Compensation and Benefits Bulletin
The 2015 proxy season is wrapping up, so anticipating next year is the last thing on the minds of most SEC registrants and their boards. But the 2016 proxy season is already shaping up to be more exciting than 2015, with the possibility of three new required disclosure items, two of which are discussed in this article.
SEC’s proposed rules
The SEC is responsible for implementing most of the executive compensation and governance provisions in the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). In the first four months of 2015, the SEC released two proposed rules: required disclosures covering hedging policy and practice, and pay for performance:
Hedging disclosure related to Section 955 of Dodd-Frank — SEC registrants’ annual proxy filings will have to disclose whether employees and board members are permitted to engage in the following types of transactions related to the company’s stock:
Purchases of financial instruments such as prepaid variable forward contracts, equity swaps, collars and exchange funds that mitigate market risk
Other transactions such as short sales that in substance establish downside price protection
If an SEC registrant doesn’t allow its employees or board members to engage in any hedging transactions or allows them to engage in all hedging transactions, the company can state that without more detail. However, if a company permits certain hedging transactions, it will be required to disclose sufficient detail about which hedging transactions are permitted and which are prohibited. In addition, a company must provide sufficient detail about the types of people allowed to engage in or not allowed to engage in such hedging transactions.
The proposed rules don’t prohibit hedging transactions by an SEC registrant’s employees or board members. But the expected public scrutiny, especially by shareholder advisory groups, will likely discourage companies from allowing such transactions.
Issue for the wary:
This disclosure will be required for virtually all SEC registrants (foreign private issuers and unlisted investment companies are excluded), including emerging growth companies and smaller reporting companies, which have been exempted or allowed to provide less-detailed disclosure under other implemented Dodd-Frank requirements. The rationale is that shareholders for smaller companies will find hedging practices relevant, just as larger, more-mature companies do.
Pay-for-performance disclosure related to Section 953 of Dodd-Frank — SEC registrants will have to complete a new table in the annual proxy filing to disclose the alignment of their named executive officers’ (NEOs’) actual pay with the performance of the company and the company’s defined peer group. Actual pay will be calculated the same as the compensation provided in the Summary Compensation Table but includes changes to the value of equity awards and pension values. Actual pay will need to be disclosed for the CEO and as an average for the other four NEOs (the four most highly compensated executive officers other than the CEO who served as executive officers at the end of the last completed fiscal year). Company and peer group performance will be measured using annual total shareholder return (TSR). The tabular disclosure must reflect the most recent five years and will include a phase-in whereby companies will need to report three years’ worth of data in their first disclosure followed by one year of data for each of the next two annual proxy filings.
In addition to the tabular disclosure, companies will need to describe — via a narrative, a graphic or a combination of the two — the alignment of their NEOs’ actual pay with the performance of the company and of their peer group.
Smaller reporting companies are subject to the proposed rules on a modified basis, but emerging growth companies are exempt.
Issue for the wary:
Many companies commonly expand their proxies with alternative discussions and illustrations that provide perspectives on pay for performance. Two types of illustration are typically used for perceived pay for performance:
- Realized or realizable pay — Illustrations of how actual pay over a period has or can be realized, taking into account actual pay received including fixed compensation plus incentive award payouts and stock value realized or potentially realized. This alternative disclosure has been used to illustrate that pay as reported in the Summary Compensation Table can be misleading, because it primarily includes the specific accounting value of equity-based grants versus how much has been or could be realized by the executive.
- Non-TSR pay-for-performance relationships — Pay-level relationships for how the company has performed relative to underlying financial or other operational metrics — sometimes relative to peers, sometimes absolute. Many organizations try to illustrate the relationship between pay and shareholder return. However, pay related to fundamental operating metrics can often be at least as relevant as a one- to five-year relationship to TSR, considering market volatility. For example, an organization in the oil and gas industry may be experiencing a severely depressed absolute or relative TSR, significantly related to a market downturn. However, the organization may be producing return on equity, cash flow growth or reserves that are positive on an absolute or relative basis.
Given that this new disclosure references TSR as the primary pay-for-performance anchor, it will be imperative for companies to balance their selected performance measures versus TSR, if different, in their disclosure.
The proposed rules were released for public comment, and the SEC will consider all comments received before issuing final rules, which could happen for the 2016 proxy season.
With the possible requirement of two disclosure items in next year’s proxy (maybe three, considering past discussions about internal pay ratios), it’s never too early to start preparing. Boards should consider how these new required disclosures will affect their company, including completing the calculations as currently proposed. Now may also be the time for companies to change their compensation programs and to plan shareholder outreach initiatives before these anticipated required disclosures increase negative scrutiny.
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