A Transitional Year for Executive Compensation Disclosures
In many ways, the 2016 proxy will be a transitional one for executive compensation disclosure, with issuers awaiting the implementation of the remaining significant Dodd-Frank mandates.
In the meantime, what will be interesting to watch in 2016 is public companies’ response to the plaintiff bar’s recent challenges to director compensation at Citrix, Goldman Sachs, Facebook and other companies. The vulnerability of companies on this score arises from the fact that, in approving their own pay, including but not limited to equity awards, nonemployee directors are conflicted and therefore not protected by the business judgment rule under Delaware and other state laws. Accordingly, unless the relevant director compensation has been approved or ratified by shareholders, in any litigation attacking director pay the directors will have to prove the “entire fairness” of the challenged compensation. This may be difficult if the director pay at issue is outsized relative to peer and market practice.
For an asserted defense of shareholder approval or ratification of director compensation to be successful, the courts have held that the caps on per person awards in a plan must be “meaningful,” which often is not the case in omnibus equity plans. As a consequence, many public companies are considering whether to ask shareholders to approve the inclusion of more restrictive limits on equity and/or cash compensation to directors in their compensation plans. To what extent issuers decide to submit amendments to shareholders solely for this purpose, or instead wait until they need to amend plans for other reasons, remains to be seen.
Pay for Performance Alignment
Demonstrable pay for performance alignment will be a hot-button issue for 2016, as it has become the holy grail of CD&As. Notwithstanding the looming SEC pay for performance disclosures, shareholders are ahead of regulators in expecting companies to demonstrate how they align pay with performance.
One challenge is that compensation values in a given year are typically based on prior year performance, future performance, financial performance and share price performance, all over one, three and five years or longer. This inherent timing disconnect has spawned new approaches to valuing compensation (e.g., realizable compensation) and to illustrating pay for performance alignment ahead of required disclosures.
Based on proposed SEC rules, it is well understood that required disclosures alone will be insufficient, with supplementary disclosures likely needed. One way to supplement the pay for performance picture now is to clearly disclose a rigorous “front-end process” for selecting incentive plan performance measures and setting goals. Companies that do this well should clearly disclose the process, and, if possible, provide investors answers to the following questions:
When companies use a rigorous “front-end process” to select appropriate performance measures and set appropriate goals, pay and performance will be aligned over the long-term. And by disclosing this “front-end process,” future pay for performance disclosures will be viewed in context and help secure Say on Pay votes.
Corporate Use of Capital
Corporate use of capital is likely to be a “hot-button” issue for the 2016 proxy season. It is notable in this regard that stock buybacks have attracted attention from stakeholders, including the public at large.
Media attention on this subject has been significant, and the statistics are interesting. For example, FactSet reported on September 21, 2015, that “on a trailing twelve-month basis (TTM), dollar-value share repurchases totaled $555.5 billion;” and that “the aggregate BuyBack to [free cash flow] FCF ratio for the S&P 500 exceeded 100% for the first time since October 2009.”
C-suite executives, in modeling their capital structure and how it can be optimized in their own corporate circumstances, must balance the benefits of capital investment with other uses of capital, including dividends and stock buybacks. As a matter of strategy and risk management, boards have an oversight role to make sure the policies remain appropriate—in particular, that they contribute as intended to strategy and are in step with the corporate risk appetite. This balance is a key issue for institutional investors and one might therefore expect it to be a front-of-mind issue for them, and a prime candidate for focus in 2016. In the event this issue does arise, you’ll be in a great position having ensured your C-suite is coordinated and has engaged in proactive dialogue with major shareholders, including with the portfolio managers and the governance teams. Such dialogue is especially helpful if it is educational and informed—the key is to tell the story and be transparent.
Shareholder Activism: The Need to Know Your Shareholders
There were record numbers of proxy contests in 2015, a surge in new bylaws enabling qualifying shareholders to nominate directors and more shareholder-to-shareholder communications campaigns than we’ve seen in years. While some observers suggest shareholder activism may decline in 2016 due to changing market conditions, the fact is the high performance expectations of directors and boards are here to stay.
By mid-year 2015, 10% of Say on Pay proposals and nearly 1,200 company directors failed to surpass the 70% support benchmark considered important to many companies and some proxy advisors, and that is likely to result in more pressure on votes in 2016. New rules on disclosing CEO pay ratios will add scrutiny to pay plans as they kick in beginning in 2017. Moreover, a recent SEC legal bulletin narrows the exclusions companies can use to limit shareholder proposals and, as a consequence, proposal activity is expected to remain robust in 2016. Shareholder interest in corporate governance shows no sign of abating even if the specific matters and issues change. There’s simply more at stake now for shareholders, management and directors.
Given this, many managers and directors are looking to better understand the views of all of their shareholders, to better know them and to engage with them more regularly throughout the year. This includes retail shareholders, who as a group owned more than 30% of the shares of U.S. companies in 2015. It goes without saying that the participation of individual investors as buyers and sellers makes a difference to share ownership levels at many companies. And although their participation in proxy voting has generally waned in recent years, it logically follows that retail shareholders can also make a difference in voting outcomes. More data and technology are being made available for these purposes including, for example, aggregated analyses of shareholder ownership and voting patterns, virtual shareholder meetings and the use of popular digital mail sites for regulatory and other communications.
Active and ongoing engagement between directors and shareholders is becoming the norm. Even if the number of actual battles for control moderates a bit in some areas in 2016, shareholder interest in corporate governance continues to expand. With these developments, it is essential for companies to know all of their shareholders for effective governance.
Succession Planning: Resolve to Make a Difference in 2016
With the 2016 proxy season under way, if “succession fitness” isn’t at the top of your board’s to-do list, it should be. And as with any fitness regimen, be prepared to persevere so it doesn’t follow the usual fate of New Year’s resolutions.
“Succession fitness” is best viewed in broader terms, as part of a rigorous, evergreen succession planning process. Given the intense scrutiny of boards and their increased level of accountability, boards can have significant impact in this area in 2016 as they manage risk and seek to provide long-term value.
But succession fitness doesn’t happen overnight. It requires ongoing commitment and discipline to build succession muscle—i.e., ongoing leadership development linked to strategic business priorities—to reap the benefits for years to come.
The most daunting aspect of implementing and maintaining a results-driven succession fitness process is getting started. Step one is an annual team exercise for the board, beginning with a few fundamental questions:
Beyond identifying immediate CEO successors, we advise board clients to “go deep.” Organizations at “peak performance” use succession planning to look three generations out when identifying promising leadership talent and set development goals to build skills that support strategic imperatives for the business.
This ongoing work requires a shared understanding by directors that the ultimate responsibility for effective succession fitness rests squarely with the board. Don’t wait to act. While your board is in 2016 resolution mode, commit to implementing a succession fitness process with the framework, support and actionable steps that will result in visible, measurable progress—in the coming year and beyond.