There is a buzz in the air about renovating corporate culture in the name of innovation. Directors hear the changing desires of their stakeholders, and are developing a greater understanding of their business’s role for society at large. That buzz guided a recent roundtable discussion in Miami at NACD’s Leading Minds of Governance event.
A panel of governance experts and directors discussed recent trends in corporate governance with a full room of directors (fuller remarks from the panel will follow in the March/April 2018 issue of NACD Directorship magazine). Panelists included:
John Borneman, managing director, Semler Brossy Consulting Group LLC
Stuart R. Levine, nominating and governance committee chair and audit committee member, Broadridge Financial Solutions
Kathleen Misunas, director, Boingo Wireless and Tech Data Corp.; principal, Essential Ideas
Michael Stevenson, partner, BDO USA LLP
Peter P. Tomczak, partner, Baker McKenzie LLP
Highlights from their answers to select questions from directors in the audience follow. Comments have been edited for length.
To Build an Innovative Culture, Start with Hiring
I work in a heavily regulated industry. We’re in a very steady environment, but our industry is changing rapidly in all directions. Helping shift that culture is essential, so I’d love to hear your differing perspectives.
Misunas: I think it starts with the people you hire—and you need the buy-in from your senior staff. The people that are hired help you move in the right direction.
Levine: One of the criteria for hiring should be intellectual curiosity. If you’re hiring people at any level, including on the board, if those people do not express intellectual curiosity, I think you’ve got a problem on your hands. In the boardroom, consider sharing content that stimulates discussions around technology or governance trends. By discussing strategic material, it encourages excellent outcomes.
Misunas: Right. This absolutely should cascade down through the organization. The C-suite alone shouldn’t be concerned with curiosity. The next level should be doing the same thing with their staff, and so on.
Tomczak: When you consider innovation strategy, what does innovation mean to your board? Do you mean bringing in new ideas from outside your industry? If you’re hiring the same 20-year industry veterans, you’re probably going to get the same 20-year-old strategy. I’ve also found that tying individual economic incentives to strategy outcomes is useful, and it’s hard. There’s no right answer to the compensation question and innovation.
Borneman: I’ll add that innovation should be on the CEO’s scorecard. Is it one of the top priorities that you want to hold her accountable to for the organization? You can say it’s important, but if it’s not on the scorecard, you’re merely talking about innovation. There’s no accountability. It doesn’t have to be tied to compensation—to put dollars on it gets tough. But we can find innovation measures in some kind of meaningful, quantifiable way.
Stevenson: I think that when some boards assess themselves, when they probe their expertise, they find that because of the complexity of transactions (for example, in financial instruments and other changes associated with this current business environment), audit committees are finding themselves ill-equipped to handle changes happening in their organizations. As you take a fresh look at your board, understand the other situations that they have been involved with will arm them for change. That’s a critical point to know about members of this committee. Boards that are refreshing [their composition] with this understanding are also the easiest to work with from an audit perspective.
Don’t Miss the ESG Bus
How do we translate ESG into something with real business meaning that management can be held accountable for to deliver results?
Levine: Approaching the governance standpoint, regardless of the business you’re in, we’re all trying to anticipate client and customer needs. If you don’t have people of diverse backgrounds on your board, you risk not understanding the people who are buying your products and services. If you’re looking to deploy capital, and you look around and don’t have representatives on your board of the populations you’re serving, I don’t know how you develop the right strategy.
Misunas: I don’t walk into a business anymore where this is not a topic of conversation. Boards and executives are peeling back the onion to see where their companies stand, and where they should be, on environmental issues. ESG is top of mind for millennials. They speak up about real environmental issues. As a result, companies can look at their distribution lines, for instance. What are our transportation means? What are those contracted companies doing to protect the environment? Could we switch out business partners for a company that is more responsive to these issues?
If there’s no penalty for not doing anything, you’re omitting ESG from culture. I’m not saying you should give an extra reward for doing something, but should there not be some penalty other than getting left off the bus?
Borneman: The penalty is the impact on your business, your employee population, and getting kicked off the bus. It’s not about your bonus. It’s not about compensation. It’s about a longer perspective on business.
This article is the second half of the discussion of the sweeping ramifications of The Tax Cuts and Jobs Act of 2017 (“Tax Act”). Part one discussed the transition tax on deemed repatriation of foreign earnings, the reduction in the corporate tax rate from 35 percent to 21 percent, the changes in the taxation of the international operations of U.S. companies, and changes to interest and depreciation deductions.
In this article, we address provisions of the Tax Act that potentially accelerate tax liabilities, repeal the performance-based exception to the limits on compensation deductions for certain corporations, change the treatment of net operating losses, and cut back the favorable tax treatment of research and development expenses.
David C. Cole
1. Potential Acceleration of Tax Liabilities. Before the Tax Act became law, the requirements for the recognition of taxable income were independent from those for financial reporting—or so-called “book” purposes. In fact, certain types of income could be recognized for tax purposes later than the period in which they were recognized as revenue for book purposes. The Tax Act narrows these taxable income deferral opportunities by accelerating the recognition of certain taxable income to more closely match financial reporting.
This new rule is of particular concern in light of the new accounting rules under the Financial Accounting Standards Board’s Accounting Standards Codification (ASC) Topic 606. Under those accounting rules, expected revenue must generally be recognized as goods or services are provided to customers. Thus, unbilled receivables for partially performed services might be recognized for book purposes—and now for tax purposes, too—ratably as the services are performed, rather than when the services are complete or when the taxpayer has the right to demand payment from the customer. Similarly, items such as performance bonuses might be recognized for book purposes—and now for tax purposes—over the life of the contract, rather than when the standards for receiving the bonus have actually been met.
David C. D’Alessandro
The new tax rules may also affect taxpayers whose contracts with customers contain multiple-element deliverables (e.g., software sales agreements that include a license, updates, and support services, or sales of goods that include a warranty), because the rules now require that the allocation of payments among these deliverables be the same for tax and financial reporting purposes.
What Directors Should Do. This potential acceleration of the recognition of taxable income could have significant cash flow consequences for certain businesses. Directors, and in particular audit committee members, should ensure that the company’s treasury and tax departments have coordinated and evaluated the potential acceleration of tax liabilities as a result of the combined effect of the Tax Act changes and ASC 606. Depending on the extent of any accelerated tax liabilities, it may be necessary for a company to consider potential liquidity sources to meet its 2018 tax obligations.
2. Repeal of Performance-Based Exception to Limits on Compensation Deductions. Public companies may not deduct compensation paid to certain executives in excess of $1 million. Previously, there was an exception to this rule for performance-based compensation that met certain requirements. However, the Tax Act removed the performance-based exception effective for tax years beginning after December 31, 2017. As a result, a public company will generally not be able to deduct compensation in excess of $1 million paid to its chief executive officer, chief financial officer, or its three other most highly-compensated officers. The Tax Act provides some relief through a transition rule, which preserves the deduction for performance-based compensation that is paid pursuant to a written binding contract that was in effect on and not materially modified after November 2, 2017 (the “Transition Rule”).
What Directors Should Do. In light of the removal of the tax incentives for granting performance-based compensation to certain executives, companies may be interested in revising their performance-based compensation programs by, for example, shifting a greater percentage of a covered executive’s compensation to guaranteed salary. However, the terms of some equity and cash incentive plans nevertheless require performance-based compensation to comply with the now-repealed requirements for deductibility, which would limit the changes that could be made to programs without amending the plans. As such, before changes are made to a company’s compensation programs, directors should ensure that the terms of the applicable plans are reviewed to determine if amendments to the plans are necessary to accommodate such changes to the compensation programs.
Additionally, some large institutional investors and proxy solicitation firms have indicated that they expect companies to continue with their existing compensation programs that condition awards on the achievement of rigorous, transparent, pre-established performance goals. Directors should also consider how changes to a company’s performance-based compensation programs will be viewed by the company’s shareholders.
Finally, it will be important for companies with outstanding long-term, performance-based awards to preserve the deductibility of those awards pursuant to the Transition Rule. As such, companies should determine whether performance-based compensation arrangements that were in effect on November 2, 2017 qualify as grandfathered under the Transition Rule and, if so, consider the implications of any potential modifications to such plans.
3. Changes to the Treatment of Net Operating Losses. The Tax Act makes significant changes to the utilization of net operating losses (“NOLs”). Previously, NOLs could generally be carried back to a taxpayer’s prior two tax years and carried forward for 20 years. Extended carryback periods applied to certain product liability-type losses and casualty and disaster losses. Also, under prior law, the corporate alternate minimum tax precluded corporations from completely eliminating their tax liability through NOL deductions. Instead, the alternative minimum tax (AMT) imposed an effective 2 percent tax rate on a corporation that otherwise would owe no tax because of NOLs.
Under the Tax Act, corporations (other than certain farmers and property and casualty insurers) cannot carry back NOLs arising in tax years beginning on or after January 1, 2018. Those losses are no longer a means to generate cash refunds of previously paid taxes. Also, a corporation may not eliminate more than 80 percent of its taxable income (determined without regard to the NOL deduction) for a given year. Thus, although the corporate AMT was repealed under the Tax Act, this limitation effectively results in a minimum tax of 4.2 percent on a corporation suffering losses (more than doubling the previous effective rate). On the positive side, NOLs now can be carried forward indefinitely instead of only 20 years.
What Directors Should Do. The changes to NOLs are particularly troublesome for early stage companies, corporations in cyclical businesses, and companies that suffer product liability-type and substantial casualty or disaster losses. Losing the ability to carry back NOLs to generate tax refunds and the ability eliminate all taxable income with NOL deductions will negatively affect cash flow. Because of these changes, corporations should attempt to better match their income and deductions annually to reduce the extent of the NOLs they generate.
Directors of companies that incur NOLs should ensure that their tax departments are sensitive to this issue and are considering ways to better match income and deductions. For example, in years that appear likely to generate a net operating loss, opportunities to trigger or accelerate taxable income should be considered. Also, the new 100 percent deduction for the acquisition of tangible assets (discussed in Part I of this article) is not mandatory. Accordingly, consideration should be given to electing out of that “immediate expensing” if doing so avoids creating NOLs.
4. Cutbacks to the Favorable Treatment of Research and Development (R&D) Expenses. The tax laws have long provided favorable treatment for certain R&D expenses in order to encourage U.S. companies to invest in research. These include a current deduction for such expenses and a tax credit based on specified increases in the level of certain R&D spending. Under the Tax Act, however, the favorable treatment of R&D expenses is scheduled to be reduced in future years.
First, beginning in 2022, corporations may no longer currently deduct R&D expenses. Instead, those expenses must be capitalized and amortized over 5 years (in the case of U.S. research) and 15 years (in the case of non-U.S. research). Also, the Tax Act created a new Base Erosion and Anti-Abuse Tax (BEAT) that applies to larger U.S. corporations that make certain payments to non-U.S. affiliates. Beginning in 2026, the amount of tax a U.S. corporation would owe under the BEAT will no longer reduced by its R&D credit—potentially resulting in a significant decrease in the value of such credit.
What Directors Should Do. Given the future effective date of the R&D changes, companies may wish to consider lobbying Congress to repeal the Tax Act changes before they become effective. In addition, the numerous changes to the taxation of international operations discussed in Part I of this article should be considered as part of any restructuring or expansion decisions. In the case of locating or expanding R&D centers, the pending changes reducing the tax benefits of U.S. R&D expenses should be included in that analysis.
George M. Gerachis serves as head of Vinson & Elkins’ Tax and Executive Compensation and Benefits (ECB) department. He represents corporate and individual clients in a wide range of tax planning and tax controversy matters. David C. Cole is a tax partner at Vinson & Elkins and represents corporations, partnerships, and high net worth individuals in a wide range of domestic and international tax matters. David C. D’Alessandro is an executive compensation and benefits partner at Vinson & Elkins and advises employers and executives in the structuring of employment agreements and executive compensation arrangements.
Two NACD panels recently tackled issues surrounding sexual harassment in the corporate setting, and how directors should act and react to issues that could have profoundly negative impacts on company reputation and workforce satisfaction.
Key takeaways for directors ranged from careful CEO hiring to board composition. The following concepts could be readily applied to your own board’s conversation about overseeing this risk.
Aggregate Data to Spot Problems Before They Happen. Given that the board is ultimately responsible for overseeing company culture (including a culture that tolerates sexual harassment), the board should work to mitigate risks rather than taking up sexual harassment issues once a problem has surfaced, according to Michael Aiello, chair of the corporate department at Weil, Gostshal & Manges LLP. Lucy Fato, executive vice president and general counsel for American International Group (AIG), stated that boards should aggregate information to get the full picture, including:
Internal audit findings related to culture;
Employee relations/human resources reporting, including hiring trends, turnover statistics, and reports from exit interviews;
Hotline reporting, including whether there are too many or too few complaints; and
Company legal settlements and insurance payouts.
Board members should also probe whether the company’s investigative processes are fair and thorough.
Go the Extra Mile in CEO Hiring. In light of the board’s primary role of hiring and firing the CEO, along with the fact that fallout from CEO misconduct can significantly impact shareholder value, a board should take steps to ensure that its candidate of choice does not have a history of sexual misconduct or even tolerance for a culture in which harassment is an open secret. According to Sabina Menschel, president and chief operating officer at Nardello & Co., to really know who you are hiring into the corner office, conduct an investigation that includes public records, social media, and supplemented standard reference checks. With regard to CEO hiring, Fato stressed, “Ethics, integrity, and how you carry yourself as a public figure should be a factor in whether you can lead the brand.”
Risk Starts at the Top. The CEO and senior management are not alone in the potential spotlight of the #MeToo movement. Board members also must be vetted fully, and once in place, board members should receive code of conduct training, just as employees do, said Fato. In addition, the board should pick one corporate policy per year on which to do a deep dive as part of its oversight duties. Tabletop crisis preparedness exercises also should be conducted.
Superstar? Irrelevant. A board may face a difficult choice if a superstar CEO is found to have violated the company’s code of conduct, fearing that a dismissal could impact short-term shareholder value. According to Brenda Gaines, director, Tenet Healthcare, Southern Co. Gas, and NACD, superstar status is always irrelevant when investigating misconduct. She suggests that the board should take action to remove an offending CEO and then have a separate conversation about revenue and valuation implications. She added that the company must be clear about its culture and key principles, and should have zero tolerance for misconduct, applied to everyone in the company equally. “Board members have to keep each other honest,” she said.
Expand the Company’s Enterprise Risk Management (ERM) Framework. Sexual harassment should be a part of each company’s ERM framework, given that fallout from a misstep can be quite severe, emphasized Fato. Also, when doing employee surveys, ask specifically about harassment issues. To do so demonstrates that the company cares about these issues, said Menschel. Also, in terms of monitoring potential issues with long-tenured employees or even board members, consider updating background checks at regular intervals, stressed Fato.
Diverse Boards Matter. The #MeToo movement will have an impact on the boardroom, as well as on investor relations, according to Renee Glover, director, Fannie Mae, Enterprise Community Partners, and NACD Atlanta. Indeed, large shareholders are asking about diversity on the board, and they may request sexual harassment policies and pay equity measures. Gaines emphasized the clear-cut nature of the need for more diverse boards. “Diversity is good business,” she said, “and we are nowhere near where we should be. We need more gender diversity and more people of color on boards. Don’t miss this in the search for skill sets.”
Find an Ally. Rochelle Campbell, manager for board recruitment services at NACD, says that she encourages boards to have at least two diverse members on the board, as such boards tend to be more successful. For women and people of color who are new to a board, they can play an important role in discussions about sexual harassment and equal pay for equal work. When asked for practical advice for new board members, Gaines shared best-practice approaches to oversight of misconduct:
Get the facts right.
Take the emotion away.
Look for an ally on the board.
Glover summed up the issue: “We can do better. And when we do, we can get on with realizing the deeper value that a diverse board can deliver.”
Kimberly Simpson is an NACD regional director, providing strategic support to NACD chapters in the Capital Area, Atlanta, Florida, the Carolinas, North Texas and the Research Triangle. Simpson, a former general counsel, was a U.S. Marshall Memorial Fellow to Europe in 2005.