Practising Law Institute ERISA: The Evolving World 2014 An Introduction to Executive Compensation/ Nonqualified Deferred Compensation Plans/SERPs

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1 Practising Law Institute ERISA: The Evolving World 2014 An Introduction to Executive Compensation/ Nonqualified Deferred Compensation Plans/SERPs August 4, 2014 Regina Olshan Charmaine L. Slack

2 Introduction What will we cover in this session? Generally, compensation arrangements that are not broad-based that is, don't generally cover the rank and file Various types of executive compensation arrangements Structure is determined by the purpose of the compensation What rules apply to executive compensation arrangements? Various rules including ERISA, tax and securities rules The rules impact the structure, payment, funding and disclosure of nonqualified deferred compensation 2

3 Types of Executive Compensation Supplemental Executive Retirement Plans (SERPs) Elective Deferred Compensation Severance Plans and Arrangements Bonus and Incentive Plans Equity-Based Plans 3

4 Differences between Nonqualified Deferred Compensation Arrangements and Tax-Qualified Retirement Plans Nonqualified deferred compensation (NQDC) is generally compensation earned in one year and payable in a future tax year No monetary limitations, funding, vesting, accrual or nondiscrimination requirements No employer deduction until the employee recognizes income Trusts are not tax exempt No IRA rollovers Subject to the claims of the employer's creditors No PBGC insurance coverage 4

5 Supplemental Executive Retirement Plans (SERPs) Excess Plans Top-hat plan maintained solely for the purpose of providing employees with benefits which cannot be provided due to Code Section 415 limitations Other SERPs Provide selected employees with retirement income to supplement benefits under tax-qualified pension plans May make up for accruals or contributions that cannot be made under the qualified plan because of Code limitations or may be a separately calculated benefit offset by any qualified plan benefits 5

6 Elective Deferred Compensation Provide employees with tax-efficient saving opportunities Employees may elect to defer payment of a portion of the compensation they would otherwise earn until a later time or event May allow employees to choose the amounts to be deferred and/or the time and form of payment of those amounts May also provide for employer contributions, which are sometimes subject to vesting requirements Amounts contributed to the plan may be nominally invested in investment accounts/vehicles, including employer stock 6

7 Severance Plans and Arrangements Employment Agreements and other Individual Agreements Often provide for payments of severance (lump sum or over time) Paid for termination by employer without "cause" or by employee for "good reason" or due to death or disability May provide for higher severance or other more favorable terms that apply after a change in control of the employer 7

8 Severance Plans and Arrangements (Cont'd) Severance Plans Provide severance protection benefits for a broader class of employees Often formula based, providing for a certain number of weeks of base salary based on title and/or years of service Most often paid due to an involuntary termination of employment 8

9 Bonus and Incentive Plans Adopted to attract, retain and/or motivate employees to achieve preestablished business goals Commonly structured to pay at the completion of the employer's fiscal year based on the achievement of performance targets May establish performance periods of multiple years, with payments subject to performance and/or service vesting requirements 9

10 Equity-Based Plans Includes stock options, stock appreciation rights (SARs), phantom stock, deferred shares, restricted stock and restricted stock units Serve to incentivize employees and more closely align the interests of employees with those of the granting company's stockholders May be granted subject to performance and/or service vesting requirements Compliance with the securities laws is critical 10

11 Applicable Rules Internal Revenue Code Sections 409A, 280G, 162(m), 83 ERISA Top-Hat Pension Plans Reporting and Disclosure Securities Rules Registration Disclosure Listing Rules Section 16 11

12 Applicable Tax Rules: Section 409A Adopted in 2004 as last piece of "Enron" legislation Has brought about fundamental changes in the way executive compensation matters are negotiated and drafted Far-reaching, e.g., covers many severance arrangements and equity-based awards Covers compensation deferred in taxable years beginning after December 31, 2004 Transition relief has ended Good faith compliance requirement began January 1, 2005 All documents must now be in documentary compliance 12

13 Applicable Tax Rules: Section 409A (Cont'd) What is nonqualified deferred compensation for purposes of Section 409A? The employee has a legally binding right during a taxable year to compensation that is or may be payable to the employee in a later taxable year No legally binding right if employer has unfettered discretion to reduce or eliminate compensation, unless the negative discretion lacks substantive significance or can only be exercised upon a condition Section 409A applies to all service providers (directors and employees and many independent contractors) 13

14 Applicable Tax Rules: Section 409A (Cont'd) Examples of nonqualified deferred compensation subject to Section 409A: Supplemental retirement and deferred compensation plans and programs Many employment, change in control and severance agreements plans and arrangements Stock options or SARs that are granted "in the money" Phantom stock, deferred shares and restricted stock units, if not payable within short-term deferral period often because of retirement or other termination provisions Stock options/sars that are materially modified, resulting in new grant at "in the money" price 14

15 Applicable Tax Rules: Section 409A (Cont'd) Effect of failure to comply with Section 409A: Service provider is required to include in income and pay 20% surtax and interest on amounts deferred under an arrangement that violates Section 409A, in the year in which a violation occurs (but not for prior or subsequent years in which a violation does not occur) No consequences to the service recipient (employer), although it has reporting and withholding obligations 15

16 Applicable Tax Rules: Section 409A (Cont'd) Amounts not subject to Section 409A (not exhaustive) Short-term deferrals Compensation paid no later than 15 th day of the third month following the end of the service provider's (or, if later, the service recipient's) first taxable year in which the payment is no longer subject to substantial risk of forfeiture If never a substantial risk of forfeiture, then must be paid no later than the 15 th day of the third month following the end of the service provider's taxable year in which he has legally binding right to the payment Common examples of short-term deferrals: annual bonus, some restricted stock units, lump sum severance pay 16

17 Applicable Tax Rules: Section 409A (Cont'd) Amounts not subject to Section 409A (Cont'd) Partnership interests, including profits interests Restricted stock Stock options (including ISOs) or SARs, if granted on "service recipient stock" with exercise price that may never be less than fair market value as of the date of the grant Qualified plans Payroll practices, vacation, sick pay, COBRA premiums Compensation that was earned and vested (i.e., no longer subject to a substantial risk of forfeiture) as of December 31, 2004 (so long as plan is not materially modified) 17

18 Applicable Tax Rules: Section 409A (Cont'd) Effect of deferred compensation being subject to Section 409A Strict limitations on the timing of initial deferrals Limited permissible payment events Specified time or schedule, Death, Disability, Unforeseeable Emergency, Separation from Service, Change in Control event Limited ability to modify time and form of payment Must be pursuant to a written plan that complies in documentary respects, as well as in operation Six-month delay in payment for "specified employees" unless exception applies 18

19 Applicable Tax Rules: Section 280G Payments that are considered parachute payments under Section 280G have two adverse effects: "Excess parachute payments" are not deductible by the employer The recipient of the payments is subject to a 20% excise tax on excess parachute payments under Section 4999 A "parachute payment" is any payment (including non-cash compensation) if: The payment is contingent on a change in ownership or control of a corporation; and The aggregate present value of all such payments equals or exceeds 300% of the executive's base amount (detail follows) 19

20 Applicable Tax Rules: Section 280G (Cont'd) Golden parachute rules only apply to "disqualified individuals" An employee or independent contractor who is also An officer, a highly compensated individual (as defined in the rules) or a shareholder who owns greater than 1% of the total fair market value of the outstanding shares of all classes Excess parachute payment is the excess of the disqualified individual's parachute payments over the disqualified individual's base amount "Base amount" is the disqualified individual's average taxable compensation from the company in the five taxable years preceding the year in which the change in control occurs 20

21 Applicable Tax Rules: Section 280G (Cont'd) Safe harbor is provided for change in control-related payments, the present value of which is in the aggregate less than 300% of the disqualified individual's base amount Some exceptions: Payments that are not in the nature of compensation, e.g., acquisition consideration that is received by a disqualified individual for vested shares already owned Compensation to be paid with respect to fully vested stock options/sars Compensation paid by a non-public company, if the stockholder approval requirements of the regulations are met 21

22 Applicable Tax Rules: Section 280G cont'd Some exceptions (cont'd): Reasonable compensation for personal services to be rendered after the change in control or payments made pursuant to an agreement entered into after the change in control ("post-change" agreements) 22

23 Applicable Tax Rules: Section 162(m) Generally provides that annual compensation in excess of $1 million that is paid to the top executives of a public company is not deductible Exception for performance-based compensation (more below) Covers CEO and the three other highest compensated officers (other than the CFO) serving at the end of the taxable year for whom disclosure is required under Item 402 of Regulation S-K Most often, executives of a target company will no longer be subject to Section 162(m) for the year of the transaction (often no executive compensation disclosure required for short taxable year ending with the transaction) 23

24 Applicable Tax Rules: Section 162(m) (Cont'd) Performance-Based Compensation Exception: 162(m) limitation does not apply to compensation that is payable solely on account of attainment of one or more performance goals that have been pre-established by a compensation committee made up of outside directors performance goals must be objective none of the award will qualify for the exception if the payment is only nominally or partially contingent on attainment of goal shareholders must approve performance criteria 24

25 Applicable Tax Rules: Section 162(m) (Cont'd) Performance-Based Compensation Exception (Cont'd): Compensation paid representing the spread of stock options and SARs always qualifies because there is no payment without appreciation in stock price, so long as granted by a compensation committee of outside directors under a shareholder-approved plan which includes a per-person award maximum Restricted stock or restricted stock units will not qualify unless vesting is based on the achievement of one or more performance goals 25

26 Applicable Tax Rules: Section 83 Governs the transfer of property in consideration for services Value of transferred property, less purchase price, is ordinary income Income included upon vesting of restricted stock unless election is made under Section 83(b) to include value at time of grant Section 83(b) election may not be made with respect to restricted stock units; units are not property but a promise to pay compensation at a later date Income (equal to the excess of the value of stock received over the exercise price) included upon exercise of stock options and SARs, but not the grant 26

27 Applicable ERISA Rules: Top-Hat Plans Unfunded pension plans maintained by an employer primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees Exempt from the participation, vesting, funding and fiduciary requirements of ERISA Must still comply with the ERISA provisions pertaining to reporting and disclosure, and administration and enforcement actions 27

28 Applicable ERISA Rules: Top-Hat Plans (Cont'd) DOL requires that each participant be part of a select group of management or highly compensated employees Some courts have held that both a qualitative and quantitative analysis must be performed to determine whether a plan's participants are a "select group" Factors to be considered: percentage of eligible employees covered nature of employment duties compensation disparity between plan members and nonmembers actual language of the plan 28

29 Applicable ERISA Rules: Reporting and Disclosure Most NQDC plans are structured to be exempt from ERISA's substantive requirements but some must comply with the reporting and disclosure requirements of ERISA Many NQDC arrangements will not qualify as plans under ERISA and will be completely excluded from its requirements 29

30 Applicable ERISA Rules: Reporting and Disclosure (Cont'd) Pension Plans Most often structured as top-hat plans Reporting and disclosure requirements apply Regulatory exemption limits the applicable requirements to a brief, one-time filing 30

31 Applicable ERISA Rules: Reporting and Disclosure (Cont'd) Welfare Plans For example, certain severance plans that are not limited to the "top-hat" group Employer will be required, among other things, to file a Form 5500 annually, provide Summary Plan Descriptions to participants, and establish compliant procedures for the appeal of adverse claim determinations 31

32 Applicable Securities Rules: Registration Potential requirements to register Shares issued with respect to stock options, restricted stock units or phantom investments in company stock "Deferred compensation obligations" under an elective arrangement For public companies Form S-8 can be used to register the sale of securities to be issued to employees and consultants A separate prospectus, which is not filed with the SEC, must be prepared and delivered to eligible participants For private companies, an exemption from registration requirements must generally be utilized 32

33 Applicable Securities Rules: Disclosure Exchange Act registrants (and their directors and officers) are required to file: Periodic reports: annual reports (10-K), quarterly reports (10-Q), current reports (8-K) Proxy statements Section 16 reports (tracking the purchase and sale of company securities) Beneficial ownership reports on Schedule 13D and 13G These reports and filings have complex and comprehensive disclosure requirements relating to NQDC, particularly with respect to directors and officers of the registered company 33

34 Applicable Securities Rules: Shareholder Approval/Exchange Listing The New York Stock Exchange and Nasdaq Stock Market generally require shareholder approval of all equity compensation plans and material revisions to such plans Excludes certain plans: Plans pursuant to which employees receive only cash Plans that merely allow employees, directors or service providers to buy shares for their current market value Plans made available to shareholders generally 34

35 Applicable Securities Rules: Section 16 Section 16 of the Exchange Act Reporting obligations and trading restrictions on certain public company "insiders" Deters the use of confidential information for personal trading gain "Insiders" are the company's directors and officers and beneficial owners of more than 10% of any class of the company's equity securities "Officers" are the company's president, principal financial officer, principal accounting officer (or controller), any vice president in charge of a principal business unit/division/function, and any other person who performs a policy-making function for the company 35

36 Applicable Securities Rules: Section 16 (Cont'd) Insiders must publicly report their holdings of and transactions in company equity securities in Section 16 reports Insiders are subject to strict liability for recapture by the company of profits realized on "short-swing transactions" "Short-swing transactions" are any non-exempt purchase and sale, or sale and purchase, of company equity securities within a period of less than six months 36

37 Attorney Bios Regina Olshan Partner Skadden Arps Slate Meagher & Flom LLP Profile Regina Olshan is the global head of Skadden's Executive Compensation and Benefits Group. Her practice focuses on advising companies, executives and boards on navigating the regulatory complexities of executive compensation and benefits. This includes tax laws (including laws governing deferred compensation, golden parachute arrangements and deduction limitation rules), securities laws (including reporting and disclosure requirements and registration issues) and compensation-related litigation matters. 37

38 Attorney Bios Regina Olshan Partner Skadden Arps Slate Meagher & Flom LLP Profile (Cont'd) In addition, Ms. Olshan regularly advises public companies, boards, private equity clients and members of management on executive compensation and benefits issues arising in the context of mergers, acquisitions, spin-offs, initial public offerings, restructurings and other extraordinary corporate events, including private equity and leveraged buyout transactions. She also regularly advises large public companies and individual senior executives on the adoption, revision, and negotiation of executive employment and severance agreements, as well as litigation and controversies involving executive compensation. 38

39 Attorney Bios Regina Olshan Partner Skadden Arps Slate Meagher & Flom LLP Profile (Cont'd) Ms. Olshan is the author and editor of the Section 409A Handbook. She speaks and writes frequently on executive compensation issues and cochairs "Hot Issues in Executive Compensation," an annual seminar presented by PLI. She also has been quoted in various major publications on significant executive compensation issues of the day. Ms. Olshan is ranked in the top tier in Chambers USA: America's Leading Lawyers for Business for New York employee benefits and executive compensation. She also is listed in The Best Lawyers in America and The Legal 500 U.S. In 2013 Chambers USA also recognized Skadden's Executive Compensation and Benefits Group with its Award for Excellence, given annually to a select group of firms on the basis of pre-eminence in key practice areas. 39

40 Attorney Bios Charmaine L. Slack Partner Jones Day Profile Charmaine Slack advises senior executives, boards of directors, and compensation committees of public and private entities on a wide variety of executive compensation and equity arrangements. She counsels clients on the diverse and complex compensation matters that arise in substantial domestic and cross-border M&A, leveraged buyout, and private equity and other fund investment transactions across a spectrum of industries. 40

41 Attorney Bios Charmaine L. Slack Partner Jones Day Profile (Cont'd) Ms. Slack regularly counsels on the broad array of legal and business issues that arise in executive compensation programs affecting CEOs and other senior executives, including employment, change in control, and severance arrangements; and equity performance/incentive, deferred compensation, and director compensation programs. She provides corporate governance advice and technical guidance on tax and securities rules affecting compensation and benefits. 41

42 Questions? Regina Olshan Skadden Arps Slate Meagher & Flom LLP 4 Times Square New York, NY regina.olshan@skadden.com Charmaine L. Slack Jones Day 222 E. 41 st Street New York, NY cslack@jonesday.com 42

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