Compensation Season 2018

Boards of directors and their compensation committees will soon shift attention to the 2018 compensation season. Key considerations in the year ahead include the following:

Tax Cuts and Jobs Act Implications.

The new tax law has significantly altered the compensation design landscape. Notable implications of the new tax law include:

No Performance-Based Exception to §162(m). The new law eliminates the performance-based exception to the $1 million per-executive annual limit on the deductibility of compensation for certain public company executives under §162(m) of the tax code. This change will result in a significant increase in disallowed tax deductions. Nevertheless, we expect that companies will accept this result as a necessary consequence of the competitive marketplace for talent. Ultimately, it remains within the business judgment of the board of directors to set compensation at the levels and in the manner that it determines to be appropriate to attract and retain the executives the board believes will best serve the needs of the corporation.

Opportunity to Simplify Compensation Design. The new law is an invitation for companies to take a fresh look at their compensation plan designs. From a corporate tax standpoint, the Act places discretionary bonuses and service-based awards on equal footing with performance-based arrangements and provides companies with greater flexibility to address the impact on performance of unexpected events without compromising the deductibility of an award. While we expect that sound incentive design and shareholder expectations will continue to link pay to performance, companies will no longer need to limit themselves to the rigid framework of the §162(m) performance-based exception.

Impact on Stock Options. The elimination of the performance-based exception removes a tax incentive for the grant of stock options. However, we expect that most companies that currently utilize stock options will continue to do so. Companies generally grant options because they view the economic characteristics of options as an appropriate growth motivator; tax attributes are an ancillary benefit.

Scope of Covered Employees. The new law expands the definition of “covered employees” to include CFOs and makes “covered employee” status permanent for any executive who was a “covered employee” for any tax year beginning after December 31, 2016, thereby increasing the number of active employees who can be “covered employees” in a given year and eliminating a corporation’s ability to deduct amounts in excess of $1 million paid following employment termination. This change may encourage companies to structure future severance and other deferred compensation payments over a multi-year period, although we expect that commercial considerations, rather than tax deduction planning, will drive design in most cases. The grandfathering rule discussed below may preserve the deductibility of amounts payable under preexisting arrangements.

Grandfathering of Certain Existing Arrangements. The changes to 162(m) do not apply to compensation under “written binding contracts” in effect as of November 2, 2017, so long as the contracts are not materially modified thereafter. Subject to Treasury guidance on the scope of this exception, it should allow companies to deduct compensation (1) under existing performance-based arrangements, (2) for amounts earned and deferred under deferred compensation arrangements as of November 2, 2017, and (3) under existing arrangements with CFOs and any individual who would be covered by §162(m) solely by virtue of that individual’s permanent “covered employee” status. Companies should carefully monitor Treasury guidance and avoid non-essential amendments to arrangements that may otherwise qualify for grandfathering.

Impact on Compensation Committees. Companies should maintain a compensation committee of §162(m)-qualified outside directors in order to certify performance results for grandfathered performance-based arrangements. In any case, the continuing applicability of the compensation committee independence rules of the major stock exchanges and of the SEC “non-employee director” definition for purposes of exempting certain compensation from the short-swing profit rules make it unlikely that the new tax law will affect the composition of compensation committees at most companies.

Plan Design and Approval. Companies will no longer need to (1) have cash bonus plans approved by shareholders, (2) include performance goals in their equity plans, or (3) obtain shareholder approval of applicable performance goals every five years. Individual award limits will also be unnecessary in equity plans, other than for companies that grant tax-qualified incentive stock options. Going forward, the expiration of a plan term or the need to increase shares available under a plan will be the principal reasons to seek shareholder approval of equity plans, including for new public companies whose equity plans were adopted and approved prior to becoming public. When a plan does expire or a company does require additional plan shares, we recommend that the company adopt a new plan, rather than amend an existing plan, in order to minimize the risk of losing grandfathered status of existing arrangements.

Dodd-Frank Regulations

In 2015, the SEC adopted final rules regarding pay ratio disclosure. Notwithstanding speculation that the Trump administration would roll back Dodd-Frank, these rules have taken effect. Registrants are preparing to include the pay ratio disclosure in the Form 10-K or annual meeting proxy statement filed in 2018. We continue to await final regulations regarding clawbacks, disclosure of pay for performance, disclosure of hedging by employees and directors and financial institution incentive compensation.

Director Compensation

A recent Delaware Supreme Court decision has increased the spotlight on director compensation, which has been a target of the plaintiffs’ bar in recent years. Delaware companies should, at a minimum, include meaningful director-specific limits in new or amended equity plans being submitted for shareholder approval that cover director awards, and should monitor further developments in this area.

ISS

ISS continues to be an influential voice in the compensation arena, with companies focused on obtaining a favorable ISS say-on-pay vote recommendation. For the most part, ISS made only modest updates to its compensation-related policies and scorecards applicable in 2018. Notably, however, it indicated that it would begin to evaluate non-employee director compensation and would consider the possibility of negative vote recommendations related to excessive director pay as early as the 2019 proxy season.