Train Kept A Rollin' (by Aerosmith)
Rock N Roll Train (by AC/DC)
Train in Vain (by The Clash)
Runaway Train (by Soul Asylum (not the Denzel movie))
Train (Patrick Monahan's band)
(I'd also include the original The Taking of Pelham One Two Three, but it doesn't specifically include the word, "train," and I'm afraid this is already getting out of hand)
So this got me thinking about railroad tracks. Which brings me to a certain track-ing rule in the 409A regs. that I believe is widely misinterpreted. (I'm lying, of course, about the progression that got me to thinking about the 409A rule in question. The truth is that I wanted to find some kind of pop-culture tie-in for this piece, and the foregoing, sadly, is the best I could do.) Enough of this, and onto 409A.
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On occasion, we all, or at least some of us, allow assumptions to be embedded in our heads as to what a particular rule means or how it must work. Every now and then, though, it may make sense to take a step back and look at what the underlying rule really says, before we proceed in accordance with our working assumptions.
The issue I want to raise involves what to do with equity-based deferred compensation that is to be pushed out in connection with the consummation of a change in control, so as to track payments made in respect of the underlying equity. The working assumption is that the payments can't be pushed out to more than five years after the CiC.
But is that always right? I don't think so, where the deferred-comp. documents are pre-wired so as to provide for the additional deferral. (Pre-wiring could be of particular relevance and utility in the case of a plan (e.g., a so-called "carve-out" plan for management of a private-equity portfolio company) being established in the context of a possible impending transaction.) I think you can draft a plan that, from the outset, has equity-related distributions track payments made in respect of underlying equity, no matter how long the payments are extended.
Heresy, you say? (Or maybe, if you're less excitable than I, you more calmly suggest that I simply don't get it.) Well, I think that that's the result you get on a completely straightforward reading of the rule and, to be frank, I'm not sure how you get to the adverse result, in the pre-wired case.
The rule in question is the tracking rule found at Section 1.409A-3(i)(5)(iv)(A) of the Treasury Regulations (the "Tracking Rule"), which states:
"Payments of compensation related to a change in control event described in paragraph (i)(5)(v) of this section (change in the ownership of a corporation) or paragraph (i)(5)(vii) of this section (change in the ownership of a substantial portion of a corporation’s assets), that occur because a service recipient purchases its stock held by the service provider or because the service recipient or a third party purchases a stock right held by a service provider, or that are calculated by reference to the value of stock of the service recipient (collectively, transaction-based compensation), may be treated as paid at a designated date or pursuant to a payment schedule that complies with the requirements of section 409A if the transaction-based compensation is paid on the same schedule and under the same terms and conditions as apply to payments to shareholders generally with respect to stock of the service recipient pursuant to a change in control event described in paragraph (i)(5)(v) of this section (change in the ownership of a corporation) or as apply to payments to the service recipient pursuant to a change in control event described in paragraph (i)(5)(vii) of this section (change in the ownership of a substantial portion of a corporation’s assets), and to the extent that the transaction-based compensation is paid not later than five years after the change in control event, the payment of such compensation will not violate the initial or subsequent deferral election rules set out in §1.409A-2(a) and (b) solely as a result of such transaction-based compensation being paid pursuant to such schedule and terms and conditions."
On its face, what does the Tracking Rule say? Well, first, it says that, in the case of a covered CiC, you don't have a bad payment date or schedule merely because equity-based payments are made on the same basis as that which is applicable to payments made in respect of the underlying equity. And then, additionally and separately, the Tracking Rule provides that, where there's a covered CiC, you don't have a bad deferral election merely because the equity-based payments are made on such basis, if the compensation doesn't continue to be paid more than five years after the CiC.*
The Tracking Rule is comprised of these two completely distinct rules, and the five-year limitation plainly applies only to the latter one. It has to be the case that there is meaning in that obviously intentional structure. I submit that the evident meaning is that the five-year rule applies only to changes in the plan or elections under the plan - which are the things that can implicate the election rules identified in the second (but not the first) part of the Tracking Rule.
Thus, I'm suggesting, if you have an equity-based plan and it provides when implemented at the outset that distributions in respect of equity units will track third-party post-CiC payments for underlying equity, then the provision doesn't have to limit tracking to third-party payments made within five years. In that case, I believe, you can simply say that the payments will track the third-party payments, whenever made. For example, in the case of a unit payable at the time of the CiC, the provision could say something like: "The Unit Value will be paid no later than 30 days after consummation of the Covered Transaction; provided that, if holders of Shares receive payment for their Shares in connection with the Covered Transaction pursuant to a different schedule and subject to other terms and conditions, then Participants shall receive payment of the Unit Value of their Units pursuant to such schedule and subject to such other terms and conditions."
Is this abusive drafting based on a too-clever deconstruction of the regulatory language that reads out the five-year limitation in certain cases? Am I playing interpretive games mired in linguistic Sophistry? At the risk of "protest[ing] too much,"** I think the answer to those questions is a resounding "no." I'm saying that the bifurcated structure of the Tracking Rule really could only mean that the first part of the rule, the part to which the five-year rule does not apply, just must have, and indeed does have, independent application - else it simply wouldn't have been drafted that way. I believe that's what you get when you just read the words on the page and apply their plain meaning.
Importantly, it seems entirely reasonable to surmise that the regulations purposefully take a more flexible view of a plan that from the get-go provides for a particular type of permissible payment, and seek to add constraints and limitations where, after the arrangement is in place, efforts are made later to add provisions for additional deferral. Under this view, the rule says what it says, and there simply is no five-year limitation applicable where the plan is not later amended (and there otherwise are no later elections) to provide for a new time or form of distribution. At the risk of saying it too many times, it is suggested here that this is precisely how the regulations clearly and straightforwardly read.
The preamble to the proposed regulations all but confirms that the regulations say what I'm arguing clearly emerges on the face of the regulatory language. The proposed preamble not only reiterates the bifurcated approach taken by the regulatory language, but it goes on to use grammar that further disconnects the two separate rules that comprise the Tracking Rule. Section VI(E) of the preamble to the proposed regulations states:
"These regulations . . . provid[e] that compensation payable pursuant to the purchase by the service recipient of service recipient stock or a stock right held by a service provider, or payment of amounts of deferred compensation calculated by reference to the value of service recipient stock, may be treated as paid at a specified time or pursuant to a fixed schedule in conformity with the requirements of section 409A if paid on the same schedule and under the same terms and conditions as payments to shareholders generally pursuant to a change in the ownership of a corporation that qualifies as a change in control event or as payments to the service recipient pursuant to a change in the ownership of a substantial portion of a corporation’s assets that qualifies as a change in control event, and any amounts paid pursuant to such a schedule and such terms and conditions will not be treated as violating the initial or subsequent deferral election rules, to the extent that such amounts are paid not later than five years after the change in control event."***
One possible response to what I'm suggesting above is that the five-year rule applies in all cases, even where the tracking is build into the plan initially, because the later CiC transaction will effectively act as a putative election to defer, thereby (i) activating the 409A election regime and (ii) therefore rendering the election late and noncompliant, unless the second piece of the Tracking Rule, which requires compliance with the five-year rule, is satisfied.
Well, first, to me, that's just wrong. Assuming that the transaction in question isn't some sham attempt to effect a compensation deferral is intended to evade the 409A rules, there's no way, I submit, that the effectuation of a transaction with independent business significance is tantamount to a distribution election. If there's no distribution election, then, ipso facto, there's no late, non-compliant deferral election.
Maybe more to the point, riddle me this, Batman - even if we're to believe that the intent really may have been to apply the five-year rule across the board, including to tracking provisions included in a plan from the outset, then why isn't the Tracking Rule more simply structured (if "simply structured" is the right turn of phrase for anything under 409A) along the following lines: "For purposes of the permissible-payment rule and the election rule, you're deemed OK if the transaction-based compensation is paid on the same schedule and under the same terms and conditions as apply to payments to equityholders generally, but only to the extent payments under the plan are not made over more than five years"?****
If you don't believe me, I would ask you to read the words of the Tracking Rule again, with a fresh, unjaundiced eye. If they really thought that the five-year rule is so all-fangled important, then why is it relegated to the second (election/amendment-related) piece of the rule, instead of being set forth in both halves? And, moreover, there has to be SOME point to the carefully bifurcated approach that the regulations take.***** Stated another way, if in writing the regulations they were trying to say to say that all uses of the Tracking rule require satisfaction of the five-year limitation, well, then, fine - just draft a rule that says that you can't use this rule unless you satisfy the five-year requirement. That's just not what the rule says.******
What may well be happening here is that the second part of the Tracking Rule is acting as an unfortunate distraction to the interpretation of the first. There's almost misdirection. What do I mean? Let's imagine for the moment that there was no second part of the Tracking Rule. Let's say that the entire rule said:
"Payments of compensation related to a change in control event described in paragraph (i)(5)(v) of this section (change in the ownership of a corporation) or paragraph (i)(5)(vii) of this section (change in the ownership of a substantial portion of a corporation’s assets), that occur because a service recipient purchases its stock held by the service provider or because the service recipient or a third party purchases a stock right held by a service provider, or that are calculated by reference to the value of stock of the service recipient (collectively, transaction-based compensation), may be treated as paid at a designated date or pursuant to a payment schedule that complies with the requirements of section 409A if the transaction-based compensation is paid on the same schedule and under the same terms and conditions as apply to payments to shareholders generally with respect to stock of the service recipient pursuant to a change in control event described in paragraph (i)(5)(v) of this section (change in the ownership of a corporation) or as apply to payments to the service recipient pursuant to a change in control event described in paragraph (i)(5)(vii) of this section (change in the ownership of a substantial portion of a corporation’s assets)."
If that's all you had, would you then construct the concern that the rule is effectively unusable because the later effectuation of a transaction is somehow an impermissible noncompliant late election? C'mon - no way. So then why does the addition of the second piece of the Tracking Rule, which says that the use of the Tracking Rule won't result in a violation of the election rules to the extent that the five-year limitation is satisfied, somehow diminish the force of the first part of the rule, which says that there's a permissible time or schedule of payment if the stock-based deferred-comp. payments track the underlying equity? The answer? The second piece of the Tracking Rule does not diminish the independent force of the first, and the first part of the rule applies in accordance with its terms, which do not include a five-year requirement. You don't have an election problem about which to worry if, well, there's no election.
I'm not saying that Treasury and the IRS couldn't have reasonably promulgated a rule that says that in order to use the Tracking Rule you can't ever have the tracked payments go out beyond five years. I'm saying that, where the plan provides from the get-go that the manner in which post-CIC payments are made will track the manner in which payments are made in respect of underlying equity, that's simply not the rule they wrote.
Happy New Year!
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* And then there's the question of whether this whole issue arises to any extent whatsoever when it comes to extinguishing options for fair consideration. Many will not proceed with option cash-outs that track payments of underlying equity unless the cash-out payments will not extend to beyond more than five years after the CiC. Arguably, however, such transactions don't implicate 409A issues at all. In this regard, the Tracking Rule on its face only has significance for deferred comp., as opposed to non-409A options, in that the relief provided by the rule by its terms only (i) helps with whether you've got a permissible time or schedule for payment and (ii) allows you not to run afoul of the 409A election rules. See also Treas. Reg. § 1.83-7(a) (fifth sentence) (providing generally that, if an option (although, unfortunately, not necessarily an SAR) is disposed of in an arm's length transaction (which presumably would be the case if the terms of the disposition track the terms applicable to transaction-related payments for underlying equity generally), "sections 83(a) and 83(b) apply to the transfer of money or other property received in the same manner as sections 83(a) and 83(b) would have applied to the transfer of property pursuant to an exercise of the option"). Indeed, if there really is a problem with options in this context, the problem would seem to arise under the rule proscribing the additional to an option of an additional deferral feature. See generally Treas. Reg. § 1.409A-1(b)(5)(i)(A)(3), (B)(3), (D). But, oddly, satisfying the Tracking Rule wouldn't address the separate question of whether one has added an additional deferral feature to an option, given that the option, by hypothesis, isn't subject to 409A, leaving one with the analytical conundrum that, if you really believe that stretching out payments received in connection with the cashing out of an option is an issue, then there's no way out of the box ("What's in the box?!?" asked Brad Pitt), even if you're willing to satisfy the five-year limitation. It's a bit of a mess, no? See also 39 TMCPJ 79 (possibly indicating that Treasury and the IRS are aware that the rules may be glitchy as to these matters, to the point of maybe justifying a technical correction to the regulations).
** W. Shakespeare, Hamlet, Act III, Scene II.
*** You may reasonably ask, but what about the preamble to the final regulations? Well, unfortunately, it appears by the time of the final regulations Treasury and the IRS themselves remembered only that there's a five-year limitation out there, without focusing on the particular purpose (the election rules) for which the five-year rule applies. Thus, unfortunately, Section VII(F) of the preamble to the final regs. states:
"The final regulations continue to provide that in the case of a payment on account of certain change in control events (a change in ownership of a corporation or a change in the ownership of a substantial portion of a corporation’s assets), compensation payable pursuant to the service recipient’s purchase of service recipient stock or a service recipient stock right held by a service provider, or payment of amounts of deferred compensation calculated by reference to the value of service recipient stock, generally may be treated as complying with the requirements of section 409A if paid under the terms and conditions that govern the payments to shareholders or the service recipient in connection with the change in control event. The final regulations continue to require that such amounts be paid no later than five years after the change in control event."
Arguably, the last sentence of the passage quoted immediately above is not persuasive as to the interpretive question I'm addressing here. First, the proposed preamble, discussed in text, gets it right, reciting what may well be an even more clear bifurcation than the words of the actual regulation. Second, the reference quoted above in the final preamble to the five-year limitation is almost flippant, and I submit that, to the extent there's an implication in the final preamble that the five-year rule is a rule that applies broadly to the entire Tracking Rule, the drafter thereof may have lost track of the details regarding the manner in which the two-pronged Tracking Rule is actually structured.
Finally, no matter how much the drafter of the final preamble may have purposefully intended to be saying that the five-year limitation applies for all purposes of the Tracking Rule, there's that pesky little nettlesome point that the structure of the Tracking Rule is what it is and the words thereof say what they say. In this regard, I would point to the old witticism that may be paraphrased as decrying an inclination to look to the statute only when the legislative history is unclear. See Greenwood v. United States, 350 U.S. 366, 374 (1956) (Justice Frankfurter quipping, ‘‘This is a case for applying the canon of construction of the wag who said, when the legislative history is doubtful, go to the statute’’); see also Easterbrook, ‘‘Challenges in Reading Statutes,’’ (Sept. 26, 2007) (presented at a dinner talk for the Lawyers Club of Chi.) (‘‘The canonical way to [look for legislative intent] was to look at what legislators said - at legislative history. One wag - who happened to serve on the Supreme Court - quipped that the judge would turn to the statute only when the legislative history was unclear’’); Scalia, A Matter of Interpretation: Federal Courts and the Law 31 (Princeton Univ. Press 1997) (joking that ‘‘one should consult the text of the statute only when the legislative history is ambiguous’’).
**** A provision under which satisfaction of the five-year limitation rule would be necessary as a gateway matter in order generally to avail oneself of the Tracking Rule might have read in full as follows:
"Payments of compensation related to a change in control event described in paragraph (i)(5)(v) of this section (change in the ownership of a corporation) or paragraph (i)(5)(vii) of this section (change in the ownership of a substantial portion of a corporation’s assets), that occur because a service recipient purchases its stock held by the service provider or because the service recipient or a third party purchases a stock right held by a service provider, or that are calculated by reference to the value of stock of the service recipient (collectively, transaction-based compensation), if the transaction-based compensation is paid on the same schedule and under the same terms and conditions as apply to payments to shareholders generally with respect to stock of the service recipient pursuant to a change in control event described in paragraph (i)(5)(v) of this section (change in the ownership of a corporation) or as apply to payments to the service recipient pursuant to a change in control event described in paragraph (i)(5)(vii) of this section (change in the ownership of a substantial portion of a corporation’s assets), to the extent that the transaction-based compensation is paid not later than five years after the change in control event, may be treated as paid at a designated date or pursuant to a payment schedule that complies with the requirements of section 409A, and the payment of such compensation will not violate the initial or subsequent deferral election rules set out in §1.409A-2(a) and (b) solely as a result of such transaction-based compensation being paid pursuant to such schedule and terms and conditions."
***** I would also note that they knew darn well how to have a special rule apply for purposes of multiple concepts, when the rule applies in a unitary fashion across the board. For example, in Section 1.409A-3(j)(4)(i), relating to certain permitted accelerations, the regulations state that, "provided all other requirements of this section are met, the making of such a payment or the addition of a plan term permitting the making of such a payment will not constitute the acceleration of a payment, AND [(emphasis added)] the failure to make such a payment or the deletion or modification of a plan term permitting the making of such a payment will not be subject to the rules regarding a change in the time and form of payment under §1.409A-2(b)." Simple and to the point - there's a rule and, in stark contrast to the five-year limitation under the Tracking Rule, the rule applies for purposes of both the permitted-payment rules and the election rules.
Similarly, in subclause (B) of Section 1.409A-3(i)(5)(iv), right after subclause (A) (which contains the Tracking Rule), they showed that they knew how to extend the scope of a provision to both permissible-payment provisions and election provisions when they wanted to do so. There, in the provision permitting the extension of a SRoF in limited circumstances, the regulations say that "the continued application of a fixed schedule of payments based upon the lapse of the substantial risk of forfeiture, so that payments commence upon the lapse of the modified or extended condition on payment, will not be treated as a change in the fixed schedule of payments for purposes of §1.409A-2(b) (subsequent deferral elections) or paragraph (j) of this section (prohibition on the acceleration of payments)." Again, the first part of the Tracking Rule does not contain a five-year limitation; only the second, election-related portion of the Tracking Rule does so. See also Treas. Reg. § 1.409A-2(b)(2)(iii) (relating to installment payments) ("[A] schedule of payments does not fail to be an installment payment solely because such plan provides for an immediate payment of all remaining installments if the present value of the deferred amount to be paid in the remaining installment payments falls below a predetermined amount, and the immediate payment of such amount does not constitute an accelerated payment for purposes of §1.409A-3(j), provided that such feature including the predetermined amount is established by no later than the time and form of payment is otherwise required to be established, and provided further that any change in such feature including the predetermined amount is a change in the time and form of payment.").
****** I recognize that the existence of a potentially more streamlined way of drafting the Tracking Rule so as to apply the five-year limitation for purposes of the entire rule doesn't in and of itself prove that the five-year limitation must somehow be limited in its scope. I take the point that there frequently are other, and arguably better, ways to draft any given provision. In this case, though, it is not just the existence of another potential drafting alternative that shows that the five-year limitation is limited in application only to amendment/election situations; rather, it's the structure and substance of the Tracking Rule itself, as drafted.
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