Five years after going into effect, Dodd-Frank and Say on Pay have led the way into a new age of shareholder engagement. In particular, investors, proxy advisors and other stakeholders are paying more attention to how companies perform financially and how that performance relates to executives’ compensation.
Since Dodd-Frank passed, the SEC has adopted 61 mandatory rulemaking provisions for companies to follow, considering the implementation of these rules integral to the protection of investors and perpetuation of market stability.
In 2015 alone, several key provisions to Dodd-Frank were either passed or proposed, each of which could have significant implications on the future of shareholder engagement around compensation. At the dawn of the 2016 proxy season, C-Suite looks at trends in past disclosures on each of these hot topics to see who was disclosing this information already in anticipation of what we can expect to see in the coming year.
One of the most talked-about provisions, and the only one on this short list that has passed, may actually have the least impact on the 2016 proxy season. In August 2015, the SEC formally announced the adoption of a pay ratio disclosure rule requiring public companies to relate the compensation of their CEOs to that of a median employee. The rule, which will be mandatory as of January 1, 2017, attempts to further implement the provisions of Dodd-Frank and increase transparency amongst company stakeholders and the public at large.
At least one company in the S&P 500 voluntarily disclosed its CEO-to-median employee pay ratio in 2015, though there is little evidence of any other companies doing so explicitly. In fact, for the past several years, Noble Energy, Inc. provided its own calculation, although the process for identifying the median employee was not disclosed. In 2013, Noble Energy estimated that the ratio was approximately 85:1 when its CEO compensation was $9,720,334 and its median employee compensation was $114,376. The following fiscal year, Noble’s CEO earned 82 times the compensation of its median employee. In both cases, the company’s ratio was significantly lower than the median S&P 500 CEO to median U.S. employee ratio, which Equilar calculated to be 247.4:1 in 2014. (Graph 1)
“It is not anticipated at this time that the final CEO pay ratio rule will by itself impact the form or amount of executive compensation,” noted Alex Bahn, a partner at Hogan Lovells, whose firm contributed independent commentary for Equilar’s annual Governance Outlook research report. “Issuers are hard at work analyzing their employee base to estimate the potential pay ratio figures to be prepared to defend the disclosures to shareholders when required.“
“The new CEO pay ratio is unlikely to materially change Say on Pay voting patterns, but it may influence some investors who consider internal pay equity to be an important factor, or in cases where the ratio is dramatically different than a company’s peers,” added John Beckman, also a partner at Hogan Lovells.
The SEC proposed a rule in April of 2015 that, if passed, would require public companies to disclose executive pay and the company’s performance for themselves and their peers. The regulation would stipulate that company performance be measured by total shareholder return (TSR) and require each company to display the last five fiscal years of TSR relative to its peer companies.
While currently not required, companies already share similar information voluntarily, evidenced by the upward trend in the disclosure of the words “pay for performance” in proxies from 2011 to 2015, which increased from 74% to 83% of S&P 500 companies. (Graph 2, Source: Equilar)
“Many issuers already address the relationship between executive compensation and TSR, partially in response to proxy firms’ views on linking pay for performance in its voting recommendations,” said Bahn. “However, the SEC’s proposed pay versus performance rule would demand greater disclosure of this relationship, which may cause compensation committees to select more TSR-based performance measures for executive incentives compensation in future years.”
As with pay for performance, many companies have anticipated forthcoming rules by the SEC related to clawback policies. In July 2015, the SEC officially proposed rule 10D-1, requiring companies to adopt guidelines for the recovery of certain pay incentives that an executive would have otherwise not received as a result of a financial restatement. Because executive pay has been increasingly linked to performance, a restatement could alter whether or not an actual performance target was achieved and thus incentive awards paid out. In a press release, SEC Chair Mary Jo White stated “the proposed rules would result in increased accountability and greater focus on the quality of financial reporting, which will benefit investors and the markets.”
From 2011 to 2015, the percentage of S&P 500 company proxies disclosing a clawback policy increased significantly, from 50.4% to 77.1%. Moreover, the prevalence of clawback policies explicitly triggered by a financial restatement was shy of but close to doubling from 29.3% to 51.1% over the last five years. (Graph 3, Source: Equilar) There has been a general expectation that this rule will be approved, and companies have responded by gradually adopting policies that conform to such a proposal.
In addition to a company performance disclosure, the SEC’s proposed rule would also require public companies to disclose a table displaying their NEOs’ “actual pay” as compared to the Summary Compensation Table (SCT). Though methodologies for calculating realized pay differ, the SEC’s formal definition of actual pay is total compensation for the covered fiscal year as provided in the SCT with two modifications.
First, the aggregate change in the actuarial present value of the accumulated benefit under all defined benefit pension plans, plus the service cost under all such pension plans will be deducted from SCT total compensation. And second, equity awards, including options, stock, units and performance shares, will be valued at the vesting-date fair value instead of grant-date fair value. As such, actual pay would exclude certain long-term compensation, such as equity and incentive awards that have not yet vested. Once the new rules are finalized, companies will need to provide a clear explanation of both the actual pay of the CEO and the average actual pay to the other NEOs. Although only 14% of companies in the S&P 500 mentioned ”realized pay” in their proxy statements in 2015, that marks an increase from just 2% in 2011. (Graph 4, Source: Equilar)
Each of these compensation-related items hearkens back to the initiation of Say on Pay and the influence this shareholder vote has on company pay practices, and moreover, communications about those pay practices.
“Say on Pay has changed the way public companies engage with their shareholders on executive compensation, prior to which engagement on executive compensation occurred but was less prevalent and tended to be more issue specific,” said Beckman.
Given the extensive disclosures now required by the SEC, shareholders have more access to information and a better understanding of their portfolio companies’ overall operations than ever before. Likewise, investors are more actively expressing their opinions and suggesting changes they feel appropriate. As a result, issuers have established active shareholder engagement and outreach programs to ensure they proactively distribute relevant information and establish open lines of communication with their investors. With more regulations pending from the SEC in 2016, transparency on compensation matters will continue to be front and center.