REIT Advisor - June 2017

In This Issue:

  • Business Disruption Risk

  • Why Proper Disclosure Of Executive Perks Is Important

Business Disruption Risk

Joe Quinn and Brent Gilfedder

Given the recent events around the world, including both terrorist attacks and severe storms, REITs continue to cite business interruption risks as a significant concern for implementing corporate strategy. Business leaders worry that in the event of a mass destruction, substantial losses may be incurred and development initiatives may be hindered. The business interruption risks likely to cause the most apprehension among companies are natural disasters and terrorist attacks. Within the last several years, extreme weather events have devastated communities across the globe, impacting market activity and preventing the continued operation of certain properties. Additionally, potential geopolitical conflict and recent high-profile terrorist attacks underscore the need to focus on how companies can best prepare for these unpredictable risks.

Unfortunately, companies cannot prevent these disasters from occurring. However, planning and response is key to a REIT's ability to successfully navigate the business challenges posed by such events. At a property level, REITs should evaluate the location and surroundings of a property when conducting acquisition due diligence. In assessing the potential risks for disaster at a property, consideration should be given to the likelihood of an area to experience flooding, earthquakes or other types of severe weather (hurricane, tornadoes, etc.). Moreover, the company should discern if the improvements on the property have been constructed in a manner appropriate to prevent damage in such situations to the extent possible. REITs should also create  contingency plans that focus on continuity in business operations. Such plans may include emergency power sources for critical equipment or the temporary transition of operations to an off-site location. The security of computer networks, with data stored in areas unaffected by the disaster, can play an important role in ensuring that a business can continue operations when disaster strikes. 

Although diligence and planning are critical to mitigating the effects of a disaster, even the best made plans may encounter obstacles given the unpredictable nature of such events. Companies are able to protect against these instances by purchasing business interruption insurance. These policies can cover profits for periods where a business must cease operations as the result of a covered event. In determining the type of business interruption insurance to purchase, a company should consider the types of losses that it may incur in the event of a disaster. The types and potential quantities of such losses will impact the coverage that may be best for the company. In any case, since the types of losses will differ across businesses, the company should review any business interruption policy it purchases to ensure that the losses it may incur are in fact covered by the policy.

Why Proper Disclosure Of Executive Perks Is Important

Jeffrey Stein, Hap Shashy, Alana Griffin and Ellen Sueda

The following article was originally published on Law360 on June 13, 2017. 

The U.S. Securities Exchange Commission investigation of and the action taken against MDC Partners Inc. and its former CEO, Miles S. Nadal, underscore the importance of proper disclosure of executive compensation. Between 2009 and 2014, MDC disclosed in its proxy statements some, but not all, of the perquisites paid to Nadal and on his behalf. The estimated $11.285 million worth of perquisites that MDC failed to disclose included private aircraft usage, club memberships, cosmetic surgery, yacht- and sports car-related expenses, jewelry, charitable donations, pet care, and personal travel expenses. The director of the SEC’s Philadelphia Regional Office highlighted the importance of properly disclosing named executive officer compensation: “Perks paid to corporate executives should be properly disclosed so that investors can make informed decisions.”

On Jan. 18, 2017, the SEC issued a press release describing the terms of the settlement related to MDC’s problematic disclosure practices, in which MDC agreed to pay a $1.5 million penalty in settlement for various disclosure violations, including the failure to fully disclose Nadal’s perquisites as the SEC compensation disclosure rules require.[1] In settling the matter with MDC, the SEC took into consideration the remedial actions that MDC promptly undertook, including adding three new independent directors to its board of directors, creating a role of a senior vice president of internal controls and compliance, replacing its chief accounting officer, and implementing new internal controls and compliance policies and procedures, in addition to training programs for its executives concerning expense reimbursements.

The SEC not only took action against MDC as an issuer, but also against Nadal individually since his compensation was not fully disclosed. On May 11, 2017, in a separate settlement related to the same matter, the SEC announced that Nadal agreed to pay $5.5 million to settle charges for failure to properly disclose his compensation, and the related SEC order indicated that Nadal was prohibited from acting as an officer or director of a public company for a five-year period. The $5.5 million settlement was punitive in nature as the $1.85 million was designated as disgorgement, while the $3.65 million balance was attributed to penalties and interest payments. Preceding his settlement with the SEC, Nadal had resigned as the company’s chief executive officer, and Nadal returned to MDC the unreported $11.285 million, along with $10.582 million in cash bonus awards.

The SEC’s proxy disclosure rules require that the compensation received by each of a company’s named executive officers, which typically includes the chief executive officer, be set forth in the issuer’s proxy statement. Named executive officer compensation is set forth in the proxy’s summary compensation table, which requires the disclosure of perquisites and other personal benefits or property provided to a named executive officer, the aggregate value of which is equal to or greater than $10,000. If the aggregate amount of the perquisites is at least $10,000, then regardless of the amount each perquisite must be identified by type, and any specific type of perquisite or personal benefit that exceeds the greater of $25,000 or 10 percent of the aggregate value of the perquisites must be quantified and disclosed in a footnote. MDC neither identified the types of perquisites that Nadal received, nor quantified in a footnote specific perquisites above the $25,000/10 percent threshold. MDC had taken the position that the unreported items at issue were business expenses, rather than properly identifying them as personal expenses and benefits treated as compensation.

The SEC penalties may not be MDC’s or Nadal’s only legal problem. Perquisites, as compensation, are generally deductible business expenses by a corporate taxpayer. The Internal Revenue Service, however, may question MDC’s deduction of Nadal’s perquisites on the grounds that some or all of his perquisites were not “ordinary and necessary” or otherwise were unreasonable, and therefore not deductible. Furthermore, the amounts treated as a reimbursable business expense, and not compensation, may result in the IRS imposing penalties on MDC for the failure to withhold employment taxes.

Not only would MDC face scrutiny of the tax authorities, but Nadal would as well. If Nadal did not include the perquisites that constitute compensation in his tax return, he likely would be subject to U.S. federal income tax, interest and penalties with respect to the perquisites, assuming the relevant tax year or years are not barred by the statute of limitations. The relevant statute of limitations is either three years or six years from the due date of the return of the implicated tax year, unless the reporting omission constitutes civil tax fraud for which case there is no statute of limitation. Moreover, his income omission could lead to criminal sanctions. State and local income tax, interest and penalties could also be implicated. Nadal would not be entitled to deduct the amount paid to the SEC to settle the matter if it constituted a fine or a penalty. Finally, whether Nadal could deduct the amount he returned to MDC, and whether he could use the deductions to offset income, are unclear absent more facts.

The two matters demonstrate that the SEC will not only bring enforcement against the issuer who fails to disclose perquisites and personal benefits provided to a named executive officer, but may also pursue enforcement against the named executive officer. In addition to the enforcement action against Nadal for the failure to disclose, the SEC also could have sought penalties under the Sarbanes-Oxley Act, as Nadal signed certifications covering each annual report that incorporated the fiscal year’s proxy statement.

We recommend that each company regularly review and update internal control and compliance policies and procedures, and ensure that the legal, finance and tax departments have appropriate participation in the updating of such policies and procedures. Training should be provided to executives, as well as accounting personnel, as to the difference between, and treatment of, a business expense and personal expense/benefit. Finally, prior to preparing the proxy statement, legal and tax personnel should carefully review each named executive officer’s perquisites and business expense reimbursements for the fiscal year to ensure that perquisites are properly disclosed.

[1] The $1.5 million payment includes settlement for a separate disclosure violation regarding non-GAAP financial measures, which violation is not addressed in this article.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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