Public companies should consider a number of items for 2019, including recent SEC and proxy advisory developments and other perennial executive compensation considerations.
Even as the US government shutdown continues to create complexities for many companies, 1 it is business as usual for US public companies that are continuing their annual planning for the upcoming proxy season. Although 2019 introduces fewer significant changes than 2018 to the executive compensation landscape, this Client Alert offers a brief summary of the key executive compensationrelated reminders and considerations that public companies should continue to prioritize early in 2019 and in the course of their preparations for the proxy season.
New Requirement to Disclose Hedging Practices and Policies
As mandated under the Dodd-Frank Act, the Securities and Exchange Commission (SEC) has adopted a new disclosure requirement under which US public companies must disclose their hedging practices or policies in their annual proxies or information statements. Specifically, Item 407(i) of Regulation S-K will require a company to describe any practices or policies it has adopted regarding the ability of its directors, officers and employees to purchase securities or other financial instruments, or otherwise engage in transactions, that hedge or offset, or are designed to hedge or offset, any decrease in the market value of equity securities granted as compensation, or held directly or indirectly by the employee or director. This requirement extends to policies relating to equity securities of the company, any parent company, and any subsidiary of the company or the parent company, and to equity securities whether granted as compensation or otherwise held by such persons. If a company does not have any hedging practices or policies, the rule generally requires disclosure of the absence of such practices or policies or a statement that hedging transactions are generally permitted.
The disclosure is required in any proxy or information statement relating to the election of directors. The requirement becomes effective for fiscal years beginning on or after July 1, 2019; though smaller reporting companies and emerging growth companies (EGCs) may delay compliance until fiscal years beginning on or after July 1, 2020. Foreign private issuers are exempt from this disclosure requirement and the disclosure is not required to appear in an initial public offering (IPO) prospectus.
As a reminder, proxy advisory firm Institutional Shareholder Services (ISS) will now recommend against members of a board committee that oversees risks related to pledging, or against the full board, if ISS determines that a significant level of pledged company stock by executives or directors raises concerns. ISS will consider factors such as a disclosed anti-pledging policy, the magnitude of the pledged stock, disclosure that ownership or holding requirements do not include pledged stock, and progress towards reducing the magnitude of pledging over time.
Proxy Action Item
Companies should review their existing practices and policies that address hedging transactions and prepare any necessary disclosure in advance of the implementation date. If a company does not maintain such practices and policies, it may wish to consider adopting a hedging practice or policy in order to avoid the requirement to disclose the absence of such practices and policies.
Proxy Advisory Policy Updates
ISS and Glass Lewis recently released updates to their 2019 voting policies (along with corresponding ISS FAQs), effective for all companies with annual meetings on or after February 1, 2019. Set forth below is a summary of certain compensation-related policy changes and updates that companies should consider while preparing for the 2019 proxy season.
Consequences for Excessive Non-Employee Director Pay
In 2018, ISS introduced a new policy that will provide for negative vote recommendations for any compensation committee members or other board members who are responsible for setting or approving director compensation if ISS establishes a “pattern of excessive non-employee director pay” in two or more consecutive years without a compelling rationale or other mitigating factors. ISS has confirmed that application of this policy will not trigger a negative recommendation until meetings occurring on or after February 1, 2020 (i.e., for companies with respect to which ISS identified a pattern of excessive nonemployee director pay in its review in both 2019 and 2020). To determine whether non-employee director compensation is excessive, ISS further confirmed that it will compare individual non-employee director pay totals to the median of all non-employee directors at companies in the same index and sector (within the same two-digit Global Industry Classification Standard group). Any non-employee directors paid at the top 2-3% of all comparable directors (ISS deems these to be the “extreme outliers”) may be found to have received excessive compensation. Following ISS's identification of a director pay outlier using these measures, a qualitative evaluation of the company's disclosure will determine if concerns are adequately mitigated. Mitigating factors may include one-time awards, special payments related to unusual transactions or circumstances or payments in consideration of special expertise. If any of these factors exist, companies should consider expanding their disclosure to address them.
Additionally, in recognition of the pay premium often associated with non-executive chairs and lead independent directors, non-employee directors in these roles will be compared against other directors in such leadership positions in the same index and sector.
With respect to narrow distributions of non-employee director pay within any specific index and sector grouping, the lack of a pronounced difference in pay of the top 2-3% of directors as compared to the median director may be considered a mitigating factor.
Equity Plan Proposals
ISS made some minor adjustments to its methodology for the review of equity plan proposals for the 2019 proxy season. The passing score for companies under the ISS equity plan scorecard (EPSC) will remain at the same levels in effect for 2018 (53 points out of 100 (increased to 55 points out of 100 for those companies subject to the S&P 500 scoring model)), but ISS implemented the following changes to its equity plan scoring model:
- ISS revised the change in control vesting factor to focus on the quality of the disclosure of change in control vesting, rather than evaluating the treatment of awards upon a change in control. ISS now provides that full credit will only be awarded with respect to the change in control vesting factor if the plan specifically discloses the vesting treatment for both time- and performance-based awards. Points will not be awarded if the plan provides for discretionary vesting or is silent as to the change in control vesting treatment for either time- or performance-based awards. ISS has increased the weighting of the plan duration factor, and will only award full points where the proposed share reserve should last five to six years or less (based on the company's three-year annual average burn rate).
- ISS has confirmed that it will consider equity plan amendments involving removal of general references to Section 162(m) as administrative and neutral. However, ISS will view the removal of individual award limits in an equity plan as a negative change, as ISS considers such limits to be a good governance practice and a stockholder-favorable practice. Additionally, ISS’ 2019 policies specifically note that shifts away from performance-based compensation to discretionary or fixed pay elements will be viewed negatively by ISS.
- ISS has also provided that, while it will generally follow its EPSC model in evaluating equity plan proposals, ISS may recommend against the proposal despite a passing score if it is deemed “excessively dilutive.” ISS considers a proposal excessively dilutive if the proposal is estimated to cause share capital dilution2 of more than 20% (for S&P 500 model) or 25% (for Russell 3000 model). This new policy does not apply to companies that are covered by a model other than the S&P 500 model or Russell 3000 model.
ISS’ 2019 policies specifically address “front-loaded” awards intended to cover multiple future years, which awards have become more prevalent in the last several years. ISS is unlikely to support any such grants that cover more than four years (calculated as the grant year plus three future years). ISS will also look for specific and firm commitments not to grant additional awards over the period covered by the grant. The presence of these types of awards will also receive more scrutiny with respect to ISS’ usual pay-for-performance considerations and companies will want to ensure they provide complete disclosure, especially around the vesting and performance conditions and the rigor of any performance criteria.
Decreased Disclosure for Smaller Reporting Companies
In connection with the SEC’s recent change to expand the definition of “smaller reporting company” (SRC), which is further discussed below under Other Proxy Season Reminders, Glass Lewis has updated its voting guidelines to clarify that it will consider the impact of materially decreased executive compensation disclosures in the proxy statement. If Glass Lewis determines that the reduced executive compensation disclosures substantially impacts a stockholder’s ability to assess the company’s executive pay practices, then Glass Lewis may recommend against compensation committee members. Similarly, ISS notes that companies with scaled compensation disclosure will need to provide sufficient disclosure to allow stockholders to meaningfully assess the board’s compensation philosophy and practices and make an informed decision on any say-on-pay vote.
Proxy Action Item
Companies should consider how ISS’ and Glass Lewis’ voting policies may affect companies’ proxy proposals. Enhanced disclosure and additional planning prior to a proxy filing may be appropriate in certain cases to counter a potential adverse recommendation.
Director Compensation Litigation Risk — Potential Mitigation Efforts
Directors have historically avoided the compensation scrutiny applied to executives; however, there has been increased attention towards director compensation in recent years. In late 2017, the Delaware Supreme Court issued an opinion that continued the trend of enabling plaintiffs to sue companies for director compensation. The decision in In re Investors Bancorp, Inc. Stockholder Litigation, Case No. 1693, 3 found that equity awards granted to Investors Bancorp’s directors were “self-interested decisions” and must be reviewed under the “entire fairness” standard (as opposed to the business judgment rule).4 The court found that director awards were self-interested decisions and must be reviewed under the entire fairness standard because the directors retained discretion to determine the specific awards to directors under the stockholder-approved equity plan, even within the confines of a stockholder-approved limit on the aggregate awards that could be made to directors under the plan.
Delaware courts have consistently refused to treat stockholder approval of an equity plan as ratification of director equity awards if the challenged equity plan did not include “meaningful” limits on the director awards. However, courts have historically failed to define what constituted meaningful for this purpose. 6 The Investors Bancorp opinion clarified that even meaningful limits on awards to directors alone may not be sufficient to ensure application of the business judgment rule to director equity award decisions. The safest approach under Delaware law is stockholder approval of specific awards or a self-executing stockholder-approved formula plan if there is no director discretion over individual awards
While each company’s situation will be unique, companies may take a number of possible actions to mitigate the risk of potential claims alleging breaches of fiduciary duty in connection with director compensation, including one or more of the following:
Reviewing Existing Director Compensation Arrangements
At a minimum, companies should review their director compensation program and practices, including the process for determining director compensation, any applicable limits on director compensation, a comparison of director compensation (both cash and equity) against the company’s compensation peer group, and proxy disclosure regarding the process for determining and amounts of director compensation. Benchmarking non-employee director compensation annually to ensure consistency with the company’s peer group is also advisable. By proactively reviewing current director compensation practices on an annual basis, a company will be best-positioned to determine what, if any, modifications to its director compensation practices and governing documents may be appropriate in light of the current litigation environment. Companies should consult with the company’s compensation consultant to complete this review. Companies will also want to ensure their public disclosure does not indicate unreasonable benchmarking practices.
Considering Potential Plan Changes
If a company determines that changes to its director compensation program are warranted, the company may wish to consider:
- Stockholder Approval of Formulaic Director Awards. The most protective measure a company may take to insulate itself and its directors from attacks on director compensation practices is to have its stockholders approve a director compensation plan prescribing the precise terms of formulaic cash and equity awards, or to include such formulaic cash and equity awards in the company’s omnibus equity plan. A standalone directors’ plan may provide certain benefits, including (1) maintaining a distinct framework for a company’s director compensation, and (2) allowing for clear and distinct proxy disclosure and a more straightforward process for stockholder approval of director compensation. 7 However, including director compensation in the company’s equity compensation plan is also a feasible approach, and avoids the need to submit director compensation for stockholder approval separately from the equity plan. Companies can adopt various structures to implement a stockholder-approved formulaic director compensation program, while still retaining some flexibility for future decisions. Companies should consult with outside counsel and compensation consultants if they are interested in pursuing this approach.
- Stockholder Approval of Specific Director Compensation Limit. Companies may alternatively consider adding (or continuing to include) specific meaningful annual limits on total director compensation under stockholder-approved compensation plans, most typically their equity compensation plans. Companies can usually amend such plans to include director limits without obtaining stockholder approval.8 While these limits may not provide absolute protection against stockholder claims in Delaware, they may help to deter claims. Companies may wish to consider seeking such approval in conjunction with other amendments, such as an increase in the share pool, as opposed to seeking approval separately from other amendments.
Reviewing Director Compensation Disclosure
In light of the increased focus on director compensation, and regardless of whether any plan changes are determined to be advisable, companies should — more so than ever — clearly disclose their director compensation. Companies should consider providing their reasoning in establishing the programs and amounts, as well as the relationship of such director compensation to that of the company’s peers and any material variances from the median of such peers, in their proxy statement and other filings. Also, any mitigating factors that will help explain director compensation that may be out of line with peers should be disclosed. While disclosure alone will not ensure the application of the business judgment rule to director compensation decisions, fulsome and thoughtful disclosure may help deter claims by plaintiffs or, in the event a claim is brought, rebut allegations from plaintiffs.