On June 21, 2012, the IRS issued Rev. Rul. 2012-19 to clarify the treatment of dividends paid on awards that satisfy the requirements to be considered performance-based compensation under Section 162(m). For today’s blog entry, I summarize this ruling.
Background on Section 162(m) (That You Probably Already Know But I Feel Compelled to Include Anyway, Just in Case)
Section 162(m) limits the tax deduction companies can claim for compensation paid to specified executive officers to $1 million per year. Performance-based compensation, as defined under the code and associated regulations, is exempt from this limitation. There are numerous conditions that must be met for awards to be considered performance-based, including that the awards must be payable only upon achievement of performance targets and cannot be paid out prior to certification (by the compensation committee) that the targets have been satisfied.
Treatment of Dividends Under Section 162(m)
Under the ruling, the dividends (and dividend equivalents) are viewed as separate awards–thus, they don’t taint the status of the underlying awards even if they will be paid to award holders before the performance conditions have been met (or will be paid even if the conditions aren’t met). But the dividends or equivalents themselves are considered performance-based compensation only if they also meet the requirements for this treatment under Section 162(m)–i.e., if they will be paid only upon attainment of performance targets and meet the other requirements specified under Section 162(m).
The easiest way to ensure that the dividends/equivalents will be considered performance-based under Section 162(m) is to pay them out only when the underlying award is paid out. If the award is forfeited, the dividends/equivalents accrued on it are forfeited as well. This is also a best practice for accounting purposes and from a shareholder-optics standpoint (ISS specifically identifies paying dividends on unvested performance awards as a “problematic pay practice”–see my December 15, 2010 blog entry, “ISS Policy Updates“).
Interestingly–in a grotesque-but-can’t-look-away sense–the ruling says that the dividends/equivalents don’t have to be subject to the same performance criteria as the underlying award–you could have one set of goals for the award and different goals for the dividends. That seems like a disaster just waiting to happen–a mess from both an administrative and participant education standpoint (as if your executives really need another set of goals to focus on, in addition to the award goals and the cash bonus plan goals). But now that the IRS has suggested it, I fear there is a compensation consultant already trying to design a plan that incorporates this feature. Just say “No!”
No Deduction for Dividends Paid on a Current Basis
Where the dividends will be paid out prior to satisfaction of the performance conditions–i.e., where they are paid to award holders at the same time they are paid to shareholders–the dividends are not considered performance-based compensation and are subject to the limit on the company’s tax deduction under Section 162(m).
This is just one more nail in the coffin for paying out dividends on a current basis. Even if the dividend payments aren’t that significant, I imagine trying to separate them from the original award for purposes of computing the company’s tax deduction will be a challenge. I have a headache just thinking about it.
No Surprises
My sense, from reading Mike Melbinger’s blog on CompensationStandards.com (“Code Sec. 162(m), RSUs, Dividends and Dividend Equivalents,” July 2, 2012) and the Skadden memo we posted on this, is that this is pretty much what everyone was doing anyway. It certainly seemed like common sense to me–if there is such a thing when it comes to the tax code. So, just like last month’s “Section 83 Update” (June 12, 2012), I’m a little surprised that the IRS doesn’t have anything more important to worry about. I’m sure this will be discussed at the IRS and Treasury Speak panel at the NASPP Conference–it will be interesting to hear why the IRS felt the need to issue this ruling.
NASPP “To Do” List We have so much going on here at the NASPP that it can be hard to keep track of it all, so we keep an ongoing “to do” list for you here in our blog.
Don’t miss the Silicon Valley chapter all-day conference this Wednesday, July 11. Robyn Shutak and I will be presenting on life events and equity compensation, with Liz Stoudt of Radford–we hope to see you there!
Chapter meetings are also being held in Chicago, Los Angeles, NY/NJ, and Philadelphia. I’ll be speaking at the NY/NJ and Philadelphia meetings–be sure to stop by and say hello!
This week, we feature another installment in our series of guest blog entries by NASPP Conference speakers. Today’s entry is written by Brian Frost of Towers Watson, who will lead the session “The Better Part of Valor: Discretion in Performance Share Plans”
Discretion and Long-Term Performance Plans By Brian Frost of Towers Watson
Long-term performance plans are becoming more prevalent every year as companies strive to align executive pay with shareholder returns. However, some compensation committees have become uncomfortable with establishing fixed goals for a three-year period due to the uncertain economic environment or changes happening at the company. To address these challenges, one approach might be for the committee to establish some initial performance goals while reserving the discretion to adjust the payout after taking into account likely outside perceptions and company-specific issues. Maintaining this flexibility comes with some downsides, however, and a particular concern is the potential for significant changes in the timing and amount of compensation reported in the company’s Summary Compensation Table (SCT). This, in turn, can influence the views of shareholders, proxy advisors and the press, which makes the decision to retain and exercise discretion one that requires a full understanding of the implications.
These are among the issues we’ll address in our October 10 session (6.3) at the 20th Annual NASPP Conference entitled “The Better Part of Valor: The Complicated World of Discretion in Performance Plans.” While the accounting rules are fairly straightforward when dealing with mainstream plan designs, more complicated plans, including those involving discretion, often reside in a gray area where accounting guidance is vague and the company and its accountants must use judgment to determine the appropriate accounting treatment. While the accounting interpretation may not have a material impact on the company’s financial statement, it can have a profound impact on the amount and timing of reported pay for NEOs. Participants in our session will gain insights about the plan design considerations that lead companies to use more discretion in determining performance plan payouts, the technical accounting rules that drive proxy reporting and other implications of discretion. Since how equity awards are reported in the SCT is determined under Accounting Standards Codification Topic 718 (ASC 718), we’ll explore the basics of those rules as well as the nuances of when and how discretion can influence the mysterious complexities of “grant date” and “service inception date.”
We also will explore the recent SEC decision in the Verizon case, which received significant publicity and involved his complicated mix of rules. Finally, we’ll review a list of items compensation professionals should know to better understand the decisions that influence the accounting and disclosure of discretionary plan awards so they can anticipate areas of potential concern before they arise.
NASPP “To Do” List We have so much going on here at the NASPP that it can be hard to keep track of it all, so we keep an ongoing “to do” list for you here in our blog.
Don’t miss your local NASPP chapter meetings in NY/NJ and San Diego. Robyn Shutak, the NASPP’s Education Director, and I will be presenting at the San Diego chapter meeting–we hope to see you there!
Wondering what the hottest topics in stock compensation are today? You can find out at the 19th Annual NASPP Conference, with the session “Today’s Hottest Topics in Stock Compensation.” I happen to have caught a glimpse of the panel’s slide presentation, so, in today’s blog entry, I “leak” a few of the topics that will covered.
Today’s Hottest Topics in Stock Compensation I’ve been saying all year that performance-based awards are red-hot and I’m pleased to see that our expert panel agrees (it’s always nice to be right). The panel plans to discuss a number of tricky issues relating to performance-based pay that have emerged over the past year, including:
Setting long-term performance goals in today’s volatile economy without jeopardizing 162(m) deductibility.
Best approaches for disclosing in the CD&A the use of non-GAAP financials for performance awards.
Trends and emerging practices with respect to double-trigger CIC vesting of performance-based awards.
The panel also plans to discuss whether stock options will become more performance-based in light of ISS concerns.
Next year’s proxy season is also clearly on everyone’s minds these days. Here are the proxy-related topics that the panel plans on discussing:
Under what circumstances might a company defy ISS guidance and how should they prepare for the consequences?
Drafting the CD&A disclosure of the Compensation Committee’s response to Say-on-Pay votes.
How will ISS’s new policy (currently in draft form–see the NASPP alert “ISS Issues Draft of 2012 Policy for Comment“) regarding the evaluation of executive pay affect plan design, benchmarking, and support for management’s Say-on-Pay proposals?
What best practices have evolved for developing a strategy for shareholder Say-on-Pay?
The panel will also discuss clawback provisions (particularly what to do about them if the SEC doesn’t finalize rules before the 2012 proxy season).
Don’t miss “Today’s Hottest Topics in Stock Compensation” at this year’s NASPP Conference. The panel wil be moderated by Art Meyers of Choate Hall & Stewart (and of the NASPP Executive Advisory Committee). Art’s co-panelists will be Mike Melbinger of Winston & Strawn (and author of Melbinger’s Compensation Blog on CompensationStandards.com), Mark Borges of Compensia (and author of Borges’ Proxy Disclosure Blog on CompensationStandards.com), and Paula Todd of Towers Watson (and of the NASPP Advisory Board).
See You Next Week in San Francisco! It’s hard to believe, but the 19th Annual NASPP Conference is next week! I hope to see all of my readers at the Conference, which starts next Tuesday, November 1, in San Francisco. We expect to have around 2,000 attendees–it’s going to be a very exciting event; register today to ensure you don’t miss out (and make your hotel reservations, because the hotel is close to selling out).
NASPP “To Do” List We have so much going on here at the NASPP that it can be hard to keep track of it all, so I keep an ongoing “to do” list for you here in my blog.
Today’s blog entry is guest authored by Jon Burg of Radford, who will be moderating a discussion on designing performance-based equity programs using market conditions at the 19th Annual NASPP Conference in November. The panel will include Gloria Estrada of Agilent Technologies, Susan Stemper of Biogen Idec, and Kathryn Neel of Frederic W. Cook & Co. We asked Jon to give us a sneak peak at what the panel will cover.
Taking the Difficulty Out of Setting Performance Goals By Jon Burg of Radford
Designing a performance-based equity plan can be one of the bigger compensation challenges companies face. Limited line of sight and unforeseen obstacles impacting financial results make choosing a metric and determining the appropriate target an uphill struggle.
With increased pressure to align shareholder and executive interests, I anticipate that market-based plans will continue to be implemented for the following reasons:
They do not depend on the ability to set long-term operational or financial goals;
The payouts are directly linked to stock price performance (absolute or relative) which allows for higher perceived alignment between shareholders and award recipients;
The accounting treatment is more predictable since the expense accrual is fixed at the time of grant and not adjusted, regardless of eventual outcome; and,
They are simpler to administer than plans with other internal performance conditions, and they are measurable at any time for regular and frequent communication to plan participants and the Board
Agilent Technologies was one of the early adopters of a relative total shareholder return program in 2004. In fact after a brief two-year experiment of using a combination of relative TSR and SAGE (must be present to understand) metrics, Agilent has since focused solely on relative TSR. Relative TSR plans come in many shapes and sizes, but the basic premise is the same–award holders receive a higher (or lower) level of payout for excess (or under) performance in TSR as compared to a peer group or benchmark. Gloria will share with us Agilent’s plan design, the continued evolution, and lessons learned over the past seven years.
But relative TSR is not necessarily the answer for all companies. Biogen Idec considered relative TSR as a primary metric for their performance-based plan before opting for a Market Stock Unit (“MSU”). An MSU is a unique equity instrument that effectively combines the upside opportunity of a stock option with a limited downside protection of a restricted stock. Given Biogen Idec’s business model and market position, MSUs were considered a more appropriate replacement of stock options, which are not viewed as performance-based by ISS. Susan will take us inside the compensation committee discussions as well as share a wealth of experience she has gained over the years from literally hundreds of one-on-one executive meetings about equity awards.
Kathryn has worked with numerous companies to perform an assessment of business strategies and performance in order to identify optimal performance metrics that drive sustainable performance. This often involves a balancing act of setting goals that are fair to executives and shareholders. While not always the end result, market-based performance metrics are always a central component of the discussion and the fastest growing area. Kathryn will share her perspective on why she believes the pace has quickened the past few years and possibly even prognosticate on where we are headed.
Collectively, this panel will demonstrate that a well-designed market-based program can both mitigate the most troublesome flaws with traditional equity vehicles, and provide better compensation delivery.
Learn Even More About Performance Awards Round out your knowledge of performance based awards by attending the pre-Conference program, “Practical Guide to Performance-Based Awards,” offered on Nov 1, in advance of the NASPP Conference. This intensive one-day program will cover everything you need to know to implement and administer this complex emerging form of compensation.
On June 23, the IRS and Treasury proposed new regulations under Section 162(m) relating to the requirements for options and SARs to be considered performance-based compensation and the transition period for newly public companies.
Not-So-Surprising Proposed Regs for Section 162(m) (Well, Maybe a Little Surprise for IPO Companies)
Section 162(m) limits the tax deduction public companies can take for compensation paid to specified executive officers to $1 million per year. As I’m sure you all know, however, performance-based compensation is exempt from this limitation.
The recently issued proposed regs are not nearly as controversial as the IRS’s 2008 surprise ruling on 162(m), but are still worth taking note of–especially since, as the Morgan Lewis memo we posted on the proposal points out, some of these clarifications are the direct result of compliance failures the IRS has encountered during audits.
Stock Options and SARs
Normally, for compensation to be considered performance-based, it must meet a number of rigorous requirements. At the time that Section 162(m) was implemented, however, at-the-money stock options and SARs were considered inherently performance-based, so the requirements applicable to them are significantly more relaxed (a decision I can only imagine regulators regret today, given current public sentiment towards stock options). The primary requirements are that the options/SARs be granted from a shareholder approved plan, individual grants are approved by a committee of non-employee directors, the exercise price is no less than the FMV at grant, and the plan states the maximum number of shares that can be granted to an employee during a specified period.
The proposed regs clarify that, for this last requirement, the plan must state a per-person limit; the aggregate limit on the number of shares that can be granted under the plan is insufficient (although, the stated per-person limit could be equal to the aggregate limit).
Disclosure
For all performance-based compensation, including stock options and SARs, the regs already require that the maximum amount of compensation that may be paid under the plan/awards to an individual employee during a specified period must be disclosed to shareholders. For stock options and SARs, it’s pretty hard to determine what the maximum compensation is, since this depends on the company’s stock price over the ten years or so that the grant might be outstanding. The proposed regs clarify that it is sufficient to disclose the maximum number of shares for which options/SARs can be granted during a specified period and that the exercise of the grants is the FMV at grant.
Newly Public Companies
For a limited “transition” period, Section 162(m) doesn’t apply to arrangements that were in effect while a company was privately held (provided that the arrangements are disclosed in the IPO prospectus, if applicable). This transition period ends with the first shareholders’ meeting at which directors are elected after the end of the third calendar year (first calendar year, for companies that didn’t complete an IPO) following the year the company first became public (unless the plan expires, is materially modified, or runs out of shares or the arrangement is materially modified before then).
For stock options, SARs, and restricted stock, the current regs are even more generous–any awards granted during this transition period are not subject to 162(m), even if settled after the transition period ends. The proposed regs don’t change this, but they do make it clear that RSUs and phantom stock are not covered by this exemption. My understanding from some of the memos we’ve posted in our alert on this is that this reverses a couple of private letter rulings on this issue (see the Morrison & Foerster, Morgan Lewis, and Edwards Angell Palmer & Dodge memos). The current regs specifically state that the exemption applies to stock options, SARs, and restricted stock, but are silent as to the treatment of RSUs and phantom stock–providing the IRS/Treasury with the leeway to exclude them now.
Subtle Changes
Several of the changes are pretty subtle–so subtle that when comparing the proposed regs to the current regs, I couldn’t figure out what had changed. So I used the handy-dandy document compare feature in Word to create a redline version of the new regs, which I’ve posted for the convenience of NASPP members.
Chickens, Stock Plan Administrators, and Whiskey The author of the joke that appeared in last week’s blog entry is John Hammond of AST Equity Plan Solutions (and poet laureate of the NASPP blog). Ten points to Erin Madison of Broadcom, who was the only person to email me the correct the answer. I can’t believe no one else figured it out!
This week I write about how stock compensation can introduce volatility into the P&L and why this is a problem.
The Problem with Liability Treatment
The recent article “Higher Stock Price Triggers First-Quarter Loss for Barnwell” (Honolulu Star Advertiser, May 12, 2011, Andrew Gomes) highlighted for me the exact problem with stock compensation that is subject to liability treatment. The article explains that Honolulu-based Barnwell Industries experienced a $1.5 million loss this quarter–a reversal of a $1.5 million profit for the same quarter last year. The reason for the loss is that their stock price doubled during the quarter.
How can a stock price increase cause the company to recognize a loss? The answer is that Barnwell has granted options that can be paid out in cash (the options include a cash SAR component) and are therefore subject to liability treatment. Thus, the increase in their stock price had a very significant impact on their stock compensation expense. Although they haven’t granted options since 2009, Barnwell’s stock option expense went from $46,000 for the comparable quarter last year to $1,677,000 for the current quarter. That’s an increase of 3,546%–kind of hard to explain to shareholders, who, for the most part, probably don’t have the foggiest understanding of liability vs. equity treatment.
Performance Awards Too
While performance awards receive equity treatment under ASC 718, they can also introduce the potential for similar volatility to the P&L. When performance awards are contingent on non-market based goals (e.g., revenue, earnings, and other internal metrics), the likelihood of forfeiture is estimated and expense is recorded based on this estimate. If the company does well, the likelihood of forfeiture will be lower and the expense for the awards will increase.
It’s important to keep this in mind when designing performance award programs and to set appropriate caps on payouts as a means of controlling stock plan expense (not to mention, how do you handle a situation where awards vest based on earnings, the earnings target is hit, and this decreases the forfeiture estimate to the point where the additional expense for the awards reduces earnings below the target). This is also a reason to consider market-based awards–i.e., awards that vest based on stock price targets or total shareholder return. For these awards, the likelihood of meeting the targets is baked into the initial fair value estimate and there are no further adjustments if the likelihood that the targets will be achieved changes.
Need to know more about the accounting treatment and design considerations for performance awards? Don’t miss the NASPP’s pre-conference program, “Practical Guide to Performance-Based Awards” at this year’s NASPP Conference.
IFRS 2
If ever required for US companies (see last week’s blog entry, “IFRS 2: The Saga Drags On“), there are three requirements under IFRS 2 that could introduce significant volatility to the P&L:
Tax Accounting: IFRS 2 requires all tax shortfalls to run through the P&L and, moreover, requires companies to estimate their tax benefit/shortfall each accounting period and adjust tax expense accordingly. This is the opposite of Barnwell’s problem. Here, an increase in stock price wouldn’t be a problem, but a decrease that causes options and awards to be underwater (i.e., the current intrinsic value of the award is less than the expense) could result in significant increases in tax expense, which would reduce earnings for the period. Sort of rubbing salt into the wound–reduced earnings is not going to help get the stock price back up.
Share Withholding: Share withholding on either options or awards triggers liability treatment (for the portion of the award that will be withheld to cover taxes) under IFRS 2. As the company’s stock price increases, this liablity–and associated P&L expense–will increase.
Payroll Taxes: The company’s matching tax liability for payroll taxes (Social Security and Medicare in the US) is also treated as a liability that must be estimated and expensed each accounting period. Again, as the company’s stock price increases, this liability and expense will also increase.
See the NASPP’s IFRS 2 Portal for articles on these IFRS 2 requirements.
Last Chance to Qualify for Survey Results This is the last week to participate in the NASPP’s 2011 Domestic Stock Plan Administration Survey (co-sponsored by Deloitte). Issuers must complete the survey by this Friday, May 20, to qualify to receive the full survey results. Register to complete the survey today.
New “Early-Bird” Rate for the NASPP Conference If you missed last Friday’s early-bird deadline for the 19th Annual NASPP Conference, you can still save $200 on the Conference if you register by June 24.This deadline will not be extended–register for the Conference today, so you don’t miss out.
NASPP “To Do” List We have so much going on here at the NASPP that it can be hard to keep track of it all, so I keep an ongoing “to do” list for you here in my blog.
Register for 19th Annual NASPP Conference (November 1-4 in San Francisco). Don’t wait; the new early-bird rate is only available until June 24.
Participate in the NASPP’s 2011 Domestic Stock Plan Administration Survey (co-sponsored by Deloitte, with survey systems support provided by the CEP Institute). Don’t wait–this week is your last chance to participate.
I recently attended a San Francisco NASPP chapter meeting that featured a presentation by Yana Plotkin of Towers Watson on trends in equity compensation. Yana included some data from the Towers Watson “2010/2011 Report on Long-Term Incentives, Policies and Practices.” Here are a few highlights:
Portfolio Approach
More companies are granting at least two types of awards–73% of respondents indicated this practice, an increase of 10% from 2009. Larger companies are more likely to utilize three types of awards than smaller companies.
Pay for Performance
Towers Watson is seeing a strong trend towards performance awards, which are now the second most common type of long-term incentive offered by survey respondents, ahead of stock options. Full value shares (RS/RSUs) were the most common type of LTI offered. In the NASPP’s 2010 Stock Plan Design and Administration Survey (co-sponsored by Deloitte), we also saw a strong trend towards performance awards, although we did not see them outpace the usage of stock options.
Full Value Awards
Towers Watson reports that full value awards have outpaced stock options for grants to employees at the manager/individual contributor level. In the NASPP survey, we also saw an increase in full value awards and even performance awards to employees at these levels, but many respondents were still granting stock options.
Award Sizes
For employees earning under $200,000, award sizes (as a percentage of salary) remained flat from 2009 to 2010 in the Towers Watson survey. But for employees at higher salary levels, award sizes increased, although not quite to 2008 levels.
Award Design
In terms of performance award design, Yana mentioned that they are seeing interest in awards with shorter performance periods, e.g., two years, and some sort of trailing service requirement after the performance goals have been met. I am a proponent of this design; for executives, it helps facilitate compliance with ownership requirements and clawback provisions and, for everyone, it can simplify tax withholding procedures.
Interestingly, Towers Watson reports that 35% of respondents to their survey measure performance relative to peers or a market index. For the NASPP survey, this was about the same (41% of respondents). Both surveys also agree on how commonly TSR is used as a performance metric (25% of respondents in the Towers Watson survey, 29% of respondents in the NASPP Survey). Yana indicated that Towers Watson is seeing more companies use TSR than in the past and that certainly aligns with the buzz I am hearing from compensation consultants, etc.
Performance Awards Are the Future
The biggest takeaway I got from Yana’s presentation is that the Say-on-Pay, the disclosures required under the Dodd-Frank Act, and shareholder expectations are making performance awards the hottest thing going today in terms of equity compensation. If you aren’t fully up to speed on them, don’t miss the pre-conference session, “Practical Guide to Performance-Based Awards,” to be held on November 1 in San Francisco, in advance of the NASPP Conference. Register by May 13 for the early-bird discount!
Online Fundamentals Starts in Two Weeks–Don’t Miss It! The NASPP’s acclaimed online program, “Stock Plan Fundamentals,” begins on April 14. This multi-webcast course covers the regulatory framework and administrative best practices that apply to stock compensation; it’s a great program for anyone new to the industry or anyone preparing for the CEP exam. Register today.
NASPP “To Do” List We have so much going on here at the NASPP that it can be hard to keep track of it all, so I keep an ongoing “to do” list for you here in my blog.
Register for 19th Annual NASPP Conference (November 1-4 in San Francisco). Don’t wait; the early-bird rate is only available until May 13.