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E-MailJeannemarie O’Brien, Andrea Wahlquist, and Adam Shapiro are partners at Wachtell, Lipton, Rosen & Katz. This post is based on a Wachtell memorandum by Ms. O’Brien, Ms. Wahlquist, Mr. Shapiro, David E. Kahan, Michael J. Schobel, and Erica E. Bonnett. Related research from the Program on Corporate Governance includes Executive Compensation as an Agency Problem by Lucian Bebchuk and Jesse Fried; and Paying for Long-Term Performance by Lucian Bebchuk and Jesse Fried (discussed on the Forum here).
While the past year witnessed only modest changes to the rules governing compensation arrangements, practices and trends continued to evolve. We note below various developments worthy of consideration in the year ahead.
Limits on Compensation Deductions Clarified. The IRS issued proposed regulations in December with respect to the 2017 statutory change that significantly expanded the scope of the $1 million annual limitation on the deductibility of compensation paid to specified executives under §162(m) of the tax code. The proposed rules clarify, among other things, that the limitation on deductibility will apply to executives of successor entities in M&A transactions if the executives were previously covered by these limits. In addition, the proposed regulations may extend the application of §162(m) to cover executives of private companies with publicly-traded debt and executives of foreign private issuers. For a more detailed discussion of the proposed regulations, see our December 19, 2019 memorandum. Companies should carefully track their covered employees, avoid unnecessary classification of employees as executive officers and take care to preserve arrangements that are grandfathered for §162(m) purposes.
ISS Policy on Excessive Director Compensation. ISS made relatively few updates to its compensation-related voting guidelines for 2020. Most notably, the previously announced ISS policy related to excessive director compensation takes effect this year. For shareholder meetings occurring on or after February 1, 2020, ISS may issue a negative recommendation for board members responsible for approving non-employee director pay if it identifies a pattern (two consecutive years) of “excessive” non-employee director pay. ISS may consider director pay “excessive” if it exceeds pay received by the top 2–3% of directors within the same index and sector. While this “two strike” rule may appear to enable companies to take a wait-and-see approach, for most companies compensation for the 2020 fiscal year will be set prior to receiving ISS feedback on 2019 director compensation.
Deferred Compensation Risks. Elective deferred compensation plans are a staple of executive compensation programs at many public companies. While most companies have a general understanding of these arrangements, our recent experience has included several situations in which directors and executives were surprised by the lack of flexibility to modify payment elections and the risks inherent in a deferred compensation arrangement. Most important is the risk of loss in the event of a company’s insolvency. When a company experiences a significant financial downturn, there are few good alternatives for distributing deferred compensation, and a company reorganization or liquidation could result in a complete or partial loss of deferred compensation. Additionally, deferred compensation reduces the formulaic threshold that triggers application of the golden parachute excise tax under Section §280G of the tax code, which creates issues for executives in a climate where excise tax gross-ups are much less prevalent than they once were. Companies, directors and executives should be mindful of these consequences when implementing deferred compensation plans and making deferred compensation elections.
Dodd-Frank Act Regulations. The upcoming proxy season will be the first time that most public companies must comply with the new rule under Item 407(i) of Regulation S-K that requires a company to describe any employee or director hedging policies or to state that it does not have any such policies. This rule does not mandate any particular policy; rather, it requires disclosure of whatever policy is in effect. When adopting a policy, consider whether all directors and executives are in compliance with its terms and, if not, whether to provide for a transition period for compliance or the grandfathering of prior existing transactions. We continue to await final regulations regarding clawbacks, disclosure of pay for performance, and financial institution incentive compensation.
Spotlight on ESG Issues. There remains a strong focus on environmental, social and governance (“ESG”) issues, including as they relate to compensation and human capital, such as gender pay equity and diversity. State legislatures are increasingly addressing these matters, with most states having enacted legislation requiring equal pay for equal work. We find that company boards are deeply engaged in these issues and expect that there will be an increased focus on these matters through shareholder proposals and requests for disclosure in the coming years. We do not currently expect to see the use of ESG measures as stand-alone performance goals in incentive programs (other than in a unique circumstance where such a measure is integral to business performance), although ESG-type goals may be used for purposes of the qualitative or individual performance aspect of incentive awards or as a modifier within specified parameters.
Employee Noncompetition Covenants. Employee noncompetition covenants are governed by state law and several states have specific statutes that govern the enforceability of these restrictions. While non-competes continue to come under pressure, reasonably tailored restrictions remain an appropriate way for an employer to protect its investment in talent. However, employers should recognize that a one-size-fits-all approach may not maximize enforceability. Where state law prohibits or limits noncompetition covenants, there may be alternative ways to structure compensation arrangements in order to achieve similar objectives. Companies that rely on noncompetition covenants should stay abreast of developments and ensure that they structure covenants to maximize enforceability based on applicable law.
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Today’s compensation committee has more responsibilities than ever and must stay abreast of the rapidly evolving landscape of best practices. The increasingly complex compensation landscape makes it all the more important for compensation committees to return to first principles as company stewards—structuring compensation programs to attract and retain talented executives who will produce exceptional results over the long term.
