As 2018 comes to a close and before “Auld Lang Syne” begins to play, we thought we’d take a look back at the year and some of the main developments in compensation & benefits during 2018. The year was full of regulatory changes that we will continue to deal with for years to come. We also are waiting for much-needed guidance in several areas and to see how companies, in general, will respond to the new environment. This article serves as a compensation & benefits highlights-reel for 2018 and explores what we might see in 2019 after the ball drops.
1. Changes to Section 162(m) – The $1 Million Deduction Limit
Although the Tax Cuts and Jobs Act (TCJA) was technically a 2017 gift signed into law by the President just before Christmas last year, 2018 is when we’ve all begun to unpack what the new law means. The main change made by TCJA in the compensation & benefits area is around Section 162(m), which provides that compensation in excess of $1 million paid to “covered employees” of certain corporations is nondeductible by the corporation. The TCJA made three significant changes to Section 162(m):
- The performance-based exception was removed, effectively making all performance-based compensation includable in the $1 million deduction limitation that was previously excluded under the old law.
- The definition of a “covered employee” was expanded to include the CFO position and any covered employees from a prior year (2017 and later). Now, any individual who served as CEO or CFO during the current year, as well as any individual who is among the next top three highest-paid executives during the current year is considered a “covered employee” for that year and any subsequent years.
- The definition of a “publicly held corporation” was expanded to also include entities that have publicly-traded debt rather than just companies with publicly-traded stock.
The TCJA contained a grandfathering rule that provides that the new changes do not apply to “written binding contracts” that were in effect on November 2, 2017. However, the application of the grandfathering rule was rather murky since many of these contracts contain a discretionary component and therefore may not fit within the definition of a “written binding contract.”
Thankfully in August 2018, the IRS issued Notice 2018-68, which provided some much-anticipated guidance, in particular on the application of the grandfathering rule. The guidance stated that remuneration is only grandfathered to the extent the corporation is obligated under applicable law (such as state contract law) to pay such amounts. Since many 162(m) agreements contain negative discretion to reduce amounts, many arrangements will not be grandfathered if those provisions are valid under applicable law.
Notice 2018-68 also clarified that an employee does not have to be employed on the last day of the fiscal year to be considered a covered employee. This is a departure from old Section 162(m) as well as the current SEC disclosure requirements in some cases.
2019 and Beyond
Many are speculating what this Section 162(m) change will do to the design of executive compensation programs. For one, the removal of the performance-based exception has created some buzz as to whether companies will put less emphasis on performance-based awards. With shareholder pressure to link awards to performance, it is not likely that the performance-based exception removal will have much effect on incentive packages. Going forward, however, we might see an increase in individual performance metrics due to the removal of subjectivity as to what awards met the performance-based compensation exception. It will also be imperative for companies to keep track of who is considered a covered employee for 2017 and beyond, especially companies going through a period of uncertainty where the CEO, CFO and next three highest-paid executives may be changing frequently.
The IRS has also said that new regulations are in the works for additional guidance around Section 162(m). Notice 2018-68 requested comments from the public on several open issues from the IPO exemption to predecessor entities and foreign private issuers. It is unclear when we should expect to see proposed regulations on Section 162(m), but hopefully, we will receive guidance in the near future.
2. CEO Pay Ratio
2018 was the first year we saw the required disclosure of the CEO pay ratios for most public companies. Essentially, public companies must disclose the CEO’s total compensation, the median employee’s compensation, and the ratio of those two amounts as well as their methodology for calculating the numbers. The CEO pay ratio rules took years to implement and have been controversial, to say the least. However, we did not see as much backlash as was expected when high CEO pay ratios were disclosed this past spring. This was most likely due to the fact that there are so many factors that impact the analysis and companies were given some flexibility on how to calculate their ratio.
These ratios differ greatly between industries, and even within the same industry, so it can be difficult to determine what an acceptable CEO pay ratio is. The ratio is not indicative of whether a company is paying its employees in accordance with market standards, mainly because the ratio is dependent on numerous items such as business model, location of employees and operational methods. Rather, the ratio is one of the many data points that can be used by investors and other stakeholders to evaluate a company’s pay practices for both CEOs and its rank-and-file employees.
2019 and Beyond
The 2019 proxy season will bring about the 2nd round of CEO pay ratios for most public companies. Many are interested to see how much these ratios will change from year to year and what trends may emerge. It is conceivable that some companies with different or special circumstances like a new CEO hire could have a wild swing in the ratio. It will be interesting to see the response from shareholders in these situations and when companies make changes to their methodology to avoid having sharp increases in their ratios. We are also monitoring whether these rules will bleed into other areas -- several taxing authorities have already attempted to link taxation to companies’ CEO pay ratios, but it is too early to tell if many of these efforts will be successful.
Also, once we have several years of data, it will be interesting to see if there is any correlation between the CEO pay ratio and company performance. Again, with the number of factors that can change from year to year, it may be difficult to draw strong conclusions, but time will tell.
3. Me-Too Movement
In light of recent events and the increased following of the Me-Too Movement, executives are under a larger spotlight regarding workplace harassment of all types. More specifically, sexual harassment has been a hot topic for news outlets and activists. Loud outcries were heard in 2018 when several executives received payouts to leave their employers after being accused of inappropriate behavior. In the wake of the many sexual misconduct allegations being made against high-profile executives, companies have begun tweaking employment agreements with language pertaining to how misconduct can affect severance arrangements. Employment agreements define what constitutes termination for “cause,” with examples being fraud, conviction of a felony, or other crimes the company deems to be of high moral wrongdoing. Definitions of “cause” in termination scenarios are being expanded to specifically include sexual misconduct, meaning companies can avoid paying severance or accelerating the vesting of equity awards for executives who are terminated because of sexual misconduct. Without the specific language including sexual misconduct in for “cause” termination scenarios, the executive’s termination is effectively discretionary and may lead to an even messier departure from the company.
2019 and Beyond
Many companies are following the trend of including specific sexual harassment language in the definition of “cause” and this can be expected to continue to increase in prevalence. These companies are taking the opportunity to implement these additions in their executive’s employment agreements to convey to shareholders the emphasis being placed on proper behavior and treatment of employees. In addition, the concept of clawbacks is being explored to make executives pay back bonuses if misconduct was discovered at a later date. If a company plans to make these additions to employment agreements, the language needs to be very clear as to what is considered “cause” because executives can, and should, be hesitant to sign something with cloudy terms. Overall, paying executives for their departure from a company in the event of harassment allegations can have huge reputational risks, so adding these provisions into their employment agreements, rather than simply including it in company policy, sends a clear message to both executives and shareholders of how the company will treat the misconduct.
Alvarez & Marsal Taxand Says:
This year brought about many changes in the compensation & benefits space that we will be living with for many years to come. The TCJA will be the gift that keeps on giving as we still work through what the new rules mean practically and wait for additional guidance. With our culture’s focus on equality and fair treatment of all, the emphasis on pay parity and financial consequences for workplace harassment will likely only grow in the future. As we get ready to wrap up 2018 and look forward to 2019, we will continue to be available to assist with issues in the ever-changing landscape of compensation & benefits. From everyone at Alvarez & Marsal, Seasons Greetings and a Happy New Year!