The COVID-19 pandemic dealt an unexpected blow that pushed a number of companies into bankruptcy. The impact of pandemic-related shutdowns was broad: Companies in a diverse range of industries – including retail, oil and gas, consumer goods, restaurants, and entertainment and recreation – filed for Chapter 11 bankruptcy protection in the first half of 2020. While the number of filings has not yet reached the level seen in the 2008 financial crisis, the number of bankruptcies is expected to rise through the remainder of the year.

The 2020 surge in bankruptcies has been accompanied by heightened scrutiny of executive pay in restructuring situations. Bankruptcy filings are often preceded by announcements of executive retention and other short-term performance-based awards. These awards can draw criticism as excessive and even inappropriate given the impact of bankruptcy on shareholders and the broader employee population. However, 2020 is unique. While situations vary by industry, most agree that this flurry of bankruptcy filings is not the result of poor management but rather the inevitable impact of unprecedented and unforeseeable broad shutdowns across the country to contain the pandemic. The companies entering bankruptcy need continuity, stability, and motivated leadership. Carefully designed and communicated retention and performance awards can play an important role in keeping leadership in place and focused on moving the company through the restructuring process.

The Evolution of Prepaid Awards

Corporate bankruptcies cause a significant amount of uncertainty for executives and employees, who can be tempted to leave for more stable work situations with predictable, secure compensation streams. Poor company performance means that annual incentives are unlikely to pay out, and equity holdings lose almost all value. In situations where shareholders need to retain executives through the bankruptcy period, cash retention awards to critical members of management can be effective by providing compensation stability. These programs are often called Key Executive Retention Programs (KERPs).

Executive retention awards in bankruptcy situations today have a unique design: they are paid before the bankruptcy filing and are subject to clawback provisions. Clawback provisions are triggered if the executive terminates employment during a specified time period or is terminated for cause. In addition, some clawbacks are tied to performance goals not being achieved. If triggered, the clawback provisions require executives to pay back the after-tax award value. The fact that the awards are prepaid differentiates them from most other cash incentives and makes them the subject of criticism and misunderstanding.

The Evolution of Prepaid Executive Retention Awards in Bankruptcies

Executive retention awardsgranted and paid out duringbankruptcy process Favored payment status inbankruptcies Negative opticsSignficantly changed U.S.bankruptcy law Restrictions effectivelystopped executive retentionawards from being grantedafter a bankruptcy filing Pre-2005 ExecutiveRetention AwardsBAPCPA 2005Announced and paid beforebankruptcy filing (BAPCPAworkaround) Retention enforced throughclawbacks Prepaid ExecutiveRetention Awards

The unique design for executive retention awards emerged from changes to the U.S. bankruptcy code made through the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA). Prior to BAPCPA, a large portion of executive compensation in bankruptcy situations was delivered through retention awards. Executive retention awards were typically paid out in a lump sum or through several payments based on the executive’s continued employment. Executive retention awards also had special status in the bankruptcy proceedings that ensured payment ahead of many other company obligations. As a result of the special status and lack of performance features, executive retention awards were not viewed favorably.

BAPCPA imposed stringent restrictions on awards to “insiders” implemented during the bankruptcy process that are based solely on retention and that lack performance features (“Insiders” are defined as directors, officers, individuals in control of the corporation, and relatives of such individuals). BAPCPA’s restrictions effectively stopped the use of executive retention awards once companies file for bankruptcy. Despite BAPCPA, executive retention awards eventually re-emerged – as prepaid awards subject to clawbacks. By paying the awards before the bankruptcy filing, companies can generally avoid the BAPCPA restrictions and avoid having the award subject to Bankruptcy Court approval.

Prevalent Executive and Employee Pay Practices during Bankruptcy

CAP analyzed the 8-K filings of a number of companies that entered bankruptcy in 2020. Based on this analysis, companies today often use a mix of compensation programs to retain and motivate executives and employees leading up to, and during, the bankruptcy process:

  • Pre-filing, prepaid executive retention awards
  • Performance-based Key Employee Incentive Plans (KEIPs)
  • Employee retention and incentive programs

 

Pre-Filing, Prepaid Executive Retention Awards

A number of companies that filed for bankruptcy during 2020 announced prepaid retention awards for executives anywhere from days to months before the legal filing. The 8-K filings indicate that the prepaid retention awards are designed by the board with advice from compensation consultants, as well as bankruptcy and other advisors. Typical design parameters for executive retention bonus awards include:

Participation:

CEO, other key executives and officers

Objectives:

Retain key employees before and during the bankruptcy proceedings

Award Value:

  • Retention award values often range from 1X to 2X base salary
  • Any previously issued retention awards can serve as precedent

Form of Payment and Timing:

Awards are made in cash, prepaid in a lump sum prior to the bankruptcy filing

Clawback Provisions:

Executives must repay the awards, net of taxes, if they 1) Terminate employment prior to the earlier of a specified period or the conclusion of the bankruptcy period, or 2) Are terminated by the company for cause

Clawback Period:

Most often one year

While less common, some companies, including Chesapeake Energy and Ascena Retail Group, include base-level performance criteria in the clawback provisions to add a performance element to the prepaid retention awards. This improves the overall optics of such awards and helps avoid additional scrutiny during bankruptcy.

Select Pre-Filing Retention and Incentive Programs

Company

Revenue FY2019 ($000s)

Industry

Bankruptcy Date

Program

Award Term

Description

J.C. Penney

$12,019

Retailing

5/15/2020

Retention & Incentive

0.6Y

Adopted a prepaid cash compensation program equal to a portion of NEO annual target variable compensation; NEO awards ranged from $1M to $4.5M; clawbacks are tied 80% to continued employment through January 31, 2021, and 20% to milestone-based performance goals

Retention

1.6Y

Accelerated the earned 2019 portion of three-year long-term incentive awards ($2.4M for NEOs); clawbacks are tied to continued employment through January 31, 2022

Hertz Global Holdings

$9,779

Transportation

5/22/2020

Retention

0.8Y

Cash retention payments to 340 key employees at the director level and above ($16.2M in aggregate); NEO awards ranged from $190K to $700K; clawbacks tied to continued employment through March 31, 2021

Chesapeake Energy

$8,408

Energy

6/28/2020

Retention & Incentive

1.0Y

Executives: Prepaid 100% of NEO and designated VP target variable compensation ($25M in aggregate for 27 executives) based 50% on continued employment and 50% on the achievement of specified incentive metrics Employees (retention only): Converted annual incentive plan into a 12-month cash retention plan paid quarterly, subject to continued employment

Ascena Retail Group

$5,493

Retailing

7/23/2020

Retention & Incentive

0.5Y

Executive and Employee Retention and Performance Awards: Six-month cash award for NEOs (NEO awards ranged from $600K to $1.1M), 3 other executives, and employees who are eligible for the company’s incentive programs based 50% on continued employment through Q4 2020 and 50% on performance; award amounts are based on a percentage of annual and long-term incentive targets Earned Performance-Based LTIP Awards: Accelerated earned 2018 and 2019 performance-based cash awards for all employees ($1.1M for 2 NEOs), subject to continued employment through August 1, 2020 for the 2018 award and August 3, 2021 for the 2019 award

Whiting Petroleum

$1,572

Energy

4/1/2020

Retention

1.0Y or Chapter 11 Exit

NEO awards were prepaid and ranged from $1.1M-$6.4M; clawbacks are based on termination of employment before the earlier of March 30, 2021, or Chapter 11 exit; employees receive quarterly cash awards that in aggregate may not exceed that employee’s target annual and long-term incentive compensation

GNC Holdings

$1,446

Food, Beverage and Tobacco

6/23/2020

Retention

1.0Y

Cash exit incentive awards for key employees (including executives) based 75% on the Company’s exit from bankruptcy and 25% on the 60th day following an emergence event that occurs on or prior to June 23, 2021. Prepaid NEO awards ranged from $300K to $2.2M

Diamond Offshore Drilling

$935

Energy

4/26/2020

Retention

1.0Y

Past Executive Long-Term Cash Incentives: Payment of a portion of past three-year cash incentive awards was accelerated for retention; awards are subject to clawbacks based on termination of employment for one year; NEO payouts ranged from $140,208 to $1.75 million. Other Plans: The Company announced a Key Employee Incentive Plan, a Non-Executive Incentive Plan and a Key Employee Retention Plan, which are all subject to approval by the Bankruptcy Court

Performance-Based Key Employee Incentive Plans (KEIPs)

After BAPCPA, KEIPs emerged to provide incentives to executives without running afoul of the bankruptcy code. KEIPs, which are approved during the bankruptcy process, are performance-based incentives that pay out in cash based on the achievement of financial and operational goals. The goals can be very short-term in nature, such as quarterly performance periods.

Typical design parameters for KEIPs include:

Participation:

CEO, other key executives and officers (ultimately those designated as “insiders” in the bankruptcy proceeding)

Objectives:

Incentivize key executives before, but primarily during, the bankruptcy proceedings

Award Value:

  • KEIPs often collapse the annual and long-term incentive opportunities into a single program
  • In most cases, the executives can earn 100% of their target annual incentive and between 50% and 100% of their prior long-term incentive award value
  • The KEIP must be performance based to receive court approval, and payouts are often determined using absolute measures, such as earnings before interest and taxes (EBIT) or earnings before interest, taxes, depreciation and amortization (EBITDA)

Form of Payment and Timing:

  • Awards are paid in cash upon certification of performance in pre-established goals
  • Performance periods range from quarterly to annual

A current trend is to design and implement the KEIP prior to filing. This is especially true in pre-packaged bankruptcies where the financial reorganization of the company is prepared in advance in cooperation with its creditors. Having these programs in place with payouts contingent on performance improves continuity throughout the entire process, incentivizes the management team to perform, and meets the court’s requirement that any variable compensation to executives be performance based.

One recent example of a company announcing a KEIP before the bankruptcy filing is Diamond Offshore Drilling. The company announced a prepaid retention program for executives, as well as a KEIP, a non-executive incentive plan and an additional retention plan. All plans except for the prepaid executive retention program are subject to Bankruptcy Court approval, according to the 8-K. The KEIP, nonexecutive incentive plan and the additional retention plan replace past incentives – including requiring the forfeiture of past restricted stock unit awards and stock appreciation rights – and current incentives that would have been granted in 2020. The KEIP includes nine participants, including the senior executive team.

Employee Retention and Incentive Programs

Retention and incentive programs for employees are also used during the bankruptcy process. The use of employee programs depends on the company’s business needs and other factors, such as size and industry. Retention and incentive programs for non-executives typically replace the value of annual incentives and sometimes long-term incentives. Employee retention programs are cash-based and pay out at specific intervals, often quarterly given the uncertainties associated with companies in restructuring situations. The duration of employee retention programs often mirrors those for executives.

Severance programs, which provide compensation to individuals at termination, are also used in bankruptcy situations. When communicated broadly during bankruptcy, severance can be considered a retention program as it helps employees have some financial security and focus on their current jobs rather than finding new positions. Severance programs tend to be used more commonly for employees than executives because BAPCPA limits the value that can be delivered to “insiders.” However, a recent example of a severance program for executives came from Hertz Global Holdings, which announced amendments to its executive severance programs prior to its bankruptcy filing in May 2020. The severance programs, which were disclosed in the same 8-K filing as a prepaid key employee retention program, cover senior executives and vice presidents, and the payment multiple was reduced to 1X salary and bonus from 1.5X.

Conclusion

Executive compensation programs implemented in conjunction with a bankruptcy should be carefully designed and reviewed with outside advisors to ensure that the company is complying with bankruptcy code. Companies should carefully review the value of executive awards to ensure that they are reasonable while also in line with competitive practices and past incentive opportunities. Executive award amounts should be considered in the context of employee awards and the company’s overall financial situation to ensure fairness and avoid the appearance of excess. Lastly, companies should carefully communicate the rationale for executive awards and what the company is doing for employees in the 8-K current report or other announcement. Clear communication up front can help head off later public relations and optics headaches.

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 December 18, 2018, the SEC adopted new rules that will require disclosure of a company’s hedging policy. The hedging policy was initially proposed by the SEC on February 9, 2015 under Section 955 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. It requires companies to disclose in the proxy (or information statements relating to the election of directors), any practices or policies regarding the ability of employees or directors to engage in certain hedging transactions with respect to company equity.

The rules become effective beginning with proxy statements filed for the first fiscal year beginning on or after July 1, 2019 and apply to all publicly traded U.S. companies (other than foreign private issuers and listed closed-end funds). Smaller reporting companies and emerging growth companies will have an additional year to comply.

The final rules are consistent with much of the original proposal from four years ago, with key changes noted below:

  • Companies are required to describe any practices or policies they have adopted regarding the ability of its employees, officers or directors to purchase securities or other financial instruments, or engage in transactions, that hedge or offset any decrease in the market value of equity securities granted as compensation, or held directly or indirectly by the employee or director
  • Companies can satisfy the disclosure requirements by either providing a fair and accurate summary of the hedging practices or policies that apply, including the categories of persons they affect and any categories of hedging transactions that are specifically permitted or specifically disallowed, or, alternatively, by disclosing the practices or policies in full
  • If the company does not have any such practices or policies, the company must disclose this fact or state that hedging transactions are generally permitted

These requirements are different from the proposed rules which only required a company to disclose whether they permitted employees and directors to hedge.

For most companies, the impact of the rules may likely require only slight modification to existing disclosure, given that many public companies already disclose hedging policies on a voluntary basis.

Click on this link to see the final SEC rule and this link for the press release.

In anticipation of the SEC’s upcoming “Roundtable on the Proxy Process,” the SEC has withdrawn letters issued in 2004 to Egan-Jones Proxy Services and Institutional Shareholder Services, Inc. (ISS) that many argue were responsible for entrenching the influence of shareholder advisory firms. The SEC’s roundtable is expected to be held in November 2018, and more recommendations to the Commission regarding proxy advisory firms from investment advisors and corporate issuers may result.

On Thursday, September 13th, the SEC’s Division of Investment Management released this statement: “(it) has been considering (among other topics) whether prior staff guidance about investment advisers’ responsibilities in voting client proxies and retaining proxy advisory firms should be modified, rescinded or supplemented.” The statement went on to assert that “staff guidance is nonbinding and does not create enforceable legal rights or obligations.” Under this rationale and with the upcoming roundtable in mind, the letters were withdrawn to encourage and facilitate debate on the most appropriate role for the proxy advisory firms.

How did we get here?

In 2003, the SEC issued rules which required mutual funds and investment advisors to design and implement policies and procedures intended to ensure that proxies are voted in the best interests of their clients, i.e. to avoid a conflict of interest influencing decisions made on their behalf. In 2004, Commission staff issued the now withdrawn letters which allowed the outsourcing of fiduciary obligation of investment advisors to independent proxy advisory firms. This allowed advisors to rely on proxy advisory firm recommendations to fulfill their fiduciary responsibility to clients. Since then, we have witnessed the significant increase in power and influence of companies like ISS and Glass Lewis, the leading proxy advisory firms. For example, today an ISS “Against” recommendation on a Say on Pay proposal will typically reduce shareholder support by about 30%.

Proxy advisory firms play an important role in developing acceptable governance practices for companies and boards. Yet they are often criticized for applying a rigid, “one size fits all” model to companies across all industries that often disregard market conditions. While there are instances where recommendations against compensation programs and the directors responsible for them are warranted, this cookie cutter approach has led to some unfair recommendations. Companies are then left scrambling to respond, trying to draw attention to faulty analysis and salvage the shareholder vote. The frustrations produced in these instances are amplified further by the apparent conflict of interest that arises when the proxy advisory firm responsible for the “against” vote recommendation charges fees for consulting services intended to avoid similar outcomes in the future.

Impact of the Withdrawal?

While the withdrawal of these letters does little other than provide a clean slate for an open discussion in the fall, it feels like a solid punch landed for those in the corporate community lobbying for greater oversight of the proxy advisory firms. House Financial Services Committee Chairman Jeb Hensarling, R-Texas, welcomed the move this week saying, “The proxy advisory firm duopoly is in serious need of reform and SEC attention. The market power of proxy advisory firms demands greater accountability for these firms’ actions and the information that they provide institutional investors.”

In response, both ISS and Glass Lewis issued public statements that they have never relied upon these no-action letters and the withdrawal has no impact on the services they are providing or how investors use their advice.

We anxiously await the discussion at the SEC’s roundtable in November. Perhaps the withdrawal of these letters will lead to a renewed and meaningful discussion on an appropriate level of oversight, transparency, and accountability of proxy advisory firms that ultimately strengthens corporate governance.

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).

Nearly three months after President Trump signed the Tax Cuts and Jobs Act (“Tax Reform”) into law, company management, Compensation Committees, and outside advisors have been evaluating the impact the notable changes to Internal Revenue Code Section 162(m) (“Section 162(m)”) will have on executive compensation.

Tax Reform now eliminates the loophole of exceptions of performance-based pay and expands the list of “covered employees.” With these changes, companies face the challenge of understanding what impact this will have on their executive compensation programs, often specifically designed to qualify for the performance-based tax deduction, and the loss of tax deductibility.

Section 162(m) was first passed into law in 1993, with the intent to rein in executive compensation by eliminating the tax deductibility of executive compensation above $1 million for “covered employees”, effectively named executive officers (NEOs), unless the compensation was performance-based. The purpose of the tax law was to “punish” firms paying excessive executive compensation; however unforeseen was the performance-based loophole that has led to the unintended consequence of increased executive compensation post-1993.

Flash forward to 2018; 25 years later, Tax Reform now eliminates the loophole of exceptions of performance-based pay and expands the list of “covered employees.” With these changes, companies face the challenge of understanding what impact this will have on their executive compensation programs, often specifically designed to qualify for the performance-based tax deduction, and the loss of tax deductibility.

This article explores CAP’s perspective on the implications of these significant changes on compensation programs in 2018 and beyond.

Highlights of the Changes to Section 162(m)

Change: The new rule expands coverage to include any person serving as the Chief Executive Officer (CEO) and Chief Financial Officer (CFO) during the tax year, as well as the three highest paid executive officers other than the CEO and CFO (commonly referred to as NEOs). If a “covered employee” is paid $1 million a year in base salary, that is all the company will be able to deduct and annual performance-based bonuses, stock options, performance-based equity and deferred compensation will no longer be deductible.

Previously, a covered employee was an employee who, on the last day of the company’s fiscal year, was the CEO and the highest four paid executive officers. The CFO was excluded due to a change in the SEC’s definition of an NEO in 2006. Under the Tax Reform, CFO’s will be considered a covered employee as SEC and Section 162(m) rules now align.

CAP Perspective on Incentive Plan Design: We do not expect wholesale changes to compensation arrangements for executives.

The table below highlights the potential impact on the three major elements of pay for executives.

Pay Element

Impact on Plan Design

Salary

  • We do not expect significant changes to base salaries
  • We may see some companies who have historically capped salary at $1 million slowly exceed it
  • Driving force in setting base salaries is market competitiveness and not tax deductibility
  • Expect to continue to see base salary represent 15-20% of the total pay mix for executives

Annual Incentive

  • We expect companies to maintain the performance-based design of annual incentive plans, and many to keep current design features (i.e., goal attainment plans, threshold, target and maximum payout opportunities)
  • Investors and proxy advisory firms endorse transparent and performance-based plans and therefore we do not expect these types of plans to go away
  • Companies will now have more flexibility in simplifying incentive plan design and administration
    • Ability to use either negative or positive discretion on final bonus payouts; previously only negative discretion was permitted under the old tax code
    • Ability to adjust performance goals for any unforeseen circumstance that impacts the financial results; any adjustment to a performance goal will not need to be objective and stipulated in advance
    • However, companies will still need compelling rationale for use of discretion or adjustments to address shareholder expectations
  • Individual performance metrics and other more qualitative metrics may increase in prevalence as measures no longer need to be ‘objective’
  • Expect to continue to see annual incentives represent 25-30% of the total pay mix for executives

Long-Term Incentive (LTI)

  • While the elimination of the performance-based exception removes a tax incentive to grant stock options, we expect that companies that currently use stock options will continue to do, as they attract, motivate and retain talent
    • We expect any shifts away from stock options due to lost tax deductibility to be very modest
  • We expect performance-based LTI to continue to represent at least 50% of the total LTI mix
    • Performance-based compensation will still be an important tool in supporting business objectives
    • Proxy advisory firms and institutional investors alike still expect to see companies align pay and performance, with performance-based LTI representing the largest piece of the pie at >50%
    • Similar to annual incentives, we may see modestly more discretion and adjustments with accompanying rationale
  • We may see some companies adopting longer vesting schedules to spread out the income realized to maximize tax deductibility
  • Restricted stock often reflects a smaller piece of the LTI pie for the most senior executives as they are viewed as less performance based; we do not expect that to change
  • Expect to continue to see LTI represent the largest piece of the total pay mix at 60-65% of the total pay mix for executives

CAP Perspective on Administrative Requirements: Going forward, companies no longer need to follow certain administrative requirements around incentive plans and may need to revisit severance payment timing as certain practices were adopted based on the old tax code.

Additionally, once an executive is a covered employee, they will always be considered a covered employee, even if they appear in the proxy for just one year. Thus, compensation of covered employees for all future years of employment will be impacted, potentially creating an ever-growing group of covered employees subject to the $1 million cap.

The table below highlights the potential impact on these three key areas.

Administrative Requirements

Impact on Plan Design

Incentive Plans

  • Stockholder re-approval of incentive plans every 5 years are no longer necessary
  • Approval is only necessary when there is a need to increase shares available, the plan term is set to expire or if there are changes in the plan document
    • Companies will likely be adopting new plans, rather than amending existing plans to minimize the risk of losing the grandfather status which is further explained later in this article
  • Tax Reform removes the following:
    • Requirement for shareholders to approve performance metrics and adjustments of performance goals
      • Companies will be able to use any performance metrics and will not be limited to the shareholder-approved performance goals and adjustments
    • Requirement to set goals within the first 90 days of a performance period
      • We do not expect this to change given this is a formality for most companies though it gives committees and management more flexibility if needed
    • Shareholder approval of individual award limits (other than incentive stock options); however, shareholders may view the elimination of these limits negatively

Severance Payments

  • Previously, payments to executives leaving the company were fully tax deductible, as it only applied to NEOs who were employed on the last day of the taxable year in which the deduction was being claimed
  • Under Tax Reform, severance payments, including distribution of deferred compensation are subject to the deduction limitation
  • Bonuses or performance-based LTI can now be paid out at target in the year of termination without a different tax consequence; prior to Tax Reform, a company could only claim a tax deduction if the payout was based on actual performance

List of Covered Employees

  • The list of covered employees can now grow and may have tax implications of compensation and severance arrangements from an expanded group that will increase over time
  • To the extent possible, companies should try to have a consistent or narrow group of NEOs
  • Companies will want to be careful about unintentionally moving an executive into the proxy for a one year due to one-time payments
    • If possible, companies should structure those one-time payments in a way that would not cause an individual who would not typically be one of the three highest compensated executive officers to become an NEO for just one year
    • Companies need to maintain an ongoing list of all “covered employees” and monitor the compensation arrangements that apply to such individuals

Change: Tax Reform included some transition relief. The elimination of the performance-based exception applies to taxable years beginning after December 31, 2017. However, the changes do not apply to compensation provided pursuant to a written binding contract in effect as of November 2, 2017, and are not “modified in any material respect” as of November 2, 2017.

CAP Perspective: Under the “transition rule,” deductibility is preserved for compensation provided under a written binding contract in effect as of November 2, 2017, as long as there is not a subsequent material modification. At this time, it is not clear how the transition rule will be interpreted and implemented. While we await further clarification, companies will have to evaluate if they plan to claim a tax deduction under the transition rule based on the limited guidance provided to date, and the specific facts related to the grants / award agreements. During this waiting period, companies should carefully consider any changes to existing arrangements, including outstanding long-term incentive grants, as they could disqualify those arrangements from being grandfathered under the transition rule.

Change: Prior to Tax Reform, under Section 162(m) the definition for “outside directors” was different than the stock exchange rules of “independent directors.” The difference is that a former officer could never be considered an outside director but can be independent.

CAP Perspective: The Compensation Committee can now include independent directors who are not “outside directors”. We are not seeing companies make changes at this time, as they still need to approve (outstanding) payouts that are grandfathered under annual incentive or performance-based plans. However, we still expect the Compensation Committee to be comprised of “outside directors” given the independence factors. Companies may want to amend Compensation Committee charters to remove any references to Section 162(m) outside director or procedural requirements.

Planning for 2018 and Beyond

Beginning in 2018 companies will lose the tax deduction on compensation over $1 million for covered employees; however, the reduced corporate tax rate will provide an offset to the lost deduction. As companies evaluate the effect of the lost tax deduction and full impact of Tax Reform on their compensation programs, we would recommend companies to work with outside advisors to determine the impact the changes will have their compensation program design, particularly grandfathered performance-based compensation arrangements.

Companies should await further guidance from the IRS, proxy advisory firms and stock exchanges before making substantial changes to their compensation programs. Any change should ensure the appropriate behaviors and results are being rewarded, performance targets are reflective of the long-term strategy, and incentive plan design supports current business needs, while considering good governance practices.

Compensation Advisory Partners (CAP) reviewed executive compensation pay levels and trends at 50 companies (Early Filers) that filed their most recent proxy statement between November 2017 and January 2018 (fiscal year ends from July 2017 to October 2017; 35 companies have September 30 fiscal year ends). Industry sectors reviewed include: Consumer Discretionary, Consumer Staples, Financials, Health Care, Industrials, Information Technology and Materials. Among these 50 companies, median Revenue was $7.5B, median Market Capitalization (based on each company’s fiscal year-end) was $13.0B and 1-year Total Shareholder Return, or TSR (based on each company’s fiscal year-end) was 19.3%.

Overall Findings

Performance: 2017 performance (based on Revenue growth, EBIT growth, EPS growth and 1-year TSR) was strong. Revenue and EBIT grew by approximately 6%, EPS was up 4% and TSR was up nearly 20% vs. prior year.

CEO Pay: Median CEO pay increased slightly by 3.3% mainly driven by actual annual incentive payouts. The grant date value of long-term incentives (LTI) was generally flat.

Annual Incentive Payout: Overall, the median 2017 annual incentive payout was 115% of target, reflective of strong financial performance.

2017 Performance

CAP reviewed Revenue growth, EBIT growth, EPS growth and TSR performance for the Early Filer and the S&P 500 companies. Overall, 2017 median performance for Early Filers was strong. Revenue and EBIT grew approximately 6%, EPS grew around 4% and TSR was up nearly 20%. TSR among the Early Filers showed double-digit growth for the second year in a row; this growth is due to strong financial performance as well as market expectations around tax reform in light of the current political climate.

Financial Metric (1) 2016 Median 1-year Performance 2017 Median 1-year Performance
S&P 500 Early Filers S&P 500 Early Filers
Revenue Growth 2.1% 2.0% 6.3% 5.7%
EBIT Growth 2.2% 7.6% 6.6% 6.0%
EPS Growth 4.2% 5.2% 9.9% 3.9%
TSR 3.3% 18.4% 17.0% 19.3%

(1) TSR and Financial performance for the S&P 500 is as of September 30, 2016 and September 30, 2017. Financial performance and TSR for Early Filers is as of each company’s fiscal year end.

CEO Total Direct Compensation

Among Early Filers with CEOs in their role for at least two years (n=39), median total direct compensation increased 3.3%. This increase was mainly due to higher actual annual incentive payouts in 2017; the grant-date value of LTI was generally flat year over year. Actual annual incentive payout was up nearly 4% reflective of strong financial performance while LTI, the largest component of CEO pay, was up only 1%. Median base salary for CEOs in our sample was unchanged from 2016.

3.3% 0.6% 6.2% 3.8% 0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 1-Year Median Change in CEO Compensation Actual Annual Incentive Actual Total Cash Grant-Date LTI Value Total Comp

Annual Incentive Plan Payout

The median actual annual incentive payout in 2017 was 115% of target, higher than the median payout in 2016 of 106% of target. In fact, the 25th percentile bonus payout in 2017 was at target, noticeably higher than last year (86% of target).

Summary Statistics Annual Incentive Payout as a % of Target
2015 2016 2017
75th Percentile 134% 141% 147%
Median 106% 106% 115%
25th Percentile 97% 86% 100%

Performance for companies with at or above target annual incentive payouts was substantially stronger than that of companies with below target payouts. Companies with payouts at or above target had strong EPS (10.9%) and TSR (23.2%) growth and solid Revenue (6.3%) and EBIT (7.2%) growth. Performance for companies with below target payouts was flat or declining from prior year.

Financial Metric (1) 2016 Median 1-year Performance 2017 Median 1-year Performance
Below target payout (n=21) At/above target payout (n=29) Below target payout (n=12) At/above target payout (n=38)
Revenue Growth (0.7%) 3.0% 2.1% 6.3%
EBIT Growth (2.8%) 15.9% 1.0% 7.2%
EPS Growth (3.9%) 16.9% (4.3%) 10.9%
TSR 16.9% 19.6% (3.9%) 23.2%

(1) Financial performance and TSR is as of each company’s fiscal year end.

76% of companies in 2017 provided a payout at or above target which is considerably higher than 2016 and 2015 (58% and 62%, respectively). In 2017, significantly more companies provided a payout between 100 – 150% of target than below target. This distribution is more evenly split in prior years. The distribution of payouts in 2017 aligns with stronger overall performance than 2016 and 2015.

8% 10% 8% 30% 32% 16% 42% 38% 54% 20% 20% 22% 2015 2016 2017 Annual Incentive Payout as a Percentage of Target < 50% 50% - 100% 100% - 150% > 150%

Incentive Plan Design

Among Early Filers, 75% of companies use 2 – 3 financial metrics in the annual incentive plan and nearly 83% use 1 – 2 measures in the LTI plan.  Metrics in the annual incentive plan typically focus on growth and profitability, while LTI plans are more likely to reward executives based on profits, return measures or stock price performance. A growing number of companies are beginning to use non-financial strategic goals, primarily diversity and inclusion and creating a more engaged workforce, in the annual incentive plan design. With the recent amendment to 162(m) due to the Tax Cuts and Jobs Act, we anticipate more companies will use strategic measures and individual objectives to reward executives in the future.

As performance-based compensation continues to be championed by both shareholders and proxy advisory firms, the use of performance-based LTI continues to be very prevalent. Performance plan usage remains high, at 90% of Early Filers. Option use declined among the Early Filers (54% down from 62%) and shifted to use of restricted stock.

86% 66% 62% 54% 30% 16% 90% 76% 54% 52% 34% 14% Perf Awards Time-basedRS/RSU Stock Options 2 Vehicles 3 Vehicles 1 Vehicle LTI Prevalence 2016 2017 Vehicle Prevalence Vehicle Mix

TSR continues to be the most prevalent LTI metric, with approximately 60% of companies using a performance-based plan with this metric. Of the companies that use TSR, 25% use it as a modifier, 50% use it as a stand-alone metric in conjunction with a financial measure and 25% use it as the sole measure. The prevalence of TSR as the sole measure has decreased somewhat over the last several years as companies use a balanced approach to reward executives for long-term financial and stock price results. We anticipate its usage as a sole measure to plateau or continue to decline particularly given ISS’ recent shift towards the use of other financial measures in its quantitative pay for performance assessment (ISS and Glass Lewis Policy for the 2018 Proxy Season).

Governance Practices

Over the last decade, many companies adopted good governance practices. Increased scrutiny from shareholders and proxy advisory firms has quickened the pace with which companies incorporated clawback, or recoupment, policies as well as hedging and pledging policies. It is no surprise that more than 90% of companies in our sample have a clawback policy in place. 85% of companies also have implemented hedging and pledging policies for their executives.

Nearly all companies (96%) in our sample have stock ownership guidelines in place; these guidelines encourage executives to hold a meaningful equity stake and align with shareholder interests. The guideline is most commonly expressed as a multiple of salary, with a median CEO multiple of 5x base salary and other NEOs with a multiple of 3x base salary. About one-third of companies also require executives to hold stock (typically 50 – 100% of net shares received) until stock ownership guidelines are met. It is less common for companies to require executives to hold shares for a period of time (e.g., 1 year) in lieu of stock ownership guidelines. Good governance practices continue to be a focus of shareholders, and companies are routinely implementing and updating policies as appropriate in the current regulatory environment.

Conclusion

2017 was a year of strong financial performance for the Early Filers, which resulted in above target annual incentive payouts for approximately 75% of companies. CEO actual total cash compensation increased by 6%, and when combined with generally flat LTI award values, total pay increased by 3%.

2018 will be the first performance year after the passage of tax reform. We do not expect companies to unwind their use of performance-based pay and good governance practices, yet we foresee greater use of individual and strategic performance measures, along with increased use of discretionary pay decisions, in moderation.


For questions or more information, please contact:

Lauren Peek Principal
[email protected] 212-921-9374

Joanna Czyzewski Associate
[email protected] 646-486-9746

Melissa Burek Partner
[email protected] 212-921-9354