United States: Say-on-Pay, The Golden Parachute, And Other Executive Compensation Issues


In the aftermath of the 2008 financial crisis, compensation programs and practices have become the subject of intense regulatory and shareholder scrutiny. In light of the non-binding shareholder say-on-pay vote required by Dodd-Frank, as well as the other executive compensation provisions of Dodd-Frank that the SEC is in the process of implementing, public companies are enhancing both their proxy disclosures and their shareholder engagement efforts. As these companies adapt to this new regulatory regime, they are also facing new challenges to their director compensation programs in light of recent Delaware case law. This chapter will discuss the new challenges facing executive compensation decision makers, and the strategies employed in response.

Regulatory Pressures and Corporate Governance

Executive compensation governance measures form a key part of the Dodd- Frank Act (Dodd-Frank)1 and, by the end of the summer of 2015, the SEC had either finalized or proposed rules implementing all of Dodd-Frank's executive compensation provisions. The most well-known reform under Dodd-Frank is the required say-on-pay vote, which mandates that each public company provide its shareholders with a non-binding vote on the company's executive compensation program. Since being implemented in 2011, say-onpay has caused many companies to reconsider their pay programs and the manner in which those programs are disclosed to shareholders.

In addition to say-on-pay, Dodd-Frank will require each public company to disclose the relationship of its pay to its performance (using a total shareholder return metric), the ratio of its CEO's compensation to the median compensation of all other employees, and the company's policies on hedging. Further, Dodd-Frank will require each company to implement and disclose a policy requiring the recovery of certain erroneously awarded incentive-based compensation.

Although certain of these rules have yet to be finalized, companies have already begun to adapt to this new regulatory regime. Each year, Shearman & Sterling LLP surveys the corporate governance and executive compensation practices of the one hundred largest US companies (Top 100 Companies). This year's survey shows, for example, that of the Top 100 Companies, ninety-six already disclose that they prohibit hedging of company stock and eighty-seven of the Top 100 Companies already maintain clawback policies. This voluntary compliance reflects the fact that many proxy advisory groups consider these policies to be an element of sound corporate governance and risk management.

Clawback Policies and Practices

In July of 2015, the SEC proposed rules to implement Dodd-Frank's clawback provision. Under Dodd-Frank, issuers will be required to recover incentive-based compensation that is received by an executive officer of the issuer during the three-year period preceding the date on which the company is required to restate a financial statement due to a material error, to the extent that compensation is in excess of what would have been received had it been determined using the restatement.

Unlike the clawbacks mandated by Sarbanes-Oxley, which require misconduct to trigger a clawback, the proposed Dodd-Frank rules provide for unqualified "no-fault" recovery. In addition, companies will have limited discretion as to whether to enforce the clawback policy. Unless recovery would be impracticable due to expense, or recovery would violate a home country rule, the policy must be enforced.

Our survey shows, however, that the voluntary policies currently in place at the Top 100 Companies are not uniform, and that their application varies as to the events that trigger recovery, culpability standards, the individuals covered, the types of compensation subject to recovery, the level of board discretion as to whether to seek enforcement, and the time period covered by the recovery policy. Once the rules under Dodd-Frank are finalized, most companies will need to either amend their current clawback policies or adopt a supplemental policy that conforms to the SEC's requirements.

Compensation Committee Requirements

Directors charged with sitting on a company's compensation committee must comply with the independence standards of the securities exchange or association on which the company is listed. In addition, companies need to be aware of the "outside director" requirements of Section 162(m)2 of the tax code, and the non-employee director requirements of Section 16 of the Exchange Act. The possibility exists that a compensation committee member will satisfy the independence requirements of the exchange, but will fail to be an "outside director" under Section 162(m) or a nonemployee director under Section 16. Companies need to carefully monitor the activities and relationships of their board members to ensure they do not lose an expected deduction under 162(m), or inadvertently cause an insider to have to disgorge profits under Section 16.

Section 162(m)

Pursuant to Section 162(m) of the tax code, compensation payable to a company's CEO and its three other highest paid officers (other than the CFO) is not deductible if it is in excess of $1 million. An exception exists, however, for performance-based compensation that is approved by a compensation committee consisting entirely of two or more "outside directors." An "outside director" is a director who:

  1. is not a current employee of the company,
  2. is not a former employee of the company who receives compensation for prior services (other than benefits under a taxqualified retirement plan),
  3. is not a former officer of the company (regardless of whether he or she receives compensation for prior services), and
  4. does not receive "remuneration" from the company, either directly or indirectly, in any capacity other than as a director.

Notwithstanding the fact that Treasury Reg. 1.162-27(e)(2)3 states that the committee must consist "solely of two or more outside directors," the IRS has stated that these regulatory requirements will be met in the case of board action by unanimous written consent (so long as at least two members were outside directors), and actions by committees in which inside directors recuse themselves.4

Section 16(b)

Section 16(b) of the Exchange Act5 provides that a company insider, including a director, officer or 10 percent owner, is liable to the company for any profits resulting from his or her purchase and sale of the company's equity securities within any period of less than six months. To ensure that grants of equity compensation are exempt from this rule, the SEC promulgated Rule 16b-3 of the Exchange Act,6 which exempts transactions between an issuer and a director or officer that are approved by either the full board or a committee composed solely of two or more "non-employee directors."

To qualify as a non-employee director, the director cannot:

  1. Be an officer or employee of the company;
  2. Receive in excess of $120,000 in compensation, either directly or indirectly, from the company (or from a parent or subsidiary) for services rendered as a consultant or in any capacity other than as a director; or
  3. Have an interest in any "related party" transaction for which disclosure in the proxy statement would be required pursuant to Item 404(a)7 of Regulation S-K.

Although Exchange Act Rule 16b-38 states that the committee must consist "solely of two or more non-employee directors," the SEC has stated that non-qualifying directors can abstain or recuse themselves from action on the transaction, or the committee can form a subcommittee composed of two or more non-employee directors to approve the transaction.9

Director Independence Requirements of the Securities Exchanges

With respect to the independence requirements of the securities exchanges, both the NYSE and NASDAQ require members of their listed companies' compensation committees to be independent. One of the executive compensation provisions in Dodd-Frank requires the SEC to adopt rules directing the national securities exchanges and associations to prohibit the listing of any security of an issuer that does not comply with certain compensation committee (and compensation adviser) requirements. The exchanges and associations were charged with developing listing standards requiring each member of the compensation committee to be "independent." The SEC finalized its requirements in June of 2012, and in January of 2013, approved the listing standards of each of the NYSE and NASDAQ. Although it does not define the term "independent," Dodd-Frank does state that the exchanges must take into account certain "relevant factors" which include:

  1. A director's source of compensation, including any consulting, advisory or other compensatory fee paid by the issuer to such directors, and
  2. Whether a director is affiliated with the issuer, a subsidiary of the issuer, or an affiliate of the issuer.

Although the NYSE and NASDAQ have different definitions of "independent," both generally look to ensure that the directors have not, in the three previous years, been employees of the company, had a business relationship (other than stock ownership) with the company or familial relationship with employees of the company.

Although each exchange lists certain relationships that are a per se bar to independence, this list is non-exclusive and the board must examine each relationship and make an affirmative determination, considering all relevant facts and circumstances, as to a particular director's independence. Further, to the extent a director has a relationship that the company reviewed before determining that the director was independent, this relationship will need to be disclosed in the company's proxy statement pursuant to Item 40410 of Regulation S-K.

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1 Dodd-Frank Act, Pub. L. No. 111-203, 124 Stat. 1376.

2 26 U.S.C.A. § 162(m).

3 Treas. Reg. 1.162-27(e)(2).

4 Priv. Ltr. Rul. 9732007, 9811029, respectively.

5 15 U.S.C.A. § 78p.

6 17 C.F.R. § 240.16b-3.

7 17 C.F.R. § 229.404(a).

8 17 C.F.R. § 240.16b-3.

9 American Society of Corporate Secretaries, SEC No-Action Letter, Q.1(b) (Dec. 11, 1996).

10 17 C.F.R. § 229.404.

Previously published in Inside the Minds—Recent Changes in Employee Benefits and Executive Compensation

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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