1 Quality in Everything We Do e Identifying the Risks in Compensation and Incentive Plans Human Capital Quality in Everything We Do e Susan Marcille Practice

1Quality in Everything We Do

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Identifying the Risks in Compensation and Incentive Plans

Human Capital

Quality in Everything We Do

e

Susan Marcille

Practice Leader

Susan Marcille

Practice Leader


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Today’s Environment

Increased Risk

Heightened focus on corporate controls

Increased legal and regulatory

complexity

Restatements of corporate

financials

Occurrences of corporate fraud

and scandal

Increased litigation and

media attention

As a result of heightened focus on issues

of corporate governance, companies are

increasingly turning their attention to the

potential risks and exposure associated

with their compensation policies and

practices.


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Administration

Recruiting

Benefits

Compensation

HR Operations

Cost Issues

SOX 404

HR Risk

Fiduciary

Administration

Recruiting

Benefits

Compensation

HR Operations

100%Resource Capacity

Yesterday’s HR Function

Operations and Outsourcing

Regulatory Issues

Strategic HR

Operations and Outsourcing

Regulatory Issues

Strategic HR

Global

Expectations and Demands

AJCA

Today’s HR Function

Today’s HR Function


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Potential High Risk Areas

Due to increased potential for exposure to risk

attention has turned to the

following areas:

High

Exposure

Deferred Compensation

Plans

Executive Use of

Company Aircraft

Compensation Committee

Executive Compensation


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Deferred Compensation Plans


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Deferred Compensation Plans-409A

High

Exposure


Plans

Executive Use of

Company Aircraft



• Enacted as part of the American Jobs Creation Act of 2004

• Provides new compliance rules for the deferral of compensation under a nonqualified deferred compensation (NQDC) plan, including:

• The timing of elections to defer compensation

• When distributions from a NQDC plan may be made

• Special rules for equity compensation plans

• Violation of the rules results in current taxation of amounts deferred, 20% additional income tax, and potential assessment of interest

• New rules are effective for NQDC that is either earned or vested after 2004

Background


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Background (cont’d.)

• Initial guidance was provided in Notice 2005-1, issued on December 20, 2004 • Definitions • Transition relief through (including a plan amendment deadline of) December 31, 2005

• Proposed regulations were issued on September 29, 2005 • Clarifications/modifications of definitions • Guidance on operational rules relating to timing of

elections and distributions• Extension of the plan amendment deadline and

certain other transition relief through December 31, 2006 High

Exposure


Plans

Executive Use of

Company Aircraft




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• An initial election to defer compensation must be made before the beginning of the taxable year in which services are performed

• An election for performance-based compensation based on the performance of services over a 12-month period or longer must be made at least six months before the end of the service period

• A 30 day rules applies to new participants; new legally binding rights

• An employee may make subsequent deferral elections and/or change the payment form

• Such election must be ineffective until the expiration of 12 months after the date the election is made, made at least 12 months prior to the first scheduled payment, and be for a minimum of five years from originally selected date..

General Rules for Timing of

Deferral Elections

High

Exposure


Plans

Executive Use of

Company Aircraft




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• The timing and schedule of any payment under the plan cannot be accelerated, except:

• Acceleration of vesting that does not change the permitted payout events

• Payment to fulfill a domestic relations order, comply with a certificate of divestiture or pay income tax upon vesting under a tax-exempt nonqualified plan

• Cashout of de minimis amounts

• Payment of employment taxes

• Plan termination, change in control

• Distributions are not permitted earlier than:

• Separation from service

• Disability or death

• A specified time or pursuant to a fixed schedule

• The occurrence of an unforeseeable emergency

• A change in ownership or effective control of the employer

General Rules for Distributions

High

Exposure


Plans

Executive Use of

Company Aircraft




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• The term “stock rights” includes stock appreciation rights (SARs) and nonstatutory stock options

• As under the Notice, both stock options and SARs

• Must be granted at no less than FMV

• Cannot have any additional deferral feature

• Parity for private company and public company SARs

• Parity for stock settled and cash settled SARs

General Rules for Equity Compensation –

“Stock Rights”

High

Exposure


Plans

Executive Use of

Company Aircraft




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• Establishing Fair Market Value

• For stock that is readily tradable on an established market:• Last sale before or the first sale after the grant• The closing price on the trading day before, or the trading day, of the grant• Any other reasonable basis using actual transactions and consistently

applied• Also can set the exercise price based on an average of the

price of the stock over a specified period within the 30 daysbefore and after the grant date, provided the commitment togrant is irrevocably established before the measurement

Equity Compensation Exposure Issues

High

Exposure


Plans

Executive Use of

Company Aircraft




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• For all other stock - Reasonable application of a reasonable valuation method• Valuation of tangible and intangible assets• Present value of future cash-flows• Market value of stock or equity interests in similar entities

engaged in substantially similar trades or businesses• Other relevant factors such as control premiums or

discounts for lack of marketability• Whether the valuation method is used for other purposes

that have a material economic effect on the service recipient, its stockholders, or its creditors


High

Exposure


Plans

Executive Use of

Company Aircraft




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• A valuation is not reasonable if:• It doesn’t take into account all available information that is

material to value,• It fails to take into account information available after the date

of the calculation, or• The value was calculated as of a date that is more than 12

months earlier than the date on which the valuation is being used


High

Exposure


Plans

Executive Use of

Company Aircraft




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• Extension of Stock Rights

• If a stock right is extended or renewed, it’s treated as having had an additional deferral feature from the date of grant

• Exception if the extension goes no later than the later of the 15th day of the third month following the date on which the right would have expired, or December 31 of the year the right would have expired

• Exception if the stock right is unexercisable because exercise would violate securities laws

• Other Modifications

• If a stock right is modified in any other way, the modification istreated as the grant of a new stock right

• A modification (other than an extension or renewal) means any change in the terms that may provide the holder with a direct or indirect reduction in the exercise price or an additional deferral feature, regardless of whether the holder in fact benefits


High

Exposure


Plans

Executive Use of

Company Aircraft




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• Identify all plans subject to 409A• SERPS, separation pay, discounted options, phantom stock,

traditional nonqualified deferred compensation.• Analyze the impact of section 409A on plans and on any preliminary

compliance and design decisions • Evaluate any year-end planning and actions relating to the transition

rules that will expire on December 31, 2006

Addressing the Issues

High

Exposure


Plans

Executive Use of

Company Aircraft




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• Re-Evaluate Business Objectives• Review business strategies associated with existing deferred compensation arrangements

in light of emerging compensation practices• Assess deferral arrangements in terms of the company’s current

or emerging compensation strategy • Amend the plans as necessary to comply with 409A • Re-evaluate current program effectiveness

• Cost and Risk Assessments• Understand design features from a risk perspective• Identify areas of noncompliance with required

taxation, accounting, and corporate governance requirements

• Identify key areas of weakness and/or areas for improvement

• Develop appropriate strategies to correct violations

Methodology

High

Exposure


Plans

Executive Use of

Company Aircraft




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• Cost and Risk Assessments (cont’d.)• Provide cost analyses of programs and varying features of the deferred compensation

arrangements• Conduct review and assessment of cash, tax, and financial statements• Work with Compensation Committee to ensure that

risk is minimized and program effectiveness is maximized

• International Implications• Review non-U.S. plans

• Achieve uniformity between U.S. and foreign plans • Evaluate tax implications for employer and employee

• Assess potential impact of proposed plan design changes on non-U.S. plans

Methodology (cont’d.)

High

Exposure


Plans

Executive Use of

Company Aircraft




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• Education• Identify training requirements, resources, and constraints• Educate participants on program changes and impact on their individual plans • Ensure timely communications to shareholders and employees• Define the scope of training required for different company

positions/personnel• Identify personnel who are required to meet

training requirements• Develop educational/training materials

• Establish procedures to ensure for timely revision and updating of training materials


High

Exposure


Plans

Executive Use of

Company Aircraft




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Excessive Executive Compensation


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High

Exposure


Plans

Executive Use of

Company Aircraft



• Executive compensation practices have come under increased scrutiny by the IRS, the SEC, other regulatory entities and the public

• The increased scrutiny has primarily been in response to the belief that corporations were providing excessive compensation arrangements to senior employees

• The new SEC Chairman, Chris Cox, has made executive compensation one of his top priorities

• On January 27, 2006, the SEC released proposed new disclosure requirements for executive and director compensation

• Proposed regulations are 370 pages in total.

• Open for public comment until April 1, 2006.

• Generally believed will not be in effect prior to 2007 proxy season (disclosure of 2006 compensation)

Background


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High

Exposure


Plans

Executive Use of

Company Aircraft



• In response to the belief that corporations were providing excessive compensation arrangements to senior employees upon a change of control, resulting in a windfall for the executives at the expense of the shareholders, Code Sections 280G and 4999 were enacted in response to the perceived abuse

Background (cont’d)


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• Reasonable Compensation

• Only reasonable compensation paid to employees may be deducted as a compensation expense by the company

• Determination of whether compensation is reasonable requires an analysis of the particular facts and circumstances

• Compensation in Excess of $1 Million

• Subject to certain exceptions, a publicly held corporation may not deduct employee compensation in excess of $1 million per taxable year paid to certain employees (Code Section 162(m))

• The $1 million limit is reduced by any excess parachute payments under Code Section 280G that are not deductible by the company

General Rules

High

Exposure


Plans

Executive Use of

Company Aircraft




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• Compensation in Excess of $1 Million (cont’d.)

• Section 162(m) only applies to: (1) the company’s chief executive officer (“CEO”), or individual acting in such capacity, as of the end of the taxable year; or (2) any employee employed as of the end of the year whose total compensation for the employee’s taxable year is required to be reported to the company’s shareholders under the Securities Exchange Act of 1934 by reason of the employee’s being among the four highest paid officers for the taxable year (other than the CEO)

• The limitation does not apply to certain types of compensation, such as performance-based compensation, commissions, contributions to a qualified retirement plan (including salary reduction contributions), and amounts that are excludible from the covered employee’s gross income (e.g., tax-favored employee welfare benefits)

General Rules (cont’d.)

High

Exposure


Plans

Executive Use of

Company Aircraft




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• Golden Parachute Payments

• If a company provides compensation contingent on the change in control in excess of described limits, a portion of those payments will be subject to a 20% excise to the individual, and the company will be disallowed a deduction for the same amount

• This excise tax is in addition to ordinary income and employment taxes otherwise due

• In addition to the excise tax levied on the disqualified individual receiving an excessive parachute payment pursuant to Section 4999, the organization loses their tax deduction under Section 280G on the payments in excess of the base amount, which are subject to the 20% excise tax

General Rules (cont’d.)

High

Exposure


Plans

Executive Use of

Company Aircraft




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• Reasonable Compensation

• Establish procedures to assess the reasonableness of compensation paid to company employees

• Identify those employees whose compensation may not meet a reasonableness standard

• Develop remediation procedures to address potential areas of risk

• Establish procedures for addressing IRS challenges on the reasonableness of compensation, including responses to IRS inquiries, identification of those parties (internal and external) who are responsible for communicating with IRS personnel, etc.

Methodology

High

Exposure


Plans

Executive Use of

Company Aircraft




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• Compensation in Excess of $1 Million

• Establish procedures to identify whether the limitation on the deductibility of compensation applies to the company and, if so, to which individuals such limitation is to be applied

• Establish procedures for tracking elements of compensation in order to identify the amount of annual “compensation” received by certain individuals, paying particular attention to amounts that may be deemed performance-based compensation

• Ensure documentation of all compensation tracking

• Establish procedures to ensure that any limitation on the deductibility of compensation takes into account the impact excess parachute payments may have


High

Exposure


Plans

Executive Use of

Company Aircraft




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• Golden Parachute Payments

• Establish procedures for the identification of possible strategies to mitigate the impact of Code Section 280G, including identification of potential alternatives for reduction of the impact of Section 280G on the individual (e.g., gross-up payments, identification of reasonable compensation for services performed, cutback provisions, etc.)

• Establish procedures for identifying who within the organization is eligible to receive payments upon a change in control and, if so, what types of payments are to be received

• Identify inconsistencies in the definition of a change in control that exist among the company plans

• Establish a written policy providing that the company shall have the discretion to appoint one firm to do the calculations to avoid high costs and risks


High

Exposure


Plans

Executive Use of

Company Aircraft




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Executive Use of Company Aircraft


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• Notice 2005-45 issued by the IRS in May 2005

• Provides the IRS’ interpretation of changes provided by the American Jobs Creation Act of 2004

• Provides guidance on the new rules for determining the amount of deduction disallowance under Code Section 274 for the entertainment, amusement, or recreational use of a company-provided aircraft by certain company employees

• Prior to this new rule, companies had been allowed to deduct the full value of entertainment flights taken by certain company employees

Background-New Deduction

Disallowance Rules

High

Exposure


Plans

Executive Use of

Company Aircraft




e

• A company’s deduction for the use of a company-provided aircraft by certain company employees (e.g., company executives and their guests) is disallowed to the extent not included in the employee’s income or reimbursed by the employee

• In determining the amount subject to the disallowance, employers are required to allocate all costs of maintaining and operating an aircraft between the number of seats or miles of specific individuals for entertainment use and those for non- entertainment use (e.g., business or non- entertainment personal use such as commuting)

• New IRS method for deduction disallowance rules is effective beginning July 1, 2005

General Rule


High

Exposure


Plans

Executive Use of

Company Aircraft




e

• Administrative Oversight and Compliance

• Monitor purpose of flights on company-provided aircraft

• Work with company personnel to establish procedures for ensuring the purpose of flights on company-provided aircraft by certain employees is properly categorized as either business, personal/ entertainment, or personal/non-entertainment

• Ensure the purpose of each flight is documented and maintained

• Establish protocols whereby flight purpose is communicated to appropriate company personnel

• Develop appropriate strategies to correct violations

Methodology


High

Exposure


Plans

Executive Use of

Company Aircraft




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• Administrative Oversight and Compliance (cont’d.)

• Calculate seat miles/seat hours for allocation purposes

• Establish procedures whereby the number of miles flown and/or the number of total aircraft seats is tracked for each flight (business and entertainment) taken during the year

• Identify aircraft that may be aggregated for tracking purposes

• Ensure the purpose of each flight is documented and maintained



High

Exposure


Plans

Executive Use of

Company Aircraft




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• Administrative Oversight and Compliance (cont’d.)

• Determine value of entertainment flights for income inclusion

• Adopt a company-wide policy for determining the value of entertainment flights by certain company employees and their guests

• Establish procedures to capture factors impacting the value of entertainment flights; factors include:

• Distance of each one-way flight (measured in statute miles)

• Date of each one-way flight

• Type of employee to whom each flight is attributed (control vs. non-control employee)

• Weight of the aircraft

• Establish procedures to ensure the amount included in income correctly corresponds with the deduction amount



High

Exposure


Plans

Executive Use of

Company Aircraft




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• Policies and Disclosures

• Disclosure requirements

• Identify those disclosure requirements that may include the valuation of entertainment flights by certain company employees

• Establish procedures for the proper calculation of the amounts to be disclosed (e.g., disclosure of flights pursuant to SEC requirements is to be based on the incremental cost of the flight)

• Monitor internal procedures to ensure accurate and timely disclosure

• Company policy regarding aircraft usage

• Assess feasibility of a company-wide policy regarding the usage of entertainment flights by company personnel

• Identify a standard method of valuing all entertainment flights to ensure consistency



High

Exposure


Plans

Executive Use of

Company Aircraft




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• Policies and Disclosures (cont’d.)

• Education

• Identify those individuals whose responsibility it is to monitor and/or document flights for purposes of income inclusion and deduction disallowance

• Monitor legislative/regulatory changes that may impact valuation methodologies

• Ensure routine training of key company personnel



High

Exposure


Plans

Executive Use of

Company Aircraft




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High

Exposure


Plans

Executive Use of

Company Aircraft



• The role of the compensation committee in the overall corporate governance initiative has increased in importance over the last few years

• Members of the compensation committee serve as fiduciaries who engage in arms’ length negotiations of executive compensation arrangements

• Duties of the compensation committee members include:• Strengthen general oversight and governance of the

board of directors• Promote and protect shareholders’ interests• Develop and review executive compensation plans

for executive management staff• Ensure that pay levels are positively correlated

with company performance • Establish salaries that are positioned appropriately

with respect to the competitive market • Communicate with the board of directors, shareholders,

and employees

Background


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• Composition• Work with company personnel to establish guidelines for the creation and composition of

the committee• Ensure that committee members have clear independence from management team • Develop a process for monitoring the independence of

the compensation committee members• Establish procedure for nomination and selection of the

compensation committee members• Ensure that selected compensation committee

members possess the correct qualifications to adequately address the company’s needs

• Develop standard criteria as it relates to (i) integrity, (ii) accountability, and (iii) informed judgment

• Establish standard criteria as it relates to (i) industry knowledge, (ii) business judgment, (iii) leadership skills, and (iv) technical proficiency in the areas of finance, accounting, and management

Methodology

High

Exposure


Plans

Executive Use of

Company Aircraft




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• Composition (cont’d.)

• Determine whether committee members are nominated by independent directors

• Develop procedure for investigating nominees’ backgrounds and reviewing qualifications

• Ensure that committee structure complies with SEC regulations

• Operations

• Work with company personnel to establish guidelines for operations of committee

• Identify areas over which the committee has authority

• Develop procedures for the development, review, and approval of executive compensation arrangements

• Document the committee’s guidelines for the design of executive compensation plans

• Develop and implement policy regarding amount and scope of committee’s authority to hire or terminate outside advisors who assist with evaluation of executive compensation arrangements


High

Exposure


Plans

Executive Use of

Company Aircraft




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• Operations (cont’d.)• Test current committee practices to ensure compliance with company policies and objectives• Assess whether committee practices and policies align with shareholder interests• Ensure that executive compensation plan meets statutory and regulatory requirements

(domestic and foreign)• Define reporting protocols for the committee

• Establish communication program between the committee and (i) management team, (ii) board of directors, (iii) shareholders/investors, and (iv) employees

• Objectives• Work with company personnel to develop and/or assess

company objectives as they relate to committee operations • Meet with committee members to discuss roles and

responsibilities• Develop and execute charter that summarizes

role of the committee & its members


High

Exposure


Plans

Executive Use of

Company Aircraft




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• Objectives (cont’d.)• Establish factors to be considered in establishing committee objectives

• Assess the desired mix of cash and equity awards • Evaluate goals for distribution of the awards throughout the company • Compare executive salaries to the salaries of other

employees in the company• Draft and/or review executive compensation

provisions within employment contracts• Establish procedures requiring regular reporting to the

board of directors• Ensure that the board of directors periodically assesses

whether the committee is meeting its objectives• Determine whether compensation plans are cost-effective

• Analyze tax/financial consequences of executive compensation arrangement for company and its executives

• Address ways to minimize tax/financial burden


High

Exposure


Plans

Executive Use of

Company Aircraft




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• Organization

• Work with company personnel to conduct organizational analysis

• Identify areas that may be administratively problematic

• Explore ways to restructure compensation arrangements to mitigate risk

• Determine whether salary levels accurately reflect overall company performance

• Ensure that there is a direct connection between the executive’s salary and his contribution to achievement of organizational goals

• Establish procedures to review salary determinations and adjustments on an annual (or otherwise regular) basis

• Assess whether the executive compensation arrangement aligns with the company’s overall business and governance strategies


High

Exposure


Plans

Executive Use of

Company Aircraft




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• Market• Work with company personnel to conduct market analysis

• Assess whether executive salaries align with salary packages for executives in comparable organizations

• Analyze data samples of organizations with similar profiles in size, revenue, product or service line, etc.

• Analyze any distinguishing characteristics of the company that may warrant a compensation package that does not align with competitors (e.g., unusually high/low overhead, unique product/service offering, etc.)

• Analyze the compensation policies and practices of competitors

• Ensure that the company’s compensation practices are competitive in the market (domestic and global)


High

Exposure


Plans

Executive Use of

Company Aircraft




e

• Susan is the Mid Atlantic Area Practice Leader for the Human Capital Performance and Reward Practice.

• Susan specializes in advising on the financial and tax aspects of executive compensation and has 20 years of experience in the design and implementation of total compensation programs.

• Susan has extensive experience with compensation issues relating to mergers and acquisitions, initial public offerings and other strategic business transactions.

• In addition to assisting companies with strategic compensation and organizational issues, she is a frequent speaker and leads seminars and workshops for professional organizations and employer-sponsored programs. She has appeared on radio and television programs, has contributed to various magazines and has been a member of the editorial board for the annual bestseller, The Ernst & Young Tax Guide. She is also a contributing author for The Ernst & Young LLP Guide to the IPO Value Journey.

Susan H. MarcillePartner – Ernst & Young Mid Atlantic Area Practice LeaderHuman Capital – Executive Compensation


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Documents

1 Quality in Everything We Do e Identifying the Risks in Compensation and Incentive Plans Human Capital Quality in Everything We Do e Susan Marcille Practice