Opportunities and Challenges for Compensation Committees

January 16, 2019

2019 presents both an opportunity and a challenge to board compensation committees to consider rethinking their approach to performance-based executive compensation.

Since 1992, public company shareholders have been asked to vote every five years on the “material terms of the performance goal under which compensation is to be paid” to the company’s top executives in order to preserve corporate tax deductions under Section 162(m) of the Internal Revenue Code. Under Section 162(m), the “performance goal” included the business criteria on which the goal was based and the maximum amount of compensation that could be paid to an executive if the goal was attained. In addition, the compensation could be paid solely on the basis of the attainment of pre-established, objective performance goals with no exercise of positive discretion by the compensation committee. These requirements for “qualified performance-based compensation” tied in nicely with, and helped to frame, the increased focus over the last 25 years on executive compensation generally, and “pay for performance” specifically, by shareholders, proxy advisory firms and the SEC.

The removal of the “qualified performance-based compensation” exception in 2018 from the compensation deduction limits of Section 162(m) knocked out the statutory parameters within which public companies have historically structured their incentive compensation programs and largely eliminated the need for shareholder approval of the plan parameters set by companies (other than approval of the overall number of shares to be issued pursuant to equity plans pursuant to stock exchange listing conditions).

This tax law change frees compensation committees from strict reliance on objective criteria with pre-established goals in the design and implementation of their executive incentive compensation. Subjective performance measures may be employed more widely and greater discretion may be exercised in translating performance results into compensation decisions, all without the threat of negative tax consequences. However, freedom means choice. One initial decision, especially if a company is bringing a plan to shareholders for approval in 2019, is whether to discard all Section 162(m)-related provisions from incentive compensation plans as no longer applicable or leave certain of them in place.

Predictably, shareholders have expressed their own views about performance-based compensation, notwithstanding the tax law change. As expressed by ISS in its recently updated U.S. Equity Compensation Plan FAQs (the “FAQs”), “Section 162(m)’s requirements for qualifying performance-based compensation included items that are recognized by investors as good or best practices. If a plan contains provisions representing good governance practices, even if no longer required under the revised [Section 162(m)], their removal may be viewed as a negative change in a plan amendment evaluation. For example, the removal of individual award limits would be viewed as a negative change.” In addition to ISS’ possible reaction, large institutional shareholders who are accustomed to voting independently of ISS’ recommendations on plan features such as individual award limits could also react negatively to their removal without shareholder approval.

The concept of compensation committees using discretion in compensation decisions, unfettered by Section 162(m) concerns, also troubles ISS as stated in its recently updated FAQs: “While the tax deduction for performance pay afforded under 162(m) provided an added benefit, it was seldom a primary reason behind investors’ expectation for performance-based programs. Shifts away from performance-based compensation to discretionary or fixed pay elements will be viewed negatively.” Interestingly, in the same FAQs, ISS also added the following statement, which suggests that the tax law change may result in some softening of the mandate on compensation committees to stick strictly to objective, formulaic approaches: “While recognizing that investors prefer emphasis on objective and transparent metrics, ISS does not endorse or prefer the use of TSR or any specific metric in executive incentive programs. ISS believes that the board and compensation committee are generally best qualified to determine the incentive plan metrics that will encourage executive decision-making that promotes long-term shareholder value creation.”

When deciding whether to continue adhering to incentive plan structures driven primarily by objective GAAP/non-GAAP measures or to take advantage of the potential for increased flexibility, compensation committees should also consider other trends in the corporate governance realm. Interest in corporate sustainability, especially the impacts of companies on, and the impacts on companies of, ESG issues has steadily been increasing over recent years. Groups such as the Global Reporting Initiative, the Task Force on Climate-related Financial Disclosures and the Sustainability Accounting Standards Board (“SASB”) have promulgated standards and recommendations for company disclosure of ESG risks and sustainability policies and practices. Many companies now routinely post sustainability reports on their websites.

2018 was a big year for the sustainability movement. Early in 2018, ISS unveiled its E&S QualityScore representing its measurement of the quality of corporate disclosures on environmental and social issues, including sustainability governance. In late 2018, Glass Lewis stated that it would begin to integrate guidance on material ESG topics from SASB’s recently published standards into its research and voting reports. Shareholder proposals relating to social and environmental issues were the topic of approximately 43% of all shareholder proposals submitted in 2018.

While the idea of including ESG metrics in executive compensation plans has been around for years (and adopted around the edges by some companies), given the current climate, compensation committees that have not begun to contemplate the use of sustainability metrics in executive compensation may wish to start. Of the approximately 55 shareholder proposals on executive compensation in the Russell 3000 in 2018, 20 requested companies to include social or environmental performance metrics in their executive compensation plans. Recently, Royal Dutch Shell and certain of its institutional investors released a joint statement regarding the company’s long-term goal of reducing its carbon footprint, including a plan to incorporate carbon emissions measures tied to that goal into the company’s executive compensation program.

SASB uses the term “sustainability” to refer to “corporate activities that maintain or enhance the ability of the company to create value over the long term. Sustainability accounting reflects the governance and management of a company’s environmental and social impacts arising from production of goods and services, as well as its governance and management of the environmental and social capitals necessary to create long-term value.”  Performance-based compensation designed to incentivize the creation of long-term value is the cornerstone of every company’s executive compensation program. Although the use of sustainability metrics in executive compensation will present challenges, any compensation committee contemplating its historical incentive compensation framework should consider the inclusion of pertinent ESG measures.