’Tis the season, and no, we do not mean the holiday season. Although it may seem like you just filed your 2018 proxy, the 2019 proxy season is upon us. This quick reference guide, which is intended to supplement Shearman & Sterling’s 16th Annual Corporate Governance & Compensation Survey, identifies some of the things we think you should be thinking about as you turn to your 2019 proxy and annual meeting. In developing this list, we looked at themes from the 2018 proxy season and trends we see developing for 2019, and we offer recommendations and resources for the upcoming proxy season. We also discuss potential future changes in disclosure rules that public companies will want to keep on the radar as proxy preparations begin.
Looking Ahead to 2019
- Pay Ratio. The 2018 proxy season was the first year for pay ratio disclosures and the consensus was that companies spent much more time preparing for it than investors and advocacy groups spent discussing the ratios once they were public. We do not expect that responses to the second year disclosures will be much different, but companies should consider whether to modify the information presented in the 2019 proxy statement based on 2018 experience. The pay ratio disclosure requirements give companies some flexibility in the calculation of the median employee and the inclusion (or exclusion) of employees outside of the United States. Companies are also permitted to include an alternative pay ratio calculated using a different methodology, and based on a different median employee. We describe many of these considerations in our article, “CEO Pay Ratio: Perspectives on the First Year and a Look Forward.” For many companies, leaving things alone may be the best path, but for others, after looking at industry data, additional or alternative disclosures may be considered helpful in telling the whole story.
- Shareholder Proposals. The 2018 proxy season was the first to see the implementation of the new SEC Staff guidance (Staff Legal Bulletin 14I) describing a new approach to considering requests to exclude shareholder proposals on the basis of the “economic relevance” or “ordinary business” exceptions. The new approach places the perspective of the board of directors at the center of the analysis. In our article, “Shareholder Proposals 2018 – Was 14I Really a Game Changer,” we provide detailed observations on how the new approach unfolded in 2018. The key takeaway for 2019 is to plan ahead. For companies that have annual meetings in the spring and are seeking to exclude shareholder proposals, engagement must happen quickly. Most companies faced with this calendar will need meaningful board consideration of the issue underlying the shareholder proposal within the first few weeks of 2019. With respect to shareholder proposals, you should also be mindful of the SEC staff’s 2017 guidance and 2018 guidance when relying on Rule 14a-8(i)(5) or 14a-8(i)(7) to exclude a shareholder proposal from your proxy materials under the “ordinary business” and “economic relevance” exclusions. Our client publication on the 2017 guidance is available here.
- Pay for Performance. Consider whether you are effectively telling your “compensation story.” Investors have become more sophisticated in evaluating whether companies are paying their executives for performance. To effectively support your compensation program, make sure you outline your company’s strategic business goals and how your performance metrics and targets drive performance against these goals. Note that although relative total shareholder return (TSR) is still a dominant performance metric used by investors to assess whether your pay program is properly aligned with performance, increasingly investors are looking at performance against additional financial and operational metrics.
- ESG. An ever-increasing focus of investors in 2019 will be on environmental, social and governance (“ESG”) issues, and this interest is no longer limited to public pension funds. The largest institutional investors have made ESG issues an important part if their engagement with the companies in which they invest. Institutional investors see companies that ignore the key ESG issues most relevant to them as being exposed to significant economic, legal and reputational risk, both in the short- and long-term. Larry Fink, BlackRock’s Chairman and CEO, stated, in his Annual Letter to CEOs for 2018, that in order to achieve financial performance, and to sustain it, a company must “understand the societal impact of [its] business as well as the ways that broad, structural trends – from slow wage growth to rising automation to climate change – affect [its] potential for growth.” This year, ISS launched the Environmental & Social QualityScore scorecard to provide a new metric for institutional investors to use to factor ESG considerations into their investment and voting decisions and engagement efforts. The interest in ESG issues is not limited to shareholders. A company’s other stakeholders – from the cities and towns companies do business in, to the people (both current and future) that a company employs, to the consumers of their products and services – are also actively focused on ESG issues. So what should boards and companies be doing? Consider (i) identifying the core ESG issues that are relevant to the company, looking at its business and industry, but also looking at the broader community and societal impacts and concerns, (ii) formulating a strategy on how to address ESG issues and (iii) communicating this information to investors and the market through a combination of direct engagement, proxy statement disclosures and corporate social responsibility reporting. Critical to this process is engaging senior executives of the company with oversight from the board.
- Board Diversity. Board diversity has been a focus of the NYC Comptroller’s Board Accountability Project 2.0 and the current voting policies of the largest institutional investors and guidelines from proxy advisory firms. Whether through a skill matrix or otherwise, boards must be prepared to demonstrate to shareholders progress toward greater diversity. Further, beginning in 2019, Glass Lewis has announced that it will recommend a vote “against” the chair of the nominating committee of large companies with no female directors, and Blackrock has indicated that it would also vote “against” if there are not at least two female directors. Our article “Board Diversity and the Skills Matrix” provides companies with strategies to address the heightened focus on board diversity.
- Engagement. Historically passive institutional investors have become more active, focusing on such hot-button issues as performance and pay misalignment, board diversity and non-objective performance criteria. Open letters to public companies and voting guidelines issued by investors such as Vanguard and Blackrock are must-reads for understanding the increasing focus of institutional investors on diversity, talent development and succession, risk management, environmental issues and culture in defining the critical elements of long-term value creation. Companies should also consider how the proxy statement itself can be better used as a tool to tell the company’s governance and compensation story. We outline what companies are doing in this regard and provide some suggestions in our article, “Shareholder Engagement:Using Proxy Statements and Corporate Websites”.
- Cybersecurity and Data Privacy. Institutional investors (and the government at all levels) have become increasingly interested in understanding the board’s role in cybersecurity and data privacy risk management. Over the last year, we have seen a number of major cyber and data breaches at some of the largest public companies. We have also seen the SEC getting more focused and aggressive in its oversight on these issues. If cybersecurity and data privacy are areas of risk focus for your company (and we do not know many for which they are not), we recommend describing in your proxy statement which committee of the board owns that risk management responsibility and how that risk is managed. Our articles “Cybersecurity – Board Oversight” and “Can a Cyber Breach be a Violation of Internal Controls? The SEC Says, ‘Maybe’” provide a useful checklist for board oversight of this challenging issue.
Recommendations for 2019
- ISS and Glass Lewis recently released their 2019 benchmark proxy voting policies, which will apply to shareholder meetings on or after February 1, 2019 for ISS and January 1, 2019 for Glass Lewis. In addition, ISS released its final 2018 FAQs in mid-December describing changes to its Director Pay Evaluation and its Equity Plan Scorecard. The following is a summary of ISS and Glass Lewis’s compensation-related updates for the United States:
- Director Elections - Board Gender Diversity. ISS announced that it will provide adverse voting recommendations on nominating committee chairs and, on a case-by-case basis, other directors responsible for the board nomination process, at companies whose boards have no female directors. This policy will take effect for meetings occurring on or after February 1, 2020. Beginning January 1, 2019, Glass Lewis will similarly recommend voting against the chair of a nominating committee and possibly the entire nominating committee of a board with no female members. ISS and Glass Lewis will consider exceptional circumstances for the absence of board gender diversity.
- Non-Employee Director Pay. In its 2018 FAQs, ISS stated that it would delay implementation of negative voting recommendations for board and committee members responsible for implementing non-employee director compensation with two or more consecutive years of “excessive” non-employee director pay without a compelling rationale or mitigating factors. This policy will now take effect for meetings held after February 1, 2020. ISS also described factors that would mitigate concern around high non-employee director compensation pay and methodology around identifying non-employee director pay outliers.
- U.S. Employee Plan Scorecard (EPSC). ISS announced that although passing scores for all EPSC models will remain the same as in effect for 2018, change in control (CIC) vesting factors will be updated to provide points based on the quality of disclosure of CIC vesting provisions. Additionally, ISS stated that a new negative factor will be triggered when a company’s equity compensation program is estimated to dilute shareholder holdings by more than 20% for the S&P 500 model or 25% for the Russell 3000 model.
- Compensation Committee Performance. When assessing the performance of a board’s compensation committee, Glass Lewis will now consider the inclusion of new excise tax gross-up provisions as another factor that may contribute to a negative voting recommendation, as well as the impact of materially decreased CD&A disclosure, where the reduction substantially impacts shareholders’ ability to make an informed assessment of the company’s executive pay practices.
- Pay-For-Performance Model. ISS now includes, as part of its qualitative analysis, CEO pay of peer companies using multiple financial metrics rather than just TSR. ISS also announced that Economic Value Added data would be phased-in over the 2019 annual meeting season rather than included in the Financial Performance Assessment screen. For 2019, ISS will continue using GAAP measures in the Financial Performance Assessment screen.
- Contractual Payments and Arrangements. Glass Lewis has clarified that when evaluating contractual payments and arrangements, such as severance and sign-on arrangements, it will consider general U.S. market factors and the size and design of entitlements as possible contributing factors to a negative voting recommendation on say-on-pay. ISS has also indicated that a “good reason” trigger in a change in control severance arrangement should be limited to circumstances that are reasonably viewed as an adverse constructive termination.
- Other Executive Compensation Clarifications. Glass Lewis has also included a discussion on its rationale for assessing grants of front-loaded awards, clarified its policy regarding clawback policies and on how peer groups and benchmarking contribute toward say-on-pay voting recommendations, and added discussion on the consideration of discretion in incentive plans, among others.
- In light of recently adopted final SEC rules regarding smaller reporting companies, your company may now qualify as a smaller reporting company subject to scaled disclosure requirements. It is worth confirming your status.
- Check and then double-check your company’s perquisites disclosure in light of recent SEC actions on this topic. The mere fact that a benefit is provided for a business reason is not sufficient to conclude that the benefit is not a perquisite.
- Familiarize yourself with the recently enacted amendments to the disclosure rules that are intended to simplify disclosure and reduce the compliance burden for companies, such as eliminating certain financial disclosure requirements to the extent they are duplicative. These amendments were enacted in furtherance of the objective of the Fixing America’s Surface Transportation Act due to their obvious importance with respect to providing “long-term funding certainty for surface transportation infrastructure planning and investment.”
- If your company is adopting a stock incentive plan or amending an existing plan, consider whether your plan’s limits on director compensation are sufficient in light of recent litigation. Consider also ensuring that shareholder approval adequately takes into account cash compensation paid to directors.
- Consider whether there should be changes to your compensation committee charter in light of the repeal of the performance-based compensation exception to 162(m). Remember, if covered employees hold grandfathered awards, you will still need a committee of outside directors to certify the performance goals. More information on US tax reform and the impact on executive pay can be found here.
- Review the independence of your board’s compensation committee advisors under NYSE and Nasdaq listing standards and ISS’s affiliated outside director test, as well as Section 162(m) of the Internal Revenue Code (to the extent covered employees hold grandfathered awards) and Section 16 of the Securities Exchange Act.
- Non-GAAP measures continue to be a focus of SEC comments, and the proxy statement is not being overlooked by the SEC Staff. Remember that, to the extent non-GAAP financial measures are cited in the CD&A, other than with respect to performance target levels, the regulations regarding use of non-GAAP financial measures must be met.
- Check your company’s director & officer questionnaire to make sure it is up to date.
- Consider whether you will include alternative pay disclosures, such as realized or realizable pay, in your CD&A. Keep in mind that if included, shareholders may ask questions to the extent such disclosures are omitted or modified in future years. That being said, do not be afraid to remove duplicative or stale disclosures throughout your proxy more generally, such as your 162(m) disclosure in light of the repeal of the performance-based compensation exception.
- In preparing your proxy, it is always a good time of year to check your annual compliance matters like executive HSR thresholds.
Still to Come
- Of the remaining compensation-related rules required by the Dodd-Frank Act, on December 18, 2018, the SEC announced that it approved final rules for disclosure of hedging policies. Our publication on these rules will be out shortly. Hedging disclosure will be required in proxy statements for the election of directors during fiscal years beginning on or after July 1, 2019, and, for smaller reporting companies and emerging growth companies, on or after July 1, 2020. Final rules with respect to clawbacks, pay-for-performance and incentive-based compensation requirements remain on the SEC’s long-term agenda.
- On November 15, 2018, the SEC staff held a roundtable on proxy process. The roundtable focused on three areas: (i) proxy voting mechanics, (ii) shareholder proposals and (iii) proxy advisors. It remains to be seen what concrete actions may result from the roundtable.