otherwise tax is at vesting). So, the company needs to communicate with the award recipients the pros and cons of section 83(b) elections, provide forms, etc. This is all compressed, in that any section 83(b) election must be made within 30 days of grant.

My experience is that essentially no one at a public company makes a section 83(b) election on restricted stock, so the availability of this election is more of a curse than a benefit for restricted stock.

RSUs are, of course, economically equivalent to restricted stock (assuming dividend equivalents are provided on the RSUs), but the shares are not typically issued until vesting. Tax rules are almost identical (although RSUs are technically taxed under constructive receipt principles, so release is the income tax event rather than vesting, but these are typically the same). No actual dividends are paid during the vesting period (since no shares have actually been issued), but dividend equivalents can be paid or (better yet, in my view) accumulated as notionally reinvested into shares and paid only at vesting along with the underlying shares.

Pros and Cons of Restricted Stock/RSUs

The accounting treatment for restricted stock and RSUs is essentially identical, with relatively minor differences too complicated to discuss here. So, why are RSUs superior to restricted stock?

First, companies do not need to worry about section 83(b) elections, communicating the pros and cons of this to a broad range of employees and hearing the complaints when an employee makes a bad choice or files his/her form a day late. Second, since the shares are not issued until vesting/release, there is no need to deal with the hassles of recovering forfeited shares. Third, net share withholding (the method of withholding which most companies choose for broad based RSU grants) is certainly no more difficult to deal with than withholding with respect to restricted shares which have already been issued.

Finally, restricted stock issued outside the U.S. is typically taxed at grant (with no election) in many countries, including many key European countries, which presents adverse tax consequences to the employee and withholding challenges for the employer. I am aware that restricted stock is not subject to the section 409A rules whereas RSUs may be. However, if RSUs are designed properly (e.g., paid out at vesting) or in accordance with a fixed payment schedule, the section 409A problems are manageable.

So, for my part, issue RSUs and forget about restricted stock.

– Broc Romanek, CompensationStandards.com

In this podcast, Chris Plath of Moody’s Investors Service discusses Moody’s new report entitled “Expanded Disclosure On U.S. Executive Compensation Offers New Clues For Creditors,” including:

– Why has Moody’s issued this new report?
– How can better disclosure of performance metrics targets enhance a creditworthiness evaluation?
– What type of peer group benchmarking disclosure is Moody’s looking for?
– How about for payments following a change in control?

– Melissa Means, Pearl Meyer & Partners

Absolute performance goals are specific targets against which future performance is measured. Typically linked to the company’s business strategy; they are relatively easy to measure and communicate; are consistent with shareholder expectations of typical practices; and give plan participants a strong sense of control and influence. For example, a company might set an absolute goal of $1B in revenue from a starting point of $900M, with achievement based on actual revenue at the conclusion of the performance period. The downside is that absolute goals rely heavily on effective planning and forecasting and also may create an incentive for executives to set lower goals to increase their chances of a payout.

In contrast, relative performance goals measure company performance against a group of peers or a company index. For example, a performance-based LTIP might require performance in the first quartile relative to a group of 20 peer group companies, based on revenue growth for the performance period. Such comparative performance assessments tend to be motivational in both good years and bad, with the greater likelihood of payouts even in a down year likely to aid retention. While suited to longer performance periods, relative metrics are more sensitive to changes in the composition of the comparator group or the alignment of different companies’ fiscal year-end. Relative measures also can be more difficult to communicate to a broad-based population, while outcomes may be inconsistent with investor expectations, the company’s cash flow or its ability to pay out the awards.

Generally speaking, companies that are facing significant change and prefer a performance-based LTIP with a one-year performance period would be better off using absolute metrics, while a similar company facing significant change that is measuring results over two to three years may prefer relative performance measures.

– Ed Hauder, Senior Attorney and Consultant, Exequity, LLP

As the clamor for better corporate governance at U.S. companies continues and activist shareholders push companies to revisit their severance plan designs and equity compensation practices, a note of caution is in order. While more companies embrace lower severance multiples (2x for top executives and 1.5x and less for lower-level executives) and adopt performance-based equity programs (in whole or part), these changes may interact in ways that are not always obvious at first glance.

For example, these trends when coupled with investor concern over gross-ups, could lead a company to also adopt a policy of no gross-ups for its executives. Companies need to be vigilant and fully review the possible consequences of such design changes, and not just leave things to what folks intuitively believe should be “ok” in order to avoid unintended consequences of their compensation design changes.

Example

For example, I just finished up some modeling under Section 280G of the Internal Revenue Code for a company that has adopted a more shareholder-friendly severance policy using the lower multiples mentioned above. The company also has adopted a change to its long-term equity incentive program so that half of the LTI value is delivered by stock options (time-based vesting) and half by performance shares (performance-based vesting) – both have their vesting accelerated upon a change in control. Currently, the company does not have gross-ups for all of its executives (but does have them for several newly-hired executives).

Section 280G Modeling: The Surprising Results

When modeling out the impact of Section 280G on this company’s executives, a surprising result occurred. For quite a few of the executives, even though they received only 1.5x their base salary and annual target bonus, they ended up being “over” the Section 280G cap (or “parachute limit”) or very close to it. Once an individual executive’s severance amount plus other applicable payments contingent upon a change in control exceed the Section 280G cap (generally, 3x the “base amount”), all amounts in excess of the “base amount” (generally, the average of the past 5 years’ W-2 income – from Box 1) become subject to a 20% excise tax under Section 4999.

Well, you might think, that is ok. After all, the executives obviously will receive quite a bit in severance (1.5x of base salary plus bonus) so they can afford to give-up some of that in order to come-in under the Section 280G cap. In some cases they could; in others, while they could, it would represent more than half of the cash severance payment they would have to forego; and, for others, even if they gave up their entire cash severance amount, they still would exceed the Section 280G cap and the only way they could come under the cap would be by giving up some of their equity awards.

What Caused These Results?

The cash severance amount intuitively seems reasonable. Also, the LTI grants were lower than market median and half were delivered as performance shares. So what happened to cause the severance amounts to these executives to come close to or exceed the Section 280G cap? In a nutshell, it was due to the change in their LTI program in which they switched from an all-stock option program to a half stock option, half performance share program. If the company had simply maintained an all stock option program, perhaps only one executive would have exceeded the Section 280G cap (and that was a newly hired executive who was given a 110% alternate cap gross-up – see below for an explanation of “alternate gross-ups”).

Why Did Switch in LTI program Cause This Result?

The reason is in how the Section 280G regulations handle equity awards based on whether their vesting is strictly time-based or has a performance-based aspect to it. In the former case, time-vested awards only have an incremental amount included in the Section 280G calculation – determined based on the amount of time by which the award’s vesting is accelerated. Whereas for performance-based awards, the full amount gets included (full spread for performance-based options and full value of performance shares at deal close).

Consequences

If the company does nothing, then its severance program may not end up producing the results it wants – making the executives indifferent to whether a transaction that is in the best interests of the company and shareholders occurs. If the company goes ahead and grants a standard full gross-up, it likely would be pilloried in the press.

So what to do? Here is where the Board and Compensation Committee need to take ownership and decide what is in the best interests of the company and its shareholders. First off, they should commit to monitoring the potential expense of any solution they implement (preferably on an annual basis as part of their Tally Sheets). Second, they need to balance the objectives of the severance program with shareholder concerns on severance multiples, gross-ups and using performance-based awards. If a company simply adopts all the current practices being proposed without thinking about how they will actually interact, and reviewing the likely consequences of such interaction, it could be in for a surprise.

In the above example, the company adopted lower severance multiples and adopted performance-based equity awards. If it also then blindly adopts the position of some activist shareholders to avoid any gross-ups entirely, the interests of the company and shareholders could actually be hurt, because it could cause the severance plan to fail in its primary purpose.

One possible solution that balances ensuring the goals of the severance program are met with shareholder concern on “excessive compensation” might be to adopt a gross-up provision that only is triggered if the after-tax benefit to an executive exceeds some threshold as compared to the after-tax benefit to the executive with the gross-up applying. Such a provision is generally referred to as an alternate gross-up and a typical threshold is 110% of the after-tax benefit without the gross-up in order for the gross-up provision to be triggered. If the after-tax benefit doesn’t exceed such threshold, then the executive’s compensation is cut back so that it falls under the Section 280G cap and the executive avoids the 20% excise tax.

The Bottom Line

As companies seek to adopt more progressive corporate governance policies and take actions to re-design their compensation plans and programs, they need to stop and review the practical consequences of their actions to determine the possible impact relative to the underlying purpose for having particular compensation plans and programs. It might be a little extra work, but it helps avoid unwanted surprises and unintended consequences later.

– Michael Album, Partner, Proskauer Rose

During the summer doldrums, what better topic to think about than withholding tax obligations. The IRS just issued an important Revenue Ruling concerning signing bonuses and severance payments. Revenue Ruling 2008-29 (June 16, 2008) provides much needed guidance on satisfying withholding payment obligations under I.R.C. § 3402 of the Code for certain types of “supplemental wages.” Two of the situations described determine the required withholding rate on signing bonuses and severance pay.

The first step in the analysis is determining whether the amount involved is a “regular wage” or a “supplemental wage.” The wage classification can have a significant impact in determining how much income tax must be withheld. Treas. Reg. § 31.3402(g)-1(a), as amended by T.D. 9276, 2006 C.B. 423, governs the classification of wages for this purpose.

The distinguishing feature of regular wages is they are paid within a particular payroll period. Two scenarios will satisfy the test for a regular wage: (1) when the amount is paid at a regular hourly, daily, or similar periodic rate (and not an overtime rate) for the current payroll period; or (2) when it is paid at a predetermined fixed determinable amount for the current payroll period. Treas. Reg. § 31.3402(g)-1(a)(1)(ii). For purposes of I.R.C. § 3402, an employee can only have one payroll period with respect to wages paid by any one employer. Treas. Reg. § 31.3401(b)-1(d).

Supplemental wages are all wages paid by an employer that are not regular wages. Treas. Reg. § 31.3402(g)-1(a)(1)(i). Supplemental wages include amounts paid without regard to an employee’s payroll period, but may also include payments made for a payroll period if the payments aren’t tied to a regular periodic rate or a predetermined fixed amount. Id. Sales commissions paid within a payroll period are an example of supplemental wages in the latter group. Id. The regulations provide many examples of supplemental wages, such as bonuses, non-qualified deferred compensation, commissions and back pay. Id. The supplemental nature of such wages remains the same regardless whether the employer paid the employee any regular wages during the calendar year of the payment or any prior calendar year. Id.

Once the wages are identified as supplemental, the method of determining the proper withholding depends on whether the total amount of supplemental wages paid by the employer to the employee during the calendar year exceeds $1,000,000. Treas. Reg. § 31.3402(g)-1(a)(2). If the amount paid for the calendar year exceeds $1,000,000 then mandatory flat rate withholding applies to the portion exceeding $1,000,000 for the calendar year. Id. Under mandatory flat rate withholding, the applicable rate on the excess amount equals the highest rate of tax under the Code for taxable years beginning in such calendar year.

Mandatory flat rate withholding applies to the excess amount without regard to: (1) whether income tax has been withheld from the employee’s regular wages; (2) the number of withholding allowances claimed by the employee on Form W-4, “Employee’s Withholding Allowance Certificate,”; (3) whether the employee requested additional withholding on Form W-4; or (4) the withholding method used by the employer. Id.

Two procedures may be used for withholding on amounts not exceeding $1 million during the calendar year: (1) the aggregate procedure (which keys to the tax rate applicable to the aggregated regular wages and supplemental wages up to first $1,000,000 of supplemental wages) or (2) the optional flat rate withholding (applying a flat rate without reference to regular wages). See Treas. Regs. § 31.3402(g)-1(a)(6) and (7). (The IRS regulations discuss both approaches in detail).

The IRS’ Examples

Here are two examples addressed in the Revenue Ruling:

1. Application to Signing Bonuses (Situation 5 of Rev. Rul. 2008-29):

Under an employment contract entered into on May 1 of Year 1, Employee F is scheduled to begin performing services for employer P on October 1 of Year 1. F will receive regular wages of $75,000 per month for his services as an employee of P, and will have a monthly payroll period. On June 1 of Year 1, P pays F $2,100,000 as a bonus for signing the employment contract. F has received no wage payments from P’s agents or any other person treated as the same employer as P under Treas. Reg. § 31.3402(g)-1(a)(3)(i).

The bonus payment on June 1 of Year 1 is a supplemental wage. See Rev. Rul. 2004-109, 2004-2 C.B. 958, and Treas. Reg. § 31.3402(g)-1(a)(1). P must apply mandatory flat rate withholding to the portion of the bonus exceeding $1,000,000 for the calendar year, or $1,100,000 in this example. Treas. Reg. § 31.3402(g)-1(a)(2).

P has the option of applying either the aggregate procedure or treating the payment as subject to mandatory flat rate withholding for the first $1,000,000 of the bonus. Treas. Reg. § 31.3402-(g)-1(a)(4)(iv). If P uses the aggregate procedure, the payroll period to be applied with respect to determining the amount of income tax on the first $1,000,000 of the bonus is the monthly payroll period, because the regular wage payments to be paid to F during the calendar year are scheduled to be paid on a monthly basis. P may not use the optional flat rate withholding to determine income tax withholding on F’s signing bonus because at the time the bonus is paid P has not withheld income tax from regular wages paid during Year 1 or the preceding year. Treas. Reg. § 31.3402(g)-1(a)(7)(C).

2. Application to Severance Pay (Situation 6 in Rev. Rul. 2008-09)

Employee G performs services for employer S, which has a severance pay plan for its employees. The plan generally provides that if an employee is involuntarily terminated, the employee receives weekly severance pay equal to his or her ending regular weekly pay. The severance pay continues after termination for the number of weeks equal to the number of full years the employee performed services as an employee for the employer multiplied by 3. G is involuntarily terminated by S on June 30 of Year 1, after G has performed services as an employee of S for 17 years. Thus, G will receive 51 weeks of severance pay, paid weekly starting in July of Year 1 and continuing into Year 2.

The severance payment is a supplemental wage because it is not a payment for services in the current payroll period. It is a payment made upon or after termination of employment. Thus, although the payments in this situation are for a fixed determinable amount for 51 weeks, they are not regular wages because they are not fixed payments for the current payroll period.

S may use the aggregate procedure to determine withholding on the payments or, if S has withheld income tax on regular wages paid to G in Year 1, S can use optional flat rate withholding to determine the withholding with respect to the supplemental wage payments in Year 1 and in Year 2.

Now, go to the beach, have a cold drink, enjoy Summer. Having read this you earned it!

(Katie Gerber, a third year law student at Temple University’s Beasley School of Law and a Summer Associate at Proskauer Rose LLP, assisted in the preparation of this blog posting. We also want to thank our tax partner, Mitchell Gaswirth, who provided his assistance on this blog.)

– Fred Whittlesey, Buck Consulting

I was amused a few weeks ago when the “Quote of the Day” on my iGoogle homepage – “People everywhere confuse what they read in newspapers with news.” – seemed the fitting introduction to the first article I saw when I clicked to the Wall Street Journal: “Hiring a CEO From the Outside Is More Expensive: New Study Highlights Cost of Failing to Plan For Leader Succession.” I’d say that journalists everywhere confuse what they read in studies with fact.

Having spent the last several years working with clients to clarify the notions of “expense” and “cost” I was eager to read the article. Sure enough, the first sentence went further to state that “Chief executives recruited from outside a company earn significantly more in their first year than those promoted from within.”

Of course, the study cited median pay and proceeded to employ so many of the misleading statistical flaws that pepper the field of executive compensation – the most significant of which is the continued focus on annual pay and the associated confusion about what is granted, earned, and realized.

I was reminded of another Wall Street Journal article published in 2006 concluding that a Silicon Valley CEO had taken an 86% pay cut from the previous year because he had received a new hire package the previous year and no additional equity or signing bonus the next. This journalist went further and concluded that this was the harbinger of a trend of massive pay cuts for Silicon Valley executives – a conclusion supported by data from a firm citing the reduced “value” of stock option grants…due of course to lower share prices.

I think we’re all tired of the continued media irresponsibility resulting from a combination of subject matter ignorance and lack of due diligence. It’s unfortunate that stories like the “overpaid new hires” are not the result of flawed proxy reading by an inexperienced journalist but an interpretation of a so-called “study” performed by a data firm in the field of executive compensation.

Stepping off of that soapbox, this underscores the need to use a rigorous multi-year approach to executive pay analysis. The high rate of turnover among NEOs and the inclusion of both new hire and termination payments in the proxy data tables have contaminated proxy data, and most published and proprietary surveys do little better by continuing to focus on the annual snapshot approach. We have seen many peer groups in which half of the executives received zero LTI awards in a given year while others show massive new hire awards, and it’s irresponsible to just hope that those extremes “wash out.”

This most recent study also overlooks the fact that most externally hired CEOs are experienced CEOs while internally promoted CEOs are new to the job. Any compensation professional understanding the concept of “position in range” could explain to both the journalist and the data firm that this factor – plus the new hire package factor – fully explain the purported scandal.

Those reading Monday’s WSJ article will note that one fellow blogger supported the notion that “it’s expensive to go outside.” Conversely, kudos to another colleague, Tim Sparks, who tactfully points out the flaws in the journalist’s thinking which apparently had no impact on the journalist who had already decided on the headline and didn’t want to be confused with the facts. As oft-quoted experts in the media, we all know how that feels.

Interestingly, the journalist’s column is titled “Theory & Practice” and is described as “a weekly look at people and ideas influencing managers.” Therein lies the problem. Not only will managers be influenced, but inevitably so will one or more directors in the next Board meeting I attend who’ll be discussing those expensive external hires. Fortunately, I always keep my soapbox in my briefcase.

– Laura Thatcher, Alston & Bird LLP

Blogging has proved to be both a novel and rewarding exercise! Since my blog a few weeks back about whether it is too late to change a good reason definition, I have received several thoughtful responses – which just goes to emphasize my point that Section 409A is way too complicated in the fringe areas of deferred compensation.

One commenter suggested that I am perhaps being too liberal in concluding that a “deficient” good reason definition can be reformed in 2008 for purposes of the two-times/two-year exemption. (I hold my ground on that one, based on Notice 2007-78, last paragraph of Part IV.A.)

In the other direction, Max Schwartz of Sullivan & Cromwell chimed in with an interesting dialog suggesting that I am being overly conservative in concluding that it is too late to reform a “deficient” good reason definition in 2008 for purposes of the short term deferral exemption. At the risk of paraphrasing his point, let me paraphrase his point:

Notice 2007-78, Part IV.A, sixth paragraph says:

The Treasury Department and the IRS understand that taxpayers may desire to conform existing good reason conditions to the requirements of the definition of an involuntary separation from service under the regulations. Accordingly, to the extent that a right to a payment subject to an existing good reason condition is subject to a substantial risk of forfeiture, the modification of the good reason condition on or before December 31, 2008 to conform to some or all of the conditions set forth in § 1.409A-1(n)(2) will not be treated as an extension of the substantial risk of forfeiture. However, if the right to a payment subject to existing good reason conditions is not subject to a substantial risk of forfeiture, the modification of such condition to include one or more of the conditions set forth in § 1.409A-1(n)(2)(ii), or to remove one or more of the existing good reason conditions, will not cause the amount to be treated as subject to a substantial risk of forfeiture.

Max correctly notes that this paragraph of the Notice keys the ability to reform the good reason definition on whether the right to payment is “subject to a substantial risk of forfeiture” – not on whether the good reason condition is tantamount to an “involuntary termination” condition under Section 409A. He also points out that the final regulations (§1.409A-1(d)(1)) say that if a right to payment is conditioned on “involuntary termination” it will be subject to a “substantial risk of forfeiture” — but do not say the converse – i.e., that if a right to payment is not conditioned on involuntary termination it is not subject to a substantial risk of forfeiture (because there other ways to be subject to a substantial risk of forfeiture).

Given that these are two distinct standards (with involuntary termination being a subset of substantial risk of forfeiture), he concludes that as long as the right to payment is still subject to a substantial risk of forfeiture, you can fix at will (for the rest of 2008).

To illustrate the point, let’s take an absurd example of a good reason definition triggered solely by the company requiring the CEO to park in a different parking space (an example often used by IRS speakers in conference settings as being a good reason definition that is way off the safe-harbor mark and definitely not tantamount to “involuntary termination”). To earn the severance payment the CEO has to continue to perform services until the company actually requires him to park elsewhere.

That action is not within the control of the CEO (one assumes) and the company would not take that action until it was prepared to terminate the CEO (because the company knows that moving the parking spot would trigger the right to severance). If the company has not yet taken that action, is the severance payment still subject to a substantial risk of forfeiture? One could argue that it is. If so, then Notice 2007-78, Part IV.A would not preclude the parties from changing to the safe-harbor good reason definition in 2008 and thereby salvage the short-term deferral exemption for a termination of employment occurring in 2009 or later. I had never thought of it that way.

Moving to a more realistic example: a good reason definition that is close to the safe-harbor but is missing on a few cylinders, such as one that triggers on any reduction in compensation, without a materiality qualifier, or that has no cure period. It is much easier to conclude that the right to payment under that definition is “subject to a substantial risk of forfeiture” even if it does not chin to the bar of “involuntary termination” (which is a closer call). The further removed you get from the safe-harbor good reason definition, the closer the call on the involuntary termination analogy.

Whether a particular hair trigger is a good “substantial risk of forfeiture” depends on the facts. Max’s view would be that if it’s in the control of the employer and not the employee, then it may well be a under a substantial risk of forfeiture until the employer decides to take the action. For example, a trigger based on the employee getting his feelings hurt would not suffice.

I am inclined to agree with Max that, given the right facts, there is still time to reform a “bad” good reason definition in 2008 to avail the short-term deferral exemption. Let me hear from you if you have other views on the subject. This is great forum for sharing timely advice before the final curtain falls.