The Dodd-Frank Wall Street Reform and Consumer Protection Act allows public company shareholders to vote on Named Executive Officer (NEO) compensation arrangements related to a merger and acquisition (M&A) transaction. This vote, required beginning in 2011, is also referred to as say on golden parachute. Similar to say on pay, these votes are advisory and non-binding. The say on golden parachute proposal must be in the same merger-related proxy in which shareholders are approving the deal. Companies are required to disclose all compensation that may be paid to the NEOs because of the transaction as well as the conditions under which they become payable.

Both parties of a deal are required to have a say on golden parachute proposal for shareholder approval. However, if a company’s executive compensation program has already been voted on by shareholders and the pay levels and program design are unchanged from the last shareholder vote, the company does not need to submit a say on golden parachute proposal; this typically applies to the surviving entity only.

Companies put golden parachutes in place for the most senior executives so they can continue to make decisions that are in the best interest of the company. These arrangements also encourage executives to stay through the close of the transaction. Over the past ten years, many companies have adopted shareholder-friendly practices, such as double-trigger vesting of equity (i.e., change-in-control occurs plus termination of employment) and removing excise tax gross-ups, given increased shareholder scrutiny and the advent of the say on pay vote.

Say on Golden Parachute Vote Outcome

In 2021, the majority of say on golden parachute proposals received shareholder support. Three-quarters of these proposals received 80% support or higher (average support is approximately 85%). Around one in ten proposals received less than 50% support.

1%1%2%4%4%4%3%6%12%63%0-9%10-19%20-29%30-39%40-49%50-59%60-69%70-79%80-89%90-100%Percent SupportShareholder Support for Say on Golden Parachute in 2021 (n=164)Received < 50% shareholder supportReceived ≥ 50% shareholder support

Source: Proxy Insight

Proxy Advisors Perspectives

Proxy advisory firms, such as Institutional Shareholder Services (ISS) and Glass Lewis (GL), give investors a say on golden parachute vote recommendation. While these firms assess proposals on a case-by-case basis, they outline criteria used for the evaluation. ISS, for example, has multiple criterions used in their evaluation, but only note three that will most likely result in an against recommendation:

  • Excise tax gross-ups
  • Cash severance payment upon change-in-control without termination of employment (i.e., single-trigger)
  • Single-trigger vesting of performance-based long-term incentives (LTI) with above target payout, unless there is a compelling rationale disclosed

Unlike ISS, Glass Lewis does not note any specific factors that could result in an against recommendation. Instead, they list criteria considered when evaluating the proposal including (but not limited to) the value (or magnitude) of payments, excise tax obligations, tenure and position of executives, use of single-trigger vesting, etc.

Shareholder Perspectives

CAP reviewed shareholder concerns from five recent acquisitions that failed their say on golden parachute proposal. Among these five companies, single-trigger vesting of LTI was the most common concern followed by excise tax gross-ups and large CEO retention bonuses. Shareholders are particularly concerned with single-trigger LTI vesting because executives could receive a windfall without termination of employment.

Company

Industry

ISS Rec’d

GL Rec’d

% Support

Commonly Disclosed Shareholder Concerns

ZAGG Inc

Specialty Retail

Against

Against

45%

  • Single-trigger equity vesting
  • Large CEO retention award in connection with transaction

Extended Stay America, Inc.

Lodging

Against

Against

45%

  • Single-trigger equity vesting
  • Excise tax gross-up

Covanta Holding Corp

Waste Management

Against

Against

41%

  • Single-trigger equity vesting
  • Excise tax gross-up

Kansas City Southern

Railroads

Against

For

26%

  • Single-trigger equity vesting
  • Excise tax gross-up
  • Large CEO retention award in connection with transaction

Five9 Inc

Software – Application

Against

Against

4%

  • Excise tax gross-up

Source: Proxy Insight

While not commonly cited, some shareholders were critical of how the equity vests at time of termination. Specifically, some were critical of accelerated or continued vesting (i.e., no pro-ration) of time-based equity while others cited above target payouts of unvested performance plans. It is unlikely that these provisions alone would result in an against say on golden parachute vote. Regardless, a company should provide a rationale for pay decisions, particularly if providing one-time retention awards or when deviating from previously disclosed shareholder-friendly practices.

Implications of Failing Say on Golden Parachute

Say on golden parachute votes are one-time, advisory, and non-binding but companies should be aware that there could be consequences of failing for the surviving entity. Beginning with the 2021 proxy season, Glass Lewis stated that they may recommend against the next say on pay vote or compensation committee members of the acquirer if an excise tax gross-up is introduced. To-date, we have not seen many shareholders vote against say on pay proposals of the surviving entity. Given continued scrutiny, we anticipate companies will carefully weigh the pros and cons of implementing non-shareholder-friendly provisions at the time of the deal; for those that do, we would expect to see robust disclosure on the rationale.

Say on Pay arrived in 2011, born out of the SEC’s rule-making efforts to reform corporate governance under Dodd-Frank after the financial crisis. This non-binding advisory vote, which is an annual event at most companies, allows shareholders to cast votes for or against Named Executive Officer (NEO) compensation. While earning simple majority support is technically a passing result, most companies strive for and achieve significantly higher levels of support. Investor support of compensation programs is influenced by many factors, which primarily include magnitude of pay, pay practices, and stock price performance.

In 2020, COVID-19 significantly disrupted the global economy, causing many companies to re-evaluate their compensation programs. Proxy statements filed in 2021, which will discuss compensation during the COVID pandemic year, will depart from previous norms. In anticipation of these filings, CAP has reviewed Say on Pay voting results at Russell 3000 companies in 2020, and since inception, to gauge the current landscape with an eye on what may occur with 2021 Say on Pay results.

Say on Pay Overview

Russell 3000 Historic Results

2020 marked the 10th year of Say on Pay voting. To date, voting results have generally been very consistent over time. Median support among Russell 3000 companies has been approximately 95% in each of the past 10 years. Most companies receive support from over 90% of shareholders, with an average of 74% of companies receiving support in the 90-100% range. Consistent vote outcomes are seen at the top and the bottom end of the range. The percentage of companies falling in each range shown below has been consistent throughout the 10-year history of Say on Pay voting.

All Companies

2020

2011 – 2020

Average

Range

Median Level of Support

94.9%

95.2%

94.7% – 95.6%

>90% Support

74.0%

73.8%

70.0% – 76.8%

2%2%3%1%2%2%2%2%2%2%2%2%2%2%2%2%2%2%3%2%3%4%4%4%4%3%4%4%3%4%5%6%5%5%6%6%6%7%7%8%14%12%11%11%13%12%13%13%13%15%74%74%75%77%74%76%74%73%72%70%0%10%20%30%40%50%60%70%80%90%100%20202019201820172016201520142013201220110% - 50%50% - 60%60% - 70%70% - 80%80% - 90%90% - 100%Level of Support - All Companies

Only 2.2% of companies failed to receive majority support for Say on Pay votes in 2020. The number of companies that have failed the Say on Pay vote has also been very consistent over the 10-year period, with an average of 2.0% of companies failing over the past 10 years. For companies that failed in 2020, the median level of support was approximately 38%, mirroring historical results.

All Companies – Failed Say on Pay Vote

2020

2011 – 2020

Average

Range

% of Companies Failing

2.2%

2.0%

1.4% – 2.4%

Median Level of Support

38.2%

39.2%

33.1% – 42.7%

Proxy Advisor Impact

Proxy advisors have a substantial impact on the Say on Pay vote for companies. The most influential proxy advisory firm is Institutional Shareholder Services (“ISS”) which grades companies on a pay-for-performance scale to determine if, in their view, CEO pay and company performance are well-aligned. ISS will then issue a recommendation “For” or “Against” the NEO compensation program, ISS’ vote recommendation often has a substantial impact on the vote result, as outlined below.

The two main inputs that ISS looks at are CEO compensation and Total Shareholder Return compared to an ISS-defined peer group based on company size and industry. Companies will then receive a “Low”, “Medium” or “High” concern level that determines whether ISS performs a qualitative evaluation of the compensation program. The overall concern level drives ISS’ ultimate recommendation For or Against the Say on Pay resolution. Historically, approximately 95% of companies with a Low concern receive support from ISS, compared to about two-thirds of companies rated Medium concern and roughly half of the High concern companies. Often, shareholders will reference the ISS recommendation (i.e., For or Against) when casting their vote on Say on Pay; however, many institutional investors have their own proprietary tests to evaluate compensation programs at companies.

ISS has consistently recommended Against Say on Pay for approximately 12% of companies per year, over the last decade. Among companies that have failed Say on Pay, the vast majority, 96% on average, have received an Against recommendation from ISS. In 2020, roughly 20% of companies that received an ISS Against recommendation ultimately failed the vote and for all companies with an Against recommendation from ISS, the median level of support was only 67%.

ISS Against Recommendation Impact

2020

2011 – 2020

Average

Range

% of Companies with ISS Against Recommendation

10.4%

11.6%

10.0% – 13.5%

% of Companies with ISS Against Recommendation Failing Say on Pay

19.5%

16.3%

10.6% – 21.5%

Median Level of Support

67.0%

67.4%

65.1% – 70.4%

As shown below, the percentage of companies with an ISS Against recommendation, at each support level range, has been generally consistent since the Say on Pay vote was established.

20%19%18%11%14%23%17%17%18%13%15%16%17%12%19%15%15%18%23%16%25%26%26%26%24%23%22%22%16%21%21%24%23%24%20%20%21%22%23%23%12%10%10%17%16%14%16%13%11%17%8%6%7%10%7%5%10%8%8%10%0%10%20%30%40%50%60%70%80%90%100%20202019201820172016201520142013201220110% - 50%50% - 60%60% - 70%70% - 80%80% - 90%90% - 100%Level of Support - Companies Receiving an ISS Against Recommendation

Expectations for 2021

Institutional Shareholder and Proxy Advisor Commentary

2021 proxy statement disclosures will reflect the impact of COVID-19 on company performance which influenced both executive compensation in 2020 and the development of 2021 incentive programs. While the degree of impact will vary by industry and company, many more companies than usual will disclose adjustments to their compensation programs than in past years. During 2020, shareholders and proxy advisors provided some general guidance on how they will be assessing and evaluating these unique circumstances.

Institutional shareholders and proxy advisors have both stated that they recognize that 2020 was a more challenging year than most due to the impact of COVID-19. Because of this, they will review companies on a case-by-case basis, evaluating the facts and circumstances that went into any adjustments that were made. Guidance has generally encouraged proactive, enhanced disclosure that clearly explains the situation and rationale for COVID-related changes as opposed to generic descriptions of a challenging year, which may be viewed as insufficient.

How shareholders and proxy advisors interpret and assess the COVID-related disclosures and adjustments will ultimately influence Say on Pay votes and recommendations. While ISS and Glass Lewis did not make wholesale changes to their pay-for-performance evaluations for 2021, ISS did call out key disclosure items that would help investors evaluate COVID-related changes. This indicates that there may be more discretion and flexibility applied for companies with more robust disclosure. Even with greater flexibility in the qualitative evaluations, pay-for-performance misalignment will continue to be the main driver for Against recommendations from ISS in the broader market.

CAP Expectations

Since pay-for-performance is expected to remain the primary driver for proxy advisor recommendations, Say on Pay results will continue to depend on the magnitude of pay, pay practices and stock price performance. For companies that may have a pay and performance misalignment, we expect reduced shareholder support if a company has not provided sufficient rationale for the following actions:

  • Annual and long-term incentive plan adjustments
  • Major employee actions (e.g., layoffs)
  • Performance that is dramatically below investor expectations
  • Low relative financial performance
  • Above-target discretionary adjustments to payouts that previously missed threshold performance
  • Awarding one-time special cash/equity grants

Shareholder outreach will be more important in 2021 as companies can use these discussions to supplement their required disclosures. Proactive outreach may help to prevent a significant impact on the Say on Pay result even if proxy advisors recommend Against a company’s compensation program. There will also likely be more disclosure on go-forward incentive programs, as the impact of COVID-19 lingers into 2021.

Say on Pay results in 2021 will likely depart from prior norms. Even if the percentages of Against recommendations and companies passing remains relatively consistent with historic levels, we expect to see a downward shift in the median level of support and in the percentage of companies receiving at least 90% support. For companies that do receive an Against recommendation from proxy advisors, the level of support may decline compared to historic norms if disclosures do not sufficiently justify the actions taken.

Conclusion

2021 Say on Pay results will likely test the “steady state” seen over the previous 10 years. While the full picture will not be clear until later this year, CAP has begun to look at companies with fiscal years ended in late 2020 to get an early read. We will continue to monitor Say on Pay results throughout the year to see how the COVID-19 pandemic shapes these results.

Principal Shaun Bisman discusses the renewed investor and public interest of clawbacks and that companies are beginning to broaden their policies beyond a financial restatement.

On August 21, 2018, the IRS issued long-awaited guidance on the amendment of Section 162(m) made in the Tax Cuts and Jobs Act (TCJA).

This initial guidance is limited in scope and intended to respond to comments requesting clarification on the amended rules for identifying covered employees and the operation of the grandfather rule applicable to written binding contracts in effect before November 2, 2017. The initial guidance contains commentary, as well as numerous examples, on:

  • The definition of publicly held corporations covered by Section 162(m);

  • The definition of covered employees;

  • The definition of applicable employee remuneration;

  • The grandfather rule for compensation arrangements made under a written binding contract; and

  • Material modification of written binding contracts.

Highlights

The most important highlights include:

  1. The definition of publicly held corporations covered by Section 162(m) is broadened.
  2. The definition of covered employees is modified to better align with current proxy disclosure rules, although differences continue to exist primarily because the “end-of-year” requirement is eliminated for purposes of Section 162(m).
  3. The definition of covered employees is expanded to include chief financial officers, former covered employees and payments to a covered employee’s heirs and estate.
  4. The tax deductibility of compensation is preserved if the compensation is paid under a written binding contract in effect on November 2, 2017 and not materially modified after that date.
  5. The ability to use negative discretion to reduce compensation under such an arrangement is likely sufficient to limit tax deductibility, since the contract is not binding. We expect companies to test this concept in the courts over time.
  6. A material modification increases compensation, or provides additional compensation, on substantially the same elements or conditions.
  7. Additional payments equal to or less than reasonable cost of living adjustments do not result in a material modification.

Amendments to the Definition of Publicly Held Corporation

The TCJA amendment broadened the definition of publicly held corporations covered by Section 162(m). Rather than limiting the scope to companies issuing common equity securities, the new definition includes “any corporation:

  1. Which is an issuer the Securities of which are required to be registered under section 12 of the Securities Exchange Act of 1934 (the 1934 Act), or
  2. That is required to file reports under section 15(d) of the 1934 Act.”

The new definition expands coverage to companies issuing various equity securities and publicly traded debt, as well as companies that may be otherwise exempt from filing a proxy statement. For example, the executive officers of a public company that delists its securities, thus eliminating the requirement to file a proxy statement and disclose executive compensation, would be covered employees for tax purposes and subject to the amendment’s limits on tax deductibility.

Amendments to the Definition of Covered Employee

Under the TCJA, the definition of covered employees is modified to better align with current proxy disclosure rules. Under the new definition, a covered employee means “any employee if:

  1. Such employee is the principal executive officer (PEO) or principal financial officer (PFO) of the taxpayer at any time during the taxable year, or was an individual acting in such a capacity,
  2. The total compensation of such employee for the taxable year is required to be reported to shareholders under the 1934 Act by reason of such employee being among the three highest compensated officers for the taxable year other than any individual described in (a), or
  3. Such employee was a covered employee of the taxpayer (or any predecessor) for any preceding taxable year beginning after December 31, 2016.”

Importantly, the initial guidance clarifies that a covered employee is not limited to only those serving in their role at the end of the year. By eliminating the end-of-year requirement, disconnects between the individuals reported in the proxy statement and actual covered employees may occur. The IRS notes that SEC rules do not constitute the sole basis for interpreting Section 162(m).

By including covered employees for any preceding taxable year beginning after December 31, 2016, the initial guidance clarifies that the pre-amendment rules for identifying covered employees will apply for taxable years beginning during 2017. These employees will be wrapped in under the amendment, with tax deductibility strictly limited beginning in taxable years beginning in 2018 and beyond.

Amendment to the Definition of Applicable Employee Remuneration

Applicable employee remuneration was defined, under Section 162(m), as the total amount allowed to be deducted for the tax year. Prior to the amendment to Section 162(m), applicable employee remuneration excluded commission-based and qualified performance-based compensation. The amendments to Section 162(m) removed these exclusions from the definition. The Act also added a rule that limits the deductibility of applicable employee remuneration even if the compensation is paid to a beneficiary in the event of the death of a covered employee.

Application of the Grandfather Rule

The amendment to Section 162(m) allows for the tax deductibility of compensation to be preserved (in other words “grandfathered”) if the compensation is paid under a written binding contract in effect on November 2, 2017 and not materially modified after that date. The initial guidance preserves the pre-amendment definitions of “written binding contract” and “material modification” as first detailed in the original 1993 grandfather rules included when Section 162(m) was added to the Internal Revenue Code.

Written Binding Contract

The initial guidance defines a written binding contract as a contract that requires the company under applicable law (for example, under state law) to pay compensation if the employee performs services or satisfies the vesting conditions attached to the compensation. If a contract contains elements that are binding and other elements that are discretionary, the amounts that are binding will continue to be deductible under the grandfather rule, absent a material modification, and the discretionary amounts will be subject to the amendment's limits on tax deductibility and not grandfathered.

Grandfathering is not available to contracts that are renewed after November 2, 2017. Instead, these are treated as new contracts. If a company has the right to cancel or terminate a contract without the executive’s consent after November 2, 2017, the loss of grandfathering occurs as of that date and the amendment’s limits on tax deductibility apply at that point and going forward. One common scenario plays out when a contract contains a notice period. For example, if a company can give notice of non-renewal after a defined initial term ends, or annually thereafter, the contract is treated as a new contract when the notice period ends or upon renewal, if earlier.

There are important caveats to this rule to keep in mind. If a contract can only be cancelled or terminated by ending the employment of the executive, the contract does not lose grandfathered status. Similarly, if the executive has the unilateral right to cancel the contract after a certain date but chooses not to do so, the contract does not lose grandfathered status after this date.

Consensus has developed that the ability of the board or compensation committee to exercise negative discretion and adjust payments down to zero makes a compensation plan or arrangement non-binding. This results in a loss of grandfathering and limits on tax deductibility under the amendment to Section 162(m).

We expect this position to be tested by issuers in tax court and/or state court. For example, if performance metrics and targets are clearly articulated in a contract or award agreement and the company has no history of actually applying negative discretion, a case could be made that the executive has a valid claim to receive that compensation. We will monitor developments on this point, since negative discretion is built into the majority of executive incentive plans.

Finally, if a compensation plan or arrangement is binding, the amount that is required to be paid as of November 2, 2017, will be grandfathered with no loss of tax deductibility, provided the executive was employed on that date by the corporate sponsor or the employee had a written binding contract as of that date. Supplemental executive retirement plan (SERP) benefits are a good example of this. If an executive has a binding right to receive SERP benefits, the accrued benefit as of November 2, 2017 will continue to be deductible when paid in the future, while amounts accrued for service after that date will be subject to the amendment’s limits on tax deductibility.

Material Modification

The IRS defines a material modification as an amendment that increases the amount of compensation payable to the executive, or provides additional compensation, on substantially the same elements or conditions. If a material modification occurs, amounts received prior to the date of the modification are grandfathered and amounts received after that are not grandfathered, but rather subject to the amendment’s limits on tax deductibility.

Another aspect identified by the IRS as a material modification to a written binding contract includes the acceleration of the timing of a payment unless the payment is discounted to reasonably account for receiving the compensation early. The IRS notes that modifying a contract to defer a payment does not constitute a material modification as long as the excess amount payable is based on a reasonable rate of interest or the rate of return of a predetermined investment.

The adoption of a supplemental contract that increases compensation or provides for an additional payment is a material modification, when the facts and circumstances demonstrate that the “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.”

On the other hand, companies may increase compensation to offset the impact of cost-of-living without loss of grandfathering. The guidance clarifies that an additional payment that is less than or equal to a reasonable cost- of-living increase (for example, a modest salary increase) would not be a material modification.

Effective Date

According to the guidance, the amendment to Section 162(m) applies to taxable years beginning on or after January 1, 2018. The regulators anticipate that the guidance will be incorporated in future regulations and will apply to taxable years ending on or after September 10, 2018. The IRS also notes that any future guidance or regulations that address issues covered in the guidance that would broaden the definition of covered employee or limit the definition of written binding contract would apply prospectively only.

IRS Request for Comments

Treasury and the IRS expect to issue additional guidance on Section 162(m) and is requesting comments on other aspects of the amendments to Section 162(m) that should be addressed. These include a number of highly technical points, such as:

  • The definition of “publicly held corporation” applicable to foreign private issuers,
  • The definition of “covered employee” to an employee who was a covered employee of a predecessor of the publicly held corporation,
  • The application of Section 162(m) to corporations immediately after an initial public offering or a similar business transaction, and
  • The application of the SEC executive compensation disclosure rules for determining the three most highly compensated executive officers for a taxable year that does not end on the same date as the last completed fiscal year.

Written comments are being requested through November 9, 2018.

Conclusion

The IRS has provided initial guidance on key questions from practitioner after the TCJA passed. Plenty of examples as to how the new rules would be applied going forward are provided. However, the guidance is complex. Companies should evaluate how the rules apply by consulting internal and external subject matter expert that understand compensation, as well as the tax and legal perspectives. We will keep clients informed as consensus develops on various aspects of the guidance and as the IRS issues further guidance on Section 162(m).

Beginning with fiscal years ending on or after December 31, 2017, companies are required to disclose the ratio that compares the compensation of the CEO to the compensation of the median employee (pay ratio). This disclosure was part of the Dodd-Frank Wall Street Reform and Consumer Protection Act signed into law in 2010.

Compensation Advisory Partners LLC (CAP) researched early pay ratio disclosures. As of March 9, 2018, we obtained pay ratios from 150 companies with a median revenue of $2.1B from a cross-section of industries.

Pay Ratio

The median pay ratio disclosed by these companies is 87x. The lowest ratio is 1x (Apollo Global Management, Dorchester Minerals and The Carlyle Group) and the highest ratio is 1465x (Fresh Del Monte Produce Inc.).

Summary Statistics Median Employee Pay Median CEO Pay Pay Ratio
75th percentile $88,612 $10.5M 172x
Median $58,256 $5.6M 87x
25th percentile $43,966 $2.5M 36x

As expected, the pay ratio correlates with company size, with larger companies disclosing higher ratios. CEO pay varies greatly depending on the size and complexity of the organization. Employee pay has less variability since it reflects the job function and does not vary significantly based on the size of the organization. The median ratio in our sample of 150 companies ranges from 20x for companies with revenue less than $500M to 218x for companies with revenue greater than $15B.

20x 54x 84x 157x 183x 218x <$500M $500M-$1B $1B-$5B $5B-$10B $10B-$15B >$15B Median Pay Ratio by Revenue Size

Few companies, 15, disclose a supplemental pay ratio with only a handful of companies (three) disclosing more than one additional ratio. These companies with supplemental ratios are typically adjusting the CEO’s pay which may exclude anomalies such as a one-time special bonus or equity award. Interestingly, three companies disclosed a higher supplemental pay ratio likely to provide context for a large year over year increase in the 2019 proxy statement.

Location of Disclosure

Nearly 70% of companies disclose the pay ratio after the Potential Payments upon Termination or Change in Control section of the proxy statement. Approximately 25% of companies disclose the pay ratio just before or after the Summary Compensation Table and a small minority, 5%, disclose it in the Compensation Discussion and Analysis (CD&A).

Pay ratio is typically not disclosed in the CD&A, signaling to shareholders that the pay ratio is not used to determine CEO pay levels. Additionally, around 25% of companies include language in the disclosure that the ratio should not be used to compare pay levels to other companies within the industry, region of the country or revenue size.

Measurement Date

The SEC’s final rules give companies the flexibility to use any date within the last quarter of the fiscal year to identify the median employee. Companies most commonly used the last day of the fiscal year or a date within the last month of Q4. It is also common for companies to use a day within the first month of Q4 to identify the median employee.

Measurement Month Prevalence Measurement Date Prevalence
First Month of Q4 29% Last day of Q4 44%
Second Month of Q4 8% First day of Q4 17%
Third Month of Q4 57% Other 33%
Not Disclosed 6% Not Disclosed 6%

Exclusions from Median Employee Determination

Approximately one-third of companies excluded a portion of their workforce when determining the median employee. The most common rationale is the de minimis exemption (approximately 55%) whereby a company can exclude up to 5% of its non-U.S. employee workforce. Companies also commonly cited an acquisition or corporate not responsible for setting pay (e.g., independent contractors) as rationales for excluding certain employee groups.

Conclusion

As more companies continue to file their proxy statements in the coming weeks, we will likely see larger pay ratios, particularly as companies with a significant part-time workforce begin to disclose their ratios. We do not anticipate an increasing trend in the number of companies filing supplemental pay ratios though it will be interesting to see the rationale for those that do. We expect to continue to see companies placing the pay ratio outside of the CD&A with most disclosing it after the Potential Payments upon Termination or Change in Control section.

CAP reviews proxy disclosures of S&P 500 companies on a weekly basis as part of an on-going Say on Pay study. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank”) mandates that public companies provide shareholders with a non-binding vote on executive compensation every one, two or three years. This study tracks all Say on Pay and Say on Frequency related proposals and the corresponding vote results.

Congress approved the Tax Cuts and Jobs Act on December 20th, 2017, achieving its objective of delivering a bill for President Trump’s signature before Christmas. The Act makes many dramatic changes to the tax code, including sharp reductions in the corporate tax rate, modest reductions in individual tax rates and some progress in simplifying the tax code. The biggest change from an executive compensation perspective involves amendment of Section 162(m).

Since going into effect in 1994, Section 162(m) has limited the deductibility of remuneration to covered employees to the extent the amount exceeds $1,000,000. Under current law, important exceptions to the limits on deductibility apply to stock options, other performance-based compensation and commissions. The amendments in the Act greatly expand the limits on deductibility by eliminating these exceptions.

Highlights of the Amendments to Section 162(m)

Amendment

Implication

Exceptions allowing deductibility of stock options, other qualifying performance-based compensation and commissions are eliminated

Effectively caps deductibility of senior executive compensation to $1 million per year and raises company cost of compensation

Definition of covered employees aligned with SEC disclosure rules

Expands coverage to include any person serving as Principal Executive Officer (PEO) and Chief Financial Officer (CFO) during the tax year, as well as the three highest paid executive officers other than the PEO and CFO

Expands coverage to include compensation of covered employees for all future years of employment whether or not they remain in the proxy, payments made after retirement, death or other termination of employments and payments to beneficiaries

Widens the net by eliminating loopholes allowed under current law, such as leaving the role of PEO before the last day of the year and making non-qualified deferrals of compensation until after termination

Amendments apply to taxable years beginning after December 31, 2017, except that the amendments shall not apply to remuneration provided pursuant to a written binding contract in effect on November 2, 2017, and not modified in any material respect on or after such date

Effectively grandfathers existing arrangements and provides companies with an opportunity to capture tax deductions as existing arrangements wind down over time

Possible Benefit from Amended Section 162(m): More Flexibility for Compensation Committees

Public companies subject to Section 162(m) use a variety of techniques to comply with the current law and maximize tax deductibility. Going forward, for new awards that are not made under grandfathered written binding contracts, these techniques will no longer be needed. Tax deductibility will be capped at $1,000,000 regardless of plan design:

  • “Plan within a plan” structure, also known as an “umbrella plan,” will no longer be necessary, providing companies with an opportunity to simplify current plans
  • Tax incentives to grant performance-based compensation will be eliminated in most instances, encouraging greater use of time-based awards.
  • Potentially more flexible performance metrics may be instituted over time. Non-GAAP metrics, individual goals and metrics that incorporate discretion are likely to occur more frequently.
  • Tax penalties for adjusting or restating performance targets will be eliminated in most instances.
  • Compensation committees will have greater opportunities to exercise discretion, including positive discretion.
  • While amendments clearly raise the cost of compensation for companies, the corporate tax rate cut makes the lost tax deductions less valuable, with a deduction on $1 million of compensation declining from $350,000 to 210,000.

What Should Companies Do Now?

Companies should take the following steps now to develop a clear picture of their particular situation with respect to the amendment of Section 162(m):

  1. Take an inventory. Make a list of outstanding compensation arrangements and awards to determine which may continue to be deductible going forwards. These would include contractual benefits and other awards made under written binding contracts in place on or before November 2, 2017.
  2. Double check your assessment with tax counsel. Make sure internal resources and outside advisors agree with your analysis and conclusions.
  3. Determine administrative processes needed to capture tax deductions going forward. For example, achievement of the goals of a grandfathered performance share award must be certified by the Compensation Committee prior to payment to comply with current Section 162(m) rules.
  4. If contractual arrangements and awards will continue over time, continue to seek re-approval of the material terms of incentive plans every 5 years. Shareholder approval of metrics, maximum awards and the class of participants are required to comply with current law. Obtaining shareholder approval of these proposals is almost always easy to accomplish.
  5. Be wary of making changes. Modification to awards or arrangements in effect on or before November 2, 2017 could result in the loss of valuable tax deductions.
  6. Determine which executives appear in the proxy and become covered employees under amended Section 162(m).
  7. Do your best to limit new entrants into the proxy disclosed group. Once an executive becomes subject to amended Section 162(m), the limits on deductibility become permanent.
  8. Prepare a pro forma showing current law and amended law to review with the Compensation Committee. It is important to brief the Committee and senior management to avoid surprises. All will benefit from understanding the magnitude of lost deductions.
  9. Review your proxy disclosure. Determine how best to address the issue of tax deductibility in the CD&A.
  10. Follow case law as it develops. Without a doubt, companies will test the amendments and new thinking will develop. You will benefit if you track the issue as it is tested in the marketplace.

We will keep our readers informed of new developments. Undoubtedly the Tax Cuts and Jobs Act will have other implications for executive compensation.