Incentive compensation

Typical structures

What are the prevalent types and structures of incentive compensation? Do they vary by level or type of organisation?

Short-term incentive compensation (STI) is typically paid in cash either upon achievement of pre-established performance targets or on a discretionary basis. In some cases, STI awards are settled partially in cash and partially in equity awards that are subject to additional vesting conditions, such as in cash and restricted stock, effectively providing short-term and long-term incentives within the same arrangement.

Long-term incentive compensation (LTI) usually takes the form of equity awards or equity-based awards that are settled in stock although sometimes LTI is denominated and paid in cash. Common types of equity and equity-based awards include stock options, stock appreciation rights (SARs), restricted stock, restricted stock units (RSUs) and performance stock units (PSUs). Settlement of LTI awards in cash is significantly more prevalent in private companies than in public companies owing to the lack of a market for the equity and the desire to have a limited number of equity holders. LTI awards are typically payable upon achievement of pre-established performance hurdles (performance-vested) over a performance period (typically at least three years) although there may be a service-based vesting requirement also (or in limited circumstances, in lieu of performance-based vesting). It is becoming increasingly common to require at least one year of service before any portion of an LTI award will vest (without regard to whether the award otherwise provides for performance-based vesting). Equity-based awards for partnerships are typically granted in the form of profits interests, which have no value on grant and entitle the holder solely to future profits.   

The foregoing information outlines the common types and structures applicable to incentive compensation. In the US, short and long-term incentives are typically granted and, if applicable, performance targets are established, in early to middle of the first quarter of a calendar year.  In 2020, that practice was followed by many companies. Unfortunately, however, the covid-19 pandemic began shortly after the grants were made and targets established, thus requiring companies to revisit what they had projected and, in some cases, modifying awards to meet the needs of the company in light of the pandemic. As of the date of publication of this update, it is too early to tell what impact the pandemic will have on actual performance (and it will undoubtedly vary depending on the industry and location)  or the actual payments that are made by companies for the 2020 year.

Restrictions

Are there limits generally on the amount or structure of incentive compensation? Are there limits that adversely affect the tax treatment of the compensation relative to the employer or the executive?

There are generally no legal limits on the amount or structure of incentive compensation. It is not uncommon, however, for an employer’s arrangements to include employer-based limitations on the amount that can be paid under an incentive plan. In addition, prior to the modifications to Code section 162(m) made by the Tax Cuts and Jobs Act of 2017 (Jobs Act), equity plans of public companies almost always included individual limits on the awards (both cash and equity) that could be granted to individuals in a specified period if the award was intended to satisfy the performance-based compensation exception of section 162(m). Although the Jobs Act effectively eliminated the performance-based exception and thus those individual limits are no longer relevant for section 162(m) purposes, institutional investor advisers (such as ISS and Glass Lewis) expect such limitations to remain in the plan or the company risks negative recommendations on the plan.

There are certain Code provisions that impose adverse tax consequences in the event that compensation exceeds certain limits. In particular, Code section 162(m) limits a public company’s tax deduction on compensation that may be paid to its chief executive officer, chief financial officer and the next three most highly compensated executives (‘covered employees’) to US$1 million annually (US$500,000 in the case of certain health insurance issuers). This limit applies both during the individual’s period of employment and thereafter if the person was ever a covered employee (‘once a covered employee, always a covered employee’).

Code sections 280G and 4999 impose a 20 per cent excise tax on the employee and deny a company’s tax deduction on certain payments that are made in connection with a change in control (‘excess parachute payments’) to ‘disqualified individuals’ (generally officers, shareholders and highly compensated individuals, each as determined under applicable regulations) in connection with a change in control. In non-public companies, the penalites of Code sections 280G and 4999 may be avoided by disclosing the applicable payments and having the shareholders approve them prior to the change in control. 

Deferral

Is deferral and vesting of incentive awards permissible? Are there limits on the length or type of vesting and deferral provisions?

It is legally permissible for a company to permit deferral and vesting of an incentive award, whether by the terms of the award or by election of the award recipient. Vesting may be time-based or performance-based (or a combination thereof). There are generally no legally required minimum or maximum vesting or deferral periods, but any such terms would need to comply with the terms of the company’s equity award plan and the applicable award agreement. Many equity plans (particularly in the case of public companies) require minimum vesting conditions (most commonly a minimum of one year of service). Further deferral of incentive awards will result in the delay of taxable income only if such deferrals are structured to comply with or be exempt from Code section 409A. Certain states, such as California, have also adopted state tax laws similar to section 409A that impose conditions on deferrals under state laws.

In the case of a deferral arrangement, the ‘top hat’ rules of ERISA (ie, relating to plans that are unfunded and maintained primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees) would need to be considered. In the event that deferrals are permitted until the termination of employment or beyond, the arrangement may constitute an ERISA retirement plan and if, even inadvertently, it is made available to a group that does not constitute a top hat group of employees, the plan will not be eligible for the exceptions from certain portions of ERISA afforded to top hat plans.

In addition, Code section 457A imposes significant limitations on the extent to which taxation of compensation can be delayed where the deferral is made pursuant to a plan of a nonqualified entity. A nonqualified entity means:

  • a foreign (non-US) corporation unless substantially all of its income is conducted through a US business or is subject to a comprehensive foreign income tax; or
  • a partnership unless substantially all of its income is allocated to persons other than foreign persons with respect to whom income is not subject to a comprehensive foreign income tax and organisations that are exempt from US income tax.

Are there limitations on the individuals or groups eligible to receive the compensation? Are there aspects of the arrangement that can only be extended to certain groups of employees?

Each plan or arrangement providing incentive or deferred compensation will specify the eligibility requirements for the plan or arrangement. In the case of incentive plans of listed companies involving the issuance of equity or equity-based awards, the eligibility requirements of the plan generally must be disclosed to, and approved by, the company’s shareholders and any change in such eligibility is treated as the adoption of a new plan that requires new shareholder approval.

ERISA defines a ‘pension’ plan as a plan, programme or arrangement that is established or maintained by an employer to the extent that, either by its terms or as a result of the surrounding circumstances, provides retirement income to employees or results in a deferral of income by employees for a period extending to termination of employment or beyond. Pension plans that are subject to ERISA are required to meet ERISA’s funding, accrual, minimum participation standards, and vesting requirements. Top hat plans (plans that are unfunded and maintained by an employer primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees) are considered ERISA plans, but are exempt from many of ERISA’s requirements, including the foregoing requirements. Note that executives may in some instances have an incentive to challenge a plan’s top hat status in order to obtain ERISA protections. No definitive guidance has been issued on when a plan will satisfy the top hat rules. The Department of Labor, in advisory opinions and amicus briefs, has taken the position that the word ‘primarily’ modifies the employer’s purpose in maintaining the plan rather than the group of employees covered. In reviewing the issue of whether the group covered is a select one, courts may look at qualitative or quantitative factors. For example, court cases have held that an employee’s bargaining power and duties are relevant in determining whether he or she is a member of the applicable group. The courts may also take into account the number or percentage of executives covered. In any event, there is no ‘bright-line test’ as to how many employees (or percentage of employees) may comprise a select group, but based on some cases, it is often recommended that the plan cover no more than the top 15 to 20 per cent of a company's highest paid employees. In the absence of a ‘bright-line test’, employers may wish to avoid a challenge to top-hat-plan status by restricting eligibility in a deferred compensation plan to a small group of the highest paid employees with executive responsibilities.

Recurrent discretionary incentives

Can it be held that recurrent discretionary incentive compensation has become a mandatory contractual entitlement? Is this rebuttable?

A pattern of payment of recurrent discretionary incentive compensation does not result in a mandatory contractual entitlement under applicable laws, and most incentive plans specifically disclaim any such interpretation. Depending on the facts and circumstances and applicable state case law, however, employees may be able to bring a common law claim that the employer had a pattern and practice of paying or granting incentives and the employee continued employment in reliance on that practice. It is unlikely that such a claim would be successful unless there were promises (express or clearly implied) of continued incentives.

Effect on other employees

Does the type or amount of incentive compensation awarded to an executive potentially affect the compensation that must be awarded to other executives or employees?

The type and amount of incentive compensation awarded to an executive does not affect the compensation that is legally required to be paid to other executives or employees. In certain cases, however, an executive may have a contractual right to incentive compensation that is comparable to levels or types of incentive compensation provided to similarly-situated executives of the company (eg, in relative amounts and earned based on the same criteria). However, this is provided that, without contractual provisions to the contrary, there is generally significant latitude to interpret who similarly-situated executives are and what the relative compensation of any individual should be. In addition, significant discrepancies in compensation (incentive or otherwise) can lead to discrimination claims by employees. Whether such a claim would be successful would depend on the facts and circumstances and what proof the employee could offer (eg, claims of sex or racial discrimination in the amount/type of compensation).

Mandatory payment

Is it permissible to require repayment of incentive compensation under certain circumstances? Are there circumstances under which such repayment is mandatory?

Every state has wage and hours laws that protect an employee’s ‘earned’ wages. These laws generally significantly limit an employer’s ability to recover previously paid wages (or offset future wages ) without the employee’s consent. That same level of protection typically does not apply to incentive compensation, but it is important for any recoupment rights to be clearly communicated to employees to avoid possible wage and hour claims. In any event, it has become increasingly common for bad acts and, in the financial institution context, adverse risk outcomes, to provide a basis for recovery of incentive compensation, particularly in the case of executives.

SOX requires chief executive officers and chief financial officers of public companies to disgorge incentive compensation and profits from company stock sales that they receive within the 12-month period following the public release of financial information if there is a restatement because of material non-compliance with financial reporting requirements as a result of misconduct. The SEC has proposed rules (under Dodd–Frank) that would require stock exchanges to prohibit companies from listing their shares if they do not adopt, disclose, and enforce clawback policies applicable to excess incentive compensation received by current and former executive officers in the three-year period preceding the date the issuer is required to prepare an accounting restatement, without regard to whether a specific executive engaged in the misconduct or whether misconduct actually occurred. Guidance on the specifics regarding these rules has not yet been provided.

Most companies, particularly public companies, have clawback policies that are somewhat broader than federal law currently requires and these policies are disclosed in the company’s publicly filed documents, if applicable. Under these policies, clawbacks may be triggered by any number of behaviours, including violation of restrictive covenants or company policies, overly risky business practices or #MeToo movement issues. Section 16(b) of the Exchange Act also requires an insider (generally any officer, director or 10 per cent shareholder) to return any profits obtained from the purchase and sale (or sale and purchase) of company stock within a six-month period.

Can an arrangement provide that payment is conditioned on continuing employment until the payment date? Are there exceptions?

There are no prohibitions on payment being conditioned on continuing employment until the payment date and it is very common to include such a restriction on payment, particularly in the case of annual bonuses that are service-based. If the employment condition applies after the end of a performance period, it is important to be very clear as to the conditions for payment so as to avoid employee claims that the award was ‘earned’ (for state wage and hour law purposes) as of the last day of the performance period. Some states (eg, California) have stricter rules than other states as to the clarity and enforcement of conditions on required continuing employment past the end of the performance period.

Law stated date

Correct on

Give the date on which the information above is accurate.

8 September 2020.