Deferred Compensation Arrangements: The Clock Is Ticking On §409A

Tuesday, July 1, 2008 - 01:00
Paul M. Ritter

Editor: Mr. Ritter, would you give us an overview of Kramer Levin's Executive Compensation Group?

Ritter: There are six lawyers in the group providing expertise from a variety of practices, including tax, labor, ERISA, litigation, corporate governance and corporate securities. We are engaged in the design and implementation of a full range of compensation arrangements, such as deferred compensation and equity-based compensation. Much of what we do currently involves §409A of the Internal Revenue Code, which covers non-qualified deferred compensation arrangements. We also are heavily involved with structuring and negotiating employment and severance arrangements.

Editor: What are some of the issues that you have seen in this area of the law in recent years?

Ritter: When I began my work in executive compensation in the mid-'80s, compensation packages for senior management mostly consisted of cash compensation. Beginning in the early '90s, a movement began among institutional investors to tie executive pay to company performance in order to better align the interests of executives with those of shareholders. Institutional investors strongly encouraged companies to utilize stock options. In response to this pressure, as well as several other factors, options increased from around 27 percent of a CEO's total compensation in 1992 to 51 percent in 2000. That period of increased option grants corresponded with the great bull market of the 1990s which, in turn, led to a dramatic increase in the compensation of many executives. Of course, a dramatic increase in the value of a company's stock during the 1990s did not necessarily reflect an executive's performance. In many cases, the increased stock values resulted from a rise in the stock market. More recently, options have become a smaller portion of compensation packages, while restricted stock, restricted stock units and performance-based plans with cash payouts have become a larger portion of the packages.

Given the current focus on and outrage with respect to executive compensation, we should remember that executive compensation was a bipartisan campaign issue in the 1992 presidential election. After Bill Clinton's election to the White House, he attempted to fulfill his campaign pledge to stop "excessive" CEO compensation by pushing for legislation, which was adopted in 1993, that generally disallows a public company's deduction for compensation paid to certain executives in excess of one million dollars. So-called "performance based compensation" is exempt from the $1 million limitation. Non-discounted stock options are considered to be performance-based compensation and, therefore, the compensation attributable to options is not subject to the $1 million limitation. This legislation was an additional reason that companies emphasized stock options as a form of compensation. If you compare the compensation packages given back in 1993 to current compensation packages, it appears that this legislation was not successful in stopping "excessive" CEO compensation.

The accounting treatment accorded stock options has also been an issue. Until the relatively recent changes in the accounting rules, options did not generally reduce the earnings of corporations and therefore received preferential accounting treatment relative to other forms of compensation. Today options are treated as an expense for the period in which they vest, which means that options are now on the same accounting playing field as other forms of compensation.

Most recently, of course, we have seen the timing of option grants as an issue.

Editor: You mentioned §409A. What has been the impact of this legislation?

Ritter: The statute took effect January 1, 2005, and we have since been in a transition period which will end on December 31 of this year. Basically, while plans subject to §409A have been required to be administered in compliance with the applicable rules since January 1, 2005, plans have until December 31, 2008 to be amended to be in written compliance with §409A. This is one of those Code provisions that appears to be simple on its face but actually extends to many arrangements that, in the past, were never contemplated as deferred compensation. A stock option, for example, is a deferred compensation arrangement, as is a stock appreciation right. Even severance can be a deferred compensation arrangement. The reach of the statute was sufficiently expansive that the regulations had to be written in such a way as to provide a variety of exceptions, including an exception for non-discounted stock options (that is, options granted with an exercise price that is not less than the then fair market value of the underlying stock). A stock appreciation right is also exempt generally so long as the threshold for determining the appreciation payable is at least equal to the fair market value of the stock on the date of the grant.

Editor: What are the penalties if you don't comply?

Ritter: First, there is an immediate inclusion in income of all deferrals made under the arrangement in the year of noncompliance as well as all deferrals made under the arrangement in prior years, to the extent the deferrals are not subject to forfeiture. Second, there is a 20 percent excise tax on the deferrals that are included in income as a result of the noncompliance. Third, there is an interest charge with respect to amounts deferred in prior years that are included in the current year's income. Thus, even if deferred compensation will not be paid for, say, five years, if the executive is currently vested and the arrangement is not in compliance with §409A, the income tax on the deferral is immediately due, not in five years. In addition, there is a 20 percent excise tax on the payment and, if the payment had been deferred in a prior year, interest would also be imposed. Section 409A was intended to get attention.

Editor: Has the heightened awareness of compensation and benefits on the part of the investing public having an impact on your practice?

Ritter: With the changes to the SEC's disclosure requirements, it is essential to know those requirements if you are going to be able to help clients with compliance and the presentation of clients' compensation policies and practices. Similarly, you must be cognizant of the changes in the accounting rules. And it is simply common sense to know how various elements of a compensation package, like the use of the company plane for personal trips or reimbursement for multiple country club memberships and annual dues, are perceived by the investing public and to advise clients accordingly. These are hot buttons, and it is essential that you call them to the attention of the client. Eliminating perks and adding its cash equivalent to the executive's base salary is often sufficient to make the problem go away, but in order to get a client to take this step, a good lawyer must have an awareness of what is a hot button issue and what is not.

Editor: As you know, most of our readers are general counsel and the members of corporate legal departments. What suggestions do you have for them on compliance with the plethora of statutes and regulations that are now focused on executive compensation?

Ritter: As I mentioned, all non-qualified deferred compensation plans must be in written compliance with §409A by the end of this year. Quite literally, there must be thousands of arrangements in place which are not generally thought of as non-qualified deferred compensation plans but need to be amended to comply with §409A. Even when companies are generally aware of the upcoming deadline, many have yet to think about getting their plans into compliance. December 31 is not that far off, particularly for those plans that will require shareholder and/or participant approval of the amendments.

This is a very specialized area of the law, and I think it is important for corporate counsel to have access to the kind of expertise that will enable him or her to bring the company plans into compliance in a timely manner. The first step, I think, is to bring someone into the company to examine what plans and arrangements are in place and determine whether they are subject to §409A, and then to consider the steps necessary for them to become compliant. That expertise is not inexpensive, of course, but a failure to achieve compliance within the requisite time frame can be a great deal more expensive for the company.

Editor: Tell us about your views regarding the negotiations of employment agreements with senior executives.Ritter: I try to stay focused on the ultimate goal of the negotiations between the company and the senior executive. As an executive compensation lawyer, I work toward accomplishing a reasonable accommodation between the company and the senior executive that advances the interests of all of the relevant parties - the executive, the company and the company's shareholders. An intense adversarial negotiation can have the opposite result. The company is looking to attract, motivate and retain the best executive talent available, and the executive is looking to be "appropriately and fairly" compensated, which often means combining career and compensatory opportunities with a degree of security. I do not find these interests - those of the company and the executive - to necessarily be in conflict. The trick is to find sufficient common ground to enable both sides to be satisfied in a way that will encourage them to work smoothly together for the benefit of the shareholders. Both the company and the executive need to understand each other's positions and the justification or rationalization for such positions, and then try to meet each other's needs to the extent possible. I continually remind my clients - on both sides of this equation - to make every effort to avoid creating ill will during negotiations which could have an adverse effect on future relationships and cooperation. Unless that lesson is understood, it is quite possible to win the battle and lose the war in this particular arena.

Editor: Is there anything you would like to add?

Ritter: Another point I should make is that corporate directors, and particularly those who serve on the board's compensation committee, have a heightened degree of responsibility in the executive compensation area due to recent developments in the law. If directors are to meet their fiduciary obligations, they must understand the executive compensation environment, must determine the company objectives they wish to attain through the company's compensation polices and practices and must deliberate in a careful and thoughtful way. In other words, their decisions must be informed and thoughtful decisions. A number of best practices have been developed in recent years that directors should consider and, to the extent appropriate, adopt. The ability to meet these director responsibilities will be enhanced with the help of qualified compensation consultants.

I am very encouraged by the direction that corporate governance has taken over the past four or five years in the executive compensation area. For a number of reasons, directors are more independent and less beholden to CEOs today than they were in the past. They take their responsibility seriously. While the press continues to focus on egregious examples of executive compensation, I think the important thing to remember is that the press has been focusing on the exceptional cases, not on the much more common cases. Many, if not most, of the inappropriate practices that prevailed in the past have been corrected, and the truly outrageous cases that come to light are remarkable for their relative rarity.

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