As the calendar turns towards the fall and winter months, companies and their boards are yet again refreshing their focus on executive compensation. Both regulatory updates and broader changes in the economy are forcing companies to review their executive compensation levels, incentive programs and governance policies.
Public companies should address five key compensation items as they prepare for 2020 and the upcoming proxy season.
1. Implement updated hedging disclosure requirements
In December 2018, the SEC approved final regulations
for the disclosure of company’s hedging policies in their annual proxy statements. The final regulations, which originated from a Dodd-Frank Act mandate in 2010, require organizations to “describe any practices or policies regarding the ability of employees, directors or their designees to purchase financial instruments, or otherwise engage in transactions, that hedge or offset, or are designed to hedge or offset, any decrease in the market value of company equity securities.” Importantly, companies do not necessarily have to adopt a hedging policy, but rather must (1) describe their policy if one exists or has been adopted, or (2) disclose that no policy exists and that hedging transactions are “generally permitted.” Updated disclosure rules go into effect for proxy statements or shareholder meetings beginning in 2020, meaning that companies should review the disclosure in their proxy if they already have hedging policies, or consider whether it is appropriate to adopt a policy if one does not already exist.
2. Prepare compensation plans for an economic slowdown
As of June 2019, the United States has experienced its longest-ever period of economic expansion (120 months). There are, however, a number of economic concerns that have led 62% of C-level executives to predict a recession in the next 18 months
. Executives point to movements in interest rates, trade regulations/tariffs and slowed global growth as the most likely contributors of a potential recession.
With these potential concerns in mind, compensation committees should holistically evaluate their executive compensation plans to ensure they are “recession ready” in case of an economic downturn. The sections below highlight a few key areas that should be a part of any review:
- Conduct a total compensation benchmarking for NEOs and other top executives. Although many organizations conduct annual compensation benchmarking for their senior most talent, it may be even more important to do so in the face of an economic downturn. Given that executive pay levels stagnate (or even decrease) during recessionary periods and drastically increase in early stages of post-recession expansion, compensation committees should conduct annual reviews of executive pay to ensure they are aware of any movements in the competitive market. While we typically recommend that companies take a custom approach by comparing their compensation against organizations of similar financial size and business focus, Grant Thornton’s annual proxy survey of the Russell 2000 can be an initial point to compare data against.
- Review equity holdings for top executives. It can also be helpful for compensation committees to review the equity holdings of executives during periods of volatile share-price movement or financial turbulence. Particularly for organizations that place a heavy emphasis on stock options or performance-based equity (PSUs), a financial downturn can quickly reduce (or eliminate) the value of executive’s unvested equity, which may cause unexpected retention risks. Grant Thornton recommends that organizations proactively manage this issue by testing various share-price scenarios and performance-based equity outcomes to evaluate whether the organization is at risk for losing key talent in the event external market conditions, beyond management’s control, drive share prices lower.
- Evaluate incentive and equity-based compensation vehicles. As mentioned in the previous section, companies with a heavy emphasis on stock options and PSUs can be at a high risk of having “broken performance cycles” during recessionary periods. Stock options have no value if the company’s share-price drops below the initial strike/exercise price, and PSUs may have 0% payout when performance is below predefined threshold levels. In the event of a recession, where external factors have a larger impact on a company’s stock price than a company’s and management’s actual performance, companies may consider adopting one or more of the following incentive programs:
3. Review proxy advisor guidelines and policy changes
- Time-based equity (such as restricted stock or RSUs), which will (1) provide retentive value if a company’s share-price decreases, (2) result in less overall dilution, and (3) will provide incentive to create value/minimize value erosion
- Relative PSUs, which compare an organization’s financial/operational performance against a peer group or index of similar companies
- PSUs with non-traditional performance periods, such as one year or five-plus years. The measurement of performance on a shorter-term basis may be appropriate if it is difficult to establish long-term goals during uncertain periods. Conversely, performance periods of five or more years may actually reduce the need for goal setting by allowing companies to set absolute goals that can be achieved over a longer performance period
- Cash-based performance plans which can provide comparable incentive to traditional equity-based plans while reducing the dilutive impact of using real shares
- Dilution caps that limit total equity usage in a given year to preserve shareholder value and lengthen the available pool of equity reserved for future use.
Prominent proxy advisors Institutional Shareholder Services (ISS) and Glass Lewis release updated proxy voting policies in October or November of each year, effectively kicking off the beginning to each proxy season. Companies should study new/updated policy changes, as well as any negative commentary from their company-specific reports, to ensure that they are aware of any issues that may lead to negative vote recommendations. Sample policy changes from recent years include the consideration of board gender diversity and ISS’s introduction of an “economic value added” metric in the assessment of financial performance.
4. Review the design, layout, and content of a proxy statement
The beginning of each proxy season presents a new opportunity for companies to take a fresh look at the design, layout and content of their company proxy statement. Along with the 10-K, the proxy is one of the two most important public documents that companies have to communicate their strategic vision with investors and the outside world. Unfortunately, many organizations maintain the design of their proxy by simply updating their compensation and financial information from the prior year. Companies should go beyond a “same as last year” approach, and critically review both the quality of their disclosure and the readability of their compensation programs and policies. The bullets below highlight a number of areas in which organizations may make simple improvements to improve their proxy statement:
5. Consider amending or strengthening clawback policies
- Substitute long blocks of text with graphics/tables (where appropriate)
- Use an executive summary to highlight key financial, operational, or compensation accomplishments from the prior year
- Provide robust description and rationale for whenever board discretion is used to modify incentive payouts
- Include a discussion of how the company’s executive compensation program aligns participants with the long-term performance of the company and the company’s shareholders
- Review proxy with outside consultants to provide a new or secondary perspective.
On July 1, 2015, the SEC proposed Dodd-Frank mandated clawback regulations that would “claw back” certain incentive compensation that was awarded/paid as the result of a financial misstatement. While many companies used the proposed regulations to formulate their own clawback policies, the SEC has yet to formally implement any regulations (note that reduced clawback regulations from the Sarbanes-Oxley Act of 2002 exist for certain types of compensation for public company CEOs and CFOs).
In recent years, however, organizations have considered extending their clawback policies to cover non-financial related misconduct. Societal events such as the #MeToo movement, data breaches of confidential information, and damages to organizational reputation have forced companies to review their existing (or non-existent) clawback policies to evaluate whether there are other scenarios in which compensation should be recouped. While there has been healthy discussion at the board level concerning the scope of clawbacks, there has been little widespread change to actual policy. Organizations should review current or proposed clawback policies with internal and external counsel, understand any tax and accounting ramifications of a proposed clawback policy and be prepared to act if/when the SEC releases final regulations.
There are a number of regulatory, governance, and economic factors that will impact executive compensation in 2020. Hedging and clawback-related polices, which historically represented a secondary consideration for compensation committees, are receiving newfound attention in the wake of regulatory and societal developments. Proxy advisor policies and proxy statement design, which have long played a prominent role in executive compensation, must still be reviewed as a matter of best practice. And lastly, the potential for an economic slowdown or recession can have a major impact on how organizations design and message their incentive compensation. Companies and their boards should continue to conduct robust reviews of their programs in tandem with outside advisors to ensure they are aware of trends as they develop.
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