Strategies for Executive Compensation: Design and Tax Issues for a Turbulent Environment. Tuesday, April 17, 2012

Strategies for

Executive Compensation:

Design and Tax Issues for

a Turbulent Environment

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April 17, 2012

Strategies for Executive Compensation: Design and Tax Issues for a Turbulent Environment

As hosts, we welcome you to today's session.

This morning you will be hearing Speakers from the Blakes Pensions, Benefits and Executive Compensation Group and the Mercer Executive Compensation Group. We are speaking on a variety of issues relating to the design and taxation of executive compensation arrangements, with a particular focus on private equity and mergers and acquisition transactions.

Each of the presentations, as well as additional related materials, is available electronically by visiting http://www.blakes.com/StrategiesforExecutiveCompensation.

Profiles of Blake’s presenters and other lawyers in the Blakes Pensions, Benefits and Executive Compensation Group are available on our website at www.blakes.com. For your convenience profiles for Lisa Slipp and Kenneth Yung are included in our booklet.

Members of the Pensions, Benefits and Executive Compensation Group and Mercer Executive Compensation Group will be available during breakfast and at the end of the session to meet with you. Please also feel free to contact any of our lawyers or members of the Mercer Executive Compensation Group directly at any time should you have further questions with which we can be of assistance.

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Incentive And Stock

Compensation Arrangements For

Private Equity Transactions

Presented by:

Jeremy Forgie

Sean Maxwell

Overview of Presentation

•

Types of Private Equity Transactions

•

Corporate Governance Considerations

•

Participation of Target/Portfolio Company

Management

•

Exit Strategies and Investment Horizons

•

Key Design Considerations and Commonly

Overview of Presentation

_(cont’d)

•

Stock Options – Rules for Canadian-Controlled

Private Corporations and Ordinary Stock Option

Rules

•

Share purchase loans

•

Cash Based Long Term Incentive Plans and the

SDA Rules

•

Non-Portfolio Company Incentives

•

Focus on employee-level tax issues – corporate

tax considerations may also affect compensation

design

Types of Private Equity

Transactions

•

The structure of the transaction and

objectives of the principal investors will

have a significant impact on design of

incentive compensation arrangements –

resulting in differences from public

company equity and incentive

compensation arrangements

Types of Private Equity

Transactions

_(cont’d)

•

Most common are leveraged buyouts of

target (or portfolio company), often with

the participation of management

•

Transaction may be structured as a

take-over bid, court-approved plan of

arrangement, amalgamation or sometimes

as an asset sale

Types of Private Equity

Transactions

_(cont’d)

•

In some cases, a private equity fund or

firm will take a minority equity position in

the portfolio company or invest in debt of

the company with the possibility of taking a

longer-term equity stake

Sources: Getting the Deal Through: Private Equity 2011, David I.

Walker, Executive Pay Lessons from Private Equity, Boston Law

Review May 2011 (survey of 144 U.S. portfolio companies) and

Types of Private Equity

Transactions

_(cont’d)

•

After initial investment by private equity

fund or firm in portfolio company, there will

often be “follow-on” investment that is

intended to raise further capital to facilitate

additional growth of the portfolio

Types of Private Equity

Transactions

_(cont’d)

•

The private equity fund will also often

recapitalize the business of the portfolio

company by re-leveraging and taking out

invested funds - those funds can then be

distributed to investors in the private equity fund,

deployed by the fund to make new investments

or even redirected to other portfolio companies

in which the private equity fund invests

Corporate Governance

Considerations

•

Private equity fund or manager will often

prefer to be the majority shareholder so

that it retains ultimate decision-making

power over the portfolio company

Corporate Governance

Considerations

_(cont’d)

•

Where there are minority shareholders

(including management and other institutional

investors) following the transaction, the

shareholders’ agreement will typically dictate the

manner in which the target company is

governed, including any negotiated veto rights

for minority shareholders and special liquidity

events for shareholders including management

Participation of Target/Portfolio

Company Management

•

A private equity fund will often regard

management of the portfolio company as

being critical; for example, where the

portfolio company is in an industry that is

not familiar to the private equity fund or

where the portfolio company’s existing

management team was a significant factor

in the attractiveness of the investment

Participation of Target/Portfolio

Company Management

_(cont’d)

•

From the perspective of the private equity

fund and other investors, the objective will

often be to emphasize retention and

improvement in the portfolio company’s

business and downplay compensation tied

to the closing of the transaction

Participation of Target/Portfolio

Company Management

_(cont’d)

•

Often there will be employment contracts

with key management and target financial

performance hurdles that may be

incorporated into equity and other

Participation of Target/Portfolio

Company Management

_(cont’d)

•

Bearing in mind (particularly in a take-over bid)

disclosure requirements relating to proposed

management incentive compensation

arrangements, it is quite common for there to be

negotiation between members of key

management and the private equity fund of

different (and, in some cases, enhanced) salary,

bonus and incentive compensation

Exit Strategies and

Investment Horizons

•

Due to the additional debt that is incurred

by the portfolio company, leveraged

buyouts can present greater potential risk

to equity investors

Exit Strategies and

Investment Horizons

_(cont’d)

•

The private equity firm or fund will usually

develop a strategy that is intended to

result in adding value to the portfolio

company’s business with the objective of

realizing on its investment in the portfolio

company as soon as is practical

Exit Strategies and

Investment Horizons

_(cont’d)

•

The mechanism for realization (i.e., the

exit strategy) may be a private sale or

initial public offering together with

Exit Strategies and

Investment Horizons

_(cont’d)

•

The time horizon for a liquidity event or

exit can vary significantly – for example,

the private equity fund may have a

long-term investment strategy with the objective

of recouping its investment along with a

Exit Strategies and

Investment Horizons

_(cont’d)

•

On the other hand, there could be other

factors which make a faster exit attractive

including opportunistic events such as a

particular buyer (or type of buyer)

becoming interested in the portfolio

company due to a variety of different

factors including tax, regulatory or

Exit Strategies and

Investment Horizons

_(cont’d)

•

Portfolio company shareholder agreements

often contain provisions dealing with anticipated

liquidity events such as merger, sale to another

corporation or initial public offering and, where

there is an initial public offering, ensuring that

shareholders, including management, have

freely trading shares in the event of an IPO

Key Design Considerations and Commonly Used

Incentive Compensation Arrangements

•

Plan governance – compared to public

companies (board reacting to

management proposals), in many cases,

compensation decisions such as approval

of management contracts, equity grants

and other incentive compensation plans

require only approval of principal investors

Key Design Considerations and Commonly Used

Incentive Compensation Arrangements

_(cont’d)

•

Performance objectives – because of significant

leveraging, promoting cash flow and debt

service are often important objectives which

impact on plan design – incentive compensation

plans may be designed, for example, to reward

management’s contribution to control of

discretionary costs, improving productivity,

strategic repositioning and growth of the

business that exceeds the rate of return

Key Design Considerations and Commonly Used

Incentive Compensation Arrangements

_(cont’d)

•

Importance of equity-based incentives –

studies noted above suggest that for

portfolio companies:

–

equity-based incentives for key management

often represent 65% to 70% of total

compensation opportunity

Key Design Considerations and Commonly Used

Incentive Compensation Arrangements

_(cont’d)

–

providing a piece of the total appreciation in value of

the portfolio company is a main driver as opposed to

competitive equity grants

–

relatively large up-front equity grants for key

management – most often in the form of stock

options, a portion of which may be subject to

time-based vesting and a portion subject to

performance-based vesting, including measures such as EBITDA

and internal rate of return (IRR)

Key Design Considerations and Commonly Used

Incentive Compensation Arrangements

_(cont’d)

–

expectation that key management (e.g., CEO)

will make a significant personal equity

investment in the portfolio company at the

outset and investment in the company

Key Design Considerations and Commonly Used

Incentive Compensation Arrangements

_(cont’d)

•

Equity grants will often be reserved for key

management and principal investors may

be reluctant to authorize increase in

available option or equity pool – provision

in original pool for additional grants to

employees promoted into key

Key Design Considerations and Commonly Used

Incentive Compensation Arrangements

_(cont’d)

•

Equity grants may not be available for

management beneath the top “key

management” tier, in which case, cash-based

long-term incentive plans can be important,

including appreciation rights, cash-settled

restricted share units (RSUs), cash-settled

performance share units (PSUs) and sometimes

even cash-settled deferred share units (DSUs)

which incorporate vesting provisions

Key Design Considerations and Commonly Used

Incentive Compensation Arrangements

_(cont’d)

•

Private equity fund often wants to limit ability of

portfolio company executives to liquidate their

equity holdings prior to an IPO or other defined

liquidity event. Sometimes, there will be an

exception for shares already acquired by the

executive as opposed to outstanding stock

options or in some cases for certain narrowly

defined events (e.g., death or disability).

Stock Options – Rules for Canadian-Controlled

Private Corporations and Ordinary Stock

Option Rules

•

Employee stock options and other equity

awards granted by a Canadian-controlled

corporation (CCPC) have preferential

Canadian income tax treatment:

- taxable employment benefit arises when shares

are disposed of (subsection 7(1.1) of Income Tax

Act (Canada) (ITA)) – the exercise of the stock

option or the issuance of shares under a stock

bonus or share-settled restricted share unit is not a

taxable event

Stock Options – Rules for Canadian-Controlled

Private Corporations and Ordinary Stock

Option Rules

_(cont’d)

–

the employee may claim a 50% deduction

(paragraph 110(1)(d.1)) against the taxable

employment benefit (e.g., in-the-money

amount when the option was exercised or in

the case of a stock bonus, the fair market

value of the share at the time it was issued)

provided:

Stock Options – Rules for Canadian-Controlled

Private Corporations and Ordinary Stock

Option Rules

_(cont’d)

•

the employee does not dispose of the share (other

than because of death) or exchange the share

within 2 years of the date the employee acquired

the share

•

the employee has not claimed the regular stock

option deduction under paragraph 110(1)(d)

•

Alternatively, employee may be able to claim the

50% deduction under paragraph 110(1)(d) that

is also available for “ordinary” non-CCPC

Stock Options – Rules for Canadian-Controlled

Private Corporations and Ordinary Stock

Option Rules

_(cont’d)

•

Unlike with publicly traded companies subject to

stock exchange rules, there is no requirement

that private company options be issued at fair

market value provided that when shares are

issued they are “fully paid” in cash, past services

or a combination

•

“Fully paid” requirement can be an issue with

stock bonuses or immediately exercisable

discounted options for new employees or

employees of a new entity

Stock Options – Rules for Canadian-Controlled

Private Corporations and Ordinary Stock

Option Rules

_(cont’d)

•

For some CCPCs, employee may be able to

claim capital gains exemption for “qualified small

business corporation shares” (sections 110.6(1)

and 110.6(2.1)) although this is subject to

various restrictions where the taxpayer has

cumulative net investment losses (CNIL) and

allowable investment business losses (ABIL)

and claiming the deduction may trigger

Stock Options – Rules for Canadian-Controlled

Private Corporations and Ordinary Stock

Option Rules

_(cont’d)

•

The determination of whether the portfolio

company is a CCPC is not always

straightforward

•

A CCPC is a Canadian corporation (generally a

corporation resident in Canada constituted

under the laws of Canada or a province) that is

not controlled by a publicly listed corporation or

by one or more non-residents

Stock Options – Rules for Canadian-Controlled

Private Corporations and Ordinary Stock

Option Rules

_(cont’d)

•

In determining CCPC status “control” in the

ordinary sense is not required – where the

shares of a corporation are widely held by

non-residents and/or publicly listed corporations such

that none of those shareholders controls the

corporation, the corporation will not be a CCPC

if it would be controlled by one person if that

person owned all of the shares held by such

non-residents and publicly listed corporations

Stock Options – Rules for Canadian-Controlled

Private Corporations and Ordinary Stock

Option Rules

_(cont’d)

•

By “ordinary stock options,” we refer to an agreement by

a particular corporation that is not a CCPC (or mutual

fund trust) to sell or issue its shares (or trust units) to an

employee or an employee of a corporation (or mutual

fund trust) with which the particular company does not

deal at arm’s length

•

General stock option tax treatment: (i) no tax on grant;

(ii) tax on benefit arising on exercise; (iii) benefit equals

excess of fair market value of shares acquired under the

option over the exercise price (i.e., the in-the-money

Stock Options – Rules for Canadian-Controlled

Private Corporations and Ordinary Stock

Option Rules

_(cont’d)

•

Employee can claim a 50% deduction under

paragraph 110(1)(d) against the taxable benefit arising

on the exercise of the options if the following conditions

are met:

–

the exercise price is at least equal to the fair market value of the

shares at the time the options were granted

–

the employee deals at arm’s length with the corporation granting

the option and the employee’s employer (if different from the

grantor of the option)

Stock Options – Rules for Canadian-Controlled

Private Corporations and Ordinary Stock

Option Rules

_(cont’d)

–

paragraph 110(1)(d) deduction can apply to ordinary options or

to CCPC options where deduction under paragraph 110(1)(d.1)

does not apply

–

threshold question – is there an agreement to sell or issue

shares of the employer or a corporation with which the employer

does not deal at arm’s length?

–

query whether there is such an agreement where option

provides that it can only be exercised on a liquidity event and will

be automatically cashed out

–

fair market value exercise price can also be a challenge to

Stock Options – Rules for Canadian-Controlled

Private Corporations and Ordinary Stock

Option Rules

_(cont’d)

•

Arm’s-length requirement – generally,

employees, including senior management,

are considered at arm’s length from their

employer but where management is part

of control group, arm’s-length requirement

for paragraph 110(1)(d) deduction would

not be met

Stock Options – Rules for Canadian-Controlled

Private Corporations and Ordinary Stock

Option Rules

_(cont’d)

•

Prescribed shares under Regulation 6204

–

where dividends or liquidation entitlements are limited

to a maximum or fixed at a minimum, shares will not

be prescribed shares

–

where shares can be reacquired by issuer or person

with whom the issuer does not deal at arm’s length,

this may preclude shares being prescribed shares

Stock Options – Rules for Canadian-Controlled

Private Corporations and Ordinary Stock

Option Rules

_(cont’d)

–

some exceptions to repurchase restrictions if price

does not exceed fair market value and/or to provide a

market or protect employee from loss

–

relevant dividend, liquidity and repurchase provisions

can be in share terms or under an agreement in

respect of a share or its issue, which could include

shareholders agreement, credit agreement, etc.

–

prescribed share test is at time shares are issued (or

Stock Options – Rules for Canadian-Controlled

Private Corporations and Ordinary Stock

Option Rules

_(cont’d)

–

paragraph 110(1)(d) deduction will not be available on

an option cash-out unless company that granted

option files election under subsection 110(1.1) to

forego any deduction of cash-out amount

•

subsection 110(1.1) election is made on employee’s T4

for the year in which the option is cashed out

•

where options cashed out on exit event, purchaser will

control company at time T4s are prepared

•

commitment from purchaser to cause election to be

made can be included in purchase agreement but

employees may not be parties

Share Purchase Loans

•

Management investment can be facilitated

through a share purchase loan, as loans

generally not included in income unless forgiven

•

Where employee is a shareholder, need to

consider shareholder loan tax rules, in particular,

subsections 15(2) and 15(2.4), as well as

section 80.4 which provides for a taxable benefit

where employee receives a low interest or

interest-free loan as a consequence of his/her

office or employment

Share Purchase Loans

_(cont’d)

•

Under s. 5(2), the amount of a loan

received by a shareholder of a corporation

from the corporation, a related corporation

or a partnership of which the corporation

or related corporation is a member, is

included in the shareholder’s income for

the year in which the loan was received,

subject to certain exceptions:

Share Purchase Loans

_(cont’d)

•

S.15(2.4) provides that s.15(2) will not apply where the

loan is provided to an individual who is both an

employee and a shareholder of the lending corporation

or of a related corporation to enable the individual to

acquire newly issued shares of the lending corporation

or a related corporation where:

–

it is reasonable to conclude that the loan was provided because

of the individual’s employment and not because he/she is a

shareholder

–

at the time the loan is made, bona fide arrangements were made

for repayment within a reasonable time

Share Purchase Loans

_(cont’d)

•

Requirement for bona fide arrangements for repayment

within a reasonable time does not require all of the loan

terms be “commercial”, e.g., would not preclude an

interest-free loan and may not require specific

contractual repayment terms, but does require that

arrangements for repayment exist when the loan is

granted and the loan be repayable within a “reasonable

time”

•

Requirement for repayment on termination of

employment, sale of shares or other event, the timing of

which is uncertain, is unlikely to constitute bona fide

Share Purchase Loans

_(cont’d)

•

Interest-free loans and loans at an interest rate

below the “prescribed rate” for employee loans

will result in a taxable benefit under s. 80.4

•

Essentially, benefit equals difference between

the prescribed rate and amount of interest

actually paid by the employee for the year and

not later than 30 days after year-end

Share Purchase Loans

_(cont’d)

•

S. 80.4 applies to loans provided because of or

as consequence of an individual’s previous,

current or intended office or employment

•

Taxable benefit under s. 80.4 is deemed under

section 80.5 to be interest for purposes of

paragraph 20(1)(c), which may allow employee

to deduct interest benefit (provided shares can

be said to have been acquired to earn income)

Cash-Based Long-Term Incentive

Plans and the SDA Rules

•

Where real equity reserved for key

executives, other employees typically

receive cash-based long-term incentives,

including:

–

restricted share units

–

performance share units

–

unitized awards not based on shares values

Cash-Based Long-Term Incentive

Plans and the SDA Rules

_(cont’d)

•

Salary deferral arrangement (SDA) rules

will be relevant

•

Components of SDA definition

–

right to receive an amount after the year

–

in respect of an amount on account of salary

or wages for services in the year or a

preceding year

Cash-Based Long-Term Incentive

Plans and the SDA Rules

_(cont’d)

•

Components of SDA definition

_(cont’d)

–

must be reasonable to consider that one of

the main purposes is to postpone tax

–

includes a right subject to conditions unless

there is a substantial risk one such condition

will not be satisfied

Cash-Based Long-Term Incentive

Plans and the SDA Rules

_(cont’d)

•

There is virtually no jurisprudence relating to the

SDA rules

•

Deferred compensation plans generally

designed to minimize CRA assessing risk

•

Commentary to date suggests the following

about CRA’s position with respect to the SDA

rules

Cash-Based Long-Term Incentive

Plans and the SDA Rules

_(cont’d)

•

Share unit plans that pay out by the end of the

third year following the year in which the

relevant services are rendered should fall within

the paragraph (k) exception to the SDA definition

applicable to bonuses and similar payments

•

Share appreciation rights should not result in an

SDA provided payments occur promptly

following vesting

Cash-Based Long-Term Incentive

Plans and the SDA Rules

_(cont’d)

•

Where awards subject to genuine,

reasonably stringent performance

conditions, there may be a substantial risk

that one of the conditions will not be

satisfied such that no SDA arises

•

In private equity context, may want to tie

Cash-Based Long-Term Incentive

Plans and the SDA Rules

_(cont’d)

•

Where incentive is based on appreciation rights

model, some concern that CRA may challenge if

share value is based on a formula that reflects

financial measures (e.g., EBITDA, sales etc.) but

not necessarily a commercial fair market value

or where appreciation not based on share

values at all but on increases in a notional unit,

although favourable rulings have been granted

in the past

Non-Portfolio Company Incentives

•

Private equity incentives sometimes provided at

“holdco” level

•

Common where “holdco” is U.S. LLC to provide

employees with “profits interests” in LLC

•

LLC not specifically recognized under ITA but

CRA position to date seems to be that LLCs will

generally be treated as corporations, while in

Non-Portfolio Company

Incentives

_(cont’d)

•

Profits interests share in increases in the

value of the LLC only after the agreed

upon value is allocated to other LLC units

•

Profits interest should be a security under

Canadian securities laws so in principle

should result in same tax treatment as

acquisition by employee of any other

security as a result of employment

Non-Portfolio Company

Incentives

_(cont’d)

•

If LLC is a corporation for Canadian tax

purposes, profits interest may be a share

for purposes of section 7 of ITA

•

Regardless of whether section 7 applies, if

profits interest granted to employee, it

appears that fair market value at grant

would be taxable benefit of employment

Non-Portfolio Company

Incentives

_(cont’d)

•

Profits interests generally have no intrinsic

value at grant since if LLC liquidated at

that time holders of profits interest would

receive nothing

•

In U.S., current tax rules allow profits

interests to be granted at zero value (i.e.,

no income inclusion on grant) and any

Non-Portfolio Company

Incentives

_(cont’d)

•

Would expect profits interests to have

some positive fair market value for ITA

purposes, but can be difficult to establish

•

Appears to be no published CRA

commentary on taxation of profits interests

granted to employees as a form of

Non-Portfolio Company

Incentives

_(cont’d)

•

Where “holdco” or “opco” is actually a partnership for ITA

purposes, this may affect available forms of incentive

compensation

•

In particular, partnerships cannot grant options on

partnership units under section 7, although CRA’s

published statements indicate that employees may still

benefit from section 7 where options granted by partners

that are corporations

•

Not clear how CRA’s position applies with multi-tiered

partnerships or structures involving trusts; sometimes

see separate management holdco established which

grants options subject to section 7

RISK MITIGATION & INCENTIVE PLAN DESIGN

MERCER (CANADA) LIMITED

Risk

• Types of risk

– Financial

– Operational

– People

– Etc.

Regulatory Requirement

• CSA Rules

– Requires enhanced disclosure about risks associated with

compensation policies and practices

– Not limited to compensation policies of NEOs

– Disclosure should include:

- Extent and nature of the Compensation Committee’s role in

risk oversight

- Practices used to identify and mitigate compensation risks

- Description of any policies/practices that present a material

Regulatory Requirement

• What is the intent?

– Controlling excessive/inappropriate risk

– NOT eliminating all risk

• What are the implications?

– Educating board members about broader rewards policies

and practices

– Conducting formal risk assessments

– Redesigning incentive plans

Managing Risk

• How do you manage risk?

– Internal Controls

- Risk management function

- Board oversight

- Defined business processes

– Proper Incentive Plan Design

- Incents the right behaviour and mitigates excessive risk

taking

Incentive Plan Design

Overview

• Risk management in incentive design?

– Performance measures

– Goal setting and leverage

– Funding

– Performance period

– Pay mix

– Controls and process

– Other provisions

Incentive Plan Design

Performance Measures

• Choosing appropriate performance measures

Correlation

Correlation

Accuracy

Accuracy

Complexity

Complexity

Industry

Industry

Company

Company

Measure Choice

Measure Choice

Incentive Plan Design

Performance Measures

Link to Shareholders

Line of Sight

Non-Financial Measures

Financial Measures

Corporate

Unit-specific

Efforts (Inputs)

Results (Output)

Incentive Plan Design

Performance Measures

9

9

Stock Options

Cash

Flow

Shareholder

Value

Returns

9

Profit

Growth

Performance Measured

2 Years

3 Years

Other

1 Year

9

Time Horizon

Annual Bonus

Component

Illustrative Example of a Performance Measurement Framework

• Diversifying measures across multiple incentive plans, and

reflecting full range of performance

Incentive Plan Design

Goal Setting and Leverage

Performance

Goals

Incentive Plan Goal-Setting

Internal Perspectives

External Perspectives

Internal

Budgets/Forecasts

Internal

Budgets/Forecasts

Historical Company

Performance

Historical Company

Performance

Analyst and Shareholder

Expectations

Analyst and Shareholder

Expectations

Historical Performance of

Peer Companies

Historical Performance of

Peer Companies

• Setting reasonably achievable goals vs. significantly stretch

targets that might create need to take excessive risk

Incentive Plan Design

Goal Setting and Leverage

• Capping incentive plans

Incentive Plan Design

Funding

• Self-funding – costs are always covered by profits?

• Cost ratio, dilution, shareholder value transfer

Illustrative Example: Cost Ratios

Incentives:

$2M

Value to

Shareholders:

$8M

Profit: $10M

Incentives:

$2M

Value to

Shareholders:

$8M

Profit: $10M

Incentives:

$3M

Value to

Shareholders:

$9M

Profit: $12M

Incentive Plan Design

Performance Period

Incentive Plan Design

Pay Mix

• Balancing salary vs. short- vs. long-term incentives, cash vs.

equity compensation

Incentive Plan Design

Controls and Process

• Override formulaic outcomes

• Reward programs for risk managers

Incentive Plan Design

Other Provisions

• Clawbacks

• Ownership guidelines

• Holding requirements

• Deferral of compensation

• Overlapping awards

Long Term Incentive Plan

Clawbacks: Design, Tax and

Other Legal Issues

Presented by:

Kathryn Bush

April 17, 2012

Introduction

•

Since 2008, substantial growth of the use

of clawbacks in Canada

•

_{Blakes Bulletin: “Clawbacks Coming to}

Canada” dealing with securities and

corporate law aspects

•

Current public examples

U.S. Statutory Clawbacks

•

_{Sarbanes-Oxley Act of 2002 (SOX)}

–

negative revision of financial results

–

executive misconduct

–

material non-compliance in the financial

results

–

any incentive payments and entire payment

–

1-year period

–

CEO and CFO

U.S. Statutory Clawbacks

_(cont’d)

•

_{Dodd-Frank Wall Street Reform &}

Consumer Protection Act (DFW)

–

applies in wider circumstances and to more

employees than SOX

–

any material non-compliance that results in a

financial restatement

U.S. Statutory Clawbacks

_(cont’d)

–

3-year look back

–

absolute liability

–

excessive portion of the award

Financial Stability Board Principles

•

FSB co-ordinating national financial

authorities

•

Bank of Canada, OSFI and federal

Ministry of Finance are FSB members

•

Principles for Sound Compensation

Financial Stability Board

Principles

_(cont’d)

•

OSFI best practices for Canadian financial

institutions

•

Canadian issuers which are subject to

Contractual Clawbacks

in Canada and the U.S.

•

Executive misconduct or bad behaviour

•

Joining a competitor

Type and Relative Prevalence of

Clawbacks in the U.S. and Canada

•

450 public companies surveyed by Hay

Group

–

> 50% use clawbacks

–

82% of Fortune 100 companies use

clawbacks

–

clawbacks used in

•

annual incentives

•

stock options

Type and Relative Prevalence of

Clawbacks in the U.S. and Canada

(cont’d)

–

less frequent in Canada except top-tier banks

and insurance companies are almost 100%

now

Three Major Categories of

Clawbacks

•

Bad faith (including breach of

non-compete)

•

Fraud, negligence or intentional

misconduct resulting in a financial result

revision

•

Any restatement of financial results

Three Major Categories of

Clawbacks

_(cont’d)

Paper includes 9 examples of U.S. and

Canadian clawback provisions in 2011

proxies

Canadian Taxation

•

Clawback in current year poses no

difficulty

•

Clawback in later year creates problems

due to section 8 of Income Tax Act

(Canada)

Potential Tax Relief for

Later Year Clawbacks

•

Filing an Amended Tax Return

Potential Tax Relief for

Later Year Clawbacks

_(cont’d)

•

Mistake

–

“If the parties base their contract on a fundamental

error about the assumptions supporting their

agreement, and neither party agrees to bear the risk

of the assumption turning out be false, the contract

can be held void on the basis of the doctrine of

common-law mistake.”

Potential Tax Relief for

Later Year Clawbacks

_(cont’d)

•

Remission

–

“The Governor in Council may, on the

recommendation of the appropriate Minister, remit

any tax or penalty, including any interest paid or

payable thereon, where the Governor in Council

considers that the collection of the tax or the

enforcement of the penalty is unreasonable or unjust

or that it is otherwise in the public interest to remit the

tax or penalty”

Potential Tax Relief for

Later Year Clawbacks

_(cont’d)

•

Unjust enrichment

Potential Tax Relief for

Later Year Clawbacks

_(cont’d)

•

Rectification

–

“In order for a party to succeed on a plea of

rectification, he must satisfy the Court that the parties,

all of them, were in complete agreement as to the

terms of their contract but wrote them down

incorrectly. It is not a question of the Court being

asked to speculate about the parties’ intention, but

rather to make an inquiry to determine whether the

written agreement properly records the intention of

the parties as clearly revealed in their prior

Design Alternatives to Avoid Adverse

Canadian Tax Consequences

•

3-year bonus

–

exclusion from the Definition of Salary Deferral

Arrangement

–

a plan or arrangement under which a taxpayer has a

right to receive a bonus or similar payment in respect

of services rendered by the taxpayer in a taxation

year to be paid within 3 years following the end of the

year, …

–

downside

•

delayed receipt by executive

Design Alternatives to Avoid Adverse

Canadian Tax Consequences

(cont’d)

•

Employee loan

–

taxable benefit with respect to interest may

result

–

downside

•

cumbersome

Design Alternatives to Avoid Adverse

Canadian Tax Consequences

(cont’d)

•

Use of a trust

–

s. 7 income inclusion by s. 8(12) deduction if

clawback occurs

–

downside

•

immediate tax without cash unless a loan is also

used

•

trust needs to be established

Conclusion

•

Clawbacks in Canada seem to be growing

in prevalence and scope

•

Canadian tax result likely to be harsh

unless there is planning at the time of the

relevant award

Long Term Incentive Plan Clawbacks:

Design, Tax and Other Legal Issues

Kathryn Bush

Partner

416.863.2633

kathryn.bush@blakes.com

Blake, Cassels & Graydon LLP

Barristers, Solicitors 855 - 2nd Street S.W.

Suite 3500, Bankers Hall East Tower Calgary AB T2P 4J8

Canada

Long Term Incentive Plan Clawbacks: Design, Tax and

Other Legal Issues

Kathryn Bush, Blake, Cassels & Graydon LLP

1.

INTRODUCTION

In recent years, particularly since the global financial crisis, the use of clawback

provisions in executive compensation plans has become more widespread in Canada. Basically, clawbacks are arrangements under which an employee’s compensation that has previously been awarded is forfeited or ‘clawed back’. Canadian public companies listed in the United States are subject to statutory clawbacks for certain employees. As well, certain Canadian financial institutions regulated by the Office of the Superintendent of Financial Institutions (“OSFI”) have adopted clawbacks as an OSFI-recommended best practice. Other Canadian public companies are not required to adopt clawbacks, but may choose to do so by agreement with affected employees. The increasing use of these provisions in Canadian employment contracts raises a series of interesting and potentially difficult issues that should be kept in mind when designing executive

incentive plans. A potentially problematic example is the income tax consequences of compensation clawbacks in the context of the Canadian income tax laws. As will be discussed, the potentially harsh tax treatment of the clawed back amounts in Canada is an added layer of complexity that should be taken into account, particularly when using existing U.S. policies as a source for drafting Canadian clawback provisions.

As explained in the Blakes Bulletin “Clawbacks Coming to Canada”, clawback

provisions can take a variety of forms and be triggered by different types of events.1 They may apply to vested and unvested awards, affecting different forms of

non-- 2 non--

equity compensation. Triggers range from fraudulent misconduct to bad faith behaviour and even the mere occurrence of a negative restatement of financial results.

2.

U.S. STATUTORY CLAWBACKS

Specific types of clawbacks are statutorily mandated under the U.S. Sarbanes-Oxley Act of 2002 (“SOX”), and Dodd-Frank Wall Street Reform and Consumer Protection Act (“DFW”). These measures are relevant for Canadian corporations which are foreign private issuers under U.S. securities laws. These provisions are also of more general interest since the concepts introduced and developed in the U.S. statutory clawbacks are widely adopted by both US and Canadian issuers in drafting their contractual clawback policies.

The clawback provisions in SOX adopted the basic notion, incorporated in most current clawback policies, that executive bonuses based on materially inaccurate financial results that are subsequently subject to a negative revision should be forfeited. The forfeiture, or clawback, is conditioned on a finding of executive misconduct that has resulted in the material non-compliance in the financial results. These provisions apply to any incentive payments, covering both cash and equity awards, in the one-year period following the issue of the financial results that later had to be restated. The clawback is mandatory for U.S. public companies but only applies to the CEO and the CFO. However, the misconduct required to trigger the provision is not required to be that of the CEO or the CFO.2

The DFW introduced ‘bigger and better’ clawbacks that apply in a wider set of circumstances to a wider base of employees. Under these provisions, any material non-compliance with reporting requirements that necessitates a restatement of financial results triggers a clawback mechanism that applies to incentive awards received by all current or former executives. There is a three year look-back period, which means that incentive awards handed out during the three years preceding the date of restatement

1

- 3 -

are subject to recoupment. It is significant to note the absolute-liability nature of these provisions in that there is no misconduct requirement for the DFW clawbacks to be triggered.

DFW measures apply in addition to the already in place SOX provisions discussed above, yet they are in one aspect narrower: DFW clawbacks only apply to the excessive portion of the award that was received by the executive based on inaccurate financial results, whereas, under the SOX, the entire payment may be subject to forfeiture. This is probably an appropriate policy choice in light of the no-fault nature of DFW

clawbacks. Also unlike SOX, which tasks the SEC with enforcing the clawbacks by litigation, the DFW provisions are required to be enforced by the issuer, who should disclose its policies for doing so as part of its securities reporting requirements.3

3.

FINANCIAL STABILITY BOARD (“FSB”) PRINCIPLES AND CANADIAN

ADVISORY POLICIES

The FSB is an international organization co-ordinating national financial authorities of countries such as the U.S., and Canada. Bank of Canada, OSFI and the Federal Ministry of Finance are members of FSB, which has issued FSB Principles for Sound Compensation Practices – Implementation Standards. The Principles espouse the basic notion that executive incentives based on inaccurate financial results that are subsequently subject to downward revision should trigger some form of recoupment or clawback mechanism. Further, unvested portions of deferred compensation should also be clawed back based on the actual performance of the business in the year of vesting.

There are no regulatory or statutorily mandated clawbacks in Canada. However,

Canadian issuers which are subject to SEC listing requirements are subject to clawback provisions, and clawbacks following the general guidelines of FSB Principles are

- 4 -

regulates. As the OSFI-regulated entities are not subject to a specific legislative provision in this regard, there is no prescribed form of clawback as in the U.S.4

4.

CONTRACTUAL CLAWBACKS IN CANADA AND THE U.S.

The Canadian clawback is therefore primarily a contractual measure. In drafting

contractual provisions, Canadian companies have tended to follow the U.S. precedent, which has a longer and more established history of using such provisions. The

historical use of U.S. contractual clawbacks has been directed at executive misconduct or bad behaviour, a common example being situations where employees left to join competitors.

Following the example of U.S. lawmakers, however, clawback provisions are increasingly being used to address a much more far reaching set of issues, going beyond ‘bad behaviour’ to include absolute liability-type situations where a negative restatement leads to disgorgement regardless of executive fault. This signals a new understanding of clawbacks as a risk-management mechanism and more generally a “corporate governance tool to deter management from taking actions that could potentially harm the company’s financial position”.5

5.

TYPES AND RELATIVE PREVALENCE OF CLAWBACKS IN U.S. AND

CANADA

According to the HayGroup report, a survey conducted over 450 US public companies with revenues over $4 billion showed (i) more than half of them adopting some form of clawback; (ii) this figure is at 82% for Fortune 100 companies; (iii) clawbacks are applied to annual incentives as well as unexercised stock options and restricted stock/share units (RS/RSU), (iv) clawbacks are a much less frequent sight in Canada overall, apart from top tier banks and insurance companies which have been almost unanimous in adopting some form of recoupment policy since 2009, and (v) as in the

4

- 5 -

U.S., a wide range of incentives are subject to disgorgement in Canada, with a typical look-back period of two to three years.6

Clawback provisions have been commonly categorized into the following three major categories:

(1) the first category covers “bad faith” conduct which includes the breach of non-compete policies, and more generally conduct that is not in good faith and goes against the best interests of the company.

(2) The second major category covers fraud, negligence or intentional misconduct, where the employee has unearned income as a result of fraudulent or negligent conduct leading to financial results that need to be revised at a later point.

(3) The third major categories are clawbacks that are triggered directly by a restatement of financial results, with no need for the company to show a causal link between the negative revision and employee misconduct.

Companies may adopt a combination or all of these measures in their clawback policies, and the following examples will demonstrate that companies may adopt

language that is not clearly caught by these categories. Overall, it seems however, that the inclusion of strict restatement clawbacks is increasingly common, particularly in Canadian entities that adopt such provisions.

- 6 -

6.

EXAMPLES OF U.S. AND CANADIAN CLAWBACK PROVISIONS IN

2011 PROXIES

(a)

U.S. Public Issuers Clawbacks; DEF 14A forms available on EDGAR

(i)

General Motors Company

GMC’s initial clawback policy was adopted in response to TARP measures and covered

fraud, negligence and intentional misconduct. More recently, the board has

expanded the recoupment policy to cover material inaccuracy in financial statements, applying to any SEO and the next top 20 earners of the company. The policy however adds a knowledge condition for recoupment which separates it from the absolute-liability type provisions:

“Recoupment Policy on Incentive Compensation

On September 8, 2009, our Board reaffirmed and expanded our policy regarding the recoupment of incentive compensation paid to executive officers in situations involving financial restatement due to employee fraud, negligence, or intentional misconduct and posted it on our website, www.gm.com/investors, consistent with the requirements for TARP recipients. Our recoupment policy now provides that if our Board or an

appropriate committee thereof has determined that any bonus, retention award, or incentive compensation has been paid to any SEO or any of the next 20 most highly compensated employees of the Company based on materially inaccurate misstatement of earnings, revenues, gains, or other criteria, the Board or Compensation Committee shall take, in its discretion, such action as it deems necessary to recover the

compensation paid, remedy the misconduct, and prevent its recurrence. For this

purpose, a financial statement or performance metric shall be treated as

materially inaccurate with respect to any employee who knowingly engaged in providing inaccurate information or knowingly failed to timely correct information relating to those financial statements or performance metrics. We will continue to