It's reasonable to expect that directors and senior management at many public companies will be considering changes to executive pay packages in the coming months. As of June 6, there were more than 30 public companies with failed "say-on-pay" votes and several others with significant levels of negative shareholder votes.

These results can be attributed partly to evolving corporate-governance standards for executive compensation. Executive pay practices that have been labeled by Institutional Shareholder Services as "problematic," and likely are driving some of the negative say-on-pay results, include:
• Excessive Supplemental Executive Retirement Plans (SERPs) and perquisites;
• Liberal triggering events for large severance benefits;
• Tax gross-up payments for golden-parachute payments and perquisites; and
• Multiyear guaranteed incentive-compensation awards.

But in yet another lesson why the Internal Revenue Code is a poor vehicle for regulating executive pay, tax legislation enacted in response to the Enron debacle — referred to as Section 409A — is now creating yet more problems for public companies.

Section 409A restricts when and how nonqualified deferred compensation may be paid without triggering immediate tax upon vesting. Once a permissible payment event is in place, there are very few opportunities to change it. Unless an exception is available, accelerating payment of a scheduled deferred-compensation benefit will violate Section 409A. Further deferring a scheduled payment is permissible only under certain conditions, including that the deferral for a specified payment event be for at least another five years.

End-run Defense
Congress enacted Section 409A following published reports that Enron accelerated payment of unfunded retirement arrangements to its executives shortly before filing for bankruptcy. But instead of amending the Bankruptcy Code or allowing the Internal Revenue Service to publish regulations to address targeted situations, Congress decided to impose new strict payment requirements to a broad range of compensation arrangements as a condition for continued tax deferral. Failure to follow those requirements results in not only the immediate taxation to the executive of vested rights under covered compensation arrangements prior to payment but also a 20% penalty and interest.

Particularly challenging about Section 409A, when considering changes to executive pay in response to shareholder concerns, is the so-called substitution rule. The IRS was apparently concerned that employers would be able to do an end-run around the Section 409A payment restrictions by terminating nonqualified deferred-compensation arrangements and then later establishing other types of compensation arrangements.

To close that perceived loophole, IRS final regulations broadly provide that compensation extended in "substitution" for forfeited or forgone payments of deferred compensation that are subject to Section 409A will themselves be treated as an immediate payment of that forfeited or forgone deferred compensation. There is no exception for changes due to legitimate business considerations, and it doesn't matter whether the substituted amount is paid earlier or later than the original deferred compensation. The result is that it may prove difficult to replace problematic deferred-compensation arrangements without triggering adverse tax consequences for executives.

Intentions Gone Awry
To illustrate the complexity of the interaction between Section 409A and corporate governance, let's say there's a negative say-on-pay vote against XYZ Corp. that appears to result, in part, from the CEO having accrued a $20 million vested SERP benefit. In order to convince shareholders that their concerns have been properly taken into account, the compensation committee negotiates a $5 million reduction to this SERP benefit with the CEO. This reduction, if implemented, would result from disregarding certain types of incentive pay that had counted as eligible compensation when calculating the SERP.

As a practical matter, XYZ's compensation committee intends to make larger annual equity compensation awards in future years based on the company meeting objective and challenging performance goals. The awards would allow the executive an opportunity to make up for the loss of the $5 million through future performance. It would seem that this type of negotiation and restructuring is what Congress had in mind when it enacted the say-on-pay provisions in Dodd-Frank.

Well, not so fast. The CEO could be stuck with a significant tax bill. As noted above, the SERP is nonqualified deferred compensation subject to Section 409A. So, if the later performance share awards are viewed as a substituted payment for the forfeited portion of the CEO's SERP, then there will be a Section 409A violation. Whether the larger performance share awards made after the change to the SERP's definition of eligible compensation will be considered a substitute for the forgone SERP is to be determined based on all the facts and circumstances. In part, the answer depends on whether any new right to payment is "proximate" to the forfeited deferred compensation, but there is no definition in the IRS final regulations what "proximate" means in this context.

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