As our clients and friends know, each year Mintz Levin provides an analysis of the regulatory developments that impact public companies as they prepare for their fiscal year-end filings with the Securities and Exchange Commission (the "SEC") and their annual shareholder meetings. This memorandum discusses key considerations to keep in mind as you embark upon the year-end reporting process in 2018.1
The primary change for many companies this year is the new requirement to comply with the "pay ratio" disclosure rule, which was adopted as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"), and applies to all companies except for emerging growth companies, smaller reporting companies and foreign private issuers. This rule, which is discussed in more detail below, requires companies to disclose the ratio of median employee compensation to principal executive officer compensation and is set forth as Item 402(u) of Regulation S-K. The disclosure rule requires companies to begin providing this pay ratio information in their executive compensation disclosure with respect to the fiscal year beginning on or after January 1, 2017 in time for the 2018 proxy season. Contrary to many people's hopes, Congress did not repeal the rule prior to its enactment. However, in September 2017, the SEC provided some additional practical guidance that the SEC hopes will reduce the cost of compliance with the new rule.
In addition to the pay ratio disclosure rule, there are a few additional key issues that companies should focus on this year.
Elimination of Section 162(m) Performance-Based Compensation Exemption on Corporate Tax Deductions for Executive Compensation in excess of $1 million. The Tax Cuts and Jobs Act (the "Tax Act"), which was signed into law in December 2017, significantly expands the limitations on corporate tax deductions under Section 162(m) of the Internal Revenue Code for executive compensation in excess of $1 million. Prior to the Tax Act, executive compensation that was performance-based did not count against the $1 million corporate tax deduction limit. Now, no compensation paid to "covered employees" that is above $1 million will be deductible by the employer company; and there will no longer be an exemption available for performance-based bonuses, compensation attributable to the exercise of stock options and the vesting of certain stock awards. The Tax Act also broadens the applicability of Section 162(m) to individuals in two ways. First, the definition of "covered employee" has been expanded to include the chief financial officer of the employer, and second, any employee deemed a "covered employee" in 2017 will remain subject to Section 162(m) for as long as they are employed by the company and beyond. This means companies will no longer be able to defer an employee's compensation to a year when the employee is no longer deemed a "covered employee." The Tax Act grandfathers certain compensation in excess of the $1 million cap subject to the performance-based exemption which becomes payable pursuant to a binding contract that was in effect on November 2, 2017, and which is not modified in any material respect on or after that date. The details respecting the grandfathering provision are still unclear, and IRS interpretations on this topic are expected. However, deductions in 2018 for performance-based awards granted in previous years in compliance with the Section 162(m) performance-based exception may still be allowed, and compensation pursuant to an employment agreement with the chief financial officer entered into prior to November 2, 2017 and not subsequently modified may also still qualify for the tax deduction without limitation.
Companies submitting compensation plans or agreements for a shareholder vote may need to revise the standard tax discussion in their proxy statements to reflect the absence of the exemption under Section 162(m). In addition, we expect that new compensation plans will no longer set forth pre-established performance goals to be approved by stockholders, although we expect performance-based awards to continue to be prevalent but designed with more flexibility. In addition, despite the renewed interest in compensation limits for directors, we expect that caps on equity plans for employees also will be eliminated. In order for existing plans and agreements to remain grandfathered under the Section 162(m) performance-based exception, we recommend that companies that are considering amending their equity plans instead adopt a new plan.
Director Compensation Remains in the Spotlight. As we noted last year, the Delaware courts have shifted direction towards more shareholder protection in the area of alleged "excessive" director compensation by applying an entire fairness standard of review instead of the business judgment rule with respect to such claims. This trend continued throughout 2017, and culminated in a new decision by the Delaware Supreme Court making it clear that the entire fairness standard of review will be applied to decisions by directors concerning their compensation, unless the specific decision is ratified by stockholders. Even decisions made pursuant to shareholder ratified plans that include a cap or other "meaningful limit" on the total amount of compensation that the directors can award themselves will be subject to this more stringent standard of review. Because the entire fairness standard makes it easier for plaintiff shareholders to survive a motion to dismiss, companies face an increased risk of shareholder litigation in this area. To eliminate this litigation risk in its entirety, a company would have to create a non-discretionary shareholder approved director compensation program. Unless this becomes the new norm (or the "old norm," as it used to be required in order for grants to be exempt under Section 16 of the Exchange Act of 1934, as amended (the "Exchange Act")), our prior guidance on how to best structure director compensation remains the same. For example, the equity compensation plan should include a shareholder-approved cap representing the maximum amount that the company may compensate its non-employee directors with equity on a yearly basis, which cap should be set at a meaningful limit. If the cap is based on a number of shares, we recommend that an absolute dollar cap based on a valuation formula such as Black-Scholes also be included to prevent outsized value awards from being granted based on dramatic changes in stock price. This cap should be included in the equity plan when the plan is next brought to shareholders for approval. Companies should continue to evaluate director pay each year and make adjustments accordingly and confirm that director compensation is in line with the company's peer group. Cybersecurity Risk Disclosure. In the wake of recent well-publicized cybersecurity breaches, cybersecurity disclosure is expected increasingly to become the focus of both shareholders and the SEC. Shareholders are calling for proactive management and transparency in cybersecurity risk mitigation. The SEC is also focused on cybersecurity risk disclosure. The SEC Investor Advisory Committee, which is tasked with advising the SEC on regulatory priorities, has put forth a discussion draft on the issue of cybersecurity. The draft includes recommendations for enhanced substantive disclosure of potential risks, the scope and progress of programs aimed at addressing those risks and a discussion of board of director and management skills and resources available to address those risks on an ongoing basis. We expect that the SEC will likely issue updated guidance on cybersecurity risk disclosure soon. Until then, companies should carefully consider whether to include or augment disclosure of company-specific cybersecurity risks and the capacity to respond to those risks in their Form 10-K. Technical Changes to Form 10-K: Changes to Form 10-K Cover Page, Hyperlinks Required to all 10-K Exhibits; and Requirement that Exhibit Index Appear Before Signature Pages. Several technical rule changes became effective in 2017 that will affect upcoming Form 10-K filings for all public companies. First, there are changes to the Form 10-K cover page requiring inclusion of additional required language and check boxes regarding emerging growth companies. Second, there are changes that will affect every company's exhibit index. Companies must now include a hyperlink to each exhibit that is set forth in the exhibit index of filings made with the SEC, rather than simply including cross-references to the location of the original filing, to allow readers to gain easier access to those filings. Additionally, the exhibit index must now appear prior to (not following) the signature page to a registration statement or report. Companies' Form 10-K filings generally contain a substantially longer list of exhibits than other SEC filings. Therefore, it would be prudent for companies to begin to identify the URLs for their Form 10-K exhibits well before the filing of the report, and to coordinate with their financial printers in advance to ensure the hyperlinks will be functioning as of the Form 10-K filing. If a registrant that is a "smaller reporting company," as defined in Rule 405 of the Securities Act of 1933, as amended and Exchange Act Rule 12b-2, or that is neither a "large accelerated filer" nor an "accelerated filer," as defined in Exchange Act Rule 12b-2, submits its filings generally in ASCII it need not comply with the final rules until September 1, 2018, one year after the effective date of the new technical changes.
Say-on-Frequency: Consider need for another shareholder vote. For companies that held their first say-on-pay vote six years ago, it is now time to revisit the say-on-frequency vote. Companies that first held a say-on-frequency vote at their 2012 annual meeting are required to again include a...