More on Potential Limits to Deferred Compensation

Gretchen Morgenson's "Fair Game" column in the January 28 edition of the New York Times highlights the potential problems for executives who participate in deferred compensation programs if the Small Business and Work Opportunity Act passes in its current form. The proposal would apply both to initial deferrals and to earnings on those deferrals and will affect even executives who earn substantially less than the $1 million maximum cap. As the article states, "'[t]he vast majority of people affected by this will be in the $100,000 range.' And it is unlikely that their companies will cover taxes generated by exceeding the limit."

• Example: If your salary is $100,000, and you have $1 million in your deferred compensation account, your savings would have to earn only slightly more than 10% to push you over limit. If that happened, your entire account would be subject to taxes and the penalty.

• Example: A start-up company pays a small salary but has a generous equity-based deferred compensation program. If the value of the deferred equity in one year fails the annualized compensation test, the entire account becomes taxable and subject to penalty.

From a policy standpoint, it is unfair to impose a tax on money that you have not yet received and have no control over. But the Senate Finance Committee would argue that employers can easily solve that problem by paying higher (taxable) salaries if they want to maintain a certain level of compensation for key employees. Or, they can limit deferral amounts to essentially 100 percent of salary, which is far more than the average worker can defer in 401(k) plans.

There is no specific reason to limit deferrals to 100 percent of yearly compensation, other than it is a convenient measure and one the probably tests well politically. Perhaps the final proposal will be modified to raise the limit, but in the wake of the various executive pay controversies and scandals (e.g., option backdating, enormous severance packages), Congress is unlikely to feel substantial pressure to drop the proposal entirely from the bill.

Wal-Mart Discounts Severance Package to $0?

As reported in Advertising Age, Julie Roehm, the former Wal-Mart senior VP-marketing communications, filed a lawsuit alleging that Wal-Mart breached her employment contract when it fired her in December 2006. Roehm has a high profile in the advertising world and her dismissal garnered much attention. There were allegations of ethical misconduct in the selection of an advertising agency and an "inappropriate" relationship with a subordinate, all of which Roehm denies. Her dispute with Wal-Mart over her severance, however, is one that any executive might encounter.

Roehm's contract provided that she would receive base pay of $325,000, a signing bonus of $250,000, annual incentive-based payments and restricted stock worth up to $300,000. The agreement also included severance in the amount of one-year of base pay in the event her employment was terminated. According to Roehm, Wal-Mart fired her ostensibly because she had not "been fulfilling the expectations of an officer of the company." But she claims that Wal-Mart never identified any conduct that failed to meet that standard. She has not received any compensation from Wal-Mart since she was fired, according to the complaint. Presumably this includes the promised severance payments.

Typically, a "failure to meet expectations" is insufficient to qualify as a reason not to pay severance under a termination for "cause" provision of an employment agreement. That kind of language would give the employer far too much leeway to avoid paying severance. It is likely that this case will settle fairly quickly unless there is some unusual language in Roehm's employment contract that gives Wal-Mart more leverage.

Note for Pennsylvania executives: In Pennsylvania, the employer's failure to pay severance due could open the employer up to a lawsuit under the Wage Payment and Collection Law ("WPCL"). If the executive can prove that severance was owed, the court could order the employer to pay the executive additional damages equal to 25% of the severance amount plus the executive's attorneys' fees.

The Ad Age article with more details is here.

When is the Company's Lawyer Not Your Lawyer?

As reported on Law.com, a former Citigroup executive, David H. Trautenberg is suing Paul, Weiss, Rifkind, Wharton & Garrison, "claiming the law firm was conflicted when it advised Citigroup on [his] severance package." Trautenberg was involved in the litigation that ensued after WorldCom imploded because he had approved large personal loans for former WorldCom CEO Bernard Ebbers.

Paul Weiss represented both Citigroup and Trautenberg in his capacity as a Citigroup employee during that litigation. Trautenberg claims that the Paul Weiss lawyers obtained confidential information from him which they then used against him in subsequent negotiations over a severance agreement. Trautenberg claims that he lost $20 million because of Paul Weiss's involvement and is seeking $80 million in damages.

The lawsuit is a cautionary tale for executives:

• First, if the company's lawyer represents both the company and you in litigation, you should remember that there may come a time when your interests diverge from those of the company. Consider seeking independent advice from another lawyer and asking your company to reimburse you for the expense.
  
  
• Second, when negotiating an employment contract or severance agreement, the company's lawyer is not your lawyer and is committed to achieving the best result for the company, not you.

Senate Finance Committee Votes to Limit Deferred Compensation

The Senate Finance Committee approved the Small Business and Work Opportunity Act of 2007. If adopted as written, the Act would cap nonqualified deferred compensation deferrals to the lesser of $1 million or your average taxable compensation for the previous five years. The provision applies to taxable years beginning after December 31, 2006 i.e. this year. Earlier years will be taken into account for purposes of computing the five-year average. So if your deferral for 2007 will exceed your average compensation for the past five years, you could have a problem.

Summaries of this proposal have emphasized the $1 million upper limit, but the proposal would limit deferrals for all executives even those who are deferring substantially less than $1 million.

Failure to comply will result in ordinary income tax on the entire deferral, not just the amount over the cap. Furthermore, the executive would be subject to the same penalties that apply for a failure to comply with Section 409(A) -- interest at the underpayment rate plus one percentage point on the "underpayments" that would have occurred had the compensation been included in income when first deferred, or if later, when not subject to a substantial risk of forfeiture. The amount required to be included in income would also be subject to a 20 percent penalty.

Hollywood Dispute Should Prompt Executives to Review Employment Contract

The dispute between book publisher Judith Regan and News Corporation’s Harper Collins publishing house highlights the thorny issues that can crop up when a top executive is fired. Regan is preparing a to file a lawsuit against News Corporation for wrongful termination and libel, according to her attorney, Bert Fields.

The wrongful termination claim is a breach-of–contract matter that will turn on whether she was fired for "cause.” News Corporation alleges that Regan made anti-Semitic remarks in the wake of the O.J. Simpson “If I Did It” book debacle. Apparently, it is those remarks that News Corporation will rely on to support its claim that Regan was fired for "cause." Regan claims she never made the remarks. But if she did, there may still be an issue whether her alleged statements constituted "cause" for firing her under her contract.

Typically, “cause” includes such behavior as dishonesty, theft, sexual harassment and similar conduct. Depending on the contract language, however, the term “cause” can include a range of other conduct that might be more open to interpretation such as “immoral conduct” or conduct that otherwise “injures” the employer. Naturally, an executive would want the contract to include the narrowest possible definition while the employer would want an expansive definition that gives it more leeway to discharge the executive without having to buy-out the contract or pay severance. Whether Regan’s alleged anti-Semitic remarks, if she made them, are sufficient to constitute "cause" will depend on how her contract was drafted. Millions of dollars are at stake.

Check your contract to see how “cause” is defined. You may want to try to narrow the definition in your next contract, if possible.

For more on the dispute, click here.