Learn about the importance of supporting your executive compensation decisions and the authority the Board of Directors has over this important and sensitive topic - Peterson Sullivan - Seattle CPA Firm.

1. AUGUST 2013
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JUDGMENT CALL -
EXECUTIVE COMPENSATION DECISIONS
During the past few years, shareholders, government agencies and the general public
have closely scrutinized how public companies compensate their executives.
However, directors are still accorded con-
siderable leeway in setting executives’
salaries and bonuses.
In fact, a recent decision by the
Delaware Supreme Court reaffirms a
board’s discretion when it comes to
compensation decisions. The case also
provides valuable guidance on protect-
ing those decisions against shareholder
challenges.
Current Climate
The 2008 financial crisis sparked a flurry
of legislative and regulatory activity —
much of it focused on compensation
practices in public companies. For
example, in 2009, the SEC amended its
rules to require companies to disclose
certain risks presented by their
compensation policies and practices.
And in 2010, the Dodd-Frank Wall Street
Reform and Consumer Protection Act
introduced several new compensation-
related requirements, including:
• “Say on pay,” which requires companies
to give shareholders a nonbinding vote
on the compensation of top executives at
least once every three years,
• “Say on frequency,” which mandates a
separate nonbinding shareholder vote,
at least once every six years, on the
frequency of say-on-pay votes,
• “Say on golden parachutes,” which
requires a nonbinding shareholder vote
on golden parachutes given to execu-
tives in connection with mergers and
acquisitions,
• New proxy disclosures, including
descriptions of pay-for-performance
arrangements, the ratio of CEO
compensation to the median, and
whether employees or directors may
engage in hedging activities involving
the company’s stock, among others,
• New exchange listing standards
regarding the independence of
compensation committee members and
use of compensation consultants, and
• Mandatory clawbacks of incentive com-
pensation when a company restates its
financial statements.

2. 2 PUBLIC COMPANY INSIGHTS | AUGUST 2013
Paying for Performance
Internal Revenue Code (IRC) Section
162 limits a public company’s deduc-
tion for top executives’ compensation
to $1 million per year. But Sec. 162(m)
provides an exception for qualified
performance-based compensation.
Your compensation plan qualifies if
your compensation committee —
comprised solely of two or more
outside directors — establishes written
performance goals within the earlier of
90 days after the performance period
begins or before 25% of the perfor-
mance period has elapsed. It’s also
mandatory that:
• Attainment of the performance goals
be substantially uncertain at the time
of establishment,
• Compensation be nondiscretionary
— that is, based on an objective
standard or formula set by the
compensation committee,
• Compensation be payable only on
achievement of the performance goals
(except in the case of death, disability
or a change in ownership or control of
your company), and
• Your company’s shareholders
approve the plan’s material terms.
Many of these requirements have already
been implemented, while others await
the adoption of new SEC rules. Overall,
they reflect a heightened level of trans-
parency and shareholder oversight.
Freedman v. Adams
Despite heightened shareholder scrutiny,
the courts continue to defer to directors’
judgments regarding executive compen-
sation. Unless a board’s decisions are
considered to be irrational or made in
bad faith, courts are reluctant to second-
guess them. Freedman v. Adams,
decided in 2013 by the Delaware Su-
preme Court, is a case in point.
Freedman involved a shareholder’s
derivative suit challenging a company’s
policies and practices related to execu-
tive bonuses as “corporate waste.” From
2004 to 2007, the company paid its
executives bonuses totaling more than
$130 million. The bonuses were not paid
pursuant to a performance-based
compensation plan, which, the plaintiff
alleged, could have made the bonuses
tax deductible to the company under
Internal Revenue Code Section 162(m).
(See the sidebar “Paying for perfor-
mance.”)
Had the bonuses been tax deductible,
the company would have saved approxi-
mately $40 million in taxes. The com-
plaint alleged that it was irrational “for a
corporate board of directors not to have
a stockholder-approved, objective,
performance-based compensation plan.”
Among the remedies sought by the
plaintiff was an injunction requiring the
board to adopt such a plan.
Shortly after the complaint was filed, the
company’s board approved a Sec. 162(m)
plan, causing the plaintiff to drop the
case. The plaintiff’s attorneys subse-
quently filed a motion seeking $1 million
in attorneys’ fees, reasoning that the
complaint benefited the company by
causing it to adopt the plan. The Dela-
ware Chancery Court denied the motion.
On appeal, the plaintiff challenged the
lower court’s ruling that the plaintiff had
failed to state a claim for corporate
waste.
Court rules on waste claim
The Delaware Supreme Court upheld the
lower court’s ruling, explaining that waste
claims arise only “in the rare, unconscio-
nable case where directors irrationally
squander or give away corporate assets.”
The court also noted that, under the
“business judgment rule,” courts gener-
ally defer to board decisions — even
poor ones — unless they can’t be
attributed to a rational purpose.
In this case, the complaint fell short for
two reasons. First, it failed to allege that
any of the bonuses in question would
actually be deductible if a Sec. 162(m)
plan had been in place. And second, the
board’s compensation policies involved a
“classic exercise of business judgment.”
The court emphasized the following
language in the company’s proxy
statements: “While the compensation
committee monitors compensation paid
to our named executive officers in light of
the provisions of Section 162(m), the
committee does not believe that com-
pensation decisions should be con-
strained necessarily by how much
compensation is deductible for federal
tax purposes.” So the board was aware of
the tax issue, but made a conscious
decision to forgo the tax benefits in
exchange for greater flexibility and
discretion in awarding bonuses.
Protect yourself
Boards have a lot of discretion in making
executive compensation decisions. But as
Freedman demonstrates, those decisions
should be well reasoned and well
informed if your board hopes to avoid
shareholder litigation — or minimize its
impact. This is particularly true if you
elect not to take advantage of available
tax benefits. It’s also important to disclose
your executive compensation decisions,
and the rationale behind them, in your
proxy statements.