Executive compensation trends in the United States are affected by a network of interrelated factors, including legal and regulatory requirements, market and cultural trends, and shareholder pressures. C-suite and senior executives should know the significant roles that securities and tax laws play in compensation structures.
Securities Regulations and Executive Compensation
Congress enacted the Sarbanes-Oxley Act (SOX) in 2002 in response to a slew of corporate business scandals – Enron in particular – in which a company’s officers and employees misrepresented earnings reported to shareholders to line their own pockets. SOX attempts to prevent this type of corporate misconduct by imposing specific internal financial controls on publicly-traded companies.
Specifically, Section 304 of SOX requires CEOs and CFOs of publicly-traded companies to give up bonuses, incentive pay, other equity-based compensation, and any profits from sales of company stock they received within 12 months following a financial restatement caused by their misconduct.
In 2010, the Dodd-Frank Act was enacted in response to the 2008 financial crisis and focused on regulating financial markets to ensure market stability and prevent another such disaster. Section 954 of the Act amended the Securities Exchange Act of 1934 to empower the SEC to implement rules requiring publicly-traded companies to adopt clawback policies with a three-year lookback period. The amendment targets a broader set of executives than just the CEO and CFO, and without the requirement of executive misconduct.
The SEC proposed rules under Section 954 in 2015, but they remain in limbo five years later. However, the SEC recently included Section 954 on its Short-Term Agenda – Spring 2020, listing October 2020 as a final action date. Given the impending election, it remains to be seen whether this is just another false alarm regarding implementing Dodd-Frank clawback regulations. Meanwhile, absent such rules, many publicly-traded companies have designed their own limits on executive compensation, often in response to shareholder pressure.
Tax Amendments Affecting Executive Compensation
Over the past 15 years, the U.S. has passed new tax laws limiting executive compensation, and like SOX and Dodd-Frank, these rules seek to regulate compensation levels for senior executives.
For example, Section 409A of the Internal Revenue Code (IRC), passed as part of the American Jobs Creation Act of 2004, imposes complex requirements on deferred compensation schemes, which are broadly defined and can include severance plans and even separation agreements. The provision also imposes a 20 percent excise tax on employees who violate its requirements. Sections 280G and 4999 of the IRC regulate so-called golden parachutes by denying a corporate tax deduction (280G) for and imposing a 30 percent excise tax (4999) on payments that exceed a statutory threshold made to senior executives in connection with a change-in-control.
New laws have placed a strict cap on corporate tax deductibility for executive compensation. IRC Section 162(m) imposes a $1 million limit on corporate tax deductibility for certain senior executives. That section was amended recently to include the CEO, the CFO, and the three other highest-paid executives; before the amendment, Section 162(m) did not cover the CFO automatically. More importantly, the change covers all aspects of compensation within the $1 million limit, including performance-based bonuses, equity-based compensation, and deferred compensation.
While it is still unclear exactly how this change will affect executive compensation trends, one important implication is apparent. Under the modified rule, severance payments, accelerated vesting, and distributions of deferred compensation upon separation would be included in the $1 million limit. This means that companies will be disincentivized to make these payments in one year and will be more interested in maintaining the original vesting schedule or agreeing on a schedule of installments that keeps the total annual payment to the executive under $1 million.
We will continue to monitor developments and trends affecting executive compensation, including the influence of recent case law.