The Advisors' Blog

– Broc Romanek

Tune in tomorrow for the webcast – “The Latest: Your Upcoming Pay Ratio, Tax Reform & Proxy Disclosures” – to hear Mark Borges of Compensia, Alan Dye of Hogan Lovells and Section16.net, Dave Lynn of CompensationStandards.com and Jenner & Block and Ron Mueller of Gibson Dunn discuss all the latest guidance about how to overhaul your upcoming disclosures in response to tax reform, pay ratio and say-on-pay – including the latest SEC positions, as well as how to handle the most difficult ongoing issues that many of us face.

And I just calendared another tax reform webcast for next week: “Tax Reform: What’s the Final Word?“

– Broc Romanek

In his blog, Steve Quinlivan listed these recent Section 162(m) disclosures:

The cash bonuses paid and equity-based awards granted to executive officers under the MIP are intended to be fully deductible under section 162(m). In addition, the Company has adopted a policy that equity-based awards granted to its executive officers should generally be made pursuant to plans that are intended to satisfy the requirements of section 162(m). However, the Compensation Committee retains discretion and flexibility in developing appropriate compensation programs and establishing compensation levels and, to the extent consistent with the Company’s compensation philosophy, may approve compensation that is not fully deductible. Also, legislation recently signed into law would expand somewhat the number of individuals covered by section 162(m) and eliminate the exception for performance-based compensation effective for our 2018 tax year.

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The Compensation Committee believes that the use of a strict formula-based program for annual awards could have inadvertent consequences such as encouraging the NEOs to focus on the achievement of one specific metric to the detriment of other metrics. In addition, tying compensation to a strict formula would not allow for adjustments based on issues beyond the control of the NEOs. The Compensation Committee recognizes that each NEO other than the CEO (each, a “Senior Executive”) may be most able to directly influence the business unit for which he or she is responsible and therefore believes it is appropriate to use negative discretion to adjust annual awards for each such Senior Executive to take into account the achievement of objectives that are directly tied to the growth and development of their respective business unit. Furthermore, with respect to our overall executive compensation program, the use of discretion provides the Compensation Committee with the flexibility to compensate our NEOs for truly exceptional performance without paying more than is necessary to incent and retain them while structuring awards to be potentially deductible as performance-based compensation under Section 162(m) of the Code, when appropriate. However, as discussed below under “Tax Considerations,” while the tax law included an exception to the $1 million limit on deductibility for “performance-based” compensation under Section 162(m) of the Code when the Compensation Committee made its fiscal year 2017 compensation decisions, this exception was repealed.

At the beginning of fiscal year 2017, the Compensation Committee approved a maximum KEIP award amount for each NEO, other than Mr. Sethi, who became an NEO at the end of fiscal year 2017. The maximum award that each NEO is eligible to receive, however, is not an expectation of the actual bonus that will be paid to him or her, but a cap on the range ($0 to the maximum amount) that an individual may be paid while maintaining the tax deductibility of the bonus as “performance-based” compensation for purposes of Section 162(m) of the Code. See “Tax Considerations” below for a brief discussion of the “performance-based” compensation exception under Section 162(m) of the Code and its repeal. As described above in our “Compensation Philosophy,” the Compensation Committee has historically exercised negative discretion to pay significantly less than the maximum amount available to the NEOs under the KEIP award pool based on its evaluation of the achievement of business unit, Company-wide and individual performance measures for such NEOs, as described above in this CD&A.

In evaluating compensation program alternatives, the Compensation Committee considered the potential impact on the Company of Section 162(m) of the Code. Section 162(m) limited to $1 million the amount that a publicly traded corporation, such as the Company, may deduct for compensation paid in any year to its chief executive officer and certain other named executive officers (“covered employees”). At the time the Compensation Committee made its compensation decisions, the tax law provided that compensation which qualified as “performance-based” was excluded from the $1 million per covered employee limit if, among other requirements, the compensation was payable only upon attainment of pre-established, objective performance goals under a plan approved by our stockholders. However, this exception was repealed in the tax reform legislation signed into law on December 22, 2017. As a result, it is uncertain whether compensation that the Compensation Committee intended to structure as performance-based compensation under Section 162(m) will be deductible.

As a general matter, in making its previous NEO compensation decisions, the Compensation Committee endeavored to maximize deductibility of compensation under Section 162(m) to the extent practicable while maintaining competitive compensation. The Compensation Committee, however, believes that it is important for it to retain maximum flexibility in designing compensation programs that are in the best interests of the Company and its stockholders.

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Salaries are deductible, except for the portion of the CEO’s salary in excess of $1 million. The Compensation Committee designs the ACIP and equity awards, including RSUs that have a financial performance threshold, to comply with the requirements for tax deductibility under Internal Revenue Code Section 162(m) (Section 162(m)), to the extent practicable. The Compensation Committee considers tax reform enacted under the Internal Revenue Code on an annual basis when designing the compensation programs.

To maximize tax deductibility, amounts earned under the ACIP are designed to qualify as performance-based compensation under Section 162(m). This design provides that if certain financial objectives are met, our executive officers may receive up to 2x their target amounts, subject to the Compensation Committee’s negative discretion to pay any amount less than the maximum.

RSUs generally vest in equal annual installments over three years. The RSUs also include a requirement that the Company must meet an adjusted GAAP operating income target (over a 6-month period) in order for them to vest, which is intended to qualify the RSUs for tax deductibility under Section 162(m).

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Section 162(m) of the Internal Revenue Code generally places a $1 million limit on the amount of compensation a company can deduct in any one year for certain executive officers. While the Compensation Committee considers the deductibility of awards as one factor in determining executive compensation, the Compensation Committee also looks at other factors in making its decisions, as noted above, and retains the flexibility to award compensation that it determines to be consistent with the goals of our executive compensation program even if the awards are not deductible by Apple for tax purposes.

The 2017 annual cash incentive opportunities and performance-based RSU awards granted to our executive officers were designed in a manner intended to be exempt from the deduction limitation of Section 162(m) because they are paid based on the achievement of pre-determined performance goals established by the Compensation Committee pursuant to our shareholder-approved equity incentive plan. In addition, the portion of Mr. Cook’s 2011 RSU Award subject to performance criteria with measurement periods that begin after the June 21, 2013 modification was designed in a manner intended to be exempt from the deduction limitation of Section 162(m).

Base salary and RSU awards with only time-based vesting requirements, which represent a portion of the equity awards granted to our executive officers, are not exempt from Section 162(m), and therefore will not be deductible to the extent the $1 million limit of Section 162(m) is exceeded.

The exemption from Section 162(m)’s deduction limit for performance-based compensation has been repealed, effective for taxable years beginning after December 31, 2017, such that compensation paid to our covered executive officers in excess of $1 million will not be deductible unless it qualifies for transition relief applicable to certain arrangements in place as of November 2, 2017.

Despite the Compensation Committee’s efforts to structure the executive team annual cash incentives and performance-based RSUs in a manner intended to be exempt from Section 162(m) and therefore not subject to its deduction limits, because of ambiguities and uncertainties as to the application and interpretation of Section 162(m) and the regulations issued thereunder, including the uncertain scope of the transition relief under the legislation repealing Section 162(m)’s exemption from the deduction limit, no assurance can be given that compensation intended to satisfy the requirements for exemption from Section 162(m) in fact will. Further, the Compensation Committee reserves the right to modify compensation that was initially intended to be exempt from Section 162(m) if it determines that such modifications are consistent with Apple’s business needs.

– Broc Romanek

Here’s the results from our recent survey on director compensation in the wake of the 2015 Citrix decision:

1. When it comes to limits on our director pay:
– Yes, we have adopted limits since Citrix – 51%
– Yes, we had limits even before Citrix – 22%
– No, we don’t have limits – 26%

2. For those that have limits, our limits apply to:
– Cash only – 0%
– Equity only – 56%
– Both cash & equity – 44%

3. For those that have equity limits, our limits are based on:
– Dollar limit – 85%
– Share limit – 33%

4. For those that have limits, our limits are based on:
– Multiple of annual compensation – 35%
– Maximum number based on estimates of future compensation for a set period – 36%
– Other – 35%

5. For those that have limits, our limits are based on:
– Peer review – 43.6%
– What we could derive from the case law & settlements – 20.0%
– Our discretion – 58.2%
– Other – 16.4%

Please take a moment to participate anonymously in these surveys: “Quick Survey on More on Blackout Periods” – and “Quick Survey on Whistleblower Policies and Procedures.”

– Broc Romanek

This study by FW Cook analyzes LTIP trends among the 250 largest S&P companies. Notable findings include:

– Companies continue to employ a portfolio strategy for long-term incentives to balance the advantages and drawbacks of each vehicle type, with nearly 90% using two or more grant types.

– Stock options are trending down – 59% of companies awarded them last year.

– TSR remains the most prevalent performance metric, with almost every company that uses it measuring on a relative basis.

– 95% of companies grant performance awards, with 59% utilizing two or more performance metrics and 88% using a 3-year performance period.

– Broc Romanek

In this paper, Stephen O’Byrne & David Young provide analysis that highlights a major roadblock to better governance and better pay practices. Here’s a note that Stephen sent about it:

One major “roadblock” is that the modern director is not a steward of his own capital, but a paid labor provider, just like management. Directors and management have a strong common interest in pay practices that protect labor providers at the expense of capital providers, e.g., providing competitive pay regardless of past performance. Their common interest is the governance problem, not “managerial power” as Bebchuk & Fried would have us believe. And the problem is hidden because the governance discussion focuses on director independence, not director incentives to increase shareholder value.

Earlier this year, we published a paper on the “Evolution of Executive Pay Policies at General Motors 1919-2008.” The paper chronicles the demise of management incentives based on fixed sharing in economic profit. From 1918 to 1977, the GM incentive pool was 10% of profit in excess of a 7% return on capital (with some minor variations over time in the sharing percentage and capital charge). This pool covered all management incentive compensation at GM, both cash and stock. In 1977, GM directors dropped fixed sharing and switched to competitive pay concepts (i.e., target dollar compensation).

One remarkable thing about the fixed sharing period is the lengths to which GM directors went to achieve compensation objectives without sacrificing the fixed sharing. To strengthen management ownership, they set up two eight-year long leveraged stock purchase plans when they could have easily increased the sharing percentage or made stock grants outside the incentive pool. To realize the post-WW II tax benefits of stock options, they developed an elaborate system of “contingent credits” to charge the stock option expected value against the incentive pool.

A second remarkable thing about this period is the magnitude of the directors’ stock interest relative to their director fees. In 1947, in the middle of the fixed sharing years, the median director owned $1.65 million in stock and received a director fee of $900. Assuming a 10% expected return, this means that the directors fee only made up for the loss of two days of expected stock return (one day = $1,650,000 x 10% / 365 days = $452). In 1977, when the directors dropped the fixing sharing plan in favor of competitive pay concepts, the median director owned $34,000 in stock and received a director fee of $47,000. This means that the directors fee made up for the loss of almost 14 years of expected stock return. The GM director in 1947 was a steward of his own capital, while the GM director in 1977 was a paid labor provider, just like management.

In a recent analysis, I looked at S&P 1500 directors to compare their expected stock return with their directors fee. For this analysis, I used an 8% expected return and classified a director as a “steward of his own capital” if his expected stock return was 10x or more his directors fee (vs 183x for the 1947 GM director). With this definition, only 3% of S&P 1500 directors are stewards of their own capital, while 97% are paid labor providers like management.

– Broc Romanek

This LA Times article is critical of Netflix’s move to higher salaries for top management in the face of the new tax laws. Here’s an excerpt:

The big news Friday on the executive compensation front is that Netflix is converting some of its “performance-based” pay for its top executives to straight salaries, thanks to the recently-passed tax bill. But people may be taking the wrong lesson from the change. On the surface, it looks like the five executives covered by the change are getting big raises thanks to the tax bill. But the reality is a bit more complicated. And what the new policy at Netflix really tells us is that the old “performance-based” executive compensation system always was a sham, anyway.

And this Quartz article presents this argument about why CEO pay is so high:

Many board members say there’s little reason to risk under-paying a CEO when, in terms of the company’s overall costs, the excess isn’t material, said Xavier Baeten, professor of management practice at Vlerick Business School in Belgium. Keeping stable, capable management at the company’s helm is one of the board’s duties.

Also see this article from “The Street” entitled “Activist Investors May Use New Tax Law to Push for Big Stock Buybacks”…

– Broc Romanek

Two noteworthy things in this Bloomberg article:

1. Norway has this unique issue where one fund is so large that it may be able to dictate corporate policy – and the fund is part of their government.

2. Oddly, as identified in the top left corner when you go to the article, this article is part of the Bloomberg enterprise called “Gadfly” – which is a 4-letter word in the shareholder proposal world. Something that I just blogged about over on TheCorporateCounsel.net.

– Broc Romanek

Here’s the intro to this blog by Steve Quinlivan:

The Delaware Supreme Court found in In re Investors Bancorp Stockholders Litigation that director equity grants based on director discretion are subject to an entire fairness standard of review. According to the Court, “when stockholders have approved an equity incentive plan that gives the directors discretion to grant themselves awards within general parameters, and a stockholder properly alleges that the directors inequitably exercised that discretion, then the ratification defense is unavailable to dismiss the suit, and the directors will be required to prove the fairness of the awards to the corporation.”

Accordingly, the Delaware Supreme Court reversed the Court of Chancery’s decision which found that the stockholder ratification defense applied because the plan provided for “specific limits on the compensation of” the non-employee and executive members of the Board. The Court of Chancery had reasoned that the stockholders’ approval of the plan reflected their ratification of all of the specific awards later approved by the Board. Hence, the Court of Chancery found that the director grants should be subject to the business judgement standard of review.

We’re posting memos in our “Director Compensation Practices” Practice Area…

– Broc Romanek

In this article, Stephen O’Bryne shares four analyses that can be part of an institutional investor’s toolkit:

1. Measuring realizable pay
2. Calculating market rates and estimating the expected future value of market pay to express realizable pay as a “market pay multiple”
3. Calculating “industry betas” and relative TSR adjusted for industry beta
4. Calculating pay leverage

– Broc Romanek

I love the new “Vea World Recipes” crackers – particularly the flavor of “Andean Quinoa & Spices.” In this 20-second video, Cap’n Cashbags foregoes holiday bonuses for employees so he can buy Vea World Receipes for himself!