A Primer on the Impact of the New Economic Stimulus Laws and IRC §409A on Executive Compensation in Mergers and Acquisitions

A Primer on the Impact of the New Economic Stimulus Laws and §409A on Executive Compensation in Mergers and Acquistions Paul E. Starkman ARNSTEIN & LEHR LLP 120 SOUTH RIVERSIDE PLAZA | SUITE 1200 CHICAGO, IL 60606 P 312.876.7890 | F 312.876.0288 [email protected]

ABOUT PAUL E. STARKMAN

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Paul E. Starkman Paul E. Starkman is the Chair of the Labor & Employment Law Practice Group at Arnstein & Lehr LLP in Chicago, Illinois. He assists clients who are employers and executives on a broad range of corporate transactions, executive compensation and employee benefit issues, and employment-related litigation. He is a fellow of the College of Labor and Employment and a co-chair of the Contingent Worker Sub-committee of ABA Employment Rights & Responsibilities Committee. Mr. Starkman frequently speaks on employment issues at conferences throughout the country and has been published extensively. Most recently, he is a principal author of Employment Arbitration: Law and Practice (West/Thomson 2007-2008).

Paul E. Starkman Arnstein & Lehr LLP

120 South Riverside Plaza Suite 1200

Chicago, Illinois 60606 (312) 876-7890

(312) 343-1220 (Cell) [email protected]

PAUL E. STARKMAN | A PRIMER ON THE IMPACT OF THE NEW ECONOMIC STIMULUS LAWS

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I. The New Economic Stimulus Laws: The American Recovery and Reinvestment Act of 2009 ("ARRA"), the Emergency Economic Stabilization Act of 2008 ("EESA"), and the Troubled Assets Relief Program ("TARP")

A. Introduction

i. On February 17, 2009, the American Recovery and Reinvestment Act of 2009 ("ARRA") or the Economic Stimulus Bill became law and expanded the executive compensation requirements previously imposed under the Emergency Economic Stabilization Act of 2008 ("EESA") and the Troubled Assets Relief Program ("TARP"). ARRA's executive compensation restrictions apply to any entity that has received or will receive financial assistance under TARP (a "TARP Recipient") and generally will continue to apply for as long as any TARP financial assistance obligation remains outstanding, other than government-held warrants (the "TARP Assistance Period"). The ARRA restrictions are not limited to recipients of the TARP Capital Purchase Program, but rather they potentially apply to anyone participating in any TARP program or the Financial Stability Plan announced on February 10, 2009, unless participation is solely connected to loan modification programs under Section 109 of EESA.

ii. ARRA imposes a more comprehensive set of executive compensation restrictions on all TARP Recipients that depend on the nature of the assistance received by a TARP Recipient. The ARRA rules are a combination of some of EESA's prior executive compensation rules, prior Treasury guidance, and a number of the proposed executive compensation guidelines announced by the Treasury Department on February 4, 2009 (the "Treasury Guidelines"). ARRA left in place EESA's tax deductibility and excise tax provisions, but the $500,000 annual compensation limit under the Treasury Guidelines for certain TARP Recipients was not included in ARRA.

B. ARRA’s General Standards. ARRA requires TARP Recipients to meet the following executive compensation and corporate governance standards during the TARP Assistance Period:


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i. Any compensation plan that encourages any senior executive officer to take unnecessary and excessive risks that threaten the value of the institution, or that encourages the manipulation of reported earnings, is prohibited.

ii. A claw-back provision allowing the TARP Recipient to recover any bonus, retention award, or incentive compensation paid to a “senior executive officer” and any of its next 20 most highly compensated employees based on statements of earnings, revenues, gains, or other criteria that are later found to be materially inaccurate.

iii. A TARP Recipient's "senior executive officers" are its five most highly paid executives whose compensation is required to be disclosed pursuant to the Securities Exchange Act of 1934 (the "Exchange Act") and its regulations (or, for nonpublic companies, comparable employees).

iv. During the TARP obligation period, golden parachute payments (defined as any payment to a person who departs a company for any reason, except payment for services performed or benefits accrued) are prohibited to any senior executive officer and the next five most highly compensated employees, regardless of the amount of TARP assistance received.

v. ARRA prohibits any compensation plan that would encourage manipulation of the reported earnings of the TARP Recipient to enhance the compensation of any of its employees.

C. Prohibition Against Accrual of Certain Bonus, Retention Award, and Incentive Compensation

i. During the TARP Assistance Period, TARP Recipients are prohibited from paying or accruing any bonus, retention award, or incentive compensation, other than the payment or accrual of long-term restricted stock that:

a. does not fully vest during the TARP Assistance Period; and


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b. has a value not greater than one-third of the total amount of annual compensation of the employee receiving the stock.

ii. The ARRA prohibition against the payment or accrual of bonus, retention awards or incentive compensation applies to different employees of TARP Recipients depending on the amount of financial assistance they receive under TARP:

a. If the financial institution received less than $25 million in financial assistance, only the most highly compensated employee of the institution is subject to the ARRA restrictions.

b. If the financial institution received at least $25 million but less than $250 million in financial assistance, at least the five most highly compensated employees of the institution are covered.

c. If the financial institution received at least $250 million but less than $500 million in financial assistance, the senior executive officers and at least the next 10 most highly compensated employees are subject to the restrictions.

d. If the financial institution received $500 million or more in financial assistance, the senior executive officers and at least the next 20 most highly compensated employees of the institution are subject to the ARRA restrictions.

iii. The Treasury Department can decide to apply the ARRA restrictions to a greater number of employees. In the case of all TARP Recipients, ARRA does not prohibit any bonus payment required to be paid pursuant to a written employment contract executed on or before February 11, 2009.

D. Board Compensation Committee

If they have not already done so, TARP Recipients must establish a Board Compensation Committee that is composed entirely of independent directors; and meets at least semiannually to evaluate the risks posed by employee compensation


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plans to the TARP Recipient. However, if the TARP Recipient's common or preferred stock is not registered and it has received $25 million or less in financial assistance under TARP, these responsibilities are to be carried out by the TARP Recipient's board of directors.

E. Luxury Expenditures Limitation Policy

Each TARP Recipient's board of directors must implement a company-wide policy on excessive or luxury expenditures that may relate to:

• entertainment or events;

• office and facility renovations;

• aviation or other transportation services; or

• other activities or events that are not reasonable expenditures for staff development, reasonable performance incentives, or other similar measures conducted in the TARP Recipient's normal course of business operations.

F. Nonbinding Shareholder “Say on Pay” Votes on Executive Compensation

Each TARP Recipient must permit a separate shareholder vote to approve the TARP Recipient's executive compensation at any annual or other meeting of its shareholders during the TARP Assistance Period, but the vote will not be binding on or overrule any decisions by the TARP Recipient's board of directors, does not create any additional fiduciary duty on the part of the board, and will not restrict the TARP Recipient's shareholders from making proposals in proxy materials related to executive compensation.

G. Treasury Department’s Review of Prior Payments to Executives

The Treasury Department is to review bonuses, retention awards, and other compensation paid to the senior executive officers and the next 20 most highly compensated employees of each entity receiving TARP assistance before the date of enactment of ARRA to determine whether any such payments were inconsistent with


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the purposes of the revised executive compensation requirements or TARP, or were otherwise contrary to the public interest. If the Treasury Department makes such a determination, it is directed to seek to negotiate with the TARP Recipient and the subject employee for appropriate reimbursements to the federal government with respect to compensation or bonuses.

H. Certification of Compliance with ARRA’s Executive Compensation Requirements

As under the Sarbanes-Oxley Act, each TARP Recipient's chief executive officer and chief financial officer (or their equivalents) is required to provide a written certification of the TARP Recipient's compliance with ARRA’s executive compensation requirements to the SEC in its annual filings (or, in the case of a nonpublicly traded company, to the Treasury Secretary).

I. Section 162(m)

Each TARP Recipient is subject to the $500,000 compensation deduction limitation of Internal Revenue Code Section 162(m)(5). Because this Code provision is premised on government acquisitions of assets rather than government stock purchases, it is not clear how it will apply, if at all, to TARP Recipients.

J. Post-ARRA Developments

On March 19, 2009, the United States House of Representatives voted 328-93 to approve H.R. 1586, a bill that will retroactively impose a 90 percent tax on executive bonuses paid after December 31, 2008 by companies that have received over $5 billion in Troubled Asset Relief Program (“TARP”) funds (i.e., AIG, Citigroup and 9 other large institutions).


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II. The Impact of §409A on Executive Compensation in Pre- and Post-Acquisition Settings

A. How Does §409A Affect Mergers and Acquisitions?

i. Enacted in 2004, §409A of the Internal Revenue Code may be the most significant development affecting executive compensation since the passage of ERISA, especially in pre- and post-acquisition settings.

ii. Because the penalties for failing to comply with §409A’s rules on defined compensation arrangements are so onerous (see Section II(C) below), the parties to mergers and acquisitions must be extremely careful about §409A compliance, not only in pre-acquisition stage, but also in the drafting of the acquisition agreement and in the post-acquisition setting. The failure to exercise proper due diligence may cause the parties to lose some of the benefits of the transaction due to unanticipated §409A liabilities and may increase the cost of acquiring (or divesting) a public or private company.

iii. In the pre-acquisition setting, sellers often try to make their companies more attractive to buyers by accelerating, pushing back or eliminating the payment of deferred compensation to employees – which can have significant §409A effects. Likewise, in a post-acquisition, some buyers may want to re-negotiate or terminate deferred compensation arrangements in order to align management with the new owners and eliminate vestiges of what may be viewed as wasteful compensation practices of the old regime.

iv. The potential hidden costs of §409A noncompliance to a buyer include liability for the target company's failure to satisfy its tax withholding obligations with respect to deferred amounts. Unanticipated §409A liabilities may pass through to the buyer for amendments or terminations of benefits that the seller may have imposed or negotiated with its employees. The buyer may also find itself liable to pay for §409A penalties imposed on executives of the target company as a result of “gross-up” provisions (discussed below) in employment contracts and plans that the buyer may have agreed to assume.


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v. A seller, on the other hand, often wants to limit the §409A liabilities that it may owe to its own executives (because of "gross up" provisions) and the buyer. A seller usually will try to minimize its obligations to indemnify its executives and the buyer for §409A violations. A seller will also try to qualify its §409A representations to the buyer, limit escrow amounts and periods involved in the transaction, and attempt to eliminate the buyer’s right to terminate an agreement for a breach of §409A representations.

vi. Consequently, the parties to mergers and acquisitions often must spend a considerable amount of time and money in the pre-acquisition stage dealing with §409A issues. Many acquisition agreements now contain specific representations regarding §409A compliance as well as extensively negotiated indemnity and claims period provisions. And even in the post-acquisition setting, buyers (and sellers) may find themselves having to deal with §409A issues. In today’s economic crisis and the corresponding credit crunch, §409A issues may become a deciding factor in whether a transaction goes forward or is successful.

B. What are the basics of §409A?

i. §409A regulates “nonqualified deferred compensation plans,” which are virtually any compensation arrangement, whether pursuant to a company-wide plan or in a clause in an employment agreement with a single individual, that provides for the deferral of compensation from the year in which the related services were performed to a subsequent year, unless specifically excluded. Treas. Reg. §1.409A-1(a)(1) and (b)(1).

ii. Under §409A, a deferral of compensation occurs when “a service provider” (i.e., an employee or, in some circumstances, an independent contractor) has a "legally binding right" to compensation in one year that is not subject to a substantial risk of forfeiture and that is or may be payable in a later tax year. Treas. Reg. §1.409A-1(b)(1).

a. An employee has a legally binding right to the payment of compensation even if the payment is conditioned on


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the future performance of services or other conditions (such as achieving the financial or performance goals) set by the employer or “service recipient”.

b. A legally binding right may exist even if the amount may be offset by benefits under a qualified plan or if the amount may be reduced due to investment losses. Treas. Reg §1.409A-1(b)(1).

c. No deferral of compensation occurs, however, if the employer reserves the unfettered discretion to reduce or eliminate the compensation. Treas. Reg. §1.409A-1(b)(1).

iii. To comply with §409A, a plan must be in writing, though unwritten plans are covered by §409A and the material terms of the plan can be set forth in more than one document. Treas. Reg. §1.409A-1(c)(3)(i).

iv. Some of §409A’s compliance requirements include the following:

a. A plan does not satisfy the requirements of §409A unless it is established and maintained in accordance with §409A’s requirements.

b. Under §409A, a plan is established on the latest of the date on which (i) it is adopted, (ii) it is effective, and (iii) the material terms of the plan are set forth in writing. §409A (d)(3) (a plan does not have to be in writing to be covered). The material terms of the plan include the amount (or the method or formula for determining the amount) of deferred compensation and the time and form of payment.

c. Notwithstanding the foregoing, a plan will be deemed to be established as of the date the participant obtains a legally binding right to a deferral of compensation, provided that the plan is otherwise so established by the 15th day of the third month of the service recipient’s subsequent tax year.

d. The election to defer the compensation must be made by the end of the year preceding the year in which the


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services are rendered (with some exceptions – see Treas. Reg §1.409A-2).

v. Generally, if an arrangement is subject to §409A, the time and form of the payment of deferred compensation cannot be manipulated or changed, except in narrow circumstances.

vi. As a general rule, §409A does not apply until the right to the compensation is “vested” or not subject to a substantial risk of forfeiture. A payment ceases to be subject to a substantial risk of forfeiture on the first date the service provider has a legally binding right to the payment.

vii. General "savings" provisions of a plan that purport to nullify noncompliant plan terms, or to supply any specifically required terms that are missing from the plan will be disregarded, but incorporating by reference a specific term from §409A may be permissible. Treas. Reg. §1.409A-1(c)(3)(i) and (3)(v).

viii. The payment of an amount as a substitute for a payment of deferred compensation may be treated as the acceleration of a payment of deferred compensation.

ix. Deferred compensation plans must be compliant in form and operation by December 31, 2008.

x. There are reporting and withholding tax payment requirements for the employer.

C. What are the penalties for failing to comply with 409A?

i. §409A provides, among many other things, that if employment-related compensation qualifies as deferred compensation, and the compensation arrangement is a nonqualified deferred compensation plan that is not exempt from 409A or does not comply with 409A’s requirements related to timing of elections, distributions and funding, the employee will be hit with the immediate income taxation in the current tax year (rather than when received) of all amounts deferred or payable in future taxable years to the extent not subject to a substantial risk of forfeiture and not previously included in income, plus FICA, and


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the amounts of the purported deferral (whether actually received or not) also will be subject to an additional 20% penalty tax. Interest on the amounts that would have been included in income if not deferred is assessed at a "nonpayer rate" (which is higher than that imposed for other violations) plus 1%. IRC §409A(a)(1)(A) and (B).

ii. Likewise, §409A invalidates any efforts between an employer and an employee to agree to fix any §409A problems that may later arise.

iii. Although the penalties under §409A are primarily assessed on executives, the companies that employ them are required to report deferred compensation and to withhold taxes and to pay employment taxes. These employers may face tax penalties under other tax provisions if they fail to report amounts deferred under a nonqualified deferred compensation plan on the employee’s W-2 form and must withhold taxes on any amounts in the gross income of an employee under Section 409A. Notice 2005-1, Q&A 24 through 38 (Notice 2005-1 is no longer valid, but is referred to herein for guidance purposes only).

iv. “Gross Up” Provisions. Employers may incur contractual liability to gross-up payments to executives under employment agreements that require employers to “gross up” or compensate executives for unanticipated §409A liabilities.

a. The downside of a "gross up." When an employer has “gross up” provisions in its employment agreements for payments characterized as excess parachute payments under IRC §4999 and/or subject to §409A, the costs to the company can triple and the gross ups can become a significant cost item in a merger and acquisition.

1. Employers can agree to "gross up" or increase an executive's compensation by the amount of any §409A liability that may be imposed on a deferred compensation arrangement that does not comply with §409A. However, while a "tax gross up" provision will lessen the impact of §409A on the executive, it will not solve the problem of the unpaid payroll taxes (FICA, FUCA, etc.) and the deductibility of the payments by the employer.


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2. If an employer “grosses up” the employee on the §409A excise taxes and penalty, in a way that does not comply with §409A, then interest and an additional 20% penalty may also be assessed on any “gross up” payment, and the gross up payment will not be deductible by the employer.

b. Tax Gross-Up Safe Harbor. However, a tax gross-up will be treated as a permissible distribution if the employment agreement provides that the gross-up will be paid by the end of the taxable year following the taxable year in which the executive pays the taxes to be grossed up; and the gross-up must, in fact, be made as provided in the employment agreement. See Treas. Reg. §1.409A-3(i)(1)(v).

D. What is a nonqualified deferred compensation plan under 409A?

i. A nonqualified deferred compensation plan under 409A is any plan, agreement or arrangement (written or otherwise) that "provides for the deferral of compensation if, under the terms of the plan and the relevant facts and circumstances, the service provider has a legally binding right during a taxable year to compensation that, pursuant to the terms of the plan, is or may be payable to (or on behalf of ) the service provider in a later taxable year." Treas. Reg. §1.409A-1(b)(1). A "service provider" includes an executive. Treas. Reg. §1.409A-1(f ).

ii. Examples of nonqualified deferred compensation plans potentially subject to §409A include, but are not limited to, the following:

a. Executive Employment Agreements with future payouts other than base salary that may provide for “deferral” of compensation and/or the payment of bonuses, severance payments, post-termination consulting and non-compete payments, post-termination salary continuation payments, or post-termination medical expense reimbursements in future tax years. See Treas. Reg. §1.409A-1(c).


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b. Bonus Plans and Incentive Compensation Plans with payments in future years are covered by §409A whether they are:

• Discretionary;

• Formula based ($X times number of months employed); or

• Based on individual and/or entity performance criteria.

1. Sign-on Bonuses. If the period between when an executive is hired and the date when payments of a sign-on bonus are completed covers more than one taxable year and the executive has a legally binding right to payment in a future year, the payment represents deferred compensation under Code §409A. Unless the future payments of the sign-on bonus are subject to a substantial risk of forfeiture or, following the year in which they cease to be subject to a substantial risk of forfeiture, they must be paid within the 2-1/2 month "short-term deferral" exception of Treasury Regulation §1.409A-(1)(b)(4), or these payments must comply with, among other provisions, the permissible distribution requirements of Code §409A(a)(2)(A), which (as discussed below) include a separation from service, disability, death, a specified time (or a fixed schedule), a change in control of a company or ownership of assets and the occurrence of an unforeseeable emergency.

2. Performance-Based Compensation. Compensation is performance-based if it is based on pre-established (in writing at least 90 days before the period starts) organizational or individual performance criteria relating to performance period of at least 12 months. An employee may elect to defer performance-based compensation if the election is made during the performance period, but no later than 6 months before the end of the period over which


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performance was measured and before the performance-based compensation has become readily ascertainable. Treas. Reg. § 1.409A-2(a)(7).

c. Severance Agreements (discussed below).

d. Change in Control Agreements (discussed below).

e. Fringe Benefit and Expense Reimbursement Arrangements (unless there is a legally binding entitlement that goes beyond the taxable year in question, which may result in them being treated as nonqualified deferred compensation plans). Treas. Reg. §1.409A-3(i)(1)(iv)(governing expense reimbursement); Treas. Reg. §1.409A-1(p)(defining "in-kind" benefit plans).

f. Split-dollar Life Insurance Arrangements (unless specifically excluded).

g. ERISA “excess” plans (where the statutory limits are exceeded under qualified plans and made up in add-on arrangements).

h. SERPs - supplemental executive retirement plans (usually pension type plans with multi-year benefit payments.

1. Tax-qualified pension plans are excluded by Code §409A(d)(1)-(2) from the list of nonqualified deferred compensation plans subject to Code §409A, but supplemental pension benefits provided to executives by employment agreements (or by supplemental pension plans referenced in such agreements) are subject to §409A.

i. Executive deferral plans (such as “super”-401(k) plans).

j. Stock appreciation rights.

k. Phantom stock plans.


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l. Restricted stock units (but not actual restricted stock grants).

m. Discounted or misdated stock options (i.e., options with exercise prices below the stocks’ fair market value) are subject to §409A, but stock options and stock appreciation rights are treated as deferred compensation that is excepted from Code §409A if they have an exercise price no less than the fair market value of the stock on date of grant. Treas. Reg. §1.409A-1(b)(5)(i)(A)(1).

E. What Payments are Excluded from §409A’s Definition of “Deferred Compensation”?

i. Short-term deferrals. Amounts to be paid within 2 and ½ months after the end of the year in which the payment ceases to be subject to a substantial risk of forfeiture) are excluded from §409A’s definition of “deferred compensation.”. Treas. Reg. 1.409A-1(b)(4).

a. Substantial Risk of Forfeiture. Under §409A, a substantial risk of forfeiture is a risk that must apply by the terms of the plan to the deferred amounts so the deferrals are not treated as income to the recipient.

1. Deferred compensation is subject to a substantial risk of forfeiture if the receipt of deferred compensation is conditioned on the performance of substantial future services or the occurrence of a condition related to a purpose of the compensation and the possibility of forfeiture is substantial. Treas. Reg. §1.409A-1(d)(1).

2. The attainment of a prescribed level of earnings or equity value, or the completion of an IPO can be substantial risks of forfeiture. Treas. Reg. §1.409A-1(d)(1).

3. An amount conditioned on the executive’s involuntary separation from service without cause can be subject to a substantial risk of forfeiture, if


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the possibility of such a separation from service is substantial. Treas. Reg. §1.409A-1(d)(1).

4. Noncompete agreements or agreements to refrain from the performance of services do not create a substantial risk of forfeiture.

5. The addition of any risk of forfeiture or extension of an "at risk" period is disregarded once a legally binding right to compensation arises.

6. Elective deferrals of compensation cannot be subject to a substantial risk of forfeiture unless the amount subject to risk is materially greater than the amount that is electively deferred.

7. The determination of whether deferred compensation is subject to a substantial risk of forfeiture is important for purposes of short-term deferrals (discussed below), as the short-term deferral rule requires that payment be made within 2 1/2 months following the year in which the amount to be paid is no longer subject to a substantial risk of forfeiture.

ii. Stock options for the purchase of the stock of the employer or a member of the same controlled group, including incentive stock options, are not subject to §409A where the exercise price may never be less than the fair market value of the underlying stock on the date the option is granted and the number of shares is fixed on the original date of the option grant. Treas. Reg. 1.409A-1(b)(5)(i)(A)(1). Stock appreciation rights (if the same requirements are met) and equity based compensation are also excluded, Treas. Reg §1.409A-1(b)(5)(i)(B), but non-statutory stock options are not excluded.

a. “Backdated”, “Misdated” or Discounted Options – Under §409A’s rules, any option granted where the exercise price could be less than the grant date fair market value (as defined below) is deemed a discounted option and the spread (increase in value) when vested is immediately taxable (and subject to withholding) under §409A.


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b. Fair market value §409A imposes stringent requirements on the fair market valuation of the shares:

1. A public company must use either a closing trade price or a stated average price (over a pre-established period if the averaging period does not exceed 30 days). Treas. Reg. §1.409A-1(b)(5)(iv)(A).

2. A private company must satisfy the “reasonable valuation method reasonably applied test.” Included as reasonable are the valuation method used consistently for all equity-based compensation arrangements, such as the appraisal by a reputable third party that involve the use of the following specific factors:

• Value of tangible and intangible assets

• Present value of future cash flow

• Market value of similar companies (either public or established by arm’s length transactions)

• Control premiums and/or discounts for lack of marketability

• Whether the valuation method is used for other purposes that have specified material effect

3. The use of an ESOP appraisal within the last twelve months, a formula price used for regulatory filings, or a third party’s expertise if experienced with illiquid stock may also be reasonable valuation methods under §409A. Treas. Reg. §1.409A-1(b)(5)(iv)(B)(2)(iii) and (B)(1)..

4. However, a valuation will not be considered reasonable if it is more than twelve months old or fails to take into account all material information. Treas. Reg. §1.409A-1(b)(5)(iv)(B)(1).


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c. Modifications, Assumptions, Substitutions or Replacements of Options as a Result of a Corporate Transaction. In a merger or acquisition, equity awards are often assumed, substituted or replaced by the acquiring corporation.

1. Generally, the assumption or substitution of an equity award in the context of a merger or acquisition will not result in an impermissible modification or be treated as the grant of a new right or a change in the form of payment for purposes of §409A as long as the following requirements of Treas. Reg. § 1.409A-1(b)(4) are met:

(i) The same aggregate spread must be presented. Treas. Reg. § 1.409A-1(b)(5)(v)(D).

(ii) The ratio of exercise price to FMV may not be more favorable after the transaction. Treas. Reg. § 1.409A-1(b)(5)(v)(D). However, note the exception to this rule if fewer shares are issued.

(iii) The new or assumed option must contain all terms of the old option, except to the extent such terms are rendered inoperative by reason of the corporate transaction. Treas. Reg. § 1.409A-1 (b)(5)(v)(D).

(iv) The new option or assumed option must not give the optionee additional benefits that the optionee did not have under the old option. Treas. Reg. § 1.409A-1 (b)(5)(v)(D).

2. Generally, a change in an option or issuance of a new option is considered to be by reason of a corporate transaction, unless the relevant facts and circumstances demonstrate that such change or issuance is made for reasons unrelated to such corporate transaction.


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3. The eligible issuer of service recipient stock can either be the direct service recipient corporation or a corporation in a line of corporations ending with the direct service recipient corporation. Treas. Reg. 1.409A-1(b)(5)(iii)(E)(1).

4. In the case of adjustments to and substitutions of options following a spin-off or similar transaction, FMV can be determined based on market quotations as of a predetermined date not more than 60 days after the transaction, or based on an average of such market prices over a period of not more than 30 days ending not later than 60 days after the transaction. Treas. Reg. § 1.409A-1(b)(5)(v)(C).

5. In a change of control transaction, awards can be "cashed-out" or substituted with a cash payment equal to the spread between the exercise price and the FMV of the underlying stock.

6. Modifications that may be considered the grant of a new stock right. A modification of the terms of a stock right, other than an extension or renewal, may be considered the grant of new stock right, which must be analyzed to determine if it is deferred compensation under Section 409A. Treas. Reg. § 1.409A-1(b)(5)(v)(A

(i) A modification is any change in the terms of a stock right which may.provide the grantee with a reduction in the exercise price, an additional deferral or an extension or renewal of a stock right.

(ii) Extensions of stock rights. Extending the exercise period of a stock right is not a grant of a new stock right, if it is extended no later than the day the stock right would have expired or the tenth anniversary of the original stock grant.


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(iii) Extending the Exercise Period of Underwater Stock Options. If the exercise period is extended when the stock is underwater (i.e., the exercise price is greater than the fair market value of the stock, it will be treated as if a new stock right had been granted, rather than as an extension of the original stock right. Treas. Reg. § 1.409A-1(b)(5)(v)(C)

(iv) Accelerating Exercisability. Accelerating the time when a stock right may be exercised may be impermissible under Section 409A(a)(3), unless it is in connection with a permitted distribution event (e.g., a change in control). Treas. Reg. § 1.409A-1(b)(5)(v)(E).

(v) Swapping Out Underlying Stock. Unless new stock is substituted for old stock pursuant to a corporate transaction, swapping out stock in a way that increases the value of the stock is a modification of the stock right. Treas. Reg. § 1.409A-1(b)(5)(v)(D) and (G).

iii. Separation Pay Plans (discussed below); Some separation pay plans that are permissible under §409A include the following:

a. Involuntary separation plans (based on amount not exceeding 2 times the lesser of annualized compensation or the IRS compensation limit for qualified plans [$240,000 for 2009]) where paid by the end of the second year after separation.

b. Window termination programs involving voluntary terminations.

c. Reimbursement plans (including medical expenses during the COBRA period).

iv. Certain indemnification and liability insurance plans.


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v. Other Plans Excluded from §409A. Some other plans specifically excluded from 409A’s definition of a nonqualified deferred compensation plan include the following:

a. “Qualified” employer plans. Code §409A(d)(1)-(2)(excluding tax-qualified pension plans from the status of deferred compensation plans); Treas. Reg §1.409A-1(a)(2).

1. Offsets. A provision for offsetting deferred compensation with benefits accrued under a qualified plan will not negate the existence of a legally binding right to the deferred compensation for §409A purposes. Notice 2005-1 Q&A-4(a), 2005-1 C.B. 274, Q&A-4(a) (Jan. 15, 2005)(herein after cited as Notice 2005-1)(no longer valid, but cited here for guidance only).

b. Split-dollar life insurance arrangements under certain conditions.

c. Certain foreign plans.

d. Section 457 plans.

e. Restricted stock and property (until no longer subject to a substantial risk of forfeiture)

f. Bona fide vacation, sick leave, compensatory time, disability pay or death benefit plans as well as specified medical savings account plans and certain health reimbursement arrangements. §409A(d)(1); Treas. Reg. §1.409A-1(a)(5)(excluding these categories of welfare benefits from nonqualified deferred compensation plan status).

1. The reimbursement of medical expenses can be a form of separation pay subject to Section 409A unless it is allowed only for a limited period of time not extending beyond December 31 of the second calendar year following the separation from service. Treas. Reg §1.409A-1(a)(5).


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F. When can distributions of deferred compensation be made under §409A?

i. Permitted Distribution Events. Except for the exemptions and exclusions discussed elsewhere, distributions to service providers generally may be made only in connection with the following permitted distribution events or times:

a. Separation from Service. IRC §409A(a)(2)(A)(i) defines payments made to an executive upon a "separation from service" as a permitted distribution event.

1. Generally, separation from service occurs upon an employee's death, retirement or other termination of employment with the employer.

2. M&A Note: In an asset sale, seller and buyer may retain discretion to specify whether an employee who works for the seller immediately before an asset sale transaction and for the buyer immediately afterwards has experienced a separation from service, as long as the transaction involves arm’s length negotiations and the treatment is applied consistently and specified in writing prior to the closing date. Treas. Reg. §1.409A-1(h)(4).

3. An employee’s separation from service must be from all entities under common control, which requires a near total cessation of duties for all of those entities.

4. An employee on an approved leave of absence will be treated as having incurred a separation from service on the day after a six-month leave (or longer period if the employee's right to reemployment is a longer period as required by applicable law).

5. A reduction in an employee’s work schedule is presumed to be a separation from service. If the


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level of service drops to 20% or less of the average level of service performed during the immediately preceding 36-month period. If the level of service drops to a level that is 50% or more of the average level of service performed during the immediately preceding 36-month period, no separation from service is presumed. No presumption applies where the level of service is more than 20% but less than 50%.

6. Different kinds of separations from service can have different times and forms of payment.

(i) Payments due to a separation from service after a change of control must be made in a limited time period not to exceed two years from the change of control event.

(ii) Payments due to separations from service before or after a specified date (e.g., attaining age 65) or a combination of a specified date and either a specified length of service (e.g., attaining age 65 and 20 years of service). Treas. Reg. §1.409A-3(c).

b. Disability. §409A(a)(2)(A)(ii) permits distributions on the date when an executive becomes "disabled," as defined in §409A(a)(2)(C), whether or not the executive's employment terminates on that date.

Under the final regulations, a plan can deem an employee to be disabled if such employee is totally disabled for purposes of receiving Social Security disability benefits. Further, an employee can be deemed disabled if the employee is disabled pursuant to a disability insurance arrangement sponsored by the employer, provided such determination is at least as restrictive as the definition of disability set forth in §409A.

c. Death. §409A(a)(2)(A) lists death is a permissible event for payment of deferred compensation, provided the agreement also specifies the time and method for the payment).


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1. Deferred compensation generally may be distributed by the end of the calendar year of death or, if later, by the 15th day of the third month following death.

d. A fixed time or fixed schedule specified in the plan which, among other things, must be objectively determinable.

1. A fixed time or schedule means that distribution of deferred compensation will occur on fixed date, during a specified year or pursuant to a fixed schedule (for installments or annuity forms of distribution.

2. A distribution date is fixed if it is non-discretionary and objectively determinable at the time the compensation is deferred.

3. A plan may provide for payment at the earliest or latest of more than one of the permitted distribution events. Treas. Reg. §1.409A-3(b).

4. The specified date of payment rule allows for payments later within the same calendar year if the specified payment date is missed. Treas. Reg. §1.409A-3(d).

5. Tax gross-up payments are made pursuant to a fixed time or schedule if the plan sets forth the time or schedule and payments are made no latter than the end of the tax year following the tax year in which the taxes giving rise to the gross-up payments are paid. Treas. Reg. §1.409A-3(i)(1)(v).

e. Earn-out Provisions. Earn-outs are treated as paid at a specified time or pursuant to a fixed schedule in conformity with the requirements of §409A if paid on the same schedule and under the same terms and conditions as payments to shareholders generally pursuant to a change in the ownership of a corporation that qualifies as a change in control event or as payments to the service recipient pursuant to a change in the ownership of a substantial portion of a corporation's assets that qualifies


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as a change in control event. Treas. Reg. § 1.409A-3(i)(5)(iv).

f. Change of Control. IRC §409A(a)(2)(A)(v) states that "to the extent provided by the Secretary, a change in the ownership or effective control of the corporation, or in the ownership of a substantial portion of the assets of the corporation" constitutes a permissible distribution event.

1. A change in control event includes all of the following:

(i) A change in ownership of a corporation. Treas. Reg. § 1.409A-3(i)(5)(v)(A)(a person or group acquires more than 50% of the voting stock of the corporation., although the plan can designate a level higher than 50% as a change in control}.

(ii) A change in effective control of a corporation. Treas. Reg. § 1.409A-3(i)(5)(vi)(A)(a person or group of persons acting as a group acquire 30% or more of the total voting power of the corporation’s stock or a majority of the corporation’s board of directors is replaced by members not endorsed by the previous board members).

(iii) Change in the ownership of a substantial portion of a corporation's assets. Treas. Reg. § 1.409A-3(i)(5)(vii)(A)(a person or group acquires assets of the corporation with a fair market value at least equal to 40% of the FMV of the corporation’s total assets, determined immediately before the transaction and without regard to the liabilities associated with the assets).

2. A plan may provide for a more restrictive definition of change in control, but may not distribute deferred compensation based on a less restrictive definition of change in control.


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3. M&A Note: A payment will treated as occurring because of a change in control event if the payment is made due to the corporation’s irrevocable action (under the terms of the plan) to terminate the plan and to distribute the plan’s benefits within 30 days preceding the change in control event and 12 months from the corporate action to terminate the plan. Treas. Reg. § 1.409A-3(j)(4)(ix)(A).

4. To qualify as a change in control event: (i) the occurrence of the event must be objectively determinable and (ii) any requirement that any other person, such as a plan administrator or board of directors compensation committee, certify the occurrence of a change in control event must be strictly ministerial and not involve any discretionary authority. §409A(a)(2)(A)(v); Treas. Reg. §1.409A-3(g)(5)(i).

5. The arrangement may provide for a payment on any change in control event, and need not provide for a payment on all such events, provided that each event upon which a payment is provided qualifies as a change in control event. Treas. Reg. § 1.409A-3(i)(5)(i).

6. To constitute a change in control event as to the service provider, the change in control event must relate to:

(i) the corporation for whom the service provider is performing services at the time of the change in control event;

(ii) the corporation that is liable for the payment of the deferred compensation (or all corporations liable for the payment if more than one corporation is liable); or

(iii) a corporation that is a majority shareholder of a corporation identified in (1) or (2) above, or any corporation in a chain of


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corporations in which each corporation is a majority shareholder of another corporation in the chain, ending in a corporation identified in (1) or (2) above. Treas. Reg. § 1.409A-3(i)(5)(ii)(A).

7. “Single trigger” and “double trigger” change in control provisions.

(i) Employment agreements with a "single trigger" change of control provision (whereby the deferred compensation is distributed solely upon the occurrence of a change of control), the agreement's definition of change in control must be consistent with §409A's definition.

(ii) Employment agreements with "double trigger" provisions (i.e., where distribution occurs only after separation from service following a change in control), a plan's definition of change in control need not meet §409A's definition as long as the distribution pursuant to a subsequent separation from service after the change in control complies with §409A.

8. Non-corporate change of control transactions. Because §409A's change-in-control rules currently address only corporate transactions, pending further guidance, non-corporate change in control transactions involving partnerships and other entities will by governed by §409A's change-in-control rules. Notice 2005-1, Q&A 7.

g. An unforeseeable emergency (limited to the amount necessary to satisfy the emergency)

ii. The timing of Permitted Distributions. Under §409A, a distribution does not have to be made immediately upon the occurrence of a permitted distribution event. Instead, it can be made at a time fixed by reference to a permitted distribution event (e.g., three months after separation from service). In


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addition, the distribution will be deemed to have been made on a timely basis if it is made within the same calendar year or, if later, by the 15th day of the third month following the distribution date specified by the plan.

a. An early distribution of deferred compensation is permitted it the distribution is made no earlier than 30 days prior to the designated distribution date.

b. If the plan specifies that distribution will occur on a specified payment date or within a specified period (e.g., within 60 days following a distribution event), the distribution will be deemed to have been timely made if distribution occurs within the period and the period begins and ends within the same tax year or the period does not exceed 90 days. Treas. Reg. §1.409A-3(d).

c. Generally, only a single time and form of distribution may be designated for each permitted distribution event, with two exceptions:

1. For distributions that do not occur because of separation from service or at a fixed time/schedule, a plan may provide for a different time and form of distribution for a distribution event occurring before or after a specified date; and

2. For distributions that occur upon separation from service, a plan may provide for a different time and form of distribution with respect to a separation from service that occurs:

• within two years after a change in control; or

• before or after a specified date, a specified age or a specified combination of date and age.

iii. Restrictions on Delaying the Time and Manner of Distribution Elections. If permitted by the plan, an employer


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may delay distribution of the employee's deferred compensation if:

a. With respect to amounts payable at a specific time, the election to delay payment is made at least 12 months prior to the date the payment is otherwise scheduled to be made;

b. The election does not take effect for at least 12 months following the date the election is made; and

c. With respect to distributions other than on account of death, disability or unforeseeable emergency, the distribution commencement date is delayed for at least five years from the date the payment would have otherwise been made.

iv. Restrictions on Accelerating the Time and Manner of Distributions.

a. Generally, there can be no acceleration of payment of the deferred compensation - with some exceptions, including the following:

1. Domestic relations order

2. Compliance with ethics laws or conflicts of interest laws

3. “Small” cash-outs ($15,000 or less)

(i) Cashout Rules. A service recipient may exercise discretion to cash out a service provider's entire amount deferred under a plan at any time so long as the amount deferred under the plan is less than the applicable dollar amount under Section 402(g)(1)(B) for that calendar year.

b. State and Local Taxes, FICA, RRTA Tax and Foreign Taxes. The acceleration of payments is permitted under a deferred compensation plan to cover state and local


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taxes, income taxes and employment taxes, FICA, RRTA taxes, and foreign taxes.

c. Plan terminations (subject to certain conditions)

d. Bona Fide Settlement Agreements. Payments do not become deferred compensation subject to Section 409A if the right to such payments arises as part of a settlement between the service provider and the service recipient of bona fide legal claims, such as wrongful termination, FLSA violations, retaliation and harassment claims, but this exception does not apply to amounts that would have been deferred and paid regardless of whether the claim existed. Treas. Reg. §1.409A-1(b)(12).

1. If a bona fide dispute exists between an employer and an employee regarding the employee’s right to a payment under the plan, the plan may provide for accelerating the time or schedule of payments as part of a settlement of the dispute;

2. However, a payment is presumed not to meet the requirements of a bona fide settlement if it is not discounted by at least 25 % from the disputed payment amount or if it is made proximate to a downturn in the employee’s financial condition. Treas. Reg. § 1.409A-3(j)(4)(xiv).


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G. What Are 409A’s Rules on Severance Pay Arrangements?

i. §409A exempts certain separation pay arrangements. Treas. Reg. §1.409A-1(b)(9).

a. Short-term Deferrals. Public and private company severance arrangements that result from involuntary terminations are exempt from §409A where the terms of the plan require that such severance pay be paid out in full within either (1) in the year of such involuntary termination of service or (2) prior to the later of (a) March 15 of the following year or (b) 2 ½ months following the end of the fiscal year of the employer in which the involuntary termination occurs or the amount is no longer subject to a substantial risk of forfeiture. Treas. Reg. §1.409A-1(b)(4)(i)(A).

1. The only exceptions to the requirement that the payments must be made within the above short-term deferral period is if:

(i) Administrative Impracticability. Making the payment earlier was administratively impracticable due to unforeseen circumstances;

(ii) Threat of Insolvency. Making of the payment would jeopardize the ability of the service recipient (e.g., employer) to continue as a going concern;

(iii) Nondeductability. Code section 162(m) would prevent a current deduction of the payment. Treas. Reg. §1.409A-1(b)(4)(ii).

(iv) However, for all three delaying events, the event must have been unforeseeable and the payment must be made as soon as practicable thereafter. Treas. Reg. §1.409A-3(d).

2. Note: A plan should specify that payments are to be made by the fifteenth day of the third month


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after year end or within 2-1/2 months of the end of the taxable year in which the separation from service occurred, so that if the short-term deferral payment date is missed, the specified date of payment rule (discussed above) can be used to allow payment later within the same calendar year if the specified payment date is missed. Treas. Reg. §1.409A-3(d).

b. “Two Times, Two Year” Exemption. Severance arrangements involving involuntary terminations that are paid after the end of the time periods described in the above paragraph are also exempt from §409A if the aggregate amount of severance payments does not exceed the specified amount over the specified time period.

1. The specified amount is the lesser of (1) two times the employee's annual compensation or (2) two times the limit on annual compensation that may be taken into account for qualified plan purposes under IRC Section 401(a)(17)(for 2009, $240,000) in the calendar year preceding the year in which the separation from service occurs.

2. The specified time period is the period that starts from the date of involuntary termination of service and ends no later than the end of the second calendar year in which the separation from service occurs. Treas. Reg. §1.409A-1(b)(9)(iii).

c. The “Six Month” Payment Rule for ”Specified Employees” of Publicly Traded Companies. For public companies, severance arrangements that do not meet either of the exemptions discussed above such arrangements may nonetheless be 409A compliant if the payments are not made to (1) a "Specified Employee" (defined below) and (2) are paid pursuant to a fixed payment schedule.

1. "Specified Employee" means, any employee of a publicly traded employer who is (1) an officer of the employer with annual compensation greater


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than $130,000, (2) a 5% owner of the employer or (3) a 1% owner of the employer having annual compensation greater than $150,000.

2. An entity need not be traded in the United States to be a publicly traded company for purposes of this rule; it can be traded anywhere in the world and the determination of who is a specified employee is made on a "controlled group" basis.

3. Privately-Held Company Severance Arrangements. Private company severance arrangements that do not meet the §409A exemptions discussed above must comply with §409A's rules. Because the "Specified Employee" concept does not apply to private companies, their severance arrangements will comply with §409A if the payments are paid pursuant to a fixed payment schedule, regardless of whether the severance arrangements involve involuntary terminations, resignations for "Good Reason" or "constructive terminations."

d. Collectively Bargained ("CBA") Separation Pay Plans.

e. Involuntary Separation Plans.

1. Involuntary separation from service occurs only when the employer exercises its "unilateral authority" to terminate the employee's services. It includes a failure to renew a contract when it expires and an employee’s resignation for “Good Reason” as defined in the final regulations. Treas. Reg. §1.409A-1(n).

2. Generally, determining whether the separation was voluntary is determined according to the particular facts and circumstances, and if the employee signs a document indicating that the separation was voluntary, then a rebuttable presumption arises that it was.


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3. An involuntary separation plan must meet the requirements of the “Two Times, Two Year” Exemption (discussed above). In other words, the separation payment under an involuntary separation pay plan must be paid no later than December 31 of the employee's or employer's second taxable year after the separation. Treas. Reg. §1.409A-1(b)(9)(iii)(B);Treas. Reg. §1.409A-1(n).

4. A voluntary quit by the employee is not a separation from service with the only exceptions being a resignation for “Good Reason” or a resignation pursuant to a “window program.” Treas. Reg. 1.409A-1 (b)(9)(i).

f. A Window Program will qualify for an exception to §409A to the extent it is a program whose purpose is to make separation pay available to employees who apply to the employer under the program during a limited period of time of not more than 12 months and who separate during that period whether or not additional requirements are specified by the program; and

1. The separation pay under the window program does not exceed the amount permissible under the “two times, two year” exception.

2. Note: If the employer has a pattern of providing window programs on a more or less periodic basis, the programs will lose the exemption. Treas. Reg. §1.409A-1(b)(9)(vi).

3. In determining whether a pattern exists, the IRS will consider whether the window program relates to a specific business event or condition, the degree to which the separation payments relate to such event or condition, and whether the event or condition is isolated or merely a permanent feature of the employer's on-going business.

4. §409A Rules on “Good Reason” Terminations. Executive employment agreements that contain a


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clause permitting executives to terminate their employment for “good reason” (e.g., a breach of the agreement by the employer, the transfer to a distant location, or the diminution of duties or title) and receive enhanced severance pay, must comply with §409A requirements in order to be considered an involuntary termination (necessary to maintain the severance pay plan exemption).

(i) §409A “Good Reason” requirements include: (1) the existence of bona fide conditions equivalent to an involuntary termination; (2) the conditions must require action by the employer that results in a material adverse impact to the employee (e.g., the diminution of job duties and compensation changes), (3) whether the compensation paid as a result of a "good reason" termination is equivalent to compensation to be paid on an actual involuntary termination, and (4) whether executives must give their employers notice and a stated period of time to “cure” or correct the conditions causing the good reason to terminate employment. Treas. Reg. §1.409A-1(n)(2)(i), (ii).

(ii) The "Safe Harbor" for “Good Reason” Separations. Treas. Reg. 1.409A-1(n)(2)(ii) lists the following circumstances that may be included in a definition of Good Reason so that a resignation for “Good Reason” will qualify as a “separation from service”:

a) The separation from service must occur during a pre-determined limited period of time not to exceed two years following the initial existence of one or more of the following conditions arising


35

without the consent of the service provider;

b) The amount and form of the payment for good reason must be substantially identical to the payment that would be made for an involuntary separation;

c) The contract must provide that the employee must give notice to the employer of the good reason within 90 days of when it occurs and the employer must have at least 30 days to remedy the condition and if it does so, no payment will be made. Treas. Reg. §1.409A-1(n)(2).

d) Any separation must occur within a pre-determined time period not to exceed two years following the initial occurrence of one of the following circumstances without the employee’s consent:

(1) A material diminution in the service provider's base compensation;

(2) A material diminution in the service provider's authority, duties, or responsibilities;

(3) A material diminution in the authority, duties, or responsibilities of the supervisor to whom the service provider is required to report, including a requirement that a service provider report to a corporate officer or employee instead of


36

reporting directly to the board of directors of a corporation (or similar governing body with respect to an entity other than a corporation);

(4) A material diminution in the budget over which the service provider retains authority;

(5) A material change in the geographic location at which the service provider must perform the services; or

(6) Any other action or inaction that constitutes a material breach by the service recipient of the agreement under which the service provider provides services. Treas. Reg. 1.409A-1(n)(2)(ii)(A)(1)-(6).

g. Foreign Separation Pay Plans (relating to separation payments required by foreign laws).

h. Separation Expense Reimbursements Payment Plans. Under this exception, even if a separation was voluntary, the amounts paid for reimbursement of medical expense or COBRA premiums would not be covered by Section 409A, but only for the time period permitted under COBRA. Treas. Reg. §1.409A-1(b)(9)(v)(B).

i. Special Note about Separation Pay Plans that result in forfeiture of other deferred compensation: A severance agreement or plan that results in the cancellation, replacement, substitution or forfeiture of an existing entitlement to other deferred compensation in exchange for severance pay may be presumed to be not


37

in compliance and may also result in the impermissible acceleration of the deferred compensation under the other plan, especially If the separation is voluntary. Treas. Reg. §1.409A-1(b)(9)(i); Treas. Reg. § 1.409A-3(f )(recognizing that any payment as a substitute for the payment of deferred compensation will be treated as a payment of deferred compensation).

1. Otherwise, whether separation pay not subject to §409 is a substitution for, or a replacement of, deferred compensation under another plan that is subject to §409 will be determined according to the facts and circumstances of each case. One "factor" that can rebut the presumption that arises in a voluntary separation is whether the separation plan payment is materially less than the forfeited, substituted or replaced amount.

2. An initial election to defer the payment of separation pay if the separation pay was the result of arm’s length negotiation at the time of the separation from service, provided that the employee did not have a pre-existing right to the separation pay before negotiations began. Treas. Reg. § 1.409A-2(a)(11).

III. Sample TARP and §409A Executive Employment Agreement Provisions

(Disclaimer: These are samples. They should not be used without careful analysis of the applicable facts and law.

A. Sample §409A Executive Employment Contract Provisions (Pre-Acquisition Setting)

i. "Change in Control" means:

a. a change in the ownership of the Parent or the Employer (as defined in Treasury Regs. Section 1.409A-3(i)(5)(v)) (other than a transfer to a group comprised of members of the Owners or an Employee Stock Ownership Plan established by Parent); or


38

b. a change in effective control of the Parent or the Employer (as defined in Treasury Regs. Section 1.409A-3(i)(5)(vi)), or

c. a change in the ownership of a substantial portion of the assets of the Parent or the Employer (as defined in Treasury Regs. Section 1.409A-3(i)(5)(vii)).

However, a Change in Control shall not occur under Paragraphs (a), (b) or (c) if the Owners continue to be the beneficial owners, directly or indirectly, of at least 30% of the combined voting power of the then outstanding securities of the Parent (or of the Employer for a Change in Control under Subparagraph (c) involving the Employer), and no other person or group is or becomes the beneficial owner, directly or indirectly, of securities of the Parent (or the Employer for a Change in Control under Subparagraph (c) involving the Employer) having combined voting power greater than that beneficially owned, directly or indirectly, by the Owners.

ii. “Disability” for the purposes of this Agreement, shall be deemed to have occurred if Parent determines that Executive has a physical or mental impairment, as confirmed by a licensed physician selected by Parent, which renders Executive unable to engage in any substantial gainful activity, and is expected to result in death or is expected to last for a continuous period of not less than twelve (12) months. This definition of "Disability" is intended to comply with §409A of the Internal Revenue Code of 1986, as amended, ("Code"), and the regulations promulgated thereunder, and shall be interpreted and administered in accordance with said provisions. Termination due to disability shall be deemed to have occurred upon the first day of the month following the determination of Disability as defined in the preceding sentence.

iii. “Separation from Service” means Executive’s termination of employment with Parent or the Employer which constitutes a “separation from service,” as such term is defined under §409A of the Internal Revenue Code of 1986, as amended (the “Code”) or applicable guidance or regulations thereunder.

iv. §409A “gross up” clause [Note: Extensively negotiated and drafted prior to 2007 final regulations] (i) It is intended that


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any income or payments to Executive provided pursuant to this Agreement or other agreements or arrangements contemplated by this Agreement (any such income or payments being referred to for purposes of this Section 4.3(d)(ii) as “Payments”) will not be subject to the additional tax and interest under §409A(a)(1)(B) of the Code (a “§409A Tax”). The provisions of the Agreement and such other agreements or arrangements will be interpreted and construed in favor of complying with any applicable requirements of §409A of the Code (“§409A”) necessary in order to avoid the imposition of a §409A Tax. The Employer, Parent and Executive agree to amend (including retroactively) the Agreement and any such other agreements or arrangements in order to comply with §409A, including amending this Agreement or other agreements or arrangements contemplated by this Agreement to facilitate the ability of Executive to avoid the imposition of, or reduce the amount of, any §409A Tax. The Employer, Parent and Executive shall reasonably cooperate to provide full effect to this provision and consent to any amendment described in the preceding sentence shall not be unreasonably withheld by any party hereto. Notwithstanding the foregoing, if any Payments due or made to Executive are subject to a §409A Tax solely as a result of the negligence or intentional act or omission of the Employer or Parent, then Executive shall be entitled to receive a gross-up payment (a “§409A Gross-Up Payment”) in an amount equal to (A) the §409A Tax on any Payments, plus (B) any federal, state, and local income taxes, employment taxes (including FICA) or other taxes payable by Executive with respect to the §409A Gross-Up Payment, in order to put Executive in the same position he would have been had the §409A Tax not become due with respect to any Payments; provided, however, that the Employer and Parent shall only be responsible to make a §409A Gross Up Payment with respect to the §409A Tax on Payments made (i) in contravention of the terms of this Agreement or other agreements or arrangements contemplated by this Agreement, or (ii) in contravention or violation of any §409A guidance or authority that is promulgated or effective after the date hereof; further provided, that the Employer and Parent shall not be responsible to make a §409A Gross-Up Payment with respect to the §409A Tax on the Payments if (1) Executive refuses or fails, following a specific written request of the Employer or Parent, to make an election to alter the form and/or timing of any Payment


40

(including by amending this Agreement or other agreements or arrangements contemplated by this Agreement pursuant to this subsection(ii)) that could reasonably be expected to result in the reduction or avoidance of any amount of §409A Tax while minimizing (to the extent reasonably practicable) the delay in such Payment to Executive, (2) Executive refuses or fails, following a specific written request of the Employer or Parent, to take any reasonable action which would have the effect of reducing or eliminating the §409A Tax that may become due with respect to any Payment by use of the correction program described in IRS Notice 2007-100 or any other program made available by the Internal Revenue Service or under applicable law, or (3) a payment practice which is commonly accepted as compliant with the requirements of §409A pursuant to which a Payment is made is determined by the Internal Revenue Service to be subject to a §409A Tax.

v. Clauses disclaiming any §409A representations.

a. This Release is intended to comply with §409A of the Internal Revenue Code of 1986, as amended, but the parties agree that the Employer is making no guarantee, warranty, or representation in this Release regarding the tax effect of this Agreement or the position that may be taken by any benefit plan administrator or plan regarding the effect of this Release upon Employee’s rights, benefits, or coverage under any benefit plan.

b. The Company intends all payments and other consideration provided by this Agreement to be compliant with Internal Revenue Code § 409A; however, the Company recommends that you review all such terms with your own counsel or accountant to ensure compliance with § 409A.

B. Sample §409A Incentive Compensation Plan Provisions

In the event of any merger, consolidation or reorganization of the Company with or into another Company other than a merger, consolidation or reorganization in which the Company is the continuing Company and which does not result in the outstanding shares of Common Stock being converted


41

into or exchanged for different securities, cash or other property, or any combination thereof, there shall be substituted, on an equitable basis as determined by the Committee, for each share of Common Stock then subject to an Award under the Plan, the number and kind of shares of stock, other securities, cash or other property to which holders of shares of Common Stock of the Company will be entitled pursuant to the transaction so long as substitution complies with Treasury Regs. Section 1.409A-1(b)(5)(iii)(E)(4) and Section 1.409A-1(b)(5)(v)(D).

i. Other Provisions. Awards under the Plan may also be subject to such other provisions (whether or not applicable to the Award granted to any other participant) as the Committee determines appropriate, including without limitation, provisions for the installment purchase of Common Stock under Stock Options, provisions for the installment exercise of Stock Appreciation Rights, provisions to assist the participant in financing the acquisition of Common Stock, provisions for the acceleration of exercisability or vesting and/or early termination of Awards in the event of a change of control of the Company (provided that such provisions do not result in an acceleration that is prohibited under Treasury Regs. Section 1.409A-3(j), provisions for the payment of the value of Awards to participants in the event of a change of control of the Company, provisions for the forfeiture of, or restrictions on resale or other disposition of, Common Stock acquired under any form of Award, provisions to comply with Federal and State securities laws, or understandings or conditions as to the participant's employment in addition to those specifically provided for under the Plan. For purposes of this Section 12, a "change of control" means a change in the ownership or effective control of a corporation or a change in the ownership of a substantial portion of assets of a corporation pursuant to Treasury Regulation § 1.409A-3(i)(5).

ii. Time of Granting of Awards; Fair Market Value. The date of grant ("Date of Grant") of an Award shall be the date specified by the Committee on which an Award under this Plan will become effective (which date shall in no event be earlier than the date on which the Committee takes action with respect thereto), provided that for a non-qualified stock option the date shall be the date on which the maximum number of shares that can be purchased under the option and the minimum purchase price are fixed or determinable, and further as for Stock Appreciation


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Rights the date on which the maximum number of shares which the right is based and the setting of a date upon which the appreciation of the right is to commence, provided that in the case of an Incentive Stock Option, the Date of Grant shall be the later of the date on which the Committee makes the determination granting such Incentive Stock Option or the date of commencement of the Participant's employment relationship with the Company. Except as otherwise expressly provided in a written Award, for purposes of this Plan and any Awards hereunder, the "Fair Market Value" of a share of Common Stock shall be closing price of a share of the Company's Common Stock as reported on the Nasdaq National Market (or such other consolidated transaction reporting system on which such shares are primarily traded) on the date of calculation (or on the next preceding trading date if shares of Common Stock were not traded on the date of calculation); provided, however, that if shares of the Company's Common Stock are not at any time readily tradeable on a national securities exchange or other market system, "Fair Market Value" shall mean a value determined by a reasonable application of a reasonable valuation method determined pursuant to Treasury Regulation § 1.409A(1)(b)(5)(iv)(B).

iii. §409A of the Code. To the extent applicable, it is intended that this Plan and any Awards granted hereunder comply with the provisions of §409A of the Code. This Plan and any Awards hereunder shall be administrated in a manner consistent with this intent, and any provision that would cause this Plan or any Award hereunder to fail to satisfy §409A of the Code shall have no force and effect until amended to comply with §409A of the Code (which amendment may be retroactive to the extent permitted by §409A of the Code and may be made by the Company without the consent of Participants). Any reference in this Plan to §409A of the Code will also include any proposed, temporary or final regulations, or any other guidance, promulgated with respect to such Section by the U.S. Department of the Treasury or the Internal Revenue Service.

iv. Duration, Termination and Amendment. This Plan shall terminate upon the earlier of a termination by the Board, or at such time as there shall be no remaining shares available for grant hereunder, or June 20, 2012. Also, by mutual agreement


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between the Company and a participant hereunder, under this Plan or under any other present or future plan of the Company, Awards may be granted to such participant in substitution and exchange for, and in amendment or cancellation of, any Awards previously granted such participant under this Plan, or any other present or future plan of the Company, provided any such amendment, termination, substitution, exchange or cancellation does not result in an acceleration that is prohibited under the Treasury Regs. Section 1.409A-3(j). No amendment, termination, substitution, exchange or cancellation may adversely affect any incentive awards for which the Participant was previously eligible to receive. The Board may amend the Plan from time to time or terminate the Plan at any time, subject to any requirement of stockholder approval required by applicable law, regulation, or stock exchange rule. However, no action authorized by this Section 17 shall reduce the amount of any outstanding Award or adversely change the terms or conditions thereof without the participant's consent.

C. Sample TARP Separation Agreement Provisions [with “claw back” clause]

i. Section 12. The parties agree that this Release is intended to comply with the rules and regulations of the Troubled Asset Relief Program (“TARP”). To the extent that the Employer later determines in the exercise of its reasonable discretion that the terms of this Release or the payments hereunder do not comply with TARP or the Employer may not deduct the full amount of the payments to Executive for federal income tax purposes, she agrees that the Employer may alter or reduce the amount or nature of the payments under this Release in order to comply with TARP and obtain the maximum income tax deduction of the payments to Executive permitted by law.

a. The parties further agree that the payments under this Release are not being made on account of any involuntary termination of Executive’s employment (including but not limited to any “good reason” resignation or constructive termination) or on account of any change of control involving the Employer and do not


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constitute parachute payments or excess parachute payments, as those terms are defined under TARP or other applicable tax rules.

b. The parties also agree that any and all payments made by the Employer pursuant to this Release are subject to recovery (“claw back”) by the Employer and immediate repayment by Executive in the event that the Employer determines in the exercise of its reasonable discretion that they were made on the basis of financial statements or other criteria (including but not limited to violations of the Employer’s Code of Conduct and policies on ethical behavior) that later turn out to have been materially inaccurate.

Paul E. Starkman

(312) 876-7890 direct(312) 876-6290 [email protected]

Chicago Office120 S. Riverside PlazaSuite 1200Chicago, IL 60606-3910

www.arnstein.com

About Paul E. Starkman

Mr. Starkman is the Chair of the Labor & Employment Law Practice Group at Arnstein & Lehr LLP. Since joining the firm in 1986, he has acquired extensive experience counseling public and private employers on a broad range of personnel matters and corporate transactions with employment-related issues. He has also successfully handled litigation involving “cutting edge” discrimination claims, actions seeking injunctive relief, class actions, compensations and benefit claims and other employment related issues in federal and state courts throughout the country.

Professional Activities and Achievements

Mr. Starkman is a Fellow of the College of Labor and Employment lawyers. He is an active member of the American Bar Association and the Society of Human Resources Professionals (SHRP). He is a Co-Chair of the Contingent Worker Subcommittee, a past Chair of the At-Will Employment Subcommittee and has served as the Management Chair of the Worker Dislocation Sub committee of the ABA Employment Rights & Responsibilities Committee.

Mr. Starkman also frequently speaks at conferences and seminars throughout the country sponsored by the Bureau of National Affairs (BNA), the Practicing Law Institute (PLI), American Law Institute-American Bar Association (ALI-ABA), and other professional groups on employment issues. He has also appeared on television and other media outlets on employment-related issues.

Recent Publications and Lectures

Mr. Starkman has been quoted in such national publications as the Wall Street Journal, the National Law Journal, Lawyer USA Today, among others.

Mr. Starkman is one of the principal authors of Employment Arbitration: Law and Practice (West 2007-2008), the 1,200 page treatise on employment arbitration and updates are available for purchase at: http://west.thomson.com.

Mr. Starkman also authored “Measuring the Effectiveness of Corporate Compliance and Ethics Programs: An Outside Counsel’s Perspective,” 1661 PLI Corp 225 (Practicing Law Institute (March-June 2008)

Some of his other published articles and written materials include: “Refuling Assistance for Drivers with Disabilities” 32 ABA Mental and Physical Disability Law Reporter 493 (July August 2008). Co-authored with John D. Kemp and Elizabeth Doyle.

A 90-minute DVD, “Video Leadership Seminars™: Winning Legal Strategies for Employment & Labor Law” (ReedLogic. September 2006), featuring Paul Starkman discussing winning strategies for harassment and discrimination litigation and other commonly faced employment issues. Available for purchase directly from ReedLogic at 1-877-34-LOGIC, www.reedlogic.com/rl79.asp, and at Amazon.com, Barnes & Nobel. Ingram Book Group, Baker & Taylor and through Bowker at its title listings for Books/DVDS in Print.

“Protecting Your Company’s Competitive Advantage – Rethinking Restrictive Covenants & Alternative Strategies” (Executive Reports – Aspatore Publishing 2006). Available for purchase at http://www.reportbuyer.com/business_services/law/protecting_companys_competitive_advantage.html. Paul Starkman’s 40-page research report written for company executives features strategies for protecting confidential information and forming more effective restrictive covenants.

“Handling Requests For Personal Attorneys During Internal Investigations,” 94 Illinois Bar Journal 290 (May 2006) and reprinted in The Brief 26 (Spring 2007) the newsletter for the ABA Tort Trial & Insurance Practice Section.

“Perspectives of Outside Management Counsel on Sexual Harassment Cases,” published in the book entitled Dealing With Employee Lawsuits: Strategies for the Prevention and Defense of Workplace-Related Claims (Aspatore 2005). Available at www.aspatore.com/store/bookdetails.asp?id=61.

Mr. Starkman’s article on “Blogging and Instant Messaging in the Workplace” was published in Law Technology News (Nov. 2005).

“The Employment Law Impact of the Sarbanes-Oxley Act,” 28 Employee Relations Law Journal 25 (Spring 2003).

“Open Issues after Circuit City: Still No Easy Answers on Mandatory Arbitration,” 27 Employee Relations Law Journal 69 (Spring 2002).

“The ADA’s Essential Job Function Requirement: Just How Essential Does An Essential Job Function Have To Be,” 26 Employee Relations Law Journal 43 (Spring 2001).

“Mergers and Acquisitions: A Checklist of Employment Issues,” 13 DePaul Business Law Journal 47 (Fall/Spring 2000/2001).

“Answering the Tough Questions about Alcoholism and Substance Abuse Under the ADA and FMLA,” 25 Employee Relations Law Journal 43 (Spring 2000).

“Learning the New Rules of Sexual Harassment: Faragher, Ellerth and Beyond,” 66 Defense Counsel Journal 317 (July 1999) (Selected as one of the year’s best articles by the Insurance Law Review.).

“The Good, the Bad, and the Uncooperative: Dealing with the Uncooperative Employee During an Internal Investigation,” 25 Employee Relations Law Journal 69 (Summer 1999).

Education

DePaul University College of Law, Chicago, Illinois (J.D., 1984)University of Wisconsin/Madison (B.A., 1980)

Bar Admissions

State of IllinoisU.S. Court of Appeals for the Seventh CircuitU.S. District Court for the Northern, Central, and Southern Districts of Illinois (including Trial Bar)

Documents

A Primer on the Impact of the New Economic Stimulus Laws and IRC §409A on Executive Compensation in Mergers and Acquisitions