– Broc Romanek

Here’s a note that I received from a member last night worth reading:

Recently proposed tax legislation (first by the by the House of Representatives, which has since reversed its position – but then the Senate bill revived this position) would impose federal income tax on the value of employee stock options as they vest, which could severely curtail the use of this long-standing equity compensation scheme. Under current tax law, stock options are generally not taxed until exercise, which allows the option holder to trigger taxation based on a stock price and date the option holder feels is optimal for their situation.

The proposed legislation also taxes subsequent increases in the value of the stock option on an annual basis in the event the participant does not exercise the stock option on the vest date. Under the proposed legislation it is unclear if a subsequent reduction in the value of an unexercised stock option would result in a reduction in taxable income, although it’s hard to imagine option holders delaying exercise after the option is taxed at vest, hoping to see the stock price drop so they can recoup some of the tax.

Most employee stock options vest over a three- to four-year period, typically in equal increments. A number of high tech companies vest stock options in monthly or quarterly increments after the 1st anniversary of the award. Putting aside the tax inefficiency created by the new tax legislation, the administrative burden of taxing stock options annually, monthly or quarterly might be sufficient reason for many employers to abandon stock options.

For some stock option critics, including a well-known investor from Omaha, Nebraska, the demise of stock options is long overdue. These critics argue that stock option holders benefit from a rising stock market (“rising tides lift all ships”) and the resulting gains are often undeserved. Others have referred to stock options as a “blunt instrument” for delivering compensation, as the resulting value is usually much higher or lower than the “expected” value at the time of grant.

Based on a recent survey of over 400 companies conducted by Deloitte Consulting in conjunction with the NASPP, the prevalence and emphasis on stock options has been on the decline for some time. Based on the latest findings, 51% of survey participants grant stock options compared to 89% of participants who grant time vested restricted stock and 81% of whom grant performance shares. Even among “high tech” survey participants, only 51% grant stock options.

There are several reasons for the decline in stock options, including the high level of uncertainty and compensation volatility, the significant number of shares and corresponding dilution required when using stock options compared to other equity compensation alternatives, and proxy advisory firm pressure to award performance-vested stock awards.

Despite the decline in stock option usage (with an increase in RSUs, etc.), there are a number of companies that continue to rely exclusively on stock options to attract & reward employees. Among these are start-up companies that have limited resources, and can only share future value creation with employees. Private equity owned portfolio companies are also significant users of stock options, as private equity owners are paid based on stock price appreciation, and stock options are an elegant way to align the interests of the owners and employees.

What is truly perverse about the proposed legislation is it actually produces less tax revenue for the Federal government than the current rules. Here is a simple example, to illustrate the point. Assume a stock option is granted with an exercise price of $10, and it vests on the third anniversary of the grant when the FMV is $13. The option is exercised in year 7 when the FMV is $20.

Under current tax law, the option holder earns $10 of ordinary income, and assume the federal government collects 25%, or $2.50. Under the proposed rule, the option is taxed at vest, which will most likely cause the option holder to exercise and sell the shares. In this case, the option holder realizes $3 of ordinary income, and at 25%, the Federal Government collects $.75 of tax. While it is true, the Fed gets its money in year 3 versus year 7, given the Fed’s low cost of funds, the present value of the year 7 tax equals about $2.30 in year 3 compared to $.75, a reduction of close to 68% in collections.

Of course, the stock has to increase beyond the year 3 stock price of $13 at 10% per year for the math to work as illustrated, but why would the Fed want to bet against future appreciation of 10’s of millions of stock options, when it is trying to pursue policies that spark accelerated economic growth for the economy?

The proposed stock option law, if passed, will be hugely unpopular among many companies and their employees, rob start-ups and other very entrepreneurial organizations with an effective way to share value creation with employees, lower tax receipts and undoubtedly result in a shift to other forms of compensation that cost shareholders more and are less effective in motivating employees. So, let’s hope Congress takes a deep breath, counts to 10, and decides to forget the whole thing.

– Broc Romanek

This MarketWatch article by Francine McKenna narrates the moving parts of the executive pay provisions in the Senate & House versions of the tax reform bill. This Fenwick & West memo describes the Senate version of the bill if you missed that on Friday night (here’s all the memos)…

– Broc Romanek

This Pearl Meyer blog offers “lessons learned” from integrating pay programs after a deal. While harmonizing programs sounds nice – it’s difficult to achieve without damaging the culture you’ve just paid to acquire. Here are some takeaways:

If you reframe the desired outcome of this process as compensation program optimization, which is a subtle, but important distinction, real value can be created. This may mean maintaining separate philosophies between the organizations for an indefinite period of time. Or it may mean that deliberate choosing of specific elements of one approach over the other. The key is to ensure each compensation program decision is guided by the overall business strategy of the combined entity.

In the short-term, this usually means fairly minor changes for each entity on factors such as performance metrics embedded in incentive plans, expanding and/or contracting eligibility for certain programs, and shifting the definition of “market” used to benchmark pay practices. In the long-term, this is best viewed as a process and not an event. The effort to optimize a compensation program for the new combined entity ideally will provide a template for ongoing evaluation and tailoring of programs for the next round of evolving business opportunities and challenges.

– Broc Romanek

Here’s the news from this FW Cook blog (also see this Fenwick & West memo – and Davis Polk blog):

Yesterday evening, Senate Finance Committee Chairman Hatch released details of the Senate’s version of the Tax Cuts and Jobs Act. The most notable development for executive compensation is that the Senate bill generally contains the same executive compensation related provisions that were included in the first, and now outdated, release of the House bill (H.R. 1).

As previously reported, H.R. 1 was amended yesterday to remove Section 3801 of the bill, which provided for sweeping changes to the tax treatment of non-qualified deferred compensation, including stock options, under a new “Section 409B.”

For the moment, the new deferred compensation rules may be back on the table. The Senate Finance Committee meets for the first time on Monday, November 13 to begin consideration of the bill. Both the House and Senate versions are subject to further change, votes, and eventually reconciliation before final passage.

– Broc Romanek

It’s quite rare that I blog other than early in the morning. It’s too tempting to chase news across the day. But I thought I would throw up some big news regarding the earth-shattering House tax bill – even though it could be more complete if I waited til morning (including where we stand with the Senate version). Here’s the skinny about how the House made changes to its tax bill today (see this official summary):

1. The House has deleted the offending provisions about equity compensation from the bill (Section 3801 of the bill) – but it left in the provision allowing deferral of tax of stock options for private companies. And it sounds like the provision is modified that so it no longer applies to RSUs (it originally applied to both RSUs & options).

2. The changes to Section 162(m) still stand (Section 3802 of the bill). I think that’s a done deal, assuming they can get the rest of the bill passed. It’s clearly a revenue raiser and if the corporate tax rate is only 20%, companies probably don’t care about the deduction as much anyway. I’m sure it’s a trade-off many companies are willing to make.

So the upshot is that all of Section 3801 is struck – so no changes to the taxation of NQDC – and 409A still stands, so no big changes to the taxation of options & RSUs. And this is a week of my life I can never get back. We’ll be posting the new horde of memos that are sure to come in our “Regulatory Reform” Practice Area…

– Broc Romanek

Last month, I blogged about changes that companies have made after getting a low say-on-pay vote. But if you want to avoid being in the 12-14% of companies that get a negative ISS recommendation each year, there are also things you can do in advance.

This Davis Polk blog lays out the 7 main drivers that lead to say-on-pay issues, in addition to the magnitude of pay & shareholder return (also see this Willis Towers Watson memo). Here’s a teaser:

1. Compensation committee responsiveness. Failure of the compensation committee to demonstrate responsiveness after a low, although passing, say-on-pay vote.

2. Discretionary awards outside of plans. Retention grants, replacement grants and make-whole awards are all discretionary awards that can be particularly problematic if they are essentially re-grants of previously forfeited awards or used to replace foregone performance-based awards. Discretion, or any adjustments, can be appropriately applied, even upward discretion, if specifically linked to tangible business events that benefited shareholders. A separate ISS Analytics report indicated that discretionary cash bonuses have continued to decline, making up just 10% of the S&P 500 in 2016, while 86% of those companies paid non-equity incentives.

3. Incentive plan construction. Questions may arise around a program that relies exclusively on subjective components or has an ineffective mix of time-and performance-based awards.

4. Selection and disclosure of performance metrics. Disclose your metrics in a way that ties them to your strategy. There continues to be a love-hate relationship with relative TSR – but companies with high TSR tend to have higher say-on-pay approvals regardless of pay structure. There’s also a lack of consensus on whether three years is too short of a performance period – consider selecting other metrics for that time span as part of long-term incentive programs.

5. Rigor of performance goals. The situations that generate the most concern include setting goals below last year’s actual or target performance without explanation, goals that always achieve maximum payouts or a company’s failure to disclose goals at all even after the award cycle is completed.

6. Peer group and benchmarking practices. Some companies continue to select aspirational peer sets where the median company is significantly larger, or benchmark above the median without explanation.

7. Employment agreements. While there has been tremendous change in practices over the last seven years, some perennial issues that arise and always garner attention include large severance multipliers, guaranteed multi-year awards, inducement grants, replacement awards, retirement grants and separation benefits.

– Broc Romanek

Here’s the teaser for this Pay Governance memo:

Incentive plans have the potential to drive executives towards achieving superior results for their companies and investors. At the same time, real and perceived risks in these programs can either blunt the potential drive of management or encourage excessive risk taking. A key goal in well-designed executive incentive programs is to motivate executives to take the actions necessary to achieve strong results for shareholders while mitigating the motivation to take excessive risks.

To date, the annual report that Compensation Committees provide in the CD&A on the presence of material risk in pay programs has been based largely on overall qualitative assessments done by the Company or their independent advisor. The most common risk assessment approach has been to look at each of the major incentive design elements in isolation – such as the presence or lack of a “cap” on annual incentives – and then judge the overall risk based on the types and number of potential risk-creating elements observed in the entire pay program. This qualitative approach is a self-assessment, and rarely does it look at relative risk compared to peer companies or a comparator group.

Pay Governance has recently developed a quantitative measurement tool, tested with the Fortune100, that will generate an overall score for both Pay Energy™(the first measurement tool that identifies the degree to which any company’s pay program creates “drive, discipline and speed”) and Pay Risk (in this context, risk refers to financial risk). This can then be used as an additional diagnostic tool to evaluate the potential of a new or existing pay design to achieve an efficient balance of Pay Energy™and risk management.

– Broc Romanek

As we continue to post memos in our “Regulatory Reform” Practice Area about the new House tax bill – here’s the intro from this hilarious blog by Performensation’s Dan Walter:

Stock Options, Restricted Stock Units, young Performance Units and their cousin Non-Qualified Deferred compensation tragically died in 2017 as an unintended consequence of colliding with the 429 page U.S. tax reform called the ‘‘Tax Cuts and Jobs Act.’’ It should be noted that Employee Stock Purchase Plan is currently in critical condition at a local hospital.

– Stock Options had lived an exciting and robust life since the 1980s. Friends and associates attribute the success of their business and the growth of nearly all technology we enjoy today to Stock Options.

– Restricted Stock Units, fondly remembered as “RSUs,” had recently provided stability to the family. After gaining prominence in the early 2000s, RSUs had recently become a leader in the family.

– Performance Units were just youngsters at the time of the accident. Vibrant and imaginative, their creative approach was an inspiration to companies and investors looking to build a brighter, more just, tomorrow. Their surprising loss will change the course of history for years to come.

– Non-Qualified Deferred Compensation (“NQDC” to its friends), a beloved cousin, lived a quiet life at edges of the family. While less well-known, NQDC was a vital component for many of its supporters.

Also impacted by the accident was Employee Stock Purchase Plans (ESPP). ESPP is a beautiful blend of many of the best features found in other members of the family. A favorite of a broad section of the population, ESPP’s mission was to provide an uplifting experience to the “regular folks” who often did not get a chance to meet other family members. ESPP is currently on life-support, with no additional information available at the time this was written.

The Equity Compensation family was often misunderstood, but lived to make people more successful. They enjoyed spending time with small, private companies in need of a spark for growth and well-known public companies working to provide the tools, system, medicine and other advancements that make the world a better place. Their extended family has moved all over the world and remain exciting contributors to the success of individuals in nearly every country on the planet. The loss of Equity Compensation in the United States will put all of us at a disadvantage in the competitive future.

– Broc Romanek

Last week’s tax bill from House Republicans would have a tremendous impact on executive pay if enacted into law. We’re posting memos in the “Regulatory Reform” Practice Area – but here’s a teaser from Skadden that will blow you away:

If enacted, the newly proposed “Tax Cuts and Jobs Act” would effectively put an end to many of the most widely used forms of executive compensation:

– Deferred compensation and stock options would disappear

– Use of performance-based compensation would be severely limited

– Compensation over $1 million to senior executive officers would be nondeductible for public companies and subject to an excise tax for tax-exempt organizations.

Of course, the tax reform bill released by the House Republicans today (November 2) is likely to change, perhaps drastically, in the coming days.

– Broc Romanek

Check out BDO’s latest study on middle-market board director compensation, finding that total board director compensation for middle market companies rose 4%, from $153k to $159k. Other findings include:

– Companies favor equity compensation over cash: use of stock options rose 3%
– Board retainers and fees increased an average of 9% across all industries
– Technology remains the highest compensated industry: Bank directors remain the lowest, earning $45k compared to their tech counterparts at $219k