By Susan Eichen, Carol Silverman and Amy Knieriem
February 25, 2019
Executive compensation and governance are key priorities for US public companies as the 2019 proxy season ramps up. Hot-button issues include CEO pay ratio disclosures, recent tax law changes, and increased investor opposition to say-on-pay (SOP) proposals. And investors and proxy advisers are intensifying their focus on director pay and board diversity. Read on for six tips to help you mitigate risks in a turbulent business climate.
Despite apprehensions about determining and disclosing the CEO pay ratio, the first year of compliance went relatively smoothly, and reactions from investors, employees, and the media were muted. But 2019 presents a few new challenges for executive compensation teams. Here are issues to consider as you prepare your 2019 CEO pay ratio disclosure.
Use the same median employee? A company may use the same median employee for up to three years. However, if changes in the employee’s or the company’s circumstances (such as the employee’s promotion or a company merger) would result in a significant change in the pay ratio, you may have to identify a new median employee.
Provide context? To address concerns over pay equity, institutional investors want more information on workforce structure, pay and benefits. According to a letter sent to Fortune 500 companies, the investors “favor ratios that indicate companies are making investments in their employees,” and believe the added disclosure will help put the ratio in the context of a company’s overall approach to human capital management.
Monitor proxy adviser reactions. Institutional Shareholder Services (ISS) and Glass Lewis aren’t expected to consider companies’ pay ratios in developing voting recommendations for 2019, but ISS will report both the new ratio and prior ratio — drawing attention to year-over-year volatility at individual companies. The advisers may also question industry outliers.
Watch for shareholder proposals. Last year, several companies agreed “to reexamine their CEO and executive pay and adopt policies that take into account the compensation of the rest of their workforces,” in response to a shareholder proposal from the New York State Common Retirement Fund.
US public companies have historically structured incentives to maximize deductibility of executive pay under Code Section 162(m)’s “million dollar cap.” The Tax Cuts and Jobs Act eliminated the “performance-based” exception and expanded the definition of covered employees subject to the cap.
Protect grandfathered amounts. Amounts that would have been deductible under the old rule are grandfathered if they are paid under written binding contracts in effect on Nov. 2, 2017, that aren’t materially modified. Steps to take include reviewing pay arrangements for grandfather eligibility, monitoring grandfathered amounts, and avoiding changes that could jeopardize grandfather status.
Track covered employees. There’s a new “once a covered employee, always a covered employee” rule, so you must track both current and former covered employees as long as they receive compensation from the company.
Take advantage of more flexibility for new incentives. Not having to comply with the performance-based exception provides new flexibility for incentive plan design. Performance goals can be subjective and companies can increase payouts, or exercise negative discretion. Also, plans no longer need boilerplate provisions, and shareholder approval is required for equity plans only under stock exchange rules. But too much discretion could raise objections from shareholders and proxy advisers, and may trigger adverse accounting consequences.
SOP failures are rare: While a record 72 companies received shareholder support below 50% in 2018, these comprise just 3% of all proposals. But the higher number of failures may continue in 2019 given that some investors are voting against more proposals. In 2018, CalPERS voted against 43% of SOP proposals, up from 18% in 2017. You can take several steps to turn around low SOP votes.
Engage with shareholders. Meeting with key investors to hear their concerns about executive pay and governance, and disclosing those concerns and the company’s response in the proxy statement is an effective way to turn around a low vote. Proxy advisers expect this disclosure after a low SOP vote (below 70% for ISS and 80% for Glass Lewis), and may penalize companies that omit it.
Strengthen pay-for-performance link. Effective ways to demonstrate pay-for-performance alignment include:
Enhance disclosures. Proxies should explain how:
Pay decisions shouldn’t be driven by proxy adviser voting policies, but it’s important to be aware of how recommendations from ISS and Glass Lewis impact support for SOP and other proxy proposals.
Stock price volatility may impact pay-for-performance assessments. Neither proxy adviser made significant updates to its quantitative tests. In fact, ISS backed off a proposal to replace commonly used financial measures with economic value added measures. But companies should be prepared for the potential impact of recent stock market volatility on their scores because total shareholder return remains ISS’s key performance indicator. A dip in share price toward year-end can flip a “for” SOP recommendation to an “against” recommendation the following year. And support levels average 25% lower where ISS recommends against a SOP proposal.
Use special compensation awards cautiously. Both proxy advisers have upped their scrutiny of front-loaded awards, one-off awards, and other contractual entitlements.
Excess dilution could tank an equity plan proposal. Equity plan proposals will garner an automatic negative ISS voting recommendation if ISS estimates a company's equity program would dilute shareholders by more than 20% (S&P 500) or 25% (Russell 3000). ISS also warns against removing Section 162(m) provisions that are considered best practices, such as individual award limits.
Director pay programs continue to be challenged in court and scrutinized by proxy advisers and investors.
Monitor litigation. Directors are vulnerable to excessive director pay lawsuits because they set their own pay. In 2017, the Delaware Supreme Court refused to dismiss a case because shareholders hadn’t approved the actual director pay, or a formula to calculate pay. (Before that, lower courts had dismissed cases where shareholders approved “meaningful” director-specific limits.) Shareholder-approved limits continue to be common, but formulas could gain traction.
Benchmark director pay and enhance disclosures. Another way to mitigate litigation risk is to benchmark director pay against peer companies and ensure that your process for determining director pay is explained in your company’s proxy.
Review proxy adviser individual research reports. Beginning in 2020, ISS will recommend voting against board committee members responsible for director pay at companies with a pattern (i.e., two or more consecutive years) of “excessive” director pay — the top 2‒3% of a company’s index and industry. In 2019, ISS’s proxy research reports will note if director pay is excessive.
Progress is slowly being made toward increasing the number of women board members. But the spotlight on board makeup from proxy advisers, investors, lawmakers, and regulators is increasing in intensity.
Proxy advisers may recommend voting against directors. In 2019, Glass Lewis may recommend voting against the nominating committee chair if a board has no female members. A similar ISS policy will kick in for 2020. In 2019, ISS research reports will note a lack of gender diversity, and updates to its governance assessment tool (Governance QualityScore) feature a new board diversity subcategory that includes questions on women serving as board leaders and named executive officers.
Investors are campaigning for diversity. Investors — including BlackRock, CalSTRS, New York City Pension Funds (NYCPF), and State Street — may vote against nominating/governance committee members at companies that don’t have a minimum number of women directors or haven’t shown progress toward diversifying their board. NYCPF has called for disclosing a matrix of directors' gender, race, and skills.
Lawmakers push for more diversity and disclosures. California is the first state to require companies headquartered in the state to have at least one woman director by Dec. 31, 2019, and up to three women, depending on board size, by Dec. 31, 2021. At the federal level, Democratic lawmakers recently reintroduced a bill in the House that would require public companies and large federal contractors to release data on the racial, ethnic, and gender composition of their boards and senior management teams, as well as strategies to improve diversity.
SEC issues guidance on disclosure. New SEC staff guidance clarifies when companies must disclose “self-identified specific diversity characteristics” voluntarily provided by directors. Characteristics may include race, gender, ethnicity, religion, nationality, disability, sexual orientation, or cultural background.
Using these six tips as a guide to addressing key executive compensation and governance issues in your 2019 proxy statement can help you mitigate potential risks. If your team needs additional guidance on how to finalize your proxy statement to comply with regulatory requirements and effectively present your pay program to shareholders, contact us to speak with a Mercer consultant.