Executive Compensation

Transcription

1 Executive Compensation Bulletin Known Unknowns: Meeting 162(m) in Corporate Transactions Steve Seelig and Russ Hall, Towers Watson September 28, 2011 [T]here are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns the ones we don't know we don't know. Former Defense Secretary Donald Rumsfeld Recently, we ve been asked by several clients if they can craft their performance-based incentive plans to preserve tax deductibility under Code Section 162(m) (the million-dollar pay cap) in the event of a corporate acquisition, reorganization or recapitalization. We ve also read articles suggesting that this goal can be accomplished through careful planning, with one stating: If the Compensation Committee s authority to make adjustments is not properly structured and designed, then any adjustment will cause the bonus award to be considered non-performance-based compensation, and [thus] may not be tax deductible by the company. Based on that promising statement, we ve thought hard about the meaning of properly structured and have concluded there is no one-size-fits-all approach that can be employed by all companies in every situation. That said, there are strategies that can maximize companies chances for success, depending on their specific circumstances. Also, keep in mind that the Section 280G rules may also come into play with regard to the tax treatment of payments that occur due to corporate transactions; these rules need to be carefully considered in tandem with 162(m). Here s a closer look. Defining Performance-Based Compensation While most practitioners understand how 162(m) permits performance-based compensation to remain deductible, it s helpful to review the following statement in the 162(m) regulations: Qualified performance-based compensation must be paid solely on account of the attainment of one or more pre-established, objective performance goals [emphasis added]. Not only must the performance goals be the sole trigger for whether compensation is paid, but these goals must be pre-established within a certain period before or after the start of the performance period and must be based on an objective formula or standard so that a third party having knowledge of the relevant performance results could calculate the amount to be paid to the employee. Not only must the performance goals be the sole trigger for whether compensation is paid, but these goals must be pre-established within a certain period before or after the start of the performance period, and must be based on an objective formula or standard so that a third party having knowledge of the relevant performance results could calculate the amount to be paid to the employee. Known Unknowns: Meeting 162(m) in Corporate Transactions I 1

2 Process-wise, this objective formula or standard must be set by a compensation committee consisting of outside directors at the start of the performance period, and must be based on performance metrics and compensation limits for executives approved by a vote of the corporation s shareholders. This would mean that, for performance-based plans designed to preserve tax deductibility under 162(m), two things must take place at the outset: Shareholders must approve all possible performance metrics and the maximum compensation that can be paid under the plan. (Several different approaches can be taken in setting the maximum.). The compensation committee must set the goals within 90 days of the start of the performance period (but no later than after 25% of the performance period has elapsed). Umbrella Plan Approach to Meeting the Performance-Based Exception The 162(m) regulations also permit companies to adopt umbrella plans that include a so-called plan within a plan. The linchpin of this approach is a plan structure that permits the compensation committee to reduce or eliminate plan payments due upon the attainment of a pre-established performance goal (often called an exercise of negative discretion ). The umbrella plan s performance formula must satisfy the 162(m) performance-based requirements summarized above, but there s an expectation that, in virtually all cases where this approach is used, the committee will exercise negative discretion to reduce the amount otherwise payable under the umbrella formula. To some extent, the committee will be guided in its exercise of discretion by performance relative to the goal under the plan within a plan. The 162(m) regulations also permit companies to adopt umbrella plans that include a so-called plan within a plan. How exactly does that work? The answer is that the compensation committee establishes two sets of performance goals for any given performance period, a complication that steers some companies away from using this approach. Example: Shareholders vote to approve a performance plan that would pay executives from an annual bonus pool funded at 5% of net operating income (NOI) and would cap the amount to be paid to each participating executive at 1% of NOI. (Assume this maximum individual payout greatly exceeds the annual bonus that would be paid even in optimal circumstances.) At the start of fiscal year 2012, the compensation committee establishes two sets of performance targets, one for the umbrella plan and one for the plan within the plan, as follows: 1. For the umbrella plan, the CEO would receive 1% of the forecast $500 million of NOI (i.e., $5 million) contingent on achieving that NOI goal. 2. However, the plan within the plan sets alternative performance goals that the compensation committee expects to be met for the year, calling for a payout at threshold, target or maximum based upon the attainment of certain net earnings goals. Let s assume that the payout to the CEO for attaining the maximum net earnings goals would be $3 million. Known Unknowns: Meeting 162(m) in Corporate Transactions I 2

3 At the close of fiscal year 2012, we ll assume the company has attained the maximum net earnings target under the plan within the plan, but the CEO has also helped the company accomplish several other important goals so that the compensation committee wants to pay him a bonus of $4 million. This would exceed the $3 million maximum under the plan within a plan, but would be lower than the $5 million umbrella plan award to which the executive is also entitled based on that plan s performance goal. Even though the compensation committee is exercising upward discretion from the plan-within-a-plan maximum, the $4 million payout would be considered a permissible exercise of negative discretion because it s below the $5 million payable under the umbrella plan formula. If all of this seems a rather complicated exercise, keep in mind that not all companies have adopted this approach. Not only is it difficult to explain to the compensation committee, but it offers real challenges when describing these mechanics in the annual proxy. However, as discussed below, even companies that normally would shy away from this approach might well consider it in anticipation of a corporate transaction to help preserve the tax deductibility of bonus payments. Approaches to Preserving Deductibility in a Corporate Transaction The practical challenge in preserving the 162(m) exemption in a corporate transaction is the difficulty of establishing objective performance goals that can remain workable for the entire performance period in which an unanticipated corporate event takes place. This challenge is especially daunting for smaller companies and smaller transactions that are more likely to take place during the same year as that in which they re announced when there is no time to adopt a special performance goal that contemplates the transaction. The key question is whether it s possible to craft a formula that can take into account a significant change in a company s size and revenue, and adjust performance targets fairly and accurately for the potential transaction. This question is largely rhetorical, which is why we rarely see companies adopt these types of formulas in this context. The practical challenge in preserving the 162(m) exemption in a corporate transaction is the difficulty of establishing objective performance goals that can remain workable for the entire performance period in which an unanticipated corporate event takes place. In contrast, the larger the corporation or the larger the transaction, the less likely it is that a transaction will close in the same year the deal is announced, often due to the regulatory approvals that must be obtained. So, for a larger company or deal, there may be more opportunity to plan for the transaction s impact on payouts under an annual bonus plan. In these situations, companies can craft an approach to preserve the full deductibility of the compensation paid using the umbrella plan approach described above, assuming they can correctly forecast the results under an objective performance goal used in the umbrella formula. Following are three potential approaches for coping with a transaction in this context: 1. Continue using existing targets. In many cases, it s axiomatic that acquiring a company with good financial performance will make it more likely the purchaser can attain annual bonus plan goals set at the start of the year in which an the acquisition takes place. In this situation, one approach would be for the compensation committee to examine a post-year-end pro forma calculation of the company s performance metrics under the bonus plan, factoring out the effects of the acquisition, to measure whether the pre-established goals have been attained. The problem with this approach, in many instances, is that pro formas would be compiled solely for purposes of the annual bonus plan, which might prompt complaints from the company s finance department. Known Unknowns: Meeting 162(m) in Corporate Transactions I 3

4 As an alternative, the compensation committee could make a more subjective adjustment that examines how the acquisition affected the company s ability to attain its performance metrics, using negative discretion to reduce the payout that otherwise would have been made. Without pro formas to consult, however, this exercise would require significant judgment on the committee s part, which may or may not be appropriate under the circumstances. Although the 162(m) regulations are silent as to whether the plan itself must include a provision that permits the exercise of negative discretion, it seems preferable for plans to expressly authorize the committee to have this option. In the absence of such a provision, the company s tax advisors and auditors would need to agree that this adjustment can nevertheless occur. Legal counsel would also need to weigh in as to whether, as a matter of state law, the plan would permit the compensation committee to make this type of adjustment to recognize the effect of a corporate transaction. For long-term incentive plans, it may be more difficult to continue using existing performance goals, which is why companies frequently change these goals and accept the resulting loss of deductions following corporate transactions. Similarly, companies involved in divestitures or spinoffs tend to discontinue their existing incentive programs because it becomes difficult, if not impossible, to attain the original performance goals. 2. Truncate the performance period, and start a new one. As noted above, there are many situations when companies are unwilling or unable to continue using the goals under existing performance-based plans. In these situations, we often see companies truncate the existing plan and make pro rata awards based on performance for the truncated period. There are a number of challenges to taking this approach, with the main one being whether the plan itself permits the use of a shortened performance period. Even assuming the plan permits this, the company again would face the complicated matter of creating a pro forma financial statement to measure the extent to which the plan goals were attained. As in the acquisition situation described above, such a measurement would not be required for financial statement purposes, so this would represent additional work for the finance department. Although the 162(m) regulations are silent as to whether the plan itself must include a provision that permits the exercise of negative discretion, it seems preferable for plans to expressly authorize the committee to have this option. There are also some mechanical and interpretational questions under the 162(m) regulations to resolve. The first would be whether the performance goals for the shortened performance period were established before 25% of the now-shortened performance period had elapsed. The second would be whether 162(m) permits companies to shorten a performance period from that originally specified in the pre-established goals and still meet the criteria for the performance-based exception. There are differing viewpoints on this question, but the argument that truncated performance periods are permissible under 162(m) is strengthened if the plan specifically references shortening the performance period in the event of a corporate transaction. As for the remainder of the performance cycle post-transaction, establishing a new set of performance goals for a new performance period should be fairly straightforward, especially for longterm incentive plans where a measurable performance period remains. However, for annual plans, if the deal happens late in the year, it may not make sense to establish a new plan for just the few remaining months. In these instances, companies would either forgo the tax deduction for the remaining period or extend the performance period for next year s annual plan to a period longer than 12 months. While feasible, this latter approach can be challenging because the compensation committee might need to accelerate its calendar for the year. Known Unknowns: Meeting 162(m) in Corporate Transactions I 4

5 3. Use an umbrella plan and negative discretion. Companies that have adopted plans authorizing the committee to use negative discretion can adjust the plan-within-a-plan performance targets, as described in the example above, to take into account the effects of significant corporate transactions. Situations in which the company knows it s likely to do a deal in the coming year would be a prime example of where the umbrella plan approach can offer the compensation committee the maximum flexibility to make downward adjustments. As in our example above, the compensation committee would make a best efforts attempt to set a realistic, year-end, net earnings goal for its plan within a plan, taking into account the anticipated date of the transaction and its likely impact on the company s ability to attain those goals for the year. Since the timing of transactions is rarely carved in stone, having the umbrella plan in place to set the maximum amount payable will help maintain the tax deductibility of plan payments no matter when the deal is closed and how the annual plan would be affected. For this approach to succeed, the forecast NOI goals for the umbrella formula must be correctly anticipated so that the amount payable under that formula would not itself be reduced as a result of the transaction. With this approach, the compensation committee can rest assured that it did its best to set realistic goals to take into account pre- and post-transaction results, while preserving the flexibility to make adjustments to take into account changes in deal timing. This flexibility may be desirable even for companies that would not consider using an umbrella plan under normal circumstances. Companies that have adopted plans authorizing the committee to use negative discretion can adjust the planwithin-a-plan performance targets to take into account the effects of significant corporate transactions. Clearly, this is a complicated area, and companies should carefully consider all of the alternative approaches with the assistance of their legal counsel, tax advisors and auditors. But companies do have access to several possible alternatives to best maintain the tax deductibility of payments under their executive compensation programs. Known Unknowns: Meeting 162(m) in Corporate Transactions I 5

6 About Towers Watson Towers Watson is a leading global professional services company that helps organizations improve performance through effective people, risk and financial management. With 14,000 associates around the world, we offer solutions in the areas of employee benefits, talent management, rewards, and risk and capital management. Information in this publication should not be used as a substitute for legal, accounting or other professional advice. Known Unknowns: Meeting 162(m) in Corporate Transactions I 6