This article originally appeared in Law360.
Companies have had a lot to digest since the passage of the Tax Cuts and Jobs Act (the “TJCA”) late last year. But for executive compensation attorneys and professionals who work with or advise public companies, the elimination of the tax deduction for performance-based compensation under section 162(m) of the Internal Revenue Code was perhaps the most significant change brought about by tax reform. Since then, the changes to section 162(m) have been top of mind for everyone involved with structuring executive compensation arrangements and strategies at public companies.
Among the many questions companies face following the changes to section 162(m) is whether to continue seeking periodic shareholder approval for the performance criteria under their incentive plans. Before tax reform, companies were generally able to deduct performance-based compensation if, among other things, the performance criteria used in the arrangement were approved by shareholder vote at least once every five years. The repeal of the performance-based compensation exception eliminated this requirement. However, there may be other reasons why companies might opt to continue seeking shareholder approval, even if it will no longer allow the compensation to be deductible.
We researched what large public companies decided to do this year with regard to shareholder approval of their performance criteria by reviewing the most recent proxy statements filed by S&P 100 companies. We discovered that most companies that under pre-TJCA law would have been scheduled to seek shareholder approval for their performance criteria (because they had previously done so five years ago) elected not to do so this year. Although a limited data set, these findings may be instructive for other public companies who are considering how to approach this matter in future years.
Section 162(m), Tax Reform, and Shareholder Approval
Section 162(m) of the Internal Revenue Code imposes a $1 million annual limit on the amount of compensation that a publicly held corporation can deduct with respect to certain executives. Before tax reform, section 162(m) allowed corporations to deduct performance-based compensation without regard to the $1 million limit, provided that certain requirements were met. One of these requirements was that companies generally had to have their incentive plans (or at least the performance criteria in those plans) approved by shareholders at least every five years.
The TCJA eliminated the ability to exclude performance-based compensation from the $1 million deduction limit under section 162(m) (with limited exceptions for certain grandfathered arrangements). Without the incentive of a corporate tax deduction, questions emerged regarding the frequency with which companies would continue to seek shareholder approval or if they would even seek approval at all.
Are Companies Still Seeking Shareholder Approval Following Tax Reform?
This year is the first year for which some companies would have to decide whether to seek shareholder approval of performance criteria in their incentive arrangements. We decided to review the proxy statements filed this year by companies in the S&P 100 to learn how many companies would have needed to seek shareholder approval this year (i.e., because they last obtained shareholder approval five years ago), and of those companies, how many sought shareholder approval this year.
Based on our review of the S&P 100, fourteen companies had last submitted the performance criteria in their equity incentive plans to a shareholder vote in 2013, and two had last submitted criteria for their cash-based plans in 2013, meaning that prior to the TCJA, section 162(m) generally would have required these plans to be put to another shareholder vote in 2018 to allow the company to continue to exclude performance-based compensation from section 162(m)’s deduction limit. After reviewing these companies’ 2018 proxy statements, we found that only four of the fourteen companies submitted their equity plans to a shareholder vote in 2018. Nine companies did not do so, while one company has not yet held its annual meeting. Of the cash-based plans, neither was submitted to a shareholder vote.
Although the data set is admittedly limited given the short period of time since the TCJA was passed, it appears that, without the incentive of a tax deduction, most companies are no longer seeking the formerly customary periodic shareholder approval of performance criteria.
Why Companies May Still Be Seeking Shareholder Approval
As seen in the data, although most companies did not to submit their plans to a shareholder vote in 2018, the TCJA has not completely ended of the practice of seeking shareholder approval. Outside of section 162(m), there are a number of reasons that may motivate companies to continue submitting plans to a vote—though perhaps not with the same five year frequency.
Listing Standards. Under both the NYSE and NASDAQ listing standards, a public company must obtain shareholder approval before it can issue shares under an equity incentive plan or make material revisions to an equity incentive plan. Of the four companies that submitted their plans to a vote this past proxy season, one company adopted a new equity plan in light of the upcoming expiration of its prior plan. Another extended the term of its current plan, which both sets of listing standards consider to be a material modification.
Corporate Governance and Proxy Advisory Services. Both of the major proxy advisory services have been supportive of measures that align pay with company performance and that subject executive compensation to shareholder feedback. Following the changes to section 162(m), both ISS (“U.S Tax Reform: Changes to 162(m) and Implications for Investors”) and Glass Lewis (“Amending 162(m): Tax Reform Implications on U.S. Executive Compensation”) have cautioned that shifts away from performance-based compensation or less transparent disclosure of performance metrics to shareholders could be viewed negatively.
It is not necessarily the case that pay-for-performance or transparency considerations would require shareholder approval of plans every five years, and as far as we are aware, the proxy advisory services have not yet come to a formal conclusion on what they will recommend in the future. However, companies should keep these advisors in mind as they consider whether to submit plans and performance criteria for approval, even if not otherwise required by listing standards. Some companies may also consider whether there could be any ramifications if they propose radical changes to their plans’ pay-for-performance provisions, or if they decide not to disclose pay-for-performance provisions and criteria in the future.
Looking at the four plans submitted to a shareholder vote this past proxy season, all of the plans retained performance-based awards, and all of the companies disclosed the applicable performance criteria in their proxies. None appear to have had a significant deviation in the available performance metrics.
Proxy advisory services have also used share reserves as another way to impose checks on companies and their equity plans, by recommending that companies strictly limit the number of shares available for award under an equity plan. It is possible that, without the section 162(m) shareholder approval requirement, proxy advisors may sharpen their focus on share reserves and equity “burn rates” as another way of getting equity plans in front of shareholders on a regular basis.
Other Tax Considerations. The performance-based compensation exception to section 162(m) was not the only provision of the Internal Revenue Code requiring shareholder approval of equity plans. In order to grant tax-advantageous incentive stock options, section 422 of the Internal Revenue requires that such options be issued under a shareholder-approved plan. The benefits of incentive stock options can be an important tool in compensating employees, as employees do not recognize income upon exercise of such options and potentially receive capital gains treatment upon the sale of the underlying stock. Although section 422 only requires companies to have plans approved every ten years, the proxy advisors often will not recommend approval of a plan that has enough shares reserved to cover awards to be issued over more than a 3-4 year period.
Looking Ahead to the 2019 Proxy Season
Overall, only a relative handful of companies have been confronted with the decision of whether to submit their incentive plans to a shareholder vote in the absence of the performance-based compensation exception under section 162(m). However, it appears that those companies faced with this decision as to whether to seek a shareholder vote have generally decided not to do so. As time goes on, more companies may face reasons outside of section 162(m) to submit plans to shareholder approval, though we would not expect that such motivations would dictate a five-year submission cycle.
When companies do decide to have shareholders approve plans, they may wish to consider amending such plans to remove references to compliance with section 162(m), which will no longer be an issue. However, companies should think carefully before making any drastic substantive changes to their pay-for-performance structures, and should continue to monitor their industries and markets as new best practices develop in the future.