Dividend Equivalent Rights II, the 409A Sequel; and Toy Story 3, the Oscar-Nominated Sequel

 

[originally posted in 2011; see note at end below]

 

DIVIDEND EQUIVALENT RIGHTS - THE 409A SEQUEL

 

General Background

 

Dividend equivalent rights ("DERs") were specifically addressed in the 162(m) regulations regarding the question of whether the grant thereof in connection with an option grant disqualifies the option from favorable treatment as performance-based compensation. Not a whole lot of fuss was made about it at the time.

 

Now we get DER II, set in 409A-Land, and, just when you thought it was safe to go back in the water (thanks, Jaws II), things get a little scary. At their speeches and other presentations, Treasury and IRS officials have for a while been informally indicating concern under 409A about arrangements under which option-related DERs cut off once the option is exercised. Supposedly, so they say, in such a case the DER is somehow contingent in the exercise of the option.

 

A DER by its nature would, however, generally cut off on exercise of the underlying option, in that, once the option is exercised, the actual dividend then becomes payable. Thus, if there is really a problem here, DERs on options could be fundamentally at odds with the requirements under Section 409A. The informal position being taken is confusing to me and I'm extremely surprised it's being taken.

 

Unfortunately, the position seems to be being taken repeatedly, and in some circles is having a bit of a chilling effect on the granting of DERs connected to options. As described below, I think that the position is wrong, and indeed clearly so.

 

The issue arises under Section 1.409A-1(b)(5)(i)(E) of the Treasury Regulations. Section 1.409A-1(b)(5)(i)(E) provides that "the right, directly or indirectly contingent upon the exercise of a stock right, to receive an amount equal to . . . dividends . . . between the date of grant and the date of exercise . . . constitutes an offset to the exercise price . . . (generally causing such right to be subject to Section 409A)."

 

DERs and Section 162(m) - Happier Times

 

First, some history. Section 1.162-27(e)(2)(vi)(A) of the Treasury Regulations set out the predecessor rule, which applied, and still applies, for purposes of the exception for certain performance-based compensation from the $1 million limit on deductions under Section 162(m). The 162(m) rules state: "Whether a stock option grant is based solely on an increase in the value of the stock after the date of grant is determined without regard to any dividend equivalent that may be payable, provided that payment of the dividend equivalent is not made contingent on the exercise of the option." Treas. Reg. § 1.162-27(e)(2)(vi)(A) (third sentence). The idea was that, if the option-related DER were to be made contingent on exercise, then the DER would effectively constitute a purchase-price reduction. And, if that's true, the option, even if otherwise granted at grant-date FMV, would nevertheless essentially be an in-the-money option not eligible for favorable treatment (as performance-based compensation) under 162(m).

 

Treasury pithily described the foregoing, when it issued the 162(m) regulations that included this rule, as follows: "If the payment of the dividend equivalent is conditioned upon the employee exercising the option, the dividend effectively reduces the exercise price of the option, thereby causing the option to be nonperformance based upon its exercise." 60 Fed. Reg. 65,534, 65,535 (Dec. 20, 1995). Historically, in those cases in which favorable 162(m) treatment was sought, the practical effect of this rule under 162(m) in at least some cases has been that the employer pays the DER up until the time the option is exercised, and keeps paying it throughout the term of the option until its expiration if the option remained unexercised.

 

It would seem to be evident that, using that approach, the DER does not operate as a mere purchase-price reduction, as the DER would be paid when there's never a purchase under the option at all (i.e., when the option expires unexercised so that there's no purchase whatsoever under the option). (Sometimes, in the case of certain more generous programs, the DER will be retained even if the option never vests. Other employers provide that the DER won't be paid if the underlying option didn't vest.

 

But the question of whether to hold the DER back depending on whether the option has vested is a different matter than the one being considered herein - the key point here is that the DER is to be paid regardless of whether the option is exercised, and indeed regardless of whether the option is ever exercised.) That all makes eminent sense - so far, so good.

 

DERs, Redux - A Scary 409A Sequel

 

409A then proceeds to make use of similar thinking in connection with requiring, for treatment as an option (or other stock right) not subject to 409A, that the option (or other stock right) not be granted in the money. Thus, as noted above, Section 1.409A-1(b)(5)(i)(E) of the Treasury Regulations says that "the right, directly or indirectly contingent upon the exercise of a stock right, to receive an amount equal to . . . dividends . . . between the date of grant and the date of exercise . . . constitutes an offset to the exercise price . . . (generally causing such right to be subject to Section 409A)."

 

Conversely, Section 1.409A-1(b)(5)(i)(E) expressly and properly confirms that, "A plan providing for a right to dividends . . . , the payment of which is not contingent upon . . . the exercise of a stock right, may provide for a deferral of compensation, but the existence of the right to receive such an amount will not be treated as a reduction to the exercise price . . . . Thus, a right to such dividends or distributions that is not contingent, directly or indirectly, upon the exercise of a stock right will not cause the related stock right to fail to satisfy the requirements of the exclusion from the definition of a deferral of compensation . . . ." Treasury seems to have described all of this correctly when the 409A regulations were finalized, saying: "The final regulations adopt the rule that a right to a payment of accumulated dividend equivalents at the time of the exercise of a stock right generally will be treated as a reduction in the exercise price of the stock right, causing the stock right to be deferred compensation subject to the requirements of section 409A. The final regulations provide that an arrangement to accumulate and pay dividend equivalents the payment of which is not contingent upon the exercise of a stock right may be treated as a separate arrangement for purposes of section 409A." 72 Fed. Reg. 19,234, 19,242 (Apr. 17, 2007).

 

Still, so far, so good. Again, this all makes sense. Now, how and why does it all go awry? The notion seems to have developed in some governmental circles* that contingency is somehow a two-way street. As the thinking apparently goes, if (i) the DER is impermissibly contingent on the exercise of the option where the right to retain already-accrued DER payments is contingent on the exercise of the option, then (ii) the DER is likewise impermissibly contingent on the exercise of the option where the right to receive new, continuing and additional DER payments is contingent on the non-exercise of the option.

 

 But this thinking turns the whole thing topsy-turvy; that is, in the foregoing clause (ii) it is the right to continue to receive additional DER payments (not the right to retain DER payments) that is contingent on the non-exercise of the underlying option (as opposed to contingent on exercise). So let's see if it is or should be true that a DER that is only paid if an option is exercised really is the same, on an analytical or policy basis, as a DER that turns off when the option is exercised.

 

Perhaps it's worth examining the fundamental difference between what the anti-contingency rule really addresses, and what is being suggested as being addressed by the anti-contingency rule. What you're not allowed to have is the following: option exercise --> retaining DER accruals. That would make the retention of the accrual "contingent" on exercise. It is suggested here, however, that the rule plainly does not (and should not) address the following: option exercise --> cessation of additional DER payments. Stated another way, "if A then B" ≠ "if A then not-C" (where (i) A is the exercise of the option, (ii) B is being able to retain accrued DER payments, and (iii) C is being able to continue the receipt of additional DER payments). Thus, the regulation expressly and properly confirms that, "A plan providing for a right to dividends . . . , the payment of which is not contingent upon . . . the exercise of a stock right, may provide for a deferral of compensation, but the existence of the right to receive such an amount will not be treated as a reduction to the exercise price . . . . Thus, a right to such dividends or distributions that is not contingent, directly or indirectly, upon the exercise of a stock right will not cause the related stock right to fail to satisfy the requirements of the exclusion from the definition of a deferral of compensation . . . ."

 

As can be seen, the reduction-in-price rationale is specifically baked into the above-quoted words of the 409A regulatory language itself, and the cessation of future additional DER payments simply does not involve a reduction in the exercise price of the underlying option. If there is no required exercise of the underlying option (no contingency!) in order to retain the DER payments , then there can be no putative impermissible exercise-price-reduction, which is the only thing the rule are or should be after. In the case of a DER that turns off on exercise of the underlying option it's not the payment that's contingent on exercise - it's the nonpayment that's conditioned on exercise! They're just not the same thing. Maybe symmetry of equating the two is facially seductive - there’s often an equitable sense of that "what's good for the goose is good for the gander, even though different considerations may apply to the goose and the gander. Cf. my prior post on provisions in employment agreement relating to attorneys’ fees.

 

From an analytical perspective, the logic underlying this distinction is arguably steel-trap. Surmise that an option vested but then expires unexercised, and there were DER accruals linked to the option which will be retained by the optionee. In that case, the DER will have gotten paid (or will at least have vested) either at or before vesting** and yet the option never got exercised. Conclusively, then, last I looked at what "contingent" means, that DER just ain't contingent. A lack of a policy problem naturally and inexorably follows. Indeed, there's not even any policy reason to try to engraft the other-way (dare I say "wrong way") directionality onto the contingency rule. As reflected right on the face of the Section 1.409A-1(b)(5)(i)(E) rule, the question is whether there's a "reduction" in "exercise price", and that's just not a concern where it's nonpayment, as opposed to payment, that's contingent on exercise. Since the DER is retained regardless of whether the option is exercised, it simply doesn't act as a purchase-price reduction, and therefore doesn't implicate the price-reduction concerns underlying the 409A (and 162(m)) regulations.

 

The rule I’m suggesting here also has the advantage of being a rational one from a business perspective. It's at least sensible to pay the DER whether the option is exercised. It makes no sense, however, for the DER to be paid after the option is exercised. That's a double payment - the continuing DER, coupled with the actual payment of the real dividend on the actual stock. In this regard, one would hope, the tax rules just don't require the implementation of an irrational or otherwise silly program. Maybe having DERs be inherently inconsistent with 409A would make some sense if DERs were somehow evil or otherwise undesirable, such that they should be discouraged altogether.

 

But I don’t think that DERs are somehow always "bad" by their very nature. The fact is - the rules do not require a DER to be structured irrationally. And the key is that it's not the payment of the accrued DER that's contingent on exercise; it's the continued payment that’s contingent on non-exercise. They're just not the same thing. So maybe you're saying that this is sophistry on my part - a manipulative exercise in linguistic gymnastics. So maybe you’re saying, "Oh, c'mon, even if the stock might not go up right away, it's bound to go up someday."

 

But that's not right. Is it possible, not only as a theoretical matter but as a practical matter, that a given option will fail to be exercised? Of course it is. First, plainly, the stock might not go up. Are we forgetting that stock does not always increase in value, maybe not ever? The internet bubble burst a long time ago, with the subprime crisis having followed, and it's now quite clear that, yes, stock can actually go down and stay down. Has anyone ever heard of attempts to reprice hopelessly out-of-the-money options? (See also Treas. Reg. § 1.162-27(e)(2)(vii) (ex. 3) (whether there will be net income is always substantially uncertain).)

 

Second, even if a given stock would be destined or otherwise likely to go up someday, it might not be up at the time the option would otherwise expire. In this regard, an optionee will commonly wait until expiration to exercise (i) for tax reasons and (ii) so as to be able to continue to ride the investment in the underlying stock without having to make a capital investment (indeed, that's a hallmark of an option - the value of the option embedded in the optionality of the option). The compensatory landscape is littered with worthless, unexercised options - proof positive that the exercise of an option is anything but inevitable.

 

Summary

 

I think that, at the end, the analysis is ultimately quite straightforward and definitive, and can be demonstrated with the use of a baseline fact pattern. Take a vested option that is never exercised.*** Now assume a DER has been granted in connection with the option and the DER is paid (or vests) before or when the option vested. Assume further that, if the option is not exercised, the DER payment will be retained and, to make it easier, assume that the option is never exercised. On those facts: - Has the option been exercised? No - Will the option be exercised? No. - Has the DER been paid and retained? Yes. - Was the payment of the DER contingent on the exercise of the option. Uh - no. Like I said, steel-trap. I'm surprised that this has been made into an issue, even informally. I really think a technical misstep here is leading to confusion. To me, turning off a DER upon option exercise is fine under 409A, and, as asserted above, even clearly so.**** Now, in honor of the Oscars, it’s onto a more traditional kind of sequel . . . .

 

SEQUELS AND OSCAR NOMINATIONS - THE STORY OF TOY STORY 3

 

I noticed today (Oscar Day ‘11) that Toy Story 3, one of my favorite movies of all time, is nominated for best adapted screenplay. I have by this time been disabused of my flirtation, reflected in an earlier post, with the notion that TS3 will win the Oscar for Best Picture (go ahead, mock and otherwise laugh); however, the nomination for best adapted screenplay is fascinating. What is the source material on which the TS3 screenplay is based? The answer lies in the fact that the rules aren't really clear regarding into which of the two writing categories (original, adopted) a screenplay goes. Apparently, according to one helpful post (assuming it's right), the actual name of the category is, “Best Writing, Screenplay Based on Material Previously Produced or Published” - thus explaining that a sequel which itself has no direct source material could somehow be considered adopted by virtue of having been based indirectly on the sequel's predecessor(s).*****

 

Cool. And, of course, good luck to TS3 in this mainstream category!!

 

[originally posted in 2011; errant citations corrected thanks to my friend Jay D.]

 

_____________________________

* It's not clear that there's uniformity within the government on this.

 

** See also Treas. Reg. §§ 1.409A-1(b)(2), 3(e) (regarding deferred payment in the case of DERs connected with RSUs).

 

*** I can almost hear Henny Youngman intoning, "Take my wife - please."

 

**** The issue can be a big one where dividends are material, such as, for example, would generally be the case for options granted by REITs. But, whether the issue is economically a big one or a small one, the analysis should not get mucked up.

 

***** Cf. Treas. Reg. § 1.409A-1(b)(5)(i)(E) (twice using the "directly or indirectly" concept to cover something with either character by the same rule) (thus (ha ha) bringing this post full circle).