Corporate Governance

Shearman & Sterling LLP ESG Slowly Finding its Way into Incentive Compensation Plans | 23 Changes to 162(m) of the Internal Revenue Code Section 162(m) of the Internal Revenue Code provides that compensation in excess of $1 million paid to certain covered employees of public companies is not deductible. Prior to the passage of the Tax Cuts and Jobs Act, "performance-based compensation" was not subject to the $1 million limitation. To constitute "performance-based compensation," the compensation was required to be paid pursuant to objectively determinable performance goals, and the corporation was not permitted to exercise discretion to increase amounts payable once performance was certified. With the removal of the "performance-based compensation" exemption from Section 162(m), companies now have greater latitude to use qualitative performance metrics and to implement a bonus "modifier," which enables companies to increase the payable bonus as a result of a subjective determination, such as a commitment to the company's ESG principles. 3 Proposed DOL Rules on ESG Investing for ERISA Plans Although institutional investors are demonstrating an increased desire to engage in ESG investing, a proposed rule from the Department of Labor (DOL) may curtail these efforts. The proposed rule addresses ESG investing in the ERISA context. The DOL holds a longstanding position that ERISA fiduciaries should consider economic returns as of primary importance in selecting plan investments, but as Administrations have changed, the guidance from the DOL with respect to investments that also consider promotion of social, environmental or other policy goals has also changed. The proposed rule is viewed as discouraging ESG investing by suggesting that ESG investing raises heightened concerns under ERISA. Pursuant to the proposed rule, ESG factors may be considered only to the extent they present material economic risks or opportunities. In addition, if two alternative investments appear economically indistinguishable, a fiduciary may "break the tie" by relying on ESG factors. However, the break- the-tie rule is not new, and because the DOL believes true ties rarely exist, a fiduciary must document the basis for concluding that the investment alternatives were indistinguishable. The proposed rule is not without controversy, as evidenced by the over 8,000 comment letters sent to the DOL. The overwhelming feedback in these letters is against the proposed rule, with opponents arguing that ESG factors are already integrated into the decision-making processes of asset managers and are considered financially material.

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