1. IS YOUR EQUITY COMPENSATION PLAN COMPLIANT WITH THE NEW DEFERRED COMPENSATION PLAN RULES? Ian C. Lofwall April 13, 2005

2. 2 Internal Revenue Code Section 409A and IRS Notice 2005-1 (http://www.irs.gov/irb/2005-02_IRB/ar13.html)

3. 3 Nonqualified Deferred Compensation Plans must comply with Section 409A Distributions from the plan may be made only at certain times. No acceleration of benefits under the plan. Elections to defer compensation under the plan must be timely.

4. 4 Permissible Distribution Events Plans must provide that benefits may not be distributed earlier than: (1) Separation from service. Exception: 6 months after separation from service for “Specified Employees.” (2) The date a participant becomes “Disabled.” (3) A specified time (or pursuant to a fixed schedule). (4) A change in the ownership or effective control of the corporation, or in the ownership of a substantial portion of the assets of the corporation. (5) The occurrence of an “Unforeseeable Emergency.”

5. 5 No Acceleration of Benefits A plan may not permit the acceleration of the time or schedule of any payment under the plan, i.e., “haircuts” are not permitted.

6. 6 Elections (Initial Deferral Elections) General Rule – Compensation for services performed during a taxable year must be deferred no later than the close of the preceding taxable year. First Year of Eligibility – Within 30 days after the date the participant first becomes eligible to participate in the plan. Performance-Based Compensation – No later than 6 months before the end of the performance period. Performance period must be at least 12 months in duration.

7. 7 Elections (Changes in Time and Form of Distribution) If a plan permits a subsequent election to delay payment or change the form of payment, it must meet the following requirements: (1) Election may not be effective until at least 12 months after the date on which election is made. (2) 1-Year/5-Year Rule – The election to delay payment must defer the payment for at least 5 years from the initial payment date and may not be made less than 12 months prior to the date of the initial payment.

8. 8 Consequences for Failure to Comply with 409A Gross Income Inclusion – All compensation deferred under the plan for the taxable year and all preceding taxable years must be includible in income for the taxable year to the extent not subject to a substantial risk of forfeiture and not previously included income. Interest – Interest at the underpayment rate plus 1%. Penalty - 20% Penalty equal to the amount required to be included in income.

9. 9 Applies to deferrals made on or after January 1, 2005. Applies to amounts deferred prior to January 1, 2005, which were not vested as of December 31, 2004. Effective Date

10. 10 Grandfather Rules Amounts earned and vested prior to December 31, 2004. No material modification after October 3, 2004.

11. 11 We thought this was about Equity Compensation Plans, not Deferred Compensation Plans. Why are we still here?

12. 12 What is a Nonqualified Deferred Compensation Plan? The term nonqualified deferred compensation plan means any plan that provides for the deferral of compensation. Definition of Deferral of Compensation. A plan provides for a deferral of compensation only if, under the terms of the plan and the relevant facts and circumstances, the service provider has a legally binding right during a taxable year to compensation that has not been actually or constructively received and included in gross income, and that, pursuant to the terms of the plan, is payable to (or on behalf of) the service provider in a later year. Exceptions. Qualified employer plans and any bona fide vacation leave, sick leave, compensatory time, disability pay, or death benefit plan.

13. 13 Legally Binding Right Negative Discretion. A service provider does not have a legally binding right to compensation if that compensation may be unilaterally reduced or eliminated by the service recipient or other person after the services creating the right to the compensation have been performed (referred to as “negative discretion”). Facts and Circumstances. if the facts and circumstances indicate that the service recipient is unlikely to exercise the negative discretion, a service provider will be considered to have a legally binding right to the compensation.

14. 14 Short-Term Deferrals Until additional guidance is issued, there is no deferral of compensation if, absent an election to otherwise defer the payment to a later date, at all times the terms of the plan require payment by, and an amount is actually or constructively received by the service provider after the later of: (i) the date that is 2½ months from the end of the service provider’s first taxable year in which the amount is no longer subject to a substantial risk of forfeiture; or (ii) the date that is 2½ months from the end of the service recipient’s first taxable year in which the amount is no longer subject to a substantial risk of forfeiture.

15. 15 How do Equity Compensation Plans fit into these Rules? IRS Notice 2005-1 indicates that stock options, stock appreciation rights (SARs) and other equity-based compensation provide for a deferral of compensation.

16. 16 Stock Options (Statutory) Incentive Stock Options – do not constitute a deferral of compensation. Section 423 Employee Stock Purchase Plan Options - do not constitute a deferral of compensation.

17. 17 Stock Options (Nonstatutory) Do not constitute a deferral of compensation if the following three requirements are met: (1) Exercise price may never be less than fair market value (FMV) on the date of grant, (2) The receipt, transfer or exercise of the option is subject to taxation under Section 83, and (3) The option does not include any feature for deferral of compensation other than the deferral of recognition of income until the later of exercise or disposition of the option.

18. 18 Example 1 – The Missing Option On January 1, 2004, Corporation X hired a new CEO, and in the CEO’s offer letter agreed to grant a nonstatutory stock option to purchase 100,000 shares of X stock. The FMV of X stock on January 1, 2004 was $20 per share. The CEO never received an award letter from Corporation X. Six months later, Corporation X discovered that it had never granted the promised options to the CEO. To correct this oversight, the Compensation Committee granted the CEO a nonstatutory stock option to purchase 100,000 shares of X stock with an exercise price of $20 per share on July 1, 2004. The FMV of X stock on July 1, 2004 was $25 per share. 50% of the options were vested on the date of grant and the other 50% were scheduled to vest on January 1, 2006. Is the CEO’s option subject to Section 409A?

19. 19 Example 2 – The Extra Year Corporation X’s Board of Directors and the CEO did not have the same vision for Corporation X and on January 1, 2005, CEO agreed to resign. In this example, the CEO was properly granted nonstatutory stock options to purchase 100,000 shares of X stock with an exercise price of $20 per share on his date of hire, January 1, 2004. The options were 100% vested on the date of grant. The option agreement provides that the options may be exercised for a period of 90 days after termination of employment. As part of CEO’s severance package, Corporation X agreed to extend the CEO’s option exercise period for an additional 1 year from the expiration of the 90 day period following termination of employment. The FMV of X stock is $22 per share on January 1, 2005. Is the CEO’s option subject to Section 409A?

20. 20 How is Fair Market Value Determined for these rules? For companies that do not have publicly-traded stock, IRS Notice 2005- 1 indicates that any “reasonable valuation method,” including the estate tax valuation methods described in Section 20.2031-2 of the Estate Tax Regulations, may be used to establish fair market value. This is the same rule for determining whether an option has been granted at fair market value for statutory stock options.

21. 21 Substitution or Assumption of Options in a Corporate Transaction If you substitute a new option pursuant to a corporate transaction or assume an outstanding option, the option will not be treated as the grant of a new option or a change in the form of payment for purposes of 409A provided the following requirements are met: (1) In the case of a new option in exchange for an old option, the rights of the optionee under the old option must be canceled. (2) The spread of the new or assumed option must not exceed the spread of the old option. (3) The ratio of the exercise price to the FMV of the shares of the new or assumed option must not be greater than the ratio of the exercise price to the FMV of the shares of the old option immediately before the substitution or assumption. (4) The new option must contain all terms of the old option. (5) The new option must not give the optionee additional benefits.

22. 22 Example 3 – New Option in a Corporate Transaction On January 1, 2005, X Corporation grants its HR Director, a nonstatutory stock option (NSO) to purchase 1,000 shares of X stock with an exercise price of $20 per share (the FMV of X stock at the time of grant). The option is not subject to Section 409A, since the grant was made at 100% of FMV. On July 1, 2005, when the FMV of X stock is $40 per share, X Corporation is acquired by Y Corporation. The HR Director’s options to purchase X stock are canceled and she is granted an NSO to purchase 4,000 shares of Y stock at an exercise price of $5.00 per share. The option to purchase Y stock has the same terms as provided under the option to purchase X stock, except for the substitution of Y stock. At the time of grant of the NSO to purchase Y stock, the FMV of Y stock is $10 per share. Is HR Director’s option to purchase Y stock subject to Section 409A?

23. 23 Stock Appreciation Rights In general, stock appreciation rights (SARs) provide for a deferral of compensation, and are subject to Section 409A, unless one of two exceptions apply. Under the first exception, an SAR will not provide for a deferral of compensation if: (1) The SAR exercise price (the base price for which appreciation is measured) is never less than the FMV of the underlying stock on the date of grant. (2) The underlying stock is publicly traded on an established securities market. (3) The SAR is settled in the publicly traded stock (no cash). (4) The SAR does not include any feature for the deferral of compensation other than the recognition of income until exercise of the SAR.

24. 24 Stock Appreciation Rights (cont.) Under the second more limited exception, and until further guidance is issued, the settlement of an SAR in cash or stock will not be treated as a deferral of compensation, provided the SAR is “granted pursuant to a program in effect on or before October 3, 2004,” and the SAR meets the following requirements: Under the first exception, an SAR will not provide for a deferral of compensation if: (1) The SAR exercise price is never less than the FMV of the underlying stock on the date of grant. (2) The SAR does not include any feature for the deferral of compensation other than the deferral of recognition of income until the exercise of the SAR.

25. 25 Example 4 – Non-Publicly Traded Stock or Cash-Settled SARs On July 1, 2005, Corporation X grants its CFO 5,000 SARs under its omnibus plan, which was adopted by Corporation X on January 1, 2004, with an exercise price of $10 per share, the FMV of X’s non-publicly traded stock on July 1, 2005. 50% of the SAR vests after 1 year and the other 50% vests after 2 years. Once vested, the SAR may be exercised at any time. The SAR may be settled in cash or in shares of X stock in the Compensation Committee’s discretion. Is the grant of SARs to CFO subject to Section 409A?

26. 26 Example 5 – Non-Publicly Traded Stock or Cash-Settled SARs Now assume that Corporation X adopted its omnibus plan on January 1, 2005. Is the grant of 5,000 SARs to CFO subject to Section 409A?

27. 27 What steps should Corporation X take before granting the SAR under its Omnibus Plan to the CFO? Provide that the SAR may not be exercised earlier than one of the following permissible distribution dates: oTermination of Employment. oDeath. o“Disability.” o“Change in Control.” oFixed Dated, i.e., upon vesting of the SAR. o“Unforeseeable Emergency.” Make sure that if the SAR is exercisable on CFO’s “disability,” “change in control,” or on account of an “unforeseeable emergency” that these terms are defined in accordance with Section 409A. Provide that the exercise of the SAR may not be accelerated. If there is a deferral feature, make sure elections are made on a timely basis.

28. 28 Restricted Stock Restricted stock is an award of stock, which is subject to restrictions, such as time-based vesting. Restricted stock generally does not constitute deferred compensation subject to Section 409A, unless the restricted stock award contains an additional deferral feature.

29. 29 Phantom Stock/Restricted Stock Units (RSUs) Phantom stock and restricted stock units are stock equivalents, representing the right to receive, on a date specified in the award agreement (referred to as the “settlement date”), an equivalent number of shares, cash, or a combination of cash or shares. Phantom stock and restricted stock units are generally subject to Section 409A unless the short-term deferral rule applies. For example, on July 1, 2005, Corporation X grants CEO 1,000 Restricted Stock Units which fully vest on July 1, 2008. The terms of the RSU Award provide that on vesting the CEO will receive an equivalent number of shares of X stock. Since the award is settled on vesting, there is no deferral of compensation under the short term deferral rule.

30. 30 Performance-Based Compensation Unless the short-term deferral rule applies, performance-based compensation is subject to Section 409A if, the service provider has a legally binding right to the performance-based compensation during a taxable year and pursuant to the terms of the plan, the performance- based compensation is payable to the service provider in a later year.

31. 31 Performance-Based Compensation (Election Timing) With respect to performance-based compensation based on services performed over a period of at least 12 months, a service provider may elect to defer such bonus compensation no later than six months before the end of the performance period. The Treasury Department anticipates issuing guidance on what constitutes performance-based compensation. Until additional guidance is issued, bonus compensation refers to compensation where: (i) the payment of or amount of compensation is contingent on the satisfaction of organizational or individual performance criteria, and (ii) the performance criteria are not substantially certain to be met at the time a deferral election is permitted.

32. 32 Performance-Based Compensation (Subjective Criteria) Bonus compensation may include payments based upon subjective performance criteria, but (i) any subjective criteria must relate to the participant service provider, a group of service providers that includes the participant service provider, or a business unit for which the participant service provider provides services; and (ii) the determination that the subjective criteria have been met must not be made by the participant service provider or a family member.

33. 33 Example 6 – Performance-Based Compensation Corporation X, whose stock is traded on the NYSE, maintains a long-term incentive plan (“LTIP”) that provides an annual payout equal to between 50% and 100% of a service provider’s base compensation based on Corporation X’s performance over a 12-month period, beginning January 1 of each year, coinciding with its taxable year. In accordance with the terms of the LTIP, CFO elected to defer 100% of any annual payout for the 2005 year under the LTIP on November 30, 2005, until her termination of employment. On March 16, 2006, Corporation X’s Compensation Committee met and determined that the 75% performance target had been met for 2005 and directed Corporation X to pay out awards on April 1, 2006, to anyone who did not elect to defer payment of the award by November 30, 2005. On January 1, 2007, CFO resigned and received the amounts she had deferred under the LTIP on January 15, 2007. Are there any problems with CFO’s deferrals under this arrangement under Section 409A? What about the payment of amounts deferred by CFO? What other problems arise under Section 409A with respect to the LTIP?

34. 34 Example 7 - My Omnibus Incentive Plan has Noncompliant Terms Corporation X maintains an omnibus incentive plan under which Corporation X’s Compensation Committee, in its discretion, may grant incentive stock options, nonstatutory stock options, stock appreciation rights, restricted stock units, and other stock-based awards to eligible employees. The omnibus plan permits nonstatutory stock options to be granted at less than Fair Market Value. Additionally, the omnibus plan’s definition of change in control does not comply with definition under Section 409A. In practice, the Compensation Committee has granted only incentive stock options and non-discounted nonstatutory stock options. Does the omnibus plan’s noncompliant terms taint the incentive stock options and non-discounted nonstatutory stock options granted by the Compensation Committee?

35. 35 Transition Relief The plan is operated in good faith compliance with Section 409A and IRS Notice 2005-1 during 2005. The plan is amended on or before December 31, 2005, to conform to Section 409A. Example. Under the transition relief, an SAR that provides for a deferral of compensation may be amended to provide for fixed payment terms, or to permit the service provider awarded the SAR to elect fixed payment terms, without the amendment or election being treated as a change in the form and timing of a payment or an acceleration of a payment if on or before December 31, 2005 (i) the SAR is so amended, and (ii) the service provider makes any such election.

36. 36 Analysis of Examples 1 and 2 Example 1: Although an argument could be made that the option to purchase 10,000 shares of X stock was granted to CEO on January 1, 2004, the terms of the offer letter probably would not constitute a grant of options. Thus, on July 1, 2004, CEO was granted a discounted nonstatutory stock option. Since 50% of the options were earned and vested as of December 31, 2004, that portion of the option is grandfathered under Section 409A. The other 50% of the options scheduled to vest on January 1, 2006 are subject to Section 409A. The provision in the option agreement permitting exercise at any time after the option is vested violates Section 409A. Under transitional guidance, the option agreement could be amended to comply with Section 409A with respect to the non-grandfathered component of the option. Example 2: Since CEO’s options were earned and fully vested as of December 31, 2004, the options are grandfathered and not subject to Section 409A unless they are materially modified after October 3, 2004. Corporation’s X severance agreement with CEO extending the exercise period for an additional year would constitute a material modification of the option agreement. When you materially modify an option, the revised terms of the option is considered to be a new grant. Since the FMV at the time of the modification is $22 per share, the option would be a discounted option subject to Section 409A.

37. 37 Analysis of Example 3 Example 3: HR Director’s options to purchase Y stock are not subject to Section 409A, since the substituted options satisfy the ratio and aggregate spread tests. The ratio of the exercise price to FMV is identical for both the option to purchase X stock ($20/$40) and the option to purchase Y stock ($5/$10). Additionally, the aggregate spread of each option is $20,000 and the terms of the options are otherwise identical. Therefore, the option to purchase Y stock is not considered to be a new grant of an option. Had the option been treated as a new grant of an option, it would have been a discounted option ($5 exercise price with a FMV of $10) subject to Section 409A.

38. 38 Analysis of Examples 4 and 5 Example 4: The July 1, 2005, SAR grant to the CFO is not subject to Section 409A. Although the amounts are not grandfathered and not subject to the publicly-traded stock exception, the SAR is granted pursuant to a program in effect before October 3, 2004. Since the SAR exercise price is equal to the FMV of the underlying stock on the date of grant, the temporary exception is available. The issuance of cash or stock on settlement is not subject to Section 409A. Example 5: The January 1, 2005 SAR grant to the CFO is subject to Section 409A, since none of the exceptions apply. The SAR was not earned and vested prior to January 1, 2005, is not settled in publicly- traded stock, and was not granted pursuant to a program in effect on or before October 3, 2004. Therefore, the SAR is subject to Section 409A.

39. 39 Analysis of Example 6 Example 6: (i) CFO’s deferral election was not made 6 months prior to the end of the performance period, which violates Section 409A. (ii) CFO is a “specified employee,” and payment two weeks after separation from service violates the requirement that payments be delayed for 6 months after separation from service for specified employees. (iii) The April 1 payouts to other service providers are subject to Section 409A, since the payments are made more than 2 ½ months after both the service provider’s and service recipient’s taxable year in which the legally binding right to the payments arose (December 31- the last day of the performance period). Had the amounts been paid by March 15, the short-term deferral rule would apply and the amounts would not be subject to Section 409A.

40. 40 Analysis of Example 7 Example 7: The omnibus incentive plan’s noncompliant terms do not taint the grant of incentive stock options and non-discounted nonstatutory stock options. Treasury officials have indicated that you analyze each component of an omnibus plan individually, and look at each service provider’s grant separately to determine whether the terms as modified by the option agreement satisfy Section 409A.

41. Ian C. Lofwall (410) 580-4234 ian.lofwall@dlapiper.com