From the Material Girl to Material Reductions in Compensation

From the Material Girl . . .

Who wins the prize for the most pointlessly silly waste of money over the past several months? Two nominees could be Madonna, who reportedly contributed more than $76 million dollars to the Guy Ritchie Charitable Foundation for Marginally Successful Directors, and Plaxico Burress, who appears to have walked away from more than $27 million in exchange for the privilege of shooting himself in the leg (which, I guess, is a more expensive dalliance than merely shooting oneself in the foot).

How frustrated must Madonna be with her undoubtedly romanticized decision not to get a prenup from Ritchie? I mean, I guess her heart was in the right place in some sense, but that was sure one expensive moment of trusting in what presumably appeared to be love. It was a circuitous route to a payoff, but I guess Ritchie finally got a return - and quite a return, indeed - on having made Swept Away and that BMW short with and for his beloved. If the A-Rod thing continues, I wonder what that agreement will look like, from both parties' perspectives.

Plaxico's story, to me, shows the dangers of treating people around you poorly. When the bejeweled one allegedly took an unlicensed handgun into a NY club and then somehow managed to cause it to discharge into his leg, there seemed like nary a soul - save for maybe the players' union - who was willing to lift a finger to catch his freefall. I guess he sorta dropped the ball on this one, huh? It has been suggested that he may have made the suboptimal business deal of forgoing more than $27 million in contractually promised compensation for having armed himself to protect thousands of dollars of bling. Oops.

My vote for who was sillier goes to Madonna. My thinking is that (i) (A) it seems her loss was more obvious to have occurred from the outset, (B) her own past should have made that obviousness still more clear, (C) Burress' series of unfortunate events seems more like a bad Rube Goldberg dream than like a patently obvious and inevitable consequence of an inadvisable choice, and (D) Burress' result may stem as much from the way he treated people before his fall as from the intrinsic nature of the allegedly offensive behavior itself (cf. Paris Hilton's jail time), (ii) Madonna's loss is irretrievable, and (iii) of course, the Material Girl lost materially more money.

But more to the point for this blog, the trials and tribulations of The Material Girl moved me, as I'm sure it must've moved all ERISA/Compensation lawyers, to reflect upon issues relating . . .

. . . to Material Reductions in Compensation

Moving now from the Material Girl's wealth-reduction plan to material reductions in compensation, I wanted to consider a nettlesome point relating to the expiration of 409A transition. Putting aside for the moment the whole debate about whether the ultimate rules are sensible or workable or whatever, it would have been nice if the rules could have found a way to allow substantially compliant arrangements to escape having to be amended just to comply with 409A.

For example, in theory, and as some Treasury personnel have informally suggested, one might have wanted to amend an existing arrangement to say that a separation from or termination of service for purposes of the arrangement is a "separation from service" as defined in the 409A regulations. Such an approach would have required literally every arrangement subject to 409A to be amended, as it is . . . ahem . . . just a bit unlikely that a pre-409A arrangement would expressly reference the 409A regulations.

(A drafting issue somewhat like this comes up in the context of the VCOC/REOC rules, where some would suggest that entities which are not initially intended to be VCOCs or REOCs, but which later want to be, somehow should magically have designated an "annual valuation period" as defined in the DOL regulations. There, the issue is potentially more dangerous, as a supposed failure timely to designate could theoretically forever disqualify and entity from VCOC/REOC status. But I digress. . . .)

While the 409A SfS x-reference does appear to have worked its way into a wide array of arrangements, it seems that a large segment of the market got comfortable that this change, standing alone, was not enough to justify amending an agreement that didn't otherwise need amending. Thus, as a practical matter, the question of whether a generic reference to a separation from or termination of service can be compliant didn't lead to an unfortunate need to amend every arrangement that's out there.

(By the way, as a general matter, I think practitioners should be at least a little circumspect before adding 409A x-references and other purported 409A-related savings provisions into compensation arrangements. Particularly from the standpoint of the service provider, a number of these provisions can have the effect of clouding or delaying a service provider's right to payment (or, at least, right to payment at an otherwise expected time). These seemingly innocuous, facially fair and even-handed and purportedly protective provisions can potentially work substantial mischief in an adversarial context. For example, take the provision that says the service recipient can effect a six-month delay if it feels necessary to protect against a 409A violation. The parties may have agreed as a substantive matter that they've successfully designed compensation that's not subject to 409A, but the service provider may have let that innocent little savings provision stay in the document. Now assume the parties later are all mad at each other, and the service recipient decides to invoke a six-month delay, not because of any new adverse authority but rather because of a supposed conservative change of heart. No big deal, you say? I would suggest that six months is a long time to pursue the proverbial witch hunt. And who knows what else could happen in the face of a six-month delay - ask AIG's Stephen Benzinger. Among the other traps that have surfaced is the one that may ensnare those who try to define CiC by simple reference to the definition in the regulations - yikes. But, with apologies for the distracting stream-of-consciousness approach, I digress again. . . .)

Another example of a potentially silly mass-amendment result related to the situation in which the receipt of an otherwise short-term deferral is made subject to the giving of a release. There are some hyper-technical arguments that a simple and common release requirement in an agreement, without more, could (i) scuttle S-TD status, if (as has historically been common) there is no deadline for the giving of the release, and (ii) worse, lead to a consequent and inexorable 409A violation. This result would be just plain silly, potentially sending countless agreements into 409A-Noncompliance Land in the absence of a 409A-driven amendment, even where the agreement is not otherwise subject to 409A. Thankfully, Treasury personnel got out of their own way on this one, at least informally, and the market seems to have gotten comfortable that the mere use of a release is not enough to cause a 409A catastrophe. Such a reasonable approach was particularly important on this analytical point, as the number of nonabusive arrangements not even otherwise subject to Section 409A that would have been snared in this web would have been staggering.

But there is one common provision which did wind up moving people to make 409A amendments before the close of '08, even if no other revisions were needed. The issue relates to what's contained in a "good reason" definition, and gets back to today's topic, materiality.

By way of background, the general rule is that an S-TD arrangement can't expressly contemplate the deferral of a payment (outside the S-TD period) after initial vesting, in the absence of a deferral election. Under the Alice-in-Wonderland pyrotechnics used by the regulations to determine what is and isn't an S-TD, the theoretical possibility of early vesting without payment during the S-TD period is apparently enough to disqualify an arrangement from S-TD treatment from the very outset.

In the case of "good" Good Reason, vesting is effectively not deemed accelerated to the occurrence of the GR event. This result is important to the S-TD analysis because, unfortunately, the ability to construct a hypothetical situation in which a payment could be deferred after the occurrence of a bad GR event could be enough to disqualify the payment from S-TD status whether or not the situation actually arises or is likely to arise. As a result, a GR definition that's "bad" (the voice of South Park's Mr. Mackey's echoes in my head every time) would seem to be fundamentally incompatible with S-TD status, thus making people a bit paranoid about their GR definitions. (Well, as the old saw goes, just because you're paranoid doesn't mean they're not out to get you.)

Against this backdrop, Treasury and the IRS gave us a GR safe harbor. I've always been worried that a GR safe harbor would drive people to parroting whatever Treasury and the IRS happened to pencil in, and, indeed, I think the safe harbor has had the inevitable and unfortunate effect of pushing people to safer ground. I think it's too bad, because I personally think that any arguably reasonable GR provision will ultimately be respected as such. How likely is it that we'll really get a 409A court case where the IRS asserts (i) a colorably GR provision was bad, (ii) for that reason, the underlying compensation is disqualified from being an S-TD, (iii) the nonqualified deferred compensation, now subject to 409A, fails for some reason to be compliant, and (iv) the service provider therefore owes a 20% tax? I would hope that the courts and even the IRS have better things to do.

Bringing this back to the expiration of transition, in the case of arrangements with GR provisions, parties were faced with the question of whether a GR definition was bad and needed to be amended.

One issue being raised involved whether the definition had the safe harbor's notice provision. It often did not, but people generally and rightfully got comfortable that the absence of such a provision should not, of itself, require an amendment. Were there other divergences from the safe harbor? Maybe those were OK, too.

(Some have suggested that there be a deletion of a GR prong providing for GR upon the assignment to the service provider of duties inconsistent with his or her position. Really (with apologies to SNL)?! Why? Because Treasury didn't think of that one in constructing the safe harbor? Really?! C'mon - we need to do better than that. (Sorry; that was yet a third digression. . . .))

But then comes a tough one, even for those taking a jaundiced view of the relevance of the safe harbor. Under the regulations - in the general rule, not merely the safe harbor - a GR definition has to contemplate material harm to the service provider for it to be a good GR definition.

This approach makes a modicum of sense. The fundamental question is and should be: Does the GR provision act as a reasonable contractual surrogate for the common-law notion of constructive termination? Does the provision require an adverse change to the services relationship that, so to speak, should allow the service provider to leave and take his or her severance?

Consistently with the foregoing, Section 1.409A-1(n)(2)(i) of the Regulations requires a GR provision, to be good, to provide for "a material negative change to the service provider in the services relationship, such as the duties to be performed, the conditions under which such duties are to be performed, or the compensation to be received for performing such services." Many clauses in GR definitions naturally and plainly conform to the general outlines of the general rule. For example, a provision stating that a material diminution of duties constitutes GR is a common provision.

However, many if not most GR definitions in employment contracts had a clause under which any reduction in compensation constituted GR. Such a clause raises the question of whether the contract has a bad GR definition because an immaterial reduction in compensation could be GR. If the definition is bad, the parade of horribles leading to the unavailability of S-TD treatment ensues.

The argument that the clause disqualifies the definition is essentially that the clause on its face allows for immaterial action to be GR. If that argument is considered sufficiently strong, a large number of employment agreements would have needed to be amended if but for no other reason than to add a materiality qualifier to the reduction-in-compensation GR clause. Not only that, but service providers would have had to have decided whether to accept the potential jerking around that comes with the addition of the qualifier, or accept the consequences of a failure of the compensation to meet the S-TD requirements (e.g., a six-month delay if applicable, onerous restrictions on possible acceleration, etc.).

Sadly, in a fair amount of cases, service recipients were ultimately moved to proposing GR amendments to add the materiality qualifier. What an unfortunate reason to have to amend a contract, if no other compelling reason exists. The rules should be administered so as to minimize a devotion of resources to such things.

I think the market had a chance to bail itself out of this mess, but didn't take the bait. The argument on the other side - the argument that a materiality qualifier doesn't need to be added - is that, in the face of an agreement requiring a specified level of compensation, the parties should be free to agree that any violation of that contractual obligation constitutes GR. Stated another way, a violation of a material contractual term - indeed maybe the most material contractual term, in some contracts - is, to use the language of the general rule, "a material negative change to the service provider in the services relationship." If it isn't, the contract has to permit, as a GR matter, the service recipient to test the patience of the service provider with small decreases in compensation. (The service provider would have an action for the decrease, but might not have GR to leave.) As support for this view, one might note that even the safe harbor includes "[a]ny other action or inaction that constitutes a material breach by the service recipient of the agreement under which the service provider provides services" (Reg. § 1.409A-1(n)(2)(ii)(A)(6)).

To me, a reduction in compensation beyond what's required is clearly a material contractual violation. It is by its nature intentional and, as indicated above, relates to a key term. To those who would say that I'm using a general required-by-contract provision to evade an otherwise applicable materiality requirement, I say no. Rather, the existence of the contractual compensation requirement is what makes the reduction in compensation into a material contractual violation. Recognizing that I seem to have a minority view on this question, I frankly don't even think the question is that close.

Maybe someday practitioners will get comfortable with what I'm saying here, as a planning matter and not just as a defensive matter. That would be nice, but it's too late to save people from having to go through Mickey Mouse amendment processes (forgive the reference - much of this is being written at Disney World, so I couldn't help it) as transition ran its course.

And so, with that, moving onto another type of transition, I hope y'all had a Merry/Happy XmaHanuZaa, and a Happy New Year!!