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Compensation in Volatile Times

Pay Governance understands that this time of considerable uncertainty and volatility can be challenging for everyone, especially as we settle into new work arrangements and routines. Still, our domain expertise is executive compensation consulting. Therefore, each week we will provide you with a short newsletter to keep you abreast of developments in the executive remuneration world.

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Featured Viewpoints

Proposed Sweeping Changes to the Taxation of Executive Compensation

Introduction

For the past several months, the business community has been focused on navigating the economic turmoil brought on by the COVID-19 pandemic. While many companies have experienced salary reductions, staff layoffs and furloughs, and corporate restructurings, there have been developments in the executive compensation arena that have gone largely unnoticed. One such development is a proposed reform that would lead to an acceleration of the taxation of certain forms of executive compensation.

On February 27, 2020, Senators Bernie Sanders of Vermont and Chris Van Hollen of Maryland introduced the “CEO and Worker Pension Fairness Act” in the U.S. Senate. [i] The proposed legislation was a response by Senators Sanders and Van Hollen to a recent report from the Government Accountability Office (GAO) commissioned by Senator Sanders: “Private Pensions: IRS and DOL Should Strengthen Oversight of Executive Retirement Plans.” [ii]

The legislative proposal would significantly change the tax treatment of two major elements of executive compensation: non-qualified deferred compensation plans and stock options. This taxation treatment found in the Sanders/Van Hollen legislative proposal was first proposed in 2016 by the Republican Party as part of the Trump administration’s own tax reform legislation. The provisions in the Sanders and Van Hollen legislative proposal regarding the taxation of stock options upon vesting were ultimately removed from the Trump administration’s major tax reform legislation enacted in December 2017: the “Tax Cuts and Jobs Act of 2017.” [iii]

Non-qualified Deferred Compensation

In today’s corporate environment, there are two forms of non-qualified deferred compensation that are most prevalent: (1) an executive’s ability to voluntarily elect to defer base salary or annual bonus, or some portions thereof, until retirement or some other specified future date; and (2) an executive’s participation in a supplemental executive retirement plan (SERP) — an unfunded arrangement that provides additional retirement benefits to executives beyond those that are available through tax-qualified retirement plans. SERPs are considered an important retention tool. It has been our experience, as executive compensation consultants, that executive voluntary deferral elections are not as popular in today’s environment as they have been in years past.

This decrease in prevalence of voluntary deferral elections may be attributed to two considerations. First, executives are inclined to believe that their current tax rate on ordinary income is relatively low and unlikely to be lower at retirement. Therefore, it might be unlikely that the executive’s effective tax rate is going to be lower at retirement or at some other specified future date. The second reason that voluntary deferrals have declined is the introduction of Section 409A to the Internal Revenue Code (“IRC”). Several years ago, Section 409A was added to the IRC, and this provision has made it more onerous for an executive to defer either base salary or bonus under attractive terms. Section 409A has rigid requirements for the timing of deferral elections, prohibitions on the timing or scheduling payments on an accelerated basis, and other limitations, including the imposition of a 20 percent excise tax penalty should the deferral plan violate certain design or operational rules of the IRC provision.

The second form of non-qualified deferred compensation, the SERP arrangement, is the more popular form of deferred compensation. The aforementioned GAO study of the 500 largest U.S. companies found that there are approximately 2,300 executives covered by SERP arrangements in this sample of companies (based upon proxy disclosure of Named Executive Officers) and that these arrangements represent a total of approximately $13 billion in accumulated plan benefits.2 There are two types of SERP arrangements that are prevalent in today’s executive compensation environment. The first type of SERP is a plan which enhances prospective retirement benefits by considering additional elements of compensation (e.g., annual bonus) and/or increasing the benefit formula (e.g., adding years of credited service, increasing the contribution formula) above those available in the underlying qualified plan. The second type of SERP restores benefits that are lost in the qualified pension due to statutory limitations on compensation in the Internal Revenue Code. These latter types of plans, frequently referred to as restoration plans, are the most common type of SERP arrangement found in the marketplace today.

The new proposed tax legislation set forth by Sanders and Van Hollen would recognize taxable income to the executive when the non-qualified deferred compensation arrangement becomes vested — not when the deferred funds are received. This is a substantive change in taxation and could result in an executive being taxed even though they may not have access to the deferred funds (a highly paid executive must wait 6 months for the actual receipt of deferred monies after retirement or other official termination events under Section 409A). Other substantive changes to the taxation of deferred compensation include the following:

  • All revenue raised from the change in tax treatment would be transferred to the Pension Benefit Guaranty Corporation to shore up multi-employer pension plans (the estimated $13 to $15 billion accrued value in current pension values would result in lost corporate tax deductions for the same amount, but the resultant gain in tax income by the government would not go far in closing the estimated $1.28 trillion funding gap in multi-employer pensions). [iv]
  • The proposed legislation requests that the Department of the Treasury and the Department of Labor implement changes to the Tax Code recommended in the GAO report, including a formal definition of employee eligibility as well as new disclosure requirements of non-qualified deferral plans.
  • The bill will also require increased disclosure of deferred compensation by requiring such compensation be disclosed on Form W-2 on a mandatory basis (currently a voluntary provision).

Stock Options and Stock Appreciation Rights

The proposed tax legislation will require that all employees earning at least $130,000 annually be taxed on non-qualified stock option gains in excess of $100,000 at the time of vesting (the first $100,000 will be exempt). This is a departure from current tax rules which require that the gains recognized on stock options be taxed at the time of exercise. [v] While stock options have declined in prevalence, many companies still use them as part of their executive stock incentives. This tax proposal will reduce their incentive effect.

Stock options are typically granted with a stated term of 7 to 10 years. Options are normally granted with an exercise price (“strike price”) equal to the stock’s fair market value on the date of grant. Most option plans are designed to be fully vested after 3 to 4 years of service, leaving the executive with the ability to time their decision to exercise from the vesting date to the end of the option’s term. The executive’s decision to exercise their stock options is typically predicated on the stock’s current share price and the amount of potential gain to be realized, the executive’s access to capital to pay for the option exercise price and the accompanying tax liability, and other personal considerations.

The amount of tax to the individual executive on the exercise of a non-qualified stock option is the gain in share price from the grant date to the exercise date, with the gain being taxed as ordinary income. The company receives a tax deduction equal to the gain realized by the executive in the year in which the exercise occurs.

The Sanders and Van Hollen tax proposal has several unusual features that will require further clarification. Vested gains above the initial $100,000 are taxable. This will be especially problematic for executives in startup companies that may be privately owned and may not have marketability of their company shares. Also, the tax legislation does not have a grandfather clause, but the proposed bill does include a 9-year transition period so that the executive could have until 2029 to settle their tax liability. [vi]

As we noted in the Introduction section of this Viewpoint, the taxation of stock options at the vesting date was initially proposed in some preliminary versions of the 2017 tax reform legislation. When this concept was floated to the business community at that time, the reaction of corporate America was unfavorable.

Pay Governance Commentary

The concept of taxing individual executives at the time of vesting without the receipt of the income would negatively impact the current executive compensation environment. Although some critics may believe that executives are overpaid and under-taxed, the notion of taxing an executive when they have yet to receive their deferred funds or stock option gains is atypical. Taxation at the time of vesting would require a major overhaul of the Tax Code, and such tax concepts as constructive receipt, risk of forfeiture, and other elements of the Tax Code would need to be rewritten.

General questions about this Viewpoint can be directed to John Ellerman at john.ellerman@paygovernance.com or Ira T. Kay at ira.kay@paygovernance.com.

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[i] “Sanders, Van Hollen Push to End CEO Tax Breaks to Protect 1.7 Million Workers’ Pensions.” Bernie Sanders Senator website. February 27, 2020. https://www.sanders.senate.gov/newsroom/press-releases/sanders-van-hollen-push-to-end-ceo-tax-breaks-to-protect-17-million-workers-pensions.
[ii] Richard Rubin and Theo Francis. “Bernie Sanders Aims New Tax Hike at Executive Retirement Plans.” The Wall Street Journal. February 27, 2020. https://www.wsj.com/articles/bernie-sanders-aims-new-tax-hike-at-executive-retirement-plans-11582815616.
[iii] Kevin Brady. “Tax Cuts and Jobs Act.” United States Congress website. December 22, 2017. https://www.congress.gov/bill/115th-congress/house-bill/1/text/.
[iv] Brian Anderson. “Sanders Bill Seeks to Limit Executive Retirement Plans.” 401k Specialist. March 2, 2020. https://401kspecialistmag.com/sanders-bill-seeks-to-limit-executive-retirement-plans/.
[v] Lauren Feiner. “Sanders’ New Tax Policy Raises Alarms in Silicon Valley.” CNBC. February 28, 2020. https://www.cnbc.com/2020/02/28/sanders-new-tax-policy-silicon-valley-reactions.html.
[vi] Dan Primack. “Bernie's Plan to Hike Taxes on Some Startup Employees.” Axios. February 28, 2020. https://www.axios.com/bernie-sanders-tax-proposal-973ef0b3-06e8-4a76-b15b-5ecbe1bb2a80.html.

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Featured Viewpoint

Impact of COVID-19 on Pre- and Early-Commercial Biopharmas

While the impact of the COVID-19 pandemic has varied across industries, most companies have had their performance impacted in one way or another. With respect to compensation programs, the fundamental balance of maintaining employee motivation and engagement while dealing with the fallout, economic disruption, and — in some cases — newfound cash and liquidity concerns are universal. The response, however, may differ significantly by company and across industries.

Our Viewpoint series has addressed many of the executive compensation considerations associated with COVID-19. The focus of this Viewpoint is on companies in the pre- and early-commercial biotech and pharmaceutical (“pre-commercial biopharma”) space as well as how these companies are dealing with the pandemic and its impact on compensation programs.

The pre-commercial biopharma business model operates with its own unique compensation and governance practices driven by two fundamental differences from other businesses:

1. Valuation based on product pipeline, clinical progress, and future expectations of scientific success more so than financial performance.

2. An inherent reliance on external financing to maintain sufficient cash flow for operations.

For example, a recent Glass Lewis paper [i] suggests that 40% of biopharmas utilize an annual incentive design categorized as non-formulaic, compared to just 7% across the full sample of small- to mid-cap companies Glass Lewis reviewed. We find that pre-commercial biopharmas’ incentive designs tend to differ from broader industry practices in the following ways:

  • Heaviest weighting given to strategic milestone measures vs. financials
  • Financial metrics focused on the balance sheet versus the income statement
  • External fund raising as an ongoing corporate objective
  • Increased use of human resources and talent attraction/retention as core metrics
  • Less reliance on strictly formulaic results driven by an explicit pay/performance scale
  • Greater emphasis on qualitative evaluations of performance achievement to determine bonus payouts.

What We Have Seen Year-to-Date in the Biopharma Industry

The biopharma industry overall has outperformed others through the pandemic’s economic disruption, resulting in fewer observed compensation cost-cutting actions. There is, however, bifurcation among biopharma companies: some have performed quite well year-to-date, while performance has slowed for others.

Those that may have recently closed an updated round of external funding have not experienced a slowdown in their clinical trials, or were able to shift to telemedecine appointments for patient follow-up are still operating largely business-as-usual, having been able to weather the storm to some extent. Further, a select few companies were able to shift focus directly to COVID-related therapies and have seen significant shareholder value creation and/or increased hiring plans.

Compensation Impact for the Balance of 2020 Remains Uncertain

As companies in all industries consider the fact that many of their 2020 performance objectives have little chance of achievement, questions are surfacing about the possibility of resetting performance goals or replacement bonus plans, using discretion in determining payouts or adjusting performance, and/or focusing more on non-financial metrics in the absence of threshold levels of financial performance. For pre-commercial biopharmas, in an environment where cash bonus payouts are not funded by financial performance, it can be informative to assess the expected impact of COVID on common categories of incentive plan performance metrics.

Other potential considerations and compensation program implications include:

Increased Merger and Acquisition Potential

  • It might be an opportune time to review current employment agreements as well as company-wide severance and change-control policies to ensure post-termination benefits are competitive and consistent with current governance norms

Continued Stock Market Volatility

  • An additional layer of caution with respect to equity awards and the impact of changing stock prices might be warranted; for example, equity awards calibrated based on desired value delivery could put pressure on equity pools without adjustment
  • Further, companies considering a shift away from an all-options approach might accelerate their thinking in order to deliver a small portion of equity as full-value shares

Increased Need to Conserve Cash

  • While being mindful of dilution and share usage concerns, consider the potential to deliver equity in lieu of cash — e.g., bonuses delivered in restricted shares.

Year-End Considerations

As we approach mid-year, those that adopted a wait-and-see approach and delayed setting 2020 goals may now be in a better position to decide where to focus the team. Others have started to discuss frameworks for 2020 performance and bonus determinations.

Come year-end, during Compensation Committee review of annual performance vs. objectives in determining bonus payouts, we expect robust discussion around the key principle of rewarding for performance results within management’s control. The scorecard approach used by many pre-commercial biopharmas for bonus payouts should help mitigate the potential for a down year in any one area to result in overall zero bonuses. Any adjustments to performance or discretionary judgments on the level of performance achievement should be considered carefully.

To the extent the discussion turns to it, areas that could support the application of discretion to adjust performance/payouts could be:

  • Broader resiliency of operations including continuity of the supply chain, ability to ensure production of trial doses, etc.
  • Management’s ability to adapt — e.g., adoption of tele-health / virtual follow-ups for clinical trials and prioritization of trials that can be completed over others
  • Understanding the root cause of delays in deciding whether to relax any time-based performance objectives
  • Prudent cash management — e.g., making the difficult decision to stop or delay trial starts if appropriate
  • Any shift to COVID-related operations that have repositioned the company favorably in the short- and longer-term
  • Long-term vs. short-term decisions — e.g., where objectives/strategy shifted, did Management favor long-term strategy at the expense of short-term performance objectives?
  • Relative performance in comparison to direct peers

Of course, any such discussions should incorporate the broader context of the overarching economic and societal impact that the pandemic has had on all company stakeholders.

General questions about this Viewpoint can be directed to Brian Lane at brian.lane@paygovernance.com or Blaine Martin at blaine.martin@paygovernance.com.

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[i] Brianna Castro et al.“2020 Meeting Notes, Under the Microscope, Talking with Biopharma Companies About Their Unique Governance and Compensation Challenges.” Glass Lewis. 2020.


Featured Viewpoint

Stock Ownership Guideline Administration

The financial impact of the current pandemic has affected most aspects of the compensation programs for executives and nonemployee members of the Board of Directors. Stock ownership requirements covering those individuals are no exception and will be reviewed by companies as they assess compliance with those guidelines.

Stock ownership guidelines are a near universal practice at larger publicly traded companies and are considered a governance best practice. Ownership guidelines require executives and directors to maintain meaningful stock ownership during their tenure. Officers have significant additional investments in the company — usually through several years of outstanding, unvested equity awards. In the case of performance shares, the award opportunity is leveraged to both achieve specified goals and stock price movement. This Viewpoint focuses on those elements of ownership guidelines often subject to greater volatility in company stock price and performance.

A common structure requires executives to achieve a specified ownership level within a five-year period. However, most companies now grant at least 50% of their target long-term incentive (LTI) opportunities as performance-contingent awards (e.g., performance shares) based on achieving financial and/or total shareholder return goals, often over a three-year period. With the current crisis potentially eliminating the opportunity to earn shares from one, two, or all three outstanding performance cycles, meeting the guidelines within a five-year timeline could be difficult. Increased stock price volatility brought about by the pandemic may exacerbate the situation, resulting in individuals shifting between compliance and non-compliance solely due to swings in stock price.

As a result, this may be an opportune time for companies to review the governance and administrative polices of their stock ownership guidelines to ensure they align with the company’s objectives and will not require numerous exceptions during periods of heightened economic and stock price volatility. Since stock prices decrease and increase, it is important to have policies that are durable in both down and up markets. For companies experiencing sustained and significant stock price declines (a decrease of 50% or more), instead of pursuing design changes some may decide to suspend updating the assessment (e.g., use the results of the prior year’s compliance review and consider the ownership guideline maintained or, for those building to compliance, “on track” as long as the individual’s number of shares considered owned did not decrease) until the stock price recovers.

The table below examines stock ownership guideline design provisions that mitigate stock price volatility and recognize that most companies emphasize performance-contingent awards in their regular LTI grants.

Thoughtfully designed officer and director stock ownership guidelines are an important part of a well-designed executive pay program. Guidelines should balance reasonable stock accumulation and retention of shares over time, external stakeholder perspectives, and desires for individuals to plan for financial needs in retirement. In the end, stock ownership guidelines are just that: guidelines. There are no “generally acceptable stock ownership principles” that must be met. However, proxy advisors and many institutional investors have well-established perspectives on executive and director stock ownership guidelines. As a result, companies should ensure their stock ownership guidelines and administration practices best align to their objectives, culture, officer demographics, and other factors they deem important.

General questions about this Viewpoint can be directed to John R. Sinkular at john.sinkular@paygovernance.com or Don Kokoskie at don.kokoskie@paygovernance.com.

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