Executive Compensation and Incentives Society of Corporate ......– Outplacement services if...

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P R E S E N T E D B Y:

Executive Compensation and Incentives

Society of Corporate Compliance & EthicsLas Vegas, NV

September 15, 2009

Daniel R. Roach, JD

VP Compliance & Audit

Catholic Healthcare West

Gerald M. Griffith, JD

Partner

Jones Day

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Overview

• The Executive Compensation Challenge

• Recent developments in executive compensation

• Aligning Incentives

• Defensible incentive compensation basics

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Executive Compensation Challenges

Regulatory

�High pay. Medicare performance

�Outraged public

�Angry shareholders

�Government scrutiny

Our capitalist society works only if the public fundamentally trusts business.

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Executive Compensation Challenges

• Ethics and Compliance

�$ Focused management

�Cognitive dissonance

�Unbalanced incentives

How can we meaningfully impact management behavior?

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Recent Developments in Executive Compensation

• New Federal Limits Tied to Bailout Funds

• Clawback Provisions

• Congressional/IRS Inquiries

• Increased Transparency

• Executive Perquisites

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New Federal Limits Tied to Bailout Funds

• Goals– Discourage incentives that encourage

unnecessary risks that threaten shareholder value … and we are the shareholders

– Expand clawbacks

– Increase transparency

• Consequences– Congressional/public backlash

– More fuel for corporate campaigns

– Target for plaintiffs’ lawyers, e.g., securities class actions

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• Emergency Economic Stabilization Act of 2008 (EESA) limits executive compensation for bank holding companies selling more then $300 million in troubled assets under TARP in the aggregate.– Limits executive compensation deduction to $500,000 for

bank holding companies selling troubled assets in the TARP program and generally eliminates the performance-based exception (IRC 162(m)(5)); applies to CEO, CFO and three other most highly compensated executives

– Further limited deductibility of golden parachute payments and severance for involuntary termination (IRC 280G(e)).

– Preclude incentives that encourage senior executive officers of financial institutions to take unnecessary and excessive risks that threaten the value of the institution; annual CEO certification requirement.

– Prohibition on golden parachute payments to senior executive officers so long as the Treasury Department holds an equity or debt position in the company, including parachutes triggered by bankruptcy or insolvency

– See, e.g., Notice 2008-94, 2008-44 I.R.B. 1070

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• American Recovery and Reinvestment Act of 2009 (ARRA), Sections 7001-7002, apply various additional restrictions on executive compensation of companies receiving TARP funds.

– Generally prohibits payment of bonuses, retention awards and incentive compensation

– Requires independent compensation committee

• Investor Protection Act of 2009 (“Say on Pay”) proposed by Treasury on July 16, 2009 would expand guaranteed shareholder voting rights over executive compensation, including golden parachutes.

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• Treasury’s Interim Final Rule on TARP Standards for Executive Compensation implementing EESA and ARRA, 74 Fed. Reg. 28,394 – 28,423 (June 15, 2009)– Applies only to companies receiving TARP funds– For compensation to Senior Executive Officers

(CEO, CFO, next three highest paid):• Special Master must approve compensation payments and plan

structure, but no hard cap on base compensation• Allows exception to bonus/incentive prohibition for restricted

stock or certain other long-term incentives and certain pre-February 11, 2009 employment contracts, and bonuses paid or accrued prior to June 15, 2009

• Prohibit tax gross-ups relating to severance payments, perquisites, or other compensation

• Annual disclosure of potential conflicts of any compensation consultant within past three years

• Requires written policy on excessive or luxury expenditures• Annual disclosure of any perquisite with a total value in

excess of $25,000

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Clawback Provisions

• Sarbanes Oxley Act (SOX), 15 U.S.C. § 7243, requires repayment of bonuses, stock profits, etc. by the CEO and CFO of any public company issuing a material restatement of its financials received within twelve months after release of the noncompliant financials.– First case pending in Ariz. SEC v. Jenkins (D.

Ariz., filed 7/22/09)

• Treasury Interim Final Rule implementing EESA and ARRA allows recovery of any bonus or incentive compensation paid to a senior executive officer or next 20 highest paid executives based on materially inaccurate statements of earnings, gains.

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Clawback Provisions

• For exempt organizations, relevant factors in the regulations for avoiding loss of tax-exempt status include seeking repayment of “excess benefits” (e.g., excessive compensation to directors and officers). 26 C.F.R. § 1.501(c)(3)-1(f)(2)(ii)(E) & (iv), Example 3.– IRS is also enforcing executive compensation standards for

exempts through compliance checks and audits.

• Towers Perrin survey (April 2009) reports that clawback provisions are in force at over half of the Fortune 100 (62% as of 2008 had clawback provisions exceeding SOX requirements) for executive compensation including long-term incentives.– Common grounds include conduct detrimental to the

company’s best interests (52%) and clawback periods range up to 3 years.

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Congressional/IRS Inquiries

• For-profit Sector– Fringe benefits on audit– TARP limits

• Tax-exempt Sector– IRS Executive Compensation Initiative; Hospital

Project; Colleges and University Project– Senate Finance Committee questionnaire– GAO Report GAO-06-907R (June 30, 2006)– CBO Report (July 2003)

• Tax law whistleblowers (IRC 7623)– 15-30% recovery– IRS Whistleblower Office for large claims– Only government can prosecute but whistleblower

can assist under tax administration contract

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Increased Transparency

• Government bailout strings … those they thought of beforehand and those they thought of after

– TARP dollars, SEC reporting

– Political and public opinion pressure (e.g., post-bailout bonuses)

• Expanded Form 990 (Part VII) and new Schedule J for Exempt Organizations

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Increased Transparency

• SEC Disclosure Rules/Enforcement– Jan. 2006 proposed rule expanding disclosure

requirements including more in-depth narratives– August 2007: 300 letters questioning proxy

disclosures– October 2007 – SEC notes disclosure has

improved but identifies potential deficiencies in disclosure related to:• How performance targets are selected;• Disclosure of severance packages• Comparable companies used to set executive pay

• Securities Class Actions– Disclosure to shareholders or lack thereof may

lead to litigation– Risk that plaintiffs counsel will try to use new

federal pay standards as support for broader fiduciary duty claims

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Executive Perquisites

• Some of the risks:

– Bad public relations

– May fuel corporate campaigns by unions

– Possible AG or other investigation (fiduciary duty, wasting corporate assets)

– Possible criminal prosecution (embezzlement, tax fraud)

– General IRS audit risk, see Fringe Benefits Audit Technique Guide (Feb. 2005):http://www.irs.gov/businesses/corporations/article/0,,id=134943,00.html

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Top 10 “Egregious Executive Perqs.” (public companies)

• Parting package of perqs. worth $2.5MM (private plane, offices, security, furnished NYC apt., chauffeur, assistant, IT, etc.)

• Office renovations over $1,000,000

• Gross-up for taxes on death benefit of $30MM

• Tax prep. of >$400,000 for exec. paid approx. $50MM

• Cars and gas

• Personal security detail ($1.7MM)

• Country club memberships and initiation fees ($150,000 – 940,000)

• Company plane to commute … from Fla. to Mich. ($517,000)

• Ultra high end pensions (up to $83,000,000)

• Stay bonus … to dead exec.

SOURCE: A. Barr, “Golden Coffins, Golden Offices, Golden Retirement” (MarketWatch, May 13, 2009)

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Hot Button Perqs. for Exempt Organizations

• First class or charter travel

• Tax indemnification or gross-up

• Discretionary spending account

• Club dues or initiation fees

• Companion travel

• Housing allowance or personal residence

• Payment for business use of home

• Personal services (e.g., maid, chauffeur, chef)SOURCE: Form 990 (2008), Schedule J, Part I, Line 1a.

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Executive Perquisites - Reporting

• Working Condition Fringe Benefits– Available to “employees” (includes independent

contractors performing services other than for parking, which may be a de minimis fringe)

– Ordinary and necessary expense that is incurred for the employee to carry out his or her trade or business

– Cash payments will not qualify unless employee is required to use the payment for expenses in connection with a specific or pre-arranged activity, the payment would be deductible, and the employer verifies that the payment is actually used for such business purpose expenses and the excess (if any) returned to the employer

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• Working Condition Fringes - Examples– Outplacement services if provided to all employees, but

may have different levels of service for executives. Rev. Rul. 92-69.

– Security related transportation as part of overall security program based on specific facts giving rise to bona fide security concern for the executive’s safety; exclude excess of value over normal transportation. Treas. Reg. §1.132-5(m).

– Relocation including moving household belongings (IRC 132(g) & 217); interview expenses for new employment (Rev. Rul. 63-77) or transfer (PLR 8321063)

– Fringe Benefit Audit Techniques Guide 02-2005 (www.irs.gov/businesses/corporations/article/0,,id=134943,00.html)

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• De minimis Fringe Benefits– Available to “employees” (includes “any

recipient of the fringe benefit”)

– Whether a benefit is de minimis depends on frequency and value of the benefit provided and whether in those circumstances it is “unreasonable or administratively impracticable” to require the employer to account for it

– No specific dollar threshold for what value is de minimis, but generally less than $100

– Limited to noncash benefits, not cash or cash equivalents such as gift cards

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• De minimis Fringe Benefits

– Meals provided at employer-operated eating facilities may be excluded as de minimis fringes under IRC 132(e)(2) if the facility is:• located on or near the employer’s business premises

• revenues from the facility’s operations normally equal or exceed its direct operating costs (a point which the IRS does routinely examine on audit)

• satisfies a number of non-discrimination requirements, such as being accessible to all employees on substantially the same terms

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• Accountable Plans– Reimbursements are disregarded, not

included in income

– To qualify as an accountable plan, the reimbursement or advance of expenses must:• Be limited to expenses incurred in the course of

performing services for the employer

• Require employee to adequately account to the employer for the expenses within a reasonable time

• Require employee to return to the employer any excess reimbursement or allowance within a reasonable time

– Two safe harbors for a “reasonable time”• Within 60 days after the expense is incurred

• Quarterly reconciliation

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• Cell Phones and Listed Property (IRC § 280F(d)(4))– Detailed records of business vs. personal use

(e.g., call-by-call for cell phones)– Administrative burden of recordkeeping has

caused many hospitals to eliminate these benefits (e.g., cell phones) or treat it all as taxable income (with or without a gross-up payment for the increased tax liability)

– Gross-up payments are reported on Form 990 (2008), Schedule J, Part I, Line 1a

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• Notice 2009-46, 2009-23 I.R.B. 1068 (June 8, 2009) requests comments by 9/4/09 on proposals to simplify recordkeeping for employer provided cell phones– Written policy requiring use for business and precluding more than

“minimal” (by number of minutes or type of use) personal use– Three alternatives for substantiation if elect not to follow the listed property

rules (but IRS is open to comments on more options):• Minimal personal use (employee has separate personal cell phone or all personal use is

“minimal”)• Fixed allocation safe harbor (75% business, 25% personal for all employees)• Statistical sampling of personal vs. business use (apply same percentage to all employees)

– Employer's cost is not necessarily fair market value to employees• Buying power/volume discounts … but compare vendor discount to supplier• No specific valuation method proposed• Requesting comments on what methods employers use today and whether a simplified

valuation method would be useful and appropriate

– One IRS agent recommended including blackberries/PDAs

• IRS Commissioner in mid-June called on Congress to eliminate tax consequences of employer provided cell phones and noted that Notice 2009-46 is an attempt to simplify current rules, not a crack down

• Simplest solution at present … discontinue the benefit or treat it as compensation, with or without a tax gross up.

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Executive Perquisites - Discounts

• Chief Counsel Advice 200923029 (Jan. 30, 2009, released 6/8/09)– Employer was a spin-off several years earlier from a

manufacturer

– Employees received a discount on manufacturer’s products equal to a specific % of retail; eligibility extended to a broaddefinition of “family” (beyond what would be allowed for IRC 132 “qualified employee discounts”)

– IRS concluded that the discount was a taxable fringe benefit because:• Discounts can be income even when provided indirectly by a customer

of the employer. Treas. Reg. 1.61-21(a)(5).

• Program was frequently renewed and extended; a “bargained for benefit” rather than one unilaterally provided by the manufacturer

• General public did not have access to the same discount

• Rejected contrary conclusion in multiple private letter rulings and narrowed Rev. Rul. 76-96 (tax-free rebates on cars)

– IRS would value the discount based on the retail price (i.e., income equal to % of retail price labeled discount)

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Financial Incentives

Positives

• Proven motivator

• Focus management’s attention

• Emphasizes most important

• Reward hard work & innovation

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Financial Incentives

Negatives

• Promote greed

• Promote “tunnel vision” or obsessive focus on target

• Encourages manipulation

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Incentive Solution

Balancing Incentives

• Meaningful ethics & compliance metrics

• Transparency

• Forfeiture (“look-back”) policies

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Incentives: Ethics & Compliance Metrics

• Specific & Measurable

�Structural – orientation, education screening, reporting, investigation, remediation

�Substantive (high risk areas)

• Fair, reasonable

• Meaningful impact

• Target leaders of key business units.

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Incentives: Transparency

• Transparency changes behavior

– Taps competitiveness and self-preservation instinct

• Requires “public” reporting to peers, management and board

• Must be objective, fair, reasonable and targeted at effectiveness

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Defensible incentive compensation basics

• Fiduciary Duties as Guiding Principles• The Disney Case – vindication for the

business judgment rule

• Cox Enterprises and waste of corporate assets

• Document reasonableness

• Fidelity bonuses … going beyond the bottom line

• Alternatives to hot button perquisites

• Board oversight of “process, process, process”

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Fiduciary Duties as Guiding Principles

• Fiduciary duties are outlined by statute and case law. See, e.g., Model Business Corporation Act, art. 8 (2005) (“MBCA”); Revised Model Nonprofit Corporation Act, art. 8 (1987) (“MNCA”).

• Directors and officers have at least three commonly recognized fiduciary duties – the duty of care, the duty of loyalty, and the duty of obedience– Duty of Care relates to the director or officer’s competence in

performing those functions and requires that the director or officer carry out those duties with the same degree of diligence, care, and skill as an ordinarily prudent person would exhibit in like circumstances, and that they act in a manner that they believe to be in the best interests of the corporation.

– Duty of loyalty dictates that the director or officer act in faithful pursuit of the interests of the corporation rather than their own financial or other interests or those of any other person or entity.

– Duty of obedience obligates a director or officer to act with fidelity to the mission and purposes of the corporation within the bounds of the law generally.

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• Directors and officers are also generally required to act in good faith in discharging their duties. – “[T]he board of directors should devote attention to whether

the corporation has information and reporting systems in place to provide directors with appropriate information in a timely manner in order to permit them to discharge their responsibilities. See In re Caremark Int’l Derivative Litig., 698 A.2d 959 (Del. Ch. 1996).” Official Comment to MBCA §8.01.

– Where a director or officer engages in self-dealing to gain approval of his or her own compensation without disclosure of relevant potential conflicts, such action may be inconsistent with fiduciary duties. See, e.g., Boston Children's Heart Foundation, Inc. v Nadal-Ginard, 73 F.2d 429 (1st Cir. 1996) (CEO breached his fiduciary duty by setting his own salary without disclosing substantial outside income from another organization or the use of corporate funds to purchase a $6 million life insurance policy; CEO also bifurcated the presentation of a severance plan, allegedly to mislead the board as to the magnitude of severance benefits he would receive).

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• Past D&O liability suits and recent negative publicity regarding executive compensation highlight the importance of transparency and full disclosure of potential conflicts, as well as the need to insist on appropriate documentation of reasonableness.– There is a general duty to disclose potential conflicts

not already known by other directors or committee members. MBCA §§ 8.30(c) & 8.60-8.63; MNCA §§8.30(c) & 8.31.

– Directors and officers generally are entitled to rely on information, opinions, reports, or statements prepared or presented by legal counsel, accountants or others as to matters the director reasonably believes are within their professional or expert competence absent knowledge that makes reliance unreasonable. MBCA § 8.30(d)-(f); MNCA § 8.30(b)-(d).

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• Failure to obtain evidence of fair market value, and failure to exercise appropriate oversight of the executive compensation process, arguably would be a breach of fiduciary duty by whoever presented or approved the compensation package. See, e.g., Spitzer v. Grasso (N.Y. App. 2008).

• Documentation of fair market value is also key to compliance with the tax rules applicable to exempt organizations and their executives. The IRS, however, has also shown concern with organizations that lack appropriate board oversight in compensation matters, including one audit where the board “had actual knowledge of … improper payments” to the CEO yet did not seek repayment and instead approved additional payments. Tech. Advice Memo. 200243057 (July 2, 2002).

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Business Judgment Rule

• Directors and officers are typically required to discharge theirduties in good faith (see fiduciary duty discussion below). The good faith requirement has been interpreted by the courts to mean the exercise of the duties of a director or officer consistent with the duty of loyalty to the corporation, i.e., without unjust enrichment, bad faith or fraud. Generally, if a director or officer has not violated any of these duties, under what is commonly referred to as the "business judgment rule" courts will not substitute their judgment for the judgment of the directors and officers in the operation of the corporation. See, e.g., Smith vVan Gorkum, 488 A.2d 859, 873 (Del. 1985).

• The business judgment rule essentially provides a presumption that D&O following proper review and discussion procedures and asking appropriate questions have in fact exercised informed judgment, and acted in good faith and with a belief that they were acting in the best interests of the company, unless there is evidence of fraud, bad faith, or self-dealing or other breach of fiduciary duty.

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The Disney Case - Vindication for the business judgment rule

• In re Walt Disney Derivative Litigation, C.A. No. 15452 (Del. June 8, 2006):– Alleged breach of fiduciary duties of due care,

loyalty and good faith and waste of corporate assets in hiring and firing of COO, including approving his compensation package which provided for a $130 million severance benefit when terminated without cause after 14 months.

– Court found board acted consistent with fiduciary duties; protected by business judgment rule.• Delegation to Compensation Committee appropriate under

state law even though Committee actions fell short of “best practices.”

• Lack of good faith would require intentional misconduct or dereliction of duty.

• Waste of corporate assets “will arise only in the rare, ‘unconscionable case where directors irrationally squander or give away corporate assets.’” Court noted clear contractual obligation and lack of grounds for a “for cause” termination.

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Cox Enterprises – Waste of Corporate Assets

• Cox Enterprises Inc. v. News Journal Corp. (M.D. Fla., Dec. 5, 2008)– Minority shareholder successfully challenged

severance package for CFO and VP at 6x annual compensation plus tax gross up (bringing total compensation to 13x base) as unauthorized, fraudulent and a waste of corporate assets.• Triggered by any “adverse employment action”; provided for • Neither executive had been seeking other employment• CEO controlled executive compensation but those figures were

available to board; CEO had no express or implied authority to agree to the golden parachutes, they were entered into in secret with no disclosure to or ratification by the board

• Not protected by the business judgment rule because not part of an initial compensation package, not consideration for any additional services, amount significantly higher than packages of similar employers and conferred minimal benefit on employer

• Only one of 15 comparator companies cited by employer’s expert exceeded 2.99 times annual salary and all limited payments to change of control situations

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Document reasonableness

• Document reasonableness– Published surveys for comparable positions

• Beware “Lake Wobegon effect”

• Upward spirals in top end of ranges

– Qualified experts for high-end packages

– Independence Standards• SOX auditor independence rules

• Independence of Comp. Committee (TG-218 and Investor Protection Act would mandate independence for public companies; IRC 4958 & model conflicts policy encourage it for 501(c)(3)’s)

– Committee on Oversight and Government Reform Inquiry on Compensation Consultant Conflicts• Letters to six compensation consulting firms

• 100 of Fortune 250 used Compensation Consultants for other services

• Report focused on other business received by compensation consultants as potential conflicts, lack of disclosure and effect on executive pay levels

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Document reasonableness

• Document reasonableness

– Establish clear performance goals and assess performance before awarding bonuses to qualify for IRC 162(m) deductibility; board or committee oversight to avoid abuse.• CRS RS22604 (5/8/07) – nothing succeeds like failure?

• CRS RL33935 (3/22/07) – stock options as stealth compensation; backdating and earnings manipulation

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Fidelity bonuses … going beyond the bottom line

• Importance of the bottom line– Shareholder Value– There’s a saying in the nonprofit world, “no

margin, no mission”• Look to revenues and expense control• Use meeting budget as condition for paying bonuses that are

earned based on non-financial targets

• Overcoming bad optics of big bonuses with non-financial performance objectives– New products, patents and ventures (future

prospects)– Worker satisfaction surveys– Maintaining employment levels– Proportionate increase in employee compensation

and benefits– Community building activities

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Alternatives to Perquisites

• Increase cash compensation (within limits of reasonable compensation for services)

• In considering possible benefits, ask how it would look if described on the front page of the local paper … or in a Congressional press release

• Consider how all compensation, including perquisites, relates to furthering the mission

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Board oversight of “process, process, process”

• Who negotiates and documents the compensation package?

• Who monitors potential conflicts of board, committees, management and advisors?

• Who hires the compensation consultant?

• Who establishes incentive goals?

• Who evaluates performance?

• Who reports on possible clawback rights?

• Who reviews final SEC/IRS disclosures?

• Who verifies that incentives qualify for deduction under IRC 162?

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Questions?

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