For Nasdaq companies that have not yet held their 2014 annual meetings, just a reminder that the deadline for amending compensation committee charters to comply with the recent compensation committee independence rues is the date of a company’s 2014 annual meeting (or October 31, 2014, if earlier). Similarly, for NYSE companies, the deadline for complying with the director independence component of the rules is the same.
There is little guidance about whether and how an executive who has compensation clawed back can take a tax deduction for the amount repaid. A new case reported by BNA today involving an insider trading forfeiture may show one path to a deduction for claw backs too. The case involves Joseph Nacchio, the former CEO of Qwest. After being convicted of insider trading, Nacchio forfeited $44.6 million in 2007 that he had realized from the insider stock sales in 2001. He amended his 2007 return to deduct the $44.6 million under Code Section 165 as a loss and also claimed a credit of $18 million under Code Section 1341 for the taxes originally paid on the stock sales. In denying summary judgment for either side, the Court of Federal Claims held that Nacchio might be entitled to the credit under Code Section 1341 if he subjectively believed that he had a claim of right to the forfeited gain.
Applying Code Section 1341 to a compensation claw back, most executives would have had a subjective belief that the incentive compensation was appropriately payable in the original year of payment. The IRS might challenge that belief in some cases, such as a claw back due to an accounting restatement based on actions by the executive.
The ability to get a credit for taxes paid in an earlier year on income that has been clawed back would soften the blow of the claw back to an executive. This also seems like the right tax result.
In the comprehensive tax reform proposal by Representative Camp issued yesterday, Section 409A would be repealed. Instead, essentially the Section 83 rules would be applied to all compensation. Tax would be imposed when a substantial risk of forfeiture ends. This would eliminate voluntary deferrals for all practical purposes. Based on enactment in 2014 (which won’t happen), any compensation earned in 2015 or later would be subject to these rules. Prior deferrals under existing plans would have to be paid out within 10 years.
The revenue estimate for this change is more than $9 billion over 10 years. The basic tax policy argument for the proposal is that 409A is too complicated and is only used by highly paid taxpayers. While you can make other arguments for deferring compensation, it is hard to disagree with those two points.
We can expect that deferred compensation will be in play if there is comprehensive tax reform next year and Camp’s proposal may be the starting point for the discussion.
Today the IRS released final regulations under Section 83 of the Internal Revenue Code, substantially as proposed last year. The regulations are in effect for transfers of property on or after January 1, 2013.
The regulations make some relatively minor adjustments to the definition of “substantial risk of forfeiture,” which is a key concept under Section 83. As long as property (such as stock) that is transferred to an individual in connection with the performance of services is nontransferable and subject to a substantial risk of forfeiture, it is not taxable to the individual unless the individual files a special election (an 83(b) election) at the time of the transfer.
The regulations clarify that lock-up periods, insider trading policies, and potential liability under Rule 10b-5 under the Securities Exchange Act of 1934 (Exchange Act) do not create a substantial risk of forfeiture for purposes of Section 83. Thus, for example, if an employee exercises a stock option during a period when the employer’s insider trading policy prohibits the employee from selling the shares purchased under the option, the fact that the employee cannot sell the shares until the trading window opens does not constitute a substantial risk of forfeiture and therefore does not delay the taxable event for the employee. The employee must recognize taxable income at the time of exercise, even if he or she can not sell the shares at that time.
This is in contrast to how Section 83 works in the context of potential liability under Section 16(b) of the Exchange Act. Under Section 16(b), a non-exempt purchase and sale (or sale and purchase) of stock by an officer, director or 10% shareholder of a public company during a six-month period may result in the insider being liable to the company for disgorgement of any profit realized in the transaction. The Section 83 regulations provide that if an insider may not sell shares of stock previously acquired in a non-exempt transaction within the past six months due to potential liability under Section 16(b), the stock is subject to a substantial risk of forfeiture and (unless the taxpayer makes an 83(b) election) is not taxable until six months after the acquisition has passed.
Importantly, for Section 83 purposes, the six-month period is measured from the original acquisition date of the stock in question, and isn’t tolled if there is a subsequent non-exempt acquisition during this period. Thus, for example, if an insider receives a fully vested option grant on June 1, 2014 in a non-exempt transaction, and exercises the option on September 1, 2014, the shares acquired upon exercise will remain subject to a substantial risk of forfeiture until (about) December 1, 2014. However, if the insider purchases additional shares on the open market on November 1, 2014, the substantial risk of forfeiture on the option shares still lapses, and the option shares are still taxable, on December 1, 2014, even though the insider may have liability under Section 16(b) if he sells any of the shares within 6 months after the subsequent purchase on November 1.
Although most compensatory stock grants are designed to be exempt from Section 16(b), the special forfeiture rule governing sales which involve potential Section 16(b) liability may create some traps for the unwary in unusual circumstances, and should be observed whenever there has been a non-exempt transfer of stock for services.
In January, ISS updated its scoring model for evaluating companies’ corporate governance practices, Quicksore 2.0. A list of the compensation-related factors for the U.S. market is set forth below, with changes for 2014 marked by an asterisk (*):
*What is the degree of alignment between the company’s annualized Three-year pay percentile rank, relative to peers, and its Three-year annualized TSR rank, relative to peers?
*Did the most recent Say-on-Pay proposal receive shareholders’ support below the industry-index level?
What is the degree of alignment between the company’s cumulative 3-year pay percentile rank, relative to peers, and its 3-year cumulative TSR rank, relative to peers? (*informational purposes only)
What is the degree of alignment between the company’s cumulative one-year pay percentile rank, relative to peers, and its one-year cumulative TSR rank, relative to peers? (*informational purposes only)
What is the size of the CEO’s one-year total pay, as a multiple of the median total pay for company peers? (multiples greater than 2.33 get flagged)
What is the degree of alignment between the company’s TSR and change in CEO pay over the past five years? (measures below -30% get flagged)
What is the ratio of the CEO’s total compensation to the next highest paid executive?
Are any of the NEOs eligible for multiyear guaranteed bonuses?
What is the ratio of the CEO’s non-performance-based compensation (All Other Compensation) to Base Salary? (ratios greater than 75% get flagged)
Do the company’s active equity plans prohibit share recycling for options/SARS?
Do the company’s active equity plans prohibit option/ SAR repricing?
Does the company’s active equity plans prohibit option/ SAR cash buyouts?
Do the company’s active equity plans have an evergreen provision?
Do the company’s active equity plans have a liberal CIC definition?
Has the company repriced options or exchanged them for shares, options or cash without shareholder approval?
Does the company grant equity awards at an excessive rate, according to ISS policy?
Did the company disclose a claw back or malus provision?
What are the minimum vesting periods mandated in the plan documents for executives’ stock options or SARS in the equity plans adopted/amended in the last three years?
What are the minimum vesting periods mandated in the plan documents, adopted/amended in the last three years, for executives’ restricted stock?
What is the holding period for stock options (for executives)?
What is the holding period for restricted shares (for executives)?
What proportion of the salary is subject to stock ownership requirements/guidelines for the CEO? (less than 3x gets flagged)
Does the company disclose a performance measure for the short term incentive plan (for executives)?
What is the level of disclosure on performance measures for the latest active or proposed long-term incentive plan?
What’s the trigger under the change-in-control agreements?
Do equity based plans or long-term cash plans vest completely on change in control?
What is the multiple of salary plus bonus in the severance agreements for the CEO (upon a change-in-control)? (more than 3x gets flagged)
What is the basis for the change-in-control or severance payment for the CEO?
Does the company provide excise tax gross-ups for change-in-control payments?
What is the length of employment agreement with the CEO?
Has ISS’ qualitative review identified a pay-for-performance misalignment?
Has ISS identified a problematic pay practice or policy that raises concerns?
As reported in this McGuireWoods news item, the SEC staff recently issued a study recommending a comprehensive review of Regulation S-K, including the executive compensation disclosure requirements. Although a process and timeframe for the review have not yet been determined, such a review could result in important changes to the current disclosure regime. The staff’s specific recommendations with respect to executive compensation disclosure were as follows:
Executive compensation requirements. The staff recommends an evaluation of executive compensation disclosure to confirm the information is useful to investors in light of concerns that this area generally contains complex, lengthy, technical disclosure. The review could also evaluate whether further scaling is appropriate.
Shareholders approved a higher percentage of non-binding “golden parachute” proposals in M&A deals in 2013 than in 2012, despite ISS’s increasing resistance to such proposals, according to this report in the WSJ from Monday.
There have been a total of 141 votes on executive compensation packages linked to company takeovers, and 86% passed, according to FactSet SharkWatch. That’s up from 82% the prior year on 113 votes.
The increase runs counter to direction from proxy adviser Institutional Shareholder Services, which is making more negative recommendations on pay perks for executives who sell their companies.
ISS advised shareholders to vote against 28% of golden parachute proposals between February and the end of October, according to compensation consultants Pearl Meyer & Partners. That was a big jump from negative recommendations in 20% of all votes held through the end of 2012.
In a recent article, the Wall Street Journal highlighted a change in the standard that ISS will use to gauge the responsiveness of boards of directors to majority-supported shareholders starting in 2014.
Under the previous standard, ISS would potentially recommend against or withhold votes on directors if a board failed to respond sufficiently to a shareholder proposal that was supported either by a majority of the outstanding shares in the preceding year or by a majority of the votes cast in two out of the three preceding years. (Prior to 2013, the standard was just a majority of shares outstanding in the preceding year.) As ISS announced last year and recently confirmed, starting in 2014 the standard will switch to majority of votes cast in the preceding year. As the WSJ reports, this subtle change could have a big impact:
Starting in 2014, Institutional Shareholder Services Inc. is changing its guidelines to recommend ousting directors who don’t implement a shareholder proposal that got a majority of the votes cast at the 2013 meeting. Previously, ISS recommended “no” votes on directors only if the proposal received a majority of all the shares outstanding—a more forgiving standard for directors because many shares go uncast….
At least two dozen of the largest 1,000 public U.S. companies will potentially be affected by the ISS change in the coming months because of shareholder initiatives that passed in 2013 with a majority of votes cast but short of the tougher standard, according the Conference Board, which tracks corporate voting habits.
On December 10, 2013, the SEC, FDIC, OCC and Federal Reserve jointly approved the so-called Volcker Rule, prohibiting banking entities and certain nonbank financial institutions (collectively, “banks”) from engaging in proprietary trading or owning interests in or sponsoring certain hedge funds or private equity funds. The rules go into effect on April 1, 2014, but banks will have until July 21, 2015 to come into full conformity with the new rule.
The new rule provides that banks may engage in certain trading activities — specifically, underwriting, market-making and risk-mitigating hedging activities — without violating the rule, provided that (among other things) the bank designs its incentive compensation arrangements for employees engaged in such activities so as not to reward or incentivize prohibited proprietary trading. The agencies state that their goal is not to prohibit employees from being rewarded when these activities generate trading profits for a bank, so long as the the riskiness of the activity is appropriately taken into account in the arrangement and so long as the primary purpose of the arrangement is to reward client service (for underwriting and makret-making activities) or risk reduction (for hedging activities), not speculation in or appreciation in the value of the underlying securities. The agencies have generally adopted a principles-based approach for determining what types of incentive arrangements might violate the rule, rejecting calls to adopt specific vesting requirements for compensation related to such activities or other bright-line standards.
The new rule also exempts certain compensatory profits interests from the general prohibition on banks (or their employees) being able to own interests in hedge funds or private equity funds and allows banks to hold ownership interests in covered funds as a risk-mitigating hedge with respect to compensation arrangements between the bank and employees who provide services to the fund, provided certain requirements are met.
In light of the new rule, banks should begin to review the incentive compensation arrangements covering employees engaged in underwriting, market-making and hedging activities to ensure that these arrangements comply with the new requirements before the July 2015 full implementation deadline.
Nasdaq is changing its listing rules to allow compensation committee members to receive compensatory fees from a company when those fees are not for board service. By allowing compensation committee members to be paid for consulting, advisory and other services, Nasdaq rules will be in line with those of other exchanges. The new rules will require that any fees be considered in evaluating the independence of the compensation committee member. The new rules take effect on December 26, 2013 so that they will be in place for the election of directors during the 2014 proxy season.
The Nasdaq rules will be helpful to smaller companies, such as financial institutions with advisory boards whose members are paid small fees. We anticipate that boards will be sensitive to the potential effects of fees on the perceived independence of compensation committee members and take a cautious approach when determining the independence of compensation committee members who receive these other fees.