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Corporate Alert: Significant Change to Compensation Deduction Under Section 16(m); Employer Liable for Overtime Wages Even If Not Authorized by Employer; U.S. Government Accountability Office Releases Hedge Fund Report
March 2008
Authors: Irwin A. Kishner, Edward B. Stevenson, Carol M. Goodman, Mara B. Levin

Significant Change to Compensation Deduction Under Section 16(m)

On February 21, the Internal Revenue Service issued Revenue Ruling 2008-13, interpreting the Performance-based Compensation Exception to Section 162(m) of the Internal Revenue Code. Because the ruling reverses the IRS's previous position, it is expected to have a material impact on executive compensation arrangements and executive employment agreements for publicly held companies.

The ruling holds that a compensation arrangement will not qualify for the exception, as it did prior to the ruling, if the arrangement includes a provision permitting the compensation to be paid without regard to the attainment of the performance goals in the event of the executive's termination without cause, or for good reason, or on account of the executive's death or disability. According to the ruling, the exception to the $1 million deduction limit under Section 162(m) will be lost even in years in which the performance goals have been obtained and the employment of the executive was not terminated.

For example, consider an employment agreement for a CEO of a public company with a five year employment term and that provides that the CEO will be paid a bonus of $1 million each year of the employment term if the public company meets certain performance goals, such as earnings-per-share targets. The employment agreement also specifies that the CEO will be paid the $1 million bonus, regardless of whether the performance goals are attained, in the year which he is terminated, whether without cause or for good reason.  Prior to the ruling, the bonus would have qualified for the exception if the performance goals are attained. Following the ruling, however, the annual bonus will not qualify for the exception for any years in which it is paid—even in years when the performance goals are attained, thereby denying the company a tax deduction for the annual bonus.

Because the ruling reverses the IRS's previous position, the IRS will allow for compensation deductions for arrangements that otherwise satisfy the exception but have provisions similar to the terms described in the ruling, provided that either (i) the performance period for such compensation begins on or before January 1, 2009, or (ii) the compensation is paid according to the terms of an employment contract in effect on February 21, 2008 (without regard to future renewals or extensions).

Public companies should review their executive compensation arrangements and executive employment agreements to determine if any of the arrangements or agreements need to be modified in response to the ruling.  Since some modifications may require shareholder  approval, advance planning for addressing the issues raised by the ruling may be necessary.

Employer Liable for Overtime Wages Even If Not Authorized by Employer

A federal appeals court held that an employer is liable for the payment of unauthorized overtime wages at the overtime rate, even if it has a written policy in place stating that an employee must get prior approval. 

The court stated that if an employer knows its employees are working overtime but wishes to avoid liability for unauthorized overtime wages, it must adopt measures to prevent them from working overtime. The court suggested that an employer establish a written policy stating that employees will not be paid for unauthorized overtime and that habitual disregard of the rule will result in discipline or termination. However, even after articulating such a measure, the court "confessed" it was skeptical that an employer with full knowledge of the activities of its employees can refuse to comply with the overtime provisions of the Fair Labor Standards Act—namely that the employee must get paid if their employer has permitted the work to be done—when its employees work overtime.

Prudent employers should consider distributing a clear and concise written policy to all employees, requiring advance written approval for overtime and stating that they will not be compensated for unauthorized overtime and will be subject to discipline or termination if they fail to comply with the policy. Despite such policy, and the employers' right to discipline or terminate employees that fail to comply with it, employers must understand that, based on this decision, they will likely be liable for work performed in excess of regular hours (usually 40 hours a week) at the overtime rate even if not approved in advance

To help prevent further abuses, employers should enforce the rule that dictates termination for employees who disregard the rule governing overtime. Employers should also consider maintaining sign-in/sign-out logs and/or time clocks to ensure they have adequate records of actual time worked. 

Elaine L. Chao v. Gotham Registry, Inc., et al., No. 06-2432, 2nd Cir.; 2008 U.S. App. LEXIS 1327

U.S. Government Accountability Office Releases Hedge Fund Report

On February 25, Reps. Paul Kanjorski (D-Pa.), Michael Capuano (D-Mass.) and Barney Frank (D-Mass.) released a U.S. Government Accountability Office report entitled "Hedge Funds: Regulators and Market Participants Are Taking Steps to Strengthen Market Discipline, but Continued Attention is Needed." The report stated that though hedge funds have improved their risk-management and disclosure practices in recent years, they still pose systemic risk to investors and need careful monitoring by regulators, especially because "not all investors have the capacity to analyze the information they receive from hedge funds."  In spite of these findings, none of the three lawmakers behind the report called for any new legislation regarding the regulation of hedge funds.

The U.S. Government Accountability Office will release a more extensive report examining the scope of public and private pension funds' exposure to hedge funds in the coming months.

For more information on general corporate matters, please contact:

Irwin Kishner at 212.592.1435 or
Edward Stevenson at 973.274.2025 or

For more information on employment matters, please contact:

Mara Levin at 212.592.1458 or
Carol Goodman at 212.592.1465

Copyright © 2008 Herrick, Feinstein LLP. Corporate Alert is published by Herrick, Feinstein LLP for information purposes only. Nothing contained herein is intended to serve as legal advice or counsel or as an opinion of the firm.