Companies Prepare for Executive Pay, Performance Disclosure

Take heart, compliance officers: here comes one batch of rules that should be a piece of cake.

In the next few months the Securities and Exchange Commission is scheduled to propose rules stemming from the Dodd-Frank Act requirement that companies disclose “information that shows the relationship between executive compensation actually paid and the financial performance of the issuer,” known as “pay on performance.” Sound familiar? That's because the SEC already requires companies to disclose performance targets used in figuring executive compensation in the Compensation Discussion and Analysis (CD&A) section of the proxy statement.

While the new rules may include a few extra wrinkles when the SEC finally proposes them, compensation experts say that by adding a few pieces of already publicly available information to current compensation disclosure, companies should be able to meet the requirement without difficulty.

The most notable difference between the two is that Dodd-Frank calls for companies to compare themselves against their peers, where the CD&A does not, says Jared Berman, senior consultant at Meridian Compensation Partners. “Dodd-Frank requires companies to not only draw a link between pay and performance but to compare the link to some measure of market performance,” he says.

Currently, the SEC only requires companies to tell shareholders in the CD&A how well the company has performed over the past year on its incentive plan goals. Existing practice is to state the prior year's performance goals in determining this year's bonus payouts for executives. The challenge, Berman says, is how companies will present the new peer comparison to shareholders and get them to understand the significance of the relationship.  

He predicts that the most common metrics companies will use under the new guidelines on pay-on-performance disclosure will be information on a macro level, such as total shareholder return and earnings per share. “It is all public information already available. It is just a matter of putting it all together in a new way to enhance communication to shareholders,” he says.

Berman doesn't expect the SEC to require companies to disclose more specific performance measures beyond those already required in the CD&A. But the SEC could take the opportunity to provide companies with fewer exemptions on disclosing the performance targets they use to influence payouts. Currently, if companies can demonstrate that revealing their performance metrics could give away too much information to competitors, they don't have to disclose them. After reviewing proxy statements in the last three years, however, the SEC staff has pushed companies to refrain from taking blanket exemptions based on competitive harm.

Russ Miller, founder and partner at consulting firm ClearBridge Compensation, doubts the new compensation disclosure under Dodd-Frank will obligate companies to give secrets to competitors. “They will not have to disclose any market-sensitive information to shareholders,” he says. Companies are free to discuss these goals in addition to other performance metrics used if they wish, but not in place of the more important financial measurements, Miller says. 

The disclosure “is only meant to inform shareholder what measures are used by management to determine executives' compensation.”

—Roger Lane,

Partner,

Foley and Lardner

During the past proxy season, many companies incorporated some information on executive pay against performance in their CD&A disclosures, Miller says. He calls it “a move in the right direction.”

Yet Miller says companies need to pay close attention to their selection of performance metrics. He says many companies relied heavily on total shareholder return as their go-to metric. “Pay-on-performance disclosure specifically wants companies to show the relationship between executive compensation to financial performance,” he says. 

Companies should choose performance metrics that are aligned with their growth strategies to give shareholders meaningful information, says Miller. For example, they might show revenue growth, near-term profitability, or earnings growth.

Compensation Philosophy

A clear internal compensation philosophy, a good mix of financial and non-financial performance metrics, will go a long way in conveying the information clearly to the public, says Roger Lane, a partner at law firm Foley and Lardner. The fundamental issue in complying with the requirement is the agreement by the compensation committee on the compensation philosophy. “Once they are comfortable with the agreed philosophy, it's easy to disclose that to shareholder,” he says.

SEC APPROVAL

Below, the SEC explains the rationale behind the final rule on shareholder approval of exec comp and golden parachute plans:

After considering the comments, we are adopting Rule 14a-21(a) substantially as proposed with some modifications. Under the final rule, issuers will be required, not less frequently than once every three years, to provide a separate shareholder advisory vote in proxy statements to approve the compensation of their named executive officers, as defined in Item 402(a)(3) of Regulation S-K. Rule 14a-21(a) specifies that the separate shareholder vote on executive compensation is required only when proxies are solicited for an annual or other meeting of security holders for which our rules require the disclosure of executive compensation pursuant to Item 402 of Regulation S-K. We have modified the proposal to clarify in the rule that the shareholder vote on executive compensation required by Exchange Act Section 14A(a)(1) and Rule 14a-21(a) is required with respect to an annual meeting of shareholders at which proxies will be solicited for the election of directors, or a special meeting in lieu of such annual meeting. In addition, we have modified the rule to clarify that a say-on-pay vote is required at least once every three calendar years. Commentators expressed the view that as proposed, the rule would have required a say-on-pay vote within three years of the date of the most recent say-on-pay vote, which in some cases could have required a say-on-pay vote more frequently than once every three calendar years.

As adopted, Rule 14a-21(a) requires a separate shareholder vote to approve the compensation of executives for the first annual or other meeting of shareholders occurring on or after January 21, 2011, the first day after the end of the 6-month period beginning on the date of enactment of the Act. In accordance with Section 14A(a)(1), shareholders would vote to approve the compensation of the issuer's named executive officers, as such compensation is disclosed pursuant to Item 402 of Regulation S-K, including the CD&A, the compensation tables and other narrative executive compensation disclosures required by Item 402. We have included an instruction to Rule 14a-21 to specify that Rule 14a-21 does not change the scaled disclosure requirements for smaller reporting companies and that smaller reporting companies will not be required to provide a CD&A in order to comply with Rule 14a-21. We understand that smaller reporting companies may wish to include supplemental disclosure to facilitate shareholder understanding of their compensation arrangements in connection with say-on-pay votes. We do not believe, however, that this possibility supports exempting smaller reporting companies from the say-on-pay votes. As more fully discussed in Section II.E ... in order to ease compliance burdens for smaller reporting companies, we are adopting a two-year temporary exemption before these companies are required to conduct a shareholder advisory vote to approve executive compensation to permit these companies additional time to prepare for the new shareholder advisory votes.

As noted in the Proposing Release, consistent with Section 14A, the compensation of directors, as disclosed pursuant to Item 402(k) or Item 402(r) is not subject to the shareholder advisory vote. In addition, if an issuer includes disclosure pursuant to Item 402(s) of Regulation S-K about the issuer's compensation policies and practices as they relate to risk management and risk-taking incentives, these policies and practices will not be subject to the shareholder advisory vote required by Section 14A(a)(1) as they relate to the issuer's compensation for employees generally. We note, however, that to the extent that risk considerations are a material aspect of the issuer's compensation policies or decisions for named executive officers, the issuer is required to discuss them as part of its CD&A, and

therefore such disclosure would be considered by shareholders when voting on executive

compensation ...

Source: Securities and Exchange Commission.

The disclosure “is only meant to inform shareholders what measures are used by management to determine executives' compensation,” Lane says—not to dictate what performance philosophy companies must adopt. Lane says companies shouldn't tie performance to one specific metric and they should also use non-financial indicators too.

Lane hopes that the SEC gives companies some latitude when it finishes rules on pay-on-performance. “They should give compensation committees the discretion to use a mix of metrics, combining financial and holistic measures,” he says. Non-financial qualitative measures used by companies to determine executive compensation such as product development, market growth, and others should be incorporated in the disclosure as well.

Steven Hall, managing director at pay consulting firm Steven Hall & Partners, says that a simplified, communicable strategy is the best approach. Everyone involved in the company, from the compensation committee to investor relations executives, should work together to ensure shareholders understand fully the company's compensation structure and performance metrics, he says. “Start by educating your shareholder now through CD&A,” Hall says.

By understanding the relationship between performance metrics used and compensation, shareholders will have a better picture of how company determines executive pay. Hall says although the SEC has yet to implement the rule and it may not be in place for next spring's proxy statements, companies should be give compensation performance measures in CD&A next year anyway. He urges companies to consider including data on revenue and profit growth and shareholder return, along with non-financial goals, such as plans for the company's development.

“Nobody really knows what SEC wants to do at this point,” Hall says. Part of the problem, according to Hall, is the difficulty in interpreting the regulation and identifying the requirement of financial performance in legal terms. Measuring compensation against financial performance will eliminate qualitative consideration from the picture, he explains, and not everyone will like that. “I believe what we are going to see are some adjustments by the SEC to incorporate relevant business measures in the performance; both financial and qualitative,” he says.

Miller agrees that the key definitions involved in the regulation are up for debate: “How will companies define pay and performance? Are the rules going to be prescriptive?”

Still, if companies do find that linking executive pay to performance in the proxy statement is easy lifting, they may not rest for long. Another provision on executive pay disclosure is expected to be much more cumbersome. The Dodd-Frank Act also requires companies to disclose the ratio of total CEO pay to the median pay of all employees. Expect the battle over the particulars of that rule to be long and nasty.