Can We Talk? Director Independence Inconsistency

It's well past time for the SEC and the IRS to coordinate on the issue of director independence, particularly as it relates to compensation committee membership. With the SEC's passage of the new executive compensation and related party transaction disclosure rules, the two agencies are even further apart than they were previously. While this is mainly a U.S. issue, it's also a good illustration of problems that can happen when financial regulators do not cooperate effectively.

Let me explain. SEC Rule 16b-3 exempts from short-swing profit liability transactions where a company officer exercises options and then sells the underlying securities (usually within a day or two of the exercise) to pay the exercise price. Without a regulatory exemption, the exercise and subsequent sale would result in short-swing profits that the executive would be required to fork over to the issuer. The exemption provides that if the options are granted by non-employee directors, then the exercise won't be counted as a purchase transaction under the short-swing profit rule.

In most cases, the options are granted by the compensation committee, and the company lawyer screens compensation committee members to assure that they meet the definition of non-employee director. Under Rule 16b-3(b)(3)(i)(C), a non-employee director is anyone who "does not posses an interest in any other transaction for which disclosure would be required" under Item 404. Now that the SEC has revised Item 404, the threshhold for disclosure has jumped from $60,000 to $120,000. Even if the transaction exceeds this amount, there are certain transactions that the SEC views as inherently arm's length, such as transactions that are competitively bid or transactions where a government regulatory body must approve rates. These transactions are exempt from Item 404 disclosure.

Now over to the IRS rules. Several years ago when the IRS engaged in rulemaking with respect to section 162(m), the IRS made a mistake. Section 162(m) of the IRC provides that companies may not deduct as ordinary business expenses compensation over $1 million per year to "covered employees" (generally, the top 5 executives) unless the company jumps through certain hoops. One of those hoops is that the compensation must be performance based, and the targets must be approved by a committee comprised of independent directors, usually the compensation committee.

Under the IRS rules, though, the definition of "independent director" differs substantially -- although apparently unintentionally -- from the SEC's definition of non-employee directors. The IRS says that any director who has a transaction of $60,000 or more with the issuer does not meet the definition of independent director.

Here's the dilemma: under the SEC rule, a director could have transactions with the issuer that are not disclosable under Item 404. The director could therefore serve on the compensation committee for the purpose of granting options, the exercise of which would be exempt from the short-swing profit rule. That same director, though, may not be able to approve compensation for executives because he or she has a competitively bid transaction that exceeds the $60,000 threshold.

My guess is that the IRS used a short-hand version of Item 404 disclosures when the IRS adopted the rules governing section 162(m). Like so many attempts to shorten things, this was done at the expense of accuracy. It's confusing for issuers because large issuers with executives making over $1 million per year may have compensation committee members who are qualified to vote on options grants, but who must recuse themselves when it comes to voting on compensation amounts.