Executive Compensation Clawbacks: Emerging Law

and Tax Treatment

Rosina B. BarkerIvins, Phillips & Barker

1700 Pennsylvania Ave., N.W.Washington, DC 20006

(202) 662-3420rbarker@ipbtax.com

GEO National Equity Compensation ForumRancho Palos Verdes, CA

September 21, 2012

What is a Clawback?Recoupment of compensation, traditionally upon violation of law, contract or company policy

Sources of clawback requirements

• Company policies

• Federal statutes• Sarbanes-Oxley Act of 2002 § 304• Emergency Economic Stabilization Act of 2008 § 111• Dodd-Frank Wall Street Reform and Consumer Protection Act § 954

• Federal agency enforcement policy

• Shareholder suits

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Company PoliciesTraditional clawbacks for enforcement of traditional company policies

• Covenants not to compete• “Bad boy” clauses

Clawbacks as tools of corporate governance

Poster children for the emerging doctrine:• USB – intended clawback of incentive compensation for “rogue” traders • July 13, 2012 – JP Morgan announces clawbacks of compensation from traders

whose trades -- made with consent of company -- accounted for estimated $5 billion trading loss

• Mercer study: 14% of global banking organizations carried out the clawing back of compensation payments in 2011, with a further 3% reclaiming payments without having yet received the funds (based on a sample of 29 banks

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Sarbanes Oxley (“SOX”) Act of 2002 § 304

Clawback of certain incentive and equity based compensation from CEO, CFO in the event of “misconduct” leading to restatement

Statute says:

• “If an issuer is required to prepare an accounting restatement due to the material noncompliance of the issuer, as a result of misconduct, with any financial reporting requirement under the securities laws, the chief executive officer and chief financial officer of the issuer shall reimburse the issuer for –

(1) any bonus or other incentive-based or equity-based compensation received by that person from the issuer during the 12-month period following the first public issuance or filing with the Commission (whichever first occurs) of the financial document embodying such financial reporting requirement; and

(2) any profits realized from the sale of securities of the issuer during that 12-month period.”

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SEC Enforcement of SOX ClawbacksSEC: SOX § 304 applies to CEO and CFO even absent personal participation in

“misconduct” leading to accounting restatement. Examples:

• SEC v. Jenkins, 718 F.Supp.2d 1070 (D. Ariz. 2010)• Court held that company’s “misconduct” leading to accounting restatement sufficient to permit SOX §

304 clawback; “specific misconduct “ of CEO or CFO not required. Settled November 2011; defendant repaid $2.8 million to the company.

• SEC v. O’Dell, Case 1:10-cv-00909-PLF (D.D.C. June 2, 2010)• SEC sought reimbursement of $470,016 in cash bonuses, plus stock and stock options, without

alleging misconduct by defendants. Settled without admission

• SEC v. Baker, Civil Action No. 1:12-cv-00285 (W.D. Tex.)• April 2, 2012, SEC filed section 304 action against former CEO and CFO of company forced to restate

earnings, without alleging that defendants participated in misconduct July 13, 2012, defendants moved to dismiss, arguing that section 304 unconstitutional as applied to them. Motions are currently set for hearing.

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Emergency Economic Stabilization Act § 111Section 111 of the Emergency Economic Stabilization Act of 2008, as amended by the American Recovery and Reinvestment Act of 2009:

• Requires all TARP fund recipients to include, as part of “appropriate” compensation standards, “provision for the recovery of any bonus, retention award, or incentive compensation paid to a senior executive officer and any of the next 20 most highly-compensated employees based on statements of earnings, revenues, gains, or other criteria that are later found to be materially inaccurate.”

Evolving theory since enactment of SOX clawbacks: Unjust enrichment. Employees must return compensation because overpaid, without regard to wrongdoing by any party

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Dodd-Frank Wall Street Reform and Consumer Protection Act § 954As condition of being listed on national securities exchange, every company must have policy requiring that

• “if the issuer is required to prepare an accounting restatement due to the material noncompliance of the issuer with any financial reporting requirement under the securities laws, the issuer will recover from any current or former executive officer of the issuer who received incentive-based compensation (including stock options awarded as compensation) during the 3-year period preceding the date on which the issuer is required to prepare an accounting restatement, based on the erroneous data, in excess of what would have been paid to the executive officer under the accounting restatement”

Not effective until SEC issues regulations – no timetable for issuance

No wrongdoing required – affected employees must return excess over what would have been paid had financials been stated correctly

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Federal Agency Enforcement PolicyFederal regulators weigh in – clawback policies adopted by companies as corporate

governance tools pursuant to settlement of civil or criminal claims

• July 2, 2012 – Justice Department announced settlement with GlaxoSmithKline LLC (“GSK”) which agreed to plead guilty and pay $3 billion to resolve criminal and civil liability arising from unlawful promotion of certain prescription drugs, failure to report safety data, and false price reporting practices

• As part of settlement, a Corporate Integrity Agreement (“CIA”) provides:

“GSK shall establish and maintain throughout the term of this CIA a financial recoupment program that puts at risk of forfeiture and recoupment an amount equivalent to up to 3 years of annual performance pay (i.e., annual bonus, plus long term incentives) for an executive who is discovered to have been involved in any significant misconduct (Executive Financial Recoupment Program).”

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Shareholder Suits“Say on Pay” – Shareholders sue for fiduciary breach, unjust enrichment when pay is

awarded contrary to shareholders “say on pay” advisory vote

• First and so far only case to survive motion to dismiss: Cincinnati Bell, Inc. (NECA-IBEW Pension Fund v. Cox, Case No. 1:11-cv-451) September 21, 2011, Federal District Court for S. District of Ohio. (Dismissed July 2012 because parties settled related state court action)

• Later cases have not followed Cincinnati Bell. Motions to dismiss granted in. e.g.,• Biomed Realty Trust, Inc.(Weinberg v. Gold, 838 F. Supp. 2d 355;D.MD

2012)• Navigant Consulting, Inc. (Gordon v. Goodyear, 2012 U.S. Dist. LEXIS

97623 (N.D. Ill , July 13, 2012))• Umpqua Holdings Corp. (Plumbers Local No. 137 Pension Fund v. Davis,

2012 U.S. Dist. LEXIS 22976 (D. Ore., February 23, 2012)

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Shareholder Suits (continued)Code section 162(m): Generally, compensation of certain top-paid officers in excess of $1 million not deductibleunless “incentive based”

• Shareholders sue for fiduciary breach, unjust enrichment on grounds that pay fails to qualify for section 162(m) deduction

• Shareholders as private IRS agents –• Suits generally allowed to proceed only if Ps successfully allege that proxy is

misleading because (i) proxy states that pay is deductible under 162(m) and (ii) Ps successfully show that pay may fail to satisfy 162(m) requirements

• COMPARE Freedman v. Adams(2012 Del. Ch. LEXIS 74March 2012)- dismissed. There is no “general fiduciary duty to minimize taxes.”

• WITH Resnik v. Woertz(774 F. Supp. 2d 614(D.Del. 2011) Motion to dismiss denied . “Misrepresentations and omissions “ in proxy statement.

• SEE latest entrants: Caterpillar, Inc. suits filed August 27,2012 , Delaware Federal District Court (Asbestos Workers Phil. Pension Fund v. Calhoun, 1:12-cv-01077-UNA; City of Lansing Police and Fire Retmt. System, 1:12-cv-01076-UNA)– Allege technical failures of 162(m) requirements, demand disgorgement of certain pay

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Issues in the Tax Treatment of Compensation Clawbacks

• Basics• Retroactive clawbacks• “Bad boy” clawbacks• 409A issues• Other former employee issues• Employer stock• FICA tax recoupments

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Repaying Compensation in the Same Year - EasyRepayment in same year as payment – treated as if never paid

EXAMPLE 1• 2012 compensation = $100 base + $10 bonus paid February 15, 2012• $10 bonus repaid December 1, 2012• Employer reports $100 as wages and income on Employee’s W-2 for 2012

Same tax treatment applies whether $10 repayment is set-off from other wages in 2012, or paid directly by check

Couch v. Commissioner, 1 B.T.A. 103 (1924), acq. 1925-1 C.B. 1 (1925), Russel v. Commissioner, 35 B.T.A. 602 (1937), acq. 1937-1 C.B. 22; Rev. Rul. 79-311, 1979-2 C.B. 25

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Repaying Compensation in Later Year –Hard Revenue Ruling 79-311EXAMPLE 2

• Employee receives $100 thousand bonus in 2010• Employee repays $100 thousand bonus in 2012, when pay = $500 thousand, by

having repayment set-off against compensation otherwise payable2010 tax return

• Employee cannot amend 2010 tax return, under “claim of right” doctrine2012 tax return under Revenue Ruling 79-311

• Net compensation paid in 2012 = $400 thousand• W-2 income and wages = $500 thousand• Employee deducts $100 thousand as miscellaneous itemized deduction

But 2012 deduction is limited by• 2% floor• Alternative minimum tax (AMT)

Employee claims section 1341 relief to avoid 2% floor and AMT

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What If Revenue Ruling 79-311 Is Not Followed?EXAMPLE 3

• Employee receives $100 thousand bonus in 2010• Employee repays $100 thousand bonus in 2012, when pay = $500 thousand, by

having repayment set-off against compensation otherwise payable2010 tax return

• Employee cannot amend 2010 tax return, under “claim of right” doctrine2012 tax return – Revenue Ruling 79-311 not followed

• Net compensation paid in 2012 = $400 thousand• W-2 income and wages = $400 thousand• Itemized deduction neither needed nor appropriate

Some support exists for this reporting and withholding position. But issue is not free from doubt and Employer is at some risk for under-withholding tax and penalties

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Section 1341 Eliminates 2% Floor and AMTSection 1341 allows “make-whole” treatment of paid back amount

Employee taxpayer gets “better of” • Deduction for year of repayment (without 2% floor or AMT) or• Credit equal to additional tax in year of payment • Both deduction and credit approach eliminate 2% floor and AMT

Statute • Repayment over $3,000• Deductible under another Code section• It appeared that taxpayer had unrestricted right to payment in year of payment• Established after the close of the year that taxpayer did not have right to payment

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Section 1341 – Inconsistent IRS Rulings“ Subsequent event” test

• Section 1341 applies only if taxpayer had “apparent” but not “actual” right to payment when first received

• Accordingly, section 1341 is not available if taxpayer had actual right to payment when received, and right is defeased by a subsequent event

IRS does not apply subsequent event test consistently• Is an earnings restatement a subsequent event? • Compare Revenue Ruling 67-437, 1967-2 CB 296 (when salary repaid following

IRS determination that salary was “unreasonable,” held, section 1341 not available because IRS determination was subsequent event) with TAM 9516002 (under similar facts, held, section 1341 applies because IRS determination is discovery of “facts in existence” at time of payment, and not a “subsequent event”). See also Revenue Ruling 68-153, Situation 3

• Some rulings don’t apply subsequent event test. Revenue Ruling 72-78, 1972-1 CB 45; Revenue Ruling 2004-17, 2004-1 CB 516

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Section 1341 – Case LawSame circumstances test

• Section 1341 applies if original payment made because of specified “circumstances, terms and conditions,” and repayment made because those “circumstances, terms and conditions” were not satisfied

• Under this view, IRS subsequent-event test is wrong

• Dominion Resources v. U.S., 219 F.3d 359 (4th Cir. 2000); Pahl v Commissioner,67 TC 286 (1976); Uhlenbrock v Commissioner, 67 T.C. 818 (1977); Kraft v. United States, 991 F.2d 292 (6th Cir. 1993); Alcoa, Inc. v. United States, 509 F.3d 173 (3d Cir. 2007)

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Section 1341 – The Two Tests IllustratedEXAMPLE 4 - Clawback Upon Earnings Restatement

• Employee receives $100 thousand bonus in 2010 based on 2009 EBIDT• Employee repays bonus in 2012 when 2009 earnings are restated • Employee claims $100 itemized deduction of Form 1040 for 2012

• Does section 1341 apply? • Unclear under Revenue Ruling 67-437 (restatement might be a “subsequent

event”)• Yes under TAM 9516002 and Revenue Ruling 68-153, Situation 3

(subsequent administrative determination is later discovery of facts in existence at time of original payment, and not a subsequent event)

• Yes under Revenue Ruling 72-78 and Revenue Ruling 2004-17 (subsequent event test does not apply)

• Yes under Dominion Resources and similar cases (clawback arises from same circumstances as original payment)

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Section 1341 – The Two Tests Illustrated (cont.)EXAMPLE 5 - Retroactive Clawback

• Employee receives $100 thousand bonus in 2010 based on 2009 EBIDT• Employer announces new clawback policy in 2012, and requires repayment of

bonus paid in 2010 because of restatement of 2009 earnings.• Employee repays 2010 bonus in 2012 under newly announced clawback policy• Is itemized deduction available?

• Probably yes – repayment is not “voluntary,” even though policy is retroactive• Does section 1341 apply?

• Unclear under Revenue Ruling 67-437, TAM 9516002, Revenue Ruling 68-153. Did employee have “unrestricted “ or “actual” right to 2010 bonus payment because clawback policy was not then in effect? Or did employee not have actual right because, had 2009 earnings been correctly stated, no bonus would have been paid?

• Probably yes under Revenue Ruling 72-78 and Revenue Ruling 2004-17 (subsequent event test does not apply)

• Probably yes under Dominion Resources and other cases (clawback arises from same circumstances as the original payment, i.e., assumptions about 2009 earnings)

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Section 1341 – The Two Tests Illustrated (cont.)EXAMPLE 6 -- Clawback for Subsequent Breach

• Employee receives a severance benefit contingent on honoring covenant not to compete, and one year later breaches covenant by entering employment with competitor -- Bonus is clawed back

• Is itemized deduction available? • Yes under section 165(c)(1). See Revenue Ruling 67-48, 1967-1 CB 5

• Is Section 1341 relief available?• Arguably no under subsequent event test. See Revenue Ruling 67-48

(section 1341 does not apply to repayment as liquidated damages for subsequent contract breach)

• Probably yes under Revenue Ruling 72-78 and Revenue Ruling 2004-17 (subsequent event test does not apply)

• Probably yes under Dominion Resources and other cases (clawback arises from same circumstances as the original payment, namely, contingency on which original payment was based turned out not to materialize) 20

409A Issues Raised by Set-OffsSection 409A – prohibited-substitution rule

• If clawback is paid by set-off against nonqualified deferred compensation, Section 409A may be violated unless set-off included in income under Revenue Ruling 79-311 at same time that compensation originally scheduled to be paid

EXAMPLE 7• Employee receives $100 thousand bonus in 2010, subject to clawback in 2012• Employee is owed $500 thousand SERP benefit (which is nonqualified deferred

compensation under section 409A) in 2012• $100 thousand bonus repayment obligation is set-off from SERP benefit• Net SERP benefit paid in 2012 is thus $400 thousand.• Employer reports $500 thousand SERP benefit (rather than net $400 actually

paid) on employee’s 2012 Form W-2 or 1099 under Revenue Ruling 79-311 Permitted under Section 409A?

• Yes. Taxable income inclusion is “payment” under 409A. Full $500 thousand SERP benefit is “paid” in 2012 as scheduled, in compliance with 409A.

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409A Issues Raised by Set-Offs (cont.)

EXAMPLE 8• Same as Example 7 except that $100 thousand repayment obligation must be

satisfied in 2012, and $500 thousand SERP benefit is payable in 2015• 2015 SERP payment is reduced to $400 thousand, to effectuate $100 thousand

repayment obligation due in 2012• Employer reports $400 thousand net SERP benefit actually paid on employee’s

Form W-2 or 1099 filed for 2015• This is a prohibited acceleration under section 409A, because $100 thousand of

SERP benefit payable 2015 is accelerated to pay obligation due in 2012

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Clawbacks of Section 83 PropertyEXAMPLE 9 -- Stock Price Rises – No 83(b) Election

• Employer stock is transferred to Employee when FMV = $90• Employee pays nothing for stock and makes no section 83(b) election• Stock vests when FMV = $100, Employee takes $100 into income • Stock is clawed back after vesting, when FMV = $110• Since the shares are forfeited pursuant to a lapse restriction after

substantial vesting, Employee takes an ordinary loss deduction equal to basis in the property, here the $100 FMV at vesting

• Section 1341 applies to $100 loss (if otherwise available)

Note 1: Examples 9-12 assume that clawback requires repayment of same number of shares as transferred. Dodd-Frank clawbacks of equity compensation may require different computation.

Note 2: In Examples 9-12, all dollar figures assumed to be in $1,000’s

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Clawbacks of Section 83 Property (cont.)EXAMPLE 10 -- Stock Price Falls – No 83(b) Election

• Employer Stock is transferred to Employee when FMV = $90• Employee pays nothing for stock and makes no section 83(b) election• Stock vests when FMV = $100, Employee takes $100 into income• Stock is clawed back after vesting, when FMV = $80• Employee claims an ordinary loss deduction equal to basis (i.e, $100) • Section 1341 treatment may be more restricted. When computing the prior year’s

tax as if the employer stock had never been transferred (under section 1341(a)(5)(B)), Employee is permitted to include only FMV of the shares restored ($80) rather than FMV included in income at the time of vesting ($100)

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Clawbacks of Section 83 Property (cont.)EXAMPLE 11 -- 83(b) Election – Employee Does Not Pay For Shares

• Employer stock is transferred to Employee at FMV = $90• Employee pays nothing for stock• Employee makes a section 83(b) election and takes $90 into income• Stock is clawed back before it vests• Employee can claim deduction only for amount paid for shares – i.e, no deduction• Employee cannot claim section 1341 relief

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Clawbacks of Section 83 Property (cont.)EXAMPLE 12 -- 83(b) Election -- Employee Pays For Shares

• Employer stock is transferred to Employee at FMV = $90• Employee pays $10 for stock• Employee makes 83(b) election and takes $80 into income (= $90 - $10)• Stock is clawed back before it vests• Employee claims capital loss deduction for $10 amount paid for shares (but not

for $80 taken into income)• Section 1341 applies only for $10 capital loss

Note: if clawback occurs after “substantial vesting,” no loss deduction is available

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Recovering FICA taxesClaim of right doctrine does not apply to FICA taxesUse procedures under Code section 6413 for erroneous overpaymentsEmployer recoups FICA taxes withheld by filing Form 941-X within statute of limitations (3

years after filing original Form 941)Employer must repay employee’s share of withheld FICA taxes to employee, by reducing

FICA taxes withheld from other wages, or directlyAlso Employee must repay compensation to Employer

• Does employee have to repay gross payment, or payment net of FICA taxes already withheld?

• Answer not entirely clear but recent IRS guidance suggests repayment of net amount is sufficient

Restoration of withheld income taxes similar, but limited to year of overpayment

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