executive compensation - some developments and reminders
TRANSCRIPT
Executive Compensation - Some Developments and Reminders
Quarles & Brady LLPJanuary 12, 2017
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PresentersKen HallettPartner, Business [email protected]
Amy CiepluchPartner, Labor & [email protected]
Robert LewisAssociate, Labor & [email protected]
Executive Compensation Generally
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Executive Compensation• Beyond “benefits” - seeking to align the interests of
officers/key managers and owners through salary, short and long term financial incentives
• Executive compensation touches on many areas of law, including corporate, securities law, labor and employment
• Requirements originate from various sources, depend on whether a company is public or private• Internal Revenue Code – public and private• Other laws/regulations (e.g., Dodd-Frank) – public • NYSE/NASDAQ – public• Governance organizations (e.g., ISS, Glass-Lewis) – public• Institutional shareholders – public
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Related Tax Rules• Several Internal Revenue Code sections govern executive
compensation, which generally apply to both public and private companies. • Section 409A — Deferral rules• Section 280G and Section 4999 — Golden parachute rules• Section 162(m) — $1 million compensation deduction limit
(only applies to public companies)
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Dodd-Frank Act, Section 956 and Developments
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Introduction – Dodd-Frank Act, Section 956• Section 956 of the Dodd-Frank Act requires U.S. financial
regulators to issue rules prohibiting types and features of incentive compensation arrangements that “encourage inappropriate risk-taking” at “Covered Financial Institutions”
• Proposed rules were revised in 2016, purportedly to reflect the latest practices of financial institutions and to align with rulemaking by foreign regulators
• Compliance would be required by no later than the beginning of the first calendar quarter that begins at least 540 days after final rule is published• The proposed rule would not apply to any incentive-based
compensation plan with a performance period that begins before the compliance date
• For calendar year institutions, the earliest that the new rules would apply is for periods beginning January 1, 2019
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Pause: But, We're Not a Bank• While Dodd-Frank 956 is initially limited to large financial
institutions, it’s likely to affect others• Experience from say-on-pay votes• Changing the vocabulary, points of reference• Changing perception of best practices• ISS/institutional pressure
• Also changes the use of some terminology, which may creep into general parlance
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Covered Financial Institutions and Covered Employees
• “Covered Financial Institutions” – classified by average total consolidated assets:• Level 1: $250 billion or more• Level 2: $50 billion or more but less than $250 billion• Level 3: $1 billion or more but less than $50 billion
• Level 1 and Level 2 CFIs would be required to subject “Qualified Incentive-based Compensation” for “Senior Executive Officers” and “Significant Risk-Takers” to: deferral of payment; risk of downward adjustment and forfeiture; and clawback
• “Senior Executive Officers” include heads of major corporate, risk, and control functions – broader than the SEC's “Executive Officer” definition
• “Significant Risk-Takers” are determined based on compensation and exposure; goes beyond officers
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Covered Financial Institutions and Covered Employees (cont.)
• Level 3 CFIs would generally only be subject to a basic set of prohibitions and disclosure requirements• Exceptions would apply to Level 3 institutions where the
activities, complexity of operations, risk profile, etc., consistent with those of a larger institution
• Each Level 3 institution’s governing regulatory agency would have the discretion to determine the applicability of the proposed rules
• Bottom line – initially only applies to very large institutions• But, effects still likely to go beyond them
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• Mandatory deferral of a portion of all Incentive-based Compensation awarded to a Senior Executive Officer or Significant Risk-Taker• "Incentive-Based Compensation" – any variable compensation,
fees, or benefits that serve as an incentive or reward for performance
• Deferral requirements vary depending on role and whether long-term or not• Can be up to 60% of Incentive-Based Compensation• Up to four years• Generally shorter deferrals for long-term compensation
• Deferrals are from the time of the “award” – which means the time when we normally considered an award to “vest” at the end of a performance period
Deferral Requirements
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• Deferred awards may not vest faster than pro-rata, on an annual basis
• Deferral must include substantial portions of equity-like instruments and cash
• Options may not represent more than 15% of the required deferral
• Required deferral can only accelerate on death or disability• Potential benefit – may reduce compensation expense• Tax issue – likely taxable to executive before the holding
period expires• Mere clawback isn’t a sufficient risk of forfeiture to delay taxes
Additional Prohibitions/ Requirements for Deferrals
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Forfeiture, Adjustment, Clawback• For defined Risk Events/Failures, deferred compensation
subject to: • Forfeiture (after Performance Period ends) • Downward Adjustment (during Performance Period)
• Risk Events/Failures go well beyond restatements, such as:• “Inappropriate risk-taking”• Regulatory non-compliance• Risk management or control failures
• Compensation also subject to clawback for a period of 7 years• Measured from “vesting” (meaning after the deferral period,
not the end of the performance period)
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• Prohibits CFIs and Covered Persons from hedging deferrals• Establishes maximum amounts to Incentive-based
Compensation opportunities • Creates standards for performance measures
• Cannot rely solely on relative measures• Cannot rely solely on transaction or revenue volume measures
without regard to transaction quality• Requires risk management and compliance systems • Mandates an independent compensation committee
• Must receive input to evaluate risk
Additional Prohibitions/ Requirements
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• Will require that plans and award agreements be reviewed and amended for compliance
• Need to create effective processes to evaluate risk• Does this cause executives to demand more non-incentive
pay?• How much will now serve as a base expectation for
institutional shareholders or governance groups?• Will this be pushed through in the new Administration?
Practical Consequences/Questions
Section 409A Basics and Developments
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Section 409A Basics• Section 409A (i) requires:
• Requires any election to defer compensation to made by certain deadlines;
• Restricts payment of the compensation to certain objective payment triggers; and
• Generally prohibits the parties from accelerating or further deferring the payment.
• A violation of Section 409A typically results in the service provider (e.g., the employee) recognizing immediate taxable income, paying a 20% penalty and paying interest.
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Basics: Plan Types Under 409A• Account balance plans for non-elective deferrals• Account balance plans for elective deferrals• Non-account balance plans• Involuntary separation or window program payments• Reimbursement plans• Certain foreign plans• Stock rights• Split dollar• All other
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Basics: Deferrals Can Come From Anywhere…• Employment Agreements• Supplemental Executive
Retirement Plans• Severance Arrangements• Stock Option Plans• Split-Dollar Life Insurance• 457(f) Plans• Commission
Arrangements• Medical or Other
Reimbursement• Tax Gross-Up Agreements
• Nonqualified Defined Contribution and Defined Benefit Plans
• Phantom Stock Plans• Restricted Stock Units• 401(k) “Wrap” Plans• Excess Benefit Plans• Bonus & Incentive Plans• Change in Control
Agreements• Foreign Plans not Covered
by Treaty
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Basics: Exceptions to 409A• Short Term Deferrals
• Payment is received no later than 2 ½ months after the year in which the employee is vested
• Payments to be paid under written arrangement between January 1 and March 15 of the following year can be paid up to the end of that calendar year
• If arrangement not in writing, amounts paid after March 15 of the following year will violate Section 409A
• Involuntary Severance Payments• Payments triggered by involuntary termination of employment• Up to 2 times pay or, if less, $540,000• Payable within 2 years of termination
• Other Exceptions Permitting Delay of Certain Payments:• Administratively impracticable and unforeseeable• Jeopardize status as a going concern• Payments for which Section 162(m) would limit the deduction
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IRS Clarifies Numerous 409A Issues• June, 2016 IRS proposed regulations (the "2016 Proposed
Regulations") clarify 19 fairly narrow issues under existing Code section 409A regulations
• The 2016 Proposed Regulations generally formalize informal guidance provided by IRS personnel in recent years and provides some helpful new flexibility in certain areas
• Taxpayers may rely on the 2016 Proposed Regulations immediately
• Focus on most significant clarifications
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IRS Clarifies Numerous 409A Issues (cont.)• Payment of Deferred Compensation Defined
• The 2016 Proposed Regulations clarify what is treated as a payment of compensation for purposes of Code Section 409A
• An amount is treated as paid or received for purposes of Code Section 409A when a taxable benefit is actually or constructively received• Examples: transfer of cash, transfer of property taxable under
Code Section 83, transfer to a “secular” trust taxable under Code Section 402(b), or income inclusion under Code Section 457(f) (affecting ineligible deferred compensation of tax-exempt employers)
• Amounts taxable under Code Sections 83 or 402(b) generally are not treated as “paid” until includible in income (generally on vesting or pursuant to an 83(b) election)
• The transfer of an option that does not have a readily ascertainable fair market value (such as a typical compensatory option) is not treated as a “payment” for this purpose
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IRS Clarifies Numerous 409A Issues (cont.)• Beneficiaries Treated Like Participants
• Death of a Beneficiary• Death of a beneficiary, like the death of a participant, can now
clearly serve as a permissible payment event• For example, a plan could provide that installment payments
being made to a participant continue to be made on the same schedule to a beneficiary after the participant’s death, but upon the death of the beneficiary remaining benefits are paid in a lump sum
• Intervening Events• Currently the regulations allow a plan to provide for a change in
timing for payments that have already commenced based on an intervening event
• For example, a plan could provide that payments that commence upon a separation from service will be accelerated and paid in a lump sum upon a participant’s death
• The 2016 Proposed Regulations provide that such an intervening event plan provision may be based on the death, disability or unforeseeable emergency experienced by a beneficiary
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IRS Clarifies Numerous 409A Issues (cont.)• New Payment Flexibility on Death
• Post-Death Payment Period• A plan can now provide that a payment triggered by a death (of a
participant or a beneficiary) will be made or commence during any period falling within the timeframe from (1) date of death to (2) December 31 of the year following the year of death (instead of being limited to the normal 90 day post-event period)
• Any such period specified in a plan can be changed within this permissible range without running afoul of the Code Section 409A rules on changes in payment timing
• Deemed Timely Payment• Regardless of any post-death payment period specified in a plan,
payments will be treated as made or commencing on time as long as the payment is made or commences between (1) date of death, and (2) December 31 of the year following the year of death
• The payment recipient may elect the year of payment without running afoul of the section 409A rules (although the normal constructive receipt rules may present an issue here)
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IRS Clarifies Numerous 409A Issues (cont.)• Correction of Unvested Amounts
• The 2016 Proposed Regulations add considerable specificity in terms of anti-abuse requirements, including that • the arrangement must be noncompliant with Code Section 409A
prior to the change• there is no pattern or practice of permitting similar failures, • the correction generally be consistent with prescribed corrections
under IRS corrections guidance (such as in IRS Notice 2008-113 and IRS Notice 2010-6), and
• that a method of correction be consistently applied• The requirement to conform to correction methods specified in
IRS corrections guidance for unvested amounts can be expected to significantly alter how many of these corrections are performed
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IRS Clarifies Numerous 409A Issues (cont.)• Other Clarifications
• Separation from Service for Dual Status Employees• When an individual moves from employee status to independent
contractor status, whether he experiences a “separation from service” at that time depends on the employee rules
• If there is no separation at that point, the independent contractor rules apply in determining whether a separation occurs thereafter
• Termination and Liquidation of Plan• If an employer takes advantage of the plan termination and
liquidation rules for one plan, all plans of the same type (e.g., nonqualified elective deferral plans) maintained in the controlled group must be terminated
• Two Times Pay Exemption for Severance• The current regulations exempt certain severance
arrangements limited to “two times pay"• The 2016 Proposed Regulations describe how this exemption
applies to individuals hired and terminated in the same year
Section 280G: Golden Parachute Rules and Section 162(m): Compensation Deduction Limit
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What are Golden Parachute Payments?• Payments are parachute payments if:
1. Made in the “nature of compensation”,2. Made to a “disqualified individual” (DI), (e.g. an officer, a
shareholder, or highly compensated individual),3. Contingent on a change in the ownership, control, or assets of
the corporation, and4. The aggregate present value of the compensation payments
equals or exceeds 3 times the base amount
• Two basic penalties:1. The company loses its deduction for a portion of the
compensation paid, and2. The individual pays 20% excise tax on the compensation
deemed to be an excess parachute payment
The Consequences
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• Applies only to publicly held corporation• No deduction allowed for applicable compensation paid
during the year• To any covered employee• That exceeds $1 million dollars
• Covered employee• CEO and 4 highest paid officers required to be reported under
Securities Exchange Act (CFO gets excluded from this definition)• Applicable compensation equals all deductible
compensation before application of this limit except• Commission• Performance based compensation
• Performance based compensation must be paid under plan approved by shareholders at least as frequently as every 5 years
Section 162(m) Overview
Other Developments for Public Companies
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SEC Dodd-Frank Proxy Rules Update• Generally applicable to publicly held companies
• Except as noted, not to emerging growth companies
• CEO Pay Ratio Rule – Now final (effective for years beginning 1-1-17 • To be disclosed in following year's proxy statement ('18 annual
meeting)• Companies required to disclose:• The annual total compensation of the "Median" employee,
excluding the CEO• The annual total compensation of the CEO• The ratio of those two amounts
• Hopes for deferral/repeal – on Congress’s target list
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SEC Dodd-Frank Proxy Rules Update (cont.)• Pay for Performance
• Still proposed• Won't be effective for 2017, for calendar year companies at least
• Companies will be required to disclose:• Tabular disclosure covering up to 5 years of comp
“actually paid” to the CEO and an average of comp “actually paid” to the other NEOs
• Relationship between:• Compensation “actually paid” and the registrant’s total
shareholder return (“TSR”), and • The registrant’s TSR and a peer group return
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SEC Dodd-Frank Proxy Rules Update (cont.)• Executive Compensation Clawbacks – Proposed
• Will apply to all current and former executive officers• Current rules cover only CEO and CFO• ISS and other governance groups already look for clawback
policies• Clawback trigger event - a "Correction of Errors“
• If the issuer must prepare an accounting restatement due to the material noncompliance with any financial reporting requirement, the issuer must claw back related compensation
• Current rules cover narrower circumstances• Also applies to emerging growth companies
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• In December 2016, ISS updated its guidelines for evaluating equity-based compensation plans
• ISS continues to employ three “pillars” – 100 total points• Plan cost – 45 points• Plan features – 20 points• Grant practices – 35 points• 53 points is “passing”• Negative points are possible
• What's new?• Tweaks of the ISS plan cost formula• Expanded minimum one-year vesting requirements• Penalties for dividends on unvested awards• Greater positive weighting for performance-based grants
ISS Updated Plan Guidelines
© 2017 Quarles & Brady LLP - This document provides information of a general nature. None of the information contained herein is intended as legal advice or opinion relative to specific matters, facts, situations or issues. Additional facts and information or future developments may affect the subjects addressed in this document. You should consult with a lawyer about your particular circumstances before acting on any of this information because it may not be applicable to you or your situation.
Thank You! Questions?Ken [email protected]
Robert [email protected]