Governmental regulation of private sector executive compensation practices, particularly at US public companies, has been a visible focus of public policy for the past few decades. Regulation has principally taken the form of special tax, corporate disclosure and securities listing rules under federal law, many of which are technical and non-intuitive and have had unintended consequences. The most important recent developments include an advisory say-on-pay regime and a complex regulatory regime for deferred compensation that subjects employees to the risk of punitive taxes for certain payments of compensation that are made after the compensation has been earned. The 2008 financial crisis caused US regulators to focus special attention on compensation in the financial services industry, in accordance with global mandates focused on that sector, which culminated in 2016 with proposed rules pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) that would (1) prohibit incentive-based payment arrangements that US regulators determine might encourage inappropriate risks by certain financial institutions by reason of providing for excessive compensation or that could lead to material financial loss; and (2) require those financial institutions to disclose information concerning incentive-based compensation arrangements to the appropriate US regulator.2 The proposed rules would greatly expand the regulatory requirements applicable to financial institution compensation arrangements, but their adoption seems unlikely in light of the change in the US administration.
Separately, the US Securities and Exchange Commission (SEC) has finalised regulations under the Dodd-Frank Act to implement a new disclosure requirement, applicable generally to public companies, that is focused on the ratio of chief executive officer to median employee pay.3 It appears that this disclosure requirement will come into effect notwithstanding the change in the US administration. Also pursuant to the Dodd-Frank Act, the SEC has proposed rules covering (1) the recoupment of incentive-based compensation from current and former executive officers that had been awarded erroneously, (2) disclosure of the relationship between compensation actually paid to executive officers and the financial performance of the company, and (3) disclosure about whether directors, officers and other employees are permitted to hedge or offset any decrease in the market value of equity securities granted by the company as compensation or held, directly or indirectly, by employees or directors. The prospect for adoption of these proposed rules is uncertain.
In addition, the structuring of executive compensation in the United States is significantly affected by state, rather than federal, rules that govern the fiduciary responsibilities of corporate directors and agreements not to compete. Neither federal nor state law imposes generally applicable statutory requirements governing the basics of the employment relationship or the structure, type or amount of incentive arrangements. Rather, employment relationships in all states are governed by contractual commitments made between the employer and the executive and, in the absence of such commitments, employment is at will, which means generally that either party can terminate the employment relationship at any time, for any or no reason.
As a result, executive compensation arrangements in the United States include a very diverse range of practices and approaches. However, particularly among public companies, best practices have substantially influenced approaches to certain issues.
US citizens and resident aliens are taxed on their worldwide income. Non-resident aliens are taxed on income from US sources, which generally includes all compensation attributable to the performance of services by an executive in the United States. This section describes the US federal income tax rules generally applicable to US citizens and resident aliens, and to non-resident aliens in connection with services performed in the United States (hereinafter, collectively, US executives). Special allocation rules may be applicable to incentive and deferred compensation allocable to services performed both within and outside the United States.4 This chapter does not extend to describing state and local tax rules, which vary considerably.
Except as described below, US corporations are generally entitled to deduct compensation paid to US executives at the same time as the compensation is required to be taken into account by the executives as ordinary income (as described below), and in the same amounts. No deduction is available for income taxable at capital gains rates.
i Ordinary income and capital gains tax rates
Compensation income for US executives – including, for example, salary, bonuses, taxable employment benefits (such as the use of a company car for personal purposes) and income from the exercise of employee stock options – is generally taxed as ordinary income at graduated rates, with a maximum rate of 39.6 per cent, which for the 2017 tax year starts at taxable income in excess of $470,700 for married individuals filing jointly. Married individuals filing separately are currently subject to a maximum rate of 39.6 per cent on all ordinary income in excess of $235,350, and the 39.6 per cent rate is applicable to income of single taxpayers above $418,400. Capital gains are subject to income tax at a maximum rate of 20 per cent if the property has been held for more than a year.
ii Income tax withholding and reporting
Employers are required to withhold income taxes from compensation paid to US executives and remit the withheld amounts to the US Internal Revenue Service (IRS). Employers are also required to report annually to the IRS the amount of compensation paid. The withholding rules apply to non-US employers, but practical and jurisdictional issues make it difficult for the IRS to monitor and enforce these requirements, particularly for non-US companies that have no business presence in the United States. US executives who have insufficient amounts withheld from their compensation may be required to make quarterly payments directly to the IRS to avoid penalties.
iii Employment tax and withholding
US executives employed by US entities are required to contribute to the US Social Security and Medicare systems, which provide retirement, disability and health insurance benefits to participants. Social Security tax contributions are made through payroll withholding by the US executive at a rate of 6.2 per cent of income up to $127,200 for 2017. In addition, employers are required to contribute 6.2 per cent of income up to $127,200 on behalf of each of their US executives. For Medicare taxes, US executives and their employers each must contribute 1.45 per cent on all earnings. Unless an agreement with the government is implemented under Section 3121(l) of the US Internal Revenue Code of 1986 (Code),5 US executives employed by non-US entities are not required to contribute, and no benefit accrues for them under the system as a result of such employment. For most US executives, this circumstance will not be material because the maximum benefit is relatively small and because many will in any case earn the maximum benefit by reason of other (prior or subsequent) employment. In addition, a supplementary 0.9 per cent Medicare tax is imposed on payroll income of US executives (but not employers). At the time of writing, it appears that changes in these taxes arising from legislative efforts to address the Patient Protection and Affordable Care Act are not likely.
iv Accounting for tax
US executives are required to account for their income on a calendar-year basis. Generally, income is accounted for on a cash basis (i.e., a US executive is generally not required to pay income taxes on compensation income until he or she has actually received the compensation in cash or other property). Notwithstanding the general cash-basis accounting rule referred to above, there are three important rules that effectively require accrual accounting. These are discussed below.
Section 409A of the Code imposes a complex tax regime in respect of deferred compensation. Compensation may be considered to be deferred compensation if the promise to pay the compensation is made in a year and the payment may be made in any subsequent year. Conditional promises are within the scope of Section 409A. For example, an employer’s promise in December 2016 to pay a US executive a bonus some time in 2018, unless profits for 2017 are below $100 million and provided that the US taxpayer executive’s employment continues until the end of 2017, is deferred compensation unless an exemption applies.
Generally, the purpose of Section 409A is to ensure that employers and employees cannot change the timing of payment of compensation in order to take advantage of changes in applicable tax rates or other circumstances. Section 409A applies, often in unexpected ways, to many routine compensation arrangements, including promises to pay severance or holiday, to reimburse for housing costs or to make future stock awards. Failure to comply with the rules may result in immediate taxation of the deferred compensation (even if the compensation is not then payable), and the imposition on the employee of a 20 per cent tax in addition to regular income taxes and an interest component calculated generally from the date that the deferred compensation was earned. The requirements of Section 409A apply to both the documentation of deferred compensation arrangements, which must reflect the many technical requirements of the rules, and the administration and operation of the arrangements. Virtually all employment and compensation agreements with US executives must reflect the rules under Section 409A.
Section 409A imposes three basic requirements in respect of deferred compensation. First, when a promise to pay deferred compensation is made, the timing of payment must be established. Any attempt to change the timing of payment, by either the employer or the employee, is subject to significant limitations. Second, a payment of deferred compensation may be made only at certain permitted times. Generally, there are six permissible payment events: death, disability, separation from employment, change in control, a specific calendar date or the hardship of the employee. Third, payments of deferred compensation to senior executives of public companies (including non-US companies) may not be made during the six-month period following termination of employment, subject to exceptions.
An exception from the requirements of Section 409A for ‘short-term deferrals’ provides one of the more important opportunities to effectively avoid the Section 409A regime. Under the exception, if a promise to make a compensation payment is subject to a material condition (such as, for example, continued employment) and the payment will always be made within approximately 75 days of the end of the year in which the condition is satisfied, then the rules of Section 409A generally do not apply. There are also exceptions for limited payments of severance benefits, reimbursements of expenses that are made shortly after the expense is incurred and other types of payments that may be relevant in particular situations. Section 409A also prohibits an employer from setting aside amounts in a non-US account or other funding vehicle to provide for the payment of deferred compensation. In some jurisdictions, such funding arrangements are common and provide tax benefits, but they may give rise to substantial adverse tax consequences for US taxpayer executives.
Employers located in tax havens or subject to certain tax benefits
As with Section 409A of the Code, Section 457A of the Code also can result in accrual, rather than cash, accounting for deferred compensation in certain circumstances, and non-compliance with these rules can result in the imposition of an additional 20 per cent tax. However, the application of Section 457A is considerably narrower than that of Section 409A. Generally, the accrual rules of Section 457A apply to deferred compensation payable to a US executive for services rendered to an entity that is not organised in a jurisdiction that has entered into a tax treaty with the United States, or that is subject to a comprehensive income tax but benefits from a favourable tax regime or arrangement, or is otherwise entitled to exclude significant portions of its non-resident source gross income from tax. Very generally, the penalty provisions of Section 457A apply to deferred compensation payable by such entities that has an uncertain value when earned. Notably, as under Section 409A, there is a short-term deferral exception under Section 457A, but it is significantly more limited.
The doctrine of constructive receipt
The third rule that effectively requires accrual basis accounting for compensation is commonly referred to as the doctrine of constructive receipt. When an employee uses a cash basis method of accounting, the employee only recognises compensation for tax purposes when the compensation is actually received. Under the doctrine of constructive receipt, compensation is treated as actually received – that is, it is constructively received – if the employee has the unrestricted current right to receive the compensation, even if the employee elects not to accept it.6 The doctrine of constructive receipt, the contours of which have largely been shaped by court decisions, requires that employers be cautious about offering US executives opportunities to receive compensation currently or in the future. Such offers often will also fall foul of the rules under Section 409A.
Acceleration of income recognition
Section 83 of the Code permits the intentional acceleration of income by US executives in limited circumstances. The opportunity to accelerate income under Section 83 is commonly referred to as the ability to make a Section 83(b) election.
Section 83 of the Code governs the taxation of transfers of property (most commonly employer stock) in connection with the performance of services. Preliminarily, consider the tax consequences to a US executive whose employer promises to pay him or her a bonus of 100 shares of stock in three years if he or she remains employed for the full three-year period (the vesting period). Under the cash-basis accrual rules described above, he or she generally will be required to recognise ordinary income equal to the value of the shares when they are delivered, at the end of the vesting period. Now consider the tax consequences if the employer delivers the stock at the time of the promise, and the US executive agrees not to transfer the stock during the vesting period and to return it to the employer if his or her employment ends before the vesting period expires: the US executive would also be subject to tax at the end of the third year based on the value of the stock at that time, unless he or she makes a Section 83(b) election.
A US executive who makes a Section 83(b) election is permitted to recognise income at the beginning of the vesting period in an amount equal to the value of the 100 shares at that time. Any appreciation in the value of the shares during the vesting period will be taxed, at the time that the shares are sold, at typically lower capital gains rates.
There are some negative consequences to making a Section 83(b) election. First, the US executive must pay taxes to the IRS at the beginning of the vesting period, and the amount to be paid generally will need to be taken from his or her savings or other earnings. Second, if shares are forfeited because the US executive’s employment ends before expiry of the vesting period, there is no refund of the taxes paid by the executive at the beginning of the period.
v Tax consequences of equity compensation awards
A substantial portion of a US executive’s compensation package typically consists of equity-based incentive awards. A description of some common types of equity awards used in the United States, and the basic federal income tax consequences for US executives who receive them, follows.
Stock options and stock appreciation rights
A non-qualified stock option (as contrasted with an incentive stock option, described below) is a right to purchase stock at a fixed price in the future. Most non-qualified stock options have terms of 10 years. For tax and other reasons, the exercise price (i.e., the fixed price at which the stock subject to the option can be purchased) is typically equal to the fair market value of the stock at the time that the stock option is awarded. Stock options are usually awarded subject to a vesting condition, such as either continued employment or the satisfaction of performance-related criteria. Stock options usually terminate upon or shortly after the termination of employment of the option holder.
A stock appreciation right (SAR) is an incentive award that is financially identical to a stock option but differs because the value upon exercise is delivered to the employee, who is not required to pay any amount to purchase the underlying stock. Employers sometimes use cash-settled SARs, rather than stock options, so that legal restrictions related to the sale or ownership of stock do not apply or to avoid issuing actual equity to executives.
A US executive is generally not required to recognise income at the time that he or she is awarded a non-qualified stock option or SAR. Rather, the US executive is taxed at the time that the award is exercised. The value at exercise is taxed at ordinary income rates as compensation. If stock is received upon exercise, any subsequent appreciation (or depreciation) in the value of the stock is treated as a capital gain (or loss).
The tax consequences described in the preceding paragraph do not apply to incentive stock options that qualify for special tax treatment. The special rules for incentive stock options were intended to provide tax benefits to executives, subject to certain conditions. Specifically, gains from incentive stock options may not be required to be recognised until the stock underlying the stock option is sold, and that gain may be taxable at capital gains rates, rather than regular, graduated rates. There is, however, also a substantial tax risk for most US executives of earlier taxation under the alternative minimum tax rules. The alternative minimum tax is a parallel regime for income tax under which taxpayers who are not liable for regular income tax (because, for example, they qualify for large tax deductions) are nevertheless liable to pay a minimum amount of tax, which can be significant. For this and other reasons, incentive stock options are not widely used.
Restricted stock and restricted stock units
Restricted stock and restricted stock units (RSUs) are two common types of equity awards under which US executives may be entitled to earn the full value of a share of employer stock, and not just the future appreciation as with stock options and SARs. An award of restricted stock is a current transfer of stock from the employer to the executive, subject to a forfeiture condition (such as continued employment or financial performance). If the forfeiture condition occurs, then the stock must be returned. When a share of restricted stock is awarded, the share is treated as outstanding under US corporate and accounting principles, so that it can be voted on and dividends may be payable to the holder of the stock. Frequently, dividends paid on restricted stock are subject to the same forfeiture conditions as the restricted stock itself. As discussed above, restricted stock is taxed under Section 83 of the Code.
RSUs, also sometimes referred to as phantom stock, provide a substantially similar financial benefit to US executives as restricted stock, but are subject to different tax rules. An RSU is a promise to deliver stock, or cash equal to the value of a specified number of shares of stock, in the future. The promise is usually subject to a vesting condition, but the delivery date does not have to be coincident with the satisfaction of the vesting condition. The US executive must recognise income for US federal income tax purposes only when the shares or cash are delivered, in an amount equal to the value of the shares at that time or the amount of cash paid. Under US corporate and accounting principles, the shares are not treated as outstanding until they are delivered, so they cannot be voted on and no dividends are paid on the shares until the delivery date. No Section 83(b) election can be made for shares subject to an RSU. RSUs are subject to the requirements of Section 409A of the Code described above, unless they are exempt as short-term deferrals, and in any case are not subject to the rules of Section 83.
Profits interests are a type of equity award commonly used in the US in certain limited business contexts, typically involving investments by private equity or hedge funds. Profits interests have financial characteristics for executives that are similar to stock options, but the income to the executive is largely taxed at capital gains rates, rather than as ordinary income. The term profits interest refers to an interest in a business enterprise organised as a partnership. The use of an entity taxed as a partnership as part of the ownership structure of a business is necessary to be able to take advantage of the special rules available for profits interests. A Section 83(b) election can be made for a profits interest.
The following chart summarises the federal income tax treatment to US executives of common types of equity awards:
Restricted stock unit (promise to deliver stock in the future)
Tax treatment upon grant
No 83(b) election: non-event 83(b) election: ordinary income equal to the FMV of the shares acquired (less any purchase price)
Tax treatment upon vesting
• No 83(b) election: ordinary income equal to the FMV of the shares acquired
• 83(b) election: non-event
Tax treatment upon delivery
Ordinary income equal to the excess of FMV of shares acquired over the exercise price
Ordinary income equal to the FMV of the shares acquired
Tax treatment upon sale of underlying shares
Capital gains equal to the excess of sales proceeds over amount previously recognised as ordinary income
Capital gains equal to the excess of sales proceeds over amount previously recognised as ordinary income
Capital gains equal to the excess of sales proceeds over amount previously recognised as ordinary income
vi Special deductibility rules
There are two important exceptions to the generally applicable deductibility rule for compensation paid to US executives described above.
Section 162(m) of the Code limits the ability of a US public corporation to take tax deductions for compensation in excess of $1 million per year paid to four of its most senior executives, including the CEO. There is a significant exception from these deductibility limits for qualified performance-based compensation. Generally, for compensation to qualify for the exception it must be determined based on pre-established, objective performance criteria pursuant to a plan approved by shareholders and administered by independent members of the corporation’s board of directors.
A corporation that pays an annual bonus that is fully earned in a taxable year not later than two-and-a-half months following the end of that taxable year may deduct the bonus payment for the taxable year in respect of which it was earned, even though it is not paid, and the US executive who receives the payment is not required to include the amount in income until the following year.
vii Golden parachute excise tax
Sections 280G and 4999 of the Code provide for a special 20 per cent excise tax on certain US executives, and a loss of deduction for their employers, for certain payments made in connection with a change in control of the corporation. Practically, these rules apply only to public corporations, as an exception applies for privately held corporations whose shareholders approve the compensation payments. The tax rules only apply to the extent that the change in control compensation payable to a US executive equals or exceeds a minimum threshold of three times the executive’s average compensation from the corporation during the previous five years. If that threshold is crossed, then the amount of change in control compensation in excess of one times that average is subject to the tax and non-deductible. Change in control compensation includes cash and stock payments linked to the change in control, including the accelerated vesting of equity and other incentive awards. Exceptions apply for reasonable compensation earned prior to and following the change in control. Any amount paid, or payable pursuant to an agreement entered into, within one year prior to the change in control, is rebuttably presumed to be linked to the change in control.
viii Medical benefits
Rules under the Patient Protection and Affordable Care Act (commonly referred to as ‘Obamacare’) continue to be implemented. While the rules have only limited applicability to executives, aspects of some executive arrangements, involving special medical care arrangements for executives, may be affected by the rules. Various legislative proposals to repeal and replace the Patient Protection and Affordable Care Act were introduced in 2017, but these proposals have not yet been enacted.
III TAX PLANNING AND OTHER CONSIDERATIONS
Special, limited, transitional rules apply under Section 409A of the Code for US aliens who become US taxpayer executives and who entered into deferred compensation arrangements prior to becoming US taxpayer executives. Generally, the rules provide a one-year period to amend such arrangements to comply with Section 409A. In addition, as noted above, Section 409A prohibits an employer from setting aside amounts in a non-US account or other funding vehicle to provide for the payment of deferred compensation. Consideration should be given to any such arrangements maintained for the benefit of US aliens who become US taxpayer executives.
IV EMPLOYMENT LAW
i Employment contracts and severance benefits
As noted above, most of the terms and conditions of an executive’s employment are established by contract between the employer and the employee, and not by statute.
Executives typically enter into contractual agreements with their employers, which provide that, if an executive’s employment is involuntarily terminated, he or she will be entitled to a severance benefit that is usually a multiple of compensation – for example, one to two times the executive’s average total compensation for the previous three years. Often, other ancillary benefits are also provided, such as vesting of equity-based compensation awards. The employer’s obligation to pay severance is almost always conditioned on the executive agreeing to release the company from any legal claims that the executive may have against the company. The severance benefit can be paid in either instalments over time or a lump sum. It is uncommon for severance benefits to be reduced in the event that the executive obtains new employment following his or her dismissal.
ii Agreements not to compete or solicit
Many US companies require their executives to agree, as part of their employment terms, that after their employment ends they will not disclose confidential information about the company to other persons, disparage the company, solicit the company’s employees or customers or, sometimes, compete with the company. While confidentiality provisions are often very broad and continue indefinitely, non-competition and other restrictions are usually narrowly tailored to the particular company’s circumstances and extend for a limited period (e.g., as little as six months or as long as five years). Furthermore, the enforceability of non-competition provisions, in particular, is often subject to some uncertainty, and in some jurisdictions (e.g., California) non-competition provisions are generally unenforceable unless the non-competition agreement is negotiated in connection with the acquisition of a business in which the executive is an owner.7 Typically, the enforceability of such provisions is linked to whether they are viewed as a reasonable means to protect the company’s proprietary interests, viewed in light of the public policy favouring employment. Garden leave or similar provisions, under which an employee is paid during a period of notice prior to termination of employment or forced inactivity, are used intermittently. While there have been proposals in recent years suggesting that non-competition provisions should be further limited, no general trend has evolved.
iii Change in control (CIC) benefits
It is very common for US public companies to provide certain benefits to their executives if there is a CIC in order to provide a strong retention incentive and to assure equitable treatment to management in the event of a sale of the company.
Enhanced severance benefits and accelerated vesting of outstanding incentive awards are the two most common types of supplemental CIC benefits. Enhanced severance benefits provide a strong incentive for executives to remain employed notwithstanding the prospect of a sale of the company. Often, the enhanced severance benefits are paid if the executive is dismissed or if the executive voluntarily ends his or her employment after a CIC because of an adverse change to his or her job (e.g., a demotion or a pay reduction) following the CIC. These are commonly referred to as terminations for good reason. In the past, it was also not unusual for senior executives to be entitled to voluntarily quit their jobs following a CIC and receive enhanced severance benefits. This is referred to as a single-trigger arrangement (as contrasted with a double-trigger arrangement, under which two events beyond the executive’s control – that is, both a CIC and involuntary termination of employment – had to occur for the executive to be entitled to the benefit), and it provides a very strong retention incentive, because executives who work until the CIC occurs are assured of the ability to collect these enhanced benefits. However, single-trigger arrangements have become less common on the basis that they are unnecessarily generous.8
Accelerated vesting of incentive awards assures executives that they can participate in the sale that constitutes the CIC with a portion of their otherwise unvested incentive compensation. Accelerated vesting can occur after only a single trigger (i.e., immediately upon the CIC) or it can be a double-trigger provision (i.e., accelerated vesting occurs if the executive’s employment is terminated involuntarily without cause or voluntarily for good reason shortly after a CIC).
iv Salary history bans
In recent years, several US states and certain cities have adopted or proposed legislation that would prohibit employers from enquiring about an employment applicant’s salary history. Salary history is generally defined broadly to encompass salary, bonus and other forms of remuneration. These legislative efforts are primarily aimed at reducing gender pay inequality and the prohibition appears to apply only to new hires. Legislation that has been adopted will become effective from late 2017 until early 2019.9
V SECURITIES LAW
i Offerings and resales of securities
The Securities Act of 1933 (Securities Act) requires that offers and sales of securities be registered with the SEC, subject to certain exceptions. Many typical executive compensation arrangements, including in particular stock options, are considered to involve the offer and sale of securities. For US public companies, and for non-US companies that are listed for trading on a US exchange, registration is not burdensome and is the typical approach. For other companies, two types of exemptions are typically available. First, such companies typically can rely on an exemption under Rule 701 under the Securities Act that specifically exempts sales pursuant to employee benefit plans, subject to certain conditions.10 The principal condition is that if more than $5 million11 in value of securities is offered or sold during any 12-month period, extensive financial disclosure is required to be made to participants of the plan. Second, there are various private placement exemptions. Generally, for offerings to very small numbers of senior executives, the statutory exemption for private placements is often utilised, under which there are no specific conditions associated with the offering. Regulation D under the Securities Act provides detailed rules for offerings to larger groups of executives, including a rule for offerings to an unlimited number of executives who qualify as accredited investors (i.e., meet certain financial requirements related to their net worth or income). Regardless of the approach for complying with the registration requirements of the Securities Act, anti-fraud provisions of that law will apply and, as a result, disclosure of material information concerning the issuer is normally highly recommended.
Very senior executives (referred to as affiliates and often limited to the top two or three most senior executives of a company) who acquire securities in registered offerings may nevertheless be permitted to resell those securities on the market in the US only pursuant to Rule 144 under the Securities Act. Typically, for registered securities being resold by affiliates, compliance with Rule 144 only requires the filing of a simple one-page form with the SEC. For securities acquired in private placements, resale in a public market, if one exists, may require compliance with that same form-filing requirement as well as a six-month holding period requirement under Rule 144.
ii Cashing out, repricing or modifying the terms of equity awards
Under the US securities laws, consideration must also be given to whether the cashing out, repricing or modification of a stock option or other equity award would constitute a ‘tender offer’. The tender offer rules apply when the recipient is asked to make an investment decision as to whether to accept the cashing out, repricing or modification of the terms and conditions of the award. If such action constitutes a tender offer, a public company would have to comply with various requirements, such as the mandate to (1) file with the SEC a Schedule TO and all written communications made by the public company relating to the tender offer from and including the first public announcement as soon as practicable on the date of the communication; (2) disclose the essential features of the tender offer, including any risks that award recipients should take into account when making the decision whether to accept the offer; (3) keep the tender offer period open for at least 20 business days from its commencement; (4) ensure that all award recipients are given the opportunity to participate in the offer; and (5) ensure that the consideration paid to any award recipient represents the highest consideration paid to any other security holder for securities tendered in the offer.12
iii Registration of issuers
When executive compensation plans involve offerings to large numbers of employees, consideration must be given as to whether the issuer of the securities being sold must, as a result, register as a public company with the SEC. In 2012, legislation was passed increasing the number of holders of securities of any class that is permissible without such registration to 2,000 employees, no more than 500 of whom may be non-accredited investors.13
iv Insider trading and short-swing trading
Generally, anti-fraud provisions of the US securities laws prohibit executives from trading in securities of their employers on the basis of material non-public information. The determination of whether information constitutes material non-public information, and whether a purchase or sale of securities is on the basis of material non-public information, is typically a very fact-intensive inquiry that is informed by court opinions rather than bright-line rules. Rule 10b5-1 under the Securities Exchange Act of 1934 (the Exchange Act) provides a safe harbour under which executives can enter into trading programmes that provide them with a defence against claims that they traded on the basis of material non-public information, subject to certain conditions.14
Separately, a complex regulatory regime prohibits executives of US public companies from profiting from short-swing price movements in their company’s stock.15 Generally, senior executives are required to return to the corporation any profits derived from purchases and sales of stock within any six-month period, regardless of the order of the transactions. These rules are inflexible and do not depend on the possession of any non-public information. They apply to trading in the actual securities of the public company, as well as in options and other derivative securities, the value of which depends on the value of stock of the public company. The rules include a broad exemption for purchases and sales by executives with the company itself, subject to certain conditions.
v Share ownership guidelines and anti-hedging provisions
Most large US public companies require executives to own employer stock in order to align the interests of executives and shareholders. Typically, employers permit new executives to accumulate shares to meet their guidelines over a period of years and through outright ownership or equity compensation programmes. The amount of stock required to be owned is typically related to the executive’s salary or seniority in the organisation, or both. In 2015, the SEC proposed rules requiring companies to disclose whether they permit employees, officers or directors, or any of their designees, to engage in transactions that are designed to or have the effect of hedging or offsetting any decrease in the market value of equity securities that are granted to them as compensation, or are held directly or indirectly by them. The proposed rules would not require a company to prohibit hedging transactions or to otherwise adopt practices or policies addressing hedging by any category of individuals, nor would disclosure be required as to whether hedging has actually occurred (whether or not in violation of any applicable policies). Nonetheless, many such companies already restrict executives from hedging their ownership of company stock through short sales, put options or other similar financial instruments.
US public companies are required to provide extensive annual public disclosure concerning the compensation of typically five of their most senior executives.16 Three years of information is required, including disclosure concerning salary, bonus, the value of equity awards made, pensions accrued during the year and the value of certain perquisites. This disclosure is generally required to be set out in the annual proxy statement related to the election of corporate directors.
In addition, US public companies will soon be required to disclose (1) the median of the annual total compensation of all its employees, except the CEO; (2) the annual total compensation of its CEO; and (3) the ratio of those two amounts. Companies will have to provide the pay ratio disclosure for their first fiscal year beginning on or after 1 January 2017, which generally means the disclosure will be required for the proxy statement to be filed for the 2018 annual meeting.17
Under the SEC’s proposal pertaining to the recoupment of erroneously awarded compensation, a company listed for trading on a US exchange would be required to file its compensation recovery policy as an exhibit to its annual report. Furthermore, if during its last completed fiscal year it either prepared a restatement that required recovery of excess incentive-based compensation or there was an outstanding balance of excess incentive-based compensation relating to a prior restatement, a listed company would be required to disclose the date on which it was required to prepare each accounting restatement, the aggregate dollar amount of excess incentive-based compensation attributable to the restatement and the aggregate dollar amount that remained outstanding at the end of its last completed fiscal year.
The SEC has also proposed rules requiring companies to disclose in a table the comparison between the compensation actually paid to their most senior executives to total shareholder return (TSR) and include a description of this relationship between pay and performance in either narrative or graphic form. A company would be required to disclose executive compensation actually paid for its CEO using the amount already disclosed in the proxy statement, making adjustments to the amounts included for pensions and equity awards. The amount disclosed for the remaining executive officers would be the average compensation actually paid to those executives. As the measure of performance, a company would also be required to report its TSR and the TSR of companies in a peer group.
Finally, US public companies are required to publicly disclose information about material new compensation arrangements and agreements for senior management at the time such agreements are established or entered into.
VII CORPORATE GOVERNANCE
i Independent directors
For US public companies, various requirements dictate that the compensation of senior executives be established by members of a company’s board of directors who are independent of management. Currently, there are at least five definitions of the term ‘independent’ as it is used for these purposes. These different definitions apply to a number of different tax and securities rules, as well as rules promulgated by the US listing exchanges.
ii Say-on-pay vote and proxy advisory firms
Since 2011, large public companies have been required to submit their pay decisions for senior executives to an advisory, non-binding vote of shareholders. Shareholders are permitted to decide on the frequency of these votes. At most companies, they occur annually.
An important factor influencing the outcomes of these say-on-pay votes has been the proxy advisory firms, which are entities that help institutional investors analyse and vote on annual proxy statements. Two proxy advisory firms – Institutional Shareholder Services (ISS) and Glass Lewis & Company – constitute 97 per cent of the proxy advisory firm industry,18 with ISS the dominant force in the market. The combination of the growth of institutional investor portfolios, the growing length and complexity of proxy statements, and a perception that institutional investors have a fiduciary duty to vote the proxies for all the companies in their portfolios,19 has contributed to a significant growth in the power and influence of these proxy advisory firms. Companies closely watch the voting policies of the firms, and monitor which of their large investors tend to vote in accordance with the firms’ recommendations.
The firms develop guidelines and issue voting recommendations both in connection with a company’s annual meetings, and any special item (e.g., a proxy contest or merger proposal) put before shareholders for approval. In the case of ISS, its recommendations on company say-on-pay votes take into consideration factors such as pay for performance, problematic pay practices (i.e., excessive perquisites or a change in control payment exceeding three times base salary and average (or target) bonus), and the level of board communication and responsiveness to shareholders. In addition to say-on-pay, these firms have policy guidelines on compensation matters, such as the election of directors who will comprise the compensation committee, as well as proposals to adopt or amend equity plans. These matters are often affected by the proxy advisory firm’s say-on-pay recommendation. For example, if a company previously received a negative recommendation on a say-on-pay resolution related to an issue that is still ongoing, ISS or Glass Lewis may also recommend voting against any compensation committee members up for re-election.
It is standard in the United States for public companies to agree to indemnify their senior executives for legal claims that may be made against them that arise from their employment, usually unless the executive has engaged in misconduct or gross negligence. Such litigation is not uncommon. In addition, many executive employment agreements provide supplementary indemnification rights and protections to executives, including, for example, the right of the executive to have the company pay the executive’s legal fees in disputing any such claim as they are incurred.
VIII SPECIALISED REGULATORY REGIMES
As noted above, the financial crisis that began to unfold in 2008 caused US regulators to focus special attention on compensation in the financial services industry, in accordance with global mandates focused on that sector. In the spring of 2016, US regulators re-proposed rules under Section 956 of the Dodd-Frank Act that seek to prohibit incentive-based compensation arrangements that US regulators determine might encourage inappropriate risks by providing excessive compensation or incentives that could lead to material financial loss to financial institutions. The re-proposal takes a more prescriptive approach than prior guidance in this area, with mandates such as:
- a requiring deferral of at least 50 per cent of incentive compensation for a minimum of three years for executive officers of covered financial institutions with $50 billion or more in total consolidated assets (‘covered institutions’);
- b prohibiting incentive-based compensation arrangements for executive officers, employees, directors or principal shareholders (‘covered persons’) that would encourage inappropriate risks by providing excessive compensation;
- c requiring a clawback provision that allows the covered institution to recover incentive-based compensation for seven years following vesting if the covered institution determines that the individual engaged in (1) misconduct that resulted in significant financial or reputational harm; (2) fraud; or (3) intentional misrepresentation of information used to determine the individual’s incentive-based compensation;
- d requiring policies and procedures for incentive-based compensation arrangements that are commensurate with the size and complexity of the institution to help ensure compliance with the re-proposed rule’s requirements and prohibitions; and
- e requiring annual reports on incentive compensation structures to the institution’s specific US regulator.
IX DEVELOPMENTS AND CONCLUSIONS
The regulation of executive compensation in the United States remains in a state of flux. Following the 2017 election, legislative proposals have been introduced that would repeal or modify many executive compensation measures under the Dodd-Frank Act, including the SEC’s final and proposed rules described in this chapter. The ultimate outcome of those legislative proposals is uncertain. However, the combination of populist politics and institutional investor concerns suggest that the United States will not see a substantial decrease in the legislative and regulatory focus on executive compensation issues.
1 Arthur Kohn is a partner and Julia Rozenblit is a practice development lawyer at Cleary Gottlieb Steen & Hamilton LLP.
2 Incentive-based Compensation Arrangements, SEC Release No. 34–77776 (10 June 2016), 81 Fed Reg 37669, available at www.gpo.gov/fdsys/pkg/FR-2016-06-10/pdf/2016-11788.pdf.
3 Pay Ratio Disclosure, SEC Release Nos. 33–9877; 34–75610 (18 August 2015), 80 Fed Reg 50104, available at www.gpo.gov/fdsys/pkg/FR-2015-08-18/pdf/2015-19600.pdf.
4 Treasury Regulations Section 1.861-4(b)(2).
5 Section 3121(l) of the Code permits a non-US subsidiary of a US corporation to enter into an agreement to permit US employees of the subsidiary to participate in the Social Security system.
6 Treasury Regulations Section 1.451-2.
7 California Business and Professions Code Sections 16600–16607 (2017).
8 2011–2012 Study of Executive Change-in-Control Arrangements, Meridian Compensation Partners LLC.
9 The Puerto Rico Equal Pay Act became effective in March 2017, but employer penalties will not take effect until March 2018.
10 17 CFR Section 230.701 (2017).
11 Legislation was introduced in 2017 that would increase the US$5 million threshold to US$10 million. The proposed legislation has not yet been enacted. See Encouraging Employee Ownership Act of 2017, H.R. 1343, 115th Cong. (2017); Encouraging Employee Ownership Act, S. 488, 115th Cong. (2017).
12 17 CFR Section 240.13e-4 (2017). Certain of these requirements are waived in certain circumstances, if the public company is incorporated outside the United States.
13 Section 501 of the Jumpstart Our Business Startups (JOBS) Act, Pub L 112-106, 126 Stat 313 (2012).
14 17 CFR Section 240.10b5-1 (2017).
15 Section 16(a) of the Exchange Act (15 USC Section 78p(a)) and the rules thereunder.
16 Item 402 of Regulation S-K at 17 CFR Section 229.402 (2017).
17 In February 2017, acting SEC Chairman Michael Piowar sought public input on this rule and directed the SEC Staff to reconsider the implementation of the rule based on any comments submitted, and determine whether additional guidance or relief may be appropriate. The SEC issued additional guidance to assist companies in complying with the rule in September 2017, and the rule remains in effect.
18 US Chamber of Commerce’s Corporate Governance Update: Public Company Initiatives in Response to the SEC Staff’s Guidance on Proxy Advisory Firms, available at www.centerforcapitalmarkets.com/wp-content/uploads/2013/08/021874_ProxyAdvisory_final-1.pdf.
19 SEC Staff Legal Bulletin No. 20, Proxy Voting Responsibilities of Investment Advisers and Availability of Exemptions from the Proxy Rules for Proxy Advisory Firms, available at www.sec.gov/interps/legal/