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July 12, 2017


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Executive Compensation & Taxation Coordinator

Executive Compensation Alert

June 5, 2017 





Arthur H. Kohn, a partner at Cleary Gottlieb Steen & Hamilton LLP, presented his annual survey of “Late-Breaking Developments in Executive Compensation” at ALI-CLE’s course on “Executive Compensation: Strategy, Design, and Implementation” held in New York City on June 8–9. Scott Spector of Fenwick & West LLP shared the podium with Mr. Kohn.


Section 16(b) lawsuits.  Mr. Kohn’s first topic was series of shareholder lawsuits filed under Section 16(b) of the Securities Exchange Act of 1934 (15 USC 78p(b)), the short-swing profit rule. An officer or 10% stockholder of a company subject to Securities and Exchange Commission (SEC) registration requirements is subject to a suit under Section 16(b) to recover profits realized from a purchase and sale, or sale and purchase, of the company’s stock within a period of less than six months.


The lawsuits, brought by the same plaintiff acting pro se, seek recovery of short-swing profits from insiders who elected to have shares withheld from equity awards to satisfy tax withholding or pay option exercise costs within six months of engaging in a nonexempt transaction in the company’s stock.


The complaints are based on two arguments. The first argument is that Rule 16b-3(e)(17 CFR 240.16b 3(e)), which exempts dispositions of issuer stock to the issuer from the short-swing profit rule if approved in advance, only applies to “automatic” withholding. It doesn’t exempt elective withholding where an insider has discretion to pay the tax or exercise price with cash in lieu of shares or the issuer has discretion to allow or require withholding, unless withholding is reapproved when the tax is due. This plaintiff bolstered this argument by citing SEC Compliance & Disclosure Interpretation (C&DI) 123.16, which in the plaintiff’s reading permits automatic withholding but bars discretion.


In April, a district court in Texas rejected this argument when it granted the defendants’ motion to dismiss one such lawsuit in a one-page order. The court held that “the transactions in question are compensation related and are designed to be exempt under” Rule 16b-3(e). (Jordan v. Flexton, No. 4:16-CV-03316 (S.D. Tex. Apr. 26, 2017))


The plaintiffs’ second argument is that withholding wasn’t exempt under Rule 16b-3(e) because taxes were deferred under Code Sec. 83(c)(3), which provides that a person’s rights in stock or other property are subject to a substantial risk of forfeiture if a sale of the stock or property would subject the person to suit under Section 16(b). Therefore, no taxes were due when the disposition of the stock occurred. According to Mr. Kohn, this argument is “clearly wrong.”


As a practice pointer, Mr. Kohn noted that many agreements between a companies and their executives provide that the company can change the rules governing withholding on equity grants in the company’s discretion. Such provisions are typically included to take account of future changes in circumstances.


Mr. Kohn believes that companies should not amend their existing agreements, as this would appear to be too defensive. Instead, he suggests that the compensation committee enter a statement into its minutes that changes by the “company” are to be made through the compensation committee. According to Mr. Kohn, if only the committee can change automatic withholding, it cannot logically undermine the prior approval.


CDX Holdings, Inc. v. Fox.  On June 6, 2016, the Delaware Supreme Court affirmed a Chancery Court ruling that Caris Life Sciences breached the terms of its equity plan by failing to properly determine the fair market value (FMV) of options that were cashed out in connection with a spin-off/merger transaction. Caris sold one of its business units to Miraca Holdings, Inc. for $725 million, using a spin-off/merger structure to minimize taxes. The merger agreement provided that option holders would receive the difference between

$5.07 per share and the exercise price of their options, less 8% held in escrow.


The Caris equity plan provided that option holders were entitled to receive the amount by which the FMV of the shares underlying each option, as determined by the Caris board, exceeded the exercise price. The plan also required the board to adjust the options to account for the spin-off.


The Delaware Supreme Court agreed with the Chancery Court’s ruling that an option cashout and application of an escrow holdback in a merger require a contractual right. The Chancery Court stated that the “rights and obligations of the parties to the option are governed by the terms of their contract,” and found that the governing contract was the equity plan, not the merger agreement. The Chancery Court also found that Section 251(b)(5) of the Delaware General Corporation Law (DGCL), which authorizes the board to approve certain changes to the corporation’s stock in a merger, “does not authorize the conversion of options in a merger.”


Mr. Kohn pointed out that the option plan in CDX Holdings was unclear about stock valuation in case of a spin-off. Option plans are often written in a deliberately vague way, because it’s impossible to predict the form that future transactions may take. Practitioners have believed that the merger agreement can be used to modify options, but the Delaware Supreme Court’s decision indicates that this faith may be misplaced.


According to Mr. Kohn, the CDX Holdings decision should make practitioners more cautious about relying on the merger agreement as a basis for taking action with regard to stock options. Mr. Spector added that it’s helpful if the option plan itself provides that the merger agreement will control, as many plans do. (CDX Holdings, Inc. v. Fox, 141 A.3d 1037 (2016))


Corporate settlements with activist investors.  Quick settlements with activist hedge funds to recompose boards and adjust strategic plans have resulted in hundreds of new directors and changes to business plans over the last two years. As an example of this trend, Mr. Kohn pointed to the campaign of the investment firm Mantle Ridge against CSX Corporation that netted four new non-management board seats, a promise that the board wouldn’t be expanded until CSX’s 2018 annual meeting, and the installation of a new CEO, Hunter Harrison, who came on board from competitor Canadian Pacific with a new strategic plan for CSX.


These changes occurred very quickly. Only 27 days into the discussions between Mantle Ridge and CSX, the CSX board announced that it had reached an impasse and would call a special shareholder meeting “to seek guidance from shareholders on whether CSX should agree to Mr. Harrison’s and Mantle Ridge’s proposals.” The board didn’t issue any recommendations to shareholders in connection with this vote. The parties settled 20 days later.


As Mr. Kohn saw it, the board turned over its business judgment to the shareholders on a fundamental issue of corporate governance, though the board would claim that it was merely looking for input from the shareholders. Mr. Kohn noted that CSX was a Virginia corporation and questioned whether this reliance on the shareholders would be acceptable under Delaware law.


Mr. Kohn noted that institutional investors have become concerned about the speed with which companies settle with the activists, pointing to a position paper issued by State Street Investors in opposition to this “quick settlement” trend. State Street called on corporate boards to develop principles for engaging with activist investors to promote long-term value creation and sustainable economic growth. While recognizing that activists can bring about positive change, State Street expressed concern about activists who favor short-term gains at the expense of interests of long-term investor. (State Street Market Commentary, Oct. 10, 2016)


Issuance of nonvoting shares. In an initial public offering (IPO) in March, Snap Inc. offered common shares that had no voting rights. Only holders of shares issued before the IPO would be entitled to vote on corporate matters. In response, the Council of Institutional Investors has proposed removing Snap from stock market indexes, claiming that Snap’s voting structure would undermine public shareholder confidence. FTSE Russell, a provider of stock market indexes, issued a statement in April indicating that it will consult with investors about whether to include companies with no voting rights in its indexes. FTSE Russell expects to announce the results in July.


The SEC’s Investor Advisory Committee discussed Snap’s capital structure at a public meeting on March 9. Proponents argued that the use of non-voting shares could offer a solution to the misalignment caused by institutional shareholder demands for short-term gains at the expense of long-term profitability. But advocates of a “one share, one vote” structure argued that non-voting shares would impair the ability of unaffiliated shareholders to hold boards accountable.


Mr. Kohn observed that there was pushback against nonvoting shares from big institutional investors such as BlackRock, Fidelity, and Vanguard, who hold stocks for the long term and have an obligation to their clients to take positions on corporate issues. The issuance of nonvoting shares will leave these investors “quite unhappy” over their disenfranchisement, said Mr. Kohn.


Mr. Spector agreed that the lack of a vote would leave shareholders without the power to affect corporate governance. One might expect the stock exchanges to delist these stocks, but there’s no pressure on them to do so. Investor advisory firms such as Institutional Shareholder Services (“ISS”) and Glass Lewis say that there’s nothing they can do if investors choose to buy these shares.


Whistleblowers.  Federal protection for corporate whistleblowers is provided by the Sarbanes-Oxley Act of 2002 (“SOX,” PL 107–204, 7/30/2002), which prohibits publicly-traded companies and their officers, employees, or agents from retaliating against whistleblowers who report potential violations of securities and anti-fraud provisions to regulators, law enforcement, or supervisory agencies.


The Dodd-Frank Wall Street Reform and Consumer Protection Act (PL 111–203, 7/21/2010) expanded on the SOX whistleblower protections. Dodd-Frank introduced significant incentives for whistleblowers. It permits whistleblowers who claim retaliation to sue in federal court without first seeking administrative relief. It also authorizes awards of two times back pay, with interest, and attorney and expert fees. And it created a bounty program to incentivize corporate whistleblowing that provides between 10–30% of monetary sanctions exceeding $1 million levied by the SEC.


Mr. Kohn pointed to Wadler v. Bio-Rad Laboratories, Inc. as an example of recent whistleblower litigation. In that case, a federal jury in San Francisco found that Bio-Rad violated federal whistleblower provisions by unlawfully firing its general counsel, Sanford Wadler. Wadler was awarded nearly $11 million in damages.


Mr. Kohn listed three key takeaways from the Bio-Rad case. First, companies should be aware that privileged communications between a whistleblower and the company’s directors, officers, in-house counsel, and even outside counsel may be discoverable and admissible in a whistleblower retaliation action if necessary to prove the whistleblower’s claims and defenses. In Bio-Rad, this applied where the plaintiff had been the company’s general counsel. It could also apply to meetings where in-house legal counsel is present.


Second, companies should make sure that policies, procedures, and training are in place to facilitate internal complaints of potential misconduct.


Third, companies should maintain timely and complete personnel files. Regular written performance evaluations should be given, and any negative performance issues should be recorded as they occur. In the Bio-Rad case, there was nothing in Wadler’s file that indicated any performance issues. In fact, Wadler noted he had received a positive performance review, a promotion, and a raise six months before he was fired.



Redistributed with written consent of Thompson Reuters 

Executive Compensation & Taxation Coordinator (ISSN 0273-7612) is published semi-monthly by Thomson Reuters, 121 River Street, Hoboken, NJ 07030. Volume 40, No. 13. Subscription rate: $1,485 per year. Periodicals postage paid at New York, NY and additional mailing offices. © 2017 Thomson Reuters/Tax & Accounting. Thomson Reuters, Checkpoint, and the Kinesis logo are trademarks of Thomson Reuters and its affiliated companies. Copyright is not claimed in any material secured from official U.S. Government sources. The views expressed in the Practice Alert column are not necessarily those of Thomson Reuters or its editors. Postmaster: Send address changes to Executive Compensation & Taxation Coordinator, Thomson Reuters Tax & Accounting, P.O. Box 115008, Carrollton, TX 75011-5008.


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