On June 23, 2021, SEC Chairman Gary Gensler provided commentary on the “2021 Unified Agenda of Regulatory and Deregulatory Actions”. The Agenda includes a list of short- and long-term regulatory actions that the SEC plans on addressing, covering nearly 50 items. In his statements, Chair Gensler focused on three of these items: public company disclosure, market structure and transparency initiatives. Given Chair Gensler’s commentary, public company disclosure will be at the forefront of this Agenda, and CAP expects the SEC to accelerate its rulemaking process with new proposals issued shortly.

As explained by Chair Gensler, the purpose of this Agenda is “to meet our mission of protecting investors, maintaining fair, orderly, and efficient markets, and facilitating capital formation, the SEC has a lot of regulatory work ahead of us… I look forward collaborating with my fellow commissioners and the dedicated staff to propose and finalize rules that will strengthen our markets, increase transparency, and safeguard investors.”

Below, CAP has summarized the items related to public company disclosure items and executive compensation as discussed by Chair Gensler or included in the Agenda.

Short-Term Agenda Items: Public Disclosure

Environmental, Social and Governance (ESG) Disclosure: Based on Mr. Gensler’s comments, and notable rulemaking areas identified by the SEC, new ESG disclosure rules are now a priority. He noted that the SEC has received more than 400 letters from investors on the subject, indicating a clear sentiment for increased disclosures. The following ESG topics are expected to have enhanced disclosure rules:

  • Climate Change – Chair Gensler asked SEC staff for recommendations on governance, strategy, and risk management related to climate risk. His staff will also be considering specific metrics, namely greenhouse gas emissions, in an effort to see what is most important to investors. The commission is also considering requirements to achieve climate-related specific targets for (i) companies that have made forward-looking climate commitments; or (ii) companies with significant operations in jurisdictions with national requirements.
  • Human Capital – Chair Gensler mentioned investors have requested a better understanding of company demographics, and as such could propose recommendations that could include specific metrics, including (i) workforce turnover; (ii) skills and development training; (iii) compensation; (iv) benefits; (v) workforce diversity; and (vi) health and safety.
  • Board Diversity – The Agenda includes enhanced disclosures on the diversity of board members and potential nominees.
  • Cybersecurity – Chair Gensler commented on the always changing technological landscape and its relationship with finance through the development of mobile brokerage apps, robo-advising and artificial intelligence. Given the heightened focus on this technology in 2021, due to notable incidents, the Agenda requires disclosures about cybersecurity risk governance.

Proxy Guidelines: The SEC is expected to address or amend current proxy rules and potential changes within the following areas: (i) amendments to regulations on proxy voting advice; (ii) allowing shareholder voting altogether by a “universal” proxy card for a contested director election; and (iii) reassessing amendments to shareholder proposals passed in October 2020 which addressed shareholder proposal eligibility, proposal limits per meeting, ownership thresholds, and proponent engagement.

Executive Compensation: The SEC is expected to address or amend executive compensation guidelines within the following areas: (i) finalizing clawback rules initially proposed in 2015 requiring companies to disclose their policy and expand the use of clawbacks; (ii) requirements to disclose relationship between pay and performance (i.e., compensation paid and financial performance).

Insider Trading: The SEC is expected to address or amend insider trading guidelines within the following areas: (i) mandatory cooling-off periods and disclosure requirements pertaining to Rule 10b5-1, which allows insiders to set up a trading plan for selling stocks that they own, selling predetermined shares at a predetermined time; (ii) modernize and enhance transparency of share repurchase disclosures, including S-K filings or Item 703, which requires the tabular disclosure of share repurchases.

Long-Term Agenda Items

Other relevant items on the agenda with an outlook beyond just the next few months include: (i) possible amendments to improve distribution of proxy materials, shareholder vote processing, and communicating with shareholders (i.e., proxy plumbing issues); and (ii) possible amendments to Form S-8 filings and Rule 701 which exempts certain sales of securities made to compensate employees.

Other Notable Regulatory Agenda Items, as listed by the SEC

  • Market structure modernization within equity markets, treasury markets, and other fixed income markets
  • Transparency around stock buybacks, short sale disclosure, securities-based swaps ownership, and the
    stock loan market
  • Investment fund rules, including money market funds, private funds, and ESG funds
  • 10b5-1 affirmative defense provisions
  • Unfinished work directed by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010
  • Enhancing shareholder democracy
  • Special purpose acquisition companies
  • Mandated electronic filings and transfer agents

2021 proxy statements will be impacted – in many ways – by the COVID-19 pandemic. This includes SEC-required CEO pay ratio disclosure.

Companies should now be thinking about – and most will soon begin to work on – their 2021 proxy statements. Such disclosure this year will be impacted in many ways by the COVID-19 pandemic. This includes SEC-required CEO pay ratio disclosure, which compares the compensation of the CEO to that of the median employee.

2021 CEO Pay Ratio Disclosure

Selected practical considerations for 2021 proxy statements related to CEO pay ratio disclosure are outlined below.

  1. New Median Employee. For most companies, 2021 proxies will be the fourth year of required CEO pay ratio disclosure. Given this, companies that have been using the same median employee for three consecutive fiscal years will have to determine a new median employee for 2021 proxy disclosure.

    Companies can use the same median employee for three consecutive fiscal years, assuming no changes to employee population and/or compensation arrangements that would be reasonably believed to significantly affect CEO pay ratio disclosure. Many companies experienced material disruption to their employee populations during the last year, and many companies made changes to their compensation arrangements during the last year. Given this, companies may have additional reason to re-calculate the median employee for 2021 proxy-based CEO pay ratio disclosure.

  2. Furloughed Employees. Many companies furloughed employees during 2020, and this needs to be considered when determining the CEO pay ratio for purposes of required 2021 proxy statement disclosure.

    The SEC has directed companies to “determine whether furloughed workers should be included as employees based on the facts and circumstances.” To-date, CAP has worked through this issue with several companies with non-calendar fiscal year ends. Several issues need to be considered, such as the timing and duration of the employment actions.

  3. Consistently Applied Compensation Measure (“CACM”). For 2021 proxy disclosures, we expect the approach companies use for their CACM to be consistent with what has been used in the previous years.

    Among the S&P 500, approximately 43% of companies used base salary plus other cash and equity compensation for their CACM in 2020, which was the most prevalent approach.

  4. Determination Date. Many companies saw their employee population permanently or temporarily disrupted during 2020 due to the COVID-19 pandemic. Given this, companies should consider if selecting a determination date later in the fiscal year would likely lead to a less atypical result from the required CEO pay ratio calculation for 2020.

    CEO pay ratio disclosure rules dictate that companies may identify the median employee with an effective date any time within the final three months of the fiscal year. If a company decides to shift the determination date used for 2020, versus what was done in past years, the company must include a rationale for the change in the 2021 disclosure.

  5. Supplemental Ratios. 2020 is likely to be viewed by many companies as having “one-time” events. As a result, there may be a significant increase in the prevalence of supplemental CEO pay ratio disclosures in 2021 proxies to reinforce that year-over-year change in the CEO pay ratio (up or down) should not be viewed as an ongoing expectation.

    Disclosing supplemental CEO pay ratios is allowed under SEC rules, as long as the prescribed CEO pay ratio is clearly disclosed as such. While disclosure of supplemental CEO pay ratios has been limited (approximately 12% of S&P 500 companies), when provided, supplemental CEO pay ratios are typically disclosed to explain a one-time event (e.g., CEO transition) that materially increased or decreased the ratio versus the prior year.

  6. Narrative Disclosure. For the most part, we do not expect that companies will significantly expand their disclosures around median employee or workforce demographics in 2021 proxy statements, as it relates to CEO pay ratio disclosure. This is despite requests from certain large institutional investors and the New York State Comptroller.

    Any changes to CEO pay ratio narrative disclosure in 2021 proxies will likely be modest and focus on year-over-year comparability, and, where appropriate, use of a different median employee. It remains minority practice to include any description of the median employee as part of CEO pay ratio proxy disclosure. When descriptive information for median employee is included, companies most often disclose the geographic location, employment type and/or role of the median employee.

    When additional narrative disclosure is used, it will be important to not lose sight of what was disclosed in the newly required Human Capital Management section of the 10-K, to ensure consistent messaging around the employee workforce.

  7. Comparability. Since inception, comparing CEO pay ratios across companies has been of limited usefulness. For example, beyond variability across industries, when looking at two competitors, the workforce of one may be largely U.S.-based while the workforce of the other may be mostly located in lower cost countries. Inconsistent disruptions in business and workforces in 2020 due to the historic COVID-19 pandemic, that may significantly impact the numerator and/or denominator of the CEO pay ratio calculation, has only reinforced the inherent issues with comparing CEO pay ratios across companies.

Year-over-year comparability of CEO pay ratios may also be difficult in 2021. For example, CEO salaries could have been temporarily reduced in 2020 and bonuses may pay out substantially lower than a typical year. In other instances, front line workers may have received additional pay, in the form of one-time bonuses, additional overtime and/or enhanced benefits.

Looking Ahead

While new considerations need to be addressed for 2020 CEO pay ratio calculations, we expect 2021 CEO pay ratio disclosures to remain primarily compliance-focused, in most cases with limited to no supplemental information. There will also continue to be pressure from outside stakeholders for greater disclosure around median employee information and related workforce demographics, though such workforce demographic information will most often be addressed and disclosed in other areas of the proxy statement and/or 10-K.

Additional CEO Pay Ratio Resources – Compensation Advisory Partners

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).