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E-MailJeremy Goldstein is a partner at Wachtell, Lipton, Rosen & Katz active in the firm’s executive compensation and corporate governance practices. This post is based on a Wachtell Lipton firm memorandum by Mr. Goldstein and Jeannemarie O’Brien.
A number of derivative suits have been filed in recent months alleging that the senior executive compensation plans at public companies do not comply with Section 162(m) of the Internal Revenue Code. Section 162(m) provides that any compensation paid to the CEO and next three highest compensated proxy officers (other than the CFO) in excess of $1 million per year is not tax deductible unless, among other things, the compensation is subject to objective performance metrics that have been disclosed to and approved by shareholders. The complaints generally allege that the performance goals established by the plans are not sufficiently objective to comply with Section 162(m) and that the purported failure of the plans to comply with Section 162(m) renders the required proxy disclosure false and misleading in violation of Section 14(a) of the Securities Exchange Act. In addition, the complaints allege that the provision of non-deductible compensation to senior executives constitutes waste, unjust enrichment of the executives and a breach of the directors’ duty of loyalty.
We view these suits as meritless and symptomatic of the excesses that led to reform in other areas of shareholder litigation. In each of the challenged plans that we have reviewed, the terms of the plans do in fact comply with Section 162(m) and the disclosure relating to the plans expressly states that non-deductible compensation may be granted if the compensation committee determines that doing so is in the best interest of the company. Moreover, the complaints that we have reviewed, alleging that the performance goals are not sufficiently objective to comply with Section 162(m), reflect a basic lack of understanding of the operation of typical Section 162(m) plans in which the compensation committee establishes an objective Section 162(m) goal, which, if met, would then provide the committee with the discretion to make an award below the amount authorized by the plan. This “plan within a plan” structure is expressly permitted by the Code. In addition, there is no legal obligation for compensation committees to grant only compensation that is deductible under Section 162(m). The courts have largely gotten this right by ruling against the plaintiffs on motions to dismiss (see, for example, Justice Stark’s well reasoned opinion in Seinfeld v. O’Connor).
These suits nonetheless serve as a reminder that careful attention must be paid to the design and administration of plans intended to comply with Section 162(m) and that disclosure relating to tax deductibility must be carefully drafted. Companies should design plans to make compliance with Section 162(m) as easy and straightforward as possible. The “plan within a plan” design (see our memo dated December 3, 2008) is the most efficient means of achieving this goal. Equally important, proxy disclosure should not guarantee that all compensation awarded will comply with Section 162(m). Instead, proxy disclosure should say that plans are “intended to” comply with Section 162(m) and that the company may elect to provide non-deductible compensation.
