On January 1, 2008, new regulations from the Treasury Department and the Internal Revenue Service (IRS) under Section 409A of the Internal Revenue Code will take effect. These regulations, which may be relied upon prior to January, are expected to alter M&A transactions involving a change of control.

Distributions Upon a Change in Control

Deferred compensation amounts subject to Section 409A may only be distributed upon certain specified events, such as separation from service or upon a permissible change in control. A permissible change in control for purposes of Section 409A includes a change in ownership of 50 percent of the stock of the company, a change in the ownership of 40 percent of the company’s assets, or a change in the effective control of a company. The proposed regulations provided that a change in the effective control of the company consisted of the acquisition of at least 35 percent of the total voting power of the stock of such company (or when a majority of members of the company’s board of directors is replaced during any 12 month period by directors whose appointment or election is not endorsed by a majority of the members of the company’s board of directors before the date of the appointment or election). The new regulations lower the threshold for an effective change in control to as low as 30 percent of the total voting power of the stock of such company. While not as low as the 20 percent requested by some commentators, the change is favorable because it allows a lower threshold for a permissible change in control, allowing a distribution of deferred amounts to participants.

Electing to Avoid Distributions in Certain Asset Transactions

The new regulations adopt a rule that allows service recipients (generally employers) to exercise additional control over whether a sale of assets will trigger a distribution to the service providers (generally, employees or independent contractors). The buyer and seller may now specify, under limited conditions, whether the service providers will qualify for a distribution or not, i.e., the parties may agree to apply a “same-desk” type rule prohibiting distributions. To rely upon this special rule, the asset purchase transaction must result from bona fide, arm’s length negotiations. In addition, all service providers of the seller immediately before the asset purchase transaction who would be providing services to the buyer, after and in connection with the asset purchase transaction, must be treated consistently for purposes of applying the provisions of any nonqualified deferred compensation plan. Such treatment must be specified no later than the closing date of the asset purchase transaction. The new regulation is favorable because it allows for greater control over whether a sale of assets will trigger distributions to service providers.

Terminating Nonqualified Plans Following a Change in Control

The proposed regulations provided that deferred compensation plans may be terminated in connection with a change in control, but required all substantially similar plans to be terminated—raising a question of whether the buyer had to terminate its plans. The new regulations specify that only the deferred compensation plans covering the employees of the acquired company need to be terminated and liquidated upon a change in control.

Identification of Specified Employees

Section 409A provides that with respect to a “specified employee,” a payment of nonqualified deferred compensation on account of separation from service may not occur until six months after the date of separation from service (or, if earlier, the date of death of the employee). For most larger public companies, a specified employee generally is one of the highest paid officers (up to 50) of the company or any of its subsidiaries whose compensation exceeds $140,000 (for 2006). The new regulations clear up ambiguity when one public company acquires another public company, i.e., are the two companies’ lists of specified employees simply added together so that up to 100 employees are subject to the six month delay, or are the two lists simply meshed and the highest paid 50 employees out of the combined 100 employees treated as specified employees? The new regulations clarify that the latter approach applies so that no more than 50 employees will be subject to the delay. This interpretation is favorable because post-merger integration may lead to many officers leaving the combined entity and becoming eligible for distributions of nonqualified amounts.

Granting Stock Options or Stock Appreciation Rights (SARs) Prior to an IPO or Change in Control

The regulations exempt stock options and SARs granted at fair market value that do not include any additional deferral features. However, this exemption puts tremendous pressure on ensuring that options and SARs are granted at fair market value, especially in the case of illiquid stock that is not readily tradable on an established securities market. The regulations provide a safe harbor for certain early stage companies that do not reasonably anticipate a change in control or an IPO. The safe harbor establishes a presumption that a valuation reflects the fair market value if the valuation is performed by a qualified individual and is based upon a reasonable application of a reasonable valuation method. In order to qualify for the safe harbor, the company may not otherwise anticipate a change in control within the next 90 days or an IPO of the stock within the next 180 days. These time periods were reduced from the 12 month requirement in the proposed regulations. This interpretation is favorable because it provides companies a longer period of time and greater certainty before becoming ineligible for the safe harbor.

Adjusting Equity Awards in Connection with a Change in Control

Consistent with the proposed regulations, equity awards, such as restricted stock units and phantom units, may constitute deferred compensation. As a result, unless the treatment of these awards upon a change in control is specified in a plan or award agreement, there will generally be less flexibility in adjusting or settling these awards. In addition, the method of converting options in a change in control transaction will need to be reviewed to ensure that the methodology is consistent with the requirements set forth in Section 409A. For example, the ratio of exercise price to the fair market value of the shares after the substitution or assumption cannot be greater than before. Although this is not a significant change from the proposed regulations, this issue needs to be addressed in virtually any change in control transaction. For more guidance, see http://www.mwe.com/info/news/ots0407b.htm