In this Viewpoint, Issues Facing Compensation Committees in 2024, comp consultant Pay Governance takes a look at how the current economic and geopolitical uncertainty, together with an “onslaught” of new SEC rules, may affect Comp Committee considerations and discussions regarding executive compensation in the new year—unbelievably, only a month or so away. The authors divide their list of new issues into three topics: “Goal Setting and Performance Measurement, Long-Term Incentive (LTI) Design, and Corporate Governance.” This post identifies highlights, but reading their Viewpoint in full is highly recommended.

Goal Setting and Performance Measurement

  • Performance ranges. All of the uncertainties currently facing companies could result in a downturn in performance. In that event, the challenge the authors identify is “to strike the right balance between rigorous yet achievable performance goals with shareholder sensitivity over potentially paying higher incentives for lower actual performance.” The authors suggest that comp committees think about using a wider range of performance levels, which “reduces the likelihood of a zero payout if actual performance falls short of expectations and minimizes the likelihood of a maximum or near-maximum payout if the company set overly conservative targets and/or an uptick in the economy boosts company performance more than originally anticipated.” As the authors point out, lowering a target could elicit criticism, so companies would need to consider providing a persuasive rationale.
  • Discretion. The authors point out that the use of discretion during Covid-19 led to “fierce backlash by investors and the proxy advisory firms,” often resulting in strict policies antagonistic to the use of discretion. Although there may be pressure to forego discretion, the authors suggest that it is still typically required for subjective determinations. Once again, they contend, disclosure of the factors that led to the evaluation and payout will be key.
  • Non-GAAP Incentive Plan Metrics. In devising plan metrics, companies sometimes exclude unusual items that they believe don’t reflect ongoing operations, such as the impact of the war in Ukraine. But NGFMs have recently also been subject to heightened scrutiny, which may lead comp committees, the authors suggest, to “implement guiding principles for such adjustments at the beginning of the performance period” and to review them throughout the period. The authors advocate including disclosure that provides a “rationale for the adjustments and their impact on incentive payouts or by adding a reconciliation of GAAP to non-GAAP results as an addendum to the proxy.” The authors contend that some exclusions might be a bit “tenuous,” for example, when exclusion of material items results in a significant incentive payout, but would otherwise lead to a low or zero incentive payout if included.

SideBar

In Question 118.08 of the recent CDIs under Reg S-K, Item 402(b), Corp Fin states that Instruction 5 to Item 402(b) provides that “[d]isclosure of target levels that are non-GAAP financial measures will not be subject to Regulation G and Item 10(e); however, disclosure must be provided as to how the number is calculated from the registrant’s audited financial statements.” This instruction applies only to disclosure in CD&A of NGFMs that are target levels. If NGFMs are used in CD&A or elsewhere in the proxy for any other purpose, such as to explain how NEO pay is structured or implemented to reflect NEO or company performance or to justify certain levels of pay, those NGFMs are subject to Reg G and Item 10(e) of Reg S-K (except for pay-versus-performance disclosure of the Company-Selected Measure or additional financial performance measures under Item 402(v)(2)(vi) of Reg S-K). The CDI provides that, in these pay-related circumstances only, the staff will not object if the company includes the required GAAP reconciliation and other information in an annex to the proxy statement, so long as the company includes a prominent cross-reference to the annex. Or, if the NGFMs are the same as those included in Part III of the Form 10-K through incorporation by reference of Item 402 disclosure, the staff will not object if the company complies with Reg G and Item 10(e) with a prominent cross-reference to the pages in the Form 10-K containing the required GAAP reconciliation and other information.

  • Foreign Exchange Fluctuations. Companies substantially affected by foreign currency fluctuations have taken different approaches. Some adjust targets or results for foreign currency fluctuations, some have been reluctant to do so for fear of alienating shareholders, and some “companies ‘split the difference’ by using a currency corridor, wherein fluctuations within 5% to 10% of budget or plus or minus 10% of the target payout are not adjusted and any fluctuations outside the corridor are adjusted.”
  • Pay Versus Performance Disclosure. The authors observe that various constituencies “have struggled to determine if the [PVP] data is useful.” But the authors believe that, in many cases, it is: the compensation actually paid data “shows strong alignment to changes in total shareholder return (TSR) and therefore can be used in combination with ‘realizable’ compensation to explain the alignment of CEO compensation and company performance, the main [tenet] of a company’s compensation philosophy.” Comp committees, the authors advise, may find PVP or realizable pay analyses “useful to gain insight into how the company’s executive pay aligns with performance.”
  • ESG goals. About 75% of the S&P 500 use ESG metrics in incentive programs, but practices vary and there is no common framework, although the expectation is that approaches would resemble those for financial metrics. The authors observe that some are skeptical that ESG metrics lead to inflated incentive payouts, but “initial research by Pay Governance…indicated that such criticism is not empirically supported.”

SideBar

It’s worth noting here that companion bills recently introduced in both the House and the Senate would apply an excise tax on companies that have a 50:1 CEO-to-median-worker pay disparity or higher. The tax would apply only to companies—public and private—with over $100 million in gross receipts for each of the three preceding calendar years and $10 million in payroll in each of those three calendar years. It’s called the Curtailing Executive Overcompensation Act—the CEO Act—and, had it been in effect in 2022, it’s estimated that it would have raised about $10.1 billion from the Fortune 100 U.S. companies. The tax would not exceed 1% of a company’s gross receipts and is designed to be levied in proportion to the amount of the executive’s compensation (including salary, bonuses, and stock awards and options) and the degree to which the pay ratio exceeds 50:1, according to the summary of the bill from Senator Sheldon Whitehouse and other sponsors. The summary explains that, since 1978, executive pay has climbed by over 1,209% and, in 2021, “CEOs earned 399 times the pay of the median worker in their industry, the highest disparity in the last half century. But it wasn’t always this way: in 1965, the average CEO made only 21 times the amount made by their typical worker.” The summary cites studies indicating that “large disparities are associated with higher levels of employee dissatisfaction and turnover, lower sales, and are disfavored by consumers.” According to the press release, the CEO Act represents an effort not only to curb executive pay, but also “to incentivize raising worker pay in all sectors.” Will Congress pass the CEO Act? Passing both chambers would certainly be quite an uphill climb, but time will tell.

LTI design

  • Prevalence of performance shares. The authors believe that the trend towards granting CEOs a higher proportion of performance-based LTI awards than options “will continue over the next few years as both a means for motivating and rewarding their performance and to ensure their compensation is heavily performance based.”
  • Performance periods. Uncertainty, as with Covid-19 or the current geopolitical crises, makes the establishment of three-year performance targets challenging, the authors suggest, leading some companies to adopt the use of more reliable one-year performance targets payable at the end of the three-year performance period, perhaps with a three-year relative TSR modifier designed to address potential criticism of the use of annual goals.
  • Relative TSR as a long-term performance metric. The majority of large companies already use relative TSR as a metric, the authors report, and more companies might decide to adopt it in light of the effect of economic uncertainty on the establishment of other reliable targets. The authors advise companies considering the adoption of relative TSR to keep in mind that it may be difficult to eliminate its use as a metric at a later point without a strong rationale. Some companies use relative TSR as a modifier to adjust payouts based on internal goals.
  • Mega Grants. The use of mega grants has experienced an “uptick,” the authors report, but these grants have sometimes faced sharp criticism. If comp committees are considering their use, the committee should anticipate shareholder reaction and consider how the company will justify the award.

Corporate governance

  • Activists leverage executive comp. The authors contend that activist investors sometimes use executive comp—especially where high pay is out of sync with performance—as a lever to pursue their broader agendas, such as strategic alternatives. In that context, the authors emphasize the need for “good corporate governance, solid relationships with institutional investors developed through outreach efforts, and careful decisions about CEO compensation.”
  • Organized labor. In its negotiations or organizing efforts, organized labor—which is having a moment right now—will often look to the pay disparity between management and workers. Comp committees, the authors suggest, may want to have a good understanding of “how the company is compensating and addressing front-line employees’ concerns,” and have a “communication plan ready that details and reconciles changes in executive compensation compared to the workforce over the past 3 to 5 years.”
  • Clawbacks. In light of the new SEC rules on compensation clawbacks (see this PubCo post), the authors suggest that comp committees should consider how the new mandatory clawback policy interacts with existing clawback policies or whether to adopt a new broader policy. The authors also point out that “the impact of a clawback policy on share-based compensation is complex,” with the implication presumably being that comp committees should be sure to reach out for accounting advice. In addition, to identify new best practices, comp committees may want to review other companies’ clawback policies that will now be required to be filed as exhibits to Forms 10-K and 20-F.
  • Insider trading policies. The SEC also recently revised the requirements for Rule 10b5-1 trading plans (see this PubCo post), which has led some companies, the authors observe, to reexamine their existing insider trading policies for provisions mandating or otherwise relating to the use by executive officers of 10b5-1 plans. For example, some companies may view the new requirements as too burdensome and want to discontinue the mandate. The authors suggest that comp committees “may want to better understand market trends on the required or voluntary use of such plans as well as whether the insider trading policy needs to be updated.” In addition, companies will need to put in place effective internal controls to assure compliance with the new quarterly reporting requirements for the establishment, modification or termination of these plans. Once again, comp committees may be able to identify new market practices from a review of other companies’ insider trading policies that, under the new rules, will now be required to be filed as exhibits to Forms 10-K and 20-F.

The authors conclude that current significant economic and geopolitical uncertainty has created a challenging environment, which is likely to demand greater attention from comp committees “in the coming months to ensure their companies’ executive compensation programs continue to attract, retain, and motivate talent while maintaining alignment with shareholder expectations.” They advocate “healthy dialogue about executive pay issues, at the compensation committee and board level and with shareholders as companies strive to maximize shareholder value and link executive pay to performance.”