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October 5, 2006 |
IRS Extends Section 409A Transition Relief Through December 31, 2007

On October 4, the IRS issued long-expected guidance extending the transition relief under Section 409A of the Internal Revenue Code (the "Code"). As described below, subject to an exception for certain "in the money" stock options granted to Section 16 officers and directors of publicly-traded companies, Notice 2006-79 generally extends the key transition rules through December 31, 2007.

Effective Date/Good Faith Reliance. Section 409A applies to compensation deferred on or after January 1, 2005. Previous deferrals generally are "grandfathered" unless the arrangement is materially modified. For these purposes, deferred compensation amounts that were not earned and vested as of December 31, 2004 are not protected by the grandfathering rules. The IRS issued proposed regulations interpreting Section 409A in October 2005.

Final regulations interpreting Section 409A are expected by year-end, and those regulations are expected to be effective beginning on January 1, 2008. Pursuant to Notice 2006-79, a deferred compensation plan adopted on or before December 31, 2007 will be treated as complying with Code Section 409A if the plan is operated through December 31, 2007 in good faith compliance with the provisions of Section 409A, IRS Notice 2005-1 (the IRS's initial limited scope guidance), and any other generally applicable IRS guidance with an effective date prior to January 1, 2008. If an issue is not addressed in IRS guidance, the plan must be operated in accordance with a reasonable, good faith interpretation of Section 409A and the terms of the plan. In addition, compliance with the proposed regulations or (once they are issued) the final regulations automatically constitutes reasonable, good faith reliance.

Plan Amendments. Plans must be amended by December 31, 2007 to conform to the provisions of Section 409A and the final regulations. Amending a plan by this date is a condition to the application of the reasonable, good faith reliance standard as well.

Changes in Payment Elections. With respect to deferrals subject to Section 409A, a plan may provide, or be amended to provide, for new payment elections on or before December 31, 2007, with respect to both the time and form of payment. However, (i) election changes cannot be made in 2006 to defer payments that otherwise would be made in 2006 or to accelerate payments into 2006, and (ii) election changes cannot be made in 2007 to defer payments that otherwise would be made in 2007 or to accelerate payments into 2007.

Mirror Elections under Qualified Plans. Elections as to the timing and form of payment under a nonqualified plan or arrangement may be controlled by payment elections made under a corresponding qualified plan through December 31, 2007 (e.g., a Code section 415 excess benefit plan), provided that the payment is in compliance with the terms of the plan or arrangement as of October 3, 2004. 

Substitution of Non-Discounted Stock Options and Stock Appreciation Rights ("SARs")/Addition of Fixed Exercise Date. Options and SARs with an exercise price that is lower than 100% of the fair market value of the underlying stock on the date of grant (often called "discounted" or "in the money" stock options or SARs) that were not vested and exercisable as of December 31, 2004 generally are subject to Code section 409A. Subject to the exception noted below, Notice 2006-79 extends to December 31, 2007 the ability to cancel a discounted stock option or SAR and substitute a non-discounted option or SAR not subject to Code section 409A. (The revised exercise price is based on the fair market value of the stock on the original grant date, not the date of cancellation/regrant.) Subject to the same exception, Notice 2006-79 allows a corporation to "correct" a discount stock option grant by imposing a fixed exercise date, subject to the rules described above regarding changes in payment elections.

An important caveat is that the transition relief will not apply to discount options/SARs to the extent they are exercised before the Section 409A violation is corrected. For example, if discount options subject to Section 409A are exercised in 2006 before the Section 409A problem is corrected, those options will be subject to Section 409A. Another important condition is that cash or vested property may not be provided to the optionee in the year the discount option is corrected. For example, cash or vested property may not be provided in 2007 in connection with the cancellation and reissuance in 2007 of stock options with an increased exercise price.

In reaction to recent stock option "backdating" scandals, Notice 2006-79 includes an important exception. Transition relief is not extended (i.e., it expires on December 31, 2006) with respect to stock options/SARs that: 

  • were granted with respect to stock of a corporation that as of the date of grant had issued any class of common equity securities required to be registered under section 12 of the Securities Exchange Act of 1934 (this will apply to most U.S. businesses with publicly traded stock); 

  • were granted to a person who, as of the date of grant, was subject to the disclosure requirements of section 16(a) of the Securities Exchange Act of 1934 (this requirement will generally apply to all members of the board of directors and senior executive officers); and 

  • with respect to the grant, the corporation either has reported or reasonably expects to report a financial expense due to the discount price of the grant that was not timely reported on financial statements or reports for the period in which the related expense should have been reported under generally accepted accounting principles. (Note: This will not necessarily cover all stock options that a company determines after-the-fact were granted with a discounted exercise price since if the additional financial expenses are concluded not to be material, the company will not be required to report restated financial results.)

Collectively Bargained Arrangements. Notice 2006-79 provides a new transition rule for collectively bargained arrangements. An arrangement maintained pursuant to one or more collective bargaining agreements in effect on October 3, 2004 is not required to comply with the provisions of Section 409A until the earlier of (i) the date on which the last of such collective bargaining agreements terminates (determined without regard to any extension of the CBA after October 3, 2004), or (ii) December 31, 2009. 

Tax Reporting for 2006. It should be noted that Notice 2006-79 does not address tax reporting (Form W-2) issues for 2006. However, IRS guidance on this issue is expected later this year.

Conclusion. The extension of these transition rules is very helpful for employers in light of the long delay in the issuance of final regulations. Employers should have sufficient time after the final regulations are issued to make plan design decisions and amend their deferred compensation plans. We will provide a follow-up client mailing when the final regulations are finally issued.


Gibson, Dunn & Crutcher lawyers are available to assist in addressing any questions you may have regarding these issues. Please contact the Gibson Dunn attorney with whom you work, or

Stephen W. Fackler (650-849-5385, sfackler@gibsondunn.com),
Charles F. Feldman (212-351-3908; cfeldman@gibsondunn.com)
David West (213-229-7654, dwest@gibsondunn.com),
David I. Schiller (214-698-3205, dschiller@gibsondunn.com),
Michael J. Collins (202-887-3551, mcollins@gibsondunn.com),
Sean Feller (213-229-7579, sfeller@gibsondunn.com),
Amber Busuttil Mullen (213-229-7023, amullen@gibsondunn.com),
Jennifer Patel (202-887-3564, jpatel@gibsondunn.com) or
Chad Mead (214-698-3134, cmead@gibsondunn.com). 

© 2006 Gibson, Dunn & Crutcher LLP

The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

September 28, 2006 |
Wave of Putative Class Actions Filed Against Sponsors of 401(k) Plans

A wave of putative class action lawsuits were filed last week against sponsors of 401(k) plans and other defined contribution retirement plans. The lawsuits were filed in federal courts throughout the country against some of the largest and best known companies in the U.S. The lawsuits, alleging violations of the Employee Retirement Income Security Act of 1974 ("ERISA"), target the fee structures found in some plans that offer mutual fund investments as well as plans that permit participants to invest in a fund comprised solely of the sponsor's stock. Several observers have predicted that additional similar lawsuits will be filed in the future against other companies and their 401(k) plans or other defined contribution retirement plans. 

While each lawsuit is founded on the specific terms of the plans in question, they all have several common characteristics: 

  • First, the named defendants are the corporate plan sponsors, the administrative committees for each plan, and, in some instances, the individual members of the board of directors for the corporate sponsor. 

  • Second, each lawsuit asserts that the compensation paid to investment managers and other service providers is excessive, thereby violating the prohibited transaction rules of ERISA. The complaints allege that, in addition to “hard dollar” forms of compensation, many of the investment managers and/or administrative service providers are compensated by undisclosed revenue sharing for having steered plan investments to a particular investment vehicle. These allegations echo complaints made by investors and others in the past few years against brokerages and mutual funds for not disclosing certain fees and compensation paid to the broker for making the fund available to investors. 

  • Third, several of the plans in question are ERISA § 404(c) plans that permit participants to select the investment fund in which their account balances will be invested. The class action suits allege that the failure to disclose the true compensation arrangement for service providers constitutes a violation of the disclosure rules under ERISA. 

  • Finally, some of the lawsuits challenge the fees charged participants in connection with funds in which the participant can invest in the sponsor's stock. 


If you are a sponsor of a defined contribution plan and are sued in one of these actions, have been threatened with such an action, or if you would like someone to review your 401(k) or other defined contribution plan, please feel free to contact the Gibson Dunn lawyer with whom you work or: 

William Kilberg - Washington, DC (202-955-8573, wkilberg@gibsondunn.com
Paul Blankenstein - Washington, DC (202-955-8693, pblankenstein@gibsondunn.com
Eugene Scalia - Washington, DC (202-955-8206, escalia@gibsondunn.com
David West - Los Angeles (213-229-7654, dwest@gibsondunn.com), 
Karl Nelson - Dallas (214-698-3203, knelson@gibsondunn.com
David Schiller - Dallas (214) 698-3205, dschiller@gibsondunn.com
Joel Feuer - Los Angeles (310-551-8808, jfeuer@gibsondunn.com
Stephen Fackler - Palo Alto (650-849-5385, sfackler@gibsondunn.com), or 
Joseph Busch - Orange County (949-451-3898, jbusch@gibsondunn.com).

© 2006 Gibson, Dunn & Crutcher LLP

The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

September 1, 2006 |
An Overview of and Practical Guidance on the SEC’s New Rules Amending Executive Compensation, Related Party, Governance and Form 8-K Disclosure Requirements

The Securities and Exchange Commission (“SEC”) has issued its new rules comprehensively revising the disclosure requirements for executive and director compensation, related party transactions, director independence and other corporate governance matters.  The final rules also modify the requirements for disclosing executive compensation actions and arrangements on Form 8-K.  With a few notable exceptions, the final rules as adopted are substantially similar to the SEC’s proposal from January 2006. 

The new rules will be effective for fiscal years ending on or after December 15, 2006, and therefore apply to disclosures of 2006 compensation in calendar-year companies’ 2007 proxy statements.  The new rules applicable to disclosure of executive compensation arrangements on Form 8-K become effective in early November 2006, 60 days after the new rules are published in the Federal Register, applying to executive compensation events that occur on or after that date. 

This Client Alert is intended to provide an initial detailed review of the new disclosure rules and compensation tables required under them.  We highlight a number of areas where these new rules require careful attention or raise significant interpretive issues, and throughout this Client Alert we note actions that companies should be taking now to prepare for the new rules.  Given the comprehensive nature of the rule revisions, we expect that additional interpretive issues will arise and that the SEC staff will provide its views on these issues.  Nevertheless, companies should begin to prepare their disclosures well in advance of filing their proxy statement. 

Among the significant aspects of the rule changes that require companies’ attention now are the following:

  • The SEC adopted the new requirement for a Compensation Disclosure and Analysis (“CD&A”).  The CD&A is intended to differ significantly from the former Board Compensation Committee Report on Executive Compensation by comprehensively addressing the design and bases for a company’s compensation of each of its named executive officers.  The CD&A will need to describe the operation and material features of each element of named executive officer compensation and the interaction of each of those elements (or lack of interaction) with one another.  The CD&A is company disclosure that is covered by the chief executive officer’s and chief financial officer’s certifications; yet, the board’s compensation committee will need to remain closely involved in the preparation and review of this disclosure.  We expect that most companies will not be able to use the Board Compensation Committee Report as a model for drafting the CD&A and that the CD&A drafting process will necessitate extensive and careful coordination between the human resources and legal departments with the input of the board’s compensation committee.  Companies will need to determine who are their named executive officers and will need to prepare drafts of the tabular and narrative compensation disclosures required under the rules in order to be best positioned to draft the CD&A. 

  • The characterization, presentation and calculation of some forms of compensation differ significantly from the present rules and are not always intuitive.  For example, some annual bonuses will no longer be reported in the Bonus column of the Summary Compensation Table but instead will be reported as Stock Awards or as Non-Equity Incentive Plan Compensation.  Careful review is necessary to determine how and where to report various forms of compensation. 

  • It may be necessary to retain outside actuaries and consultants to perform some of the calculations required under the new rules.  Companies should make arrangements with those outside advisers now. 

  • Careful descriptions and calculations of benefits payable under severance and change of control arrangements will be necessary.  Companies should begin now to identify each form of benefit and triggering event encompassed by this disclosure requirement and to determine whether any of these arrangements should be revised before the end of their fiscal year.  Given the extensive disclosure that will be required at some companies, companies should begin now to evaluate how to most clearly present the required benefit amounts and narrative descriptions. 

  • Revised related party and director independence disclosure rules reinforce the need to have procedures in place to monitor on a current basis transactions between a company and its directors, executives and immediate family members of directors and executives.  Companies that do not have written procedures for identifying and approving or ratifying related party transactions should consider adopting them.  Companies also need to revise their director and officer questionnaires. 

  • Amendments to Form 8-K generally reduce the number of executive compensation related events that trigger Form 8-K filings and eliminate the need for Form 8-K reports on most director compensation related matters, but there are also some new Form 8-K triggering events that will go into effect in the near future.  Companies should revise their disclosure controls to ensure that reportable events are timely identified. 

The entire alert is available in PDF format:
http://media.gibsondunn.com/fstore/documents/pubs/SEC_New_Exec_Comp_Rules.pdf


Gibson, Dunn & Crutcher lawyers are available to assist clients in addressing questions they may have regarding these issues.  Please contact the Gibson Dunn attorney with whom you work, or

John F. Olson (202-955-8522, jolson@gibsondunn.com),
Ronald Mueller (202-955-8671, rmueller@gibsondunn.com),
Brian Lane (202-887-3646, blane@gibsondunn.com),
Amy L. Goodman (202-955-8653, agoodman@gibsondunn.com),
Stephen Fackler (650-849-5385, sfackler@gibsondunn.com),
James Moloney (949-451-4343, jmoloney@gibsondunn.com), or
Elizabeth Ising (202-955-8287, eising@gibsondunn.com).

© 2006 Gibson, Dunn & Crutcher LLP

The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

August 8, 2006 |
Major Pension Legislation Enacted

The Congress has passed major pension legislation, the "Pension Protection Act of 2006" (the "Act"), which President Bush has promised to sign into law.  We describe below some of the most important changes the Act makes and attach a detailed chart [PDF] summarizing many of the key benefits provisions of the Act.  In addition, a Gibson Dunn update is available on certain changes affecting investment funds.

Funding of Defined Benefit Plans.  The Act significantly changes the defined benefit plan funding rules, generally effective for plan years beginning in 2008.  Plan sponsors may want to discuss these changes with their actuaries and consider whether additional contributions should be made before 2008.  In particular, plans that are “at risk” (i.e., generally less than 80% funded) are subject to various requirements, including additional funding obligations and, in some cases, prohibitions on lump sum distributions. 

Cash Balance Plan “Safe Harbors.”  The Act includes “safe harbors” for cash balance plans with regard to the age discrimination and accrual rules, as well as with respect to “conversions” of “traditional” defined benefit plans.  However, the safe harbors generally apply prospectively, and the Act specifically provides that no inference may be drawn with respect to events that occurred before enactment.  In addition, the safe harbors impose stringent requirements that most cash balance plans do not meet (e.g., full vesting after three years of service).  Finally, there is a risk that the “safe harbors” will eventually be treated by courts as the only way to satisfy the various rules.

Funding of Executive Compensation.  The Act amends section 409A of the Internal Revenue Code (the "Code") to provide for accelerated income taxation of “covered” employees (as well as a 20% additional tax) if a nonqualified deferred compensation plan provides for funding (or if there actually is funding) of a rabbi trust or other vehicle when the employer (i) is in bankruptcy and sponsors a defined benefit plan, (ii) sponsors a defined benefit plan that is “at risk” under the rules noted above, or (iii) has recently effected a “distress” termination of an underfunded defined benefit plan.  For this purpose, covered employees generally include the top-five officers of publicly-traded companies and former employees who were in that classification when they retired.

Employer Stock Diversification Rights.  The Taxpayer Relief Act of 1997 generally prohibited employers from requiring employees to invest their own contributions in employer stock.  The Act extends that rule to employer contributions once a participant completes three years of service in the plan.  This rule applies to virtually all plans with publicly-traded employer stock (other than stand-alone ESOPs that do not include employee or employer matching contributions and one-participant plans) and is phased in over three years beginning in 2007.

Participant Investment Advice.  The Act provides a prohibited transaction exemption to permit qualified fiduciary advisers to offer personal investment advice to participants in defined contribution plans and IRAs pursuant to an "eligible investment advice arrangement."  In general, the arrangement must either provide that (i) the advice is based on computer models meeting certain criteria or (ii) the adviser's compensation may not vary based on the investments selected.  Various disclosure requirements and other conditions apply.  The plan sponsor generally is protected against liability to participants in connection with such advice, provided the plan's fiduciaries act prudently in selecting and monitoring the adviser.  Employers can expect that many service providers will be calling to tout their virtues as providers of investment advice to the employer’s employees.

“Automatic Enrollment” 401(k) Plans.  The Act provides various incentives to establish “automatic enrollment” 401(k) plans under which participants contribute unless they affirmatively “opt out.”  These changes reduce various risks that have deterred employers from adopting automatic enrollment features, including clarifying the ERISA preemption of state wage laws and providing ERISA section 404(c)-type relief to default investment funds.

Faster Vesting of Employer Contributions.  Beginning in 2007, employer non-matching contributions to defined contribution plans will be subject to the same vesting rules that have applied to employer matching contributions since 2002 (i.e., the contributions must vest at least as fast as a three-year “cliff” schedule or a six-year “graded” schedule).

Rollover Rights for Nonspouse Beneficiaries.  Beginning in 2007, nonspouse beneficiaries will be permitted to “roll over” eligible rollover distributions to an IRA or another employer's plan.

Permanency of EGTRRA.  The Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA") increased a number of the limits applicable to tax-qualified plans and added “Roth” IRAs.  Those provisions were to sunset in 2010.  The Act removes the sunset provision and makes these provisions permanent.

Changes of Rules Affecting Investment Funds.  The Act relaxes the “significant" participation test for determining whether many investment funds contain plan assets.  It also provides a number of prohibited transaction exemptions that will be useful to financial service providers.  A separate Gibson Dunn Update that discusses these changes is available.


Key Provisions of the Pension Protection Act of 2006  [PDF}


Gibson, Dunn & Crutcher lawyers are available to assist clients in addressing any questions they may have regarding these issues. Please contact the Gibson Dunn attorney with whom you work, or
William J. Kilberg (202-955-8573, wkilberg@gibsondunn.com),
Stephen W. Fackler (650-849-5385, sfackler@gibsondunn.com),
David West (213-229-7654, dwest@gibsondunn.com),
David I. Schiller (214-698-3205, dschiller@gibsondunn.com),
Michael J. Collins (202-887-3551, mcollins@gibsondunn.com),
Sean Feller (213-229-7579, sfeller@gibsondunn.com),
Amber Busuttil Mullen (213-229-7023, amullen@gibsondunn.com),
Jennifer Patel (202-887-3564, jpatel@gibsondunn.com) or
Chad Mead (214-698-3134, cmead@gibsondunn.com). 

IRS Circular 230 disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any matters addressed herein. 

© 2006 Gibson, Dunn & Crutcher LLP

The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

July 26, 2006 |
SEC Adopts Amendments to Executive Compensation and Related-Party Disclosure Rules

Today, the Securities and Exchange Commission (“SEC”) voted unanimously to adopt new rules that will revise the disclosure requirements for executive and director compensation, related-party transactions, director independence and other corporate governance matters. The new rules will be effective for fiscal years ending on or after December 15, 2006, and therefore will apply to disclosures of 2006 compensation in companies’ 2007 proxy statements. The new rules applicable to disclosure of executive compensation arrangements on Form 8-K will become effective 60 days after the SEC issues the adopting release. We anticipate that the final rules and adopting release will be publicly available in the first part of August.

A summary of the new rules is set forth below. It is based on information provided at the SEC’s open meeting, and therefore may not reflect nuances that will appear in the forthcoming adopting release. We will provide further guidance on the new rules after the adopting release is issued.

Disclosure of Other Employees’ Compensation

The SEC did not adopt its proposal to require disclosure of the compensation paid to non-executive employees whose compensation exceeds that paid to any of the named executive officers. However, the SEC will propose and seek comment on an alternative provision under which companies that are “large accelerated filers” would be required to disclose the total compensation of up to three employees:

  • who are not executive officers but who have significant policy-making powers either within the company or within a significant subsidiary, principal business unit, division or function of the company; and 

  • whose compensation exceeds that of any of the named executive officers listed in the Summary Compensation Table. 

The SEC also will seek comment on whether these employees should be named in the proxy statement or identified only by job description. 

Compensation Discussion & Analysis

The new rules delete the current requirement for a Board Compensation Committee Report on Executive Compensation and require instead a Compensation Discussion & Analysis (“CD&A”). SEC officials emphasized that the CD&A is intended to provide a dramatically different perspective on executive compensation compared to the existing Compensation Committee Report, as it will address the objectives, implementation and factors underlying each element of compensation paid to the named executive officers. The CD&A will be filed, rather than furnished, and thus subject to certification by a company’s principal executive officer and principal financial officer. In addition, SEC officials stated that they intend to review and comment on the CD&A to ensure that companies avoid “boilerplate” disclosures and to enforce the requirement that companies disclose any applicable performance criteria or formula used in determining the named executive officers’ compensation unless they can satisfy the burden of demonstrating that the information is both confidential and competitively sensitive. 

In addition to the CD&A, companies will be required to furnish a compensation committee report that is similar to the existing audit committee report. This new report will be a brief statement on whether the compensation committee reviewed and discussed with management the CD&A and, based on that review and discussion, whether the committee recommended to the company’s board of directors that the CD&A be included in the company’s proxy statement and annual report on Form 10-K. 

Determination of the Named Executive Officers

The “named executive officers” for whom compensation disclosure is required under the new rules will be the principal executive officer, the principal financial officer and the three other most highly compensated executive officers. The most highly compensated executives will be determined based on each executive’s “total compensation” number for the last fiscal year as required to be reported in the Summary Compensation Table (as discussed below) except that, in contrast to the proposed rules, amounts disclosed as earnings on deferred compensation and the actuarial increase in pension benefit accruals will not be counted. We understand that the final rules also will continue to include as “named executive officers” up to two additional executive officers who would have been “named executive officers” based on their “total compensation” (including perhaps severance payments) but for the fact that they were not executive officers at the end of the fiscal year. 

Revised Compensation Tables

The new rules will require most companies to set forth six tables disclosing various aspects of the named executive officers’ compensation. 

Summary Compensation Table

The Summary Compensation Table has been substantially revised from the current table, as reflected in the sample set forth at the end of this client alert. The table will include columns reporting dollar amounts for salary, bonus, stock awards, option awards, non-stock incentive plan compensation, the actuarial increase in pension plan accruals and above-market earnings on deferred compensation, and all other compensation, and will sum-up the foregoing amounts in a new “total compensation” column. The columns showing stock awards and option awards will be measured by grant date fair value and computed using the Financial Accounting Standards Board’s Statement of Financial Accounting Standards No. 123 (revised), Share-Based Payment (“FAS 123R”). The column disclosing all other compensation will include perquisites valued in the aggregate at $10,000 or more. In addition, the adopting release will contain further interpretive guidance regarding the determination of what is a perquisite. 

The Summary Compensation Table will “phase-in” over the next three years, so that in the first two years companies will not be required to recalculate or restate compensation for fiscal years that were covered in previously filed proxy statements. Thus, companies’ 2007 proxy statements generally will include only disclosures for the 2006 fiscal year. 

Grants of Plan-Based Awards Table

The Summary Compensation Table will be accompanied by a Grants of Plan-Based Awards Table that provides additional detail regarding stock options and other equity awards (such as restricted stock or restricted stock units) granted during the fiscal year and amounts payable under other compensation plans (such as long-term incentive awards that are payable in cash or stock). In response to recent concerns about stock option grant practices, this table will require extensive disclosure on option grants, including: (1) the grant date FAS 123R fair value; (2) the grant date for accounting purposes; (3) the stock’s closing market price on the date of grant if greater than the option’s exercise price; and (4) the date on which the compensation committee (or the full board of directors) took action to grant the award if different than the grant date. If the exercise price is not the closing market price on the date of grant (for example, if the exercise price is the average of the high and low stock price on the grant date), companies will be required to provide a description of the methodology used in determining the option exercise price.

Outstanding Equity Awards at Fiscal-Year End Table

The Outstanding Equity Awards at Fiscal-Year End Table will present information on each outstanding equity award held by companies’ named executive officers at the end of the fiscal year, including the number of securities underlying both exercisable and unexercisable portions of each stock option as well as the exercise price and expiration date of each outstanding option. Unlike current disclosure requirements, this information will be presented on a grant-by-grant (instead of aggregate) basis, meaning that extensive space will be devoted to disclosure on executives who hold numerous awards. 

Option Exercises and Stock Vested Table

The Option Exercises and Stock Vested Table will show amounts realized by companies’ named executive officers on options that were exercised or other stock awards that were earned during the last fiscal year. Companies will not, however, be required to disclose the FAS 123R grant date value of these awards. 

Pension Benefits Table

The existing Pension Plan Table will be replaced with a new Pension Benefits Table, which will provide disclosure of the actuarial present value of each named executive officer’s accumulated benefit under each pension plan, assuming benefits are paid at normal retirement age based upon current levels of compensation. The value under each pension plan will be determined using the same assumptions used for financial statement purposes. 

Nonqualified Deferred Compensation Table

The Nonqualified Deferred Compensation Table will disclose executive and company contributions under non-qualified defined contribution and other deferred compensation plans, as well as each named executive officer’s withdrawals, earnings and fiscal-year end balances in those plans. In contrast to the new Summary Compensation Table, which requires disclosure of only above-market or preferential earnings on non-qualified deferred compensation, all earnings on named executive officers’ deferred compensation will be disclosed in this table.

Termination and Change in Control Payments

The rules will require a narrative description of any arrangement that provides for payments or benefits in connection with a named executive officer’s termination of employment, a change in his or her responsibilities or a change in control of the company. In addition, companies will be required to quantify the amount (or estimate the range of amounts) that would have been payable to each named executive officer under each of the foregoing triggering events, assuming that the triggering event had occurred as of the end of the last fiscal year. Any benefits that are valued based on stock price likewise will be quantified based upon the stock’s price as of the end of the last fiscal year. 

Stock Option Grant Practices

As noted above, in response to recent concerns about stock option grant practices, the rules and adopting release will contain extensive new disclosure requirements focusing on the timing of option grants in coordination with the release of material non-public information and the determination of exercise prices that differ from the stock price on the date of grant. In addition to the tabular disclosures addressed above, additional disclosure will be required in the CD&A regarding option grant practices, when applicable. With respect to both the timing of stock options and any programs under which option exercise prices are set at an amount below the closing market price of the stock on the grant date, SEC guidance will require companies to answer questions such as:

  • Does the company have a program or practice in place to time option grants to executive officers with the release of material non-public information (or to set exercise prices in coordination with such release)?

  • How does that program or practice fit into the context of the company’s program or practice, if any, with regard to option grants to employees generally?

  • What was the compensation committee’s role in approving and administering that program or practice?

  • What was the role of executive officers in the company’s program or practice?

  • Does the company plan to time, or has it timed, the release of material non-public information in order to affect the value of executive compensation?

Related-Party Transactions

The rules will make disclosure of related-party transactions more principles-based and increase the threshold for reporting such transactions from $60,000 to $120,000. Further, the rules will require disclosure of companies’ policies and procedures for reviewing and approving or ratifying related-party transactions. 

Corporate Governance Disclosures

The new rules will consolidate and enhance disclosure requirements for director independence and other corporate governance matters. Disclosure will include: (1) standards applied by companies in assessing director independence; (2) whether each director and director nominee is independent; (3) descriptions of categories of transactions, relationships or arrangements not disclosed as related-party transactions but considered by the board of directors in determining director independence; (4) whether any members of the audit, nominating or compensation committees are not independent; and (5) extensive new disclosures on compensation committees’ procedures for determining executive and director compensation and the role of compensation consultants.

Other Requirements

  • Security Ownership of Directors and Officers: The rules will require disclosure of the number of shares owned by management that are subject to any pledge. 

  • Director Compensation Table: As proposed, director compensation (including perquisites) for the last fiscal year must be disclosed in a new Director Compensation Table, which will mirror the format of the Summary Compensation Table described above.

  • Form 8-K: Under the new rules, disclosure requirements for executive compensation arrangements on Form 8-K will be revised to apply to employment arrangements and material amendments to those arrangements for named executive officers only. 

  • Performance Graph: The SEC has retained the requirement for the stock performance graph, but moved it to appear in companies’ Form 10-K and annual report to stockholders.

  • Plain English: The rules will require companies to present most of this information in plain English, in order to provide clarity for the lay reader.

Planning for the New Rules

In preparing for the new rules, we recommend that companies:

  • Evaluate who their named executive officers are likely to be based upon the total compensation number (excluding deferred compensation earnings and the actuarial increase in pension plan accruals);

  • Prepare mockups of their executive and director compensation disclosure tables for compensation committee review;

  • Assess their disclosure controls and procedures for gathering the information that will be disclosed, with particular attention to determining which departments in the company are responsible for producing the necessary information and confirming that the information is calculated in the required manner;

  • Determine what elements of compensation each named executive officer receives, including details on the bases for and objectives of these elements of compensation and the factors affecting the amount of compensation (including potentially disclosable performance criteria), so that these can be described in the CD&A;

  • Review their procedures relating to option grants, and determine whether any changes in process are desirable; 

  • Identify each benefit that is potentially payable to a named executive officer upon a change in control or termination of employment, the precise definitions of each triggering event, and the amounts (or an estimate of the range of amounts) payable under those benefits upon the occurrence of each triggering event;

  • Review and document their policies and procedures for approval or ratification of related-party transactions, and assess their procedures for identifying those transactions on a real-time basis; and

  • If relevant to the company, submit comments on the costs and possible competitive impact of the reproposed rule for disclosure of compensation to highly paid non-executives who have a significant policy-making or managerial role.

 

Summary Compensation Table

Name 
and
Principal Position









Year











Salary
($)










Bonus
($)










Stock
Awards

($)









Option
Awards
($)









Non-
Equity
Incentive
Plan
Compen-
sation
 
($)





Change in
Pension
Value and
Nonquali-
fied
Deferred
Compen-
sation
Earnings
($)


All
Other
Compen-
sation
($)







Total
($)










PEO[1]

 

 

 

 

 

 

 

 

 

 

PFO[2]

 

 

 

 

 

 

 

 

 

 

A

 

 

 

 

 

 

 

 

 

 

B

 

 

 

 

 

 

 

 

 

 

C

 

 

 

 

 

 

 

 

 

 



   [1]   PEO refers to principal executive officer.

   [2]   PFO refers to principal financial officer.

 

*  *  *  *

Gibson, Dunn & Crutcher lawyers are available to assist clients in addressing any questions they may have regarding these issues. Please contact the Gibson Dunn attorney with whom you work, or John F. Olson (202-955-8522, jolson@gibsondunn.com), Ronald O. Mueller (202-955-8671, rmueller@gibsondunn.com), Brian J. Lane (202-887-3646, blane@gibsondunn.com), Amy L. Goodman (202-955-8653, agoodman@gibsondunn.com), Stephen Fackler (650-849-5385, sfackler@gibsondunn.com), James Moloney (949-451-4343, jmoloney@gibsondunn.com), or Elizabeth Ising (202-955-8287, eising@gibsondunn.com). 

© 2006 Gibson, Dunn & Crutcher LLP

The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

July 7, 2006 |
Recent Court Decisions Suggest Greater Latitude for ERISA Fiduciaries to Retain Company Stock as Investment Option

Two recent court decisions make important contributions to the developing caselaw on the obligation that ERISA fiduciaries may have to remove company stock from employee benefits plans when the stock is declining in value. 

In Summers v. State Street Bank & Trust Co., Nos. 05-4005, 05-4317 (7th Cir. June 28, 2006), the Seventh Circuit affirmed a district court ruling that a “directed trustee” to United Air Lines’s employee stock ownership plan (“ESOP”) did not violate its fiduciary duty by failing to divest company stock from the plan before United’s bankruptcy in late 2002. Although United’s CEO had stated in a letter that the company was “in a struggle just to survive” and that unless the “bleeding [was] stopped . . . United will perish sometime next year,” Judge Posner, writing for the court, observed that the markets were aware of the letter and United’s other struggles and yet the price for the company stock still implied a market capitalization of more than $800 million. “A trustee is not imprudent to assume that a major stock market . . . provides the best estimate of the value of the stocks traded on it that is available to him,” Judge Posner stated. Indeed, “it would be hubris for a trust company like State Street to think it could predict United’s future more accurately than the market could, and preposterous for a committee of union officials (the named fiduciary) to challenge the market’s valuation.” 

The court’s decision went on to suggest that a company’s debt-equity ratio may be a better measure of the riskiness of investment, but conceded that determining the “right” point or range of points “for an ESOP fiduciary to break the plan and start diversifying” - that is, start selling company stock - “may be beyond the practical capacity of the courts to determine.” Among other things, the court explained, whether an investment risk is unacceptable to plan participants depends on the participants’ other investments as well as their individual risk tolerance. Neither of these is a matter that would be known to a plan fiduciary.

Judge Posner’s opinion for the Seventh Circuit is an important addition to the cases that have sharply questioned the circumstances in which even a substantial drop in a company stock price should cause plan fiduciaries to second-guess the market and override plan participants’ decision to invest in company stock. 

In DeFelice v. US Airways, Inc., No. 1:04cv889 (June 26, 2006), Judge Ellis of the Eastern District of Virginia rejected plaintiffs’ arguments that US Airways breached its fiduciary duty under ERISA by allowing the stock of its parent corporation to remain as a 401(k) plan investment option despite its perilous financial condition. The case is the first of the 401(k) “stock drop” cases to proceed to trial and decision. 

In his opinion, Judge Ellis accepted the modern portfolio theory of investment, noting that “an investment in a risky security as part of a diversified portfolio is, in fact, an appropriate means to increase return while minimizing risk.” He also correctly observed that “investment vehicles containing company stock are favored by ERISA.” He accordingly held that a fiduciary may continue to offer employer stock as a 401(k) investment option as long as the plan also provides “(1) a range of investment options; (2) true and accurate information regarding the risk/return characteristics of those investment options; and (3) the unfettered ability to trade in and out of the various investment options.” Thus, “the fiduciary should not be deemed to have violated any fiduciary duty for offering this option provided the investment in company stock remains viable, and the company has fully disclosed to participants the risks attendant to that investment.” 

In an earlier decision Judge Ellis had rejected the application of ERISA § 404(c) to the US Airways fiduciaries’ selection of investment options for the plan, see DiFelice v. US Airways, Inc., 397 F. Supp. 2d 758, 777 (E.D. Va. 2005), but the substantial latitude given fiduciaries in this more recent decision may provide a § 404(c)-type safe harbor for fiduciaries who maintain employer stock as an investment option while also providing plan participants a diversified portfolio of investment options and adequate information regarding investment risks and returns. Such an understanding may prove useful to courts when considering Judge Posner’s difficult questions about courts’ capability to determine when a particular stock becomes an imprudent benefit plan investment.  


Gibson, Dunn & Crutcher has extensive experience with employee benefits litigation and counseling nationwide, including handling a number of recent 401(k) "stock drop" cases and several Supreme Court ERISA cases. To learn more about the firm's ERISA litigation, contact the Gibson Dunn attorney with whom you work or William J. Kilberg (202-955-8573; wkilberg@gibsondunn.com) or Eugene Scalia (202-955-8206; escalia@gibsondunn.com) in Washington, D.C., or Labor and Employment Practice Group Co-Chair Deborah J. Clarke in Los Angeles (213-229-7903; dclarke@gibsondunn.com). To learn more about the firm's employee benefits counseling, contact Employee Benefits Practice Group Co-Chairs Stephen W. Fackler (650-849-5385; sfackler@gibsondunn.com) in Palo Alto. 

© 2006 Gibson, Dunn & Crutcher LLP

The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

April 25, 2006 |
Gibson Dunn Partners Participate in Panel on Executive Compensation, Corporate Penalties and Internal Investigations

Gibson Dunn partners Amy Goodman and Tim Roake participated in a recent Corporate Governance Forum hosted by the Daily Journal Corporation and reprinted in the Spring 2006 issue of 8-K magazine. The panel discussion [PDF] included an examination of the effect of the SEC's recent statement on corporate penalties, the agency's proposed changes to executive compensation disclosure rules, and the difficulties of overseeing an internal investigation.


Reprinted with permission from the Spring 2006 issue of 8-K magazine, © 2006 Daily Journal Corp. San Francisco, California.

January 17, 2006 |
SEC Proposes Amendments to Executive Compensation, Related Party and Independence Rules

Today, the Securities and Exchange Commission (the “SEC”) voted to propose rules that would amend disclosure requirements for:

  • executive and director compensation; 

  • related party transactions;

  • director independence and other corporate governance matters;

  • security ownership of officers and directors; and 

  • Form 8-K reports regarding compensation arrangements.

The final rules are not expected to be enacted in time for the 2006 proxy season, but likely will apply to disclosures of 2006 compensation that are made in companies’ 2007 proxy statements. As discussed below, in addition to filling gaps in required tabular presentations of compensation, the proposals would require additional narrative disclosure to elaborate on the compensation tables. The narrative disclosure must satisfy “plain English” standards. 

A summary of the rule proposal is set forth below. This summary is based on information provided at the SEC’s open meeting, and therefore may not reflect nuances that appear in the SEC’s proposing release, which is expected to be issued shortly. We expect to issue additional materials on the rule proposals once the actual rule text has been published and can be fully assessed. 

Based on the limited information currently available, the rule proposals appear to reflect a thorough, thoughtful and well-informed effort to provide comprehensive, balanced and informative disclosure on executive compensation and related issues. We expect that many shareholders and companies will welcome greater clarity in the disclosure requirements and a more level playing field for disclosure of differing types of compensation, so that disclosure considerations do not unnecessarily handicap particular types of compensation programs. At the end of this Update, we discuss actions that companies, executives and compensation committees should consider in anticipation of the new rules. 

Executive Compensation Disclosure

The proposals would eliminate the Board Compensation Committee Report on Executive Compensation and the five-year stock price performance graph. In their place would appear a Compensation Discussion and Analysis report containing details on the objectives and implementation of executive compensation programs (similar in concept to existing requirements for Management’s Discussion and Analysis covering a company’s financial condition and results of operations). The Compensation Discussion and Analysis would expand disclosure beyond existing standards for Compensation Committee Reports by requiring a discussion of compensation policies and decisions, including details on each element of compensation - its objectives, why it is provided, how amounts are determined and how the compensation fits into the company’s overall compensation program. This report would be styled as a company disclosure; it would not appear “over the names” of a company’s compensation committee. 

Existing tabular disclosure of executive compensation would be reformatted and enhanced, and would be accompanied by more narrative disclosure than is currently provided. The tables would be grouped into three broad categories: compensation over the last three years; holdings of outstanding equity-related compensation; and retirement plans and other post-employment payments and benefits.

Compensation would be presented for the Chief Executive Officer, Chief Financial Officer and three other most highly paid executive officers. The additional three executives would be determined based on their total annual compensation, whereas the current rules base that determination on the amount of salary and annual bonus paid to executives. Tabular disclosure over the past three years would be provided through a reorganized Summary Compensation Table, a Performance-Based Award Grant Table and an All Other Equity Award Grant Table.

The Summary Compensation Table:

  • would have a column reporting “total” annual compensation;

  • would contain a single column for reporting grant-date fair value of all equity awards for the year (restricted stock/stock unit grants as well as option/stock appreciation right grants), computed under Statement of Financial Accounting Standards No. 123(R); and 

  • would combine the “Other Annual Compensation” and “All Other Compensation” columns, and at the same time expand the disclosure requirements so that the column includes all compensation not elsewhere reported in the table (including, for example, dividends on restricted stock, the aggregate annual increase in the actuarial value of pension benefits and accruals under deferred compensation arrangements that are not tax-qualified plans).

The SEC’s release will contain interpretive guidance on what constitutes a “perquisite” that is subject to disclosure and will request public comment on that guidance. It is unclear whether this guidance will be prospective only, or will apply under the existing disclosure rules, as the Division of Corporation Finance has in the past not provided interpretive guidance in this area. It also is unclear whether the rule proposals will contain new valuation standards for perquisites, but the proposals would lower the disclosure threshold to $10,000 from the current $50,000 threshold. 

During the SEC’s open meeting, the Commissioners and Staff discussed a number of aspects of the proposed disclosures for option grants. In particular, it appears that the proposal would require disclosure of the full SFAS No. 123(R) valuation of an option whenever the option is materially modified (such as when the term of an option is extended in connection with termination of employment). This disclosure proposal would differ from the standard applicable for financial statement reporting, where only the incremental value arising from an option modification is expensed. 

Holdings of and amounts realized under all forms of equity compensation (including options, restricted stock and stock units) would be reported in two tables, similar to existing disclosure requirements for option holdings and amounts realized from option exercises. 

The third category of executive compensation disclosures would entail greatly expanded reporting of retirement, change-in-control and post-employment benefits. The proposed disclosure requirements include: 

  • a table showing the actual annual benefits payable to each named executive officer under defined benefit pension plans; 

  • a table showing annual executive contributions, company contributions, earnings, withdrawals and year-end balance under deferred compensation plans that are not tax-qualified (that is, excluding for example 401(k) plan amounts); and

  • a description and quantification of payments and benefits payable to each of the five covered executive officers on termination of employment or change in control. 

We expect that this last element of disclosure will be a source of extensive public comment. While many compensation committees review calculations of these potential benefits, they involve extensive use of assumptions (which would be disclosed under the rule proposals). Moreover, in our experience these potential benefits often are calculated in a manner that is sufficient to inform compensation committees of the magnitude of change-in-control or severance payments, but that does not obtain the level of precision necessary for an SEC filing. 

Directors’ Compensation Disclosure

Compensation provided to each director in the last fiscal year would be itemized in a compensation table similar to the Summary Compensation Table provided for executives, with a narrative discussion of the elements of directors’ compensation. 

Disclosure of Other Employees’ Compensation 

An unanticipated aspect of the proposed rules would require disclosure of the compensation paid to up to three employees who are not executive officers, if that compensation exceeds the compensation paid to executive officers covered in the Summary Compensation Table. Although the proposals would not require the employees to be named, their job responsibilities would be disclosed. We expect that this proposal will raise concerns regarding the competitive impact on the market for non-managerial sales staff and creative or technical talent, and that comments will address whether the proposed disclosures provide meaningful information for investors. 

Related Party Transactions

Item 404(a) of Regulation S-K currently requires disclosure of transactions in which executives, directors and large shareholders, or their family members, have a direct or indirect material interest, if the value of the transaction exceeds $60,000. While details were vague, it appears that the proposals will raise the transaction threshold to $120,000, but otherwise would expand the scope of transactions required to be disclosed. During and after the SEC’s open meeting, the Commissioners and Staff described the proposed changes as leading to a more “principles-based” disclosure requirement, and involving the repeal of existing rules that allow certain types of relationships to not be disclosed. Companies will be required to disclose their policies for approving related party transactions. 

Director Independence and Other Corporate Governance Matters

The proposals would expand the disclosure requirements for a company’s business relationships with other businesses where a director is employed or is a significant owner, so that the disclosure thresholds more closely conform to the stricter standards applied under New York Stock Exchange and NASDAQ Stock Market independence standards. While details were not clear, the proposals also would require disclosure of other material relationships that were considered when evaluating a director’s independence. Other proposed rule changes would consolidate existing corporate governance disclosure requirements into a single set of rules, while easing disclosure burdens by allowing enhanced reliance upon internet availability of committee charters and other information. 

Security Ownership of Officers and Directors

The proposals would require that the table reporting the number of shares of company stock that executives and directors beneficially own disclose the number of shares, if any, that are subject to pledges. 

Form 8-K

The proposals would revise the scope of executive compensation disclosure requirements on Form 8-K, so that only executive officers’ employment arrangements and material amendments to such arrangements are covered. It appears that this rule amendment may eliminate the need for Form 8-K reports on directors compensation. It is unclear whether the proposals also will provide greater clarity on when a Form 8-K may be required to report compensation decisions under bonus and employee benefit plans, although we expect this to be an area that companies will wish to cover in comments submitted to the SEC. 

Planning for the New Rules

Over the last several years, many companies have provided enhanced compensation disclosures that address many of the areas covered by the proposed rules, and we expect the rule proposals to expand that practice. Because the scope of required disclosures will clearly expand for the 2007 proxy season, companies and compensation committees should consider now whether to provide those additional disclosures in 2006. While it will be appropriate to provide additional disclosures on elements of compensation that are not clearly required under the existing rules, it is unclear whether 2006 proxy disclosures will be permitted to deviate from the current required tabular presentations in favor of the reformatted compensation tables set forth in the rule proposals, as consistency in presentation remains an SEC priority for compensation disclosures. 

Compensation committees should not view elimination of the Board Compensation Committee Report as easing their disclosure responsibilities. The proposed new Compensation Discussion and Analysis will require more detail on the operation of compensation programs and on the basis for compensation decisions, and that disclosure will flow from the decisions made by compensation committees. It is clear that the SEC is not only seeking additional numerical information; the narrative disclosures will cover both the “big picture” and the details of compensation programs. There will continue to be an opportunity to discuss compensation “best practices,” such as evaluations of internal pay equity and accumulated wealth. 

Compensation committees that are not already using tally sheets to evaluate “total” compensation should do so in 2006, since current compensation decisions will be reflected under the new rules in 2007. Likewise, because of the expense and effort that will be required to precisely quantify the value of change-in-control and severance benefits, compensation committees should plan on undertaking that effort in 2006. Any renegotiations or adjustments to severance programs should be in place by fiscal year-end, since that could be the point in time when those benefits are valued for disclosure purposes. Some compensation committees likely will evaluate whether to cap the value of post-employment benefits, so as to avoid disclosing, for example, that airplane use benefits are potentially of unlimited value. 

Companies should assess how the proposed “total” compensation standard may alter which executives are covered by the compensation disclosure rules. Companies that do not have restrictions on their executives’ pledging or hedging company stock should evaluate whether to implement policies addressing those practices, as the final disclosure standards may cover arrangements that are in place during 2006, and executives may wish to close-out existing arrangements over the coming year. 

Finally, investors, companies and directors, particularly compensation committee members, should carefully review the proposed rules once they are made available, and should consider submitting pragmatic comments to the SEC. If aspects of the proposals could unduly bias or burden compensation decisions, those elements should be pointed out and alternative means to enhance disclosure suggested. The comment period for the rule proposals is scheduled to end 60 days after the proposals are published in the Federal Register.


Gibson, Dunn & Crutcher lawyers are available to assist clients in addressing any questions they may have regarding these issues. Please contact the Gibson Dunn attorney with whom you work, or
John F. Olson (202-955-8522, jolson@gibsondunn.com), Ronald O. Mueller (202-955-8671, rmueller@gibsondunn.com), Brian J. Lane (202-887-3646, blane@gibsondunn.com) or Amy L. Goodman (202-955-8653, agoodman@gibsondunn.com) in the firm's Washington, D.C. office.

© 2006 Gibson, Dunn & Crutcher LLP