© 2013 Winstead PC

Compensation Governance

Presented by:Anthony J. Eppert, Winstead PCAEppert@Winstead.com713.650.2721

Presentation for:NASPP, Austin ChapterFebruary 10, 2015

© 2015 Winstead PC

© 2015 Winstead PC

Tony is a Shareholder in Winstead's Compensation & Benefits practice group. His legal practice focuses on executive compensation and employee benefit arrangements in the United States and abroad

Before entering private practice, Tony:– Served as a judicial clerk to the Honorable Richard F. Suhrheinrich of the

United States Court of Appeals for the Sixth Circuit– Obtained his LL.M. (Taxation) from New York University– Obtained his J.D., cum laude (Tax Concentration) from Michigan State

University College of Law Editor-in-Chief, Journal of Medicine and Law President, Tax and Estate Planning Society

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About Anthony ("Tony") Eppert

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2015 webinars:– Forms 3, 4 and 5: The Intermediate Training Course (3/11)– Taxation of Equity Awards: The 101 Training Course (4/8)– Insider Trading Policies, Blackouts Periods and 10b5-1 Plans (5/13)– Effective Designs: Severance Plans/Change-in-Control Agreements (6/10)– Section 409A and Executive Contracts: The Intermediate Course (7/8)– How to Identify and Build a Compensation Peer Group (8/12)– Preparing for Proxy Season: The “To Do” List (Annual Program) (9/9)– Understanding Employment Taxes: The 101 Training Course (10/14)– Benefits: A Legislative & Regulatory Review (Annual Program) (11/11)– Update: A Report on Changing Compensation Designs & Trends (12/9)

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Upcoming Monthly Webinars

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Purpose of this Seminar

The purpose of this webinar is to discuss compensation governance

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Authority of the Compensation Committee

The governance process associated with director compensation is generally as follows:

– The nominating and corporate governance committee makes recommendations to the full board

– Compensation decisions are made by the full Board

In contrast, typically it is the compensation committee that has the authority to make compensation decisions for the NEOs and other employees of the Company

– This means that pursuant to the Compensation Committee Charter, the Board of Directors delegated such responsibility to the Compensation Committee

– Alternatively, the Board could have only delegated the ability to make recommendations; thus, the Compensation Committee can only make recommendations and decisions must be had at the full Board level

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Compensation Committee Action Items

At least annually, the Charter should be reviewed and reassessed by the Committee

– Any proposed changes to the Charter must be submitted to the full Board for their approval

At least annually (or more frequently), the Committee should review and approve the compensation goals and objectives that cover the management team, to include:

– Balance between short-term and long-term compensation,– The performance of each member of the management team, and– The compensation levels of each member of the management team– NOTE: Provide the committee with tally sheets and wealth accumulation

tables so they are informed in accomplishing the above, thus bolstering their use of the business judgment rule defense if there is ever, for example, a shareholder derivative lawsuit

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Compensation Committee Action Items (cont.)

With the help of HR, legal and possibly finance, the committee should oversee the process of determining whether any of its compensation policies and practices (for any group of employees, not just NEOs) create material risk

– If a compensation policy is “reasonably likely to have a material adverse effect” on the Company, then a stand-alone discussion of this risk must be present in the proxy

– This discussion, if present, should be outside of the CD&A because it covers more than just the NEOs

– Many companies provide affirmative disclosure

HR/legal must develop a process to determine the above by:– Identifying all plans,– Assessing risk, and– Making a determination

Important to the foregoing is the “process”

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Tally Sheets

If the business judgment rule is applied:– Then the decisions of a director will be presumed to have been informed,

made in good faith, and accomplished with the belief that such was in the best interests of the company; the presumption makes it more difficult for a plaintiff to prove such director breached his/her fiduciary duties

Tally sheets– Tally sheets can be a key for a director to preserve the defense of the

business judgment rule because tally sheets act as proof that the director made an “informed” decision, even if the wrong decision

– A tally sheet lists each component of an executive’s compensation and tallies it up (i.e., a placemat)

– Compensation committees should require a tally sheet showing range of potential payments in alternative scenarios

– It should be prepared and explained by a compensation expert– It should be attached to minutes

Amounts to tally– Income for the year– Projected values under different performance and termination scenarios– Realized option and stock gains (last 5 years)– Total wealth accumulation

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Wealth Accumulation Tables

Wealth accumulation analyses focus on how much wealth the executive will accumulate at various career points

– Includes realized and unrealized equity value, plus deferred income (e.g., retirement plans)

Used to determine “how much is enough”– Determine wealth accumulation targets– Determine a reasonable minimum guaranteed wealth and from what

sources– Determine how performance metrics figure into the analyses– Determine whether accumulation is appropriate in context of overall

compensation– Determine whether shareholders should fund this level of accumulation– Determine whether improved long-term incentive plans could improve

alignment with shareholders

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Delegations: Authority to Grant Equity

The following is an overview of the rules that companies should consider when granting equity

Absent a delegation, only the Board has the authority to grant equity– Unless a delegation exists from the Board to the compensation committee,

this means that the compensation committee can only make “recommendations” to the Board

The following slides on this topic assume a valid delegation exists from the Board to the compensation committee

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Delegations: Authority to Grant Equity (cont.)

Typically, the compensation committee has the authority to implement a further delegation of its authority to grant equity to an inside director or non-director officer

– If such exists, it is typically contained in the compensation committee’s charter and/or in the equity plan document

The administrative burdens associated with the compensation committee acting through written consent are not likely sufficient enough to warrant the additional delegation cited above

However, if such a delegation is warranted/desired, then it could be made appropriate in instances where:

– The company routinely grants equity to new hires who are NOT executive officers, and

– The equity is granted within a limited period of time from the date of hire

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Delegations: Authority to Grant Equity (cont.)

Assuming it is determined that a delegation from the compensation committee is appropriate, then the following points should be considered:

– Delegations must comply with applicable state law (e.g., DGCL 157(c))– Delegations should be governed by a written equity grant policy (the

“Policy”) that was approved by the compensation committee and/or the Board

– The Policy should include a reporting mechanism to the compensation committee of all equity grants. To avoid “date of grant” issues, the Policy should clearly state that only a “reporting” to the compensation committee is required (i.e., no ratification or approval is required)

– Attached as exhibits, the Policy should contain award agreements that were pre-approved by the Board or the compensation committee. This will help avoid successful arguments that delegated awards contained terms not previously approved by the Board or the compensation committee

– The Policy should specify the total number of awards (individually and collectively) that may be made pursuant to the delegation

– [See next slide for continued list]

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Delegations: Authority to Grant Equity (cont.)

[Continued from prior slide]– Delegations should exclude the ability to make grants to those who are

Section 16 insiders as of the date of grant (e.g., compliance with Rule 16b-3 requires the full board of directors or a committee of 2 or more non-employee directors to approve in advance of all grants to Section 16 insiders)

– Delegations should exclude grants to those who would be “covered employees” as of the exercise date (if a stock option) or vesting date (if a stock grant)

Compliance with the performance-based exemption under Section 162(m) requires such grants to be approved in advance solely by two or more outside directors

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Equity Grant Practices: Date of Grant

An accurate date of grant is important to support accurate accounting charges and to avoid adverse tax consequences under Section 409A

The date of grant is generally the date the Board or the compensation committee (or delegates) “approves” a grant containing “definitive terms”

– If the Board or the compensation committee acts prior to knowing the definitive terms, then the date of grant would typically be the date all definitive terms become known

– Generally, “definitive terms” means the identity of the recipient, the number of shares subject to the award, the vesting schedule and the exercise price (if applicable)

Keep in mind that the grant is “approved” on the date the board or compensation committee acts pursuant to written minutes (though such could contain a later effective date for the grant)

– Thus, AND DO NOT FORGET, if the action is pursuant to unanimous written consent resolutions, then the grant is deemed approved on the date of the last signature

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Equity Grant Practices: Amount of Grant

Try to avoid providing “mega grants” every three or four years, and instead provide annual grants with a vesting schedule that straddles and overlaps with other annual grants over a 3 or 4 year period

– Remember that the grant date fair value of the award is included in the summary compensation table, and therefore, a mega grant could impact the identity of the NEOs

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Stock Ownership Guidelines

Consider whether to implement a stock ownership policy in conjunction with grants of equity to NEOs

– A stock ownership policy sets the parameters on the level of stock that must be owned

– Such a policy increases the message to the company’s shareholders that the latter can rely on the commitment of the NEOs to the company’s long-term success (i.e., there is a direct alignment of interest with the company’s long-term shareholders)

– Helps bolster performance pay– Could act as a mitigating factor to negate risk assessment disclosure.

Remember that companies must disclose the relationship between their compensation practices (for all employees) and their risk management philosophy, BUT ONLY IF such compensation programs are “reasonably likely to have a material adverse effect”

Though a multiple of salary (i.e., a fixed value) is a most common stock ownership policy, consider using a fixed percentage/number of shares because the former is difficult to satisfy if the underlying stock price is volatile

– A specific dollar value of shares could also be used (more common among director ownership guidelines)

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Stock Ownership Guidelines (cont.)

The Board must determine the length of the accumulation period within which executives must attain their ownership levels

– A five year accumulation period is a most common time frame

Or instead of the above, the Board might consider whether to also implement a holding requirement, which is another share retention tool:

– For an indefinite period of time, require the NEOs to retain a certain percentage of his/her net profit shares until the required ownership levels are attained (in contrast to a term of years requirement within which the ownership percentage must be satisfied)

Net profit shares refers to the shares remaining after payment of any exercise price and/or taxes owed

Holding period could be indefinite; OR

– Require the CEO to hold a percentage of net profit shares for a certain period of time (i.e., a one-year holding period is common)

Additionally, stock ownership guidelines are viewed favorably by shareholders

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Stock Ownership Guidelines (cont.)

The following is a sample stock ownership policy that was adopted by a publicly-traded company:

“[Company] has adopted a common stock ownership policy for members of the board and our executive officers. This policy requires our executive officers to own shares of common stock having a value equal to five times base salary in the case of our CEO, four times base salary in the case of our President and three times base salary for all other executive officers.

In addition, executive officers are required to retain ownership of at least 50% of any stock acquired by them through our stock compensation plans, after taxes and transaction costs, until retirement or other termination of employment.

These ownership levels will be calculated annually. Executive officers have five years to meet the minimum level with certain ownership thresholds that must be met in the interim period. Our Board believes this stock ownership policy substantially enhances stockholder value by materially aligning management’s interest with those of our stockholders.”

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Stock Ownership Guidelines (cont.)

The “stick” or penalty for failing to satisfy a given stock ownership policy is not typically disclosed in a proxy statement. Such penalties can include:

– Increased holding requirements,– Prohibiting sales of equity, and – Paying annual incentives in equity and not cash

And where satisfying a stock ownership policy would otherwise create undue hardship on an executive, a company could modify the stock ownership policy to incorporate hardship provisions

– Question is whether to incorporate the terms into the stock ownership policy, or instead to simply provide the Board or compensation committee with the discretion to deviate from the requirement if a hardship is present

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Recent FASB Announcements

On October 8, 2014, the Financial Accounting Standards Board (“FASB”) made tentative decisions to improve and simplify accounting for stock-based compensation

Minimum statutory withholding requirement– Generally, current rules require that companies limit “net withholding”

transactions to the minimum statutory withholding rates, otherwise, liability accounting could apply to the entire award

– FASB decided to relax such limitation by allowing for net withholding at the highest applicable marginal tax rate

– FASB also decided that a net withholding is really a form of financing and should be reflected on the statement of cash flows as a financing activity (i.e., its substance is a repurchase of shares)

Review equity incentive plan– Is a plan amendment required to implement the above– Would shareholder approval be required

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Clawbacks: Generally

The purpose of a well-defined clawback provision is to prospectively and contractually thwart bad behavior

– Additionally, a well-drafted clawback provision can be used to punish bad behavior

– Typical bad behavior covered by a clawback provision includes: Breach of non-compete clauses, non-solicitation clauses, and confidentiality Unethical conduct or disloyalty Acts that are injurious to the company's financial health or reputation

– More recently, clawbacks are being used in no-fault situations (e.g., Section 304 of SOX litigation, Dodd-Frank)

Compensation that is typically covered by a clawback policy can include:

– Equity– Bonuses– Severance

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Clawbacks: Dodd-Frank As background, the clawback requirements under Dodd-Frank are not

effective until final rules are issued– Such rules will require companies to implement clawback policies that are

more expansive than the current requirements under Section 304 of the Sarbanes-Oxley Act (“Section 304”)

– The Dodd-Frank clawback requirements are an issue between a company and the applicable listing agency. Therefore, a current goal of a company should be to avoid a future tug-a-war between the company’s duty to comply with the rule on the one hand, and creating a contractual breach with an executive on the other hand

To date companies have been applying a variety of approaches while they await final rules, such being:

– Do nothing and wait,– Adopt a “loose” policy that is expected to be amended in a more robust

way once final rules are issued,– Have executive officers sign a contractual arrangement whereby each

such executive agrees to comply with the Dodd-Frank clawback requirements (when effective) and any clawback policy adopted by the company as such is amended from time to time, and

– Adopt a very formal and robust clawback policy

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Clawbacks: Dodd-Frank (cont.)

As review, the current requirements of the Dodd-Frank clawback include:

– The clawback policy must be triggered any time the company is required to prepare an accounting restatement resulting from “material” noncompliance with any financial reporting requirement under the securities laws

In contrast, Section 304 applies only when a restatement of financial statements is “required” and is the result of “misconduct”

– Once the clawback is triggered, it would apply to all “incentive-based” compensation paid to current and former executive officers

In contrast, Section 304 applies only to the CEO and CFO

– The look back period for which incentive-based compensation is subject to clawback is the 3-year period preceding the date on which the restatement is required

In contrast, the look back period under Section 304 is 12 months

– The amount subject to the clawback is the difference between the amount paid and the amount that should have been paid under the accounting statement

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Clawbacks: Issues to Consider Consider revisiting the current clawback policy (if any) to determine

what changes would be required under Dodd-Frank– One reason for a strong clawback policy is that it can act as a mitigating

factor to negate risk assessment disclosure under recent SEC rules (which require narrative disclosure within the proxy statement of compensation policies and practices that are “reasonably likely” to have a “material adverse effect” on the company)

– Additionally, an expansive clawback policy acts as positive CD&A disclosure

Determine “who” should be responsible for clawback enforcement (e.g., the risk assessment officer, the compensation committee, the full board of directors) and what repayment procedure should be used once a clawback is triggered

Determine whether the clawback policy should be expansive– Should it be limited to Dodd-Frank and SOX?– Should “poor” performance, violation of restrictive covenants (e.g.,

noncompetes), negligence, etc. be covered?– Should fault be a requisite element?– Should there be a clause that if the non-compete provision is ever judicially

or administratively ruled to be unenforceable, that the executive must forfeit certain portions of his/her severance pay (including a return of any gains on equity awards that the executive sold after his/her termination of employment)?

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Clawbacks: Issues to Consider (cont.) Analyze and review all compensation arrangements between the

company and its executive officers– Such would include employment agreements, bonus arrangements, equity

awards, change in control agreements, form severance agreements, corporate policies, etc.

– Goal is to ensure proper integration between such arrangements and the company’s new clawback policy

Verify whether form severance agreements (or clauses within other agreements) contain mutual releases that will need to be amended so as to carve out Dodd-Frank clawbacks

Verify whether indemnification policies/procedures will need to be amended to carve out Dodd-Frank clawbacks

Verify whether applicable state wage and hour laws would prohibit the forfeiture of compensation that is otherwise considered to be earned wages

Consider whether enforceable contractual rights need to be entered into with the executive officers

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Risk Assessments

Disclosure continues to be required to the extent the Company’s compensation policies or practices (for both executive and non-executives) are reasonably likely to have a material adverse effect on the Company

– Disclosure is only required if risk is present– However, consideration should be given to whether positive disclosure

should be implemented even if such risk is not present

Thus, every year the Company must perform a risk assessment

This issue is more about “process”– Assemble the team– Review existing compensation policies, programs and arrangements– Look for arrangements that could incentivize individuals to take great risks

that could threaten the value of the Company– Analyze the results– Change any policies, programs or arrangements that create such risk

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