Sources of rules and practiceOverview
Provide an overview of the primary sources of law, regulation and practice that govern or affect executive compensation arrangements or employee benefits.
In the United States, broad-based employee benefit programmes are generally subject only to federal laws while executive compensation arrangements are, in most cases, subject to various federal and state laws. In the case of both employee benefit plans and executive compensation arrangements, the applicable laws affect their structure, taxation, governance and public disclosure.Federal law
At federal level, applicable laws include the following:
- the Internal Revenue Code (Code), and in many cases, the Employee Retirement Income Security Act of 1974 (ERISA);
- the Securities Act of 1933 (Securities Act);
- the Securities Exchange Act of 1934 (Exchange Act);
- the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank); and
- the Sarbanes-Oxley Act (SOX).
The Code prescribes rules governing:
- the amount and timing of the inclusion in income by an employee of executive compensation and other types of employee benefits, and the amount and timing of the corresponding employer deduction, if any; and
- the imposition of employment taxes in connection with such arrangements.
As might be expected, these rules tend to influence significantly the structure of such arrangements. Of particular importance is Code section 409A, which imposes adverse tax consequences and penalties on participants in nonqualified plans that do not satisfy its strictures.
ERISA imposes affirmative requirements on all manner of employer plans including retirement and welfare plans. Those applicable to broad-based retirement plans include extensive requirements relating to reporting and disclosure, vesting, minimum participation standards, rates of accrual, fiduciary obligations, funding and claims and appeals procedures. In addition, defined benefit plans are required to participate in a government insurance programme maintained by an agency known as the Pension Benefit Guaranty Corporation (PBGC) that protects participant benefits up to certain caps. ERISA pre-empts most state laws relating to plans subject to ERISA, a potentially significant benefit to the plan sponsor. ERISA includes exemptions from coverage, in whole or in part, for certain types of plans (such as top hat plans, as discussed in greater detail in questions 11 and 12, plans that provide benefits to a broad group of employees in excess of certain Code limits, and church and government plans). Significantly equity compensation awards are typically not subject to ERISA.
The Securities Act and the Exchange Act are the principal US federal securities laws that govern executive compensation arrangements and benefit plans. Equity-based compensation may be subject to registration requirements under (or require an exemption from) the Securities Act. In addition, the Exchange Act imposes, on companies to which it applies, extensive disclosure requirements relating to executive compensation. SOX supplemented or amended the securities laws in a number of respects, including creating a prohibition on personal loans by public companies to their executives, and imposing a ‘clawback requirement’ on chief executive officer (CEO) and chief financial officer (CFO) compensation in the event that corporate financials must be restated on account of material non-compliance with financial reporting requirements owing to misconduct.
Dodd-Frank, which passed in 2010, was intended to enhance corporate responsibility to shareholders and imposes certain significant requirements on executive compensation arrangements. A number of these are discussed in various questions and include, among others:
- non-binding shareholder votes on executive compensation (‘say-on-pay’);
- augmented executive compensation disclosures;
- an expanded ‘clawback policy’ requirement;
- independence requirements for compensation committees; and
- shareholder access to proxy materials to nominate directors.
Many of the specifics of these requirements are to be provided through rulemaking by the Securities Exchange Commission (SEC) and the national securities exchanges, Although the requirements generally apply to public companies, the concepts addressed by the requirements have begun to affect practices by private companies to some degree as a matter of perceived good governance.Rules of exchanges
Companies whose shares are listed on an exchange (NYSE, ASE, NASDAQ) are subject to the rules of the exchanges, some of which affect the structure and governance of executive compensation. Some of the requirements of Dodd-Frank (eg, clawbacks) are to be implemented through rules to be issued by the exchanges with respect to listed companies.State law
Individual states each have their laws codes that govern both private and public corporations and other business entities (such as limited liability companies) organised in their state. State corporate codes govern how corporations are formed, structured and operated, and generally include requirements relating to executive compensation arrangements, such as approval requirements for the grant of equity awards provided by entities organised in their state. Further, equity awards that are exempt from federal securities laws may be subject to state securities law requirements (referred to as ‘blue sky laws’). State laws (whether statutory or common law) generally govern the terms and conditions of employment, including ‘at-will employment’, employee duties, constraints on the forfeiture or clawback of incentive awards (subject to federal securities laws) and enforceability of post-employment restrictive covenants.Enforcers
What are the primary government agencies or other entities responsible for enforcing these rules?
The Internal Revenue Service (IRS), the Department of Labor (DOL), and the SEC are responsible for the enforcement of the Code, the federal labour laws and ERISA, and the federal securities laws and requirements of Dodd-Frank, respectively. The PBGC is responsible for the maintenance of the government insurance programme for pension plans and the enforcement of its requirements. State governments typically maintain departments of labour responsible for enforcing state labour laws, and state insurance commissions play a role in the regulation of insurance contracts used to fund pension and health benefits.
GovernanceGovernance requirements and shareholder approval
Are any types of compensation or benefits generally subject to specific corporate governance requirements or approval by shareholders or government agencies? What is the general process for obtaining approval?
For listed companies, the rules of the securities exchanges generally require shareholder approval of the establishment or material amendment of a plan or arrangement that provides equity compensation to officers, directors, employees or consultants. The rules typically provide that, for this purpose, a material amendment would include, among other things, any material expansion of the class of participants eligible to participate in the plan. Companies that are not listed may also need to obtain shareholder approval of plans that provide for equity awards on account of state law requirements. In addition, most states require that equity awards be made by the company’s board of directors (board) or a committee of the board, though some allow delegation to an executive officer under certain circumstances.
The provisions of Dodd-Frank (as implemented by SEC rules) added several governance requirements for listed companies, including that each member of a company’s compensation committee be an independent (non-management) member of the board, and that the compensation of the CEO be evaluated by such a committee and approved by the committee or by the full board. In addition, SEC rules under Dodd-Frank require that public companies subject to the proxy rules provide their shareholders with:
- a non-binding advisory vote on the compensation of the company’s chief executive officer, chief financial officer and three most highly compensated employees at least once every three years (‘say-on-pay’ vote); and
- a ‘frequency’ vote at least once every six years that gives shareholders a say in how often they would like to be presented with the ‘say-on-pay’ vote.
SEC rules also require the disclosure of compensation payable in the event of a change in control (see question 7). When companies seek shareholder approval of a merger or acquisition, they are required to conduct a separate shareholder advisory vote to approve golden parachute compensation arrangements between the target company and its own named executive officers or those of the acquiring company, unless the golden parachute disclosures were included in executive compensation disclosures subject to a prior ‘say-on-pay’ vote. Note, however, that not all mergers or acquisitions are subject to shareholder approval.
In addition, under the Code the tax-advantaged treatment of certain stock options and employee stock purchase plans (ESPPs) are conditioned on the shareholder approval of the applicable plan.Consultation
Under what circumstances does the establishment or change of an executive compensation or benefit arrangement generally require consultation with a union, works council or similar body?
Managers and supervisors are not protected by the National Labor Relations Act (NLRA) and cannot join unions or be part of the bargaining unit. With respect to employees who are members of a union, the NLRA requires employers and unions to negotiate fairly with each other in good faith to try to agree to a contract that spells out the terms and conditions of employment for the workers who are members of the union. Certain terms and conditions of employment that must be negotiated between management and unions are referred to as ‘mandatory subjects of bargaining’. Neither the employer nor the union can refuse to bargain over mandatory subjects of bargaining. Among the subjects that are mandatory subjects of bargaining are wages, and benefits such as healthcare and pensions.
An employer may not make a change in compensation and benefits that are covered by a collective bargaining agreement without providing the union prior notice and an opportunity to bargain over the desired change. This applies even if the change is favourable to the employees covered by the collective bargaining agreement. Generally, an employer is not required to seek union approval of a sale of a business (unless the union previously bargained for such right), but in some cases may have an obligation (referred to as an ‘effects bargaining obligation’) to confer with the union on ways to mitigate the effect of the sale on employees.Prohibited arrangements
Are any types of compensation or benefit arrangements prohibited either generally or with respect to senior management?
Section 402 of SOX makes it unlawful for an issuer ‘directly or indirectly . . . to extend or maintain credit, to arrange for the extension of credit, or to renew an extension of credit, in the form of a personal loan’ to any of its directors or executive officers. Companies that violate this provision are subject to civil and criminal penalties under the Exchange Act. Advances for bona fide business purposes are generally not subject to the prohibition.Rules for non-executives
What rules apply to compensation and benefits of non-executive directors?
There are no statutes with specific dollar limits on the amount of compensation that may be paid to non-employee directors, nor specific requirements with respect to the manner in which such compensation is determined. Because, however, directors generally set their own compensation, their actions, when challenged by plaintiff shareholders, are increasingly subject to scrutiny by the courts under the ‘entire fairness’ doctrine, rather than the business judgment rule. By way of background, actions by a board of directors are generally subject to the ‘business judgment’ rule. In those cases, a plaintiff shareholder has the burden of establishing that the directors, in taking the challenged action, breached their fiduciary duties of good faith, loyalty, and due care. In contrast, in the case of actions or decisions in which the directors are self-interested (such as setting their own compensation), the directors have the burden of proving that their action, including the process used and the amount involved, is fair to the company and its stockholders (unless the decision was approved by the shareholders, in which case the business judgment rule applies). In a recent decision of the Delaware Court of Chancery, Stein v Blankenfein, et al, (Del Ct of Chancery, 31 May 2019) the court, applying the entire fairness standard, refused to dismiss a breach of fiduciary duty claim based on allegations that compensation awarded to the non-employee directors of the Goldman Sachs Group was excessive. As discussed in question 47, companies are increasingly obtaining shareholder approval of director compensation limits so as to avoid challenges, or to mitigate the results of a challenge, to director compensation.
In addition to receiving cash and equity compensation, non-employee directors may participate in nonqualified deferred compensation plans, but, as non-employees, are precluded from participating in broad-based qualified plans (see questions 35 and 36). Further, a plan in which only non-employee directors participate is not subject to ERISA and thus directors participating in such a plan have none of the protections of that statute.
As noted in question 3, in the case of publicly traded companies, equity award plans, whether for employees or non-employee directors, or both, are subject to binding shareholder approval under the applicable exchange’s listing rules. Again, non-listed companies may need to obtain shareholder approval of equity award plans for other reasons. Further, under SEC Regulation S-K, all compensation, including cash, equity-based, and fringe benefits, paid or granted to directors of a publicly traded company must be disclosed in the company’s annual proxy statement. Some exchanges also require additional disclosure, such as third-party compensation arrangements with non-employee directors (‘golden leash’ arrangements).
DisclosureMandatory disclosure of executive compensation
Must any aspects of an executive’s compensation be publicly disclosed or disclosed to the government? How?
Each year, compensation paid and granted to the CEO, CFO and next three most highly compensated executive officers (‘named executive officers’) of a publicly traded company must be described in a narrative discussion (generally referred to as the ‘compensation discussion and analysis’) and various tabular disclosures in the company’s annual proxy statement in accordance with SEC Regulation S-K. Required tabular disclosures include a summary compensation table, an equity award table and a table indicating the amounts that would be paid to the named executive officers in the event of termination of employment or a change in control. The narrative and tabular disclosures are typically considered by shareholders in connection with the ‘say-on-pay’ shareholder votes described in question 3.
Within four business days after adoption of any material compensatory plan, contract or arrangement (regardless of whether such agreement is written) relating to any named executive officer, or any material amendment thereto, a brief description of the terms of such plan, contract, arrangement or amendment must be disclosed. Such disclosure is typically made on a Form 8-K. In addition, a copy of any management contract or any compensatory plan, contract or arrangement in which any director or any of the named executive officers participates, whether or not material, must be filed with the company’s next periodic report (eg, Form 10-K or Form 10-Q). A copy of any other compensatory plan, contract or arrangement in which any other executive officer participates must also be filed unless immaterial in amount or significance.
ERISA requires consolidated annual disclosure to the IRS, DOL and PBGC (as applicable) of financial and other information regarding non-exempt retirement and welfare plans but does not require such disclosure of individual information. Plan annual reports are made available to the public.
Public disclosure of information is not required by companies who do not have publicly traded securities (which can include securities other than stock, such as debt securities).
Employment agreementsCommon provisions
Are employment agreements required or prevalent? If so, what provisions are common? Are any terms prohibited or unenforceable?
Employment agreements with individual employees are not required under federal or state law and are not particularly prevalent, except for top management (ie, the chief executive officer and direct reports). Typical employment agreement provisions include the term of the agreement (which may be for a set term or may include automatic renewals), base salary, annual incentive target, participation in employee benefits, severance benefits for involuntary termination (generally, termination by the company without ‘cause’ or by the individual for ‘good reason’), release requirements applicable to severance benefits, and post-employment restrictive covenants (confidentiality, non-compete, trade secrets, and non-solicitation where permitted by applicable law). More prevalent are informal ‘offer letters’ issued at the outset of employment that document certain employer policies along with separate restrictive covenant or trade secret agreements that employees are required to sign. In an increasing number of jurisdictions, an employment agreement, offer letter or separate restrictive covenant agreement cannot include certain post-employment restrictive covenants (such as non-compete covenants) if the covenants are prohibited by applicable law. An employer may be subject to penalties for including non-enforceable restrictive covenants in an agreement or attempting to enforce a restrictive covenant that is prohibited by applicable law.
Incentive compensationTypical structures
What are the prevalent types and structures of incentive compensation? Do they vary by level or type of organisation?
Short-term incentive compensation (STI) is typically paid in cash either upon achievement of pre-established performance targets or on a discretionary basis. In some cases, STI awards are settled partially in cash and partially in equity awards that are subject to additional vesting conditions, such as in cash and restricted stock, effectively providing short-term and long-term incentives within the same arrangement.
Long-term incentive compensation (LTI) usually takes the form of equity awards or equity-based awards that are settled in stock although sometimes LTI is denominated and paid in cash. Common types of equity and equity-based awards include stock options, stock appreciation rights (SARs), restricted stock, restricted stock units (RSUs) and performance stock units (PSUs). Settlement of LTI awards in cash is significantly more prevalent in private companies than in public companies owing to the lack of a market for the equity and the desire to have a limited number of equity holders. LTI awards are typically payable upon achievement of pre-established performance hurdles (performance-vested) over a performance period (typically at least three years) although there may be a service-based vesting requirement also (or in limited circumstances, in lieu of performance-based vesting). It is becoming increasingly common to require at least one year of service before any portion of an LTI award will vest (without regard to whether the award otherwise provides for performance-based vesting). Equity-based awards for partnerships are typically granted in the form of profits interests, which have no value on grant and entitle the holder solely to future profits.Restrictions
Are there limits generally on the amount or structure of incentive compensation? Are there limits that adversely affect the tax treatment of the compensation relative to the employer or the executive?
There are generally no legal limits on the amount or structure of incentive compensation. It is not uncommon, however, for an employer’s arrangements to include employer-based limitations on the amount that can be paid under an incentive plan. In addition, prior to the modifications to Code section 162(m) made by the Tax Cuts and Jobs Act of 2017 (Jobs Act), equity plans of public companies almost always included individual limits on the awards (both cash and equity) that could be granted to individuals in a specified period if the award was intended to satisfy the performance-based compensation exception of section 162(m). Although the Jobs Act effectively eliminated the performance-based exception and thus those individual limits are no longer relevant for section 162(m) purposes, institutional investor advisers (such as ISS and Glass Lewis) expect such limitations to remain in the plan or the company risks negative recommendations on the plan.
There are certain Code provisions that impose adverse tax consequences in the event that compensation exceeds certain limits. In particular, Code section 162(m) limits a public company’s tax deduction on compensation that may be paid to its chief executive officer, chief financial officer and the next three most highly compensated executives (‘covered employees’) to US$1 million annually (US$500,000 in the case of certain health insurance issuers). This limit applies both during the individual’s period of employment and thereafter if the person was ever a covered employee (‘once a covered employee, always a covered employee’).
Code sections 280G and 4999 impose a 20 per cent excise tax on the employee and deny a company’s tax deduction on certain payments that are made in connection with a change in control (‘excess parachute payments’) to ‘disqualified individuals’ (generally officers, shareholders and highly compensated individuals, each as determined under applicable regulations) upon a change in control. In non-public companies, the penalties of Code sections 280G and 4999 may be avoided by disclosing the applicable payments and having the shareholders approve them prior to the change in control.Deferral
Is deferral and vesting of incentive awards permissible? Are there limits on the length or type of vesting and deferral provisions?
It is legally permissible for a company to permit deferral and vesting of an incentive award, whether by the terms of the award or by election of the award recipient. Vesting may be time-based or performance-based (or a combination thereof). There are generally no legally required minimum or maximum vesting or deferral periods, but any such terms would need to comply with the terms of the company’s equity award plan and the applicable award agreement. Many equity plans (particularly in the case of public companies) require minimum vesting conditions (such as a minimum of one year of service). Further deferral of incentive awards will result in the delay of taxable income only if such deferrals are structured to comply with or be exempt from Code section 409A. Certain states, such as California, have also adopted state tax laws similar to section 409A that impose conditions on deferrals under state laws.
In the case of a deferral arrangement, the ‘top hat’ rules of ERISA (ie, relating to plans that are unfunded and maintained primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees) would need to be considered. In the event that deferrals are permitted to termination of employment or beyond, the arrangement may constitute an ERISA retirement plan and if, even inadvertently, it is made available to a group that does not constitute a top hat group of employees, the plan will not be eligible for the exceptions from certain portions of ERISA afforded to top hat plans (see question 12).
In addition, Code section 457A imposes significant limitations on the extent to which taxation of compensation can be delayed where the deferral is made pursuant to a plan of a nonqualified entity. A nonqualified entity means:
- a foreign (non-US) corporation unless substantially all of its income is conducted through a US business or is subject to a comprehensive foreign income tax; or
- a partnership unless substantially all of its income is allocated to persons other than foreign persons with respect to whom income is not subject to a comprehensive foreign income tax and organisations that are exempt from US income tax.
Are there limitations on the individuals or groups eligible to receive the compensation? Are there aspects of the arrangement that can only be extended to certain groups of employees?
Each plan or arrangement providing incentive or deferred compensation will specify the eligibility requirements for the plan or arrangement. As noted in question 3, in the case of incentive plans of listed companies involving the issuance of equity or equity-based awards, the eligibility requirements of the plan generally must be disclosed to, and approved by, the company’s shareholders and any change in such eligibility is treated as the adoption of a new plan that requires new shareholder approval.
ERISA defines a ‘pension’ plan as a plan, programme or arrangement that is established or maintained by an employer to the extent that, either by its terms or as a result of the surrounding circumstances, provides retirement income to employees or results in a deferral of income by employees for a period extending to termination of employment or beyond. Pension plans that are subject to ERISA are required to meet ERISA’s funding, accrual, minimum participation standards, and vesting requirements. Top hat plans (plans that are unfunded and maintained by an employer primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees) are considered ERISA plans, but are exempt from many of ERISA’s requirements, including the foregoing requirements. Note that executives may in some instances have an incentive to challenge a plan’s top hat status in order to obtain those ERISA protections. No definitive guidance has been issued on when a plan will satisfy the top hat rules. The Department of Labor, in advisory opinions and amicus briefs, has taken the position that the word ‘primarily’ modifies the employer’s purpose in maintaining the plan rather than the group of employees covered. In reviewing the issue of whether the group covered is a select one, courts may look at qualitative or quantitative factors. For example, court cases have held that an employee’s bargaining power and duties are relevant in determining whether he or she is a member of the applicable group. The courts may also take into account the number or percentage of executives covered. In any event, there is no ‘brigh- line test’ as to how many employees may comprise a select group, but based on some cases, it is often recommended that the plan cover no more than the top 15 to 20 per cent highest paid employees. In the absence of a ‘bright-line test’, employers may wish to avoid a challenge to top-hat-plan status by restricting eligibility in a deferred compensation plan to a small group of the highest paid employees with executive responsibilities.Recurrent discretionary incentives
Can it be held that recurrent discretionary incentive compensation has become a mandatory contractual entitlement? Is this rebuttable?
A pattern of payment of recurrent discretionary incentive compensation does not result in a mandatory contractual entitlement under applicable laws, and most incentive plans specifically disclaim any such interpretation. Depending on the facts and circumstances and applicable state case law, however, employees may be able to bring a common law claim that the employer had a pattern and practice of paying bonuses and the employee continued employment in reliance on the bonuses. It Is unlikely that such claim would be successful unless there were promises (express or clearly implied) of continued incentives.Effect on other employees
Does the type or amount of incentive compensation awarded to an executive potentially affect the compensation that must be awarded to other executives or employees?
The type and amount of incentive compensation awarded to an executive does not affect the compensation that is legally required to be paid to other executives or employees. In certain cases, however, an executive may have a contractual right to incentive compensation that is comparable to levels or types of incentive compensation provided to similarly-situated executives of the company (eg, in relative amounts and earned based on the same criteria). However, this is provided that, without contractual provisions to the contrary, there is generally significant latitude to interpret who similarly-situated executives are and what the relative compensation of any individual should be. In addition, significant discrepancies in compensation (incentive or otherwise) can lead to discrimination claims by employees. Whether such a claim would be successful would depend on the facts and circumstances and what proof the employee could offer (eg, claims of sex or racial discrimination in the amount/type of compensation).Mandatory payment
Is it permissible to require repayment of incentive compensation under certain circumstances? Are there circumstances under which such repayment is mandatory?
Every state has wage and hours laws that protect an employee’s ‘earned’ wages. These laws generally significantly limit an employer’s ability to recover previously paid amounts (or offset future amounts) without the employee’s consent. That same level of protection typically does not apply to incentive compensation, but it is important for any recoupment rights to be clearly communicated to employees to avoid possible wage and hour claims. In any event, it has become increasingly common for bad acts and, in the financial institution context, adverse risk outcomes, to provide a basis for recovery of incentive compensation, particularly in the case of executives.
SOX requires chief executive officers and chief financial officers of public companies to disgorge incentive compensation and profits from company stock sales that they receive within the 12-month period following the public release of financial information if there is a restatement because of material non-compliance with financial reporting requirements as a result of misconduct. The SEC has proposed rules (under Dodd-Frank) that would require stock exchanges to prohibit companies from listing their shares if they do not adopt, disclose, and enforce clawback policies applicable to excess incentive compensation received by current and former executive officers in the three-year period preceding the date the issuer is required to prepare an accounting restatement, without regard to whether a specific executive engaged in the misconduct or whether misconduct actually occurred. Guidance on the specifics regarding these rules has not yet been provided.
Most companies, particularly public companies, have clawback policies that are somewhat broader than federal law currently requires and these policies are disclosed in the company’s publicly filed documents, if applicable. Under these policies, clawbacks may be triggered by any number of behaviours, including violation of restrictive covenants or company policies, overly risky business practices or #MeToo movement issues. (See question 34 for a discussion of the enforceability of clawbacks for violation of restrictive covenants.) Section 16(b) of the Exchange Act also requires an insider (generally any officer, director or 10 per cent shareholder) to return any profits obtained from the purchase and sale of company stock within a six-month period.
Can an arrangement provide that payment is conditioned on continuing employment until the payment date? Are there exceptions?
There are no prohibitions on payment being conditioned on continuing employment until the payment date and it is very common to include such a restriction on payment, particularly in the case of annual bonuses that are service-based. If the employment condition applies after the end of a performance period, it is important to be very clear as to the conditions for payment so as to avoid employee claims that the award was ‘earned’ (for state wage and hour law purposes) as of the last day of the performance period. Some states (eg, California) have stricter rules than other states as to the clarity of the conditions on continuing employment past the end of the performance period.
Equity-based compensationTypical forms
What are the prevalent forms of equity compensation awards in your jurisdiction? What is a typical vesting period? Must the arrangements be offered to a broad group of employees, or can the employer select the participants?
As discussed in question 9, common forms of equity compensation for corporations are stock options, SARs, restricted stock, RSUs, and PSUs, each of which may be subject to time-based or performance-based vesting. Partnerships and limited liability companies taxed as partnerships typically grant profits interests. Common vesting schedules for stock options and SARs provide for annual, graded, vesting over a period of three to four years. The typical vesting period for restricted stock, RSUs and PSUs is three to five years, usually in annual instalments, although performance-based awards typically provide for cliff vesting at the end of a performance period (with three years being a very common performance period). Performance-based conditions (which most often are also accompanied by continued employment conditions) vary greatly depending on the company’s business and shareholder concerns. Financial measures and relative total shareholder return are most common. The vesting periods and conditions for profits interests vary widely, but it is common for such interests to require continued employment through a ‘liquidity’ or ‘exit’ event or repurchase upon termination of employment prior to a liquidity or exit event pursuant to a formula that takes into account the reason for termination (eg, ‘good leaver’ or ‘bad leaver’ provisions).
Must equity-based compensation be granted by the company’s board of directors (or its committee) or can the authority be delegated to officers or employees of the company? Are there limitations or requirements that apply to delegation?
The law of the state of incorporation of a corporation will determine whether the board directors or a committee thereof must grant equity awards. Generally, however, the authority to grant actual equity (as opposed to the right to receive equity, such as stock options and RSUs) must be granted by the company’s board or a committee thereof. In addition, it is almost always the case that the board or a committee thereof, as a matter of corporate governance, will retain the authority to grant all equity and equity-based awards. The board or committee, as applicable, may delegate the authority to grant equity or equity-based awards provided that the right to grant actual equity must typically be granted to a ‘subcommittee’ of the board, for example, the CEO of the company who is also a member of the board. Any delegation must include limitations on the amount of equity that can be granted by the delegate, including, at a minimum, the value of the equity or equity-based awards that can be granted within a specified period of time. Sometimes, the delegation of authority will also include restrictions on the timing of grants subject to the delegation or limitations on the types of awards that can be made pursuant to the delegation.Tax treatment
Are there forms of equity compensation that are tax-advantageous or disadvantageous to employees or employers?
Restricted stock awards give the employee the ability to elect, by filing an election under Code section 83(b), to recognise ordinary income at the time the award is granted in an amount equal to the value of the award on the date of grant and to receive capital gains tax treatment on any appreciation. This can provide a benefit because capital gains tax rates are lower than the rates for ordinary income (and capital gains are not subject to withholding taxes). It does, however, present some risk to the employee due to the risk of forfeiture of the stock after the tax has been paid; whether the loss can be recouped depends on the individual’s personal tax situation.
Statutory options (typically referred to as ‘incentive stock options’ or ‘ISOs’) are eligible for special tax treatment. In order to qualify as an ISO, an option must satisfy the requirements of Code section 422. ISOs are not subject to tax upon grant or exercise and, provided the employee satisfies the holding requirements for the underlying stock, the difference between the amount realised upon the disposition of the shares and the amount paid for the shares will be treated as long-term capital gain (or loss, if applicable). If the holding period requirements are not satisfied (ie if there is a ‘disqualifying disposition’ of the shares, the employee generally will recognise ordinary income (for regular income tax purposes only) in the year of the disqualifying disposition equal to the excess, if any, of the fair market value of the shares on the date of exercise over the exercise price. Any excess of the amount realised on the disposition over the fair market value on the date of exercise will be taxed as long- or short-term capital gain (as applicable). If, however, the fair market value of the shares on the date of disqualifying disposition is less than on the date of exercise, the employee will recognise ordinary income equal only to the difference between the amount realised on the disqualifying disposition and the exercise price.
Code section 423 permits an employer to establish an ESPP that permits employees to purchase employer stock at a discount of up to 15 per cent of the fair market value of the stock and to receive favourable tax treatment on such purchases.
An employer should always consider the accounting treatment of equity awards that are being granted. The accounting treatment can vary significantly, positively or negatively, depending on the type of award and the structure of the award (eg, the vesting provisions and whether the award can be settled in cash rather than stock at the election of the company).Registration
Does equity-based compensation require registration or notice? Are exemptions, or simplified or expedited procedures available?
In a public company, the shares issued in connection with equity-based compensation must be registered unless an exemption from registration is available. The most common way to register shares under an equity-compensation plan is to use a Form S-8. Form S-8 is required to include a prospectus that outlines the material terms of the plan pursuant to which the shares are being offered, including the tax treatment of awards. The prospectus does not need to be publicly filed with Form S-8 but it is required to be provided to award recipients. Because of the absence of a filing requirement, preparation and distribution of a formal prospectus is sometimes overlooked.
In addition to Form S-8, shares issued in connection with equity-based compensation can be registered on other forms, including Form S-1 and Form S-3. These forms are significantly more complex than Form S-8 and are not designed for equity plan registration but rather general securities registration. Accordingly, they are rarely used to register equity-based compensation awards except in unusual circumstances.
There are certain exemptions from registration that might apply in certain circumstances. Common exemptions include:
- plans not subject to certain reporting requirements of the federal securities laws (Rule 701);
- sales to accredited investors (Regulation D); and
- private placements (section 4(a)(2) of the Securities Act).
State securities laws (called ‘blue sky laws’) are designed to protect investors from fraud and may require registration by non-public companies. Each state has different laws and a company must ensure compliance with the laws of each state in which it is offering securities as compensation.Withholding tax
Are there tax withholding requirements for equity-based awards?
Income and employment tax (Federal Insurance Contributions Act (FICA) and the Federal Unemployment Tax Act (FUTA)) withholding applies to most equity-based awards to employees. Withholding is not generally required for awards to service providers other than employees, such as awards to directors or independent contractors. Some states, however, do require withholding of state income tax on compensation payable to directors, including non-employee directors. The employer has the obligation to withhold the applicable taxes and pay them to the IRS or the applicable state tax authority.
Generally, the withholding obligation for income taxes arises when income is paid to the individual. For example, in the case of a nonqualified stock option, the individual recognises income upon exercise of the option and that is when the withholding is required. Similarly, in the case of restricted stock units, the income is recognised (and taxes due) upon settlement of the RSUs. Restricted stock is generally taxed when it becomes vested unless the employee files an election under Code section 83(b) to be taxed on grant and, in that case, the income is recognised and the withholding is due at the time of grant.
Normally, the withholding obligation for employment tax arises at the same time as the income tax withholding obligation. In the case of deferred compensation, however, Code section 3121(v) provides that such compensation is taken into account for FICA tax purposes at the time it becomes vested and the obligation to withhold generally arises at the same time. Thus, withholding for FICA taxes may be required prior to payment of the underlying deferred compensation, in which case the employer would need to make arrangements for the withholding to be satisfied at the proper time. For example, employment taxes could be withheld from other compensation payable to the employee, or the equity plan or award could provide for a distribution in an amount sufficient to satisfy the applicable withholding obligation (plus any income taxes on the amount distributed).
A company also needs to ensure that its withholding obligations are satisfied even when the payment or settlement of an award is in the form of stock, as is common in the case of equity and equity-based awards. The most common approach is to provide for the withholding to be satisfied from the shares that would otherwise be delivered to the participant upon vesting or settlement of the award (‘net withholding’). The employer could also require the employee to pay the withholding taxes, or taxes could be withheld from other income payable to the employee.
State income taxes are generally governed by the law of the state in which the services were performed that give rise to the compensation. Although withholding is generally required, state laws vary significantly as to what type of compensation is taxable and/or subject to withholding and applicable state laws need to be reviewed based on the specific facts of each case.Inter-company chargeback
Are inter-company chargeback agreements between a non-local parent company and local affiliate common? What issues arise?
Inter-company chargeback agreements for compensation are common between a parent and its affiliates when employees are employed by one entity in the group for tax purposes (eg, are paid on one company’s payroll) but provide services to other entities in the group. These agreements take varying forms depending on the compensation and employment structure of the group of companies but they generally cover tax and accounting issues relating to the arrangement. Specific issues that are frequently addressed include what is to be charged back to other companies in the group, when the chargeback is made, how much is charged back, allocations of tax deductions to each company in the group (assuming that the tax returns are not consolidated) and, if applicable, how to determine how the value of the compensation will be treated (eg, whether it will be treated as a contribution to capital from a parent to the affiliate or a dividend from an affiliate to the parent or in some other manner).Stock purchase plans
Are employee stock purchase plans prevalent or available? If so, are there any frequently encountered issues with such arrangements?
As discussed in question 19, Code section 423 permits an employer to establish an ESPP that permits employees to purchase employer stock at a discount of up to 15 per cent of the fair market value of the stock and to receive favourable tax treatment on such purchases. Code section 423 imposes many requirements on such plans. Although many companies have established ESPPs, the numerous requirements that must be met have deterred others from establishing these types of arrangements. In addition, as outlined in the next paragraph, the Code section 423 requirements preclude ESPP designs that limit eligibility to only certain segments of an employer’s workforce, and preclude many companies from establishing ESPPs altogether on account of the structure of the company’s business.
Some of the frequently encountered issues with ESPPs that are intended to satisfy the requirements of Code section 423 include the following:
- awards under the ESPP can only be granted to employees of a corporation or a direct corporate subsidiary of the issuing company;
- employees of partnerships cannot participate in the ESPP;
- with very limited exceptions, all employees of a company that establishes or participates in an ESPP must be eligible to participate in the ESPP for an offering period under the plan (and impermissible exclusion of even one employee can cause the benefits of the plan to be lost for all participants);
- all employees participating in the ESPP must have the same rights and privileges; and
- the ESPP must be approved by the issuing company’s shareholders (and any changes in the material terms thereof require new shareholder approval).
Permitted exclusions for groups of employees, including employees outside the United States, are limited.
Not all employee stock purchase plans are intended to satisfy the requirements of Code section 423. If an employee is given the right to purchase an employer’s stock at a discount, the right would be treated as a stock option with an exercise price that is below fair market value on the date of grant. If the grant is outside an ESPP that conforms to the Code section 423 requirements, the discounted stock option is subject to the rules of Code section 409A. Care needs to be taken to structure such awards so as to satisfy the requirements of Code section 409A. ESPPs that meet the requirements of Code section 423 are outside the scope of Code section 409A.
Employee benefitsMandatory and voluntary employee benefits
Are there any mandatory benefits? Are there limits on changing or discontinuing voluntary benefits that have been provided?
Employers are not required to provide their employees with paid leave. The Family and Medical Leave Act (FMLA), however, entitles eligible employees of covered employers to take unpaid, job-protected leave for specified family and medical reasons with continuation of group health insurance coverage under the same terms and conditions as if the employee had not taken leave. Eligible employees are entitled to 12 working weeks of leave in a 12-month period for, inter alia, the birth of a child, care of certain of the employee’s family members with a serious health condition, or the employee’s own serious health condition that makes the employee unable to perform the essential functions of his or her job. In certain instances, involving care for a covered service member, an employee may be entitled to 26 working weeks of unpaid leave during a single 12-month period. A number of states also have family medical leave statutes.
Employers are also not required to provide their employees with health benefits, but applicable large employers may face penalties if they do not make affordable coverage available. The employer shared responsibility provision of the Affordable Care Act penalises employers who either do not offer coverage or do not offer coverage that meets certain minimum value and affordability standards. These penalties apply to companies with 50 or more full-time equivalent employees. Employers who offer a health plan are prohibited from rescinding coverage retroactively (in the absence of fraud or the intentional misrepresentation of a material fact). Further, employers who materially modify benefits (which would include reduction or elimination of benefits) prospectively should generally provide at least 60 days advance written notice.
Employers with 20 or more employees who offer health benefits are also subject to the continuation benefit requirements of the Consolidated Omnibus Budget Reconciliation Act (COBRA), which affords employees (and certain qualified beneficiaries) who lose their employer sponsored health benefits on account of certain specified events (eg, job loss) to elect to continue to be covered by their employer plan, at the individual’s cost, for a period of 18 to 36 months. The period of continued coverage that must be made available to an employee or qualified beneficiary depends on the event causing the loss of coverage and the identity of the individual affected.
While employers are not required to provide severance or unemployment benefits, employers are required to pay (or to withhold from employee salaries) payroll taxes that fund various federal and state unemployment insurance programmes. Similarly, disability benefits are provided through federal programmes such as Social Security and Medicare, which are both financed by payroll taxes. In addition, some states maintain disability programmes.Typical employee benefits and incentives
What types of employee benefits are prevalent for executives? Are there tax or other financial incentives or disincentives for such employee benefit arrangements?
Employers typically maintain broad-based, tax qualified, retirement and welfare benefit plans that include executives as well as rank-and-file employees. In addition, because of certain limitations in the Code on benefits that may be offered under broad-based plans (both in terms of absolute amounts as well as in the disparity permitted between benefits for highly compensated employees and non-highly compensated employees), many employers provide executives with additional retirement benefits under nonqualified plans. The characteristics and tax attributes of qualified and nonqualified plans are discussed in questions 35 and 36.
Termination of employmentRules for termination
Are there prohibitions on terminating executives? Are there required notice periods? May executives be dismissed without cause?
Employers are not prohibited by US laws from terminating an executive for any reason or no reason, including without cause. Employers, however, are not permitted to terminate employees for discriminatory reasons, such as on the basis of sex, age, race, religion, sexual orientation or disability. Although there are certain federal laws that prohibit discrimination (such as age discrimination), there are also state non-discrimination laws that must be taken into account for purposes of determining what constitutes discrimination in that state and what criteria will apply in making the determination. Compliance with both state and federal law is required.
Generally, there is no minimum period of severance that must be provided in the event of a termination of employment. In some cases, however, the federal Worker Adjustment and Retraining Notification Act (WARN) (discussed further in question 27) may require minimum periods of severance in the event of mass layoffs unless certain notice requirements are met.
In addition, an employer may be a party to an employment agreement with an employee or may maintain a benefit plan that imposes notice requirements relating to termination and the consequences thereof in connection with terminations of employment. No such agreement or plan can include provisions that would permit discrimination that is otherwise prohibited by law. In addition, section 510 of ERISA prohibits any person from discharging, fining, expelling or discriminating against a participant or beneficiary for exercising any right to which he or she is entitled, or for the purpose of interfering with the attainment of any right such person may have, under the provisions of an employee benefit plan, ERISA or certain other laws.Mandatory severance pay
Are there statutory or mandatory minimum severance requirements? Are there any other mandatory, post-employment benefits?
There are not mandatory severance provisions. WARN, however, requires employers (generally those with 100 or more employees) to provide at least 60 days advance notice of covered plant closings and covered mass layoffs. This notice must be provided to either affected workers or their representatives (eg, a collective bargaining agent) and governmental entities. If the full 60 days advance notice is not provided, the employer must generally provide the employees with the pay and benefits (or the value thereof) that they would have otherwise received for the applicable shortfall in the required notice period. For example, if only 30 days’ advance notice is provided, the employee is entitled to an additional 30 days of pay and benefits (or the value thereof) to make-up for the shortfall in the notice period. A number of states (including California, New Jersey and New York) have adopted state WARN laws that are more restrictive than federal WARN or provide additional triggers.
As referenced in question 24, COBRA requires employees (and their covered spouses and eligible dependents) to be provided with the opportunity to continue employer-provided group health coverage following termination of employment (other than termination for ‘cause’) and employees and their eligible spouses or dependents must be given notice of their COBRA rights at various times, including in connection with termination of employment. Failure to give the notice can result in financial penalties on the employer. The maximum period of COBRA coverage in the event of termination of employment is generally 18 months, although it may be extended for a longer period (maximum of 36 months) in certain circumstances. The presumption is that employees will pay for the full cost of the COBRA coverage although many employers subsidise the coverage for some period, particularly in the case of executives where their termination is other than for ‘cause’, ‘constructive dismissal’ or ‘good reason’.. Many states, such as California and Illinois, have adopted state laws requiring post-employment continuation of health benefits and, in many cases, the state laws are more generous to employees than COBRA would require.Typical severance pay
What executive severance payment level is typical?
The typical level of executive severance pay varies depending on the executive’s position and whether the severance pay is provided in connection with a termination in a change-in-control context. Usually, severance is only provided for ‘involuntary’ terminations which generally means termination by the employer other than for cause or termination by the executive for ‘good reason’, the definitions of which vary widely from company to company and sometimes among various arrangements maintained by the same company. Typical severance levels range from 12 to 24 months of base salary or base salary plus target annual bonus, with the higher level being applicable to the chief executive officer and his or her direct reports. Additional severance benefits may also be included, such as a pro rata portion of the annual bonus for the year of termination and subsidised health coverage for the severance period. The benefits are usually conditioned upon the executive signing a valid release of claims against the company. In the event of an involuntary termination in connection with a change in control (usually a termination occurring within a period of one to two years following the change in control), an additional period of severance (usually 12 months) is commonly provided.Reasons for dismissal
Are there limits on dismissal for ‘cause’? Are there any statutory limits on ‘constructive dismissal’ or ‘good reason’? How are ‘cause’ or ‘constructive dismissal’ defined? Are there legal or customary rules relating to effecting a termination for ‘cause’ or ‘constructive dismissal’?
Generally, there are no limitations on ‘cause’ or ‘good reason’ terminations although the terms are usually defined by the terms of an agreement or plan. State laws often have a common law definition of what constitutes cause or ‘constructive discharge’ (a corollary to ‘good reason’) and those definitions may become relevant absent a contract or plan definition or where the definition may inform an employer’s interpretation of a plan or agreement.
Typical cause triggers under an executive employment agreement or severance plan include:
- failure to substantially perform duties;
- commission of a felony;
- engaging in illegal conduct or gross misconduct that causes financial or reputational harm to the company;
- engaging in moral turpitude;
- material breach of restrictive covenants, employer policies or other provisions of an agreement; or
- being disqualified or barred by any governmental or self-regulatory authority from serving in the contemplated position.
Typical good-reason triggers under an executive employment agreement or severance plan include:
- material and adverse change in position;
- duties and responsibilities;
- material and adverse change in reporting relationships;
- reduction in base salary and annual bonus opportunity; and
- material breach of employment agreement by the company.
Good-reason provisions typically require notice and an opportunity to cure circumstances constituting good reason and require termination within a specific period following expiration of the cure period in the event the good-reason event is not cured within the applicable time period. Code section 409A contains requirements for good-reason triggers that, if satisfied, enable some or all of the severance pay and benefits to conform to exemptions from Code section 409A, thus providing more flexibility in structuring the payment and provision of the severance pay and benefits.
Broad-based severance plans covering rank-and-file employees typically have broader cause definitions and do not have good-reason definitions.Gardening leave
Are ‘gardening leave’ provisions typically used in employment terminations? Do they have any special effect on benefits?
It is not uncommon to provide executives with an extended period of pay and benefits after they cease to perform actual services for the employer and to set the ‘termination date’ as a future date. In the United States, this period is not typically referred to as ‘gardening leave’ and is not usually contemplated at the beginning of the arrangement, but rather is something that is negotiated at the end of the employment relationship. In some cases, an employment agreement will contemplate a post-employment termination ‘advisory’ or ‘consulting’ period during which the employee may receive pay for a period provided that he or she agrees to certain conditions, such as compliance with restrictive covenants that may otherwise be more difficult to enforce under applicable state law.
Under Code section 409A, benefits are often paid on account of a termination of employment. For this purpose, the termination of employment is the date on which the parties reasonably expect that the employee will not provide substantial future services. Under these rules, the extended period of services (ie, the ‘gardening leave’ period regardless of what it is called) would be disregarded and payments of amounts that are subject to Code section 409A would need to be paid based on the date on which the section 409A termination date occurs, if applicable.
Under certain circumstances, the terms of applicable benefit plans may preclude coverage for individuals who are not providing actual services. The terms of benefit plans should be reviewed to determine whether and the extent to which services are required.Waiver of claims
Is a general waiver or release of claims on termination of an executive’s employment normally permitted? Are there any restrictions or requirements for the waiver or release to be enforceable?
Generally, a waiver and release of claims is not only permitted but is a condition commonly imposed on an employee’s eligibility for severance payments and benefits. A waiver and release must be supported by adequate consideration: if payments and benefits are not conditioned on a waiver and release when the benefits are promised, additional consideration will need to be provided in order for the release to be enforceable. Pay under WARN for the period of a notice shortfall is not valid consideration for a release.
The federal Age Discrimination in Employment Act provides that, in order for a release of age discrimination claims to be valid (generally applicable to employees who are aged 40 or older) the employee must be given a period of at least 21 days to review the release and a period of seven days to revoke the release after it is executed. In the case of a mass termination (more than one employee), the review period is 45 days. Claims under the Fair Labor Standards Act and FMLA cannot be released without approval of the DOL or a court. A waiver and release cannot prevent or impair the employee’s ability to report possible violations of law or regulation to any governmental agency or entity, including the SEC or the Equal Employment Opportunity Commission, or from making other disclosures that are protected under the whistle-blower provisions of federal law or regulation.
Many states, including California, Texas and Georgia, subject releases to additional state law requirements.
Post-employment restrictive covenantsTypical covenants
What post-employment restrictive covenants are prevalent? What are the typical restricted periods?
Among the most common post-employment restrictive covenants are covenants not to compete, covenants not to solicit customers or employees, and covenants not to disclose confidential information. While there is significant variation in restriction periods among industries, a restriction period of 12 to 24 months for senior executives and a period of six to 12 months for more junior executives would not be uncommon. Restriction periods, if any, for non-executive employees are typically significantly shorter.Enforceability
Are there limits on, or requirements for, post-employment restrictive covenants to be enforceable? Will a court typically modify a covenant to make it enforceable?
In the United States the enforceability of post-employment restrictive covenants, like other terms and conditions of employment and issues of contract, is governed by state law. In most states, a covenant not to compete is enforceable, provided that it is reasonable. In assessing the reasonableness of such a covenant, a court will focus on the duration and geographic scope of the restriction and the substantive nature of the activity being restricted, each from the perspective of whether it serves a legitimate business interest of the employer. A covenant not to compete will not be enforced if it is too long, if it is broader in geographic scope than the region in which the employer operates, or if the substantive nature of the business activity being restricted is broader than the employer’s operations. A similar reasonableness approach applies to covenants not to solicit employees. In some states, the courts will ‘blue pencil’ an overly restrictive covenant, meaning they will rewrite it to make it enforceable. Other courts will not enforce them.
A minority of states, including California, Montana, North Dakota and Oklahoma, ban covenants not to compete altogether or prohibit them except in limited circumstances. For example, the California Code generally prohibits restrictions on an individual’s ability to carry on a business or vocation. Hence the courts in California have deemed covenants not to compete to be against the state’s public policy and refuse to enforce them, with narrow exceptions. The exceptions apply when an individual sells all of his or her interest in a corporation or partnership, including the goodwill associated with the interest, and enters into a covenant not to compete in connection therewith. Even then, the California courts will enforce the non-compete only if it is reasonable in terms of duration, geographic scope and scope of substantive activity. Overall, the public policy against non-competition provisions is of such force that some courts have invalidated an entire agreement if it contains a covenant not to compete. California treats covenants not to solicit customers as covenants not to compete, but at least until recently has treated covenants not to solicit employees less restrictively. Recently federal courts and California appellate decisions have held that all non-solicitation agreements are unenforceable under California law. The California Supreme Court, however, has not weighed in, making the enforceability of non-solicitation agreements in that state a fluid issue. California also prohibits employers from requiring employees, as a condition of employment, to agree to a contractual provision that either necessitates an employee to adjudicate outside of California a claim arising in California or deprives the employee of the substantive protections of California Law with respect to a controversy arising in California. Employers should not select a forum other than California in employment agreements of employees who primarily work or reside in California, unless the agreement that includes the choice of forum clause was negotiated by the employee’s lawyer.
In recent years a number of states have enacted legislation significantly restricting the use of non-competition provisions (eg, banning their use for low-wage workers, exempt employees and involuntarily terminated employees at all levels, imposing specific duration limitations, such as 12 or 18 months, requiring their disclosure prior to or at the inception of employment, and requiring that both employer and employee sign any agreement containing such provisions). This trend continues in the form of proposed legislation in several states (eg, New Jersey, Pennsylvania and Vermont) that would follow suit.
Covenants not to disclose an employer’s confidential information/trade secrets are generally enforceable in all states provided that they are not overly broad. Some employers will attempt to circumvent the limitations on non-compete provisions by drafting confidentiality clauses to designate a wide category of information with which the employee may come into contact as confidential or trade secret information, and then prohibit the employee from using such information in any future employment. The courts, however, will generally only enforce confidentiality provisions to the extent that the information in question rises to the level of a protectable trade secret, such as proprietary information that would provide an employee with an unfair advantage, goodwill, or customer lists and the information was improperly used by the employee in his or her new employment.
The Defend Trade Secrets Act of 2016 contains immunity and anti-retaliation provisions intended to protect individuals who may need to disclose trade secrets in certain limited situations. An employment agreement must include notice of the immunity and retaliation provisions of the Act. A cross-reference to an employer’s whistle-blower policy, if any, which contains these provisions, can satisfy the notice requirement. If an employer fails to provide the required notice, the employer cannot recover punitive damages or attorneys’ fees under the act from an employee to whom the required notice was not provided. The employer may nevertheless obtain such punitive damages and attorneys’ fees under state law in nearly every state.Remedies for breach
What remedies can the employer seek for breach of post-employment restrictive covenants?
Injunctive relief is the primary means of enforcing restrictive covenants and confidentiality provisions. Damages may also be recoverable in some instances.
Because, however, as discussed in question 33, a court may invalidate (and thus refuse to enforce) a covenant not to compete, some employers will condition the provision of compensation and benefits on compliance with various types of restrictive covenants, such as non-compete and confidentiality covenants. For example, an employment agreement or benefit plan may provide for the forfeiture of an executive’s compensation or benefits or even the clawback of amounts already paid to the executive, in the event of violation by the employee of a post-termination restrictive covenant. The enforceability of these restrictions will vary with the type of restriction, the type of compensation or benefit, and the applicable law. For example, certain statutory vesting and anti-cutback rules in ERISA will generally preclude the forfeiture or clawback of an individual’s benefits under a pension plan that is subject to that statute. In the case of a pension plan maintained for a select group of management or highly compensated employees (a top hat plan), however, the ERISA vesting and anti-alienation rules do not apply. Instead, whether a plan forfeiture provision is enforceable with respect to top hat benefits will depend on federal principles of contract law. (While, as noted in question 1, ERISA pre-empts state law even as applied to top hat plans, courts applying federal principles of contract law will sometimes treat those principles as informed by state law that would have applied in the absence of pre-emption.) The analysis is similar for welfare benefits, which are not subject to ERISA’s vesting and anti-alienation provisions.
Salary, commissions, overtime and bonuses, stock options, restricted stock, SARs, and other types of incentive compensation that do not defer compensation until termination of employment, are not subject to ERISA, absent special circumstances. The enforceability of a forfeiture or clawback for violation of a post-termination restriction will generally rely on principles of state law, and varies with the type of compensation, the type of covenant and the applicable state’s laws (see also the discussion of clawbacks required by federal law at question 15).
State wage protection laws generally preclude the forfeiture of earned but unpaid wages, and the clawback of wages already paid to an employee, at least without employee consent. Even if compensation and benefits are not protected by ERISA or state wage protection laws, a court may nevertheless refuse to uphold a forfeiture for violation of a restrictive covenant. In some states, a provision for the forfeiture or clawback of compensation or benefits in the event of a violation of a non-competition agreement is viewed as an indirect restraint on trade that will be analysed under the traditional reasonableness analysis applicable to direct prohibitions on competition. The courts in such cases will uphold a forfeiture for competition only if the restraint on the employee is reasonable in temporal and geographic terms, as well as in the amount and severity of the forfeiture. In states such as California, a forfeiture or clawback provision for violation of a non-competition provision would be prohibited. In other states, forfeiture for competition clauses has been distinguished from that of covenants not to compete, and held enforceable without regard to the reasonableness of the restraint. In states such as New York, the ‘employee choice’ doctrine permits forfeiture for competition provisions to be enforced, without regard to the reasonableness of the restraint, provided that the employee has an effective choice between retaining the benefit, or competing and forfeiting the benefit; the doctrine does not apply to an employee who has been involuntarily terminated.
Pension and other retirement benefitsRequired retirement benefits and incentives
Are there any required pension or other retirement benefits? Are there limits on discontinuing or modifying voluntary benefits that have been provided?
The US government provides social security benefits funded with employer and employee payroll taxes. With limited exceptions, all employers are required to withhold from employee wages certain social security taxes, and to remit such amounts, together with corresponding employer contributions, to the Social Security Administration. Upon retirement, individuals receive monthly payments from the US government in an amount determined by a statutorily prescribed formula.
The maintenance of any retirement programme, other than participation in the Social Security System, is entirely voluntary with the employer. The types of programmes an employer may maintain include certain broad-based funded plans, known as ‘qualified plans’, for which the employer receives substantial tax benefits in return for satisfying a variety of requirements, including among others coverage of a broad cross section of its workforce in a manner that does not favour highly compensated employees. The maintenance of all manner of executive compensation programmes, including equity compensation awards and incentive compensation is entirely voluntary with the employer.
The ERISA anti-cutback rules prohibit a plan sponsor from adopting a plan amendment to a qualified plan that would eliminate or reduce benefits accrued to the date of the amendment or early retirement benefits and subsidies applicable to such accrued benefits or optional forms of payment offered under the plan. Although such a plan may be amended to eliminate or reduce benefits prospectively, ERISA requires that in the case of a defined benefit plan, 45 days advance notice be given before such an amendment becomes effective. In the case of executive compensation arrangements that are not subject to ERISA, the statutory anti-cutback rules have no application and the executive’s protection is limited to state contract laws. Even a top hat plan, which is subject to certain provisions of ERISA, is not subject to ERISA’s anti-cutback protections, and thus executives covered by such a plan must rely on contract laws (generally, the federal common law of contracts).
Similarly, plans subject to ERISA may not include provisions forfeiting retirement benefits for ‘cause’ or violation of other restrictions and bad-boy clauses (eg, non-competition, non-disclosure or non-solicitation). In the case of executive compensation arrangements not subject to ERISA, as well as top hat plans subject to ERISA, executives must look to the language of the contract and possible provisions of state law (eg, any limitations on non-competition provisions) for protection against forfeiture.Typical retirement benefits and incentives
What types of pension or other retirement benefits are prevalent for executives? Are there tax or other financial incentives or disincentives for such employee benefit arrangements?
Executives may participate in both qualified and nonqualified plans. Qualified plans (which generally provide retirement benefits or deferred compensation, rather than welfare benefits) enjoy special tax benefits not available to nonqualified deferred compensation plans as follows:
- the employer enjoys an immediate deduction for contributions to the plan;
- employees are able to defer income inclusion until those benefits are distributed; and
- income on the trust used to fund benefits is not subject to taxation.
The price to be paid for these tax benefits is satisfaction of the extensive and sometimes Byzantine requirements known as the Code ‘qualification rules’, as well as the deduction limitations and, in the case of defined benefit plans, the minimum funding rules. The qualification requirements include, among others:
- minimum participation requirements;
- permissible rates of accrual;
- minimum vesting requirements;
- anti-cutback rules;
- limitations on contributions and benefits; and
- certain non-discrimination rules designed to prevent qualified plans from discriminating (in either coverage or benefit levels) in favour of highly compensated employees.
Nonqualified retirement plans typically allow executives to elect to defer compensation and, if structured properly, delay the inclusion of income until payment or provide employer-funded benefits in excess of those that a qualified plan may provide on account of the various qualification requirements (see question 37).
Nonqualified plans, although simpler than qualified plans, require an understanding of a number of tax principles. Perhaps most significantly the requirements of Code section 409A include principles of constructive receipt of income, rules relating to whether benefits are treated as unfunded or funded and rules relating to the timing of deductions (generally Code section 404(a)(5)).
Provided that nonqualified benefits are not funded, and certain requirements described in section 409A are satisfied, such benefits are generally not included in income until paid, and the employer’s deduction generally coincides with the income inclusion by the executive.Supplemental retirement benefits
May executives receive supplemental retirement benefits?
Nonqualified retirement benefits are important and prevalent in the executive compensation arena. As noted in question 36, qualified plans are subject to non-discrimination rules which require that they deliver benefits to a broad cross-section of employees, and further are subject to dollar limitations on the amount of compensation that may be taken into account under the plans and the level of benefits that may be delivered. Nonqualified plans provide a way to limit the group covered and provide a much higher level of benefits. They may be structured as defined benefit or defined contribution plans, and frequently ‘wrap’ or supplement qualified plans offered by the employer. If they provide only benefits in excess of those permitted under certain Code section limits (section 415), they are known for purposes of ERISA as ‘excess plans’, may cover all participants, both high- and low-paid, and are exempt from ERISA, including all funding requirements. Those that provide benefits in excess of other Code limits, or are calculated on other bases, are subject to all of the requirements of ERISA, unless they meet the definition of a top hat plan, in which event they are exempt from a number of ERISA provisions, most significantly, those requiring that benefits be funded. As discussed elsewhere, a top hat plan is a plan that is unfunded and maintained by an employer primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees.
A SERP is a common top hat plan that will ‘wrap’ a qualified defined benefit plan and provide benefits for executives in excess of various Code limitations, and may also base benefits on other nonqualified deferred compensation that is not ‘pension eligible earnings’ under the qualified defined benefit plan. A section 401(k) wrap plan is also typically a top hat plan since it provides benefits based on limitations other than (or in addition to) those described in Code section 415.
One trap for the unwary that frequently arises in connection with nonqualified plans that ‘wrap’ (ie, provide benefits in excess of those permitted under) a section 401(k) plan is known as the ‘contingent benefit rule’. Under the qualified plan rules, a section 401(k) plan will not be treated as qualified if any other benefit is conditioned (directly or indirectly) on the employee electing or not electing to making pre-tax contributions to the plan. There is an exception to the contingent benefit rule for nonqualified deferred compensation plans, but the plans must be carefully structured to avoid violating this rule and causing the underlying section 401(k) plan to become disqualified.
IndemnificationDirectors and officers
May an executive be indemnified or insured for claims related to actions taken as an executive, officer or director?
It is permissible to indemnify executives for actions taken as an officer or director. These indemnification provisions are subject to applicable state corporate law restrictions (such as prohibitions on indemnifying for bad acts) and applicable federal laws (such as SEC rules). The protections are usually set forth in the company’s charter and by-laws. Most companies also have director and officer insurance policies that cover executives for actions taken in the course of their duties. In the case of a corporate transaction, it is common for the selling company to purchase a ‘tail policy’ to cover claims incurred prior to the transaction that are made after the acquisition closes.
Change in controlTransfer of benefits
Under what circumstances will an asset sale in your jurisdiction result in an automatic transfer of benefit obligations to the acquirer?
In the United States, an asset sale generally allows the parties significant flexibility as to what assets and liabilities are included in the transaction. Such a sale will generally not result in the automatic transfer of benefit obligations to the buyer unless the buyer assumes those obligations by contract, subject to an exception in certain circumstances, for the continued healthcare requirements in COBRA. In an asset sale in which the acquirer is a ‘successor employer’, as defined in COBRA, and the seller-controlled group ceases to maintain a group health plan following closing, the acquirer becomes liable for the provision of COBRA benefits (including possibly for employees who never become employed by the acquirer).Executive retention
Is it customary to provide for executive retention or related arrangements in connection with a change in control?
The provision of executive retention arrangements in the context of a change in control is relatively common, although the structure of such arrangements varies widely. The overall objective is typically to encourage those individuals considered vital to the success of the organisation to continue performing services from signing to closing and in some cases thereafter. For that reason, although the terms of such arrangements vary significantly from company to company, the overall structure will typically provide that those who continue to provide services and who remain in good standing will receive cash or vest in equity awards at a specified date or dates on or after closing. Special provisions may also be included that provide for payment of the amount in the event that the employee’s employment is involuntarily terminated prior to the end of the retention period.
In addition, change-in-control agreements, sometimes referred to as ‘golden parachutes’, which compensate executives for loss of job owing to mergers or the sale of a business, are likewise common. Similar to retention arrangements, the terms of change-in-control agreements vary from company to company, but they are generally structured with the goal of encouraging executives to pursue sale or merger opportunities when it is in the best interest of the shareholders, without regard to the fact that such a transaction may result in the loss of the executive’s position.Expedited vesting of compensation
Are there limits or prohibitions on the acceleration of vesting or exercisability of compensation in a change in control? Are there restrictions on ‘cashing-out’ equity awards?
There are no limits or prohibitions on the acceleration of vesting or exercisability of compensation, or cashing-out equity awards upon a change in control, other than limitations contained in the plan or award agreement. Institutional shareholders and shareholder advocacy groups, however, have sought to end provisions that accelerate vesting and exercisability upon change in control without a termination of employment (single trigger provisions). Continued pressure from these groups has been a factor in the increased prevalence of double triggers (requiring termination of employment before benefits are triggered. Institutional Shareholders Services (ISS), a strong proxy adviser group, considers single trigger provisions to be a ‘bad pay practice’ and carries significant weight in determining whether ISS will recommend a ‘no’ vote recommendation on a company’s compensation structure.
Likewise, there is no restriction on cashing-out benefits under deferred compensation plans upon a change in control, other than any that may be included in the plan or award agreement itself - such a provision would be enforceable by contract. Note that a cash-out may not be desired by a participant and that in some instances, participants have opposed the cash-out in a lump sum of benefits otherwise payable in the form of an annuity. (In at least one instance, participants successfully sued to enforce a prohibition on the cash-out of their benefits under a nonqualified defined benefit plan.)
Are there adverse tax consequences for the employer or the executive relating to benefits or payments provided pursuant to a change in control?
Payments to executives that exceed certain limits prescribed in Code section 280G are subject to a 20 per cent excise tax (payable by the executive and subject to withholding by the employer) and are not deductible by the employer. A small minority of companies provide a gross-up for this excise tax. Such gross-up provisions are heavily disfavoured by institutional shareholders and proxy advisory firms, and their prevalence has significantly declined in recent years. As with single trigger change in control provisions discussed in question 41, ISS considers gross-ups a bad pay practice and such provisions will likely result in a ‘no’ vote recommendation.
Finally, in the case of any arrangement that is subject to Code section 409A, a provision triggering payments or accelerated payment upon a change in control should be structured in such a way as to be exempt from or comply with section 409A to avoid adverse tax consequences.
Multi-jurisdictional mattersExchange controls
Do foreign exchange controls rules apply to the remittance of funds, or the transfer of employer equity or equity-based awards to executives?
Foreign exchange control rules do not apply to the remittance of funds or the transfer of employer equity awards to executives. As an aside, however, employers frequently provide US expatriates with protection from fluctuations in exchange rates and certain tax equalisation benefits.Local language requirement
Must employment agreements, employee compensation or benefit plans, or award agreements be translated into the local language?
There is no statutory or regulatory requirement that employment agreements, employee compensation or benefit plans or award agreements be provided in English, the language spoken by most people in the United States, but in practice this is almost universally done.
In addition, in the case of plans governed by ERISA, the Department of Labor requires, in certain circumstances, that materials related to the plan be translated into one or more foreign languages. For example, regulations issued by the DOL require that where a specified percentage of plan participants are literate only in the same foreign language, so that a summary plan description in English would fail to inform these participants adequately of their rights the plan, the plan administrator must provide these participants with an English-language summary plan description that prominently displays a notice, in the foreign language common to these participants, offering them assistance. In addition, regulations recently issued by DOL with respect to benefit claims and appeals require that ‘if a claimant’s address is in a county where 10 per cent or more of the population residing in that county are literate only in the same non-English language’, the claimant’s plan is required to provide notices in a culturally and linguistically appropriate manner. This means that the plan administrator must include with all notices of adverse benefit determinations, a statement in the applicable foreign language. This indicates how to access language services provided by the plan and must provide written notices in the applicable foreign language upon request and oral language assistance in the applicable foreign language.Net salary arrangements
Are there prohibitions on tax gross-up, tax indemnity or tax equalisation payments?
There are no statutory or regulatory prohibitions on tax gross-up or tax indemnity payments. Nevertheless, as a result of increasing pressure from institutional shareholders and shareholder advocacy groups, the prevalence of tax gross-up and tax indemnity provisions in executive compensation agreements has fallen off significantly over the last several years. In addition, such arrangements must be structured in such a way that they comply with, or are exempt from, Code section 409A in order to avoid any adverse tax consequences under that Code section.
There is likewise no prohibition on tax equalisation arrangements, which are commonly provided to expatriate executives. Again, care should be taken to ensure that such an arrangement is structured so as to be exempt from, or comply with, Code section 409A.Choice of law
Are choice-of-law provisions in executive employment contracts generally respected?
Generally, courts will respect choice of law provisions in executive employment contracts if the provision is simply a matter of typical contract negotiations. However, if the provision involves a matter of public policy, it is more common for state courts to enforce the public policy of the state where the employee is working, especially if the case is brought before the courts of that state. The classic example of a matter of public policy is a restrictive covenant. Further, as noted in question 33, California law prohibits employers from requiring employees, as a condition of employment, to agree to a contractual provision that either requires an employee to adjudicate outside California a claim arising in California or deprives the employee of the substantive protections of California Law with respect to a controversy arising in California.
Update and trendsKey developments of the past year
What were the key cases, decisions, judgments and policy and legislative developments of the past year?Key developments of the past year47 What were the key cases, decisions, judgments and policy and legislative developments of the past year?
In re Investors Bancorp, Inc Stockholder Litigation (177 A 3d 1208 (Del 2017) held that Delaware courts will not apply the deferential ‘business judgment rule’ to the review of challenges to director compensation granted pursuant to stockholder approved plans but will instead apply the ‘entire fairness doctrine’ as the standard of review. Under the entire fairness doctrine, the directors bear the burden of proving that their compensation was entirely fair to the company and it would be less likely that the directors would be able to succeed on a motion to dismiss. If the company’s shareholders have approved (or ratified) the director compensation, however, the business judgment review will be applied. Following on from the Investors Bancorp case, the court in Stein v Blankfein, CA No. 2017-0354-SG (Del Ch 31 May 2019) declined to dismiss a complaint relating to the amount of compensation payable to the directors of the Goldman Sachs Group, Inc. Applying the principles set forth in the Investors Bancorp case, the court held that the provisions of the stockholder approved plans of Goldman Sachs, which provided that stock awards were to be determined in the directors’ discretion, were not sufficient to overcome application of the entire fairness doctrine. The fact that the plan also provided that the directors’ decisions were to be performed under a good-faith standard (other than a duty-of-loyalty standard) was not sufficient to change the conclusion relating to the review standard to be applied.
In Aileen Rizo v Jim Yovino, Fresno County Superintendent of Schools, No. 16-15372 (9th Cir 9 April 2018), the Ninth Circuit held that prior salary history may not be used to justify a wage differential between men and women. Id at p13. In 2019, the US Supreme Court vacated the decision and returned it to the Ninth Circuit on a technicality. The judge who authored the majority opinion died before it was issued. Commentators have indicated that a new ruling from the Ninth Circuit similar to the first (although perhaps based on different reasoning) is expected. Further, in recent years, a number of states have enacted legislation that prohibits taking prior salary history into account in setting an employee’s wages.Further developments
- ISS proclamations: Seven Mortal Sins (John Roe, ISS Analytics, 17 May 2019).
- SEC Release 33-10593: Adoption of final rules under Dodd Frank relating to disclosure of hedging policies and any actual hedging that has been permitted.
- Department of Justice crackdown on anti-poaching agreements between employers (as a violation of the antitrust laws): Statements of Interest filed in several cases and most recently targeted franchise operations (Auntie Anne’s, Arby’s and Carl’s Jr) where such provisions are common.
- Increase in enactment of state legislation restricting or banning the use of non-competes: Massachusetts, Utah, Ohio (adopted); Pennsylvania, Vermont and New Jersey (proposed).
- Federal legislation: section 2782 of the Workforce Mobility Act 2018 was introduced to prohibit non-competition restrictions nationwide.