I. THE SARBANES-OXLEY ACT OF 2002
The Sarbanes-Oxley Act of 2002 (the "Act"),3 enacted on July 30, 2002, was designed to prevent deceptive management and accounting practices and to enhance financial reporting and disclosure. The Act was adopted to restore investor confidence in the United States securities markets and aims to accomplish this task by protecting benefit plan participants from corporate abuses, to increase transparency as to the methods used by issuers4 to compensate insiders (e.g., executive officers and directors of an issuer), to prevent deceptive practices in management, and to accelerate disclosure to the marketplace of transactions engaged in by insiders.
Prohibition on Personal Loans to Executive Officers and Directors
Section 402 of the Act5 prohibits issuers, directly or indirectly, from extending or maintaining credit, arranging for the extension of credit, or renewing an extension of credit, in the form of a personal loan to or for any director or executive officer (or equivalent thereof) of that issuer, with certain limited exceptions.6 Any loans in existence prior to the passage of the Act may continue so long as there is no "material modification" to any term of any such extension of credit or any renewal of any such extension of credit on or after the date of enactment of the Act.
Given the limited legislative history of the Act and the lack of regulatory guidance with respect to the meanings and breadth of its terms, Section 402 has created a number of issues with respect to what is a "personal loan," an "extension of credit" and when is an issuer "arranging" for an extension of credit on behalf of an insider, what types of loans are in fact grandfathered under the Act, what types of modification to a loan may be deemed "material," and/or what acts on the part of the insider or issuer may constitute a "renewal" of a loan arrangement entered into prior to enactment of the Act. These questions and the lack of regulatory guidance concerning the scope of Section 402 have left attorneys practicing in this field with as many questions as answers as to what types of transactions or actions are prohibited personal loans under the Act. In addition, until the Securities and Exchange Commission (the "SEC") or Congress clarifies the scope of this section of the Act, the prohibition of Section 402 continues to raise a number of interesting issues in the executive compensation area, including, but not limited to, the following:
Cashless Exercises of Stock Options: The Act calls into question the legality of issuers making temporary loans to executive officers and directors under cashless exercise programs provided for in their stock option plans. The basis for the prohibition arguably is that the issuer is "arranging" for an extension of credit by either (i) advancing to a broker shares, with a value equal to the option exercise price, which the broker sells into the market to raise the exercise price, or (ii) promising to deliver shares to the broker subsequent to the broker using its own inventory of company shares to raise the exercise price. While many legal professionals have weighed in with their professional opinion that most cashless exercise programs do not run afoul of the Act's prohibition, neither the SEC nor Congress has issued any guidance on this point.
Split-Dollar Insurance Arrangements: Many issuers have entered into split-dollar life insurance arrangements with their executive officers. Under these arrangements, the company pays all or a significant portion of the premiums on a life insurance policy insuring the life of the executive. These premiums are typically repaid to the company upon the death of the executive or the surrender of the policy. The Internal Revenue Service (the "IRS") has recently issued proposed regulations that would treat certain types of split-dollar arrangements as loans for federal tax purposes. The Act calls into question the legality of a public company entering into and maintaining split-dollar life insurance arrangements with its directors and executive officers. Currently, there is no clear answer to this issue and public companies must address not only whether it is advisable to enter into any such arrangement in the future, but also whether they can continue to make premium payments on existing arrangements.
Loans under 401(k) Plans: Many, if not the majority of, 401(k) plans offered by public companies offer loans to participants. While it is unlikely that the Act was intended to prohibit loans from a 401(k) plan to executive officers, the Act provides no specific guidance on this point. In fact, limiting the ability of executive officers from taking loans under a 401(k) plan would likely raise separate concerns under the Employee Retirement Income Security Act of 1974, as amended ("ERISA"), including the requirement that loans be made available on a reasonably equivalent basis to participants in order to be exempt from ERISA's prohibited transaction proscriptions.7
Accelerated Reporting Deadlines for Insider Transactions
Section 403 of the Act amended Section 16(a) of the Exchange Act by, among other matters, substantially narrowing the period in which insiders and beneficial owners of more than 10% of an issuer's equity securities must report changes in their beneficial ownership of such issuer's securities (including the purchase or sale of security-based swap agreements). Section 403 requires insiders and beneficial owners of more than 10% of a company's equity securities to file a Form 4 by the end of the second business day following a change in such person's ownership of the issuer's equity securities (unless the SEC by rule establishes that such a period is not feasible).8
On August 27, 2002, the SEC adopted new rules implementing the accelerated filing deadlines under Section 16(a) of the Exchange Act.9 The following transactions are now subject to the new two-business day filing deadline: (i) the rules amend Rule 16a-3(f) and 16a-6(a) so that transactions between officers or directors and the issuer exempted from Section 16(b) short-swing profit recovery by Rules 16b-3(d) (with respect to grants, awards and other acquisitions from the issuer, including stock option grants), 16b-3(e) (dispositions to the issuer), and 16b-3(f) (Discretionary Transactions pursuant to employee benefit plans10), all of which were previously reportable on a deferred basis annually on Form 5, will now be required to be reported within two business days on Form 4, and (ii) the rules amend Rule 16a-6(b), the small acquisitions rule, to provide that transactions under $10,000 in which the insider acquires the securities from the issuer, which were formerly reportable on an annual basis on Form 5, will now be required to be reported within two business days on Form 4.
In addition, the new rules amended Rule 16a-3(g) of the Exchange Act and identified only two types of transactions which are not feasible under the two-business day filing deadline: (i) transactions pursuant to Rule 10b5-1(c) arrangements where the insider does not select, and therefore does not immediately know the date of execution, and (ii) Discretionary Transactions pursuant to employee benefit plans where the insider does not select the date of execution and, as a result, may not reasonably expect such Discretionary Transaction to be executed immediately, but rather at a time consistent with the plan's particular administrative procedures. For both categories, the two-business day period runs from the deemed execution date rather than the actual transaction execution date, which is the date the insider is notified that the transaction has been executed and this notification date may not be later than the third business day following the actual transaction execution date. The insider must report either transaction on Form 4 before the end of the second business day following the deemed execution date.11
Beginning no later than July 30, 2003, each report must be filed electronically with the SEC and a company must make the reports available on its website the first business day after filing with the SEC.
Forfeiture of Certain Bonuses and Profits
Section 304 of the Act provides that if an issuer is required to prepare an accounting restatement due to the material noncompliance of the issuer, as a result of misconduct, with any financial reporting requirement under the securities laws, the chief executive officer and the chief financial officer will be required to reimburse the company for any bonus or other incentive-based or equity-based compensation received by that person. This provision applies to any such compensation paid or granted by the issuer during the 12-month period following the first public issuance or filing with the SEC (whichever comes first) of the financial document embodying such financial reporting requirement and any profits realized from the sale of the company's securities during that 12-month period.
Section 1103 of the Act authorizes the SEC to petition any federal court to freeze any extraordinary payments made by a public company to any of its officers, directors, and other affiliated parties during the course of an investigation for possible securities law violations.12 The Act does not contain a definition of "extraordinary payments" other than to indicate that it includes compensation.
The fines and jail time imposed for violations under Section 501 of the ERISA,13 have been increased substantially. The maximum fine for an individual has been increased from $5,000 to $100,000 and the maximum jail term has been increased from one year to ten years. The maximum fine for a corporation has been increased from $100,000 to $500,000.14
Pension Plan Blackouts
Section 306 of the Act establishes two new requirements that must be satisfied in connection with pension plan blackout periods. Specifically, Section 306 of the Act requires:
- Prohibition of Insider Trades During Pension Fund Blackout Periods -- Directors and executive officers of an issuer may not, directly or indirectly, purchase, sell or otherwise transfer any equity security of the issuer during any blackout period if the director or officer acquired the security in connection with his or her service or employment as a director or officer.15 The issuer is required to give advance notice of the impending blackout period to directors, executive officers and the SEC; and
- Notice Requirements to Participants and Beneficiaries Under ERISA -- Plan administrators of individual account plans must provide advance notice to plan participants and beneficiaries of the commencement of any blackout period imposed by the plan.16 The plan administrator must also provide timely notice of the blackout period to the issuer of any security covered by the blackout period.
Unfortunately, satisfying these two requirements is complicated by the fact that the definition of "blackout period" is different for each requirement. That is to say, for purposes of the foregoing requirements, the term "blackout period" is defined as follows:
- Prohibition of Insider Trades During Pension Fund Blackout Periods -- For purposes of this requirement, the term "blackout period" means any period of three (3) consecutive business days during which the ability of not fewer than 50 percent of the participants or beneficiaries under all individual account plans maintained by the issuer to purchase, sell or otherwise transfer an interest in any equity of the issuer held by the plan is temporarily suspended by the issuer or fiduciary of the plan; and
- Notice Requirements to Participants and Beneficiaries Under ERISA -- For purposes of this requirement, the term "blackout period" means any period for which the ability of participants or beneficiaries under the plan to direct or diversify assets credited to their accounts, to obtain loans from the plan, or to obtain distributions from the plan is temporarily suspended, limited, or restricted for any period of more than three (3) consecutive business days.17
Under the Act, both the SEC and the DOL are directed to issue rules and regulations to implement the provisions of Section 306 of the Act.
SEC Proposed Regulations on Pension Plan Blackouts
The SEC has issued proposed regulations governing the purchase and sale prohibitions set forth in Section 306(a) of the Act.18 The proposed regulations apply to blackout periods commencing on or after January 26, 2003.
The proposed regulations broadly interpret many of the key provisions and terms of the Act in order to carry out the intent of the Act. To this end, the proposed regulations provide that the term "executive officer" shall have the meaning provided in Rule 16a-1(f)19 of the Exchange Act and the term "director" shall be defined as set forth in Section 3(a)(7) of the Exchange Act. Both of these definitions require an analysis of the functions performed with respect to the corporation. Accordingly, an individual's title will not be dispositive as to whether he or she functions as a director or executive officer.
Similarly, the term "equity security of the issuer" is defined to include any "equity security" (as set forth in Section 3(a)(11) and Rule 3a11-1 of the Exchange Act) or "derivative security," whether or not issued by that issuer. The term "derivative security" is defined to have the meaning set forth in Exchange Act Rule 16a-1(c), to be interpreted in a manner consistent with the rules that have developed under the Exchange Act. Accordingly, an interest that may only be settled in cash, but the value of which is based on an equity security (e.g., phantom stock), would be considered a derivative security subject to the trading prohibition.20
The regulation also broadly defines the term "acquired in connection with service or employment" by including not only securities acquired at a time when he or she was a director or executive officer of the issuer, but also certain shares acquired prior to becoming an officer or director. For example, the regulations provide that "director's qualifying shares" acquired to meet an issuer's minimum ownership requirements, or shares acquired prior to becoming a director or executive as an inducement to service or employment with the issuer or a parent as considered "acquired in connection with service or employment." Notwithstanding the foregoing, the proposed regulations do generally exempt equity securities from the trading prohibition to the extent they were acquired before the individual became an executive officer or director. This exception, however, will likely prove meaningless for many individuals since the proposed regulations also establish an irrebuttable presumption that any equity security sold during a blackout period was acquired in connection with service or employment as a director or executive officer to the extent that the director or executive office holds any such securities.
The Act also requires that an issuer provide advance notice of a blackout period to its executive officer and directors as well as to the SEC. Under the proposed regulations, notice must generally be provided at least 15 days prior to the commencement of the blackout period. For the period January 26, 2003 through February 10, 2003, the issuer is required to provide the required notices as soon as reasonably possible. The issuer must notify the SEC of an impending blackout period upon receipt of notice of the blackout from the plan administrator, or, if sooner, actual knowledge of the blackout. Notice to the SEC is required to be reported using Form 8-K.
DOL Interim Final Regulations
The DOL has issued interim final rules with respect to the notice of blackout periods to participants and beneficiaries under Section 306(b) of the Act.21 Under the DOL's interim regulations,22 the notice of blackout period must be provided to all affected participants and beneficiaries at least 30 days, but not more than 60 days, in advance of the last date on which such participants and beneficiaries can exercise the affected rights. The regulations provide that the 30-day period must be counted back from the last date on which the participant or beneficiary had the right to take action under the terms of the plan in anticipation of the blackout period. Accordingly, in plans that do not allow for daily trading, the approach dictated by the regulations could result in notice having to be provided more than 30 days before the start of the blackout period.
While the 30-day advance notice will apply in most instances, the regulations provide that this limit will not apply (i) where it would be a violation of ERISA's fiduciary duties to wait 30 days to implement the blackout (e.g., the bankruptcy of the issuer), or (ii) in cases involving unforeseeable circumstances beyond the control of the plan administrator (e.g., a computer systems problem with the trustee that affects its ability to process loan applications). In both of these instances, the plan administrator is required to make a written-determination as to the reasons precluding the ability to give at least 30 days advance notice. The 30-day advance notice requirement also does not apply to blackouts imposed in connection with participants becoming, or ceasing to be, participants solely in connection with a merger, acquisition, divestiture, or similar transaction involving the plan or the plan sponsor. Nevertheless, in each instance where the 30-day advance notice is not required, the plan administrator must still provide the notice "as soon as reasonably possible under the circumstances."
The regulations contain a model notice (see Appendix I) to assist plan sponsors in carrying out these new obligations. The content requirements of the model notice essentially track the requirements set forth in the Act. Accordingly, the notice to employees must include the reasons for the blackout period and the identification of the rights affected, the expected beginning date and length of the blackout period, and, if the ability to direct investments is suspended, a statement that the participants should evaluate their current investments in light of their ability to direct or diversify assets during the blackout period.
The DOL, under authority granted by the Act, has also added three informational items to the notice that are not specifically provided for under the Act. First, the regulations provide that the notice must specify the expected ending date of the blackout period. In this regard, it is the DOL's view that an ending date must be specified in order to properly apprise participants and beneficiaries as to when they will be able to recommence exercising their rights under the plan. Second, in situations where the notice is not provided 30 days in advance (e.g., unforeseeable circumstances), the regulations require that the notice contain an explanation as to why the plan was unable to furnish at least a 30-day advance notice. Third, given the potential impact of the blackout period on a participant's or beneficiary's financial planning, the DOL is also requiring that the notice contain the name, address and telephone number of a person who can answer questions concerning the blackout period.
The regulations become effective January 26, 2003 and shall apply to blackout periods commencing on or after that date. For the period January 26, 2003 through February 25, 2003, plan administrators are required to furnish the required notice as soon as reasonably possible.
II. RECENT TAX LAW DEVELOPMENTS
The Internal Revenue Service ("IRS") has released a number of important rulings, notices and regulations during 2002 covering a variety of federal tax law23 provisions affecting executive compensation, including significant regulations covering golden parachute payments and split-dollar life insurance arrangements.
Transfers Incident to Divorce: In Rev. Rul. 2002-22,24 the IRS set forth the proper tax treatment of the transfer of nonqualified stock options and an interest in a nonqualified deferred compensation arrangement in connection with a divorce. Under this ruling, an employee who transfers a stock option and/or an interest in nonqualified deferred compensation arrangement to the employee's former spouse incident to divorce is not required to recognize income upon the transfer. Rather, the former spouse is required to recognize income when the stock options are exercised or when the deferred compensation is paid.25
In a related notice,26 the IRS set forth a proposed revenue ruling addressing the FICA and FUTA tax and withholding issues associated with transfers incident to a divorce. Under the proposed ruling, the IRS concluded that the transfer of nonqualified stock options or an interest in a non-qualified deferred compensation arrangement in connection with a divorce does not trigger FICA or FUTA tax liability. However, upon exercise of the options by or payment of the deferred compensation to the non-employee former spouse , the proposed revenue ruling concludes that the employee will recognize FICA and FUTA wages, but the income and employment tax withholding requirements are to be satisfied by withholding from the payments made to the non-employee former spouse.
Transfers by Shareholder to Employee of Subsidiary: In PLR 200219016,27 the IRS has ruled that an individual shareholder who transfers stock options to an employee will not recognize income at the time of the transfer nor at the time the employee subsequently exercises the stock option. Under the facts of the ruling, a shareholder held stock options to acquire shares of stock in a holding company ("Parent"). The shareholder transferred the stock options to an employee of one of the Parent's subsidiaries ("Subsidiary"). The intent of this transfer was to provide additional employment incentives to the employee. The shareholder received no consideration for making the transfer.
The IRS concluded that the substance of the transaction resembled a transfer or forfeiture of the option by the shareholder to the Parent for no consideration, with the Parent then transferring or re-issuing the option to the employee in return for services to the Subsidiary. Viewed in this manner, the IRS concluded that (i) the shareholder will not recognize income upon the transfer of the stock option, (ii) the shareholder will not recognize any income when the employee exercises the option (because the option is treated as forfeited for no consideration), (iii) the employee is receiving the stock option in exchange for services as an employee of the Subsidiary, and (iv) the Subsidiary will be entitled to a deduction equal to the amount of compensation income recognized by the employee.
Founder's Shares: In PLR 200204005,28 the IRS has ruled that the imposition of a substantial risk of forfeiture upon a fully vested equity interest is not a transfer subject to Section 83 of the Code. Under the ruling, below market call provisions were imposed on pre-existing LLC ownership interests of key management personnel. The call provisions were added at the advice of the LLC's investment bankers under the theory that a public offering would be more attractive to investors if key management personnel were retained for a significant period of time following the public offering. The IRS determined that since the equity interests were fully vested prior to the imposition of the forfeiture restrictions, the addition of such provisions did not result in a "transfer of property" for purposes of Section 83. Accordingly, the lapse of the forfeiture provisions will not be a taxable event.
Revocation of 83(b) Election: Under Treas. Reg. § 1.83-2(f), an election under Section 83(b) can only be revoked with the consent of the Commissioner, and then only if the transferee was under a mistake of fact as to the underlying transaction. Two recent private letter rulings ("PLRs") highlight the limitations on a taxpayer's ability to revoke an 83(b) election:
In PLR 200212021,29 the IRS refused to consent to a taxpayer's request to revoke an 83(b) election made in connection with the exercise of an incentive stock option ("ISO"). The taxpayer made the 83(b) election in connection with the exercise because the taxpayer received restricted stock. As a result of making the 83(b) election, the taxpayer was required to make an adjustment to his alternative minimum taxable income pursuant to Section 56(b)(3) of the Code. The taxpayer represented to the IRS that he was wholly ignorant of the tax consequences associated with making the 83(b) election and that the taxpayer only signed the 83(b) election form because he thought it was necessary to exercise his ISO.
In concluding that the taxpayer did not operate under a mistake of fact when making the 83(b) election, the IRS stated that (i) Treas. Reg. § 1.83-2(f) was narrow in scope, and that relief could be granted only if there is a "mistake of fact to the underlying transaction" (e.g., the acquisition of the restricted stock), (ii) a mistake of fact does not include an erroneous belief concerning a collateral matter (e.g., the tax consequences), and (iii) ignorance of the law is not a mistake of fact.
In PLR 200229004,30 however, the IRS consented to a taxpayer's request to revoke an election made under Section 83(b) where the taxpayer made the request within the timeframe for making the original election. The taxpayer was issued nonqualified stock options on September 17, 2001. On October 8, 2001, the taxpayer exercised the options, received restricted stock and made an 83(b) election. On October 17, 2001, the taxpayer sent a letter to the IRS seeking consent to revoke the election based on the assertion that the taxpayer mistakenly believed that the election would operate to postpone the inclusion of the value of the stock in the taxpayer's gross income.
In addressing the taxpayer's request to revoke the 83(b) election, the IRS disregarded whether the taxpayer was operating under a "mistake of fact as to the underlying transaction." Rather, the IRS focused on whether the taxpayer's request to revoke the 83(b) election was made within the 30-day time period allowed under Section 83(b) for making the election, and concluded that an election can be validly revoked within the time allowed for making it even if the statute that provides for the election states that it is irrevocable once made.31
83(b) Election Filed Under Power of Attorney: Treas. Reg. § 1.83-2(e) provides that an 83(b) election must be "signed by the person making the election . . .." A recent Chief Counsel Advisory indicates that this requirement will be satisfied even if the election is filed under a power of attorney.
In CCA 200203018,32 an employer timely filed 83(b) elections on behalf of its employees. Enclosed with each filing was an executed Form 2848 by which the respective employee authorized the employer to make an 83(b) election on his or her behalf. A number of the IRS Service Centers at which the elections were filed returned them to the employer based on a determination that the filings under Form 2848 were not acceptable. In addressing whether the 83(b) elections were valid, the IRS indicated that the employees did not meet the literal requirements of Treas. Reg. § 1.83-2(e). However, the IRS noted that the Form 2848 (which was submitted with the filing) was signed by the taxpayer. Accordingly, the IRS concluded that, based on the totality of the documents submitted in connection with the 83(b) elections, the filings satisfied the requirement of Treas. Reg. § 1.83-2(e) that the statement be signed by the employee.
Withholding on Statutory Stock Options
In 2001, the IRS reversed a long-standing position and concluded that the exercise of an ISO does result in wages for purposes of FICA and FUTA taxes.33 As part of this guidance, the IRS has indicated that it would not enforce its position on ISO exercises occurring prior to January 1, 2003.
In IRS Notice 2002-47,34 the IRS has extended its moratorium on collecting FICA and FUTA taxes on statutory stock options. The Notice provides that the IRS (i) will not assess FICA or FUTA taxes upon the exercise of a statutory stock option or the disqualifying disposition of stock acquired by an employee pursuant to the exercise of a statutory stock option, and (ii) will not treat the exercise of a statutory stock option, or the disqualifying disposition of stock acquired by an employee pursuant to the exercise of a statutory stock option, as subject to federal income tax withholding.
The Notice does not relieve individual taxpayers from the obligation to recognize income (if any) upon the disqualifying disposition of stock acquired pursuant to the exercise of a statutory stock option, and it does not relieve employers of any of their reporting obligations. Accordingly, a disqualifying disposition of stock acquired pursuant to the exercise of a statutory stock option that results in ordinary income greater than $600 generally will result in a reporting obligation on the Form W-2.
New Proposed Golden Parachute Regulations
Section 280G of the Code denies a deduction to a corporation for any payment that is an "excess parachute payment." The IRS has issued revised proposed regulations35 under Section 280G replacing the proposed regulations the IRS previously issued in 1989. The revised proposed regulations apply to any payments that are contingent on a change of control occurring after January 1, 2004. However, taxpayers may rely on the proposed regulation until the effective date of the final regulations. Alternatively, taxpayers may continue to rely on the 1989 proposed regulations for change of control payments occurring prior to January 1, 2004.
While the revised proposed regulations retain a majority of the provisions contained in the 1989 proposed regulations, several significant revisions and clarifications have been incorporated into the revised proposed regulations. The IRS has made several practical changes to limit the scope of the definition of "disqualified individual." Section 280G defines a disqualified individual to include an officer, shareholder, or highly-compensated individual ("HCE") who performs services for the corporation. Previously, the term "shareholder" meant individuals owning stock having a value in excess of the lesser of $1 million, or 1 percent of the total value of outstanding shares. The revised proposed regulations eliminate the $1 million dollar threshold. Additionally, under the 1989 proposed regulations, an individual qualified as an HCE if he was a member of a group consisting of the lesser of (i) the highest paid 1 percent of employees, or (ii) the highest paid 250 employees; provided, however, that no employee or service provider would be considered highly-compensated if such individual was paid less than $75,000. The IRS removed the $75,000 compensation limit and replaced it with the threshold used for determining HCEs under qualified plans pursuant to Section 414(q) of the Code. Accordingly, this dollar limit increases to $90,000 in 2002 and is adjusted periodically for cost-of-living adjustments.
The revised proposed regulations also clarify certain key issues surrounding stock options. Under the 1989 proposed regulations, the IRS did not specifically address the treatment of ISOs. To this end, the revised proposed regulations specifically provide that ISOs and non-qualified stock options are to be treated the same. In addition, the revised proposed regulations grant the Commissioner authority to provide published guidance on the valuation of stock options in addition to the methodology described in the 1989 regulations.36
The revised proposed regulations also make certain clarifications with respect to the exemption from 280G for payments approved by shareholders of corporations with no readily tradeable stock. First, for purposes of shareholder approval, the revised proposed regulations permit the shareholder vote to occur any time within 3 months of the change of control. More importantly, the revised proposed regulations provide that shareholder approval can be limited to only a portion of the payment to be made. This particular change should prove desirable in light of the fact that the IRS maintained the requirement that the shareholder vote must determine the individual's right to payment.
Finally, the IRS has also clarified whether a payment by a tax-exempt entity is exempt from the definition of the term parachute payment. To this end, a payment by a tax-exempt entity will not be considered a parachute payment provided that (i) the payment must be made by a corporation undergoing a change of control that is a tax-exempt organization, and (ii) the organization must meet the definition of a tax-exempt organization both immediately before and immediately after the change of control. While the loss of a deduction under 280G is not generally a concern to a tax-exempt entity, this change provides guidance as to the applicability of the 20% excise tax imposed by Section 4999 of the Code on the recipient of an excess parachute payment.
Split-Dollar Insurance Guidance
Due to the complexity of this subject, it will not be possible to adequately summarize the issues surrounding this topic. However, a brief summary of the recent guidance issued by the IRS is set forth herein.
Proposed Regulations: The IRS has recently issued proposed regulations37 to provide guidance on the taxation of split-dollar life insurance arrangements, including equity split-dollar, for federal income, employment, and gift tax purposes. Split-dollar life insurance arrangements that seek to transfer more than life insurance protection have been the focus of the IRS's attention in the past few years. Under the proposed regulations, split-dollar arrangements will be taxed either as an economic benefit or as loan transactions, depending on who owns the policy. The regulations will apply to any split-dollar life insurance arrangement entered into after the regulations are finalized and to pre-existing arrangements that are materially modified thereafter. In the interim, taxpayers must value split-dollar plans under guidance in Notice 2002-8 or may rely on the proposed regulations if consistently used by all parties to the arrangement.
Notice 2002-8: The IRS has also issued Notice 2002-8,38 which revoked Notice 2001-10, to provide guidance with respect to split-dollar life insurance arrangements entered into before the date final regulations concerning such arrangements are published. This Notice is of particular importance because it contains a number of alternatives a taxpayer may undertake to limit the potential negative consequences that may arise if the existing arrangement were to be taxed under the regime set forth in the proposed regulations. For instance, for arrangements entered into before January 28, 2002 under which the employer has made premium payments and is entitled to receive full repayment of all of its payments, the IRS will not assert that there has been a taxable transfer of property to the employee upon termination of the arrangement if (i) the arrangement is terminated before January 1, 2004, or (ii) for all periods beginning on or after January 1, 2004, all payments (from inception of the arrangement) by the employer are treated and reported as loans for federal tax purposes. Accordingly, it will be of critical importance during 2003 for employers and employees with grandfathered split-dollar arrangements to evaluate the alternatives available to them under Notice 2002-8.
Notice 2002-59: In Notice 2002-59,39 the IRS has indicated that it will not respect any arrangement using split-dollar life insurance, including reverse split-dollar, in which the parties attempt to avoid taxes by using inappropriately high current term insurance rates, prepayment of premiums, or other techniques to understate the value of policy benefits.
III. OTHER SECURITIES LAW DEVELOPMENTS
This past year has also seen a number of other securities law developments affecting executive compensation, including the release of policy statements and rules (final and proposed) by the SEC, and proposed rules by the New York Stock Exchange ("NYSE"), the Nasdaq Stock Market, Inc. ("Nasdaq") and the American Stock Exchange ("AMEX").
Shareholder Proposals Relating to Executive Compensation under Plans
Rule 14a-8 of the Exchange Act provides shareholders with an opportunity to have their proposals placed alongside management's proposals in a company's proxy materials for presentation for a vote at an annual or special meeting of shareholders. The rule generally requires a company to include the proposal unless the shareholder has not complied with the rules procedural requirements or the proposal falls within one of the Rule's 13 substantive bases for exclusion. One of the substantive bases (Rule 14a-8(i)(7)) for exclusion is for any matter relating to a company's ordinary business operations (which the SEC had historically interpreted to include any proposal related to general employee compensation).40
On July 12, 2002, the SEC issued a legal bulletin41 revising this approach with respect to submissions concerning proposals that relate to shareholder approval of equity compensation plans.
(i) Proposals that focus on equity compensation plans that may be used to compensate only senior executive officers and directors -- These proposals may not be omitted from company proxy materials.
(ii) Proposals that focus on equity compensation plans that may be used to compensate senior executive officers, directors and the general workforce -- If the proposal seeks to obtain shareholder approval of all such equity compensation plans, without regard to their potential dilutive effect, a company may rely on the exclusion to omit the proposal from its proxy materials. If the proposal seeks to obtain shareholder approval of all such equity compensation plans that would result in material dilution to existing shareholders, a company may not rely on the exclusion to omit the proposal from its proxy materials.
(iii) Proposals that focus on equity compensation plans that may be used to compensate the general workforce only, with no senior executive officer or director participation -- If the proposal seeks to obtain shareholder approval of all such equity compensation plans, without regard to their dilutive effect, a company may rely on the exclusion to omit the proposal from its proxy materials. If the proposal seeks to obtain shareholder approval of all such equity compensation plans that potentially would result in material dilution to existing shareholders, a company may not rely on the exclusion to omit the proposal from its proxy materials.
IV. SELF-REGULATORY ORGANIZATIONS
The NYSE, Nasdaq and AMEX have all proposed rules that have been submitted to the SEC for review which relate to executive compensation and the Act. The following is a description of the proposed rules of each of the NYSE, Nasdaq and AMEX which directly impact issuers in terms of their executive compensation practices.
In Nasdaq's "Summary of NASDAQ Corporate Governance Proposals" (dated as of November 20, 2002, the "Summary") and the text of the proposed rules which it has made available to the public, there are a number of proposals that either directly relate to or touch upon issuers' executive compensation policies.
Stock Options: Nasdaq has proposed to amend Rule 4350(i)(1)42 to require shareholder approval for the adoption of all stock option plans and for any material amendments to such plans. The proposed amendment exempts: (i) issuances to a person who was not previously an employee or director of the company as an inducement material to the individual's entering into employment with the company, provided that such grants are approved by a compensation committee or a majority of the company's independent directors, (ii) certain tax-qualified plans, non-discriminatory employee benefit plans (e.g., plans that meet the requirements of Section 401(a) or 423 of the Code) or parallel nonqualified plans, provided such plans are approved by the company's compensation committee or a majority of the company's independent directors, and (iii) plans relating to an acquisition or merger in two situations: (A) shareholder approval will not be required to convert, replace or adjust outstanding options or other equity compensation awards to reflect the transaction and (B) shares available under certain plans acquired in mergers and acquisitions may be used for certain post-transaction grants43 without further shareholder approval. Existing stock option plans will be unaffected under this proposal, unless there is a material modification made to the plan.
Loans: In an effort to be consistent with Section 402 of the Act, Nasdaq is considering a rule prohibiting loans to officers and directors of a listed company.44
Increase Board Independence: The Summary details a number of ways in which Nasdaq intends to ensure and increase the independence of members of a company's Board of Directors. The proposals: (i) prohibit an "independent director"45 from receiving any payments (including political contributions) in excess of $60,000 other than for board service and further extends such a prohibition to the receipt of payments by a non-employee family member of the director, (ii) prohibit any audit committee member from receiving any compensation except for in connection with board or committee service, in accordance with the Act, (iii) prohibit a director from being considered independent if the company makes payments to an entity where the director is an executive officer and such payments exceed the greater of $200,000 or 5% of the recipient's gross revenues, and (iv) apply a 3-year "cooling off" period to directors who are not independent due to (A) interlocking compensation committees or (B) the receipt by the director or a family member of the director who is not an employee of the issuer of any payments in excess of $60,000 other than for board service.
Strengthen the Role of Independent Directors in Compensation Decisions: Proposed Rule 4350(c)(3) would require the compensation of the chief executive officer to be determined either by a majority of the independent directors meeting in executive session or by a compensation committee comprised solely of independent directors meeting in executive session. The proposed rule further states that compensation of all other officers (as that term is defined in Rule 16a-1 of the Exchange Act) will be determined either by a majority of the independent directors or by a compensation committee comprised solely of independent directors. For deliberations relating to the executive officers, other than the chief executive officer, the chief executive officer may be present, but may not vote.
In Proposed Rule 4350(c)(5), Nasdaq exempted "controlled companies" from the above-described proposal. Companies are "controlled companies" if more than 50% of the voting power is held by an individual, group or another company.
Accelerated Disclosure of Insider Transactions: The Summary states that Nasdaq is considering a requirement for accelerated disclosure of insider transactions consistent with Section 403 of the Act and any SEC rules issued thereunder.
Equity Compensation Plans: On October 7, 2002, the NYSE submitted to the SEC a proposal relating to shareholder approval of equity compensation plans and the elimination of related broker voting.46 The NYSE proposal requires shareholder approval of equity-based compensation, including all material revisions to such plans, and precludes a broker from voting shares in any equity compensation plan without instruction from the beneficial owner. Similar to the Nasdaq proposal, the NYSE proposal exempts: (i) inducement grants that are material to a person first becoming an employee of the issuer or any of its subsidiaries, (ii) option plans acquired in mergers and acquisitions in two situations (A) to convert, replace or adjust outstanding options or other equity compensation awards to reflect the transaction and (B) shares available under certain plans acquired in corporate acquisitions and mergers which may be used for certain post-transaction grants,47 and (iii) any plan intended to meet the requirements of Section 401(a) of the Act (e.g., ESOPs), any parallel nonqualified plans and any plan intended to meet the requirements of Section 423 of the Act. Notwithstanding the foregoing, all of the above-described exemptions from the shareholder approval requirement must be subject to the approval of the company's compensation committee or a majority of the company's independent directors.
The NYSE stated that a "material revision" to an existing plan would include, but not be limited to, revisions that: (i) materially increase the number of shares available under the plan (other than an increase to reflect solely a reorganization, stock split, merger, spinoff or similar transactions); (ii) change the types of awards available under the plan; (iii) materially expand the class of persons eligible to receive awards under or otherwise participate in the plan; (iv) materially extend the term of the plan; or (v) materially change the method of determining the strike price of options under the plan.
Independence of Compensation Committee: The NYSE proposal requires that listed companies have a compensation committee, among other committees, comprised entirely of independent directors48, and must have a written charter providing for the compensation committee's purpose, duties and responsibilities and an annual performance evaluation of the committee. The compensation committee is to have sole discretion to retain or terminate compensation consultants to the extent they assist in evaluating executive officer compensation. In addition, for audit committee members, directors' fees are the only compensation an audit committee member may receive from the company.
Similar to the Nasdaq proposals, the NYSE proposals provide a limited exception for "controlled companies" in which more than 50% of the voting power is held by an individual, group or another company. Notwithstanding the foregoing, the NYSE does propose requiring "controlled companies" to have a minimum three-person audit committee composed entirely of independent directors.
AMEX has approved enhanced corporate governance rules, some of which impact executive compensation. These rules include: (i) a requirement that companies listed on AMEX obtain shareholder approval of all stock option plans subject to certain limited exceptions,49 and also prohibiting brokers from voting their customer's shares on stock option plan proposals without instructions from the customer, (ii) a requirement that the compensation committee approve the compensation of the chief executive officer and further that the compensation committee be comprised entirely of independent directors or by majority of independent directors on the board, with a limited exception for "controlled companies,"50 and (iii) to require the compensation committee to review all other executive compensation (or a majority of the independent directors) in consultation with the chief executive officer, which will be responsible for making a recommendation to the board.51
This article was published in the January 2003 issue of the Tax Management Compensation Planning Journal.
1 John E. McGrady, III, Esq., is a shareholder in the law firm of Buchanan Ingersoll Professional Corporation and is a member of its Employee Benefits and Executive Compensation Practice Groups. He concentrates his practice in tax and employee benefits law, executive compensation and retirement distribution planning.
2 Amy I. Pandit, Esq., is an associate in the law firm of Buchanan Ingersoll Professional Corporation and Vice-Chair of its Executive Compensation Practice Group and a Member of the Steering Committee of its Securities/SEC Practice Group. She concentrates her practice in executive compensation matters, counseling clients on compliance with the federal securities laws and corporate transactions, including mergers and acquisitions and venture capital.
3 Pub. L. 107-204, 2002 HR 3763 (July 30, 2002), 15 U.S.C.A. § 7201, et. al.
4 For purposes of the Act, the term "issuer" means the securities of which are registered under Section 12 of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), or that is required to file reports under Section 15(d) of the Exchange Act, or that files or has filed a registration statement that has not yet become effective under the Securities Act of 1933, as amended (the "Securities Act"), and that it has not withdrawn.
5 Section 402 of the Act adds new Section 13(k) to the Exchange Act.
6 The Act does not preclude any home improvement and manufactured home loans, consumer credit, or any extension of credit under an open end credit plan, or a charge card, or any extension of credit by a broker or dealer registered under Section 15 of the Exchange Act to an employee of that broker or dealer to buy, trade, or carry securities, that is permitted under rules or regulation of the Board of Governors of the Federal Reserve System pursuant to Section 7 of the Exchange Act (other than an extension of credit that would be used to purchase the stock of that issuer), that is: (A) made or provided in the ordinary course of the consumer credit business of such issuer; (B) of a type that is generally made available by such issuer to the public; and (C) made by such issuer on market terms, or terms that are no more favorable than those offered by the issuer to the general public for such extensions of credit. In addition, the Act does not apply to any loan made or maintained by an insured depository institution if the loan is subject to the insider lending restrictions of Section 22(h) of the Federal Reserve Act.
7 See ERISA Section 408(b)(1).
8 Prior to enactment of the Act, a Form 4 had to be filed on the tenth calendar day after the end of the month in which a reportable transaction took place, and the reporting of certain transactions could be deferred until 45 days after the company's fiscal year end and reflected on a Form 5.
9 Ownership Reports and Trading by Officers, Directors and Principal Security Holders, Exchange Act Release No. 46418 (Aug. 27, 2002).
10 The term "Discretionary Transaction" is defined in Rule 16b-3(b)(1) to mean a transaction pursuant to an employee benefit plan that: (i) is at the volition of a plan participant; (ii) is not made in connection with the participant's death, disability, retirement or termination of employment; (iii) is not required to be made available to a plan participant pursuant to a provision of the Code; and (iv) results in an intra-plan transfer involving an issuer equity securities fund, or a cash distribution funded by a volitional disposition of an issuer equity security.
11 The SEC has indicated that it is not adopting other rules for the purpose of identifying other non-feasible transactions for reporting within the two-business day filing deadline.
12 Section 1103 of the Act of amends Section 21C(c) of the Exchange Act.
13 29 U.S.C. § 1131.
14 See Section 904 of the Act.
15 See Section 306(a) of the Act.
16 See Section 306(b) of the Act.
17 The term "blackout period" in this instance does not include (i) a restriction which occurs by reason of the application of the securities laws (as defined in section 3(a)(47) of the Exchange Act), (ii) regularly scheduled suspensions, limitations or restrictions under the plan that are disclosed to participants and beneficiaries through any plan disclosure document, and (iii) restrictions which apply to a participant or alternate payee pursuant to a qualified domestic relations order ("QDRO").
18 See SEC Release No. 34-46678.
19 The use of this definition for an "executive officer," which is the definition of an "officer" under Rule 16a-1(f) of the Exchange Act, differs from the definition of "executive officer" that most legal professionals have been applying to the Act, which is Rule 3b-7 of the Exchange Act. The Rule 16a-1(f) "officer" definition, which the SEC has proposed to be used for purposes of Section 306(a) of the Act, is arguably broader in reach in terms of the persons it applies to than the definition of "executive officer" set forth in Rule 3b-7 of the Exchange Act.
20 The proposed regulations provide for a number of exemptions from the statutory trading prohibition of Section 306(a), including, among others, equity securities under dividend or interest reinvestment plans, purchases or sales of equity securities pursuant to certain "tax-conditioned" plans (other than discretionary transactions), and increases or decreases in the number of equity securities held as a result of a stock split or stock dividend applying equally to all equity securities of that class.
21 The DOL has also issued a second set of interim final rules under which plan administrators can be assessed up to $100 per day per participant for the failure or refusal to provide or comply with the advance notice requirements. See 67 FR 64774.
22 67 FR 64766 (October 21, 2002).
23 Unless otherwise noted, all section references are to the Internal Revenue Code of 1986, as amended (the "Code"), and the regulations promulgated thereunder.
24 Rev. Rul. 2002-22, 2002-19 IRB 849 (May 8, 2002).
25 In contrast to Rev. Rul. 2002-22, the IRS had previously concluded, in FSA 200005006, that a similar transfer of options was an "arms length" transfer requiring the transferor to recognize income upon the transfer.
26 See IRS Notice 2002-31, 2002-19 IRB 908 (May 8, 2002).
27 PLR 200219016, 2002 WL 968666 (May 10, 2002).
28 PLR 200204005, 2002 WL 96296 (January 25, 2002).
29 PLR 200212021, 2002 WL 442921 (March 22, 2002).
30 PLR 200229004, 2002 WL 1589786 (July 19, 2002).
31 The IRS cited National Lead Company v. Commissioner, 336 F.2d 134 (2d Cir. 1964), Matheson v. Commissioner, 74 T.C. 836 (1980), Rev. Rul. 56-67, 1956-1 C.B. 437 (1956), and Rev. Rul. 78-295, 1978-2 C.B. 165 (1978), as authority for its conclusion.
32 CCA 200203018, 2002 WL 64873 (January 18, 2002).
33 See IRS Notice 2001-14, 2001-6 ICB 516 (January 19, 2001) and Prop. Reg. 66 Fed. Reg. 57023 (November 14, 2001).
34 IRS Notice 2002-47, 2002-28 IRB 97 (June 25, 2002).
35 See 67 FR 7630 (February 20, 2002).
36 The IRS has issued Revenue Procedure 2002-13, 2002-8 I.R.B. 549 (February 19, 2002) which provides several alternative valuation methods that satisfy the requirements of Section 280G. Consistent with current corporate practices, Rev. Proc. 2002-13 includes a safe harbor valuation method based on the Black Scholes model. The safe harbor valuation method, however, cannot be used for an option with a term exceeding 10 years.
37 67 FR 45414 (July 9, 2002).
38 Notice 2002-8, 2002-4 I.R.B. 398
39 Notice 2002-59, 2002-36 I.R.B. 481 (August 16, 2002).
40 Other exclusions under Rule 14a-8 include shareholder proposals that: do not need to be included under state law, would violate law, would violate the proxy rules, relate to a personal grievance or special interest, are irrelevant, call for the company to seek redress that it is powerless to do, relate to elections of board members or other bodies, conflicts with the company's proposals, are already substantially implemented, are duplicative, have been previously submitted and addressed, or that deal with specific amounts of stock dividends.
41 Staff Legal Bulletin No. 14A (July 12, 2002) available at http://www.sec.gov/interps/legal/cfslb14a.htm.
42 Self-Regulatory Organizations; Notice of Filing of Proposed Rule Change and Amendment No. 1 thereto by National Association of Securities Dealers, Inc. Relating to Shareholder Approval for Stock Option Plans or Other Arrangements, 67 Fed. Reg. 64,173 (October 17, 2002) (proposed).
43 This exception applies to situations where the party which is not a listed company following the transaction has shares available for grant under pre-existing plans that were previously approved by shareholders. These shares may be used for post-transaction grants of options and other equity awards by the listed company (after appropriate adjustment of the number of shares to reflect the transaction), either under the pre-existing plan or another plan, without further shareholder approval, so long as (i) the time during which those shares are available for grants is not extended beyond the period when they would have been available under the pre-existing plan, absent the transaction, and (ii) such options and other awards are not granted to individuals who were employed by the granting company at the time the merger or acquisition was consummated. Ibid.
44 Nasdaq is only considering such a rule, no proposal has been filed with the SEC.
45 According to Nasdaq Rule Filing SR-NASD-2002-141, an "independent director" means a person other than an officer or employee of the company or its subsidiaries or any other individual having a relationship, which, in the opinion of the company's board of directors, would interfere with the exercise of independent judgment in carrying out the responsibilities of a director. The definition then lists persons who are not considered independent, such as: a director that is employed by the corporation, a family member of a director that accepts compensation for being a board member, immediate family of a director, certain business partners of the company, a director who is an executive officer of another entity where any of the members of the compensation committee of that entity are officers of the company, or a director who was a partner or employee of the company's outside auditor that worked on the company's audit.
46 Self-Regulatory Organizations; Notice of Filing of Proposed Rule Change by the New York Stock Exchange, Inc. Relating to Shareholder Approval of Equity Compensation Plans and the Voting of Proxies, 67 Fed. Reg. 63,489 (October 11, 2002) (proposed).
47 This exemption applies to situations where the party which is not a listed company following the transaction has shares available for grant under pre-existing plans that were previously approved by shareholders. These shares may be used for post-transaction grants of options and other equity awards by the listed company (after appropriate adjustment of the number of shares to reflect the transaction), either under the pre-existing plan or another plan, without further shareholder approval, so long as (i) the time during which those shares are available for grants is not extended beyond the period when they would have been available under the pre-existing plan, absent the transaction, and (ii) such options and other awards are not granted to individuals who were employed by the granting company at the time the merger or acquisition was consummated. Ibid.
48 To be independent, a director must be affirmatively determined to be "independent" by the board and not have any material relationship with the company either directly or as a partner, shareholder or officer of an organization that has a relationship with the company. Where a relationship does exist, the proposals would require the board to affirmatively determine that it is not material and to disclose the basis for its determination in the company's annual proxy statement. Independence requires a five-year "cooling-off" period for persons who are not independent due to having been (A) former employees of the listed company or its independent auditor, (B) former employees of any company whose compensation committee includes an officer of the listed company, or (C) immediate family members of the foregoing persons.
49 These exceptions have not been enumerated upon by AMEX.
50 The definition of a "controlled company" has not been publicly disclosed by AMEX.
51 Information available about Amex's proposed regulations is detailed in a September 13, 2002 press release available at http://www.amex.com/atamex/news/press/sn_CorpGovRules_091302.htm.
Important Notice Concerning Your Rights
Under the _____________________________________ Plan
[Enter date of Notice]
This notice is to inform you that the [enter name of plan] will be [enter reasons for blackout period, as appropriate: changing investment options, changing record keepers, etc.]
As a result of these changes, you temporarily will be unable to [enter as appropriate: direct or diversify investments in your individual accounts (if only specific investments are subject to the blackout, those investments should be specifically identified), obtain a loan from the plan, or obtain a distribution from the plan]. This period, during which you will be unable to exercise these rights otherwise available under the plan, is called a "blackout period." Whether or not you are planning retirement in the near future, we encourage you to carefully consider how this blackout may affect your retirement planning, as well as your overall financial plan.
The blackout period for the plan will begin on [enter date] and end [enter date].
[In the case of investments affected by the blackout period, enter the following: During the blackout period you will be unable to direct or diversify the assets held in your plan account. For this reason, it is very important that you review and consider the appropriateness of your current investments in light of your inability to direct or diversify those investments during the blackout period. For your long-term retirement security, you should give careful consideration to the importance of a well-balanced and diversified investment portfolio, taking into account all your assets, income and investments. You should be aware that there is a risk to holding substantial portions of your assets in the securities of any one company, as individual securities tend to have wider price swings, up and down, in short periods of time, than investments in diversified funds. Stocks that have wide price swings might have a large loss during the blackout period, and you would not be able to direct the sale of such stocks from your account during the blackout period].
[If timely notice cannot be provided enter: (A) Federal law generally requires that you be furnished notice of a blackout period at least 30 days in advance of the last date on which you could exercise your affected rights immediately before the commencement of any blackout period in order to provide you with sufficient time to consider the effect of the blackout period on your retirement and financial plans. (B) [Enter explanation of reasons for inability to furnish 30 days advance notice.]]
If you have any questions concerning this notice, you should contact [enter name, address and telephone number of the plan administrator or other person responsible for answering questions about the blackout period].