© 2013 Winstead PC

Top 10 Compensation Concerns of Executives

Presented by:Anthony J. Eppert, Winstead PCAEppert@Winstead.com713.650.2721

Presentation to:NASPP, Austin ChapterJuly 22, 2014

© 2014 Winstead PC

© 2014 Winstead PC

Tony is a Shareholder in Winstead's Compensation & Benefits practice group. His legal practice focuses on executive compensation and employee benefit arrangements in the United States and abroad

Before entering private practice, Tony:– Served as a judicial clerk to the Honorable Richard F. Suhrheinrich of the

United States Court of Appeals for the Sixth Circuit– Obtained his LL.M. (Taxation) from New York University– Obtained his J.D., cum laude (Tax Concentration) from Michigan State

University College of Law Editor-in-Chief, Journal of Medicine and Law President, Tax and Estate Planning Society

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About Anthony ("Tony") Eppert

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Free Monthly Webinar Program

FREE, attend from your desk, 2nd Wednesday of every month– Each session provides 1 CE credit, including CLE, CPE and HRCI

2014 webinars:– What's New with ISS and other Shareholder Advisory Services (Jan. 8)– Employee Stock Purchase Plans: The Intermediate Course (Feb. 12)– Partnerships: Structuring Profits Interests (March 12)– Designing International Assignment Policies: An Issues List (April 9)– International: Designing Equity Compensation Abroad (May 14)– Administration: Resolving Equity Compensation Pitfalls (June 11)– Tapping Internal Liquidity: The ESOP Solution (July 9)– Navigating Employee v. Independent Contractor Classifications (Aug. 13)– Preparing for Proxy Season: The To Do List (Annual Program) (Sept. 10)– The Art of Negotiating Executive Contracts (Oct. 8)– Benefits: A Legislative & Regulatory Review (Annual Program) (Nov. 12)– Compensation Governance and "Best Practices" (Dec. 10)

2015 webinars:– To be announced– Suggestions on topics are greatly appreciated!!

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Purpose of Presentation

The purpose of this presentation is to discuss various compensation concerns of executive officers and key employees

To that end, this presentation is limited to the top 10 compensation concerns (presented in no particular order):

– Point of hire compensation;– Pushing for incentive stock options or restricted stock;– Maximizing capital gains through partnership profits interests;– Achieving favorable vesting provisions;– Proactively addressing insider trading issues;– Minimizing 280G exposure;– Separation pay and termination triggers;– Six-month wait issues under Section 409A;– Limiting restrictive covenants and clawbacks; and– Ensuring proper indemnification coverage

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© 2014 Winstead PC

Point of Hire Compensation

Base salary– The amount is negotiated– Flexibility is typically afforded in the executive contract as to “how often”

the amount will be negotiated

Bonus– Contracts generally provide executives with a bonus, even though the

timing and the amount of any bonus is subject to the sole discretion of the board of directors

– It is also common to set a target bonus equal to a % of the executive’s base salary

– Be sure any provisions addressing the timing of a bonus payout comply with Section 409A

Signing bonus– Signing bonuses are typically provided in the form of cash or equity– Typically the executive has to negotiate the issue of whether any signing

bonus should be forfeited or subject to clawback if the executive terminates employment within a certain period of time or attempts to violate any provision of the contract

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Point of Hire Compensation (cont.)

Equity grants– To avoid sloppy grant practices and potential allegations of back-dating,

consider specifically indicating when the grant is to occur– Is it to occur in the future when the board of directors acts? Or is it to

occur on the “effective date” of the executive contract? – If the latter, be sure that the board of directors approves the contract

because, absent a valid delegation of authority from the board of directors to another individual or committee, only the board of directors would have the authority to grant equity

– Consider whether key terms of the equity grant should be included within the executive contract, such as number of shares, strike price (if any), vesting schedule, any restrictive covenants, etc.

Alternatively, attach the award as an exhibit to the executive contract and incorporate the exhibit into the executive

Expense reimbursement– Typically, reimbursement will be subject to the employer’s reimbursement

policies and procedures

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Point of Hire Compensation (cont.) Fringe benefits

– From the executive’s perspective, it is best to list as many fringe benefits within the executive contract as possible (e.g., gym membership, golf, etc.)

Car allowance– Providing a dollar allowance is the cleanest– However, if instead a lease is to be provided, then consider who is

responsible for the lease if the executive terminates employment prior to the end of the lease term. Who has the first opportunity to purchase the car from the lease?

Relocation assistance– Reasonable costs of relocation are often covered. What does this mean?

Does it cover sale of the prior home, a house hunting trip, broker fees/commissions, the whole family, the number of trips, etc.?

– The foregoing is usually an issue if the verbiage is vague and the employer does not otherwise have policies and procedures covering relocations

Legal fees– Depending on the position, it is customary to cover legal fees incurred by

the executive in conjunction with the review and negotiation of the executive contract

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Options v. Stock Grants: ISOs

• An incentive stock option (an “ISO”) is a stock option granted to an employee to purchase stock of the employer corporation, its parent or its subsidiary

– Numerous tax rules must be satisfied for an option to qualify as an ISO

• Generally, ISOs are preferred by optionees (compared to nonstatutory stock options, a.k.a., “NSOs”) because of their favorable tax treatment

– No taxable income is triggered to the optionee at the time of grant– No taxable income is triggered to the optionee at the time of exercise

o However, the spread between the fair market value of the underlying stock and the exercise price would be an item of adjustment for purposes of calculating any alternative minimum tax

– If the stock is held for at least 2 years from the date of grant AND at least 1 year from the date of exercise (the “Holding Period”), then any gain realized on a subsequent sale of the underlying shares would be taxed at capital gains rates

• Neither the grant nor the exercise of an ISO provides the employer with any compensation deduction

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Options v. Stock Grants: ISOs (cont.)

• A “Disqualifying Disposition” occurs when the Holding Period (prior slide) is not satisfied. In such instances:

– The optionee would recognize ordinary taxable income (and the employer would have a corresponding compensation deduction) equal to the excess (if any) of the fair market value of the stock as of the date of exercise over the exercise price

– Such compensation income would be added to the stock’s basis to determine any capital gain that must be recognized on the Disqualified Disposition

• To qualify as an ISO, the option must comply with all of the following tax rules:

– Rule 1: The plan providing for the grant of ISOs must be approved by the employer’s shareholders within 12 months before or after the plan is adopted

– Rule 2: The plan must specify the aggregate number of shares of employer stock that are available for issuance under the plan AND the number of shares subject to ISO treatment

– Rule 3: The plan must specify the employees or class of employees eligible to participate

– Rule 4: The option must be granted within 10 years from the date the plan is adopted or approved, and must be exercised (if at all) within 10 years from the date of grant of the option

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Options v. Stock Grants: ISOs (cont.)

• To qualify as an ISO, the option must comply with all of the following tax rules (continued from prior slide):

– Rule 5: The optionee must be an “employee” of the granting corporation, its parent or its subsidiary (or an employee of an entity that has assumed the options pursuant to a reorganization)

– Rule 6: The optionee must remain an employee from the time the ISO is granted until three months before it is exercised, extended to one year if termination of employment is due to disability, and no time limit if termination of employment is due to death (also known as the “post-termination exercise period”)o The terms of the plan may specify a shorter period

– Rule 7: The exercise price must be equal to or greater than the FMV of the underlying stock at the time the ISO is grantedo However, for optionees owning 10% or more of the employer’s voting power or

all classes of stock, the exercise price must be at least 110% of the fair market value of the underlying stock at the time the ISO is granted

– Rule 8: There is a $100,000 limit on the aggregate fair market value (valued at the time the option is granted) of employer stock that can be exercised under an ISO for the first time by an employee during any calendar yearo Any options exceeding this limit are treated as NSOs

– Rule 9: An ISO cannot be transferable (except at death), and during the employee’s lifetime, must be exercisable only by the employee

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Options v. Stock Grants: ISO Modifications

• Generally, modifications, extensions and renewals of an ISO and NSO would be deemed a new grant. If no other changes are made to the exercise price, then:

– The ISO would lose favorable ISO treatment and be deemed an NSO (because it did not comply with Rule 7 (see Slide 4))

– The NSO would likely violate Section 409A and therefore would likely be subject to adverse tax consequences under Section 409A. Such adverse tax consequences include:o An earlier inclusion of ordinary taxable income,o An additional tax equal to 20% of the amount that that is required to be included

as ordinary taxable income, ando Interest, fines and penalties

• Avoid modifications by addressing provisions on the front end!– Whenever an amendment to an existing option is being considered

(whether an ISO or NSO), be sure to determine whether the amendment would be considered a “modification,” “extension” or “renewal” of the option under ISO rules (if applicable) and Section 409A

– For example, adding a "net exercise" feature after-the-fact IS a modification for ISO purposes but is NOT a modification for 409A purposes

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Options v. Stock Grants: Immediately Exercisable ISOs

Immediately exercisable ISOs are prevalent in tech companies

The concept of an immediately exercisable ISO is that an optionee may exercise unvested stock options and, upon such an exercise, he/she will receive a restricted stock award subject to the same vesting schedule

The question is whether to make an 83(b) election at the time of an early exercise? Questions often arise as to why even make the election given that the ISO already protects any positive spread as capital gains (assuming the Holding Period is satisfied)

Remember AMT applies to the spread of an ISO on the date of exercise

Tax law provides that the determination of the spread for AMT purposes will occur at vesting UNLESS the optionee makes an 83(b) election (for AMT purposes) at the time of exercising the ISO and receiving the restricted stock award

Thus, assuming the stock price is on the rise at the time of exercise, the goal is to capture AMT at a lower fair market value (as opposed to capturing AMT at a higher fair market value when the underlying stock later vests)

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Options v. Stock Grants: Net Exercise of an ISO

The question is whether a net exercise of an ISO will destroy ISO eligibility as to the whole ISO? Or will ISO eligibility be lost only as to the portion that was netted?

The law is not settled on this issue (the law is silent or unclear)

A conservative position is to treat the whole option as having lost ISO status

However, the Code is a law of restraint, and since there is no direct tax law that would require the whole option to lose ISO treatments, a position could be taken that ISO treatment is not lost as to the stock that was not netted in the net exercise

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Options v. Stock Grants: Restricted Stock

• Generally, the grant of restricted shares would constitute a corporate transfer but not a tax transfer

– A corporate transfer means the executive is entitled to voting and dividend rights even if the award is subject to forfeiture

– If the award is subject to forfeiture, then the tax transfer typically coincides with vesting

• Tax treatment to the executive assuming no 83(b) election was timely filed:

– Unless an 83(b) election is timely filed, the executive would generally recognize ordinary taxable income equal to the fair market value of the award (less any amount paid) as of the earlier of: (i) the date the shares become transferable, or (ii) the date the forfeiture restrictions lapse (i.e., the date of vesting)

– Until such time, any dividends received by the executive on account of the restricted stock grant would be treated as compensation, not dividends

– After such time, any sale of the underlying stock would be treated as capital gain or loss equal to the difference between the sale price and the tax basis

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Options v. Stock Grants: Restricted Stock (cont.)

• Tax treatment to the executive assuming an 83(b) election was timely filed:

– The executive could attempt to capture as much of the anticipated future appreciation of the underlying stock at capital gains rates by making an “83(b) election” within 30 days from the date of granto The purpose of an 83(b) election is to limit the ordinary taxable income element

to the value of the stock on the date of grant (which can be much lower than the amount of ordinary taxable income the executive would otherwise recognize at the time of vesting)

o This means the executive would be taxed at the time of the initial transfer (at a time when the fair market value of the stock may be low)

o Thereafter, any increase in the fair market value of the stock subject to the 83(b) election would typically be taxed at capital gains rates when the executive sells the stock

• Tax treatment to the employer:– If the executive is an employee, the employer would have a withholding

obligation and employment taxes at the time the executive recognizes ordinary income

– Additionally, the employer would have a corresponding compensation deduction at that time

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Options v. Stock Grants: A Comparison

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Options v. Stock Grants: A Comparison (cont.)

EVENT ISO NSO Restricted Stock

Date of Exercise (Employee)

No federal income tax consequence to the optionee or the company

However, the “spread” under an ISO – i.e., the difference between the FMV of the shares at exercise and the exercise price – would be classified as an item of adjustment in the year of exercise for purposes of AMT. In order to avoid the application of AMT, the optionee would have to sell the shares within the same calendar year in which the ISOs were exercised. However, such a sale within the same calendar year would constitute a “disqualifying disposition” (see next slide)

The company would have no withholding obligation and would not be entitled to any deduction

Optionee would have compensation income (taxed at ordinary rates) equal to the difference between the option’s exercise price and the FMV of the underlying shares on the date of exercise

The company would have a corresponding withholding obligation

The company would generally be entitled to a compensation deduction equal to the amount the optionee included as ordinary income

Not applicable

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Options v. Stock Grants: A Comparison (cont.)

EVENT ISO NSO Restricted Stock

Date of Sale (Employee)

The tax consequences depend on whether the sale is a “disqualifying disposition” (i.e., no disqualifying disposition if the stock is held for at least: (i) 2 years from the date of grant AND (ii) 1 year from the date of exercise)

If the sale is not a disqualifying disposition, then the optionee would recognize long-term capital gain (or loss) equal to the difference between the sale price of the shares and the exercise price. The company would be entitled to no corresponding deduction

If instead the sale is a disqualifying disposition, the optionee generally would have compensation income (taxed at ordinary rates) equal to the difference between the exercise price and the FMV of the underlying stock at the time of exercise (the company would be entitled to a corresponding deduction). Such compensation income would be added to the stock’s basis to determine any capital gain that would have to be recognized on the disqualifying disposition

Any gain or loss would be short- or long-term capital gain or loss, depending on whether the shares were held for one year following exercise

The company would not receive a compensation deduction for any such gain or loss

Same as NSOs

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Options v. Stock Grants: Stock Grant Example

• The following example compares the tax consequences of receiving restricted stock with and without an 83(b) election

• Assume the following facts:– An executive received 10,000 shares of restricted stock on February 1,

2014, when the fair market value per share was $10– The award vests 100% on the two year anniversary of the date of grant (no

interim vesting)– When 10,000 shares vest on January 31, 2016, the fair market value per

share is $30– The executive then sells the shares for $400,000 in May 2016, when the

fair market value per share is $40

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Options v. Stock Grant: Stock Grant Example (cont.)

• If an 83(b) election IS timely filed upon receipt of the award:Ordinary income upon grant 2/1/14: $100,000Ordinary income tax 2/1/14 (40% x 100,000): 40,000Ordinary income upon vesting 1/31/16: -------Capital gain at sale 5/16 ($400,000 - $100,000): 300,000Capital gains tax 5/16 (23.8% x $300,000): 71,400

Aggregate Tax on Award: $ 111,400

• If an 83(b) election IS NOT filed:Ordinary income upon grant 2/1/14: $ -------Ordinary income upon vesting 1/31/16: 300,000Ordinary income tax 1/31/16 (40% x $300,000): 120,000Capital gain at sale 5/16 ($400,000 - $300,000): 100,000Capital gains tax 5/16 (23.8% x $100,000): 23,800

Aggregate Tax on Award: $143,800

• In this example, the tax cost to the executive for failing to make an 83(b) election is $32,400 ($143,800 less $111,400)

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Options v. Stock Grant: Stock Grant Example (cont.)

• The greater the increase in the value of the shares during the vesting schedule, the greater the tax cost to the executive for failing to make an 83(b) election

• When determining whether or not to make an 83(b) election, the executive generally must carefully consider the risk that the executive may terminate employment prior to full vesting of the award

– Under Example 2, if the executive files an 83(b) election but terminates employment prior to any vesting, the executive will forfeit all the shares and will have paid $32,400 in tax for which he/she generally cannot claim a refund

– Whereas if the executive had NOT filed an 83(b) election and terminated employment prior to any vesting, he/she would have forfeited all of the shares but would not have paid any tax

• Worth noting is that some employers negate the above economic risk by providing the executive with a gross-up at the time an 83(b) election is made. Such a formula could be:

Total Gross Up = FMV of Stock on Date of Grant

1 Minus Applicable Tax Rate

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Partnership Profits Interests

Compensatory partnership interests offer a unique ability for the executive to recognize all tax on an equity award at capital gains rates

A "capital interest" is generally defined as "an interest that would provide the service provider a share of the proceeds if the partnership's assets were sold at fair market value and then the proceeds were distributed in complete liquidation of the partnership"

– Such can take the form of restricted interests, options to acquire interests, conditional promises to be settled in equity (i.e., RSUs, SARs and performance units)

– A benefit of a capital interest is that it provides the service provider with enterprise value in the partnership as of the date of grant

– A drawback of a capital interest is the tax consequence

The tax consequences to granting a capital interest include:– To the extent it is vested or an 83(b) election is timely made, the service

provider would recognize ordinary taxable income equal to the fair market value of the capital interest, minus any monies paid for such interest

– Under Section 83, the partnership would be entitled to a compensatory deduction at the time and in the amount that the service provider recognized as ordinary taxable income

As a planning note, ensure that the partnership agreement allocates any compensatory deductions to only those partners that existed immediately prior to the grant

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Partnership Profits Interests (cont.) A “profits interest” is generally defined as an interest other than a

capital interest. It provides the service provider with a share of future partnership profits and no interest in partnership capital prior to the date of grant

– It is intended to provide an incentive for the service provider to pursue enterprise growth

– Benefits of receiving a profits interest include: (i) tax consequences, (ii) represents actual equity in the partnership, (iii) service provider generally recognizes capital gains treatment upon a sale of the partnership to a third party, and (iv) the character of income at the partnership level is generally retained when distributed to the service provider

Tax consequences to the service provider in receiving a profits interest– Under Rev. Proc. 93-27 and Notice 2001-43, and Section 83 and Notice

2005-43 (with a protective 83(b) election), the service provider would not recognize any taxable income on the date of grant

– Instead, the service provider would have taxable income on the sale of the compensatory interest and such income would be taxed at capital gains rates

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Favorable Vesting Provisions: CIC

Consider whether the applicable arrangements should require full or partial accelerated vesting upon a CIC. Alternatives include:

– No acceleration– Discretionary acceleration– If an equity award, single trigger acceleration unless such equity is

assumed or replaced– Double trigger acceleration (e.g, 6 to 18 months)– If an equity award, single trigger acceleration even if equity is assumed or

replaced Generally not advisable

Some tax considerations include:– Section 280G (later Slides)– Accelerating vesting is permissible under Section 409A– ISO status of stock options would be lost to the extent the aggregate value

of the underlying shares with respect to which the stock option became exercisable for the first time by any individual during a calendar year exceeded $100,000

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Favorable Vesting Provisions: CIC (cont.)

For public companies it is important to note that ISS highly disfavors single-trigger vesting provisions

With that said, the following is a reason why some public companies continue to use single trigger vesting provisions (as reported in some proxy filings):

– Interest alignment between employees and target shareholders is strengthened

– Equitable treatment to target shareholders, especially in instances where unexercised options are in-the-money prior to closing but underwater after closing due to inept management at acquiror level

– Possibly more effective to retaining management through closing (though acquiror would prefer double trigger for post-closing retention purposes)

– Post-closing disputes over constructive termination is higher in the double-trigger context than in the single trigger context

– Awards with significant value at time of closing would otherwise encourage employees to be among those terminated

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Favorable Vesting Provisions: Retirement

There are two types of award agreements that are at issue when a "retirement" provision within the award would accelerate vesting:

– Those with performance-based vesting provisions, and– Those with time-based vesting provisions

For agreements with performance-based vesting provisions that contain retirement provisions:

– The deferred compensation provisions of Section 409A generally do not apply to the extent Section 83 of the Code applies;

– The continuation of performance-based metrics within the award agreement should act as a substantial risk of forfeiture under Section 83 of the Code. Such is the answer even though the employee has a “contractual” right to benefits (to the extent the performance condition is satisfied) due to his or her attaining retirement age;

– For the above reasons, there is no taxation upon the employee attaining retirement age. This means no withholding obligation and no FICA/FUTA is triggered at retirement age or upon a termination of employment on or after attaining retirement age. Instead, taxation (both withholding and FICA/FUTA) would be triggered when the performance condition becomes satisfied

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Favorable Vesting Provisions: Retirement (cont.)

For agreements with only time-based vesting provisions that contain retirement provisions:

– With time-based awards, the substantial risk of forfeiture under Section 83 is eliminated upon the employee attaining retirement age. Thus, a Section 409A issue arises whenever an employee attains retirement age but does NOT then have a separation from service

– Whether Section 409A will apply depends upon “when” within the life cycle of the award the employee attains retirement age. The following are possible factual variations where the employee does not have a separation from service upon reaching retirement age:

The employee has attained retirement age as of the date of grant, The employee attains retirement age shortly after the date of grant, The employee attains retirement age within the calendar year of the regularly

scheduled vesting date, and The employee attains retirement age after the regularly scheduled vesting date

– Assuming the employee does not have a separation from service upon attaining retirement age, the compensation in question is considered “deferred” until his/her separation from service

– Due to the above, FICA and FUTA is triggered upon the employee attaining retirement age. Wage withholding will then be triggered upon the employee incurring a separation from service

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Favorable Vesting Provisions: 162(m) & Rev. Rul. 2008-13

The performance-based exception to the $1mm deductible compensation limit under Section 162(m) does not apply if the compensation is paid without regard to whether the stated performance goal is satisfied

Revenue Ruling 2008-13 clarified that a payment would not qualify as performance-based if under the terms of the executive contract (or other agreement) it is payable (without regard to satisfying the performance objectives) upon a termination of employment:

– By the company without Cause,– By the employee with Good Reason, or– Upon the employee’s retirement

However, notwithstanding this Slide to the contrary, satisfaction of the objective performance goals may be waived upon:

– The employee’s death,– The employee’s disability or– A change in control of the company

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Favorable Vesting Provisions: 162(m) & Rev. Rul. 2008-13

The point of the prior slide is that the Executive could negotiate for the bonus to be paid upon a termination without Cause, for Good Reason or upon his or her retirement

This can be accomplished by, upon the above trigger, the executive waiving rights to the performance pay and instead being paid some other compensation, such as the greater of:

– A multiple of the executive’s base salary, and– The average of the executive’s performance bonus paid to him/her over

the past three years

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Favorable Vesting Provisions: Other

Other provisions to be used to accelerate vesting include:– A termination of the executive by the employer for other than Cause, and– A termination by the executive for Good Reason (i.e., a constructive

discharge scenario)

These concepts are addressed on a later slide

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Insider Trading Solutions

Absent an applicable exception, insiders are generally prohibited from purchasing or selling a security on the basis of material non-public information

– A purpose of Section 10(b) and Rule 10b-5 is to prevent those with material non-public information from gaining a competitive market advantage over those who do not have access to the same information

Generally, the above rule is not violated if the insider has material non-public information and only (though some insider trading policies are not tightly written and could preclude an exercise or net exercise):

– Exercises and holds the shares,– Initiates a net exercise to pay the exercise price or a net withholding to pay

withholding taxes, and– Exercises and sells pursuant to a 10b5-1 trading plan

And in instances where a net withholding would be desired, but the company lacks the cash flow to effectuate the IRS remittance, the market could pay the withholding dollars if:

– The award agreement provided for such a sale in the market pursuant to a formula that otherwise satisfied the rules for a 10b5-1 trading plan

– Such could be contained within the tax withholding section of the award agreement

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Minimizing 280G

Golden parachute payments are governed by Sections 280G and 4999 of the Code. If applicable, these Code provisions generally:

– Impose a 20% excise tax on disqualified individuals for their receipt of an excess parachute payment, and

– Deny a corporate deduction for the same

Only “excess” “parachute payments” that are “contingent” on a “change in control” are subject to adverse tax consequences under Section 280G

– Negate any of these 4 elements and Section 280G would not apply to that particular payment

Payment is excessive if the aggregate present value of all payments to a disqualified individual that would otherwise be a parachute payment equals or exceeds 3x the disqualified individual’s “base amount”

However, once triggered the tax applies to parachute payments that exceed 1x base amount

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Minimizing 280G (cont.)

Alternative 1 – Do nothing– Deduction would be disallowed and disqualified individual would be subject

to an excise tax

Alternative 2 – Allow the payment but provide the disqualified individual with protection through a full or partial gross-up

– This alternative can cause shareholder relation issues– Institutional shareholder advisory services such as ISS are opposed to

gross-ups

Alternative 3 – Implement a cutback so that the parachute payment would not exceed 2.99x base amount (i.e., threshold test is never satisfied)

– May not be ideal for a disqualified individual who could be financially better off paying the excise tax (instance where payment would otherwise equal, for example, 7x base amount)

– Conversely, a cutback could be financially advantageous to a disqualified individual if the payment exceeding 2.99x base amount would otherwise be less than the amount of the excise tax (instance where payment would otherwise equal, for example, 3x base amount)

Remember, the excise tax applies to amounts exceeding 1x base amount

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Minimizing 280G (cont.) Alternative 4 – Implement a hybrid cutback whereby a disqualified

individual would be entitled to receive the greater of a 2.99x cutback or payment of the excess parachute payment (with the 20% excise tax)

Alternative 5 – Implement a hybrid cutback whereby an excess parachute payment would not exceed a certain dollar amount

Alternative 6 – Implement a shareholder vote exception (private corporations only), which generally means:

– Payment must be approved in a separate vote,– Payment must be approved by more than 75% of the outstanding voting

power (excepting disqualified individuals),– Adequate disclosure must be made of all material facts, and– Vote must establish right of disqualified individual to receive payment

(means such individual must first disclaim all rights to such payments)

Alternative 7 – Same as Alternative 6 but provide a gross-up if the corporation fails to SEEK shareholder approval (however, this alternative could not apply to the condition of “gaining” shareholder approval due to the above disclaimer requirement)

Alternative 8 – Allow employee the opportunity to rebut presumption with a tax opinion

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Minimizing 280G (cont.)

Alternative 9 – Structure the payment to be reasonable compensation paid for services rendered before the CIC

– Burden of proof is clear and convincing evidence– If burden is satisfied, the amount of the reasonable compensation reduces

the excess parachute payment– In determining reasonable compensation, relevant factors include:

Nature of the services to be rendered, Individual’s historic compensation for such services, and Compensation for those performing similar services where payment is not

contingent on a CIC

– Reasonable compensation INCLUDES compensation for refraining from personal services (e.g., for a covenant not to compete)

What is the value of a covenant not to compete? Generally, it is the difference between the enterprise value of the company with and without the non-compete

Thus, the value of the 280G reduction could be more than the severance pay that is otherwise directly associated with the non-compete

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Minimizing 280G (cont.)

Alternative 10 – Structure payment to represent payment for future services (thereby negating the “contingent” element)

– Burden of proof is clear and convincing evidence– If burden is satisfied, the amount of the reasonable compensation reduces

the excess parachute payment– Similar to prior Slide, payments for covenants not to compete can

represent payment for future services if there is a reasonable likelihood that the agreement would be enforced against the individual

– Additionally, payments for breach of contract can be structured to apply for future services if:

The contract was not entered into (or amended) in contemplation of the CIC; The compensation is otherwise reasonable under Section 162 of the Code; Damages do not exceed the present value (determined on date of receipt) of

the compensation the disqualified individual would have received had he or she remained employed until the end of the contract term;

The disqualified individual offered personal services, but such were rejected by the company; and

The damages are reduced by mitigation (e.g., the individual’s attempt to find a job)

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Minimizing 280G (cont.)

Alternative 11 – In the year preceding the year of the CIC, increase the disqualified individual’s base amount in order to increase his or her 5-year average. For example:

– The disqualified individual could exercise stock options– The company could payout deferred compensation– The company could Increase and payout the disqualified individual’s

bonus– The company could payout LTIP awards

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Separation Pay: Post-Termination Exercise Period

Consider whether to extend the post-termination exercise period for stock options

– Such is permissible under Section 409A if the option term is not extended beyond its original term (i.e., typically stock options contain a term of 10 years from the date of grant)

– However, ISO status would be lost if the stock option is not exercised within 3 months from the optionee’s termination of employment

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Separation Pay: Performance Awards

Performance-based awards have unique circumstances to consider, including:

– Should the award be paid in full or pro rata upon a CIC– How should the level of performance be measured– How should the time period for performance be measured

If the employer is a public company and the executive is otherwise subject to Section 162(m), then keep in mind Rev. Ruling 2008-13 (addressed on a prior slide)

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Separation Pay: Triggers

• Absent extenuating circumstances, severance pay is generally provided only if the executive terminates employment for “good reason” or the employer terminates the executive “without cause”

– Sometimes an employer will provide severance upon an executive’s disability, but such provisions are not too common

• Thus, a termination by the executive without good reason or a termination of the executive by the employer for cause would generally not trigger any severance pay

• Consider that severance pay should be “bridge pay”– Keep in mind that severance pay packages should be designed to act as a

“bridge” between jobs– Consider whether it makes sense to offset the amount of any future

severance pay by the amount of any income the executive earns from his/her new employer, if applicable

– REMEMBER: ISS has thoughts on this issue. Too much severance pay could trigger a no vote on the employer’s next say-on-pay, or if egregious enough when combined with other poor pay practices, a no vote on the re-election of the members of the Compensation Committee of the Board

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Separation Pay: Triggers• A typical definition of “cause” includes:

– A material breach by executive of his/her obligations under the agreement;– A willful or continued failure to follow orders or perform;– A conviction or plea of nolo contendere to any felony or a crime involving

dishonesty or moral turpitude or which could reflect poorly on the Employer;

– Executive engaging in misconduct, negligence, etc. that is injurious to the Employer;

– A material breach by executive of a written policy of the employer; and– Any other misconduct by executive that is injurious to the financial

condition of the employer and/or its reputation

• Consider defining the term “cause” to include a substantial under-performance (e.g., failure to achieve minimum financial goals for two consecutive fiscal years)

– Consider further that such a provision is not typical and would subject executive to elements that could be outside his/her control

• Consider the Board’s use of after-acquired evidence to determine whether Executive terminated employment for “cause.” Otherwise, evidence supporting a termination for cause that is found after executive’s termination could not likely be used to retroactively recharacterize executive’s termination (thus, a payout of severance benefits would likely continue)

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Separation Pay: Triggers (cont.)• A typical definition of “good reason” includes:

– A decrease in executive’s base salary or a failure by the employer to pay material compensation when due;

– A diminution of the responsibilities, positions or title of executive;– A requirement that executive move more than [__] miles from [_____]

• It is favorable to the employer to require both a notice and cure period before “good reason” can be triggered

– Consider that if a notice and cure period is used in good reason, is it fair to also apply a mirror provision to the definition of “cause”

• Should there also be a claims run out period, such that if good reason exists, executive must provide notice within [___] days of such trigger, otherwise, the claim giving rise to good reason is considered waived by executive

– Such would prevent executive from “saving” the good reason trigger for a rainy day 6 months or a year after-the-fact

– Consider whether “cause” should contain a mirror provision

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Separation Pay: Triggers (cont.)

• [Good Reason continued from the prior slide]

• Consider adding a “good reason” definition that includes:– “. . . a material breach of any provision of this Agreement . . . ” AND– A provision later in the agreement that provides something to the effect: “. .

. failure of the Company to obtain a written agreement from any successor or assign of the Company to assume the obligations of the Company under this Agreement upon a Change in Control shall constitute and be deemed a material breach of this Agreement.”

• The above should comply with the Section 409A safe harbor definition of “good reason”

• But more important, the above could provide executive with substantial negotiating power if the acquiror wants to retain executive after consummation of the transaction (i.e., any deviation from the agreement could give rise to good reason) and the existing employment agreement is otherwise too “rich” for the acquiror to continue

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Section 409A 6-Month Wait

• Generally, a "separation from service" is a permitted payout event under Section 409A; however, any payout to a "specified employee" generally must be delayed at least six months after separation from service

– A specified employee is generally defined to include the following: Employees owning more than 5% of the Company's stock, Employees owning more than 1% of the Company's stock and who have

compensation from the Company in excess of $150,000, and Officers of the Company with compensation in excess of $170,000. Whether an

individual is an officer is based on the nature of the individual's duties (not his job title)

– Whether a specified employee had a separation from service is based upon the facts and circumstances

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Section 409A 6-Month Wait (cont.)

• An issue does arise if the specified employee will provide independent contractor services immediately after his/her termination of employment

– The specified employee has incurred a separation from service if the time commitment under the consultant agreement is no greater than 20% of the time the specified employee spent performing services for the employer during the 36-month period immediately preceding his termination of employment

– Other rules apply if the time commitment is greater than 20% but less than 50%, and another set of rules apply if the time commitment is at or greater than 50%

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Section 409A 6-Month Wait (cont.)

• There are a number of payments that would be EXEMPT from Section 409A; therefore, the 6-month wait addressed above should not apply to such exempt payments:

– Such exemptions could be used in combination and cumulatively, thereby producing a larger exemption than any one exemption would otherwise provide by itself

• The most notable of the exemptions would be the two times, two year rule, under which the following could be exempt:

– An amount not exceeding the lesser of (i) two times the executive's annual compensation for the year prior to the year of termination (e.g., 2013 compensation) or (ii) two times the annually adjusted Section 401(a)(17) limit (i.e., 2x would be $520,000 for 2014), AND such severance is paid to the executive by the end of the second calendar year following the year the executive separated from service

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Restrictive Covenants: Non-Compete

• Consider tolling the non-compete provision for any period of time the executive violates the restrictive covenant

– Some states do not allow equitable tolling and therefore would not otherwise toll the non-compete beyond the terms of the contract

– Absent equitable tolling or a contractual tolling provision, it may be difficult for an employer to enforce, for example, a six-month non-compete provision (i.e., it could take more than six months to get to court)

• Consider using non-compete provisions to avoid the use of a 280G gross-up provision

– As background, tax gross-ups are generally preferred by executives and disfavored by shareholders

– Implementing a non-compete can act to reduce an otherwise golden parachute payment subject to the 280G excise tax

– Such reduction is generally not on a dollar-for-dollar basis, but rather, the reduction is generally based on the difference between the enterprise value of the company with and without the non-compete

– Thus, the value of the 280G reduction could be more than the severance pay directly associated with the non-compete

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Restrictive Covenants: Clawbacks

• Consider whether to implement robust clawback provisions

• Clawback provisions currently exist under Section 304 of Sarbanes-Oxley Act and the Dodd-Frank Act

• Additionally, consider the use of other clawback provisions, such as:• A clawback for any breach of post-employment restrictive covenants (e.g.,

violation of a non-compete clause)• A clause that if the non-compete provision is ever judicially or

administratively ruled to be unenforceable, then Executive must forfeit certain portions of his/her severance pay (including a return of any gains on equity awards that the executive sold after his/her termination of employment)

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Indemnification

• Generally, indemnification of executive officers and members of the board of directors is addressed in the articles of incorporation and bylaws of the employer

– Therefore, it is preferable from the employer’s perspective to NOT include such a provision within the employment agreement

– But to the extent such a provision is provided in the employment agreement, care needs to be taken to ensure such a provision is not outside the scope of the indemnification within the articles of incorporation and bylaws

• Same issue is applies in the context of an errors and omissions policy

• Do not overlook this issue, care should be taken. Consider the following two slides as an example that applied to a director, but could apply to executives too

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Indemnification (cont.)

• Schoon v. Troy Corp, court upheld retroactive amendments to the corporation’s bylaws that negated a former director’s right to receive advancement of expenses for law suits filed after such director left the board

– Court found any contractual right to advancement of expenses under the bylaws would have vested upon being named as a defendant, and because such naming did not occur until after amendment of bylaws, former director was not able to receive advancement of attorney fees

• Effective August 1, 2009, the outcome in Schoon was legislatively reversed due to an amendment to Section 145(f) the DGCL, which provides:

– “A right to indemnification or to advancement of expenses arising under a provision of the certificate of incorporation or a bylaw shall not be eliminated or impaired by an amendment to such provision after the occurrence of the act or omission that is the subject of the . . . [action] . . . for which indemnification or advancement of expenses is sought, unless the provision in effect at the time of such act or omission explicitly authorizes such elimination or impairment after such action or omission has occurred”

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Indemnification (cont.)

• Though DGCL amendment limited the application of the Schoon decision, it still stands as a “lesson learned” under other states’ laws. Thus, as applied to negotiations with Executives, consider:

– Charter or bylaw provisions should expressly provide that rights to indemnification and advancement of costs vest by virtue of the directors/officers services at the time the facts giving rise to the claim occurred

Subject to any limits under exculpation provisions and indemnification provisions

– Applicable charter or bylaw provisions should state that such provisions may not be amended without consent of the affected director/officer

– Determine whether to treat indemnification and advancement differently– Consider using separate indemnification agreements that cannot be

amended without mutual consent, especially where it is impracticable to amend charter or bylaws

Fewer enforceability issues Protects against unilateral amendment Provides ability to address rights in more detail Provides a greater degree of comfort to covered directors/officers

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