– 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.
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.)
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.
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.
As companies look for better ways to manage costs and retain key staff in our current turbulent economy, executive choice in long-term incentives (LTI) is emerging as one potential option. Among larger U.S. companies, such as Procter & Gamble, Herman Miller and Lincoln Electric, we have seen increased disclosure of executives being offered a limited choice among different types of LTI vehicles of equal value. For example, at P&G senior managers may choose to take 50% of the annual LTI grant value in stock options, restricted stock or a split of equal value between the two. In this specific case, the options vest in 3 years, while the restricted shares take 5 years to vest.
Why offer choice? Why take on the administrative and communications tasks required for execution? The answers appear similar among those offering choice. For participants, choice can enhance the perceived value of LTI awards of otherwise equal accounting value and:
– Aid in retention of key talent, especially if there is significant diversity in the age and tenure of the management team
– Take the sting out of actual cutbacks in LTI grant value
– Allow executives to decide how to address change in their LTI in the face of uncertain company and/or stock price performance
Choice is not, however, an abdication of a company’s pay philosophy. Participation in performance contingent plans, for example, is rarely, if ever, a choice. Choice is usually between various types of service based awards. A core LTI plan continues to cover all participants, with choice rarely involving more than 50% of total LTI value. If a company has ownership guidelines, offering covered executives choice does not excuse them from compliance with the guidelines.
In the face of Internal Revenue Code Section 409A, some caution in structuring the choice is necessary. Options and restricted stock in a choice program are generally exempt from 409A, so long as the grant date of the award is not changed by the choice. Generally, choice involving restricted stock units (RSU’s) can work as well. However, choice regarding RSU’s will be considered deferred compensation. If so, a choice should be made before the year of grant, and vesting not guaranteed on certain types of terminations, such as retirement.
Here is an interesting excerpt from Professor Lisa Fairfax posted on the “Conglomerate Blog“:
I recently ran across a 2007 study conducted by the Institute for Policy Studies, a progressive research center, which published figures on the pay disparities of various people in leadership positions. Based on 2005 and 2006 data, the study focused on the median salaries for the twenty highest paid individuals in various sectors. It found the following:
– Congress members: $171,720
– Military leaders: $178,542
– Federal executive branch: $198,369
– Heads of non-profit organizations: $968,698
– Heads of publicly held companies: $36.4 million
CEO Pay Remains in the News
Warning signs over excessive pay and those who won’t stand for it anymore continue to pop up all around us. For example, recently – as noted in this Washington Post article – the Maryland Insurance Commissioner cut in half the $18 million severance package paid to a former CareFirst BlueCross BlueShield CEO, saying the CareFirst board failed to restrain his compensation.
It’s also noteworthy that UnitedHealth Group has settled the two class action lawsuits over its options backdating for the unbelievable amount of $912 million (this is on top of the more than $600 million the former CEO has proposed to repay to settle the lawsuit against him). Shortly afterwards, the company announced it was laying off 6% of its workforce.
The May-June issue of the NASPP’s Advisor notes on the cover that “performance awards are the plans of the future” and then follows up with support from a Buck Consultants study giving “performance scores” for different types of approaches – with time based awards being rated badly (no surprise). I could not agree more, and suspect future dialogue about this will focus on three different structures for performance awards.
The first would use performance to determine the amount of a cash or stock award. The second would use performance to determine vesting for an award. And the third, and best, approach would incorporate both of these components into a single award that encourages solid performance over the longest period (both during the pre-grant performance period and the post-grant vesting period). The resulting double-layer of performance criteria should be best from an employer and shareholder perspective, and should be a first step toward establishing greater public comfort with executive compensation generally.
The reason? It strikes me that executives – like corporate directors – should not reap huge compensation from short-term success. The long view encourages appropriate risk-taking, better accountability, and riches for those who show the ability to lead their companies toward sustained success. The public would welcome that, I imagine.
– Peter Hursh, Managing Director, ECG Advisors, LLC
With CEO turnover at or near an all-time high for reasons of substantial underperformance, lots of directors are looking at the departing CEO’s employment agreement and thinking to themselves: “Gee, I wish we had…”
Here are ten key terms they wish they had written into the CEO’s employment agreement, the first time around:
1. A definition of “cause” that includes “substantial underperformance,” as measured by continuing failure (say, for two consecutive fiscal years) to achieve minimum financial goals and, in particular, failure to meet easily achievable non-financial goals. Termination of employment for “cause” would mean, of course, no severance pay – – or perhaps in the case of “cause” which is substantial underperformance, very limited severance pay.
2. A “clawback” feature that requires the CEO to repay bonuses earned, and stock option spreads cashed in, when the company’s financials have to be restated. Often, “substantial underperformance” does not mean restated financials, so the directors are relieved that the absence of a clawback feature didn’t hurt their company.
3. Provision for the CEO to resign automatically from his or her seat on the Board upon termination of employment for any reason. Who wants a disgruntled former CEO to have the right to stay on the board?
4. Severance pay, for termination of employment by the Company without “cause,” of no more than one year’s “pay” (defined as current salary plus the average of the last two years’ bonuses). The theory here is that severance pay is intended to be “bridge pay” between job 1 and job 2, and that most executives who are actively seeking re-employment should be able to find their next job within a year.
5. Severance pay in installments instead of a lump sum. Installments, with the right to discontinue them if the CEO breaches his or her post-employment duties to maintain trade secrets, not to compete, and not to solicit former employees, are the only way – – short of litigation – – to have any leverage on the executive’s post-employment conduct. Look out for the tricky rules under tax code section 409A on deferred compensation, which may apply to installment payments.
6. Severance pay that is offset, after the first several months, by earned income from the next employer. The offset keeps the severance pay from being a windfall – – collecting pay from the old and new employers at the same time. If the CEO finds a new job a week after being fired, there may be some overlap, but the board can rationalize that as compensation for the incidental expenses incurred during the transition.
7. No post-termination executive benefits or perquisites (especially automobile allowances, club memberships, subsidized travel and tax gross-ups) during the severance pay period. They were difficult enough to rationalize as “business-justified” while the executive was with us; now that he or she is gone, especially for failing to perform, why are we still providing them?
8. A definition of “retirement” that feels like a real retirement from the company – – say, at least age 60 with at least 20 or more years of service – – as opposed to leaving with only a few years of service and getting another job. Then, we won’t provide an ex-CEO who isn’t really retiring with, for example, lifetime healthcare benefit coverage.
9. Mitigation of damages – – i.e., offsets – – for benefit coverage provided by a successor employer, even if the executive declines the new coverages. If the individual could have elected to pay the premiums for the new employer’s medical, dental and vision care plans, then he or she should be treated as having done so – – instead of simply opting for the former employer’s free coverage. Thus, any successor employer’s health plan is the so-called “primary plan,” paying benefits first, with our plan paying benefits second.
10. Provision for the company to decide how to resolve legal disputes, and in what venues – – as opposed to the old “boilerplate” contract language that called for mandatory arbitration. In many cases these days, arbitration is as costly as court litigation. And at least the company can appeal a court’s decision; the company has no right to appeal from the arbitrator’s decision.
– Ira Kay and Steve Seelig, Watson Wyatt Worldwide
We enjoyed reading Broc’s posting of John Wilcox’s views of the benefits of mandating “Say on Pay” votes for the plans disclosed in a company’s proxy. Mind you, this is not a vote on the magnitude of the pay packages themselves, or whatever shareholders might think they are voting on if a blanket “Say on Pay” vote was mandated; John is simply suggesting a vote that would permit shareholders to tell the company if the plans they disclose in their proxy make sense and are properly disclosed. And John comes from an organization that “gets it” about how to write a proxy disclosure – TIAA-CREF absolutely “walks the walk” on making sure its own proxy disclosures are as transparent as they possibly could be.
While our firm remains on the sidelines regarding whether a Say on Pay vote, or John’s modest proposal, will accomplish the goals being sought, we agree wholeheartedly that many companies have fallen far short in telling shareholders how their plans actually accomplish the illusive goal of providing ‘pay for performance.” Search any proxy. You will invariably find the company touting its “pay for performance” story, with very few actually proving it. We found this to be a common failing when we performed out 2nd Annual “Report on Proxy Statement CD&A Compliance.”
We have been recommending that companies do their best to prove their case, and include the results right at the start of their CD&A in an Executive Summary so investors immediately can know:
– How the company performed for the year,
– How the company paid for those results,
– How corporate performance compared to peers, and
– How their pay compared to peers.
While we acknowledge calculating and accumulating these results can be burdensome, we believe companies owe it to their shareholders to explain these results up front. You know, something that catches people’s attention, like: “It was the best of times, it was the worst of times.”
Of course, the problem in assembling our Executive Summary is that it is based on sound analysis. And our survey found that companies have not taken the time to do the work – as encouraged by the SEC – to explain the type of performance their plans are designed to reward. We found:
– Only 46% of the companies disclosed long-term incentive compensation earned in 2007 for attaining plan goals during the 2005-2007 cycle.
– Slightly more than half – 56% – described in detail the link between total pay earned during 2007 and company performance.
– Only 36% compared the company’s performance with the performances of its industry peers.
Although roughly half of companies provided some analysis that linked pay to corporate performance, most did not provide a detailed comparison of the pay earned by their executives with the pay earned by peers. This omission leaves these companies vulnerable to criticism from institutional investors and other pay critics that their pay programs are not solidly grounded in performance.
I continue to be impressed (to use a polite term) by the complexity of 409A as it applies in the context of what I call the “fringe areas” of nonqualified deferred compensation under Section 409A. For someone who does this for a living (as I do), it should not be such a brain teaser to make a typical employment agreement safe from 409A foot-faults.
For example, to focus on just one recurring conundrum: Is it too late to tighten up a non-safe-harbor “good reason” definition to avoid a six-month delay in separation pay to a specified employee?
The answer depends on a number of factors, including:
– How far off the mark the existing good reason definition is,
– Whether you have a single-trigger or double-trigger termination arrangement,
– When employment termination might occur, and
– In the case of a double-trigger change-in-control arrangement, when the change in control might occur.
The “Good Reason” Definition Matters — Even if it is Never Triggered
As background, a “good reason” definition lists a number of employment-related indignities that if imposed upon an employee would allow her to resign and be entitled to the same severance benefits as if she had been fired without cause. Typical “good reason” triggers are a reduction in compensation, diminution of duties, or a forced relocation.
To secure a 409A exemption, the goal is to have an arrangement in which a “good reason” resignation is tantamount to an “involuntary termination” of employment. An involuntary termination can be a necessary component of both the short-term deferral exemption and the involuntary termination (two-times/two-years) exemption, but for very different reasons:
1. Under the short-term deferral exemption, an arrangement that provides for payment within a designated short time after the lapse of a substantial risk of forfeiture is not deferred compensation. Payment contingent upon involuntary termination is subject to a substantial risk of forfeiture. Resignation for a valid “good reason” is treated as involuntary termination.
2. Under the two-times/two-years exemption, the key is that the severance payment not be accessible in any manner other than an involuntary termination (which can include a resignation for a valid “good reason”).
If the contractual “good reason” definition does not meet the safe-harbor definition in Treas. Reg. §1.409A-1(n)(2)(ii), it still may be in the “close enough” category described in Treas. Reg. §1.409A-1(n)(2)(i). The problem is that you cannot be 100% confident that the Service would agree with your assessment of “close enough,” and there is probably not going to be an IRS agent standing by at the termination date to give a thumbs up or down. Some people yearn for more certainty.
For Those Who Yearn for More Certainty
Here are the possibilities of what you can do at this point:
– If you have an existing good reason definition that is “close enough” to be deemed an involuntary termination trigger (see Treas. Reg. §1.409A-1(n)(2)(i) to make an informed decision as to this), then there is still time in 2008 to change to the safe-harbor definition and be confident of the ability to satisfy either the short-term deferral exemption or the two-times/two-years exemption (assuming all other exemption requirements are met).
– If you have a single-trigger arrangement and the existing good reason definition is not “close enough” to be deemed an involuntary termination trigger, then it already is too late to change to the safe-harbor definition for purposes of regaining the ability to satisfy the short-term deferral exemption. This because the “bad” good reason definition makes the payment not subject to a substantial risk of forfeiture, and you can never regain that once is it lost. (Sound familiar?)
– BUT, if (1) you have a double-trigger arrangement (i.e., must first have a CIC followed by resignation for good reason or termination without cause), and (2) the CIC has not yet occurred and will not occur in 2008, then there is still time to change even a blatantly bad good reason definition to the safe-harbor good reason definition for purposes of regaining the ability to satisfy the short-term deferral exemption.
– Regardless of how bad your current good reason definition is, you can still change it to the safe-harbor definition and avail the (less generous) two-times/two-years exemption. This is because the two-times/two-years exemption is not concerned with whether the severance payment was ever subject to a substantial risk of forfeiture (so you can reform a woefully deficient definition), as long as it does not apply to a termination occurring in 2008). . Whew!
All This Just to Avoid a Six-Month Delay in Payment?
An executive who has negotiated a lenient good reason definition may well conclude that a six-month delay in payment is a small price to pay for the increased chance of triggering the severance payment in the first instance. That decision is a personal one and will be influenced by the facts and circumstances.
However, I am in the camp that it is generally worth positioning for a 409A exemption where possible (assuming the executive is willing to change the good reason definition) — not just to avoid the six-month delay but also to preserve flexibility to make changes to the agreement in the future without the worry of “substitution” issues and to avoid later complications if Congress pursues the annual dollar cap on Section 409A deferrals. Who knows how that cap and the ensuing rules would be applied to non-exempt separation pay arrangements.
Limited Time to Take Action
Whatever you do, be quick about it! As expressed in Notice 2007-78, the Service views the modification of a good reason definition as a change in time or form of payment, which must be done in 2008 to be within the transition rule – so it does not work if the termination of employment occurs in 2008. It’s a head-scratcher why a change to make the payment more difficult to earn upon termination of employment (by changing to a more stringent definition of good reason) is changing the time of payment – the payment trigger is “separation from service” in any event.
The key is that by availing an exemption, the change is avoiding the six-month delay for specified employees and is thereby accelerating payment, at least in part. Best to go ahead and make any changes to the good reason definition in 2008 if you are so inclined.