Ventures and Intellectual Property Letter

Transcription

1 Ventures and Intellectual Property Letter Third Quarter 2007 DEFERRED COMPENSATION COMPANIES CAN T DEFER THINKING ABOUT IT Companies reliance on deferred compensation for executives has skyrocketed in recent years along with headlines of arrangements gone awry. These developments did not go unnoticed. Congress adopted Section 409A of the Internal Revenue Code in 2004 new tax rules that prescribe stringent rules for the administration of deferred compensation arrangements and significant IN SUMMARY: DEFERRED COMPENSATION companies can t deter thinking about it basic requirements of 409A 409A action plan SEC PROPOSES REFORMS TO BENEFIT SMALLER PUBLIC COMPANIES AND ENHANCE CAPITAL FORMATION smaller public companies integrated scaled disclosure short-form registration statements relief from periodic reporting relating to numerous stock options holders modifications to ease capital raising in private placements penalties for noncompliance. With 409A, Congress cast a net much broader than the perceived abuses that spurred its enactment. Due to its scope and breadth, 409A carries potential implications for broad-based plans such as annual employee bonus programs and severance plans. Section 409A potentially applies to any arrangement under which a promise is made in one tax year to pay an amount in a future tax year (even if the promise is subject to vesting). It applies regardless of whether the arrangement is elective or non-elective, written or unwritten and regardless of the form of the arrangement, the type of compensation provided and the type of service provider (e.g., employee, independent contractor, director). Violation of Section 409A results in extremely onerous, confiscatory tax consequences for affected employees: immediate taxation, plus interest from the date first deferred, plus an additional 20% penalty tax. Although the legal penalty falls on the employee, an employer responsible for compensation design and administration will need to understand these rules in order to establish a compliant structure and to comply with 409A tax reporting obligations. The Department of Treasury and the Internal Revenue Service have spent the last three years fine-tuning the implementation of 409A, culminating in the issuance

2 Shipman & Goodwin LLP Third Quarter 2007 of final regulations on April 10, Companies have been required to be in good faith compliance with Section 409A since it became effective January 1, There s still time now, before transition relief ends on December 31, 2007, to make any changes needed to bring arrangements into full compliance with the final regulations. There s even some flexibility during this period for employees to change payout elections before more stringent election rules apply. On September 10, 2007, the IRS issued Notice , extending in some respects the deadline for amending documents to comply in writing with 409A requirements to December 31, However, the Notice does not extend the date for operational compliance with the final regulations or the deadline for specifying the time and form of payment under deferred compensation plans, which still must be done by December 31, The web of detailed rules in the final regulations is exceedingly complex. This article describes the basic rules for arrangements that are subject to 409A and provides a framework to determine whether an arrangement may be subject to 409A, as well as some practical tips and potential traps for the unwary. BASIC REQUIREMENTS OF 409A If the arrangement involves a promise made in one year to pay compensation in a future year and it cannot be made to fit within any exception to 409A, the arrangement must be stated in writing and must comply with the deferral rules and distribution rules described below. Deferral Rules. If the arrangement permits the employee to defer amounts from his or her own pay, the employee must make the election to defer before the first day of the year in which the compensation will be earned. Some exceptions are available for newly eligible participants and certain types of performance-based compensation and commissions, but they are relatively narrow and rigid. Distribution Rules. Every deferred compensation arrangement must specify the time and form of payment, or require the employee to elect the time and form of payment, before the first day of the year in which the deferred compensation is earned. Three additional rules apply to the payment of deferred compensation: Permissible payment events. The specified time of payment must be no earlier than one of the following events: separation from service, disability, death, a specified and objectively determinable date (or schedule of dates), a change in control of the employer or an unforeseeable emergency. Practical tip: Several of these payment events are defined in detail in the regulations; in order to make payment upon occurrence of the event, the arrangement must incorporate a 409A-compliant definition. For example, the final regulations contain detailed rules to determine whether a separation from service has occurred in the context of a reduced work schedule (such as a consulting arrangement), an unpaid leave of absence and certain corporate transactions. Change in time or form of payment. A payment generally can never be accelerated. It may be further deferred, and the form of payment may be changed, but only if: (1) the change is made at least 12 months before the scheduled payment date and (2) payment is delayed for at least five additional years. These rules apply regardless of whether the employee or the employer is seeking to change the time or form of payment. 2

3 Third Quarter 2007 Shipman & Goodwin LLP Six-month delay in payment. For public companies, payments to specified employees (generally, officers earning at least $145,000) upon separation from service must be delayed six months following the employee s separation. Complicated rules determine who is a specified employee and how specified employees are determined following certain corporate transactions such as an IPO or the acquisition of a private company by a public company. Practical tip: Since this provision must be included in the plan document if it applies, a private company going public might consider amending the document in advance (conditionally) to avoid any period of documentary noncompliance. 409A ACTION PLAN Identify All Arrangements Potentially Subject to 409A The first step to compliance is identifying all arrangements potentially subject to 409A. You should consult with appropriate colleagues in your legal, human resources and finance departments and review all compensation policies, plans and arrangements, including individual employment agreements, change-in-control agreements, severance plans, bonus and incentive plans, plans established to provide additional pension benefits to highly paid employees over IRS limits and equity compensation plans. Any arrangement that involves a promise made in one year to pay compensation in a future year is potentially subject to 409A. Tax-qualified plans (such as 401(k) plans, profit-sharing plans and qualified pension plans) are not subject to 409A. Determine Applicable Exceptions to 409A The next step is to determine whether the arrangements fit within, or could be modified (during the remainder of 2007) to fit within, an exception to 409A. The Code and the final regulations provide several exceptions. Three of the most useful exceptions are: Short-term deferral exception may be useful for: bonus plans, lump-sum severance payments and many other forms of compensation. Many broad-based bonus plans, although they provide for payment of compensation in the following calendar year, will be excepted from 409A under the short-term deferral rule. This rule provides an exception for amounts paid within 2 1 /2 months after the tax year in which vesting occurs (i.e., March 15 if using a calendar year). Either the company s tax year or the employee s tax year can be used. Practical tip: By stating in the plan document that payment will be made by March 15, the short-term deferral exception will be available even if administrative delay pushes the actual payment date to later in the year. This exception may also be useful for severance payments that exceed the dollar limit in the severance exception (described below), if they are payable only in the event of involuntary termination and all payments are made within 2 1 /2 months after the tax year in which involuntary termination occurs. Stock option exception for non-discounted stock options and stock appreciation rights 1. The final regulations provide a broad exception from 409A for stock options and stock appreciation rights (SARs) that satisfy certain requirements: (1) the exercise price is no less than the fair market value of the stock on the date of grant, (2) the stock is stock of the service recipient (generally the employer or a parent company, but not a subsidiary), and (3) no further deferral is permitted. Because virtually all stock options and SARs provide for exercise dates that can be elected in the future, if they fail to satisfy 3

4 Shipman & Goodwin LLP Third Quarter 2007 this exception they almost certainly will not comply with 409A. Watch out for: valuation of stock not traded on an established market. Such value must be determined in accordance with the regulations, which offer a general reasonableness approach (with a list of factors to be taken into account), as well as several methods that carry a presumption of reasonableness. An annual appraisal by an independent appraiser is presumed reasonable, but is not always required. Also watch out for: modifications and extensions. Certain changes to an option or SAR s original terms will cause it to fail the exception. Generally, an impermissible modification includes any change that reduces the exercise price. Certain extensions are permitted, including: (1) the extension of the exercise period up to the earlier of the end of the original term or the 10th anniversary of the grant date, and (2) the extension of the exercise period when an option or SAR is underwater. These rules should be reviewed in detail when contemplating any modification, for example in connection with a corporate transaction or as a special retention or severance arrangement for an individual. Practical tip: An employee s resignation for good reason will be considered an involuntary termination only if it meets certain objective criteria in the regulations; this may necessitate review and amendment of the definition of good reason in relevant documents. Otherwise Comply with 409A If you determine that your arrangement is subject to 409A, it must comply with all of 409A's rules, the most significant of which are described in the "Basic Requirements of 409A" above. Of course, the rules are much more detailed than outlined above, and you would be well-advised to consult with counsel. Shipman & Goodwin s Executive Compensation and Employee Benefits attorneys are experienced in assisting companies throughout the 409A action plan reviewing existing deferred compensation arrangements, analyzing design alternatives and drafting or amending plan documents. For more information, please contact Ali Haffner at (860) or ahaffner@goodwin.com. Severance pay exception for involuntary terminations not paid in a lump sum. Section 409A provides a limited exception for severance and separation payments to the extent that (1) payment is made only upon an involuntary termination (or pursuant to a window program as defined in the regulations), (2) the amount does not exceed the lesser of two times compensation or $450,000 (the 2007 limit, subject to increase annually), and (3) all payments are completed no later than the end of the second year following the year of termination. 4 1 This exception does not apply to restricted stock or restricted stock units (RSUs). Restricted stock is categorically exempt from 409A because it is governed instead by Section 83 of the Code. RSUs may fit within the short-term deferral exception discussed above if they provide for payment immediately upon vesting (or within 2 1 /2 months after the end of the year in which vesting occurs) and are not permitted to be further deferred.

5 Third Quarter 2007 Shipman & Goodwin LLP SEC PROPOSES REFORMS TO BENEFIT SMALLER PUBLIC COMPANIES AND ENHANCE CAPITAL FORMATION Over the past few months, the SEC has issued a string of proposals designed to benefit smaller public companies and enhance the ability of both large and small companies to cost-effectively raise capital. These proposals were made in response to the recommendations contained in the April 2006 report of the SEC s Advisory Committee on Smaller Public Companies. SMALLER PUBLIC COMPANIES If the proposals are adopted, smaller public companies a new SEC term for issuers with a public float of up to $75 million and essentially a combination of the current small business issuers and non-accelerated filers would be subject to a new integrated and scaled disclosure regime, and would have access to the SEC s short form registration statements for certain offerings. INTEGRATED SCALED DISCLOSURE Under current regulations, small business issuers (issuers with annual revenues and a public float that are both below $25 million) may take advantage of a parallel, but separate, disclosure system that relaxes many of the requirements imposed on other public companies. For example, many larger companies making an initial public offering must use a Form S-1 registration statement, which requires them to provide three years of audited financial statements, while small business issuers may use a simplified Form SB-2 registration statement, which requires only two years of audited results. Similar relief is offered from many other disclosure requirements, typically with a 5 view to making compliance less complex and less expensive. Under one of the SEC s proposals, this parallel regime would be abandoned in favor of an integrated system. All public companies would use the same set of forms and would provide disclosure based on a single set of regulations, but the regulations would contain scaled requirements under which companies of different sizes would be required to provide different levels of disclosure. Current small business issuers would see little change in the disclosure they are required to provide, while other issuers that fit within the new definition of smaller public companies, but that are too large to qualify as small business issuers, would find their disclosure burdens reduced. The scaling is not mandatory. A smaller public company will have the option to cherry pick areas where it wishes to take advantage of the reduced disclosure, but will be free to provide broader disclosure on any matter if it so chooses. In addition to reducing some of the burdens of providing disclosure, the unified system should eliminate the stigma that small business issuers sometimes face as a result of using the current small business issuer forms. SHORT-FORM REGISTRATION STATEMENTS Another SEC proposal would permit smaller public companies to use Form S-3 registration statements (or Form F-3 for foreign issuers) for primary offerings of their securities. These short form registration statements, which incorporate much of their required information by reference to the issuer s existing public filings, are much more cost effective to produce and update than full Form S-1 registration statements. However, these forms are currently available for primary offerings only to companies with a public float of at least $75 million. Under the proposals, smaller public companies would be permitted to use

6 Shipman & Goodwin LLP Third Quarter 2007 these forms, provided that they meet the other requirements for their use, such as having been current in their periodic reporting for at least the preceding year. However, a smaller public company would not be permitted to use these forms to sell securities in excess of 20% of its public float over any one year period. RELIEF FROM PERIODIC REPORTING RELATING TO NUMEROUS STOCK OPTIONS HOLDERS Another proposal would eliminate a trap that sometimes has forced growth stage private companies into becoming 34 Act reporting companies as a result of having issued options to too many employees. Section 12(g) of the 34 Act generally requires that a company register a security under the 34 Act, and as a result become subject to the requirement to file periodic reports with the SEC, if the Company has assets in excess of $10 million and a class of equity securities held by 500 or more holders of record. The securities do not have to be issued in a public offering and the issuance of stock options to the company s workforce can trigger the requirement even if none of the options have been exercised. The proposal would add an exemption to Section 12(g) for compensatory employee stock options issued under written plans by non-reporting companies provided that certain conditions are met. A similar exemption would be added for issuers that have already registered the securities underlying the options, thus eliminating the current redundant registration requirement MODIFICATIONS TO EASE CAPITAL RAISING IN PRIVATE PLACEMENTS The SEC has proposed a number of revisions to Regulation D and Rules 144 and 145 that would facilitate the private placement of securities as well as the resale of securities by stockholders that face restrictions on their ability to resell their shares. While these changes will be important for smaller public companies, which often issue securities in private placements even after going public, they apply equally to issuers of all sizes. Regulation D provides a number of safe harbors for private placements. These safe harbors are contingent on a number of factors, such as the size of the offering and the sophistication of the purchasers. Under the proposals, a new Rule 507 would be added to Regulation D that would permit offers to Rule 507 qualified purchasers through the use of limited tombstone-style advertising. These qualified purchasers would include individuals with annual incomes of $400,000 ($600,000 with their spouses) or who own $2.5 million in investments, as well as certain institutional investors and issuer insiders. These limits are well above the current limits for qualifying as an accredited investor under Regulation D. The definition of accredited investor would also be expanded to include a new category based solely on the ownership of investments: $750,000 for individuals and $5.0 million for institutions. Both the new and existing monetary thresholds for establishing investor sophistication under Regulation D would, for the first time, be subject to periodic adjustment for inflation. In addition, Form D, the notice form for Regulation D sales, would be simplified and filed by means of a new online filing system. Rule 144 provides a safe harbor for the public resale of restricted securities, such as those acquired from an issuer in a Regulation D private placement, and securities held by certain affiliates and former affiliates of the issuer, provided that certain holding period, volume, manner of sale and other 6

7 Third Quarter 2007 Shipman & Goodwin LLP requirements are met. Under one of the SEC s proposals, the Rule 144 requirements would be significantly relaxed, particularly for non-affiliates. The current holding period for the resale of restricted securities issued by reporting companies would be reduced from one year to six months. The holding period would be tolled if the holder hedges his or her interest in the securities, but not beyond the current one year holding period. For non-reporting companies, the holding period will remain at one year. In addition, non-affiliates of the issuer (who have been non-affiliates for at least three months) will no longer be subject any manner of sale, volume limitations or notice filing requirements once the holding period has expired. The Rule will still require that the issuer be current in its periodic filings for sales to occur during The SEC did not adopt all of the recommendations made last year by the Advisory Committee on Smaller Public Companies. For example, the Committee had recommended that the SEC eliminate the broad restrictions on advertising and general solicitation under Regulation D. The tombstone-style advertising permitted under new Rule 507 falls well short of this recommendation. However, taken as a whole, the SEC proposals undoubtedly represent a meaningful attempt to eliminate some of the unnecessary costs and barriers to capital formation faced by public (and private) companies. For smaller public companies in particular, many of which were hit with unexpected and exorbitant new compliance costs as a result of Sarbanes-Oxley, these developments will prove most welcome. the period from the end of the new six month holding period through the end of the one year holding period; in other words, a delinquent filer is treated in the same manner as a non-reporting company. While For more information, please contact Ed Kane at (203) or ekane@goodwin.com. Rule 144 s manner of sale, volume limitations and notice filing requirements generally will continue to apply to sales by affiliates of the issuer, the manner of sale restrictions would no longer apply to their resale of debt securities and the notice filing threshold would be increased to 1,000 shares or $50,000. A number of conforming changes would be made to Rule 145, which governs the resale of securities received in certain business combination transactions. 7

8 Shipman & Goodwin LLP Third Quarter 2007 One Constitution Plaza Hartford, CT (860) Atlantic Street Stamford, CT (203) Greenwich Avenue Greenwich, CT (203) Porter Street Lakeville, CT (860) The attorneys in the Business and Finance Group of Shipman & Goodwin represent public and private companies that are local, regional, national, and international in scope, as well as the investors that finance their activities. Our clients include businesses at all stages of development, including start-up and emerging growth companies, closely held and family businesses, and middle market companies. Our business clients are engaged in information technology and software, wireless technologies, telecommunications, e-business, manufacturing, distribution, banking, insurance, health care, specialty materials, real estate construction and development, transportation, retail and wholesale marketing, investment banking and advisory services, professional and consulting services, and agricultural business. Across the many industries we service, private equity is often the fuel for growth. For many years, we have been engaged in finance transactions on behalf of both companies and investors, including venture capital funds, mezzanine funds, SBICs, hedge funds, corporate and strategic investors, institutional investors, and angel investors. We pride ourselves on giving practical, business-oriented and creative advice, with broad industry knowledge in those sectors in which our clients do business. This Letter is published quarterly as a service to clients and friends. The contents are intended for informational purposes only, and the advice of a competent professional is required to address any specific situation. Reproduction or redistribution is permitted only with attribution to the source. Donna L. Brooks, editor Shipman & Goodwin LLP. All rights reserved. CONTACTS Thomas P. Flynn Donna L. Brooks Steven M. Gold John E. Kreitler John H. Lawrence, Jr. Marcus D. Wilkinson (860) (860) (203) (860) (860) (860) tflynn@goodwin.com dbrooks@goodwin.com sgold@goodwin.com jkreitler@goodwin.com jlawrence@goodwin.com mwilkinson@goodwin.com One Constitution Plaza Hartford, CT