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 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:
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.
Legal News Alert is part of our ongoing commitment to providing up-to-the-minute information about pressing concerns or industry issues affecting our clients and colleagues. If you have any questions about this update or would like to discuss the topic further, please contact your Foley attorney or the following:
Joshua A. Agen
Leigh C. Riley
Lauren M. Schuster