Compensation Landmines & Key Issues
By Kevin Kuschel, Brent Longnecker and Daniel Wilson
“I would not give a fig for the simplicity this side of complexity, but I would give my life for the simplicity on the other side of complexity”. Oliver Wendell Holmes, Jr.
Executive compensation practice and application is continually developing based on proxy advisory firm influence and institutional shareholder desire. Listing standards related to independence requirements for compensation committee members and the selection of their advisors are now in place, all public companies are now influenced by SOP regardless of size, pay for performance continues to be a hot button, and internal pay equity and the ratio of median company employee to the CEO is poised to be disclosed in a few short months. Bottom line, it’s tougher today than ever before if you have any responsibilities around pay, and it may get a bit tougher if the new bill in the Senate related to taxation of NQDC and stock options is passed.
As we all know, Institutional Shareholder Services (“ISS”) and Glass Lewis (“GL”) have a significant impact on how institutions and shareholders vote on compensation-related practices and the boards that govern those companies. In reaction to this influence, many companies have developed outreach programs for executives, committees and board members to reach out to their major shareholders whom ISS and GL influence the most. In fact, L&A is seeing more and more companies engaging in discussions with these key institutional shareholders to communicate to them what is important to the company and shareholders, identifying key components in compensation programs that align executives with shareholders, and ensuring that company performance plays a vital role in determining the measures used in those programs. What is most interesting is that a company can have an analyst at an institution rate them a “strong buy”, but have a compliance person at the same institution vote against the company because they just robotically follow ISS and/or GL. This is a tremendous disconnect that, in time, needs to be corrected and simply makes no sense.
That being said, the most significant impact ISS and GL have on companies relates to pay for performance. ISS and GL evaluate pay for performance alignment on both quantitative and qualitative measures. Quantitative measures seek to gauge the alignment of a company’s executive pay practices to company performance and evaluating the CEO’s compensation against the company’s total shareholder return, although ISS is beginning to move away from TSR as the sole metric, in favor of return-based measures. Qualitative measures seek to determine how a company defines its peer group for benchmarking purposes, the ratio of performance-based equity to time-based equity awards, or the appropriateness of performance goals and how easily they can be achieved. Whatever the case, companies have continued to evolve their compensation programs to meet these stringent requirements of shareholder activists.
As a result, many companies are continuing to implement performance-based equity programs to link compensation to company performance. The continued elimination of tax gross-ups, implementation of anti-hedging policies for executives, and increasing executive’s stock ownership requirements are examples of other ways that companies are combatting ISS and GL. Even though companies are implementing such devices, compensation committees and board members need to keep in mind that they must do what is in the best interests of shareholders, even if that means gaining a negative vote from ISS and GL. Committees and boards know their company better than proxy advisors and know what it takes to attract, motivate, and retain the talent needed at their company, especially with a work force dwindling with executive level talent in all industries.
To comply with regulations, companies must now disclose standards as they relate to independence rules for compensation committees, their members, and their advisors. Whether you are listed on the NYSE or NASDAQ, a compensation committee may not select or receive advice from a third-party consultant or legal advisor unless it has conducted the six-factor independence assessment as outlined in Rule 10C-1 under the U.S. Securities Exchange Act of 1934 and must be reviewed and performed annually. Likewise, NYSE compensation committees must be completely independent and NASDAQ compensation committees must have at least two independent members.
Prior to 2013, public companies with a market cap of less than $75 million were exempt from SOP voting and guidelines. However, with the increased demand from shareholder activist and the Securities & Exchange Commission (“SEC”), all public companies, regardless of size, will be required to hold SOP shareholder votes. The inclusion of these smaller companies having to abide by SOP voting guidelines brings a new thought process and manner in which pay practices are being monitored not only internally but at the board and committee levels as well. Compensation committee meetings now have a whole new meaning and significance behind them and committee members now know that they have a chance at having a negative vote cast against them by ISS and GL if the compensation program(s) implemented at their company do not meet certain guidelines and shareholder best interests.
Internal pay equity and the ratio of median company employee to the CEO will be a new disclosure item this coming proxy season. After many years, there is now more clear guidance on the calculation and many companies have conduct pre-calculations to understand the potential implications, as well as alternative disclosure strategies. There will remain discretion at the company in the identification of the population included in the calculation (i.e. contractor/seasonal/temporary), resulting in an inability to conduct a meaningful relative analysis across companies. Regardless, the data collection methodologies and the definition of a median employee will need to be consistent, repeatable, and defensible from year to year. Emerging growth companies, small reporting company, registered investment companies, and foreign private issuers will be exempt for disclosure.
Every year that passes brings more SOP legislation and new disclosures for companies to be cognizant of, which ultimately means that companies will continue to have to disclose pay practices, performance measures, independence guidelines, etc. in their respective Compensation Discussion & Analysis (“CD&A”) sections of their proxy statements to shareholders. As such, what better opportunity to let shareholders know what you as executive leaders, committee members, and board members are doing as fiduciary stewards of the company. While CD&A sections of the proxy statement were getting longer and longer, in recent years, this trend is reversing in favor of concise disclosures with enhanced graphics and developed communication strategies. This medium remains the best opportunity to disclose actions taken which align with shareholder feedback, best practices, and pay practices that set them apart from other companies. An executive summary describing changes, company performance and compensation relative to that performance is now the most key component of successful CD&A’s. A continued trend coming to the forefront, especially in light of ISS and GL pushing so hard for executive pay packages to be reeled back in, is the concept of targeted vs. reported vs. realized compensation. How many times the compensation that is reported in the summary compensation table of the CD&A is actually realized by the executive, less than the general public, ISS, or GL actually are aware of, they only see what is reported and don’t think about the latter.
The most recent and potentially troubling legislation effecting compensation is the Tax Cuts and Jobs Act which will effectively eliminate the benefits of non-qualified deferred compensation programs, representing a significant amount of an executive’s total compensation package. Further, any NQDC balances currently held by executives will accelerate tax, likely representing an enormous amount of taxable value and requiring the immediate payment of taxes based on funds these individuals do not yet have access to. Although this has yet to be passed, it is being closely monitored due to its potential implications.
Ultimately, compensation committees and boards of directors are responsible for the compensation packages provided, and a fiduciary role to shareholders to hold up their end of the bargain for it to be reasonable, market competitive, attracting, motivating, and retentive to all parties involved. As such, the buck stops there. All this legislation, new disclosures, nitpicking of company policies, and taking apart of executive compensation packages are not only getting outrageous but overwhelming for some companies. All of this could eventually leave America wondering, what just happened and why did we lose our competitive position worldwide?