Executive Compensation In 2009

This newsletter provides an overview of the following seven areas of executive compensation:

Applicable to Most Employers

• The IRS correction program for certain operational violations of Internal Revenue Code section 409A (“Section 409A”).
• Reporting obligations for incentive stock options (including ESPP grants) that must be made by January 31.
• The U.S. Department of Labor Top-Hat filing requirements for nonqualified plans subject to the Employee Retirement Income Security Act of 1974 (“ERISA”). This filing must be made within 120 days of the date the plan first becomes subject to ERISA.
• Relief from W–2 and 1099–MISC reporting obligations for deferrals made under arrangements subject to Section 409A.

Applicable to Publicly Traded Employers

• Preparing for the 2009 Proxy Season — Some “Hot Issues” to consider.
• The 8–K filing obligations for nonqualified deferred compensation plans sponsored by reporting companies.

Applicable to Certain Financial Institutions

• The Troubled Asset Relief Program (“TARP”).

The IRS Correction Program For Certain Violations of Section 409A

Violation of Section 409A

If a nonqualified deferred compensation plan fails to comply in operation with Section 409A(a) (i.e., rules regarding time of payment, anti-acceleration of payments and deferral elections), the deferred compensation is includable in income for the affected participants at the time the deferred compensation ceases to be subject to a substantial risk of forfeiture. It is then subject to a 20% federal tax as well as late payment and interest charges (if applicable), in addition to ordinary federal income taxes. California also imposes its own 20% resident tax, in addition to ordinary state income taxes.

For example, assume that a company’s nonqualified deferred compensation plan allowed for payment to a participant more than thirty days before the time specified in his election. Failure to correct that error would result in severe tax penalties to that participant. Hence, correcting the error is imperative.

On December 8, 2008, proposed Treasury Regulations were published regarding the calculation of the amount of deferred compensation includible in income upon a violation of Section 409A and the taxes resulting from that violation. (This Article does not discuss those proposed regulations.) Thankfully, around the same time, the Internal Revenue Service (“IRS”) issued Notice 2008–113 (“Notice”) which establishes a correction program for certain operational failures of Section 409A that can be used to obtain relief from the severe penalties described above.

It should be noted that the Notice does not contain a correction program for documentary failures. The corrections outlined in the Notice permit selfcorrection, but violations must still be reported to the IRS. Any corrective actions taken pursuant to this Notice should be carefully documented.

The General Requirements

For any of the corrections, the taxpayer has the burden of demonstrating that the taxpayer was eligible for the relief and that the requirements of the Notice have been met. The error must be an inadvertent and unintentional operational error. Any application of relief in the Notice is subject to examination by the IRS. In addition, for any of the corrections:

• the company must take reasonable steps to avoid recurrence of the operational failure;
• if the same or substantially similar operational failure has occurred previously, the relief is not available for any taxable year after December 31, 2009, unless the company demonstrates that it had established practices and procedures reasonably designed to ensure that this operational failure would not recur;
• the relief is not available to participants who are under examination by the IRS;
• the participant must repay the company the amount erroneously paid (meaning the gross amount, before the application of any withholding requirements);
• the relief is not available if the company experiences a substantial financial downturn;
• if the correction involves an adjustment to reflect earnings and losses, and it is impracticable to make the adjustments by the specified deadline, the company and the participant must have a legally binding right to have these adjustments made; and
• the information and reporting obligations in the Notice must be met.

Definition of Insider

Certain sections of the Notice contain additional requirements (or do not provide relief) for Insiders. An Insider is a director, officer, or a person who is (directly or indirectly) the beneficial owner of more than 10% of any class of any equity security of the company. If the company is not a corporation, these rules are applied by analogy.

Correction Programs

Each of the corrections listed below have additional requirements from those set forth above. This summary is not intended to set forth all of the requirements, but only a brief summary of the corrections.

• Failure to Defer Amount or an Incorrect Payment of an Amount Payable in a Subsequent Year, Corrected in the Same Taxable Year As the Failure
  This correction applies to amounts that should not have been paid or made available to the participant in a specific year but were erroneously paid during that year (other than the failure to meet the six-month delay for specified employees) when the correction is made in the same taxable year. There are no tax penalties for this correction.
• Incorrect Payment of Amounts Payable in the Same Taxable Year or Incorrect Payments Made in Violation of the Six–Month Delay Rule for Specified Employees, Corrected in the Same Taxable Year as the Failure
  This correction applies if the amount deferred:
  • should not have been paid or made available to the participant until a later date in the same taxable year;
  • was paid or made available more than thirty days before the due date of the payment;
  • or was made in violation of the six–month delay rule for specified employees.

  To be eligible for this correction, the repayment must occur in the same year as the failure occurred. There are no tax penalties for this correction.

• Excess Deferral Amount Corrected in the Same Taxable Year
  This correction applies if an amount that should not have been deferred is credited to the participant’s account or otherwise treated as deferred under the plan, and a correction is made for those amounts in the same year that the error occurred. There are no tax penalties for this correction.
• Correction of Exercise Price of Otherwise Excluded Options
  This correction applies if under the terms of a stock right, the stock right would not have been subject to Section 409A except that the exercise price is erroneously established at less than fair market value of the underlying stock at the date of grant. The correction must be made before the stock right is exercised and not later than the last day of the employee’s (or non-employee’s) taxable year in which the grant is made, by resetting the exercise price to an amount not less than the fair market value of the underlying stock on the date of grant. There are no tax penalties for this correction.
• Correction of Certain Operational Failures Involving Non-Insiders in the Year Following the Year in Which the Failure Occurs
  There are corrections for similar failures to those listed above that are not corrected until the year following the year in which the failure occurred. These corrections only apply to Non-Insiders. Reduced tax penalties apply for these corrections.
• Relief of Certain Operational Failures Involving Limited Amounts
  There are special more favorable corrections that may be used if the amount involved is less than the applicable limitation under Section 402(g)(1)(B) of the Internal Revenue Code (the “Code”) (which for 2009 is $16,500) and all corrective action is taken not later than the end of the second taxable year following the year in which the failure occurred.
• Other Operational Failures
  There are corrections for failures that are corrected in a year after the year in which the failure occurred, that involve either an Insider or amounts over the applicable limitation under Code section 402(g)(1)(B). Reduced tax penalties apply for this correction.

The Notice contains some special transition relief for errors that occurred on or before December 31, 2007. Specifically, the year 2009 will be treated as the immediately next following year to any year on or before December 31, 2007. For example, if the failure occurred in 2006, 2009 will be treated as the immediately next following year. Hence, if the failure occurred in 2006 and is corrected in 2009, it will be eligible for the correction in which the proper corrective action is required be taken in the immediately following year. The failure will therefore be eligible for the more favorable corrections set forth in the Notice.

It is imperative that the plan correct failures as early as possible in order to avoid the severe tax penalties for violations of Section 409A.

Reporting Obligations For Incentive Stock Options (Including ESPP Grants)

Section 6039 of the Code currently requires a corporation to furnish a written information statement (the “Statement”) to each employee (or former employee) by January 31 of the year following the year in which the employee exercises incentive stock options qualifying under Code section 422 (“ISOs”) or sells or otherwise transfers shares acquired under an employee stock purchase plan under Code section 423 (“ESPP”). Section 6039 has also been amended to require corporations to file an annual information return (the “Return”) relating to ISOs exercised and ESPP shares sold or transferred. New proposed Treasury regulations under Sections 1.6039–1(a) and 1.6039–2(a) (relating to ISOs) and Sections 1.6039–1(b) and 1.6039–2(b) (relating to ESPPs) set forth the content, time and manner for filing the Return and delivering the Statement to employees. However, the proposed regulations also provide that:

• corporations are not required to file a Return for stock transfers that occur during the 2008 calendar year: and
• corporations may continue to rely on the 2004 regulations (or comply with the new regulations) for issuing Statements to employees relating to stock transfers in 2008 relating to ISOs or an ESPP.

Therefore, for ease of administration, we recommend that corporations rely on the 2004 regulations and current forms for issuing Statements due on or before January 31, 2009. We will keep you updated for 2010 on the new forms for the Return and Statements.

For specific details on what must be included in the statements provided to participants by January 31, please contact our office.

Top-Hat Filing Requirements For Nonqualified Plans Subject To ERISA

A “top-hat” plan is a nonqualified deferred compensation plan that is unfunded and maintained by the company primarily for the purpose of providing deferred compensation to a select group of management or highly compensated employees. A top-hat plan is not subject to substantive requirements of ERISA, but it does remain subject to ERISA’s reporting and disclosure requirements.

The Department of Labor (“DOL”), under Section 2520.104–23 of its regulations has established a simple alternative compliance method for top-hat plans to meet its disclosure requirements. A top-hat plan must file a brief statement with the DOL within 120 days of the date the top-hat plan first becomes subject to ERISA. The company must also agree to provide the plan documents to the DOL upon request.

Relief From W–2 And 1099 Reporting Obligations For Deferrals Under Arrangements Subject To Section 409A

In December of 2008, the IRS published Notice 2008–115, which modified the reporting obligations for employers and payers reporting amounts deferred under nonqualified deferred compensation plans that are subject to Section 409A. Specifically, the Notice stated that until further guidance was issued:

• An employer is not required to report amounts deferred during the year under a nonqualified deferred compensation plan subject to Section 409A in Box 12 of Form W–2 using code Y; and
• A payer is not required to report amounts deferred during the year under a nonqualified deferred compensation plan subject to 409A in Box 15a of Form 1099–MISC.

If an employer must include an employee’s (or non-employee’s) deferred amounts in gross income due to a violation of Section 409A, these amounts are reported as Section 409A income in Box 12 of Form W–2 using code Z (and Box 15b of Form 1099–MISC).

Preparing For The 2009 Proxy Season — Some “Hot Issues” To Consider

Due to the current financial crisis there is increased action by shareholders and politicians to remedy much reported shortcomings in corporate America. Consequently, management and boards need to begin preparing strategic changes to company policies or well-analyzed explanations supporting their positions. Below are some of the “hot” topics that should be considered and/or addressed in the Compensation Discussion and Analysis (“CD&A”) for the 2009 proxy season.

Poor Pay Practices

Prepare for shareholder and legislative proposals addressing compensation practices and policies. Advisors, such as RiskMetrics Group, have classified as “poor pay practices” tax gross-ups for executive perks or for the excise taxes on golden parachute payments, single trigger change-in-control payments and payments of dividends or dividend equivalents on unearned performance pay. If these practices have been provided to executives because of “market demand,” instead of part of a comprehensive corporate growth and incentive package, it is going to be difficult to justify those pay practices to shareholders. This year it appears that shareholders will again propose “say-on-pay” and “pay-for-performance” policies or that “clawback” programs be implemented for executive pay in the event of a financial restatement or poor performance.

Under financial bailout laws passed by Congress, any company receiving assistance under the law is prohibited from offering incentives that encourage “unnecessary and excessive risks” to its senior executives and from making golden parachute payments to a senior executive. The law also gives “clawback” powers to recover senior executive bonuses or incentive pay based on earnings, gains, or other data that proves to be inaccurate. Currently, there are legislative proposals to extend these laws to all public companies. At a minimum, all companies should analyze whether their executive compensation policies provide these protections to shareholders. If would be prudent not only to disclose that the compensation committee has met with and vetted the compensation programs with the company’s risk officers, but also to disclose how the compensation programs are designed so that senior executives will not have incentives to take risky action that could damage shareholders’ long-term interests.

Pay and Performance

Shareholders also are looking at aligning management’s interests with shareholder’s long-term outlook through “hold-til-retirement” equity programs and to rationalize executives’ pay by requiring a more comprehensive wealth analysis of executives’ pay, and explanations about the internal pay gap between CEOs and lower level executives. Shareholders want to know that executive pay is designed to reward performance and want disclosures evidencing that compensation committees are discussing multiple performance metrics, analyzing changes in peer groups and ensuring that their consultants are providing independent advice.

John White, Director of the Division of Corporate Finance at the Securities and Exchange Commission (“SEC”), has indicated that disclosure of performance targets for executive compensation could be an area of focus in 2009. He stated that where performance targets are omitted, the SEC would request a legal analysis justifying the omission and demonstrating a nexus between the nondisclosure and any competitive damage. Therefore, it will be better for companies to disclose a contemporaneous analysis of why the nondisclosure will cause competitive damage.

Repricing and Resetting

Shareholders want clear policies on option repricing that reflect more than mere market deterioration. As indicated above, shareholders do not want compensation committees resetting performance measurements and guaranteeing that executives are paid regardless of how the company performs. Company disclosures should show a nexus between future company performance and any repricing or resetting.

Poison Pills

Companies should analyze and disclose any agreements that create a so-called poison pill in the event of a take over of the company. Consistent with past years, RiskMetrics is proposing that corporations eliminate or require shareholder approval of poison pills. RiskMetrics has stated that it will recommend withholding or voting against a board of directors that adopts or continues a poison pill agreement without shareholder approval.

Section 409 Compliance

The IRS has stated that public statements in SEC disclosures are presumed to be true. Therefore, companies need to take special care when explaining the “good faith” compliance and plan document revisions made to comply with Section 409A.

Conclusion

Preparing answers to shareholder issues now not only will prepare management to deal with shareholder proposals, but also will pacify shareholders that seem increasingly willing to join “no vote campaigns” for board members who are not addressing these issues. In addition, companies should not wait to prepare these changes and explanations just for inclusion in the company’s CD&A, but should adopt the changes earlier so the CD&A can reflect the company’s current implementation success stories.

Proxy disclosures should be part of the company’s overall communication process with investors, the government and the public to help shape media attention, anticipate shareholder concerns at annual meetings and emphasize the board’s achievements in linking pay to performance. Advance communication of the company’s adoption of revisions to its executive compensation policies or programs could create goodwill with shareholders that could lessen the adversarial nature of some meetings, or avoid proxy contests.

The 8–K Filing Obligations For Nonqualified Deferred Compensation Plans Sponsored By Reporting Companies

Item 5.02(e) of the General Instructions to Form 8–K requires public companies to file a Form 8–K with the Securities Exchange Commission within four business days after entering into, adopting or otherwise commencing a material compensatory plan, contract or arrangement (or after materially amending or modifying the plan, contract or arrangement) in which the company’s principal executive officer, principal financial officer or a named executive officer participates. In addition, if the company makes a grant or award under one of the arrangements described above, or materially modifies the grant or award, the company’s obligation to file a Form 8–K also is triggered. If the adoption or modification requires shareholder approval, then the Form 8–K must be filed within four business days of the shareholders’ approval. A copy of the plan, contract, arrangement or amendment may either be filed with the Form 8–K, or with the next Form 10–Q or 10–K.

If a company does not file a Form 8–K pursuant to Item 5.02(e) for a plan, contract or other compensatory arrangement (or for a material amendment or modification) that was recently adopted and in which a covered employee participates, the SEC provides a limited safe harbor protecting companies from liability under Section 10(b) and Rule 10b–5 of the Securities Exchange Act of 1934, as amended. The safe harbor applies until the due date for the company’s next Form 10–Q or Form 10–K for the applicable period.

Troubled Asset Relief Program

On January 15, 2009, the U.S. Treasury Department released an interim final rule setting forth certain restrictions on compensation payable to certain senior executives of banks and other eligible financial institutions participating in TARP. In general, TARP is a program designed to provide emergency economic relief to troubled financial institutions. However, the disposition of this rule became unclear when President Obama’s administration began a review affecting all proposed and final regulations that have been submitted to the Office of the Federal Register but not yet published. This interim final rule was to be published on January 21st in the Federal Register, but did not appear on that date or any subsequent date up to the date of this newsletter. The January 15th interim final rule would have, among other things, revised the current executive compensation standards issued in late 2008 and added reporting and recordkeeping requirements. We will keep you informed you of any future developments relating to this interim final rule.