Compensation paid by a publicly traded company to its chief executive officer and its three other most highly compensated officers (other than its chief financial officer) is generally not deductible by the company to the extent it exceeds $1 million per person per year under limits prescribed by Internal Revenue Code Section 162(m). There is an exception, however, for qualified “performance-based compensation,” which does not count against the $1 million limit if applicable requirements under Section 162(m) are met. One of the requirements is that the compensation be based on performance goals that are approved by shareholders. If, as is often the case, the plan governing the performance-based compensation includes a list of types of performance goals from which the compensation committee may select the specific performance target for a given performance period, then shareholders must reapprove the list of goals every five years. If shareholders do not reapprove the list of goals every five years, then any compensation (typically other than stock options or stock appreciation rights) that is based on one of the goals will not qualify for the performance-based exemption, and the company may be denied a deduction to the extent it pays more than $1 million in compensation in a given year to one of the covered executives.

Historically, whether compensation qualified as performance-based under Section 162(m) was solely a tax matter between a company and the IRS. More recently, however, shareholder derivative lawsuits based in part on claims of failure to qualify compensation as performance-based under Section 162(m) have become more prominent, suggesting that liability under corporate and securities laws could be another risk of failing to meet the Section 162(m) requirements.

Qualified Performance-Based Compensation Requirements

One of the key requirements for qualified performance-based compensation under Section 162(m) is shareholder approval of the material terms of the performance goals under which the performance-based compensation is paid. The material terms that must be disclosed and approved include:

  • The employees eligible to receive the performance-based compensation
  • A description of the business criteria on which the performance goal is based
  • Either the maximum amount of compensation that could be paid to any employee or the formula used to calculate the amount to be paid to the employee if the performance goal is achieved (including the maximum dollar amount, in the case of a formula based on a percentage of salary or base pay)

The approval must be obtained in a separate vote and must receive a majority of the votes cast on the issue, including abstentions to the extent abstentions are counted as voting under applicable state law. Many plans that award performance-based compensation give the compensation committee discretion to choose one or more specific performance goals to be used for a year from a menu of various types of goals previously approved by shareholders. Alternatively, the plan may require one or more types of goals to be used (e.g., EBITDA), but permit the compensation committee to set the actual level of performance that must be achieved. If the compensation committee retains this type of discretion, then the performance goals must be disclosed to and reapproved by a majority of shareholders every five years. For example, if a company last obtained shareholder approval of a list of performance goals in 2009, then the company must disclose the material terms and obtain re-approval in a separate vote at the first shareholder meeting in 2014.

In addition to the shareholder approval requirement, performance-based compensation must meet the following requirements:

  • Pre-Established and Objective Performance Goals. The compensation must be paid solely on account of attaining one or more pre-established and objective performance goals, which must include an objective formula or standard for computing the compensation that will be earned if the goal is achieved. The compensation committee must establish the performance goals in writing within the first 25 percent of the performance period and no later than 90 days after the beginning of the performance period. The goals also must be established before the outcome is no longer substantially uncertain. The compensation to be earned if the performance goals are achieved cannot be adjusted upward based on the committee’s discretion, but the committee may retain discretion to adjust the compensation downward.
  • Compensation Committee Independence. The performance goals must be set by a compensation committee that consists of at least two outside directors.
  • Certification of Performance. Before payment, the compensation committee must certify in writing that the performance goals and any other material terms were satisfied. The certification may be documented in approved meeting minutes of the compensation committee.

Section 162(m) and Executive Compensation Lawsuits

Although shareholder lawsuits based on executive compensation are not entirely new, there has been an increase in the prominence of such suits filed in recent years, and a new element in some of the recent suits has been claims based in part on failure to qualify compensation as performance-based compensation under Section 162(m). While many of these suits fail to survive motions to dismiss, the potential for obtaining a settlement may be sufficient to spur continued activity in this area.

Recent examples of these lawsuits based in part on Section 162(m) have alleged that proxy statements made false, misleading, or incomplete disclosures regarding the deductibility of performance-based executive compensation. These lawsuits also frequently allege that the payment of non-deductible, performance-based compensation constitutes a breach of fiduciary duty, waste of corporate assets, excessive compensation, or unjust enrichment.

For example, one recent lawsuit alleged that a company that had received shareholder approval for its Section 162(m) plan performance goals in 2007 failed to seek shareholder re-approval in its first shareholder meeting in 2012. Therefore, the lawsuit claimed, the company’s disclosure in its proxy statement that the compensation committee could grant performance-based, tax deductible compensation was misleading, violating securities laws, and also constituted a breach of fiduciary duty because of the company’s failure to satisfy the shareholder approval requirement under Section 162(m). Other recent lawsuits allege breaches of securities laws, fiduciary duty, waste of corporate assets, and unjust enrichment where companies paid compensation above the Section 162(m) limits in their equity incentive plans and later sought shareholder re-approval of the plan or approval of amendments to the plan without disclosing the fact that compensation previously paid under the plan had exceeded the plan’s limits.

Recommendations to Minimize Exposure to Potential Section 162(m) Litigation

Although plaintiffs asserting Section 162(m)-related claims must overcome significant procedural hurdles, the potential for settlements may continue to draw complaints alleging breaches of fiduciary duty and misleading disclosures. Companies should consider actions to minimize exposure to the potential for Section 162(m) litigation, including the following.

  • Monitor the five-year re-approval requirement to ensure that performance goals are resubmitted to shareholders in a timely manner
  • Review proxy statement disclosures concerning incentive awards to ensure that they do not include a promise of compensation deductibility under Section 162(m) and that they disclose any discretion of the compensation committee to award non-deductible compensation above the limits stated in the governing plan
  • Ensure that the performance goals selected by the compensation committee for specific awards of incentive compensation are included in the shareholder-approved “menu” of potential goals listed in the governing plan
  • Ensure that the proxy statement seeking approval of performance goals for Section 162(m) purposes accurately describes the plan’s operations