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10.2 The executive compensation environment
Publication date: 30 Nov 2022
us Stock-based compensation guide
In designing an executive compensation plan, companies consider how their decisions will impact the employee, the company, and market perception. Different internal and external economic and accounting factors may influence a company’s decision to offer stock vs. cash incentives, for example, or the nature of the conditions required to be met to earn the incentive. Each decision may result in differences in the timing and amount of related expense recognized by the company and have tax consequences for the company and the employee. Companies should consider each of the following factors when developing or making changes to its compensation plans.
10.2.1 Restricted stock – plan design
Institutional investors and their advisors have consistently expressed concern that significant use of restricted stock provides too much benefit to employees who have only limited downside potential (i.e., it provides employees with value even if the company’s stock price declines) and creates excessive costs for shareholders. It is important for companies to strike the right balance on the use of restricted stock to incentivize employees while protecting shareholder value.
10.2.2 Performance conditions – plan design
As discussed in SC 2.5.1, ASC 718 defines market conditions, performance conditions, and service conditions as factors affect the exercisability or vesting of stock-based compensation awards. For purposes of compensation design, the general term "performance" (e.g., performance conditions or performance shares) typically refers to any non time-based vesting or exercisability condition included in an award. Therefore, companies may use the term "performance shares" to refer to either a market condition or a performance condition under ASC 718. The use of a "performance condition vesting requirement" has both tax and accounting consequences. As such, designing a performance condition may require input from human resources, tax, and finance personnel.
IRC Section 162(m), discussed in SC 10.8.1, provides that a public company cannot deduct compensation that it pays to its top officers ("covered employees") if the compensation exceeds $1 million per year. Prior to the 2017 tax law changes, certain performance-based compensation was exempt from this limitation. Under new law, that exception no longer applies and therefore all compensation paid to one of the covered employees will be subject to the limitation. Additional changes expand the scope and duration of covered employee status. A limited transition relief rule may grandfather deductibility for compensation provided pursuant to a written binding agreement that was in effect on November 2, 2017 and is not materially modified thereafter.
10.2.3 Corporate governance - plan design considerations
Shareholders, institutional investors, and regulators continue to scrutinize executive compensation and demand “pay for performance” and executive accountability. They may question whether stock-based compensation, and specifically options, cause executives to make decisions primarily to drive short-term increases in stock price instead of what is in the company’s best long-term interest. In response, many companies actively engage in discussions with shareholders and proxy advisors on equity compensation program design, results and disclosures and describe the nature and outcome of these discussions in their proxy statement. In some cases, stakeholder feedback may influence management to redesign their compensation plans, alter grant practices, and enhance disclosures related to their plans. Changes to better align plan design and stakeholder interests may include extending the vesting schedules, setting mandatory holding periods, establishing guidelines for net share retention, and adding clawback provisions in the event of certain “bad behaviors".
10.2.4 Clawbacks of stock-based compensation awards
The Sarbanes-Oxley Act included provisions that called for clawbacks of chief executive officer (CEO) and chief financial officer (CFO) compensation when prior period financial statements had to be restated. Many companies have "noncompete" clawbacks, which require an employee to return some amount of compensation if he or she leaves to work for a competitor. Other actions that commonly trigger clawbacks include fraud, malfeasance, and the violation of a non-solicitation agreement (prohibiting a former executive from recruiting other employees for their new employer).
10.2.4.1 New guidance – SEC clawback rule
In October 2022, the SEC adopted final rules to implement the requirements of Section 954 of the Dodd-Frank Act (Dodd-Frank Clawback Rule) regarding the recovery of erroneously awarded incentive compensation from current and former executive officers in the event of an accounting restatement. This requirement is broader than the clawback provision in the Sarbanes-Oxley Act, which (1) permits the SEC to recoup monies for the company from only the CEO and the CFO extending back 12 months and (2) is applicable only in cases involving restatements resulting from misconduct.
Under the Dodd-Frank Clawback Rule, a compensation recovery analysis is triggered when an issuer is required to prepare an accounting restatement due to its material noncompliance with any financial reporting requirement under the securities laws. This would include both “Big R” and “Little r” restatements. A Big R restatement is a required accounting restatement to correct an error in previously issued financial statements that is material to the previously issued financial statements. A Little r restatement is one that would result in a material misstatement if the error were corrected in the current period or left uncorrected in the current period.
Issuers will be required to recover erroneously awarded incentive-based compensation received by executive officers during the applicable look-back period. Erroneously awarded incentive-based compensation is the amount of incentive-based compensation received that exceeds the amount of incentive-based compensation that otherwise would have been received had it been determined based on the restated amounts. Erroneously awarded incentive-based compensation is computed on a pre-tax basis (i.e., without regard to any taxes paid by the executive officer).
Incentive-based compensation is any compensation that is granted, earned, or vested based wholly or in part on the attainment of a financial reporting measure. The SEC’s adopting release provides a list of examples including:
- restricted stock, restricted stock units, performance share units, stock options, and stock appreciation rights that are granted or become vested based wholly or in part on satisfying a financial reporting measure performance goal;
- bonuses paid from a bonus pool, the size of which is determined based wholly or in part on satisfying a financial reporting measure performance goal; and
- proceeds received upon the sale of shares acquired through an incentive plan that were granted or vested based wholly or in part on satisfying a financial reporting measure performance goal.
The exchanges must file proposed listing standards to implement the SEC’s directive no later than 90 days after the final rules are published in the Federal Register, and those listing standards must be effective no later than one year after that publication date. Affected issuers will be required to adopt a recovery policy no later than 60 days after the listing standards become effective.
Although the Dodd-Frank Clawback Rule limits the ability for boards to use discretion when determining the amounts to be recovered from each executive, there continue to be a number of challenges in implementing clawbacks, especially related to the complexity and subjectivity associated with determining the impact of an accounting error on stock price or TSR. As a result, the rule permits issuers to use reasonable estimates (with appropriate documentation) when determining the impact on stock price or TSR.
As discussed in SC 2.4, the general model in ASC 718 states that a clawback is recognized when the consideration is received. The issuer would record a credit in the income statement up to the original expense recorded for an equity classified stock award and a credit to additional paid in capital for the fair value of the consideration received in excess of that amount. If the original award was a liability award, similar accounting would apply such that the maximum amount recorded in income would be equal to the final measurement of expense for the award, with the excess, if any, recorded as a credit to additional paid in capital. Because a clawback is considered a contingent event, there is generally no impact on the measurement or recognition of a stock based compensation award prior to the clawback event.
To establish a grant date for accounting purposes, it is important that any clawback provision is clear and objective such that a mutual understanding is established between the issuer and the executive officer as to the key terms and conditions governing vesting of the award. Additionally, there should not be significant discretion by the issuer regarding the triggering event of the clawback. We generally expect that plans designed to conform to the new Dodd-Frank Clawback rules will not result in a problem establishing a grant date, as the new rules provide for objective clawback triggers and very limited exceptions for impracticability of enforcement. However, it continues to be important to evaluate other clawback provisions (e.g., non-competes, non-solicitation clauses) to ensure a grant date has been established.
Previously, employment contracts may have included clawback provisions that were more vaguely worded, such as clawbacks in the event that the executive:
- Engages in conduct that is detrimental to the company;
- Takes actions that result in restatement of the financial statements or other financial harm to the company;
- Achieves performance-based targets, although expected profits were not actually achieved when considered in hindsight;
- Violates established risk management policies, considered from both a quantitative and qualitative perspective; and
- Demonstrates behavior that, in the discretion of management or the compensation committee, is improper.
In these instances, it may be difficult to determine whether the clawback provisions have been triggered. In addition, even when a provision has clearly been triggered, it might not always been clear who triggered it.
These types of clawback features may also pose accounting challenges. For example, some provisions may require stock-based compensation awards to be clawed back if certain operating or performance metrics are not met. Because such provisions are linked to the performance of the entity or individual, they might be considered "performance conditions" for accounting purposes. The accounting for awards with performance conditions is different from the accounting for awards with clawback features. Further, the company may need to determine whether those measures will be based on the performance of individuals, business units, or subsidiaries. The assessment of whether a provision is more akin to a performance condition or a clawback provision will often require significant judgment.
10.2.5 Taxation of stock-based compensation awards
The tax impact (which often differs from the accounting impact) of stock-based compensation awards to both employees (see SC 10.6) and employers (see SC 10.7 and SC 10.8) is a significant consideration in plan design. As discussed in SC 10.10, the tax law determines when an employee is taxed for certain awards such as discounted stock options and stock appreciation rights (SARs). Under IRC Section 409A, these awards are taxed on the date of vesting, even if they have not yet been exercised, and a 20% federal penalty is assessed in addition to regular income tax. In addition, every year after vesting until the option is exercised is another taxable event for the employee. Such treatment can easily result in a 75% tax rate and it is difficult to calculate the taxes due and figure out how to withhold taxes from employees, which is required. As a result, few companies knowingly grant discounted stock options or SARs to employees.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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