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Top 10 questions forcompensationcommittees in 2019.
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With over a year to digest and implementchanges made by the December 2017 taxlegislation, compensation committees are facedwith three important questions arising from theelimination of the performance-based exceptionto the $1 million cap on deductible compensationfor certain executives. Further, questions that areexpected to receive even more attention in 2019include gender diversity and gender pay equity,the expanded scope of compensationcommittees, and the role of environmental, socialand governance features in incentive awards andother decisions. Director pay litigation continuesto be a concern for compensation committeeswhile CEO evaluation is increasingly critical intoday’s complex business climate. Finally, we seea further questioning of the rigor of annualperformance targets and indications that the SECsees the proper disclosure of perquisites as anenforcement priority.
1. What are the potential impacts of, and theplanning for, the expanded definition of"covered employee” under IRC section 162(m)as amended by the 2017 Tax Cuts and Jobs Act?
An important change made by the 2017 Tax Cutsand Job Act (Act) was an expansion of thedefinition of a “covered employee” – i.e., anemployee for whom the company’s annualdeductible compensation is capped at $1 million.Here it is important to understand that the taxrules under IRC section 162(m) defining a“covered employee” differ somewhat from theSEC disclosure rules on identifying “namedexecutive officers” (NEOs) for proxy statementdisclosure purposes. In any case, there are four
important components of the revised coveredemployee definition:
first, a CFO is now a covered employee (finallycorrecting a technical glitch in the tax law);
second, an individual is a covered employee ifhe/she was the CEO or CFO at any time duringthe taxable year (not limiting the definition toindividuals who were the CEO or the CFO onthe last day of the taxable year);
third, a covered employee includes any of thecompany’s three highest compensated officers(other than a CEO or CFO) whose totalcompensation is required to be disclosed in itsannual proxy statement; and
fourth, if an employee was a covered employeefor any taxable year beginning after 2016, he/she remains a covered employee throughouthis/her employment and even for paymentsafter cessation of employment.
A consequence of the new “once a coveredemployee, always a covered employee” rule isthat it can be increasingly important for acompany to pay more attention to which officerswill be NEOs and included in the proxystatement. At some firms there may only berelatively small differences in total compensationamong the top executive team, which couldresult in year-to-year changes in the compositionof the company’s three highest-paid officers(other than the CEO and CFO). In such instances,a company may want to avoid having executivescome in and out of the proxy because of itemssuch as one-time compensation awards that areunlikely to be repeated in the future. In fact, thecompensation committee may want to
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proactively manage compensation for NEOs toensure that it doesn’t trip over this new rule andunnecessarily add to the firm’s covered employeegroup.
If a company wishes to avoid creating one-timeNEOs (who nevertheless would be treated forthat year and all future years as coveredemployees), its compensation committee willneed to be thoughtful regarding decisions onvarious one-time (or infrequent) compensationitems, including: retention grants consisting ofupfront equity awards, special bonuses,relocation expenses, and unusual changes inpension accruals. For retention incentives, thecommittee may want to take into account thetiming of these awards and potentially split anaward between two fiscal years.
In some situations, consideration might even begiven to bumping-up the pay of an individualwho already has covered employee status andwho the firm ideally wants to position in thenumber five spot in the proxy, if that action wouldavoid another officer with similar totalcompensation becoming a covered employee. Ofcourse, any such pay changes should beconsistent with the employer’s overallcompensation strategy and the desired marketpositioning for these executives. However, giventhe potential loss of a tax deduction for all futurepayments in excess of $1 million per year to or onbehalf of a covered employee, this factordeserves consideration as an employer may seekto limit its group of covered employees subject tosuch deduction limitation.
2. What cautions and steps should beconsidered for preserving any availablegrandfathering of the performance-basedcompensation exception to the new strict $1million cap on the deductibility of a coveredemployee’s compensation?
If it hasn’t already done so, the compensationcommittee should make sure that it has a fullinventory of compensation plans, programs,agreements, and awards (collectively“arrangements”) that may have been impactedby the 2017 tax legislation. This is a necessaryfirst step in the process of determining whether,and to what extent, any such arrangements may
qualify for grandfathering under an exceptionfrom the $1 million cap on deductible annualcompensation for any covered employee.
Basically, the tax change included a limitedgrandfathering of arrangements that:
were in effect on November 2, 2017, and
are not modified in any material respect on orafter that date.
Accordingly, companies and their compensationcommittees should carefully consider anyproposed modification to an arrangement thatotherwise might be grandfathered. Thesearrangements include an organization’s existingshort- and long-term incentive programs,employment contracts, severance arrangementsand other compensation awards that were inplace on November 2, 2017. In determiningwhether any grandfathering might be available,the interim guidance provided last August by theIRS and Treasury in Notice 2018-68 should beexamined.
Many incentive and other arrangements includeda right for the compensation committee toexercise negative discretion in satisfying the now-repealed performance-based exception to the $1million deduction limit. Each such arrangementshould be examined to determine whether itallows for negative discretion by the committeein determining the amount to be paid. While it ishoped that forthcoming tax regulations may takea less restrictive position, under the Notice themere existence of negative discretion generallywould taint any otherwise availablegrandfathering unless the arrangement can bedetermined to be a binding written contractunder applicable (generally state) law. Thus, indetermining whether grandfathering is availableregarding any arrangement that contains anegative discretion feature, legal counsel mayneed to be consulted.
In any case, a key take-away is to make sure notto inadvertently lose any potential grandfatheringby making material changes before evaluating anarrangement’s qualification for, and thecommittee’s desire to utilize, the conditions of theexception.
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3. Are public companies rebalancing CEO paymixes and changing incentive plan metrics inview of the tax law changes (especiallyregarding IRC section 162(m))?
When Congress enacted the 2017 Tax Cuts andJobs Act (Act) that eliminated the “performance-based compensation” exception to the $1 milliondeduction limit of IRC section 162(m), there wasspeculation about whether many publiccompanies would rebalance their CEO’s pay mixand/or incentive plan metrics (short- and/or long-term) now that companies no longer were able toobtain an income tax deduction by satisfying aseries of tax law requirements. Following thischange, most companies took a “wait and see”approach to gauge competitive market trends,investor preferences and proxy advisory firmimplications.
In the year since the Act became law, we haveobserved two trends – companies are notdecreasing overall levels of CEO compensation to“makeup” for the loss of compensation-relatedtax deductions and there has a been only amodest change to CEO pay mixes and incentiveplan metrics. In reaching their decisions, we haveobserved a largely two-fold rationale:
first, compensation committees understandthat to attract, retain and motivate CEOs, theyneed to pay competitive market ratesindependent of the increased tax cost; and
second, investors overwhelmingly prefer a pay-for-performance approach to CEOcompensation. This includes emphasizing long-term compensation relative to other elementsof pay and incorporating incentive plan metricswhich are largely based on objectiveperformance measurement that are intendedto drive shareholder value creation.
One notable exception to these trends is Netflix,which is replacing its performance-based annualincentive (bonus) plan with higher base salariesfor its executive team. Also, InstitutionalShareholder Services recently addressed thisissue in its U.S. Compensation Policies FAQs,taking the position that any shift away fromperformance-based compensation todiscretionary or fixed pay elements will beviewed negatively.
That said, we have seen some companiesimplement targeted changes in light of the Act,but only when it makes sense in the context ofthe organization’s business, talent andcompensation strategies. One fairly commonpotential targeted change includes theintroduction of (or increased weighting of) non-financial incentive plan metrics such as operatingobjectives, strategic initiatives and individualperformance. However, these conversations tendto focus on the “business case” for change ratherthan being driven by the change in tax law (sinceany changes will ultimately need to be publicly-disclosed and supported by shareholders).
While there is a no “one-size fits all” approach todecision-making around a CEO’s pay program,compensation committees should balance theaforementioned factors along with other criticalinputs such as performance, retention andshareholder optics.
4. What further advancements are anticipatedregarding gender pay equity and genderdiversity?
Organizations and institutions continue to bescrutinized as both gender pay equity andgender diversity remain front-page news. Thisfocus is not isolated, but part of a continuingmovement towards establishing greatercompensation equality and gender diversity inthe work place.
Gender pay equity became a hot topic in 2018,with several states amending equal pay laws tosupplement the 1963 Equal Pay Act which wasintended to abolish wage disparity based on sex.Recent statutory activity has included theexpansion of state and local laws that prohibitemployers from asking applicants for salaryhistory. California, Connecticut, Delaware,Massachusetts, Oregon, Puerto Rico, Vermont,and a handful of cities and counties have enactedbans on salary history inquiries. Thesejurisdictions recognize that using prior salary as ameans of setting compensation can exacerbatehistorical inequities among the genders.
Boards of directors and company executives areheavily focused on promoting both equality anddiversity initiatives as institutional investors have
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incorporated board diversity and otherenvironmental, social and governance (ESG)issues into their proxy voting guidelines. Severalinstitutional investors have specifically pushedgender pay equity into the limelight by engagingcompanies and requesting that they disclosetheir gender pay statistics.
Institutional Shareholder Services (ISS) publishedupdated voting guidelines in November 2018which will be effective for meetings on or afterFebruary 1, 2019. While ISS addressed boarddiversity, it pushed its compliance deadline outanother year, stating “For companies in theRussell 3000 or S&P 1500 indices, effective formeetings on or after Feb. 1, 2020, generally voteagainst or withhold from the chair of thenominating committee (or other directors on acase-by-case basis) at companies when there areno women on the company's board.” Severalsources are cited for ISS’ rationale, includinginvestors’ desire for gender diverse boards, thepositive correlation found in some studiesbetween board gender diversity and companyperformance, and that gender diverse boards arenow the market norm.
Gender pay equity was covered in ISS’ 2018policy updates, including these considerations:
The company’s current policies and disclosurerelated to both its diversity and inclusionpolicies and practices, its compensationphilosophy and fair and equitablecompensation practices;
Whether the company has been the subject ofrecent controversy or litigation related togender pay gap issues; and
Whether the company’s reporting regardinggender pay gap policies or initiatives is laggingits peers.
We expect institutional shareholders andshareholder advocacy groups to continue toencourage organizations to voluntarily disclosestatistics on diversity and gender pay gaps. As aresult, companies should be able to assessgender pay gaps and understand how and whyany pay disparity has occurred.
5. How and why are the role and responsibilitiesof the compensation committee expanding?
Driven in large part by social movements andconcerns about the availability of futureemployee talent, the domain of the compensationcommittee is expanding at an accelerated pace.This enlarged role is changing compensationcommittee charters, meeting agendas and theprofile of future committee candidates.
Companies cannot avoid dealing with socialmovements such as #MeToo, gender pay equityand diversity. Employees, shareholders and thegeneral public expect companies to havepositions and policies to address thesemovements due to their potential impact onbusiness environments. At the same time, lowunemployment numbers and demographicforecasts have boards worried about current andfuture workforces and leaders.
These external forces are, in large part, causing aconvergence of pay strategy, leadershipdevelopment and succession planning inmeetings of the compensation committee. Whilecontinuing to address stakeholders’ pay levelsand design issues, compensation committees aresimultaneously pushing management on diversityefforts, retention of key talent, the developmentof future leaders and the ability to claw-backexcess incentive payments.
Many compensation committees are changingtheir titles and charters to reflect these increasedresponsibilities. In addition, this broadenedsphere of responsibilities is changing the profileof future compensation committee candidates,with human resources, public relations anddiversity experience all being highly sought.
6. What ESG factors may see an increased roleas metrics in incentive plans?
Environmental, social and governance (ESG)issues have received considerable attention in thepress over the last several years and continued tobe a focus of shareholder proposals during the2018 proxy season, as well as receiving backingfrom various institutional investors and evenactivists (e.g., a policy statement by TrianPartners). The proxy advisory firms have alsointroduced ESG factors into their reports with
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Glass Lewis utilizing information fromSustainalytics and ISS factoring ESG componentsinto its overall quality score. In addition, theelimination of the performance-based exceptionto the $1 million cap on the deductibility ofcompensation under IRC section 162(m) maycause some compensation committees toprovide more attention to non-financial factorssuch as the various activities covered by thebroad ESG categories.
With this enhanced focus on ESG issues, we areseeing a few companies move towards basing aportion of incentive pay on one or more ESGfactors. For example, Royal Dutch Shellannounced that it will be linking executive pay ofup to 1,200 senior employees to carbon emissionstargets. Just like other performance metrics, theinclusion of ESG factors in an executivecompensation program should not involve a “onesize fits all” approach. Not only are the ESGfactors impacting each industry often quitedifferently, compensation committees will need toevaluate whether the inclusion of one or moreESG factors is right for their company and whatimpact an executive’s actions may have onmeeting the ESG goal. Communication of theperformance goals and what is required of theexecutives also will be important, not only for theexecutives but also in company disclosures toensure transparency with investors.
Whether a compensation committee mightinclude an ESG component in an executive’sperformance goals can require evaluation ofseveral different factors and may include:
Do the ESG goals support the company’sbusiness strategy and are relevant to acompany’s success?
Will the ESG goals translate to financial resultsand how do they impact the company’sbottom line?
Will the ESG goals be measured based on theexecutive’s individual performance orcompany-wide success?
Can the ESG goals be measured – are therequantifiable metrics or are they subjective andrequire the board to provide for specificmilestones or accomplishments to measuresuccess?
Should the ESG goals be tied to short- or long-term incentives?
How much of the executive’s incentivecompensation will be linked to theachievement of the ESG goals?
Given the increased prominence that ESG factorshave gained in recent years, compensationcommittees may decide to at least considerwhether any ESG factors can or should beincorporated into executives’ incentivecompensation programs.
7. What actions might compensationcommittees take to protect against litigation onthe reasonableness of director pay?
Over the last several years an increasinglyimportant concern for boards has been litigationregarding the compensation of non-employeedirectors. Directors set their own compensation(most commonly through action of the board’scompensation committee) which can lead toclaims of self-dealing and unjust enrichment bydirectors resulting in excessive pay. Plaintiffs alsomay allege breaches of fiduciary duty and wasteof corporate assets. After some proceduralvictories by plaintiffs, it has become increasinglyclear that board members need to be concernedabout any pay they receive that notably exceedsmedian levels at their peer group (or even onedeveloped for use by plaintiffs’ counsel). Whilecourt decisions and reported settlements havebeen mixed, the resulting uncertainty has fueledconcern among directors.
In claims relating to director pay, boards (andespecially their compensation committeemembers) are “interested parties” in decisions ontheir own compensation; the result is that theotherwise applicable protection of the “businessjudgment rule” may not apply. Rather, directors’decisions on their own compensation typicallyare subject to the “entire fairness” test, whichconsiders the overall fairness of such paydecisions, and thus may be able to survive amotion to dismiss the case in its early stages. If aplaintiff’s lawsuit is allowed to go to trial, themonetary and other costs of litigation (includingextensive discovery) may become significant,prompting a settlement even when the defendant
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directors are likely to ultimately succeed on themerits.
In reaction to the first decisions that alloweddirector pay cases to proceed, boards and theiradvisors focused on imposing “meaningful limits”first on equity compensation and then on totaldirector pay. Of course, what limit might bemeaningful varied among companies and theiradvisors, but some cap on director compensationwas thought to be helpful to avoid beingtargeted in, or to obtain dismissal of, an excessivepay lawsuit. The imposition by boards oflimitations on director compensation became acommon recommendation.
While it initially appeared that a shareholder-approved plan with “meaningful limits” would besufficient to withstand attack from derivativeshareholder strike suits, in a decision thatsurprised many, the important Delaware SupremeCourt in the case of In Re Investors Bancorp, Inc.Stockholder Litigation (December 2017) basicallyheld that the business judgment rule would notprotect directors from claims regarding breachesof fiduciary duties for paying themselvesexcessive compensation where the directorsexercised discretion over their owncompensation. In such instances, the “entirefairness” test instead would apply, requiring afactual determination that the directors engagedin a prudent process in setting theircompensation and made reasonable decisions onsuch pay.
As a direct result of the Investors Bancorpdecision, the trend has been for boards to takefurther steps to prepare for any challenges totheir compensation under the entire fairness test.This starts with a review of the company’sexisting arrangements regarding director pay. Aboard might retain independent advisors formore frequent (preferably annual) director payengagements that examine the reasonableness ofequity awards and other components of directorpay. In these studies, a peer review of directorpay programs may be undertaken to show thatthe organization’s director compensation is in linewith its peers and not an outlier (on the highside). Enhanced disclosure in proxy statementson the process and rationale used in settingdirector compensation also should be helpful.
Some advisors are counselling the adoption of adirector compensation program that then isapproved by shareholders and provides a fixedvalue, perhaps with a process that includesconditions for automatic adjustments followingthe annual shareholder meeting. Anotherapproach involves shareholder approval of adirector pay program that uses annual peergroup benchmarking to set the components ofdirector pay at median levels among such peers,subject to a process for adjustments in certainpredetermined circumstances.
By now well-advised boards should understandthat plaintiffs’ attorneys will be scrutinizingdirector pay disclosures in companies’ proxystatements, looking for instances where claims ofexcessive compensation may be viable.Accordingly, at a minimum, boards shouldconsider possible steps to limit this vulnerabilityand become less attractive targets. Of course, thelikely shareholder reaction to any actions shouldbe considered before proceeding. Whateverapproach is taken, it should be the result of aconsidered analysis of relevant facts andrespective litigation risks.
8. Do we have an effective CEO evaluationprotocol and process in place?
Both are critically important and many timesoverlooked. Far too often, a board will puttogether a somewhat generic set of questions forresponses from the directors, then will ask theCEO for his/her self-evaluation against similarcriteria. That may have been acceptable when theboard was simply looking for a high-levelassessment of the CEO’s past performance as away to justify a pay adjustment – not to mentionthat many board chairs would just prefer to getthis done and check the box. There are not manydirectors who are fond of providing feedback,particularly to their company’s CEO.
However, in the new era of relevance, where it ismore pressing for boards to demonstrate aheightened degree of savviness about theircompany’s business and entire industry than everbefore, two items have become criticallyimportant, namely: the criteria against which theCEO is measured must be relevant andpurposeful and CEO evaluation is considered an
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on-going process; not an annual event; with thecompany’s direction and strategy as the platform.Otherwise, why bother? Relevance has nopatience for “check the box” activities.
Of course this begs for more upfront work by thecommittee, typically the compensation or HRcommittee that oversees this work. But after all,isn’t good stewardship of the CEO the board’smost important activity?
This process starts with clarification of thestrategy – alignment across all directorsregarding where the organization is headed andhow the CEO is planning to take it there. Whilethere are somewhat generic “buckets” ofcategories that are important in a CEO evaluation(e.g., management of the top team, fiscalsoundness and organizational sustainability),what success looks like in each of these areasvaries greatly from one organization to the nextbased on its strategy. The exercise of debatinghow to measure success in each not only servesthe purpose of delivering relevant and meaningfulfeedback to the CEO against these criteria, but italso begs for the board overall to be clear onwhat the answers mean. Boards often stop shortof defining success and move ahead based onassumptions.
Once the criteria for evaluation are understood,the board can move ahead with the process.There are many ways to collect feedback,including a survey tool rating the CEO in eacharea with the opportunity for comments,interviews of each director that are summarized,or both. Whatever the methodology chosen, it’simportant that all directors participate to thefullest. The CEO should also have an opportunityto rate his/her own performance against thesecriteria - as what the CEO thinks vis-à-vis theboard is of critical importance.
Giving proper attention to the process is anessential component for the success of theoverall exercise. With this robust data collected,the board now has information and insight onwhich to build a solid working relationship withthe CEO. It is not only recommended that theboard chair (and vice chair perhaps) meetregularly to create an on-going forum fordiscussion but also recommended that the boarddo a mid-term evaluation using the same process.
This provides a convenient time for the full boardto weigh in during the cycle, to not only provideuseful insights but to potentially course-correct, ifnecessary.
Overall, the CEO evaluation is a perfectopportunity to build a solid and meaningfulrelationship with the CEO, while ensuring clarityaround what success looks like for the company.It complements the CEO dashboard which has amore laser-like focus on discrete metrics butnonetheless a declaration of where and how theCEO should be spending his/her time. Together,these are powerful tools that, in these days ofincreasing complexity experienced across allindustries, serve as ways to align and streamlineCEOs’ organizational priorities and behavioralexpectations.
9. Are our annual performance targetssufficiently rigorous?
This issue continues to be a priority as proxyadvisory firms and many institutionalshareholders increasingly focus on companieswhose performance targets (as disclosed in thesame proxy as the company’s performanceresults) are not viewed as appropriatelychallenging. Increasing scrutiny by shareholderadvisory firms and institutional investors areforcing compensation committees to becomemore proactive. With new data-backedcapabilities regarding performance targets,Institutional Shareholder Services (ISS) andothers have become better positioned tochallenge companies' targets relative to industryand general market performance.
Historically, many companies have not disclosedforward-looking annual performance targets.However, looking ahead, as investors have morevisibility into pay and more opportunities tocritique executive compensation strategies,boards will need to up their involvement indisclosing their views of the business cycle,estimated market conditions, and other factorsimpacting how and why performance targets areset. The approach should be to proactivelycommunicate whatever information is necessaryto ensure stakeholders are comfortable with howannual performance objectives are established.
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8 © Korn Ferry 2019. All Rights Reserved.
About Korn Ferry
Korn Ferry is a global organizationalconsulting firm. We help clients synchronizestrategy and talent to drive superiorperformance. We work with organizations todesign their structures, roles, andresponsibilities. We help them hire the rightpeople to bring their strategy to life. And weadvise them on how to reward, develop, andmotivate their people.
10. What do the SEC’s 2018 enforcement actionson insufficient and/or inaccurate perquisitedisclosures portend for 2019 perquisitedisclosures?
During 2018 the SEC brought two enforcementactions relating to inadequate or non-existentperquisite disclosures.
In the first case, the SEC found that from 2011to 2015 the company failed to discloseapproximately $3 million in perquisites as“other compensation” to its CEO in its annualproxy statements filed in 2013 to 2016.Specifically, the firm failed to apply the SEC’sperquisites test - which requires the disclosureof personal benefits not widely available andnot integrally and directly related to anexecutive’s job duties. Not only was thecompany fined $1.75 million, it also was orderedto retain a consultant for a year to review itspolicies, controls and training for perquisites.
In the second action, the company's founderand former CEO was charged with notdisclosing over $10 million in personal loans,which were obtained from company vendors(allegedly for business contracts) and from acandidate for its board (who weeks later wasappointed to the board). Further, the SECcomplaint alleged that the executive did notdisclose these loans and also that the companyfailed to disclose approximately $1 million inadditional compensation over a five-yearperiod related to perks. To settle the claims, theexecutive agreed to not hold a corporateofficer position for five years and paid apenalty of $180,000. Additional penaltiestotaling $260,000 were assessed against aportfolio manager and his firm for hiding theloan to the executive and failing to disclose theplan to place the portfolio manager on theboard.
Companies are required to report in the SummaryCompensation Table of their annual proxystatement (as "All Other Compensation")perquisites and personal benefits if the totalamount exceeds $10,000, and to identify eachsuch item by type in a footnote, regardless of theamount. Companies also must maintain andevaluate quarterly the effectiveness of acompany’s disclosure controls and procedures
(i.e., those controls and other procedures that aredesigned to ensure that information required tobe disclosed in the company’s filings with theSEC is recorded, processed, summarized andreported). Additionally, disclosure controls andprocedures need to ensure that informationrequired to be disclosed is accumulated andcommunicated to management to allow timelydecisions regarding required disclosure.
In both cases, it appears that inadequate controlsand/or procedures resulted in the exclusion ofexecutive perquisites from the SummaryCompensation Table. Given the SEC’s apparentincreased scrutiny of executive perquisitedisclosures, a take-away for companies and theirboards is that internal controls apply not only tofinancial data, but also to the compilation ofsupplemental information disclosed in filings withthe SEC. We recommend companies and boardsreview their controls and procedures, as well asensuring the individuals responsible for compilingand capturing the data are adequately trainedregarding the SEC perquisite disclosure rules andrequirements.
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