Public Companies May Need to Amend Stock Option Plans Soon to Qualify for Exception to $1 Million Compensation Deduction Limit

Posted on August 12, 2011 by Greg Daugherty

Publicly traded companies may need to act quickly to review, and, if necessary, amend their stock option and stock appreciation right ("SAR") plans in order to preserve tax deductions for compensation in excess of $1 million paid to certain executives. The reason for this review is that the Internal Revenue Service (the "IRS") and the United States Treasury Department recently issued proposed regulations that clarify a few items with respect to the application of Section 162(m) of the Internal Revenue Code (the "Code") to such plans. One item relates to requirements that stock options and SARs must meet to qualify as performance-based compensation. Another item relates to a transition rule for companies that initially are privately held but that later become publicly traded companies.

As background, Code Section 162(m) limits the deduction a publicly traded company may take with respect to remuneration paid to its "covered employees"--- its CEO and 3 most highly paid officers (other than the CEO and CFO)---to the extent that such compensation exceeds $1 million. The deduction limit does not apply, however, to qualified performance-based compensation. Publicly traded companies often structure their stock options and SARs in a manner to qualify as performance-based compensation.

The proposed regulations clarify that in order for stock options and SARs to qualify as performance-based compensation, the plan under which such awards are granted must specify the maximum number of shares relating to those awards that may be granted to any individual employee during a specified period. Previously, some commentators had argued that stating an aggregate share limit for all awards granted under the plan should satisfy the performance-based compensation exception requirements. The preamble to the proposed regulations, however, states that this aggregate approach is inconsistent with the purpose of Code Section 162(m), and that an individual employee limit is necessary to assist a third party in determining the maximum amount of compensation that could be payable to any individual employee during a specified period. Additionally, the proposed regulations require that publicly traded companies disclose to their shareholders these individual employee share limits in order for the options and SARs to qualify as performance-based compensation.

Finally, the proposed regulations clarify that an existing limited transition period will not apply to grants of restricted stock units ("RSUs") or phantom stock by a company that, at the time the grants are made, is not a publicly traded company in the event that the company later becomes a publicly traded company when the grants still are outstanding. This position is a reversal of a position taken by the IRS in previously issued private letter rulings. The transition period rule generally provides that compensation related to the exercise of stock options or SARs, or the substantial vesting of restricted stock, under a pre-existing plan will not be subject to the $1 million deduction limit for a limited grace period after the company becomes publicly traded. Many practitioners believed that this grace period would apply to phantom stock and RSUs as well, but the proposed regulations make clear that this is not the case.

The proposed regulations are somewhat ambiguous as to when these clarifications would become effective if they become final. The preamble states that all of the clarifications would first become effective in the taxable year ending on or after the date of publication of the final regulations, but in essence two different effective dates seem to have been established (pending resolution in the final regulations) for the two clarifications. The proposed regulations state that the individual employee share limit requirements for options and SARs would become effective starting June 24, 2011 (i.e., the date the proposed regulations were published) and apparently would apply to all grants on and after that date. However, the limitation of the transition period for RSUs and phantom stock awarded by newly publicly traded companies would become effective on the date final regulations are published. 

Given these effective date provisions, publicly traded companies should review their stock option and SAR arrangements now and determine with counsel whether they need to be amended to provide a per-employee share limit. Failure to do so could mean that these companies may not deduct any compensation in excess of $1 million to "covered employees" related to grants of stock options or SARs. Privately held companies that may soon become publicly traded may want to consider the payment features of any RSU or phantom stock awards they grant, and even may want to consider granting restricted stock awards, stock options, or SARs instead of RSUs or phantom stock in light of these new clarifications.
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SEC Whistleblower Rules

Posted on July 7, 2011 by Jack J. Gravelle

In mid-August the SEC’s new whistleblower rules will take effect (click here for the Final Rule).  The new rules explain and further define the requirements of a whistleblower program that has been in place since the Dodd-Frank Act took effect on July 21, 2010. In general, anyone who provides information to the SEC relating to a possible violation of the securities laws is entitled to an award if the following requirements are met:

  • The information must be provided voluntarily, before the SEC asks for it;
  • The information must be based on the whistleblower’s independent knowledge and not already known to the SEC or derived from public filings;
  • Providing the information must lead to successful enforcement by the SEC or a federal court or administrative action; and
  • The SEC must obtain monetary sanctions above $1 million.

Successful whistleblowers can receive an award of between 10 and 30% of the total monetary sanctions collected. The whistleblower program is a significant expansion of previous SEC whistleblower rules that only applied to insider-trading cases and were capped at 10% of the penalties collected (click here for the SEC press release). 

The whistleblower rules do not require the whistleblower to comply with the company’s internal compliance program, but do encourage such internal compliance. For example, a whistleblower who reports through the company’s internal compliance program is still eligible for an award if the company reports the information to the SEC, and the whistleblower receives credit for all information proved by the company, even information not initially reported by the whistleblower to the company.

Despite the expansive new rules, awards are not available for, among others, whistleblowers with a pre-existing contractual duty to report the violation, a person who obtains the information illegally, or an officer or director who gains the information through the company’s internal process for identifying violations.

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Wall Street Reform Legislation Requires Public Companies to Revise Clawback Policies

Posted on August 19, 2010 by Greg Daugherty

On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Act”). Although the Act focuses primarily on the financial industry, the Act contains a section that requires the Securities and Exchange Commission (“SEC”) to publish rules that direct the national securities exchanges and associations to prohibit the listing of any security of an issuer that does not develop and implement an appropriate clawback policy.

Specifically, a clawback policy must provide that an issuer that is required to restate its financial statements because of a material financial reporting violation must recover from certain executive officers the amount in excess of what would have been paid to them under the issuer’s restated financial statements. No showing of misconduct or negligence on the part of the affected executives is required. In other words, public companies must recover the excess, if any, between the actual pay-out under the original financial statements and the amount payable under the restated financial statements. This policy must apply to any current or former executive officer who received incentive-based compensation (including stock options) during the three-year period preceding the date on which the restatement is required. The Act also requires that companies disclose this clawback policy to shareholders. Any former employee who was an executive officer at any time apparently will be subject to the clawback policy without regard to whether he or she was an executive officer at the time of the restatement or whether the compensation that was received had been earned prior to the three-year period.

The clawback provisions under the Act differ from that required of institutions who received financial assistance under the Troubled Asset Relief Program (“TARP”). Institutions that received financial assistance under TARP generally are required to provide for the clawback of bonuses and incentive compensation awarded to senior executive officers and the next 20 highly paid employees if such payments were based on materially inaccurate financial statements or performance metrics, which, depending on the specific circumstances, may have a broader reach than the Act. The Act’s provisions also differ from the clawback provisions in Sarbanes-Oxley, which apply only to a company’s CEO and CFO, are triggered by misconduct, and apply only to the preceding 12 months.

The effective date of the Act was July 22, 2010; however, the clawback policy requirement is not fully effective until the SEC publishes its regulations. Currently, the SEC is suggesting it will publish these rules to be effective for the 2011 proxy season. As such, no action is needed now, but we recommend that once the final regulations are published, all public companies take the following actions:

1. Examine All Incentive Compensation Arrangement Clawback Policies. All clawback policies need to be revised after the SEC publishes its final rules.

2. Revise and Update Incentive Compensation Plan Design Features. Revising the clawback policy provides an opportunity to review the overall incentive compensation plan design and consider whether it should be revised. For example, some companies have begun to require employees to defer the receipt of incentive awards, in part to ease administration of the clawback policy. Companies must be careful to ensure that any changes are consistent with applicable tax rules.
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