Federal Securities Lawyer & Attorney : Porter Wright Law Firm : Securities Exchange Law : Serving Ohio, Washington DC, Florida

The IRS issued Revenue Ruling 2008-13 to clarify what constitutes “performance-based” compensation under Internal Revenue Code Section 162(m).  This classification is important because Code Section 162(m) generally prohibits public companies from deducting compensation in excess of $1 million to the CEO and certain named executive officers.  If the compensation is performance-based, however, this deduction limitation does not apply.

Under prior guidance, an executive could receive a performance award (either cash or equity) upon involuntary termination without cause, termination for good reason, or retirement, without regard to whether performance goals were actually met. In Revenue Ruling 2008-13, the IRS reversed its position, holding that such an award will not be treated as performance-based compensation under Code Section 162(m). This ruling puts many executive compensation plans and employment agreements at risk in light of the new restrictions on deductions for non-performance-based compensation that exceeds $1 million.

For more information on this latest guidance, you may view our recent law alert.

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Last week the House of Representatives Committee on Oversight and Government Reform rescheduled a hearing on CEO termination payments in connection with the mortgage lending crisis. In January, Committee Chairman Henry Waxman sent letters to Citigroup, Merrill Lynch and Countrywide Financial asking them to justify payments to outgoing CEOs despite significant subprime-related losses and decreasing stock values. The hearing follows a December 2007 hearing on the use of compensation consultants to determine CEO pay. Scheduled to testify, presumably to justify their compensation, are Angelo Mozilo, CEO of Countrywide, E. Stanley O’Neal, former CEO of Merril Lynch, and Charles Prince, former CEO of Citigroup.

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The SEC has published its observations regarding executive compensation disclosure for the first round of proxy statements that were filed under the new executive compensation rules. In summary, two themes were the focus of the report:

1. The Compensation Discussion and Analysis (CD&A) needs more attention to how and why compensation decisions are made; and
2. Companies are encouraged to think about how they present information, including by use of plain English, tables, and graphs.

The full report contains suggestions for improved disclosure and an explanation of the types of comments that the SEC issued. The following are some highlights:

1. Emphasize material information and de-emphasize less important information;
2. In the CD&A, emphasize the how and why of compensation levels and de-emphasize compensation program mechanics;
3. Charts, tables, and graphs not required by the rules were almost always helpful (for example, tables that explain payments upon a hypothetical termination or change-in-control);
4. Disclosure that is clear and concise does not have to be long;
5. Disclose how decisions affecting one element of compensation affected other elements as well; and
6. Explain how subjective performance targets translate into objective pay determinations.

The SEC isn’t the only one concerned with executive compensation. Executive compensation has been mentioned by some of the front-runner candidates for president and recently by President Bush. Specifically, compensation for CEOs of large companies may be a point of discussion in next year’s election.

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As the SEC continues to review the first round of proxy statements filed last spring under the new executive compensation rules, publicly traded companies should consider thinking about how to improve disclosures for next year.

The importance of analyzing compensation decisions, as opposed to merely stating what types of compensation are paid, is evident by the language of the rules for drafting the Compensation Discussion & Analysis (CD&A) section of the proxy statement. The rules require that the following material elements of compensation for named executive officers be discussed, described, and explained:

1. the objectives of the compensation program;
2. what the compensation program is designed to reward;
3. each element of compensation;
4. why the company chooses to pay each element;
5. how the company determines the amount/formula for each element; and
6. how decisions regarding each element fit into the compensation objectives.

 The following are suggestions for improved disclosure, as prompted by the new rules:

• Keep detailed minutes throughout the year regarding not only what compensation decisions are made but why they are made. When compensation decisions are made, the compensation committee should articulate, in writing, as many aspects of elements (1) through (6) above as possible. This allows an understanding of compensation decisions to develop throughout the year as opposed to at the last minute when it comes time to draft the proxy.
• Amend the compensation committee charter to state that the committee will review and discuss disclosures in the CD&A with management and recommend that such disclosures be included in appropriate filings.
• Draft a related party transactions policy. The new rules require companies to explain how such a policy is evidenced if not in writing. This policy will be the responsibility of either the audit committee or the nominating committee and will describe the policies for review, approval, and ratification of any related party transactions required to be disclosed.
• Monitor perks paid to executives and directors throughout the year to avoid embarrassing items that are hard to justify.
• Draft future stock option plans to ensure that a stock option’s exercise price is the same as the company’s stock price on the date of grant. Increased disclosure is required if this is not the case, including a description of the company’s methodology for determining the exercise price.
• Draft future employment agreements in a manner that makes it easy to determine what executive officers will be paid upon a hypothetical termination or change in control. Determining what executives will be paid at termination is a necessary exercise for both public and private companies that use employment agreements, but the provisions that control payments are often unclear.

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Earlier this week former Brocade CEO Gregory Reyes was found guilty of all charges in connection with stock option backdating and failing to report such backdating to auditors, regulators, and investors. This is the first conviction of an executive in the government’s option backdating investigation, and it occurred despite the fact Reyes never cashed in on his backdated options.

Reyes faces years of prison time and significant fines. More convictions are expected in a post-Enron era where juries are willing to convict not only instigators of backdating plans, but those who go along with illegal practices as well.  

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The IRS has issued a directive identifying backdated stock options as a Tier 1 Compliance Issue. The directive explains the tax implications of backdated options, including the fact that options backdated to produce a “build-in” profit do not qualify as incentive stock options (ISOs). Corporations that intended backdated options to qualify as ISOs may be required to withhold and pay income and employment taxes when the option is exercised, and the individual may owe additional taxes at the time of exercise. As the directive explains, there are also 162(m) and 409A issues.  

The designation of option backdating as a Tier 1 Compliance Issue means it is a mandatory examination item for taxpayers with backdated stock option grant and/or exercise prices.

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The IRS has revised the definition of “covered employee” under Section 162(m) of the Internal Revenue Code. The old definition used to mirror the SEC’s definition of Named Executive Officer (officers for whom compensation must be disclosed), but the SEC’s recent changes to executive compensation disclosure rules caused the two definitions to be out-of-sync.

Under new guidance from the IRS, the text of which is not yet available on the IRS website, “covered employee” means any employee who is either the principal executive officer or whose total compensation is required to be reported by the SEC for being one of the three highest paid officers. This definition aligns 162(m) with the SEC’s new executive compensation disclosure rules. Interestingly, a corporation’s principal financial officer is excluded as a “covered employee” if his or her compensation disclosure required by the SEC is simply on account of he or she being the principal financial officer.  

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As our corporate department recently reported, the U.S. Treasury has issued final regulations under Internal Revenue Code Section 409A. The following includes a summary of actions that employers should take by December 31, 2007 to comply with the final regulations and to guard against taxation of nonqualified deferred compensation and a 20 percent excise tax:

1. Review all types of compensatory arrangements to determine whether they are subject to Section 409A. Arrangements that create a legally binding right to compensation in one year that is payable in a later year are typically subject to Section 409A.
2. Amend plan documents in writing to comply with Section 409A.
3. Determine which nonqualified plan deferrals that are linked to qualified plans comply with Section 409A and which ones do not. The arrangements that are not in compliance with Section 409A should be unlinked from the qualified plans or amended.
4. Consider amending plan documents to allow participants to change the time and form of payment of amounts subject to Section 409A.
5. Consider whether stock rights that are not exempt from Section 409A should be replaced with stock rights that are exempt.
6. Update severance and employment arrangements in light of the final regulations.

Click here for the full text of the Executive Compensation Law Alert.

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