Noteworthy Developments in 2018 Affecting Executive Pay

Joseph Bachelder is special counsel at McCarter & English LLP. This post is based on a memorandum by Mr. Bachelder. Andy Tsang, a senior financial analyst with the firm, assisted in the preparation of this post. Related research from the Program on Corporate Governance includes Stealth Compensation Via Retirement Benefits; the book Pay without Performance: The Unfulfilled Promise of Executive Compensation; and Executive Compensation as an Agency Problem, all by Lucian Bebchuk and Jesse Fried.

This post reports on tax and securities law developments in 2018 affecting executive compensation.

1. Tax Developments

Change in the Corporate Tax Rate.

Effective for taxable years beginning after Dec. 31, 2017, the ordinary income tax rate for corporations is 21 percent. This replaces the prior ordinary income tax rate structure for corporations that ranged from 15 percent to 35 percent. This change is contained in §13001 of the Tax Cuts and Jobs Act of 2017 (Public Law No. 115-97, 131 Stat. 2054 (Dec. 22, 2017)) (the 2017 Tax Act).

In consequence of this change, annual incentive plans based on an increase in a corporation’s 2018 earnings over 2017 earnings, if not already modified, may need to be modified. The same is true for long-term incentive plans that are based on a corporation’s change in earnings over a multi-year period that includes a year after 2017 over a base that includes a year, or a period of years, prior to 2018.

On Aug. 21, 2018, the IRS issued Notice 2018-68 providing initial guidance on amendments to Internal Revenue Code §162(m) by §13601 of the 2017 Tax Act (the IRS Guidance).

IRS Guidance on Awards that Are Grandfathered from Amendments to Code §162(m).

Code §162(m) imposes a limit of $1 million per year on the deductibility by a “publicly held corporation” of remuneration paid to a “covered employee.” Prior to its amendment by the 2017 Tax Act, Code §162(m) excepted from the deduction limit remuneration that constituted “qualified performance-based compensation” (defined to include certain stock options) and also certain commission-based compensation. Section 13601 of the 2017 Tax Act removed this exception. As a result, performance-based compensation (as well as commission-based compensation) is subject to the $1 million deduction limit for taxable years commencing after Dec. 31, 2017. Section 13601 of the 2017 Tax Act provides that the amendments made by it to Code §162(m) do not apply to “remuneration which is provided pursuant to a written binding contract which was in effect on Nov. 2, 2017, and which was not modified in any material respect on or after such date.” The comments made in today’s column on amendments to Code §162(m) are limited to (i) what constitutes a “written binding contract” so as to grandfather the contract from the new provisions of the amended Code §162(m), and (ii) what constitutes a material modification of that contract that would take away its grandfathered status.

Written Binding Contract.

According to the IRS Guidance: “Remuneration is payable under a written binding contract that was in effect on November 2, 2017, only to the extent that the corporation is obligated under applicable law (for example, state contract law) to pay the remuneration under such contract if the employee performs services or satisfies the applicable vesting conditions.”

The IRS Guidance excludes from grandfathered status an otherwise written binding contract that is “renewed” after Nov. 2, 2017. It also excludes from grandfathered status a contract that is “terminable or cancelable by the corporation without the employee’s consent after November 2, 2017.” The latter circumstance is treated as a renewal of the contract “as of the date that any such termination or cancellation, if made, would be effective.”

Other statements as to the meaning of a “written binding contract” are contained in the IRS Guidance at page 13.

Material Modification.

The IRS Guidance provides that: “A material modification occurs when the contract is amended to increase the amount of compensation payable to the employee. If a written binding contract is materially modified, it is treated as a new contract entered into as of the date of the material modification.”

The IRS Guidance indicates that amounts already received by the employee prior to the material modification would not be affected.

The IRS Guidance also provides that:

“The adoption of a supplemental contract or agreement that provides for increased compensation, or the payment of additional compensation, is a material modification of a written binding contract if the facts and circumstances demonstrate that the additional compensation is paid on the basis of substantially the same elements or conditions as the compensation that is otherwise paid pursuant to the written binding contract.”

This quoted sentence of the IRS Guidance raises the following question: Assume there is a grandfathered performance-based award granted on or prior to Nov. 2, 2017 with a performance period of 2017-2019. What happens if a similar performance-based award is made in 2018 with a performance period of 2018-2020? Assume the second award, except for the different performance period, has the same “elements” as the grandfathered award. The second award, having a different performance period (2018-2020, rather than 2017-2019) apparently does not constitute a material modification of the first award. It lacks a key element, the performance period, that would cause it to constitute a modification of the grandfathered award. The IRS Guidance, however, does not include a statement on this point.

Finally, the IRS Guidance says that “the failure, in whole or in part, to exercise negative discretion under a contract does not result in the material modification of that contract.” The IRS Guidance, at pages 16-17, gives an example of an award that would, in part, be subject to the new rule and, in part, be grandfathered. The award, in the example, was made on February 1, 2017. The award was in the amount of $1,500,000 but was subject to reduction at the discretion of the company to an amount no less than $400,000. The company, ultimately, approved the award in the amount of $500,000. The IRS Guidance states that to the extent of $400,000 the award is grandfathered. The example suggests that to the extent the company has the discretion to reduce an otherwise grandfathered award to $0, none of the award would be grandfathered.

There are other issues addressed by the IRS Guidance regarding the amendments to Code §162(m) that are not discussed in today’s column. These include issues regarding the new definition of “covered employee” and consequences to grandfathered status of an award if payment of the award is accelerated or if the amount paid is increased as a result of the award being deferred beyond the previously scheduled date for its payment.

2. Securities Law Developments

Increase in Number of Companies Eligible for Smaller Reporting Company Treatment.

On June 28, 2018, the SEC amended the definition of “smaller reporting company.” See Smaller Reporting Company Definition, SEC Release No. 33-10513 (June 28, 2018), 83 Fed. Reg. 31992 (July 10, 2018). The new definition became effective Sept. 10, 2018. On Aug. 10, 2018, the SEC published a compliance guide entitled, “A Small Entity Compliance Guide for Issuers.”

Under the new definition, “smaller reporting company” generally means an issuer with (i) a public float of less than $250 million or (ii) less than $100 million of annual revenues and a public float of less than $700 million (or no public float). Prior to the amendment, a “smaller reporting company” generally meant an issuer with (i) a public float of less than $75 million or (ii) less than $50 million of annual revenues and no public float.

For purposes of the definition of “smaller reporting company,” public float generally is measured at the end of the issuer’s most recently completed second fiscal quarter and annual revenues are for the issuer’s most recently completed fiscal year for which audited financial statements are available. (“Public float” generally means the value of the issuer’s voting and non-voting shares of common equity held by non-affiliates.)

Smaller reporting companies have less stringent reporting requirements, including less stringent executive compensation reporting requirements. Under existing (and continuing) executive compensation reporting rules, smaller reporting companies generally have to disclose in the summary compensation table of proxy statements the pay of three named executive officers (NEOs), rather than five. (For this purpose, the NEOs are the CEO and the two highest paid executive officers other than the CEO.) Also, under existing (and continuing) rules, smaller reporting companies are required to report only two years of NEO pay, rather than three. Finally, under existing (and continuing) rules, smaller reporting companies are exempted from a number of compensation and benefit disclosures otherwise required in the proxy statement of an issuer.

Hedging Disclosure Rule.

On Dec. 20, 2018, the SEC adopted a final hedging disclosure rule to implement 955 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Public Law No. 111-203, 124 Stat. 1376 (July 21, 2010)), which added §14(j) to the Securities Exchange Act of 1934. See Disclosure of Hedging by Employees, Officers and Directors, SEC Release No. 33-10593 (Dec. 20, 2018), 84 Fed. Reg. 2402 (Feb. 6, 2019).

The effective date of the new rule is March 8, 2019 and companies other than smaller reporting companies and emerging growth companies must comply with the new disclosure rule in proxy and information statements with respect to election of directors for fiscal years beginning on or after July 1, 2019. Smaller reporting companies and emerging growth companies must comply with the new disclosure rule in proxy and information statements with respect to election of directors for fiscal years beginning on or after July 1, 2020.

The final rule amends Regulation S-K by adding a new paragraph (i) to Item 407 (and makes conforming changes to Item 402(b) of Regulation S-K and Schedule 14A). New Item 407(i) requires a registrant to describe any practices or policies it “adopted regarding the ability of employees (including officers) or directors of the registrant, or any of their designees, to purchase financial instruments (including prepaid variable forward contracts, equity swaps, collars, and exchange funds), or otherwise engage in transactions, that hedge or offset, or are designed to hedge or offset, any decrease in the market value of registrant equity securities—(i) granted by the employee or director by the registrant as part of the compensation of the employee of director; or (ii) held, directly or indirectly, by the employee or director.”

Item 407(i) provides that the required description shall “provide a fair and accurate summary of the practices or policies that apply, including the categories of persons covered, or disclose the practices or policies in full” and “also describe any categories of hedging transactions that are specifically permitted and any categories of such transactions specifically disallowed.”

Finally, if the registrant does not have any hedging practice or policies, it is required to disclose that fact or to state that the hedging transactions described in the rule are generally permitted.

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