By Stephanie Schroepfer i. Section 954 Incentivizes Decreasing Transparent Links Between Objective Pay for Performance

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1 The Clash Between Section 954 of Dodd-Frank Claw-Back Statute and Section 162(m) of the Internal Revenue Code May Cause Redesigns of Compensation Programs By Stephanie Schroepfer i Section 954 Incentivizes Decreasing Transparent Links Between Objective Pay for Performance In response to Section 954 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, Pub. L. No ( Section 954 ) some compensation committees of publicly traded companies are considering whether it is in their stockholders best interests for their companies to redesign their executives compensation packages to minimize or perhaps even avoid the application of the new rules and the inherent risks. Unfortunately, while it is clear that Section 162(m) of the Internal Revenue Code of 1986, as amended ( Section 162(m) ) promotes objectively determinable links between pay and performance, in practical effect, Section 954 is at direct cross-purposes with this goal Section 954 actually incentivizes issuers to design executive compensation programs that have fewer transparent links between objective performance criteria and pay. Section 954 Requirement to Recover From Executives Certain Erroneously Paid Executive Compensation That Exceeds What Would Have Been Paid Under Certain Accounting Restatements Section 954 requires the Securities and Exchange Commission (SEC) to issue rules directing national securities exchanges to de-list the stock of companies that do not adopt and comply with broad executive compensation recoupment policies under which executive officers incentive-based compensation for a period of three years must be recovered in the event of accounting restatements resulting from the material noncompliance with securities laws. The recoveries would apply without regard to the fault or even knowledge of the affected executive officers. Under rules to be issued by the SEC and national exchanges under Section 954, an issuer of publicly traded securities will be required to develop and implement a Section 954 recoupment policy which states that if the company is required to prepare an accounting restatement due to its material noncompliance with any financial reporting requirement under the securities laws, it will recover incentive-based compensation from any current or former executive officer to the extent that the compensation is: 1. based upon erroneous data, 2. received during the three-year period preceding the date on which the company is required to prepare an accounting restatement and 1

2 3. in excess of what would have been paid to the executive officer based on the corrected data in the accounting restatement. Types of Incentive-Based Compensation That May be Subject to the Recoupment Rules It is not yet clear what incentive-based compensation will be subject to the Section 954 recoupment rules as the term incentive-based compensation for purposes of Section 954 is not yet defined. The Section 954 recoupment rules will apply to incentive-based compensation that would not have been paid under the accounting restatement. Presumably, only executive compensation that is directly tied to financial metrics involving financial information that is required to be reported under securities laws will be subject to the Section 954 recoupment rules, but this is not certain. Certain financial information, such as revenues, net income and earnings per share, is clearly required to be reported by an issuer under securities laws. Other financial information, such as non-gaap measures including earnings before interest, taxes, depreciation and amortization and return on net assets, may be treated as financial information required to be reported under securities laws for purposes of the Section 954 recoupment rules. Stock options are expressly singled out in the statute as a form of compensation that may be subject to recoupment despite the fact that stock options are not typically granted or vested based upon the achievement of financial metrics. Although restricted stock awards are not mentioned in the statute, there does not appear to be any logical reason why stock options should be treated differently from restricted stock awards for purposes of the Section 954 recoupment rules. Many believe that both restricted stock awards and stock options with purely time-based vesting restrictions should not be subject to the Section 954 recoupment rules, provided that the awards are granted exclusively in consideration of the performance of future services and vest without regard to the achievement of any financial performance goals. Many believe it would be reasonable for the SEC to take the position that the term incentive-based compensation has the same meaning as the term incentive plans for proxy disclosure purposes. Item 402(a)(6)(iii) of Regulation S-K provides that [t]he term incentive plan means any plan providing compensation intended to serve as incentive for performance to occur over a specified period, whether such performance is measured by reference to financial performance of the registrant or an affiliate, the registrant s stock price, or any other performance measure. If this definition of incentive-based compensation were employed, stock options and restricted stock awards should not be subject to Section 954 recoupment requirements.to the extent that such awards (1) vest based solely upon the performance of services (a/k/a timebased vesting awards) and (2) are not granted based upon the attainment of financial 2

3 metrics that are, in turn, based on financial data required under securities laws to be disclosed in a company s financial statements. Possible Means of Designing Compensation That is Exempt From Section 954 Although it is not clear what the Section 954 recoupment rules will specify, it may be possible to avoid the application of the new rules with respect to certain incentive-based compensation by designing the compensation in such a manner that it is granted and vested (1) purely at the discretion of the compensation committee, (2) solely in consideration of future services using a time-based vesting schedule, (3) solely upon the attainment of performance conditions that are subjective, or (4) solely upon the attainment of performance conditions that are objective but that are not based upon financial information the company is required to report in its financial statement under securities laws. Another means of limiting the application of Section 954 would be to reduce the amount of incentive-based compensation under a total compensation package and to increase current salary levels or pay under traditional nonqualified deferred compensation (such as supplemental retirement plans). It is possible that in making its determinations concerning whether to grant discretionary compensation, an issuer s determinations could be informed by rather than based upon the achievement of financial results without triggering the applicability of Section 954, but this is not yet entirely clear. Having determinations that are informed by financial information that is required to be reported in financial statements could present opportunities for depicting to stockholders that the compensation is pay-forperformance. However, there may be more conservative means of demonstrating to stockholders that compensation represents pay-for-performance without potentially implicating Section 954. For example, discretionary pay could be informed by subjective factors or objective factors that are not based upon information that is required to be reported in financial statements. Some measures, such as stock price, total shareholder returns and operational performance measures (such as market share and customer satisfaction) are not financial information that is required to be reported under securities laws. Presumably, incentive compensation that is based on these metrics will not be treated as being subject to Section 954 recoupments, but this is not certain. Depending upon how the Section 954 recoupment rules are drafted, there may be some ambiguity concerning whether a financial measure that is not required to be reported (such as stock price) but that is indirectly impacted by financial measures that are required to be reported (such as revenues) may be subject to Section 954 recoupment. If the SEC were to take the position that stock price is based upon financial data required to be reported under securities laws, it would be virtually impossible to ascertain what the stock price would have been (and accordingly, what amount should be characterized as excess compensation) under the restated financial statement. Given that Section 954 expressly references stock options as being potentially within the scope of Section 954 recovery provisions, there may be a somewhat greater risk associated with stock options than restricted stock awards. Some practitioners have 3

4 speculated that it may be safer to utilize restricted stock awards rather than stock options. Section 162(m) Deduction Considerations In determining their responses to Section 954, some compensation committees are reassessing their views concerning whether it is more important to maximize the compensation committees flexibility and discretion in connection with granting compensation or to maximize the deductibility of compensation under Section 162(m). Section 162(m) generally imposes a $1 million corporate deduction limitation on certain compensation paid during a taxable year to a covered employee. ii Qualified performance-based compensation is exempt from the $1 million Section 162(m) deduction limitation. For compensation to qualify as qualified performance-based compensation that is exempt from the Section 162(m) deduction limitation, among other things, the compensation must be paid solely on account of the attainment of one or more preestablished, objective performance goals. A performance goal must be such that a third party having knowledge of the facts could determine whether the goal had been met. Performance goals can be based upon one or more business criteria that apply to the covered employee, a business unit of the issuer or the issuer as a whole, such as stock price, market share, sales, earnings per share, return on equity or costs. Treas. Reg (e)(2). If compensatory awards are designed so as to be based upon performance metrics that are not based upon information that the issuer is required to report in its financial statements under securities laws, depending upon how the new performance goals are structured, these awards may or may not be exempt from the Section 162(m) deduction limitation. It would appear that if a compensatory award is based upon the achievement of an objective business criterion that is not based upon information that the issuer is required to report in its financial statements under securities laws, such as market share, the award could be potentially both qualified performance-based compensation that is exempt from the Section 162(m) deduction limitation and exempt from the application of Section 954. However, so structuring a compensatory award in such a manner as to be both deductible and exempt from the application of Section 954, using objective business criterion, would materially limit a compensation committee s flexibility with respect to performance goals and its ability to drive performance. Given this restriction on flexibility, a compensation committee may wish to consider whether it believes it would instead be preferable and in the best interest of stockholders for the compensation committee to retain complete flexibility and award certain compensation in its sole discretion. Such discretionary compensation would not be deductible in some cases (as a result of the application of Section 162(m)) but the compensation may not be subject to Section

5 i Stephanie Schroepfer is a Partner at Norton Rose Fulbright in their Houston, TX office. Learn more about Stephanie in her biography. ii A covered employee of an issuer for purposes of Section 162(m) of the Code is an employee of the issuer if, as of the close of the taxable year, the employee is the principal executive officer (within the meaning Item 402 of Regulation S-K, 17 CFR ) of the issuer or, if the total compensation of the employee for the taxable year is required to be reported to shareholders under the Securities Exchange Act of 1934 (the Exchange Act ) by reason of such employee being among the three highest compensated officers of the issuer for the taxable year (other than the principal executive officer or the principal financial officer). Internal Revenue Service Notice