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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 CEO and CFO compensation in the case 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 nonsolicitation agreement (prohibiting a former executive from recruiting other employees for their new employer).
The Dodd-Frank Act requires national security exchanges to require any listed company to include clawback provisions in their incentive compensation plans for current and former executive officers. The clawback provision must indicate that, in the event of certain accounting restatements, the issuer will recover the excess of what was paid over what would have been paid to executive officers based on the restated amounts during the 3-year period prior to the restatement. The provision applies to cash-based incentive compensation programs as well as stock-based compensation arrangements. This requirement is broader than the clawback provision in the Sarbanes-Oxley Act, which permits the SEC (but not the company or its shareholders) to recoup monies for the company from only the CEO and the CFO extending back 12 months, and is applicable only in cases involving the restatement of the financial statements caused by misconduct.
The SEC proposed regulations to implement the Dodd-Frank requirement, but they have not been finalized. Even so, many companies have enhanced their employment contracts to allow for clawbacks in the event 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.
These clawback provisions are intended to help companies better align compensation and risk. However, there are a number of challenges in implementing clawbacks. Because some of these clawback provisions are vague, it may be difficult to determine whether they have been triggered. In addition, even when a provision has clearly been triggered, it might not always be clear who triggered it. For example, if a company needs to restate its financial statements, it might not be obvious whether the clawback would apply only to the individual who directly caused the restatement, or should also apply to that person's supervisor who failed to catch the error.
As discussed in SC 2.4, the accounting guidance for many clawbacks is generally straightforward. However, the new breed of clawback features may 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 would likely 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. Assessing performance at the individual level may seem like the fairest approach, and it is certainly possible in some cases (e.g., for a trader in a financial services firm). In many cases, however, tracking such measures may be impossible or cost-prohibitive.
The accounting for clawbacks presumes the company and employee mutually understand the key terms and conditions of the clawback feature when the award is issued. A grant date may not be established at the time of issuance of the award if there is subjectivity or discretion regarding the triggering event of the clawback feature. If there is no grant date, variable (i.e., mark-to-market) accounting may be required (if a service inception date is established) for the fair value of the award until settlement or the date that a mutual understanding of the terms and conditions is reached.
To ensure that these performance-type clawback features will result in the establishment of a grant date at inception, the metrics should be clear and objectively determinable. Conditions based on the operations of the employer must be based on metrics that are established up-front at the grant date. These metrics might be based on financial metrics (e.g., revenue, earnings, or EPS targets), operating metrics (e.g., number of accounts opened, new customers or loans signed), or specific actions of the company (e.g., change in control, IPO).
Conditions based on the employee's individual performance will also need to be clear and objective. If metrics are based on employee evaluations and performance ratings, the evaluation process should be well controlled and understood by the employee, be reasonably objective, and serve as a basis for promotion and other compensation decisions.
Some companies provide themselves discretion to claw back compensation awards. This discretion might be related to the contingent event itself (i.e., what triggers the clawback), or to the consequence of the clawback (i.e., what action will the company take as a result of the clawback). This discretion may result in an inability to establish a grant date for accounting purposes upon award issuance, as a grant date can only be achieved when the employer and employee mutually understand the key terms of the award. If the company has discretion to decide when a clawback is triggered, the employee may not be in a position to understand what is required in order to earn and retain the award.
Finally, since clawbacks entail recovering compensation that has already been awarded, enacting a clawback may result in litigation.

10.2.5 Executive compensation disclosures

The Dodd-Frank Act requires companies to describe in their proxy statement the relationship between executive compensation actually paid and the company's financial performance, which is measured by an issuer's Total Shareholder Return (TSR) and TSR relative to peer companies. A need to compare actual pay and financial performance may cause companies to rethink their compensation structures and may incent them to include graphical presentations that demonstrate the relationships between actual pay and performance in various elements of compensation in their CD&A. Companies may also wish to consider reviewing performance metrics to assess the degree to which existing program incentives support the increased emphasis on TSR as a measure of performance.

10.2.6 Taxation of stock-based compensation awards

The tax 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.
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