The Role of Compensation Committees in Mitigating Potential Risks of Subject Performance Goals

December 18, 2018

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The Deferred Compensation News is pleased to publish the following post, written by Michael S. Melbinger, Winston Strawn LLP, previously published by the Executive Compensation Blog.

Subjective Performance Goals After Elimination of the Performance-Based Compensation Exception

The performance-based compensation exception to Code Sec. 162(m)’s $1 million cap on deductible compensation was eliminated by the Tax Cuts and Jobs Act of 2017, effective in 2018. This likely will result in many companies losing the ability to deduct substantial amounts of compensation. However, a potential silver lining inside this dark cloud of elimination is that compensation committees no longer need to make incentive compensation payments based solely upon the attainment of objective, pre-established performance goals, approved by the company’s shareholders.

According to Treas. Reg. § 162-27(e)(2)(ii), a pre-established performance goal “must state, in terms of an objective formula or standard, the method for computing the amount of compensation payable to the employee if the goal is attained. A formula or standard is objective if a third party having knowledge of the relevant performance results could calculate the amount to be paid to the employee.”

Institutional investors and proxy advisory firms will continue to demand that companies link incentive pay to performance, and compensation committees will continue to do so. However, more companies are likely to be upfront about their application of subjective and individual performance goals now than they were in 2018.

Potential Risks of Subjective Performance Goals:

A compensation committee that adopts or applies performance targets that are too subjective could lead to one or more of the following adverse consequences:

  1. Criticism from institutional investors and proxy advisory firms for the failure to adequately link incentive pay to performance.
  2. The potential for uncertainty in the mind of executives’ as to precisely what is required of them, which would reduce the incentive value of an award.
  3. Failing to create a fixed grant date for equity-based awards under ASC 718.
  4. Required reporting of annual incentive payments in the “Bonus” column of the Summary Compensation Table, instead of the Non-equity incentive plan compensation column.

With care, a compensation committee should be able to eliminate or mitigate each of these potential risks.

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