Compensation Committee Discretion: Freedom or Fear?

With the elimination of the performance-based pay exemption of IRC Section 162(m) there are now fewer rules and more flexibility with respect to incentive compensation plan design. Previously, executive pay was structured to comply with 162(m) requirements, including the following:

1. Written plan
2. Material terms disclosed to and approved by shareholders
3. One or more pre-established, objective performance measures
4. Goals set within the first 90 days of the performance period, or before 25% completion
5. No reduction in performance goals during the performance period
6. Compensation committee certification of performance results prior to payment
7. No discretion to increase payouts above the formulaic payout level

In the absence of these requirements, is the new found flexibility a freedom to be enjoyed or a path to be feared? We believe it’s a freedom to be enjoyed…responsibly. 

In practice, the freedom resulting from the changes to 162(m) needs to be counter-balanced by the demand from shareholders to align pay and performance. Given this dynamic, we expect a continued emphasis on performance-based incentives, but with greater use of discretion on the part of compensation committees. This discretion will manifest itself in the following primary ways:

• More use of non-financial, strategic, and individual goals in short-term incentive plans that will require some level of subjective assessments or discretion to determine achievement; and
• More willingness to exercise positive discretion with respect to short-term incentive payouts in order to effectively consider all relevant facts and circumstances beyond the formulaic result.

However, given the demand for strong alignment between pay and performance, compensation committees will need to shoulder the burden of ensuring this linkage and disclosing the rationale for their decisions in the CD&A.

And did you notice the absence of expected discretion applied to performance share components of long-term incentives? That’s because accounting rules for equity-based compensation require specificity of performance goals in order to have a “grant date” upon which expense is measured. Absent specific performance goals, variable accounting applies to the award.

What the tax man giveth, the accounting clerks taketh away.

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