Key Compensation Issues in a Turbulent Market

As compensation committee chair, Susan knew 2020 was going to be an important year for the bank.

The compensation and governance committee had taken on the topic of environmental, social and governance (ESG) for the coming year. They had conducted an audit and knew where their gaps were; Susan knew it was going take time to address all the shortfalls. Fortunately, the bank was performing well, the stock was moving in the right direction and they had just approved the 2020 incentive plans. All in all, she was looking forward to the year as she put her finished notes on the February committee meeting.

Two months later, Susan had longed for the “good old days” of February. With the speed and forcefulness that Covid-19 impacted the country, states and areas the bank served, February seemed like a lifetime ago. The bank had implemented the credit loss standard at the end of March — due to the impact of the unemployment assumptions, the CECL provision effectively wiped out the 2020 profitability. This was on top of the non-branch employees working from home, and the bank doing whatever it could to serve its customers through the Paycheck Protection Program.

Does this sound familiar to your bank? The whirlwind of 2020 has brought a focus on a number of issues, not the least of which is executive compensation. Specifically, how are your bank’s plans fairing in light of such monumental volatility? We will briefly review annual and long-term performance plans as well as a construct for how to evaluate these programs.

The degree to which a bank’s annual and long-term incentive (LTI) plans have been impacted by Covid-19 hinge primarily on two factors. First, how much are the plans based upon GAAP bottom-line profitability? Second, and primarily for LTI plans, how much are the performance-based goals based upon absolute versus relative performance?

In reviewing annual incentive plans, approximately 90% of banks use bottom-line earnings in their annual scorecards. For approximately 50% of firms, the bottom-line metrics represent a majority of their goals for their annual incentive plans. These banks’ 2020 scorecards are at risk; they are evaluating how to address their annual plan for 2020. Do they change their goals? Do they utilize a discretionary overlay? And what are the disclosure implications if they are public?

There is a similar story playing out for long-term incentive plans — with a twist. The question for LTI plans is how much are performance-based goals based upon absolute versus peer relative profitability metrics? Two banks can have the same size with the same performance, and one bank’s LTI plan can be fine and the other may have three years of LTI grants at risk of not vesting, due to their performance goals all being based on an absolute basis. In the banking industry, slightly more than 60% of firms use absolute goals in their LTI plans and therefore have a very real issue on their hands, given the overall impact of Covid-19.

Firms that are impacted by absolute goals for their LTI plans have to navigate a myriad level of accounting and SEC disclosure issues. At the same time, they have to address disclosure to ensure that institutional investors both understand and hopefully support any contemplated changes. Everyone needs to be “eyes wide open” with respect to any potential changes being contemplated.

As firms evaluate any potential changes to their executive performance plans, they need to focus on principles, process and patience. How do any potential changes reconcile to changes for the entire staff on compensation? How are the executives setting the tone with their compensation changes that will be disclosed, at least for public companies? How are they utilizing a “two touch” process with the compensation committee to ensure time for proper review and discourse? Are there any ESG concerns or implications, given its growing importance?

Firms will need patience to see the “big picture” with respect to any changes that are done for 2020 and what that may mean for 2021 compensation.

A Deeper Dive Into Board Pay

How you pay your board may have a surprising effect on its total pay package, according to Bank Director’s 2020 Compensation Survey. This exclusive analysis has been created specifically for members of our Bank Services program.

Across asset sizes, banks paying an annual retainer generally award more total compensation to the board compared to their fee-only peers or those that award a mix of the two. This analysis focuses solely on cash compensation for the full board, in the form of meetings fees and retainers. Committee compensation is excluded due to variances in structure and meeting frequency, although 63% award committee fees.

Estimated Annual Pay, by Type and Asset Size

 >$10B$1B – $10B$500M – $1B$250M – $500M<$250MAll Banks
Annual Retainer Only$595,000$380,000$312,750$180,000$150,000$400,000
Meeting Fee Only$921,000$120,000$140,000$105,000$65,000$107,500
Both Retainer + Fees$225,000$118,000$90,000$85,400$77,500$105,000

*Estimated annual pay assumes 10 directors per board and 10 meetings per year, based on the 2020 Compensation Survey.

The low usage of meeting fees by banks above $10 billion in assets, and of annual retainers by banks below $500 million in assets, result in smaller data sets for those groups.

So, are retainer-only banks overpaying their boards? Are fee-only banks underpaying theirs?

Board responsibilities have risen greatly since the last financial crisis more than a decade ago. Regulators expect more from directors; while the buck stops with the CEO, that individual ultimately reports to the board. So, while it’s hard to say what’s right and what’s wrong when it comes to board pay, the gradual, increased use of annual retainers — from 61% five years ago to 70% today — reflects a realization by many boards that their members are spending more time outside of meetings on bank matters, whether that’s reviewing board packets or educating themselves on issues important to the oversight of the bank.

Annual retainers can better demonstrate the amount of the work directors put in. 

What’s more, technology has expanded how the board can meet. Some boards already offered phone and video conferencing options to more-remote members, like snowbirds who head south for the winter. The Covid-19 pandemic forced entire boards to adopt these measures, so they could become a more permanent feature for some. Should those attending virtually be compensated differently?

Annual Cash Compensation Per Director, by Type and Asset Size

 >$10B$1B – $10B$500M – $1B$250M – $500M<$250MAll Banks
Annual Retainer Only$59,500$38,000$31,275$18,000$15,000$40,000
Meeting Fee Only$92,100$12,000$14,000$10,500$6,500$10,750
Both Retainer + Fees$45,000$28,000$22,500$17,900$14,500$24,000

*Estimated annual pay per director assumes 10 meetings per year, based on the 2020 Compensation Survey. The low usage of meeting fees by banks above $10 billion in assets, and of annual retainers by banks below $500 million in assets, result in smaller data sets for those groups.

Getting the compensation mix right is vital to attracting the new talent a board needs to oversee the bank. Boards are often seeking someone younger. They may be looking to add gender or ethnic diversity. Or they may be looking for new skills.

While the 2017 Compensation Survey indicated that directors serve for loftier reasons than a supplemental paycheck — 62% cited personal growth as the top reason they serve — new, younger directors could be balancing an already high-pressure career with family obligations. And other organizations could be seeking their valuable time. Your bank likely isn’t the only one in its community on the hunt for board talent.

“It’s difficult to fully compensate someone for their time as a director,” says Flynt Gallagher, president of Compensation Advisors. “If you’re going to pay them for the time they put in, the skills they bring to the board — they’d be unaffordable.”

But boards still need to make it worthwhile to serve. Simultaneously, they may feel pressure to maintain current pay levels during the economic downturn.

Compensation committees could consider awarding equity compensation, which wasn’t factored into this analysis. Equity provides a way to pay directors more — and gives them additional skin in the game — without having an outsized effect on total compensation. Roughly half of survey respondents, primarily at public banks, awarded equity to outside directors in fiscal year 2019, at a median fair market value of $30,000. 

Bank Director’s 2020 Compensation Survey, sponsored by Compensation Advisors, surveyed 265 independent directors, CEOs, human resources officers and other senior executives of U.S. banks to understand trends around the acquisition of talent, CEO performance and pay, and director compensation. The survey was conducted in March and April 2020. Compensation data for directors and CEOs for fiscal year 2019 was also collected from the proxy statements of 98 publicly traded banks. Fifty-three percent of the total data represent financial institutions above $1 billion in assets; 59% are public.

Several units in Bank Director’s Online Training Series focus on compensation matters. You can also learn more about finding new talent for the board by reading “Cast a Wider Net for Your Next Director” and “How to Recruit Younger Directors.” If you’re considering virtual meetings, read “Best Practices for Virtual Board Meetings” to learn more about navigating that shift.

The Evolution of Strategic Business Objectives in Annual Incentive Plans


incentive-8-19-19.pngBoards are increasingly looking for ways to appropriately align pay and performance for bankers in the face of the disruptive changes in the industry.

Post-financial crisis, many bank boards shifted to a scorecard approach as a way to improve their compensation governance and accountability. However, industry disruption has sparked an evolution of the scorecard itself.

Before the financial crisis, determining annual bonus payouts at banks was a singular, annual event. The compensation committee and the CEO compared the bank’s current financial results to the prior year, assessed the operating environment, considered last year’s bonus pool and adjusted bonus accruals accordingly. Higher performers got a little more than prior year; poor performers looked for new jobs.

Following the financial crisis, a search for improved compensation governance and accountability ushered in a movement to construct incentive plans with payouts specifically tied to financial outcomes. This resulted in the popular financial scorecard approach used by many banks today.

Most scorecards include “hardwired” financial goals (usually earnings per share, net income and return on equity), banking-specific metrics (deposits, credit quality metrics and expense management) and a component that reflects “individual” or “discretionary” evaluations of performance.

Scorecards have served the industry well and addressed concerns that the lack of transparency into banking incentive plans resulted in shareholders being unclear of exactly what performance they were rewarding. The industry is now in the midst of a new phase of disruption that has banks reexamining their business models and entering a period of significant transformation.

In response, boards are increasingly enhancing the qualitative component of their scorecards to add balance and encompass the progress executives have made against clearly articulated strategic business objectives (SBOs). These strategic components balance the “backward-looking” nature of financial metrics with a “forward-looking” assessment that focuses on improving future financial performance.

Trends in Strategic Business Objectives
An SBO is a goal or metric that generally supports a key business priority and can be measured and objectively evaluated. For many boards, delivering against SBOs is critical to ensuring sustainability of their franchise. While growing earnings per share is a proven measure of current business success, achieving other critical outcomes is essential to creating long-term value for shareholders.

Detailed SBOs are specific to each bank and reflect where the bank is in its life cycle or period of transformation. Recently, we have observed banks incorporating the following eight categories into their SBOs for bank bonus plans:

  1. Executing the Digital Strategy: Depending on the bank’s current digital state, this category evaluates the success of critical milestones, such as percentage of paperless customers, “app” rollout and usage rates and expansion of service offerings through the digital interface.
  2. Technology Enhancements: This can include initiatives such as cybersecurity upgrades, automated fraud detection and general infrastructure enhancements like enterprise resource planning rollout.
  3. Corporate Development: This objective centers on the bank’s execution of its M&A strategy. It reflects the board’s evaluation of acquisitions, divestitures and integrations throughout the year. Banks often set goals based on quality, rather than quantity, to avoid incentivizing “bad deals.”
  4. Branch Strategy: This rewards the expansion, contraction or footprint-specific goals tied to the bank’s strategy for brick-and-mortar branch presence.
  5. Fee-Income Initiatives: Boards want to compensate for successful growing non-interest income from existing products, new products and complimentary service offerings.
  6. Customer Metrics: This can be measured through various means, such as net promoter score, internal customer satisfaction ratings, call center resolution rates and client retention statistics.
  7. Compliance: This generally focuses on the performance against anti-money laundering (AML) objectives and other regulator-specific compliance priorities.
  8. Risk Management: Boards define this SBO by evaluating process-related rollouts, infrastructure enhancements and talent upgrades across the risk function.

Banks are looking to drive their key initiatives during this time of significant transition in the industry. To do so, they are increasingly using SBOs to underpin the strategic drivers of future value creation in their business. Linking these initiatives to annual incentive compensation can communicate the importance of the strategies to the organization, and align compensation to the successful execution of these strategies.

A Compensation To-Do List For Your Board

Is your board effectively addressing the risk embedded in the bank’s compensation plans? McLagan Partner Gayle Appelbaum outlines a to-do list for boards in this video, and shares why new rules around hedging policies should be on your board’s radar. She also explains what banks need to know about these rules, along with considerations for your board’s annual compensation review.

  • Compensation Issues to Watch
  • New Rules on Hedging Practices
  • Other Practices to Address

Driving Accountability in Incentive Compensation Governance


compensation-7-17-19.pngI once flunked a math test because I didn’t show my work. Turns out, showing your work is important to both math teachers and bank regulators.

To drive accountability, it is important to document and “show your work” when it comes to governance of incentive compensation plans and processes. The largest banks, due to increased regulatory oversight, have made significant strides in complying with regulators’ guidance and creating robust accountability. Here are some resulting “better practices” that provide food for thought for banks of all sizes.

While the 2010 interagency guidance on sound incentive compensation policies is almost a decade old, it remains the foundation for regulatory oversight on the matter. The guidance outlined three lasting principles for the banking industry:

  • Provide employees incentives that appropriately balance risk and reward.
  • Create policies that are compatible with effective controls and risk management.
  • Support policies through strong corporate governance, including active and effective oversight by the organization’s board of directors.

Most organizations used the release of the 2010 guidance to take a fresh look at their incentive plans. It proposed a non-exhaustive list of risk-balancing methods, such as risk adjustment of awards and deferral of payment. Many banks changed their plan structures and provisions to increase sensitivity to, and better account for, risk. The changes made sense pragmatically but largely addressed only the first principle.

After the financial crisis, boards were expected to engage in the oversight and review of all incentive arrangements to ensure that they were not rewarding imprudent risk taking. However, most institutions quickly realized it was not practical for directors to be in the weeds of all their broad-based incentive plans and thus delegated that task to management.

Compensation committees outlined expectations for senior management regarding incentive plan creation, administration and monitoring in a formal document. Their expectations would include, for example, the process for reviewing incentive plan risk.

Comp, Risk Committees Cooperate
Banks also developed stronger communication or information sharing between the compensation and risk committees of the board. This was sometimes accomplished through cross-pollinating members between the committees or conducting joint meetings on the topic. It also became standard for the chief risk officer to participate in compensation committee meetings and present on incentive compensation risk, as well as the overall risk profile of the organization.

Incentive compensation review committees, made up of the most-senior control function heads such as the chief financial officer, chief human resource officer, general counsel and chief risk officer, are often delegated primary oversight responsibilities. To create accountability, this management committee operates under a formal charter, oversees the entire governance process, provides for credible challenges throughout and annually approves all non-executive plans. A summary of their activities and findings is presented to the compensation committee annually, at minimum.

Working groups representing various business lines and broad control functions support the management committee in actively monitoring incentive compensation plans. Every activity in the governance process—from plan creation or modification to risk reviews and back-testing—has a documented process map with roles and responsibilities.

These large bank practices might be overkill for smaller organizations. However, some level of documentation and process formalization is a healthy process for any size. My advice: Don’t get fixated on the red tape, as proper governance and controls can be scaled to the size and complexity of each individual bank.

Formalize the Process
The second and third principles of the 2010 guidance are aimed at driving greater accountability and efficient oversight, including enhanced information sharing. Formalizing the process simply helps to crystalize expectations for those involved and safeguards against the dodging of responsibilities.

Plus, regulators—just like that math teacher—want to see the work. It’s not enough to simply have the right answer. You must be able to document the process you went through to get there.

Review Your Director Equity Plans


equity-4-17-19.pngOutside director compensation has been on the minds of shareholders and compensation committees after a 2017 court decision and a continuing focus of proxy advisory firms that recommend how institutional investors vote on matters presented to public company stockholders.

In late 2017, the Delaware Supreme Court issued a decision involving claims of excessive nonemployee director compensation at Investors Bancorp, a Short Hills, New Jersey-based bank. In that case, the court applied a higher legal standard to decisions made by directors about their own compensation.

Since the 2017 decision, other cases have been settled involving similar claims against public companies, and more new cases were filed in 2018. The two primary proxy advisory firms have also shown an enhanced focus since the 2017 decision on compensation awarded to outside directors.

With these cases in mind, focus on outside director compensation continues, and public companies especially should review their decision-making processes about discretionary stock equity plans and non-employee director compensation.

Stockholder claims concerning the conduct of directors generally are subject to review under the business judgment rule, where the presumption is that the board acted in good faith, on an informed basis and in the best interests of stockholders.

In cases where the business judgment rule applies, the court will not second-guess a board’s business decision.

Before the Investors Bancorp decision, this was the standard applied to cases challenging director compensation decisions, with a few exceptions. In the cases where the Delaware courts reviewed challenges to director compensation approved by directors themselves, the courts recognized a stockholder ratification defense for director compensation in cases in which stockholders had approved the following:

  • An equity plan that provides for fixed awards
  • The specific awards made under an equity plan
  • An equity plan that includes “self-executing” provisions—awards that are determined based on a formula specified in the plan without further discretion by the directors
  • An equity plan that includes “meaningful limits” on director compensation—a cap on the awards that could be made to nonemployee directors

In cases where a company can take advantage of the stockholder ratification defense, the company can seek dismissal of the stockholder claim under the business judgment rule.

In the Investors Bancorp case, the Delaware Supreme Court considered the scope of stockholder ratification of director compensation decisions for the first time in more than 50 years, and in doing so limited the ratification defense when directors make equity awards to themselves under an equity incentive plan.

The Delaware court determined that the more onerous rule—the “entire fairness” test—applies, where a plaintiff can show a majority of the board was interested or lacked independence regarding the decision, or would receive a personal financial benefit from the decision.

For equity grants awarded to directors under the plan, that test requires the board to prove equity incentive awards they grant themselves are fair to the company and its stockholders. The Delaware court found that while the stockholders in the Investors Bancorp case had approved the general parameters of the equity plan that contained a limit on the aggregate amount of stock awards that could be made to directors, they had not ratified the specific awards to directors and, therefore, the business judgment rule did not apply.

The decision therefore calls into question whether the ratification defense is still feasible for plans that contain only “meaningful limits” on director awards. The Delaware Supreme Court sent the case back to the lower court to review under the entire fairness standard, and that case is currently pending.

Key Takeaways
Boards and compensation committees should consider the following to mitigate potential risks in implementing equity incentive plans or making awards to directors under existing equity incentive plans:

  • Careful consideration of peer group selection
  • Retention of a compensation consultant experienced in banking
  • Whether to include director compensation limits in equity plans
  • Ensuring that director compensation decisions are made after a robust process that accounts for market practices and peer group practices

And finally, boards and compensation committees should carefully describe the decision-making process and other key factors for equity awards to nonemployee directors in the company’s annual proxy statement.

What Your Compensation Committee Calendar Should Look Like


compensation-3-12-19.pngA goal-oriented calendar can be the difference between a productive year and a nonproductive one for compensation committees.

Planning for the year goes beyond scheduling meetings. Compensation committee chairs should have a thoughtful plan that encompasses the goals of the committee for the year. A detailed and in-depth calendar can help both new chairs and experienced chairs craft a plan for the year that considers the short- and long-term needs of the bank.

This article provides planning tips and a cheat sheet for the core topics that should be on the committee’s annual schedule. Though the cheat sheet is specific to public banks, private banks can use the list as well.

What’s on The Agenda
The old saying goes “what gets written down, gets done.” Having a written document sets a roadmap for the year and provides your committee a timeline to stay on track. You don’t need to reinvent the wheel.

Start with the committee charter, which provides a job description for the committee’s responsibilities. Review the past year’s calendar, agendas and meeting minutes for a head start in creating your annual agenda and stick to it throughout the year.

Identifying key topics at the beginning of the year allows for communication across all stakeholders: members of the committee, your management team, and outside legal and compensation advisors.

Topics should cover both short-term and long-term items. For example, if you are looking to request more shares for your equity plan, this process should start well in advance, and may include updating your equity plan document, modeling ISS and Glass Lewis share guidelines, and redesigning your grant methodology.

Getting your outside advisors involved early can help you avoid last-minute surprises.

Frequency of Meetings
Typically, public banks hold four to six meetings in a year. This allows the committee sufficient time to cover key topics and to review the goals of the committee. In any given year, the agenda may require additional meetings for special events including merger and acquisition activity, creation of new incentive plans and other events.

committee-numbers.png

What (And When) Should Be on The Calendar
Below are key topics that should be on the regular calendar for public banks as well as additional items for consideration any time during the year. The sample covers a typical schedule, however, there is flexibility depending on the subject.

In any given year, items should be evaluated both in terms of the current short-term and the longer term needs of the bank 24 months or more from now.

compensation-calendar.png

How To Prepare Compensation Plans For An IPO


IPO-11-5-18.pngThe decision to take your bank public will set the course of your company for years to come. There are several critical steps to prepare your compensation program before the IPO and before your bank is a public company.

Steps to prepare for the IPO

1. Assemble Your Compensation Team
Determine the team focused on compensation matters. If you have employees with IPO experience and compensation plans, they could be a key asset. Similarly, if you have employees without IPO experience but have public company experience, they could be a key team member as well.

2. Create Your IPO-Related Task List
Your bank may have implemented many compensation and governance related items already, but they should be reviewed for their appropriateness for a public company.

Key tasks required prior to the IPO will vary, however, here is a list of compensation tasks on every pre-IPO list.

  • Develop an executive compensation philosophy and key objectives – What is your bank’s strategy? Where do you target compensation? Is your pay aligned with performance? What are the objectives of your compensation program? What message do you want to send to shareholders? Craft overarching guidelines to support the process going forward.
  • Evaluate and establish appropriate executive and director compensation levels – Prior to the IPO, your company will have to disclose its executive and director compensation. You want to be sure your compensation programs are reasonable, competitive, and based on peer group data. Establishing a suitable peer group and incorporating the data into your process is key.
  • Equity plan considerations – Will a new equity plan be required, and when will you need shareholder approval? How will you determine the share pool so long-term incentive and equity grant needs can be met for three to five years? Have you evaluated the shareholder advisory firms’ current standards to receive favorable support? Avoid any pitfalls that would result in a “no” vote recommendation.

    If the company is considering one-time IPO-related equity grants, evaluate these in light of market trends, shareholder expectations, retention concerns, financial impact to the company and dilution. Many institutions consider sizeable one-time grants a front-loaded award, and decide to wait before awarding additional equity. Such decisions are based on share pool impact, financial implications, and size of the one-time grants. Carefully determine the value of these awards to minimize risks of unfavorable optics and legal actions.

  • Design ongoing annual and long-term incentive plans – As a public company, it is important to have annual and long-term incentive plans that align pay and performance, are competitive, consistent with company objectives and provide an appropriate mix of pay. As new incentive plans are designed, know that plan details will be disclosed in future public filings. Private banks are accustomed to implementing plans that are regulatory compliant and competitive, but public disclosure has not been required.
  • Implement executive agreements – In many cases, new employment and change-in-control agreements are put in place, often the case even if similar agreements were in effect before the IPO. Several details, including the terms, are subject to public disclosure. Shareholder advisory firms take issue with certain terms and, and having them can automatically result in ‘no’ vote for Management Say on Pay and the re-election of the board’s compensation committee. It is critical to be aware of these pitfalls and avoid them whenever possible.

3. Determine appropriate technical and governance actions
There are key technical and governance issues to evaluate. Some items are required while others are not. Many are considered best practices and important to achieving strong governance. Some of the key items in this category include:

  • Drafting of the SEC required filings including the CD&A (Compensation Discussion and Analysis), compensation tables and other requirements. Reporting errors and omissions can delay the IPO.
  • Determining company stock ownership guidelines – Many new public banks do not adopt stock ownership guidelines immediately, however, if one-time equity grants are awarded, adopting such guidelines immediately sets the parameters for holding these shares. Determine who will be covered by the guidelines (e.g., executives, Section 16 officers, non-employee directors), what the required holdings are, the timeframe permitted, and other terms.
  • Drafting the Compensation Committee Charter – A charter establishes the role and responsibilities of the committee, how it will interact with the board and management, and its ability to engage outside advisors. The charter is typically published on the company’s website.

4. Create a compensation committee calendar after the IPO
Once the IPO is completed, it is important for the compensation committee to focus on its new role, responsibilities and annual tasks. Setting up a calendar of activities supports effective management and should include all areas of committee oversight.

Taking your bank public can be a very exciting endeavor. Do not underestimate the number of new issues management, the compensation committee and the board will have to become familiar with to complete a successful IPO and operate a public company. Being organized, having the right knowledge and support and a flexible timeline will be great tools to help your organization get through this process.

Compensation Governance in Today’s Economy



Despite recent shifts in the economic and regulatory environment, bank boards still need to keep a close eye on many of the same issues—including risks related to your bank’s compensation practices, as McLagan Partner Gayle Appelbaum explains in this video. She also spells out how talent pressures, and the expectations of regulators and investors, will continue to keep banks on their toes.

  • Key Practices for Boards and Compensation Committees
  • Why You Can’t Relax in Today’s Strong Economy
  • The Need for Heightened Corporate Governance

Executive Compensation: Understanding the Tax Law’s Full Impact


compensation-3-12-18.pngOn December 22, 2017, President Trump signed into law the Tax Cuts and Jobs Act, which amended certain provisions of the Internal Revenue Code of 1986. Bank boards and management teams should take time to familiarize themselves with these changes, as several amendments to the Code relate to the payment of executive compensation.

For corporate executives and compensation committees, the change to the Code that has garnered the most attention concerns an amendment to Code Section 162(m). Prior to the Act, Section 162(m) imposed a $1 million cap per executive on the tax deduction a public company could take on compensation paid to its chief executive officer and three other highest paid executive officers, excepting the chief financial officer—generally, the “named executive officers” included in the company’s annual proxy. Historically, most companies relied on an exemption for performance-based compensation to avoid this limit, which was fully deductible even if it exceeded $1 million. The new tax law has eliminated the performance-based compensation exemption.

In addition, the tax law has expanded coverage of Section 162(m) to apply to all Securities and Exchange Commission (SEC) reporting companies (i.e., companies required to file reports under Section 15(d) of the Securities and Exchange Act of 1934, which includes many companies required to file due to public debt), rather than solely those whose common stock is registered with the SEC. It also expanded the group of executives subject to the deduction limit to include not only the named executive officers during the current taxable year—now including the CFO as a “named executive”—but also any person who was a covered executive for any prior taxable year beginning after December 31, 2016. Companies subject to Section 162(m) should review their incentive plan documents, incentive award agreements, severance agreements and employment agreements in light of the removal of the exemption for qualified performance-based compensation because these documents may have been drafted to account for the Section 162(m) performance-based compensation exemption that no longer applies.

In addition, the Act amended Code Section 83 by adding a new subsection (i) regarding deferred taxation of equity compensation. Section 83 generally governs the amount and timing of income inclusion for property, including employer stock, transferred to an employee in connection with the performance of services. Under Code Section 83(a), most individuals must recognize income for the tax year in which the employee’s right to the stock is transferable or no longer subject to a substantial risk of forfeiture. This changes for some employees with the new Section 83(i), which allows non-executive and non-highly compensated employees of privately-held corporations to elect up to a five-year deferral in the taxation of illiquid shares issued to them upon the exercise of nonqualified options or the settlement of restricted stock units (RSUs), if certain conditions are satisfied. The options or RSUs must be granted under an equity compensation plan in which at least 80 percent of a company’s full-time U.S. employees are granted awards with the same rights and privileges. The amounts of the awards may vary by employee as long as each employee receives more than a “de minimis” grant—i.e., all participating employees must be eligible to receive a legitimate economic benefit. This deferred tax election is not available to the CEO or the CFO—or to certain persons related to them—or to any person who within the past 10 years was one of the four highest paid officers of the corporation or an employee that holds 1 percent of the company’s stock. Under this new regime, eligible employees of private companies receiving stock through equity compensation arrangements may consider making an election under Section 83(i) to defer taxation on such compensation.

The IRS is expected to issue guidance on these changes, particularly the amendments to Section 162(m). Stay tuned.