Following is an excerpt. Read the full article in the pdf at the bottom of this page.
This practice note discusses trends and emerging practice in the granting of performance-based equity awards by public companies. It discusses factors that have contributed to these trends and the prevalence of certain plan design characteristics, including through the examination of survey data on plan design among mid-market companies. Finally, it predicts the effect of recent tax reform on future performance-based compensation.
The practice note is organized around the following topics:
- Rise in Prevalence of Performance-Based Equity Awards
- Using Stock-Price-Based Measures to Reduce Accounting Expense
- Deferring Compensation to Preserve Tax Deductibility
- Mandatory Post-vest Hold of Equity Awards
- Mid-market Company Incentive Plan Design Study Results
- Predicted Effects of Tax Reform on Performance-Based Compensation
- Continued Importance of Performance-Based Awards
Rise in Prevalence of Performance-Based Equity Awards
As equity compensation plays an essential role in the executive pay packages of public companies, compensation committees constantly scrutinize the terms of their companies’ equity awards. Motivated by shareholders, public outcry, congressional involvement, regulatory actions, tax law changes, and the need to increase shareholder value, there has been a staggering increase in the use of performance-based awards among companies in most industries. These awards are ever-evolving, waiting for the next big stimulus to kick off another cycle of change.
For U.S. publicly traded companies, there has been a notable decrease in the grant of stock options over the past decade. In turn, there has been a sharp rise in the grant of equity awards that focus on the achievement of preestablished, objective performance goals (referred to herein as performance-based awards) rather than simple increase in the value of a company’s stock (such as stock options), stock appreciation rights (SARs), restricted stock, and other time-based vesting awards).
Plain vanilla stock options were the gold standard of executive compensation for many years, but the mandatory expensing of stock options beginning in 2006 eliminated the compelling cost advantage of these awards over other types of equity awards. Moreover, proxy advisory firm Institutional Shareholder Services (ISS) never gave stock options their rightful due as being “performance based,” which also accelerated the decline of stock options. Nevertheless, many companies continued to grant stock options, especially in light of the tax rules under which most stock options were treated as qualified performancebased compensation exempt from the $1 million compensation deduction limit under I.R.C. § 162(m) and are exempt from the complicated deferred compensation rules under I.R.C. § 409A. In addition to the change in accounting rules that eliminated the cost advantage of stock options, the significant increase in performance-based awards from 2006 to 2017 can be attributed to the following:
- Deductibility under Section 162(m). Before tax legislation signed into law by President Trump on December 22, 2017 (known as the Tax Cuts and Jobs Act) became effective, publicly traded companies were able to deduct annual qualified performance-based compensation (which included, for example, stock options as well as performance shares) in excess of $1 million for the CEO and next three highest-paid employees (other than the CFO) serving on the last day of the year (socalled covered employees). In other words, performancebased compensation that met certain conditions was excluded from the $1 million limit imposed by Section 162(m) on publicly traded company tax deductions for most compensation payments made by the company to its covered employees in a particular fiscal year. This exclusion was basically eliminated by the Tax Cuts and Jobs Act, however. (See Predicted Effects of Tax Reform on Performance-Based Compensation for further discussion.)
- The onset of Say-on-Pay and the corresponding voting recommendations of proxy advisory firms. Starting in 2011 with Dodd-Frank’s amendment of securities law to require a nonbinding shareholder vote on public company executive compensation, scrutiny from proxy advisory firms such as ISS and Glass Lewis and their favorability towards performance-based compensation led many companies to redesign their equity plans to include performance-based awards. In formulating a voting recommendation for a public company, ISS will evaluate the proportion of the CEO’s most recent fiscal year equity awards that are conditioned on achievement of a disclosed performance goal or goals. ISS does not consider time-vested stock options or SARs to be performance-based awards. However, ISS will treat options and SARs as performance-based awards if either vesting or value received is conditioned upon the attainment of a specified performance goal or goals or the exercise price is at a substantial and meaningful premium over the grant date share price. If at least 50% of the CEO’s equity awards are performance-based, ISS will assign the maximum points for this factor. (For more information, see Dodd-Frank’s Say-on-Pay Provisions Compliance.)
With the significant increase in the use of performancebased equity compensation, certain plan design-related practices began to emerge. The next four sections discuss some of these practices.
Read the full article: