Over a year after the “performance-based compensation” exception to Section 162(m) of the IRS Code was eliminated as part of the Tax Cuts and Jobs Act of 2017, relatively few companies have made significant changes to their pay programs to take advantage of its repeal. In part, it’s because of a short time frame for making changes and a desire to preserve the deductibility of grandfathered awards. Companies also are standing pat because they are uncertain how shareholders would react even if they recrafted their programs to preserve most performance-based design elements. However, with the recently issued frequently asked questions (FAQs) from Institutional Shareholder Services (ISS), there’s a bit more clarity about changes that are acceptable and those that are cause for shareholder concern.
We consider how the 162(m) exception has led to long settled aspects of the pay-setting process and how this might change.
Shareholder approval and continued use of performance-based pay
The 162(m) shareholder approval process provided reasonable assurance to shareholders that at least some portion of executive pay would be performance-based. So there was concern use of non-performance-based compensation or fully discretionary programs could increase. But, overall, companies haven’t materially changed their senior executive pay programs. The influence of say-on-pay and greater shareholder engagement on compensation matters run counter to the notion that companies will dial back performance-based pay. In fact, ISS explicitly notes that it considers shifts away from performance-based compensation to discretionary or fixed-pay elements to be a problematic pay practice including “changes made in light of the removal of 162(m) deductions.”
Shifting away from performance-based compensation won’t necessarily result in an automatic negative say-on-pay vote recommendation, however companies would be well-advised to make it clear to outside observers that they intend to continue with performance-based plans. This position also tempers the notion that companies can move away from existing “negative discretion” designs to those that permit upward discretion, without raising concerns.
Fortunately, ISS provides more details on the 162(m) question in its U.S. Equity Compensation Plans Frequently Asked Questions Updated December 19, 2018. Although references to 162(m) can be removed, ISS notes that it “included items that are recognized by investors as good or best practices” and that “their removal may be viewed as a negative change in a plan amendment evaluation.” ISS goes further, and cites the removal of individual award limits within the plan document as an example of a negative change.
In our experience, most companies are maintaining or creating individual limits for non-employee directors when they seek new share authorizations. However, practices are mixed for maintaining individual limits for employees. An ISS analysis found that at least 7% of these proposals sought to remove certain 162 (m) plan provisions, including (i) reference to the exception for qualified performance-based compensation, (ii) individual grant limits, and (iii) references to performance cash awards.
We agree that many of the requirements under 162(m) represent good governance practices, and in our experience, many companies have continued with their long established practices in 2018 and early 2019. In particular, we encourage companies to:
- Continue to establish maximum amounts/shares payable to covered employees (per the plan document)
- Agree upon extraordinary items and rules around financial metrics exclusions at the beginning of period (not decided after the fact at year-end)
- Preestablish performance goals (i.e., within the first 90 days after the beginning of the performance period)
- Ensure performance goal outcomes are substantially uncertain when adopted
- Limit the use of “upward” discretion outside of individual performance goals (which should generally be measurable and objective)
The need for expanded disclosure may be diminished by retaining these provisions in the shareholder approved plan document. However, if the plan is stripped of most 162(m) related provisions, as we’ve seen when companies are seeking approval of new equity plans, companies must decide how to reassure shareholders their existing approach will be maintained.
Proxy disclosure of 162(m)-related issues
A company that maintains its existing approach to paying performance-based compensation should disclose this in the Compensation Discussion and Analysis (CD&A), perhaps within the executive summary where it would have the most prominence. We also believe it’s appropriate to detail the approach in the CD&A’s stand-alone section that discusses “the impact of accounting and tax treatments of a particular form of compensation,” where companies have traditionally referenced the potential application of the performance-based exception to 162(m). Companies need to craft disclosures with great care and remain sensitive to the risk of shareholder litigation when they are inadequate or don’t reflect the organization’s actual process.
Companies must also decide whether they’ll continue to use “negative discretion,” and how the plan is disclosed in the proxy with the overarching consideration being whether this would alter the Summary Compensation Table (SCT) disclosure.
SEC staff guidance in Compensation and Disclosure Interpretations 119.02 permits 162(m) compliant plan payouts using negative discretion to be disclosed in the Non-Equity Plan Compensation (NEPC) column. If positive discretion is applied instead, this would cause more compensation to be shown in the SCT’s Bonus column due to discretionary adjustments. It’s unclear whether suddenly moving disclosed values to the Bonus column will increase scrutiny from proxy advisors and shareholders, but if this approach is taken we strongly suggest that a clear description of the reasoning appears prominently in the proxy. And such action might require more detailed disclosure of actual performance thresholds, targets and maximums in the Grants of Plan Based Awards (GOPBA) table as we discussed in “162(m) changes will affect your proxy disclosure, but not in the manner some suggest”, Executive Pay Matters, December 21, 2017.
Frequency of share requests
Some companies include the 162(m) compliant plan provisions in an Omnibus Plan that includes their request for new share authorizations, and others have a stand-alone plan approved separately for 162(m) approval purposes. ISS found that equity plan proposals decreased by 40% in 2018, and only about 2% of them were submitted solely for the purposes of 162(m) reapproval, down from 13% in 2017. It isn’t clear that companies that needed the five-year approval simply decided it was no longer necessary, or if they were waiting to see how shareholders viewed the process.
As it relates to share requests, the ISS Equity FAQs disclosed an increase in the weighting of the plan duration factor of the Equity Plan Scorecard (EPSC) in light of 162(m) changes “to encourage plan resubmission to shareholders more often than listing exchanges require.” So far, this change has marginally impacted the EPSC score, possibly because institutional investors already preferred more regular requests.
Frequent requests (time/effort, and increased monetary expenses of printing and professional fees) also have their downsides, and some companies actually make larger share requests than ISS would otherwise support (and still generally obtain shareholder approval).
So, how often should companies resubmit their shareholder-approved plans? We would suggest that requesting shareholder approval every three to five years will continue to represent best practice, and will largely remain the norm, even with the changes to 162(m) and the ISS model.
There is much for companies to think about as they approach the new 162(m) world, particularly as we have not seen large institutional shareholders make any specific policy changes to their published proxy voting policies.
Based on our experience and past practice, we think it is unlikely that proxy advisors will use 162(m) related changes when issuing voting recommendations on new equity requests. What’s more likely is that proxy advisors will express the views as part of the say-on-pay analysis, particularly when there is a pay-for-performance disconnect or poor responsiveness to shareholder feedback. While proxy advisors have expressed their initial views, it remains to be seen how they will actually apply their thinking on the topic as they prepare vote recommendations this spring, and how shareholders will ultimately vote.
Ryan Beger is a director in the Executive Compensation practice, located in Willis Towers Watson’s Chicago office. Steve Seelig is a senior director in Willis Towers Watson’s Research and Innovation Center, based in Arlington. Email email@example.com, firstname.lastname@example.org, or email@example.com.