The SEC’s approval of the new PCAOB auditing standards for risk related to material misstatements creates a bridge between compensation committees and the company’s auditors. Chairs of compensation committee should expect to see auditors crossing that bridge with lots of questions, beginning next year.
In the newly revised PCAOB Auditing Standard No. 12 on Identifying and Assessing Risks of Material Misstatement, there is increased focus on financial relationships and transactions with executive officers. In addition to reading employment contracts and proxy disclosures, the auditor is facing several new requirements related to executive officer compensation that will impact compensation committees, including:
- A specific requirement to inquire of the compensation committee chair regarding “the structuring of the company’s compensation for executive officers.”
- Needing to obtain an understanding of executive compensation, including at least two specific matters under the control of the compensation committee:
- Changes or adjustments to incentive compensation arrangements, and
- Special bonuses.
Since the focus is on risk assessment, the auditors may go beyond the executive officers. If the compensation committee is involved in, for example, the incentive plan for all officers, the auditor could also ask about the structure of those incentives.
The revised standards apply to audits of financial statements for fiscal years beginning on or after December 15, 2014, including reviews of interim financial information within these fiscal years.
We expect that companies will want to prepare their compensation committee chairs for these auditor meetings. This ongoing auditor interaction may also be added to the duties of the compensation committee in its charter at the next revision.
In our September 4 post, we discussed the case for eliminating the Section 162(m) disclosures in proxy statements. Here is an alternative view of the subject.
It is worth looking back at the reasons for virtually every CD&A having a Section 162(m) disclosure. Here is a brief history:
- Before the 2006 revamp of the rules, the SEC had required discussion of a company’s Section 162(m) policy.
- The CD&A rules give as an example of possibly material information: “the impact of the accounting and tax treatments of the particular form of compensation”.
- In the adopting release, the SEC stated:
Regarding the example noting the impact of accounting and tax treatments of a particular form of compensation, some commenters urged that companies be required to continue to disclose their Internal Revenue Code Section 162(m) policy. The adoption of this example should not be construed to eliminate this discussion. Rather, this example indicates more broadly that any tax or accounting treatment, including but not limited to Section 162(m), that is material to the company’s compensation policy or decisions with respect to a named executive officer is covered by Compensation Discussion and Analysis. Tax consequences to the named executive officers, as well as tax consequences to the company, may fall within this example.
Most companies interpreted the CD&A rules to apply the prior “presumption” of materiality to the Section 162(m) disclosure and continued their prior practice of making a disclosure.
What is the right approach now? If a company wants to eliminate the disclosure, the question is materiality. As with most materiality questions, there are different ways to look at it.
Virtually all companies where the deduction may be in question will adopt Section 162(m)-compliant compensation plans and then follow the Section 162(m) requirements in paying some compensation. The potentially most material aspects of Section 162(m) from a disclosure perspective are the requirement to use preapproved performance goals and the limits on grant sizes and types. Also, most companies will not give up a deduction without Section 162(m) being a part of the decision process. Does this mean that Section 162(m) was material in the decisions?
On the other hand, the actual tax savings from Section 162(m) as a number is not material for most companies. And it is difficult to maintain that the disclosure continues to be useful to shareholders, particularly given shareholder complaints about the growing length of the CD&A and the SEC’s past statements that the CD&A should avoid boilerplate disclosures.
If a company determines that the Section 162(m) disclosure should be maintained, it is worthwhile to look at the disclosure in light of the shareholder litigation. There may be tweaks to the disclosure that would reduce the likelihood of a Section 162(m) disclosure-related shareholder claim.
Abercrombie & Fitch has negotiated a settlement to a shareholder derivative suit alleging excessive CEO pay for up to $2.78 million in attorneys’ fees and an agreement to make a series of governance-related changes:
Abercrombie agreed to appoint a chief ethics and compliance officer, tie executive pay more closely to performance, bolster anti-corruption compliance training, and limit access to nonpublic data to Jeffries’ partner and other third parties, among other provisions, court papers show.
The suit was filed in the wake of the company’s failed 2013 say-on-pay vote. In March, prior to the suit being filed, the company announced a number of changes to the executive compensation program to address shareholder concerns.
Plaintiffs’ compensation-related demands included: (i) having the chair of the compensation committee meet at least annually with the company’s 10 largest shareholders to discuss executive compensation matters; (ii) making 100% of the CEO’s long-term incentive award dependent on the achievement of performance conditions; (iii) subjecting annual and long-term incentive awards to multiple challenging performance metrics including some non-performance metrics; and (iv) removing language allowing the company to make adjustments to performance metrics to exclude certain costs.
A suggestion from John Kelsh at Sidely Austin which makes a lot of sense:
For many years, a stand-alone section on “Tax Considerations” has been a standard feature of the CD&A. These sections typically focus on Section 162(m) considerations and contain generic statements regarding the desire to maximize tax efficiency while also retaining the need for flexibility. In 2014, some companies omitted these sections. Deletion seems advisable in many instances, particularly given that these sections (i) have sometimes been targeted by plaintiff’s firms, (ii) are generally little more than boilerplate and (iii) rarely contain any material information (and thus are not required to be disclosed under Item 402(b)(2)). Companies wishing to streamline and focus their CD&A on meaningful disclosures may wish to consider doing the same.
ISS has announced a new program that allows companies to verify the data that ISS will use to evaluate a new or amended equity plan. The “Equity Plan Data Verification” should be a must-do for companies proposing a new plan or adding shares to an existing plan.
Under the program, ISS will show a company the data that ISS will use for its voting recommendation on the proxy before making the recommendation. The data includes both plan terms (such as change in control provisions and share recycling) and equity information (such as the number and type of outstanding grants and shares available for future grant).
While a company will have only two days to respond when ISS provides its initial data for review, the company can be ready. The verification program materials include the 27 data points that ISS will consider which allows the company to have its answers complete before the proxy is filed.
There does not appear to be any down side to participating in the verification program. As anyone who has gone through the ISS Compass process knows, the initial analysis of a plan may not be completely accurate. A company should not pass up this opportunity to make sure the inputs used by ISS in its proxy recommendation are accurate.
The annual ISS Benchmark Policy Survey has a significant portion devoted to executive compensation topics. In the several questions on Pay for Performance, one focuses on the issue of pay equity.
Is there a threshold at which you consider that the magnitude of a CEO’s compensation should warrant concern even if the company’s absolute and relative performance have been positive, for example outperforming the peer group?
If the survey taker answers yes, the survey asks about their view on three possible “tools for determining excessive pay magnitude“.
- Comparison to median CEO pay at peer companies
- Comparison of CEO compensation to pay of other named executives
- Excessive proportion of corporate earnings or revenue
In prior years, the ISS survey questions have often portended changes in policies. Survey results are expected in late September. The results could be interesting this year.
On June 10, the IRS issued a revenue ruling confirming that a nonstatutory stock option or stock-settled stock appreciation right (SSAR) that is exempt from Section 409A is also exempt from Section 457A.
As most readers will know, Section 457A is a special regime for certain “tax-indifferent” entities (entities such as corporations located in offshore tax havens or domestic partnerships substantially owned by tax-exempt organizations) that generally subjects such entities’ nonqualified deferred compensation arrangements to tax on vesting, rather than on payment as under Section 409A.
Previously, despite guidance in Notice 2009-8 exempting 409A-exempt stock options and SSARs from Section 457A, the IRS’s position had been in some doubt, given language in Section 457A that exempts 409A-exempt stock rights other than any “right to compensation based on the appreciation in value of a specified number of equity units of the service recipient.” It wasn’t entirely clear how the “other-than” language in the statute and the IRS’s guidance in Notice 2009-8 could be squared, since the “other than” language appears to refer to all stock appreciation rights. The revenue ruling addresses this apparent discrepancy by citing to legislative history indicating that the “other than” language was specifically not intended to apply to stock options, and holding that if stock options are exempt, SSARs should also be exempt, given the economic equivalence between net-settled stock options and SSARs.
Thus, the only difference in coverage of stock rights between Section 409A and Section 457A is with respect to stock appreciation rights that are or may be settled in cash (CSARs), which are subject to Section 457A but may still be exempt from Section 409A if certain conditions (FMV exercise price, etc.) are met.
Some may recall that the IRS originally intended to cover CSARs under Section 409A as well. Notice 2005-1 created an exemption only for SSARs of publicly traded companies, based on concern that CSARs or private company SSARs could resemble other nonqualified deferred compensation arrangements that were not exempt. Eventually, however, the IRS recongized that all SARs, public and private, cash and stock settled, were functionally equivalent and exempted them all in the final 409A regulations. Given they produce identical payouts, it’s still unclear as a policy matter why CSARs and SSARs should be treated differently under Section 457A, but the statutory language is what it is, and the revenue ruling does at least offer a welcome confirmation of the IRS’s guidance from 2009.
Recently, a Delaware court case (Newell Rubbermaid v. Storm) drew notice for enjoining the breach of a noncompete agreement contained in an equity award that had been delivered to and accpeted by the employee online.
As discussed in this recent McGuireWoods news item, the court in a recent Virginia case (MeadWestvaco Corp. v. Bates) also granted temporary injunctive relief to an employer to enforce restrictive covenants contained in equity award documents that an employee had acknowledged online. The facts in MeadWestvaco are similar to the facts in Newell Rubbermaid in that the evidence showed that the employee had agreed to online acceptance of the stock award, required by “log-in” and specific “click” to accept the grant (including terms and conditions). What makes the MeadWestvaco case even more interesting, however, is that the equity award documents in question did not even include any language identifying temporary injunctive relief as a potential remedy for breach. In fact the only remedy referenced in the documents was forfeiture of the equity compensation. The court granted the injunctive relief anyway, holding that the failure to include injunctive relief language wasn’t fatal.
Together, the MeadWestvaco and Newell Rubbermaid cases illustrate that narrowly drawn restrictive covenants in employee equity awards can, in appropriate circumstances, be enforced through the full set of available remedies (including injunctive reief), not just forfeiture of the award, even where the agreement has been accepted online and even where the award documents don’t specifically refer to remedies other than forfeiture.
Some companies think a high TSR is a panacea against negative say-on-pay votes, but the Chipotle 2014 say-on-pay vote proves otherwise. Despite 1, 3 and 5-year TSRs in the 83rd, 77th and 95th percentiles as compared to peers, over 75% of Chipotle’s shareholders voted against the say-on-pay proposal.
Although shareholder unrest appears to have existed quite apart from ISS, it’s interesting to think about how ISS arrived at its “no” vote recommendation, given Chipotle’s high TSR. Of the 3 quantitative “gating” factors used by ISS to screen company say-on-pay proposals, the only one that doesn’t take TSR into account is the multiple of CEO pay as compared to peer median. From ISS’s public statements, it appears that Chipotle’s multiple of 3.4 was indeed considered too high by ISS and a main factor in ISS’s “no” vote recommendation for Chipotle. Other, qualitative factors–such as top executives cashing out of their option positions shortly after exercising–are also cited by ISS, but of course ISS is only supposed to consider qualitative factors if one of the quantitative “gating” factors demonstrates a pay misalignment. Behind the scenes, the near 20% drop in Chipotle’s share price in the months leading up to the annual shareholder meeting may have contributed as well.
The IRS announced Friday that it has selected 50 companies to get a special 409A audit. The lucky winners had already won the audit lottery by being selected for an employment tax audit. In the 409A component, the IRS auditors will be looking at:
- initial deferral elections;
- subsequent deferral elections; and
- payments, including the six-month delay for specified employees.
The inclusion of the six-month delay indicates that all of the recipients of this IRS 409A review will be public companies. The focus will be on the top 10 highest compensated employees.
There may be time for a quick self-audit of your 409A plans before the IRS information request hits your desk or maybe your good fortune will keep you off the list. Feeling lucky today?