Compensation and Benefits Insights Year in Review

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1 Compensation and Benefits Insights Year in Review Orrick | May December 2015 2015 page 1

2 December 2015 We thought you would appreciate a compilation of the alerts we published in 2015, which covered important issues in the areas of executive compensation, global equity and qualified plans. Hopefully this collection will help you not only know about changes in the law and how to comply, but also what to expect in 2016. Best, Jon Jonathan Ocker Chair of Orricks Compensation and Benefits Group Orrick | December 2015

3 Contents I. Executive Compensation 1. Institutional Shareholder Voting Guidelines 4 2. Practical Advice for IRS 162(m) Regulations 6 3. Changing the Status Quo With Extended Option Programs 8 4. Annual Reporting Requirements for Incentive Stock Options 10 5. IRS Limits Correction Opportunities Under 409A 13 6. Pay for Performance Table and Best Practice Proxy Disclosure 14 7. A Plain English Guide to the SECs Compensation Clawback Rules 20 8. SEC Pay Ratio Rules 22 9. Summary of ISS 2016 Policy Announcements 25 II. Global Equity 10. Measures in Favour of Company Savings Plans Under the Macron Law 27 III. Qualified Plans 11. IRS Pulls Determination Letter Program 30 12. IRS Flip Flops on Pension Plan De-Risking Options 32 13. New, Easier & Less Expensive IRS 401(k) Plan Correction Procedures 34 14. The Many Potential Pitfalls of Worker Misclassification 36 Orrick | December 2015

4 Compensation and Benefits Insights Institutional Shareholder Voting Guidelines Management Say on Pay and Incentive Plan Proposals, and How to Win a Proxy Fight Despite a "NO" Recommendation from ISS and/or Glass Lewis by Jon Ocker, Brett Cooper, Jeremy Erickson and Michael Yang There is no doubt that Institutional Shareholder Services ("ISS") and Glass Lewis, as advisors to institutional shareholders, have a significant impact on the level of shareholder support for a company's Say on Pay and Incentive Plan proposals. However, a "no" recommendation from either ISS or Glass Lewis does not necessarily mean that you will fail a Say on Pay or an Incentive Plan proxy proposal. Instead, if you received a "no" recommendation Some of the larger and more prominent from either ISS or Glass Lewis, it is critical that institutional shareholders include the following: you take a proactive approach and promptly put BlackRock Fidelity in place a shareholder outreach plan to directly engage your larger institutional shareholders to T Rowe Price Morgan Stanley discuss your pay decisions and to ask for their Vanguard State Street thoughts on the ISS/Glass Lewis "no" recommendation. The shareholder outreach Because these institutions have voting plan is most effective when orchestrated by a guidelines that are broader than the bright line cross-functional team, including your proxy quantitative tests of ISS/Glass Lewis and they solicitor, inside and outside legal counsel, the tend to look at the big picture and larger time Compensation Committee's chair and horizons, often these institutions will not follow compensation consultant and internal HR and the voting recommendations of ISS/Glass Lewis. investor relations team members. These institutions will, however, want a clear explanation and perhaps additional disclosure of One of the first tasks for the team is to have your how the pay decisions are in the shareholders' proxy solicitor arrange for telephone calls with best interests. your larger investors, and it is most effective, if possible, to have the chair of the Compensation If the institutions express support for the "no" Committee lead the calls. If that is not possible, recommendation, then you should consider what investor relations, internal legal and the head of the vote will be with a "no" vote by the particular HR should take the call. If brief talking points institutions and whether it results in less than a are prepared to organize the discussion on the majority or less than 70% approval. A vote of calls, they should not have to be filed in advance less than 70% support will result in greater with the SEC. However, if an actual script is scrutiny of the Compensation Committee by ISS prepared, it would likely be considered in the following year, including a requirement "solicitation materials" and need to be filed with that the company disclose whether and how it the SEC as supplemental proxy materials. has adequately addressed shareholder issues Orrick | May 2015 page 4

5 and what changes the company has made to its Internal Revenue Code Section 162(m) has compensation programs. Our next Alert will most likely expired, the conditions can be added cover under what circumstances the institutions as a form of negative discretion that can result in will vote against the re-election of the the reduction of the portion of the award not Compensation Committee members. earned under the performance condition with no opportunity as upside. Alternatively, the If the Company wants to win the Say on Pay Compensation Committee may be able to proposal, it has two options. Depending on what persuade the CEO (or other named executive the Company hears from shareholders, the officers) to waive a portion of his/her long-term Company can: incentive awardit's too late to waive cash bonusesfor the year. The amount waived Not change anything but issue a might be the amount necessary to change the supplemental proxy explaining how the pay "medium" quantitative concern to a "low" decisions are in the shareholders' best concern. Unfortunately, companies are not interests and continue the dialogue with the generally able to determine in advance if their undecided or negative shareholders; or proposed action will change the advisor's "no" Reduce compensation and/or add recommendation, so it is a bit of a gamble and performance conditions and file an 8-K the change of compensation is generally viewed regarding these changes to try to get ISS to as "the court of last resort." In terms of timing change its "no" recommendation and the for the 8-K, a Company should assess what the large institutions to vote "yes." vote will be after it has engaged in shareholder outreach and issued a supplemental proxy. If For example, the following is a case study with a the solicitor's projected vote percentage is less couple of examples of strategies for than a majority, or if there is a majority approval supplemental disclosures or amendments to that is less than 70% approval and the reduce compensation. Compensation Committee desires greater than 70% approval, then the Compensation Supplemental Disclosure. Let's assume the Committee should take action to change the shareholder advisory firm recommended a "no" compensation and file an 8-K at least 5-7 vote based on a "medium" quantitative concern business days before the annual meeting to try and that the resulting qualitative review focused to change the ISS/Glass Lewis voting on excessive CEO pay relative to performance. recommendation(s). Under these circumstances, the supplemental disclosure should focus on the prior year's good In preparing for discussions with these record of Say on Pay votes and list examples of shareholders and preparing any amendments to the company's good governance/pay practices. compensation, it is important to know each of The disclosure should then focus on why the their proxy voting guidelines, as summarized in compensation appeared to be high and offer the charts. More significantly, it is important to extenuating circumstances, e.g., turn around, know about these guidelines and the advisors' outstanding operational results other than TSR policies well in advance of the annual meeting and why the pay decisions were in the when designing and disclosing the CEO's pay in shareholders' best interests looking at the year the proxy to avoid a recommended "no" vote. in terms of a 3- to 5-year time horizon and the company's long-term business strategy. 8-K Disclosing Changes in Compensation. If the Compensation Committee concludes that changes should be made (and assuming the same facts), one relatively painless solution is to add performance conditions to equity grants that are perceived to be too large. Since the time period to add performance conditions under Orrick | May 2015 page 5

6 Compensation and Benefits Insights Practical Advice for Compliance with Recent Amendments to the Internal Revenue Code Section 162(m) Regulations by Jon Ocker, Christine McCarthy, Juliano Banuelos and Jason Flaherty The recent amendments to the Section 162(m) regulations largely follow the changes set forth in the proposed regulations issued in 2011, clarifying two exceptions from the Section 162(m) tax deductibility limit: The treatment of restricted stock units (RSUs) and certain other forms of stock-based compensation under the transition rule applicable to newly public companies; and The requirement under the "qualified performance-based compensation" exception to set a per-employee limit applicable to stock options and stock appreciation rights (SARs) under an equity plan intended to comply with such exception. RSU Reliance Period Clarification expiration or material modification of the plan or agreement. Generally, compensation paid by newly public companies under plans or agreements in effect Under a special equity award rule, stock prior to the company's initial public offering (IPO) options, SARs, and restricted stock that are (for which adequate disclosure is provided in the granted during the reliance period will be IPO prospectus) must be "paid" during the deemed to be performance-based reliance period to be deemed performance- compensation (subject to meeting all the based compensation that does not count against other specific requirements) even if the the annual $1 million deduction limitation. equity awards are exercised or vest after the end of the reliance period. The reliance period ends on the earliest of: (a) the first annual shareholders meeting at The final regulations clarify that other forms which directors are to be elected that occurs of stock-based compensation, most notably after the third calendar year following the RSUs, do not qualify for the special equity year of the companys IPO (or, if no IPO, the rule and must be settled during the reliance first calendar year following the year in period. However, this clarification does not which the company becomes a public apply to stock-based compensation granted company), (b) the issuance of all employer prior to April 1, 2015. stock and other compensation allocated under the plan or agreement, or (c) the Orrick | April 2015 page 6

7 Practical Advice Practical Advice Public companies that want to preserve both Public companies that want flexibility with their the flexibility of their pre-IPO equity plans plans can have a single limit for all equity grants (e.g., evergreen increases to the share or separate limits for different classes of equity reserve) and the tax deductibility of their (e.g., separate limits for appreciation-based equity award grants may want to consider awards such as stock options and SARs versus the following grant practices: full-value awards such as restricted stock and RSUs). Set forth below are example plan Grant performance-based restricted provisions that generally will comply with the stock in lieu of performance-based RSUs final regulations subject to the specific terms of during the reliance period. Assuming all the applicable plan: of the other requirements are satisfied, the performance-based restricted stock Single Limit will not count against the annual $1 No participant may be granted one or more million deduction limitation even if the awards during any calendar year covering vesting and income tax event occurs more than 10,000,000 shares in the after the end of the reliance period. aggregate. Whether granting restricted stock or RSUs, the tax consequences to the Separate Limits employee generally will be the same Limits on Options. Subject to adjustment (assuming the employee does not make pursuant to Section __, no key employee a Section 83(b) election to be taxed on shall receive options to purchase shares the restricted stock at grant and that the during any calendar year covering in excess employee does elect to defer the of 7,500,000 shares. settlement of the RSUs). Limits on SARs. Subject to adjustment Grant only stock options during the pursuant to Section __, no key employee reliance period. shall receive awards of SARs during any calendar year covering in excess of Grant a lesser number of RSUs with 7,500,000 shares. modified vesting schedules such that all or a portion of the RSUs will be settled in Limits on Stock Grants and Stock Units. stock during the reliance period. Subject to adjustment pursuant to Section __, no key employee shall receive stock grants or stock units during any calendar year covering, in the aggregate, in excess of Per-Employee Limit Clarification 7,500,000 shares. The final regulations retain the rule that using an aggregate limit on the number of shares that could be granted under a stockholder-approved plan will not meet the requirement for establishing the maximum amount of compensation that may be received by an individual covered employee. This clarification does not apply to stock options or SARs granted prior to the proposed regulations' effective date of June 24, 2011. Further, the limit can be structured to include all types of equity-based awards, other than stock options and SARs. Orrick | April 2015 page 7

8 Compensation and Benefits Insights Changing the Status Quo With Extended Option Programs by Christine McCarthy and Stephen Venuto As technology companies find themselves pushing back IPO timelines and staying private for longer periods of time, they continue to aggressively compete for talent, often against public companies like Google and Facebook. Given the new dynamic in the marketplace, enhancing the effectiveness and competitiveness of equity programs is one area that can help private companies attract and retain talent. One approach that captured headlines recently wants them to realize the value of the equity that was Pinterest's announcement to offer vests during their time with the company. employees an extended period of time to Recruiting As potential new hires compare exercise stock options after employment ends. offers, the offer of a private company stock In a typical private company stock option, option without strings on the back end can be a employees are given 3 months after powerful factor in favor of the company offering employment ends to exercise vested stock it. This can be particularly helpful where a options. Under the new extended option competing offer of equity is made by a public approach, employees will be given a longer company which the recruit knows can translate period of time (e.g., 7 years) after employment into value in the public markets more quickly as ends to exercise vested stock options. the equity award vests (assuming the equity has value). Why Do This? Secondary Sales In the past few years, we Employee Morale Private company have seen many companies consider and offer employees often feel pressure knowing that they to employees the opportunity to sell shares while may be put in the difficult position of having to the company is still private. There are a number exercise vested stock options within a very short of reasons for offering this benefit, some of period of time if their employment ends, causing which will continue to make these programs them to have to pay a large amount of money attractive for private companies, including out-of-pocket to cover the exercise price and companies who offer stock options with taxes that arise in connection with the exercise. extended post-termination exercise periods. For The lower the exercise price and the smaller the others, the promise of a stock option with an difference between the fair market value and the extended post-termination exercise period will exercise price, the less of a concern this is, but it alleviate the pressure to offer employees the is often still a concern and it is a concern that opportunity to sell their shares. increases for all option holders (even those with low exercise prices) exponentially as the Option Lending Arrangements Similar to company performs well, causing the fair market secondary sale transactions, we expect that value of the shares to increase. Removing this stock options with extended post-termination pressure is a strong signal to employees that the exercise periods will reduce the number of company cares about their contributions and private company employees that seek to borrow money to exercise options (note that, in some Orrick | April 2015 page 8

9 cases, employees are engaging in these option New Stock Options/Tax Consequences lending transactions with the consent of the New stock options with extended post- company, whereas, in other cases, employees termination exercise periods can qualify as are doing this without company consent, incentive stock options at grant but will whether it is technically required, or not). automatically convert to non-statutory stock options 3 months after employment ends. What Are the Downsides? Who Should Be Included - Private companies Retention Some private companies believe should consider whether it makes sense to offer that a short, 3 month post-termination exercise extended post-termination exercise periods on a period is an important retention tool as it can broad basis, or on a case by case basis, and make it very hard for an employee to leave the whether it should be offered for outstanding company if they don't have the resources to pay stock options or just new stock options. Note the exercise price and/or taxes that would arise that a case by case basis approach minimizes upon exercise of their vested options. There is the downside issues but also minimizes the certainly some truth to this. On the other hand, benefits related to these arrangements. employees who feel compelled to stay only for their already-vested equity may not be the most motivated, best-performing employees and companies should consider whether there are other, maybe better, ways to create retention incentives for employees. Dilution A longer post-termination exercise period inevitably means more shares will remain subject to options for a longer period of time, which can reduce the pool of shares available for grant to new hires and other employees. Note, however, that this is not dissimilar to what happens when private companies grant restricted stock units to employees and this doesn't seem to be a major impediment to most companies. Accounting The accounting expense recognized for these stock options will be higher than a traditional stock option with a 3 month post-termination exercise period. Any Other Considerations? Outstanding Stock Options If private companies offer employees the opportunity to amend stock options to provide for an extended post-termination exercise period, the amendment will in most cases cause any incentive stock options to convert to non- statutory stock options immediately upon the effectiveness of the amendment. Also, private companies should work closely with their legal, tax and accounting advisors to ensure there are no surprises in the amendment process as there are some important issues to address. Orrick | April 2015 page 9

10 Compensation and Benefits Insights Annual Reporting Requirements for Incentive Stock Options and Employee Stock Purchase Plans Annual Information Statements and IRS Returns by Christine McCarthy and Michael Yang Requirement to Report For (1) any exercise of an incentive stock option instead a participant's shares are issued directly (ISO) during 2014 or (2) transfer during 2014 of to the participant or registered in the participant's a share previously purchased pursuant to a tax- name on the company's records, the transaction qualified employee stock purchase plan (ESPP) does not need to be reported to the IRS or to the where the purchase price paid for the share was participant because such transaction is not (a) less than 100% of the fair market value on considered a transfer of legal title. the date of grant or (b) not fixed or determinable on the date of grant, the Internal Revenue Code Participant information statements may either be requires companies to: delivered or mailed to the participant's last known address or, if the participant has given furnish, by February 2, 2015, annual his or her consent to receive the statement information statements to the participant electronically, provided in electronic format. The who exercised the ISO or transferred the consent to receive the statement electronically ESPP share; and must be made in a way that demonstrates that file, by March 2, 2015 (for paper filers) or by the participant can access the statement in the March 31, 2015 (for electronic filers), an electronic format in which the statement will be information return with the IRS (please note provided. For example, if the statement will be that companies may request an automatic sent as a Word attachment to an e-mail 30-day extension of this deadline by filing a message, the consent also must be sent as a Form 8809, Application for Automatic Word attachment to an e-mail message. Further, Extension of Time to File Information the participant must be provided with certain Returns, with the IRS on or before the disclosures related to the consent, including the applicable filing deadline). right to receive a paper copy and the manner in which consent may be withdrawn. With respect to reporting ESPP transactions, companies are required to report the first Format of Statement/Return transfer of legal title to any share purchased Returns for ISO and ESPP transactions must be under an ESPP plan. When a participant's submitted to the IRS on Form 3921 (for ISOs) shares are put into a brokerage account on and Form 3922(for ESPPs). You may order behalf of such participant, the transaction is Form 3921 and/or 3922 by calling the IRS at 1- considered a transfer of legal title and, if it is the 800-829-3676 or through the IRS website first transfer of legal title of the shares, it must be (please note that, even though Forms 3921 and reported to the IRS and to the participant. If Orrick | January 2015 page 10

11 3922 may be found on the IRS website, you are grant date (i.e., the first day of the offering not permitted to print and file these forms with period). In addition, if any individual participant the IRS; the IRS will only accept the official has more than one ISO transaction or more than forms ordered from the IRS). one ESPP transaction in a calendar year, you must include a unique account number on the Participant statements may be provided on Form form. The IRS has indicated that this number 3921 (for ISOs) and Form 3922 (for ESPPs) or may be any number, not longer than 20 digits, may be provided using a different format that and can contain numbers, letters and special complies with the substitute form requirements characters. The unique number assigned to found in IRS Publication 1179. At a minimum, exercises/purchases by some stock plan substitute forms will need to contain all of the administration programs could be used for this same information as the actual Form 3921 and purpose. Otherwise, you should create a 3922. system to assign numbers to each transaction. Finally, even though you are only required to We expect that companies with a limited number assign unique account numbers if a participant of transactions will likely use Forms 3921 and/or has more than one ISO or ESPP transaction in a 3922 (as opposed to substitute statements) year, we recommend that you assign a number since these forms will need to be prepared and to every ISO and ESPP transaction, as we submitted to the IRS in any event. Further, we expect that this will be used by the IRS to expect that companies that provide Form 3921 track/locate transactions and will likely be easier and/or 3922 to participants (again, as opposed to ensure compliance if it is done consistently for to providing substitute statements) will deliver all transactions. the form(s) to their participants, along with a cover letter explaining the statement in a Electronic Submission of IRS Returns manner similar to this statement for ISO Companies that are required to file 250 or more transactions and this statement for ESPP ISO returns or 250 or more ESPP returns to the transactions. IRS must file the ISO or ESPP returns, as applicable, electronically through the IRS' Filing The IRS requires that a separate Form 3921 or Information Returns Electronically (FIRE) Form 3922 as applicable be filed with the IRS for system. To submit through the FIRE system, each transaction (i.e., each ISO exercise), even you will need to set up a FIRE account through if one participant has multiple transactions the IRS website and you will need a Transmitter during the course of the year. If a company Control Code (TCC). If you are using a stock provides participants with an information plan administration firm that will be submitting statement that meets the substitute statement these returns on the company's behalf, they will requirements, the IRS has indicated that the likely use their TCC. If you are not filing through company may aggregate transactions and a stock plan administration firm and/or do not provide only one substitute statement to each have a TCC, you will have to submit a Form participant who had multiple transactions during 4419, Application for Filing Information Returns the year. Electronically, so that a TCC can be assigned to Whether you use Forms 3921 and/or 3922, or the company. Form 4419 must be submitted to you use substitute forms, certain information the IRS at least 30 days prior to filing a return electronically, and thus, must be submitted no must be included in the form, including for ESPP later than March 1, 2015 (or March 31, 2015 if transactions, the price per share of ESPP stock an extension is obtained) in order to timely file transfers. If the exercise price is not fixed or Forms 3921 or 3922 electronically. Also, to determinable on the date of grant (e.g., the exercise price is the lesser of 85% of the fair submit returns through FIRE, you will need to market value on the first day of an offering create a submission file that meets the FIRE requirements. These formatting requirements for period or 85% of the fair market value on the last FIRE are somewhat onerous and, as a result, day of an offering period), you must report the companies will likely need assistance in creating exercise price as if the purchase occurred on the Orrick | January 2015 page 11

12 the submission file due to the formatting disqualifying disposition and may subject the requirements (a number of stock plan company to certain reporting penalties. administration firms are equipped to provide this assistance). In addition, while you are permitted A sale of ISO shares before the later of the date to voluntarily file electronically, because the which is two years after the date of grant and the process is challenging and potentially involves date that is one year after the date of exercise is some cost to prepare the necessary file, most treated as a disqualifying disposition. The companies with limited transactions will find it ordinary income recognized on a disqualifying more practical to prepare and file paper returns. disposition is equal to the difference between the ISO exercise price and the lesser of the fair Penalties market value of the shares on the date of exercise or the sale price of the shares. The Internal Revenue Code imposes up to a US$100 penalty for each statement not Disposition of ESPP Stock furnished, or for each statement furnished to a participant with incomplete or incorrect If any person transferred ESPP stock for the first information, up to a maximum penalty of time during the 2014 calendar year, a company US$1,500,000 per year. In addition, the Internal must report in box 1 of the person's 2014 Form Revenue Code imposes up to a US$100 penalty W-2 the amount of the purchase price discount for each return not filed with the IRS, or for each (described below), if any, on ESPP stock and, if return filed with the IRS with incomplete or the ESPP stock was transferred in a incorrect information, up to a maximum penalty disqualifying disposition, any ordinary income of US$1,500,000 per year. Greater penalties will that the person recognized when the shares apply if a company intentionally fails to provide a were transferred. The "purchase price discount" statement or file a return with the IRS. is the difference between the fair market value of the shares on the first day of the offering period Assistance and the purchase price that would result if the shares were actually purchased on the first day Please contact any member of Orrick's of the offering period. For example, if the Compensation and Benefits Group for further purchase price of the ESPP stock is equal to the assistance on meeting these information lesser of 85% of the fair market value on the first statement and return requirements. If you use day of the offering period and 85% of the fair an external stock plan administrator, your stock market value on the last day of the offering plan administrator may also be of assistance as period (the purchase date), the purchase price many stock plan administrators have developed discount is 15% of the fair market value on the specific services to help companies comply with first day of the offering period. Failure to report these requirements. this income will prevent a company from taking a deduction for the ordinary income and may Additional Annual Reporting subject the company to certain reporting Requirements penalties. Disqualifying Disposition of ISO Shares A transfer of ESPP stock before the later of the date which is two years after the first day of the A company must report any ordinary income that an optionee recognizes in connection with a offering period or the date which is one year disqualifying disposition of ISO shares during after the purchase date is treated as a disqualifying disposition. The ordinary income the 2014 calendar year in box 1 of the optionee's recognized on a disqualifying disposition is 2014 Form W-2. Failure to report this income will equal to the difference between the purchase prevent a company from taking a deduction for price and the fair market value of the shares on the ordinary income that results from the the purchase date. Orrick | January 2015 page 12

13 Compensation and Benefits Insights IRS Limits Correction Opportunities Under Section 409A Proposed Income Inclusion Regulations and Imposes 20% Penalty by Eric Wall, Juliano Banuelos and Jason Flaherty Background regulations do not address the situation where a document failure is corrected before the vesting In Chief Counsel Advice 201518013 (May 1, date but in the year of vesting. 2015) (the "CCA"), the IRS addresses an executive retention bonus that originally vested The CCA concludes that a document failure may after three years and was payable in equal not be corrected under the proposed regulations installments on the first two anniversaries of the in the year of vesting and the 20% section 409A vesting date or, in the employer's discretion, in penalty applies to the entire bonus. The CCA a lump sum on the first anniversary of the confirms the informal position previously vesting date. Recognizing after the adoption espoused by IRS officials that has been doubted of the bonus plan that the employer's by commentators. Presumably, the IRS will also unfettered discretion to accelerate the second clarify its conclusion when it finalizes the installment payment causes the bonus plan to proposed regulations. violate the deferred compensation timing rules of section 409A of the Internal Revenue Code The CCA does not address the document failure ("section 409A"), the parties amended the corrections programs available outside the bonus plan prior to the vesting date (but in the proposed regulations (i.e., Notice 2010-6, 2010- same year as the vesting date) to eliminate the 3 IRB 275), which might have offered some employer's discretion. relief from the 20% section 409A penalty under the facts of the CCA. Analysis Proposed Treasury Regulation section 1.409A-4 Insights (the "proposed regulations") make clear that The CCA is a reminder to employers to re-visit the failure of a plan document to comply with their compensation arrangements prior to the section 409A (a "document failure") may be end of each year to correct any potential section corrected with respect to amounts that vest in 409A document failures. future years. However, the proposed Orrick | May 2015 page 13

14 Compensation and Benefits Insights Pay for Performance Table and Best Practice Proxy Disclosure by Jon Ocker and Jeremy Erickson The SEC recently released its proposed "pay for performance" rules under one of the last remaining executive compensation requirements mandated by the Dodd-Frank Act. This new "pay for performance" rule requires companies to disclose the relationship between the actual compensation paid to their named executive officers and the company's financial performance as measured by total shareholder return (TSR). While numerous other writings have focused on be easier for shareholders to visualize and the technical requirements of the proposed understand and thus, should be used to help rules, this alert focuses on the new "pay for illustrate the narrative description. We have performance" table which would be required to provided sample charts below which companies be included in a company's proxy statement and may consider using in their proxy statements to best practices to address the additional satisfy these new proposed disclosure rules (if requirement of a description of (i) the adopted). relationship between executive compensation actually paid versus the company's TSR and (ii) Pay versus Performance Table the relationship between the company's TSR Set forth below is the new table which will be versus the TSR of its peer group. required to be included in a non-exempt, large public issuer's proxy statement based on the The proposed rules give flexibility to describe proposed rules, which has been populated using these relationships in either narrative or graph hypothetical numbers. Even though the form (or both). There will inevitably be some proposed rules provide for a two-year phase-in narrative description, but as a best practice, we period, the table includes the full five years of think the use of charts will tell a better story and compensation and TSR for illustration purposes. Orrick | May 2015 page 14

15 Pay versus Performance Table Compensation versus TSR Charts Since it may be difficult to understand the link between pay and performance simply based on the compensation and TSR amounts in the table above, the below chart, which compares changes in Chief Executive Officer (CEO) and average non-CEO, named executive officer (NEO) actual compensation to TSR over the same five-year period, provides a useful illustration of the extent to which pay aligns with performance. Change in Actual Compensation v. TSR Orrick | May 2015 page 15

16 Based on the proposed rules, executive compensation actually paid is total compensation as disclosed in the Summary Compensation Table (SCT), modified to exclude changes in actuarial present value of benefits under defined benefit and actuarial pension plans which are not attributable to the applicable year of service, and to include the value of equity awards at vesting rather than when granted. Depending on a company's specific facts and circumstances, there may be material differences between compensation as reported in the SCT and compensation actually paid. In such a case, it may be appropriate to include the following chart which compares SCT compensation (not actual compensation) to TSR. Change in SCT Compensation v. TSR Orrick | May 2015 page 16

17 TSR versus Peer Group TSR Chart To address the proposed requirement that a company compare its TSR to the TSR of its peer group, the below chart provides a useful visual comparison. Based on the hypothetical inputs, there is a tight correlation. TSR v. Peer Group TSR * The chart above assumes an initial investment of $100 at the beginning of 2011. Optional Additional Charts The hypothetical amounts in the new SEC table result in illustrative charts which show a favorable relationship between NEO pay and absolute and relative company TSR. If, on the other hand, the relationship is not as favorable as this hypothetical situation, or even if it is, but a company's compensation committee focused on operational results in determining pay, then a company may wish to include the following table as an optional chart to support its compensation decisions. Orrick | May 2015 page 17

18 Achievement of Operational Goals v. Year-Over-Year TSR * 100% reflects the break-even point for TSR and full satisfaction of target operational goals. Enhanced CD&A Disclosure The Role of Absolute and/or Relative TSR in the Design of Equity-Based, The proposed new table and its focus on the Long-Term Incentives new disclosure concepts of actual pay and TSR will force companies to enhance their CD&A The new SEC table is quite similar to the disclosure to explain the role of actual pay and comparisons of pay and TSR which Institutional TSR in their decision making. For example, Shareholder Services (ISS) currently uses in its where actual pay is lower than SCT CEO pay and 5-year absolute TSR graph, the compensation, a company may want to explain CEO relative degree of alignment test and the how and why the pay they actually deliver is less disclosure of other NEO compensation. With the than what is reflected in the SCT. In addition, if emphasis on pay and TSR by ISS and the SEC, actual pay levels are high while TSR is also we think many issuers may decide to use TSR high, a company may want to justify the higher as a performance goal for long-term equity pay levels based on the level of shareholder incentives. TSR may be used in the form of an return. Conversely, where actual pay is high add-on goal to existing operational goals or as a while TSR is low, but operational results are modifier or multiplier to operational goals. The positive, a company may want to explain that latter may be the best way to acknowledge the while TSR is low, compensation decisions were role of TSR as an element of pay for driven by operational performance which is performance, but not the most important weighted more heavily than TSR. While not component. possible to address all the potential permutations in this alert, the new table will force companies to better describe and justify the decisions of compensation committees. Orrick | May 2015 page 18

19 What To Do Now Determine how and where you will want to disclose the required information While the SEC's proposed rules do not provide any indication when the new disclosure Review your peer group and determine if requirements will be effective, below are a few you need to revise it things you should consider to prepare for future Make appropriate edits to your CD&A to pay for performance required disclosures: reflect the role, if any, of TSR on Model actual compensation and your compensation for the year company's TSR to determine the level of Consider whether to add TSR as a pay-for-performance alignment and how performance goal to your long-term best to address any pay-for-performance incentives disconnect Orrick | May 2015 page 19

20 Compensation and Benefits Insights A Plain English Guide to the SECs Compensation Clawback Rules by Jon Ocker, Jason Flaherty and Keith Tidwell As accounting restatements occur relatively infrequently, and the severity is often modest, the proposed clawback rules represent more of a "check the box" compliance activity than a real enforcement threat. When to comply? Executives). For example, if a calendar year company concludes in November 2018 that a Technically, adopting a recovery policy is not restatement is required for 2017 and files it in necessary until 60 days after the exchanges January 2019, the Covered Period will be 2015, listing standards become effective. However, 2016 and 2017. the clawback rules must be enforced if there is a restatement during a companys fiscal year in What must be recovered? which the SEC adopts its final rules. Therefore, we recommend that our client's compensation The company must recover from each Covered committees be ready to adopt the sample Executive that portion of Covered Compensation Compensation Clawback Policy set forth below that would not have been paid or earned if the shortly after the SEC finalizes its rules. This financial statements issued during the Covered could happen as early as Q4 2015 but is more Period had been properly prepared. This likely to occur in 2016. includes Covered Compensation to the extent the restatement affects stock price. What compensation is covered? How is it recovered? Only performance-based cash and equity compensation that is granted, earned or vested Direct repayment of the affected Covered based in whole or in part on the attainment of Compensation on a pre-tax basis is required; any financial reporting measure is covered however, when that is not practicable, (Covered Compensation). Salaries, companies can cancel unvested equity and discretionary cash bonuses and equity awards deferred compensation. To facilitate the that vest solely on the passage of time are not enforcement of such measures we recommend covered. that companies build into bonus participation agreements, performance share and unit grant What executives are covered? agreements and deferrals of compensation, the Covered Executives acknowledgement and The rules apply to all current and former consent to such actions. Recovery is not executive officers, whether or not an officer is at required if the direct costs of seeking recovery fault, who receive payments of Covered would exceed the recoverable amount or if Compensation during the three completed fiscal recovery would violate the companys home years (the Covered Period) preceding the date country laws. the company is required to prepare the accounting restatement (the Covered Orrick | July 2015 page 20

21 When is a restatement required? A restatement is generally required when the company concludes, or reasonably should have concluded, that previously issued financial statements contain a material error. Currently, companies must file a Form 8-K when they conclude they have filed erroneous financial statements that should no longer be relied upon. Sample Compensation Clawback Policy: The compensation committee will recover from any current or former executive officer, regardless of fault, that portion of performance- based compensation based on financial information required to be reported under the securities laws that would not have been paid in the three completed fiscal years preceding the year(s) in which an accounting restatement is required to be filed to correct a material error. This policy will be enforced and appropriate proxy disclosures and exhibit filings will be made in accordance with the SEC's clawback rules and our exchange listing standards. Orrick | July 2015 page 21

22 Compensation and Benefits Insights SEC Pay Ratio RulesA Recipe for Compliance and Model Disclosure The SEC recently adopted its final pay ratio disclosure rules. by Jeremy Erickson, Keith Tidwell and Christine McCarthy Commencing in early 2018, public companies will have to disclose (i) their CEOs total annual compensation, (ii) the median total annual compensation of all of their employees (other than the CEO), and (iii) a ratio comparing the two values. This alert explains step-by-step how to comply with the final rules and concludes with a model disclosure. Step 1: Determine the CEOs Total Step 2: Determine the Median Total Annual Compensation Annual Compensation for All Other Employees The CEOs total compensation will be as reported in the Summary Compensation Table. The final rules define employee to include all If the company had more than one CEO during worldwide full-time, part-time, seasonal, and the year, it must either: (i) aggregate the total temporary employees employed by the company compensation that was paid to each individual or any of its consolidated subsidiaries. This who served as CEO during the year, or (ii) does not include independent contractors or annualize the compensation paid to the leased employees as long as they are individual serving as CEO on the determination employed, and their compensation is date the company selects to identify the median determined, by an unaffiliated third party. Given employee. The company must disclose which recent controversy surrounding this part of the method it chose and how it calculated the final rules, companies may want to consult their annual total compensation. legal expert on whether independent contractors that are self-employed are required to be If a CEOs salary or bonus is not yet calculable, counted. Fortunately, the final rules afford some the company may omit its disclosure until such flexibility with respect to identifying the median amounts are determinable and disclose when employee as explained below. this is expected. Once the information is available, the companys disclosure would then International Employees be filed under Item 5.02(f) of Form 8-K. The company may exclude non-U.S. employees Although an Item 5.02(f) filing would be triggered from its determination of median employee in when the CEOs omitted salary or bonus two limited instances. becomes calculable in whole or in part, the pay ratio disclosure is only required when the CEOs Foreign Law Exemption: If compliance with salary or bonus becomes calculable in whole. the final rules would cause the company to violate foreign data privacy laws or regulations, the employees of that foreign jurisdiction may be Orrick | August 2015 page 22

23 excluded. Reasonable efforts must first be M&A Employees made to seek an exemption or other relief under The company may exclude any employees of an the foreign data privacy laws before relying on entity that was acquired by the company during this exemption. The company also must obtain the covered fiscal year (but not future years). a legal opinion from counsel opining on the The company would have to disclose the identity inability to comply with the final rules without of the acquired company and the approximate violating foreign laws and file such opinion as an number of employees excluded. exhibit to the filing in which the pay ratio disclosure is included. The final rules also provide additional flexibility in calculating the median employees total De Minimis Exemption: If the companys non- annual compensation. U.S. employees account for 5% or less of its global workforce, all of the non-U.S. employees Reasonable Estimates: Reasonable estimates may be excluded. If the non-U.S. employees such as statistical sampling are permitted, but exceed the 5% threshold, the company may the company must disclose any material exclude up to 5% of its global workforce who are assumptions, adjustments or estimates used to non-U.S. employees. However, non-U.S. identify the median employee and determine the employees excluded under the foreign law total annual compensation. exemption will count against this 5% cap. Annualizing Adjustments: The company may If any non-U.S. employees in a particular annualize the compensation of a permanent jurisdiction are excluded, all non-U.S. employee (full- and part-time) who did not work employees in that jurisdiction must be excluded. for the entire year but not the compensation of Cherry-picking within jurisdictions is prohibited. temporary or seasonal employees. Full-time adjustments for part-time employees is also Identifying Median Employee Once Every prohibited. Three Years The company may identify its median employee Cost-of-Living Adjustments: The company once every three years unless there has been a may make cost-of-living adjustments to the change in its employee population or employee compensation paid to employees in jurisdictions compensation arrangements that it reasonably other than the jurisdiction where the CEO believes would result in a significant change in resides. If the company uses this adjustment, it the pay ratio disclosure. Also, if the identified must use the same cost-of-living adjustment in median employees compensation changes, the calculating the median employees annual total company can use another employee who compensation and disclose (i) the median previously had substantially similar employees jurisdiction, (ii) the median compensation. The company must disclose employees annual total compensation and the whether it uses the same median employee for pay ratio, both with and without the cost-of-living three years or a different median employee. adjustment, and (iii) a description of the cost-of- living adjustments used. Three-Month Determination Date Window Step 3: Formulate the Pay Ratio The company may use any date within three months prior to the last day of the year to The pay ratio must be expressed either (i) as a determine the employee population for purposes ratio in which the annual total compensation of of identifying the median employee. For the median employee is equal to one (e.g., 100 example, choosing a date before the holidays to 1 or 100:1), or (ii) narratively in terms of the could avoid the inclusion of seasonal multiple that the CEOs total annual employees. The chosen date (or a change in compensation bears to the annual total the date from a prior year) must be disclosed. compensation of the median employee. Orrick | August 2015 page 23

24 Step 4: Prepare the Disclosure The pay ratio disclosure will have to be provided in all filings in which executive compensation disclosure is required by Item 402 of Regulation S-K (e.g., Form 10-Ks, proxy and information statements and registration statements) but not in periodic filings such as Form 8-Ks or 10-Qs. As with other executive compensation information, the Form 10-K can incorporate this disclosure from a proxy statement that is filed within 120 days after the end of the fiscal year covered by the Form 10-K. After the initial pay ratio disclosure, the company will be able to benchmark how its pay ratio compares to peer group members. We expect there will be more commentary on how companies rank and why the pay ratios are what they are by the 2019 proxy season. Supplemental Disclosure. The company may supplement its pay ratio disclosure by providing additional pay ratios or a narrative discussion to address any unwarranted conclusions that may be drawn from its disclosure. Any additional ratios must be clearly identified, not misleading and not presented with greater prominence than the required ratio. Model Disclosure Our Compensation Committee reviews the internal pay ratio between the CEOs total compensation and other named executive officers and the median annual total compensation of all employees (excluding the CEO). We identified the Median Employee by taking a statistical sampling of the annual total compensation of all full-time, part-time, seasonal, and temporary employees employed by us on [Date]. In making this determination, we used a sample size of [x] from a population size of [y]. Our CEO had annual total compensation of $10,000,000, and our Median Employee had annual total compensation of $100,000. Therefore, our CEOs annual total compensation is 100 times that of the median of the annual total compensation of all of our employees. Orrick | August 2015 page 24

25 Compensation and Benefits Insights Summary of ISS 2016 Policy Announcements by Brett Cooper, Jeremy Erickson and Keith Tidwell Institutional Shareholder Services (ISS) issued new U.S. voting policies and an updated Equity Plan Scorecard FAQ, both effective for annual shareholder meetings occurring on or after February 1, 2016. This alert provides a brief summary of the key U.S. policy changes and the updates to the Equity Plan Scorecard that will be in effect for the 2016 proxy season. Director Overboarding executives; rather, they leave compensation matters to an external manager who is ISS has lowered the acceptable number of reimbursed by the EMI through a management public company board seats a non-CEO director fee. The insufficient disclosure of compensation may occupy from six to five (the board under arrangements for executives at an EMI has not consideration plus four others). However, ISS been considered a problematic pay practice. will not recommend withhold votes against Under the revised policies, an EMIs failure to directors sitting on more than five public provide sufficient disclosure for shareholders to company boards until 2017. Instead, ISS will reasonably assess compensation for the NEOs issue cautionary language in proxy advisory will be deemed to be a problematic pay practice, research reports for those directors considered which will warrant a recommendation against the overboarded under the new policy (but not the EMIs say-on-pay proposal. former policy). This will allow overboarded directors a one-year grace period to plan for an Unilateral Governance Changes orderly transition in reducing their board Adversely Affecting Shareholder Rights commitments. ISS issued two new policies relating to unilateral ISS has not changed its policy threshold at board actions (i.e., those without shareholder which a public company CEO will be considered approval) that adversely affect shareholder overboardedcurrently set at no more than two rights: one for established public companies outside board seatsthough it did express that and another for newly public companies that it may reconsider this threshold in the future as have taken actions (e.g., amending bylaw or policy surveys indicate that many investors charter provisions) to diminish shareholder rights believe only one outside board commitment is prior to or in connection with an initial public an appropriate threshold for CEOs. offering (IPO). This bifurcation was made to reflect the differing expectations investors may Compensation of Externally-Managed have for established public companies versus Issuers newly public companies. These two policies are as follows: Externally-managed issuers (EMIs) are companies that do not directly compensate their Orrick | November 2015 page 25

26 For established public companies, ISS will the IPO model) that analyzes companies with generally continue to withhold votes from less than three years of disclosed equity grant directors who unilaterally adopted a data (generally, IPOs and bankruptcy-emergent classified board structure or implemented a companies) and includes Grant Practice factors supermajority vote requirement to amend other than Burn Rate and Duration for the bylaws or charter. companies in the Russell 3000/S&P 500. The maximum pillar scores for this model are as For newly public companies, ISS will take a follows: case-by-case approach and give significant weight to shareholders ability to change the Plan Cost: 50 governance structure in the future through a Plan Features: 35 simple majority vote and their ability to hold directors accountable through annual Grant Practices: 15 director elections. If the company publicly commits to putting the adverse provisions to The Plan Features factor known as Automatic a shareholder vote within three years of the Single-Trigger Vesting is renamed as CIC IPO, that can be a mitigating factor. Query Vesting, with the following scoring levels: whether this policy will have any impact Full points if the plan provides: (i) for since most companies obtain shareholder outstanding time-based awards, either no approval of their governing documents as accelerated vesting or accelerated vesting part of the IPO process. only if awards are not assumed/converted; Unless these adverse actions are reversed or AND (ii) for performance-based awards, submitted to a binding shareholder vote, in either forfeiture or termination of outstanding subsequent years, ISS will vote case-by-case on awards or vesting based on actual director nominees. performance as of the CIC and/or on a pro- rata basis for time elapsed in ongoing Proxy Access performance period(s). ISS has not changed its fundamental approach No points if the plan provides for automatic to management and shareholder proxy access accelerated vesting of time-based awards proposals, but it is planning to release an FAQ OR payout of performance-based awards next month to provide more information on above target level. which additional provisions ISS considers overly Half points if the plan provides for any other restrictive. This FAQ will also clarify the vesting terms related to a CIC. framework ISS will use to analyze proxy access nominations, which is expected to be ISS has increased the threshold requirement for conceptually similar to that used for proxy full points under the Post-Vesting/Exercise contests. Holding Period Plan Feature to 36 months (up from 12 months) or until employment Updated Equity Plan Scorecard Changes termination. Holding periods of 12 months will for 2016 only accrue half of the points. ISSs updated Equity Plan Scorecard FAQ contains a new Special Cases model (formerly Orrick | November 2015 page 26

27 Compensation and Benefits Insights Measures in Favour of Company Savings Plans Under The Macron Law by Anne-Sophie Kerfant and Margaux Azoulay Enacted on 6 August 2015, France's law for growth, activity and equal economic opportunities, known as the "Macron law", designed to boost the French economy, aims to "establish equal economic opportunities and increase economic activity by removing restrictions, promoting investment and creating jobs". Certain employee share ownership schemes, years, (ii) by a holding period of at least two RSU (French AGA) and BSPCE (warrants for years. business creator shares) are at the heart of the new measures adopted by the Macron law. The The Macron law reduces the minimum vesting legislator wishes to encourage employees' period from at least two years to at least one involvement in the growth of the company (or year and removes the obligation for the group of companies) in which they work and extraordinary general meeting of shareholders to invest themselves each day. Through a set a holding period, provided there is a period reduction in compulsory contributions applying of at least two years between the shares being to RSU and a loosening of granting conditions of granted and the date on which when they are BSPCE, the Macron law provides companies sold. In practice, the extraordinary general with greater flexibility in the implementation of meeting may decide a vesting period and a their policies for their employee incentive holding period of one year each or, alternatively, schemes. just a vesting period of two years. Changes made to RSU Regime Reduction of the Tax and Social Pressure on Employees: Applicable to RSU's authorised by an annual general meeting of shareholders held on or after Attribution gains, taxed in respect of the year 7 August 2015, the new provisions aim to in which the shares are sold, are no longer taxed increase the attractiveness of RSU schemes by under the category of wages and salaries and reducing the legal constraints and the weight of social contributions applicable on income of 8%, tax and social security contributions both for but under the category of capital gains on employees and companies. securities and social security contributions on investment income. Accordingly, subject to the Easing of Legal Constraints beneficiaries keeping the shares that are issued to them following the vesting period for at least Before the Macron law came into force, two years, the attribution gains are subject to employees that were granted RSU could own progressive income tax but reduced (i) by tax and dispose of the shares only after a total relief for the holding period as provided for by period of four years, generally comprising (i) a law (50% for a holding period of more than two vesting period of at least two years, followed, years, or 65% for a holding period of more than where the vesting period was less than four eight years) or, if applicable, (ii) by a specific tax Orrick | October 2015 page 27

28 relief for the holding period (50% for a holding of any presence or performance conditions in period of at least one year, or 65% for a holding the plan rules. period of between one and four years, or 85% for a holding period of more than eight years) Finally, in order not to penalise rapidly growing applying to shares in a small or medium-sized SME's and to encourage them conducting a enterprise (SME)[1] subscribed or acquired in reinvestment policy rather than a distribution the 10 years following its incorporation, to sales policy, the Macron law exempts such companies of shares within a family group, and to sales of from employer social security contributions, shares undertaken by a director upon retirement provided that they have not distributed any (after, in the last case, an additional specific tax dividends since their creation and the RSU's are relief of 500,000). The gains will, moreover, be allocated within the social security annual subject to social security contributions at the rate threshold (up to 38,040 for 2015) for each of 15.5%. The treatment of tax and social employee. security contributions on gains realised on the sale of the shares remains unchanged. Easing of Conditions for BSPCE BSPCE entitle their holders to subscribe shares In practice, when shares from RSU's are sold, of a company at a pre-determinated price set on the total taxable gains will be equal to the sale the day the BSPCE's are granted by the price of the shares, reduced by tax relief for the extraordinary general meeting of shareholders. holding period, running from the date the shares are delivered. This scheme, mainly intended for start-ups and innovative young businesses, enables such Employee social security contributions, companies to incentivise their employees with which were until now paid by the employee the benefit of an attractive tax and social when the shares were sold, at a rate of 10% and treatment. calculated on the gains on acquisition, are no longer levied for RSU's granted on the basis of Reserved to stock companies, subject to the decision adopted by a shareholders' general corporate income tax in France, which have meeting held on or after 7 August 2015. been incorporated for less than 15 years, unlisted or whose market capitalisation is less Reduction of the Tax and Social than 150 million euros, and owned for at least Pressure on the Employer: 25% by individuals (or by companies directly or Employer social security contributions, indirectly owned for at least 75% by individuals it levied on employers when RSU's are granted, is being specified that holdings held by certain reduced from 30% of the value of the shares on entities such as French venture capital funds their granted date to 20% of the value of the (FCPR) are not taken into account for the shares on their delivery date (please note that determination of these thresholds), the scope of employers may no longer base these application of BSPCE was restricted because contributions on the value of the shares as they could not be granted to employees of the estimated for the needs of their consolidated issuer's subsidiaries nor issued by a company financial statements). created from a reorganisation of companies. These contributions will, therefore, now be due The Macron law, applicable to BSPCE granted (i) when the RSU's are delivered (and no longer on or after 7 August 2015, aims to ease these when they are granted) and (ii) calculated on the conditions. fair value of the benefit granted to the beneficiary, thus taking into account staff turnover between the acquisition date and delivery date of the shares as well as the risk arising from the almost systematic introduction Orrick | October 2015 page 28

29 Extension of BSPCE to Companies resulting from a reorganisation In order to end this restriction, which acted as a restraint on the growth of young businesses, especially on their ability to attract new talents, the Macron law now allows companies resulting from a reorganisation (i.e. from a merger, restructuring, extension or resumption of pre- existing activities) to issue BSPCE. They must, of course, meet all the aforementioned conditions; it being specified, however, that a company's market capitalisation should be calculated by aggregating the market capitalisations of all the companies formed from the reorganisation operation. Moreover, the age of the company or companies will be determined by using the earliest creation date of companies having taken part in the reorganization. Extension of the scheme to employees and directors of certain subsidiaries The Macron law, moreover, extends the scheme to employees and directors of the issuer's subsidiaries provided such subsidiaries are owned at 75% by the issuer and meet the aforementioned eligibility conditions. In particular, given that the subsidiary whose employees or directors are granted BSPCE must be subject to corporate income tax in France, it must be noted that only employees and directors of French subsidiaries will be eligible for the BSPCE. It is likely that this restriction will be contested and will need to be corrected in the future, to the extent that it constitutes a restriction to the freedom of establishment within the European Union. Orrick | October 2015 page 29

30 Compensation and Benefits Insights IRS Pulls Determination Letter Program Puts Premium on Plan Assessments by Sponsors by Yvonne Nyborg, Patricia Anglin and Mitchel Pahl Effective January 1, 2017, the IRS has announced that, due to limited resources, it is eliminating the existing 5-year determination letter application staggered filing cycles for individually designed plans. Off-cycle filings are eliminated immediately. Determination letter applications will no longer Under the current system, deadlines for be accepted for individually designed plans, adopting legally-required amendments often other than: were extended to the end of the applicable filing cycle. These filing cycle extensions will no Plans that have not received an initial longer be available for individually designed determination letter (no matter when plans after December 31, 2016, although the adopted) can apply for an initial IRS has announced that it intends to extend the determination letter. deadlines for individually designed plans to a Terminating plans can apply for a date that will be no earlier than December 31, determination upon termination. 2017. Cycle E filers (EIN ending in 5 or 0) can The IRS is requesting comments (October 15, continue to file through January 31, 2016. 2015 deadline) on the related issues, such as Cycle A filers (EIN ending in 1 or 6 and the legally-required amendment rules and Cycle A controlled groups) can file during deadlines, the EPCRS correction program, and the last Cycle A, which begins February 1, guidance for individually designed plans 2016, through the end of the Cycle on converting to pre-approved plans. January 31, 2017. Routine Plan Health Check Assessments Certain other limited circumstances as yet to Now In Order be determined. Prior to this change, it was relatively easy to This announcement does not address the correct errors in plan amendments as the IRS existing six-year filing cycle for volume submitter allowed sponsors to retroactively fine-tune their plans, which can be filed on a Form 5307 if they amendment language, and even adopt new have been modified by some limited individually retroactive amendments in certain cases, during designed language. The existing six-year filing the determination letter review process. This cycle for volume submitter plans ends on April flexibility is now gone under the new system, 30, 2016. Master/prototype plans, and volume and it will be more important than ever to adopt submitter plans with no modifications to the pre- carefully drafted legally-required amendments approved document (except to select among on time. Otherwise, the Employee Plans options under the plan) have not been allowed Compliance Resolution System (EPCRS) will be to file since May 2012, and must rely upon the the only alternative for fixing plan document plan's opinion letter. Orrick | July 2015 page 30

31 errors retroactively. Employers should also consider performing their own document compliance checks on a scheduled basis now that the IRS determination letter process will no longer serve that purpose. Keep in mind, however, that typically most plan errors are not plan document defects, but rather operational defects, which have never been reviewed within the determination letter process but rather are correctable under the EPCRS program. Cycle E filers (EINs ending in 5 or 0) and Cycle A filers (EINs ending in 1 or 6 and Cycle A controlled groups) now have their last chance to apply for an updated determination letter prior to the plan's termination, unless special circumstances apply in the future. Cycle E began February 1, 2015 and ends January 31, 2016, and Cycle A begins February 1, 2016 and ends January 31, 2017. Volume submitter plans with limited individually designed language should file during the current six-year cycle, which ends April 31, 2016, as the future of the pre-approved determination letter filing program is uncertain. Orrick | July 2015 page 31

32 Compensation and Benefits Insights IRS Flip Flops on Pension Plan De-Risking Options by Jason Flaherty, Patricia Anglin and Yvonne Nyborg The volatility and unpredictability of an employer's obligations under a defined benefit pension plan can have a significant impact on its bottom line. This is especially true of plans with liabilities for pension benefits earned decades ago and being paid as annuities. Companies faced with this volatility have implemented various "de-risking" methods for their pension plans in order to reduce or eliminate the volatility associated with pension obligations and their impact on the balance sheet. For the last several years, the IRS has issued available. Plan sponsors can add a permanent Private Letter Rulings to pension plans allowing lump sum option to their pension plans for active retirees to convert their annuities to lump sums. employees or offer a limited lump sum window This de-risking option first hit the news in 2012 opportunity for certain categories of plan when General Motors offered lump sum participants, the most popular being a lump sum conversions to 44,000 retirees. window for deferred vested participants (DVPs). Lump sum options transfer the risk of providing The IRS just announced in Notice 2015-49 that it a future stream of income payments from the intends to propose regulations to be effective as pension plan to the retiree. of July 9, 2015 that prohibit all conversions of existing defined benefit plan annuity payments Boosting Plan Savings on Lump Sums. If into lump sums, other than conversions under you are contemplating the addition of lump sums certain grandfathered programs. to your pension plan, you can boost your savings by changing your lump sum interest To be grandfathered, the program has to meet rate. You will have to use the Code section one of the following requirements prior to July 9, 417(e) rates as a minimum, but you can change 2015: (1) be adopted or specifically authorized the time as of which this interest rate is by a board, committee, or similar body with determined, as long as you adopt the same authority to amend the plan; (2) been timing rule for both small and large lump sums. communicated to participants in writing; (3) been If you are contemplating a lump sum window for adopted pursuant to collective bargaining; or (4) DVPs, it might be worth reviewing current have been approved by a private letter ruling or interest rate trends and changing your timing determination letter. rule to take advantage of higher rates, which result in smaller lump sums. You will have to De-Risking Options Still Available grandfather the old timing rule for small cash- outs, if more favorable, for one year, but the Lump sums. Although the IRS has shut down the option of offering lump sums to retirees in grandfather does not apply to any lump sum pay status, other de-risking options remain options that previously were not offered under the plan. Orrick | July 2015 page 32

33 Annuitizing Plan Liabilities. Alternatively, plan sponsors can still transfer their pension plan liabilities to insurance companies, either with plan assets or without. The remaining de-risking alternatives for pension plans raise complex legal, accounting, funding, design, actuarial, PBGC and employee relations issues for companies. Each alternative requires a significant amount of time to analyze and implement. If your company has been considering whether to de-risk its pension plan liabilities, now may be the time to act. Although transferring pension plan liabilities to participants through lump sums and to insurance companies through annuity purchases is not a new concept, lately it has been getting more attention from politicians and regulators as more and more companies implement de-risking strategies. There is a real conflict between those who want to preserve annuities as the preferred source of retirement income and those who want to de-risk pension plans. It is no secret that the IRS and the DOL take a paternalistic view of the ability of retirees to manage their retirement income so that it will last throughout their retirement years. On the other hand, many corporate plan sponsors will not like this new IRS position and could lobby Congress to act to reverse it. We will be monitoring this situation and working with clients to develop the best possible strategies. Orrick | July 2015 page 33

34 Compensation and Benefits Insights New, Easier and Less Expensive IRS 401(k) Plan Correction Procedures The IRS has recently issued three new, less expensive safe harbor procedures for correcting missed elective deferrals. by Patricia Anglin, Yvonne Nyborg and Mitchel Pahl These new procedures require either no employer corrective contribution to make up the missed elective deferrals, or only a 25% contribution, depending upon how soon detection of errors and correction occurs. The new procedures are intended to address the A 25% employer corrective contribution "windfall" that employees receive when they (adjusted for earnings) to make up for missed collect their full pay and also receive the current elective deferrals is required if: 50% make-up corrective contribution, and to correct deferral amounts begin to be encourage plan sponsors to adopt automatic deducted from future paychecks by the first contribution and escalation arrangements. paycheck on or after; No employer corrective contribution to make the last day of the second plan year up for missed elective deferrals is required if following the Plan year in which the error correct deferral amounts begin to be first occurred; or deducted from future paychecks by the first the month after the month the employer is paycheck on or after: notified of the error by the participant, if the last day of the three-month period that earlier; and begins on the date on which the error first the 25% corrective contribution (adjusted occurred; or for earnings) is made by the last day of the the last day of the 9-1/2-month period second plan year following the Plan year following the Plan year in which the error in which the error first occurred. first occurred (October 15 for calendar Match make-up deadline: no matter which of year plans), if the error is an improperly these three new correction procedures are used, implemented automatic contribution or 100% of the missed matching contributions automatic escalation arrangement (including (adjusted for earnings) still must be contributed improperly implemented affirmative elections by the employer. The deadline for the matching thereunder); or contribution make-up is the same for all three the month after the month the employer is new procedures: the last day of the second notified of the error by the participant, if plan year following the Plan year in which the earlier. error first occurred. Orrick | June 2015 page 34

35 Notice requirement: all three procedures require that a special notice be provided to affected participants by the 45th day after the date on which prospective correct deferrals begin. The notice generally must describe the error and the correction, including the date the error began and the percentage of compensation that should have been deferred, and inform the participant that he/she may increase his/her future deferral percentage in order to make up for the missed deferrals within the annual deferral limit. Specific dollar amounts do not have to be provided. Earnings: If the participant has not made an investment election, earnings can be calculated on the basis of either the rate of return under the Plan as a whole (the usual method); or the Plan's default investment alternative (this is new). If earnings on corrective matching contributions using the Plan's default investment alternative are negative, cumulative losses may not reduce the principal amount of the corrective matching contributions. What To Do? In order to take advantage of the new procedures, early detection is key. Plan administrators may wish to consider developing procedures to detect and correct missed deferrals on a semi-annual basis or, if the three-month correction method is desired, even more frequently. Orrick | June 2015 page 35

36 Compensation and Benefits Insights The Many Potential Pitfalls of Worker Misclassification by Laura Becking, Patricia Anglin, Mitchell Pahl and Michael Yang These new procedures require either no employer corrective contribution to make up the missed elective deferrals, or only a 25% contribution, depending upon how soon detection of errors and correction occurs. Worker classification is an area of major concern failure to provide proper wage statements, for domestic and international employers of all such as Forms W-2; sizes. Our Labor and Employment Group failure to provide employee benefit coverage recently alerted you to significant regulatory and appropriate remedial action; action by the US Department of Labor relating to classification of workers as employees versus failure to make employer and employee independent contractors. Those regulations, contributions to retirement and other along with continuing action by the National employee benefit plans; Labor Relations Board and the IRS in this area, failure to provide required benefit plan highlight that worker classification issues are disclosure and administrative notices; being closely scrutinized today. These issues will continue to present employers with the excise taxes under the Affordable Care Act difficult task of managing service relationships to (the ACA) for failure to provide required meet their business needs while ensuring proper health plan coverage; classification of their workers under the various civil tort liability to a misclassified worker as legal regimes that apply. well as third parties who are injured as a result of a misclassified workers negligent The effects of misclassification can reverberate acts; and throughout an employers Human Resources and employee benefit plan functions. To ensure violations of state, federal and/or foreign a comprehensive approach to maintaining labor laws, which may include civil penalties compliance, an employer must identify and and/or notice requirements imposed by the tackle all of the many issues that arise from government agency. misclassification. Below is a list of In the remainder of this Alert, we focus on the misclassification issues for year-end review: impact of the ACA and other misclassification risks that arise in the context of managing back pay (e.g., minimum wage and overtime employer health and welfare plans and highlight pay); certain global considerations. We conclude with failure to withhold and underpayment of our recommendations on preemptive steps to Federal and state/local income and avoid worker misclassification issues. employment taxes; Orrick | December 2015 page 36

37 Impact of the Affordable Care Act Other Misclassification Risks for Health Plans Many aspects of the ACA, including employer coverage responsibilities and the calculation of Treatment of Misclassified Employees Under penalties for failure to provide compliant health Plan Document coverage, depend on whether an individual is In light of the ACA, most health plans (both properly classified as an employee, insured and self funded) exclude independent significantly increasing the adverse contractors from coverage. Without an express consequences of misclassification. To make provision to the contrary, an independent matters worse, one misclassification may trigger contractor that is reclassified as an employee the assessment of ACA excise tax penalties may become eligible for coverage under a based on the employer's entire full-time health plan including retroactive coverage. workforce. Some employers address this issue by including express language in their health plans that Furthermore, the ACA has resulted in many excludes reclassified workers from coverage. employers struggling with joint employment This type of provision can protect an employer and co-employment issues with their staffing or from claims for retroactive coverage and enable other service providers. Abundant caution is the employer to exclude reclassified workers necessary with worker classification in this area from future coverage. because a mistake could result in both ACA non-compliance as well as liability for Often health insurance policies do not contain misclassification as listed above. the appropriate language to exclude reclassified workers from coverage because insurers will not One step employers should take now is to entertain changes to their standard format. We review existing contracts with staffing or other recommend that employers determine whether service providers to reduce their potential legal their insurance policies contain appropriate exposure. Employers should require that language to exclude reclassified workers service providers provide ACA-compliant because, without it, the insurance company coverage to their full-time employees and could disavow financial responsibility for claims acknowledge sole responsibility for the of reclassified workers, leaving the employer classification of those employees. with that liability. Service provider contracts also should address Misclassification also can impact the amount of potential co-employment issues by stating that an employers health insurance premiums. the providers workers are solely its common law Insurance companies underwrite their policies employees and that the provider exclusively based on the number and claims experience of manages all employee issues regarding an employers employees. If that population compensation, performance issues, time off, and changes due to reclassification, the cost of any other HR-related issues that typically are the health coverage also could change. responsibility of an employer. Nondiscrimination Testing Finally, the contract should contain indemnities specifically targeted to require the provider to The data that an employer uses to perform indemnify employers for misclassification errors nondiscrimination testing for self-funded health of their employees and any ACA penalties. plans and cafeteria plans does not include independent contractors. Depending on the size and attributes of the misclassified group, it is possible that the testing results could change. Thus, as part of its overall response to misclassification, an employer should assess and possibly re-run prior plan testing Orrick | December 2015 page 37

38 Legally-Required Notices for Employees. claims for discretionary leave benefits, such as generous parental leave benefits; Employers are responsible for providing various types of health plan notices to their employees the domino effect among employee at different stages of the employment cycle. An classes and individual employees. Although employer whose independent contractors are class action is generally not available reclassified as employees must evaluate not outside of the U.S., this area is closely only which notices should have been provided, followed by workers, regulators and but also how to address the prior lack of notice. employee representative bodies in most For example, an employer must consider the countries and a successful claim will likely extent to which COBRA notices or a Summary lead to audits and further claims; and of Benefits Coverage required under the ACA equal treatment claims from agency should have been provided, and the impact of workers. Even if agency workers are not failure to provide those notices at the required reclassified as direct employees of the end time. user, there is a risk, especially in the European Union, that they will be able to Other General Misclassification Issues claim a right to a wide range of discretionary Worker misclassification not only involves benefit programs under equal treatment improperly classifying someone as an rights concepts. independent contractor instead of an employee, Recommendations on Preemptive Steps to but also improperly classifying an employee as Avoid Misclassification being exempt from overtime pay and meals and rest breaks. Both of these worker Employers should consider taking preemptive misclassification issues are especially present at steps to avoid worker misclassification issues. the early stages of a company and, if left One preemptive measure is to conduct a unaddressed, the company may be faced with a privileged examination of the work force to much larger problem in the future, such as a determine whether contractors are properly class action lawsuit. classified and, if necessary, take remedial action. Employers should also consider setting In some instances, a single employee filing a up strict requirements for hiring contractors and wage claim with the state may be enough to be vigilant in meeting those requirements. prompt an audit of the company by the state Employers may also choose to engage a third employment department/division. These audits party to screen and hire its contractors, though can be extremely burdensome on the companys the contract with the third party should include a time and resources and could include a review strong indemnification clause to provide of all of the companys independent protection for the employer in the case of contractors and pay practices. In addition, the alleged misclassification. IRS may, in turn, conduct a similar audit leading to a requirement to pay back wages along with various tax penalties as discussed above. Global Considerations In most countries outside of the U.S., misclassification risks are equally an issue. Independent contractors, agency workers, and even vendor employees are potentially at risk of reclassification. The big risks are: claims for equity compensation, especially for companies that grant broad equity compensation awards; Orrick | December 2015 page 38

39 Orrick | December 2015 page 39

40 Orrick is a leading global law firm focused on representing companies in the technology, financial and energy sectors. We are committed to long-term strategic relationships with our clients, and are widely recognized for the quality of our client results. With 1,100 lawyers based in key markets worldwide, our global platform allows us to meet the needs of our clients wherever they do business. We understand that attracting and retaining top talent is critical to your success. Our clients entrust us with their most important talent issues because we solve them. We have the most talented team of experts in our clients most important areas. We offer solutions in the areas of Qualified and Non-Qualified Plans, Global Equity & Human Resources, Health and Welfare, Executive Compensation, Employee Benefit Plans in M&A and IPOs and ERISA Litigation, among others. To join our mailing list, visit Key contacts from our Compensation & Benefits Team Jonathan M. Ocker Juliano Banuelos Laura L. Becking San Francisco San Francisco New York +1 415 773 5595 +1 415 773 5961 +1 212 506 5113 [email protected] [email protected] [email protected] Nancy Chen Brett Cooper Jason D. Flaherty Silicon Valley San Francisco San Francisco +1 650 289 7128 +1 415 773 5918 +1 415 773 4273 [email protected] [email protected] [email protected] Christine A. McCarthy Eric C. Wall William D. Berry Silicon Valley San Francisco San Francisco +1 650 614 7634 +1 415 773 5974 +1 415 773 5519 [email protected] [email protected] [email protected] Mitchel C. Pahl Patricia E. Anglin Joyce Chen New York San Francisco New York +1 212 506 5023 +1 415 773 5872 +1 212 506 5118 [email protected] [email protected] [email protected] Jeremy D. Erickson Michael Y. Yang Keith A. Tidwell San Francisco Silicon Valley San Francisco +1 415 773 5862 +1 650 614 7472 +1 415 773 5592 [email protected] [email protected] [email protected] Eric Kitcho Yvonne Nyborg Wheeling San Francisco +1 304 2312671 +1 415 773 5596 [email protected] [email protected] Disclaimer This publication is designed to provide Orrick clients and contacts with information they can use to more effectively manage their businesses and access Orricks resources. The contents of this publication are for informational purposes only. Neither this publication nor the lawyers who authored it are rendering legal or other professional advice or opinions on specific facts or matters. Orrick assumes no liability in connection with the use of this publication. US | EMEA | ASIA Orrick, Herrington & Sutcliffe LLP | 51 West 52nd Street | New York, NY 10019-6142 | United States | tel +1-212-506-5000 Attorney advertising. As required by New York law, we hereby advise you that prior results do not guarantee a similar outcome. Orrick, Herrington & Sutcliffe LLP 2015. All rights reserved. Orrick | December 2015 page 40

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