A New Season for Executive Compensation Disclosure
January 17, 2024
Executive compensation issues may not have been the predominant focus for boards of directors in 2023 given the enhanced attention to antitrust, diversity and climate reporting matters, among others. However, there have been several notable developments in executive compensation that boards should be mindful of in 2024. We discuss these developments below.
Pay Versus Performance Considerations for the 2024 Proxy Season
Now that the 2023 proxy season has come to an end, most companies have already complied with the Securities and Exchange Commission’s (the SEC) new rules requiring disclosure of various “pay versus performance” metrics in their annual proxy statements (the PVP Rules). We look back at the first PVP Rule disclosures to highlight trends and developments, all with an eye toward preparation for the upcoming 2024 proxy season.
- Start the Process Early – By now, most companies are aware of how time-consuming it can be to determine methodologies and track and value equity-based awards and pension benefits for purposes of determining “compensation actually paid” (CAP) in order to comply with the prescriptive requirements of the PVP Rules. It is important to understand that compiling the information necessary to comply with the PVP Rules will likely require coordination amongst a multi-disciplinary team (including HR, legal and finance). It is best to start this process as early as possible so as to be able to gather the relevant information, work with internal constituents and external advisors as appropriate and address any issues that may arise along the way.
- Less is More (For Now at Least) – As predicted, the vast majority of PVP Rule disclosures have been exercises in disclosing the bare minimum necessary to comply, with many companies opting for simple graphs and charts in lieu of lengthy narrative discussions. According to an FW Cook Report of S&P 500 companies, the overwhelming majority of companies (91%) used graphs or charts to describe the relationship between the CAP of the primary executive officer (PEO) and other named executive officers (NEOs) and the company’s total shareholder return (TSR), net income and “company selected measure” (CSM), while the remaining 9% used a narrative only description. This trend, however, could change as institutional investors and proxy advisory firms now have had one round of disclosure analysis under their belts and may seek to more systematically integrate these disclosures into their voting analyses and models, which could impact the bare minimum approach companies have taken to date. This is not to suggest that companies should proactively seek to expand on their disclosures, but rather make sure to monitor developments should a shift in practice begin to emerge due to the pressures of these constituents.
- Simplicity – Similarly, companies overwhelmingly have opted to use a published line-of-business or industry index as their TSR comparator group, as opposed to a customized peer group used by the company for compensation-related decisions. This was largely due to the simplicity in being able to rely on a published index, which minimizes the need to recalculate disclosures (as would be the case with a custom peer group that changed over time). According to the FW Cook Report, 76% of companies used their 10-K published line-of-business or industry index as their TSR comparator group.
- Choose Wisely – Many companies spent time debating the proper CSM. Choosing the CSM is a very company-specific task and should focus on the measure that is most important to linking the company’s pay to its performance. Typically, this would be the most prominent measure the compensation committee uses when designing its performance-based compensation. For example, if 90% of incentive pay for a company’s executives is tied to EBITDA while 10% is tied to relative TSR, it would likely make more sense to use EBITDA instead of TSR as the CSM. In our experience, the most commonly selected measures were EBITDA, EPS and revenue-based measures. There was initially some uncertainty around the question of whether relative TSR could be used as a CSM, though the SEC has since clarified that relative TSR is a permissible metric for the disclosure – setting the stage for a potential uptick in its usage in this upcoming proxy season.
- Let the SEC be Your Guide – The SEC’s comment letters on companies’ initial pay versus performance disclosures provide insight into the SEC’s primary areas of focus. The SEC’s comment letters related to calculation inconsistencies, incomplete or missing disclosures (e.g., missing the breakdown of equity adjustments to calculate CAP or failure to identify each NEO included in the calculation of average non-PEO compensation) or presentation problems, such as incorrect table headers or descriptions. Companies should be careful to ensure any disclosures in their 2024 proxy statements are clear and in technical compliance with the PVP Rules. The SEC also released new Compliance and Disclosure Interpretations (C&DIs) regarding the PVP Rules. While fairly technical, the C&DIs deal with topics such as valuation methodologies, treatment of unvested awards modified in connection with a restructuring, the change in fair value of awards granted before an IPO and the meaning of “vesting” for purposes of calculating CAP for awards that either have retirement conditions, conditions requiring compensation committee certifications, market conditions or awards that fail to meet vesting conditions. When preparing their 2024 proxy statements, companies should review the new C&DIs to ensure their disclosures are consistent with the SEC’s guidance.
- Advisory Firm Guidelines –We recommend monitoring institutional shareholder and proxy advisory firm policies for their guidelines regarding how they evaluate pay versus performance. In its 2024 guidelines, Glass Lewis revised its discussion of its pay-for-performance analysis to note that the disclosure required by the PVP Rules may be used as part of its supplemental quantitative assessments supporting its primary pay-for-performance grade.
Clawbacks: From Adoption to Practice
By now, companies should have implemented clawback polices that are compliant with SEC and national stock exchange rules requiring the mandatory clawback of incentive-based compensation in the event of an accounting restatement (the Clawback Rules). But adoption of a compliant policy is not the end of the road. With delisting potentially at stake for failure to comply with the Clawback Rules, below are some steps companies should take to ensure compliance with the Clawback Rules going forward and to address uncertainties in the SEC and listing exchanges’ interpretations of the rules.
Filings and Disclosure
- Companies are generally required to file their clawback policy as an exhibit to their next annual report on Form 10-K, 20-F or 40-F, as applicable.
- Companies should review their compensation disclosure for upcoming proxy statements with the Clawback Rules in mind. This is particularly important given the inherent tension between demonstrating an alignment between executive compensation and financial performance, which will remain a focus of shareholders and proxy advisory firms, and linking elements of compensation that the compensation committee did not intend to be “incentive compensation” within the meaning of the Clawback Rules (i.e., base salary increases), but that might be deemed performance-based if the disclosure suggests it is contingent or related to attainment of financial performance metrics.
Governance and Controls
- In order to be fully prepared in the event of an accounting restatement, companies should consider adopting internal governance structures to advise on specific actions the company would need to take for accounting restatement-related matters, either regularly or in connection with a particular triggering event. This could include delegating tasks to specific committees, executives or third party advisors.
- In addition to adopting new governance structures, compliance with the Clawback Rules will require more fulsome internal controls and procedures, including documentation and decision-making processes for determinations regarding compensation (e.g., preparing materials for compensation committee meetings, including significant detail regarding the role of financial/non-financial metrics considered by the committee when making compensation decisions). Companies should clearly delineate which items of compensation may be subject to the Clawback Rules and evaluate whether certain elements of their compensation programs may be inadvertently covered by the Clawback Rules due to being awarded partially in recognition of prior achievement of financial reporting measures, even if the compensation itself is not subject to further achievement of financial goals. Having a clear record of methodology at the outset may help to quantify the appropriate amount to recover and preserve maximum flexibility in the event a clawback is triggered.
Review of Compensation Programs and Plan Design
- Companies should review their current compensation arrangements and evaluate whether and how current contracts will need to be modified to address the Clawback Rules and to assess the feasibility of recovery in the event a clawback is triggered. This review should include ensuring awards and contracts with executive officers include clawback language that could be unilaterally used by the company to permit recovery as required under the Clawback Rules, or that at least reference any clawback policies adopted by the company. In addition, for future annual equity or bonus awards, companies should consider whether to require executives to execute, as a condition to receipt of the award, an acknowledgement that such awards, as well as any previously awarded compensation that falls within the scope of the Clawback Rules, will be subject to the Clawback Rules (carefully specifying whether and to what extent such compensation will also be within the scope of any supplemental clawback policy company has in effect) and allowing for broad recovery and offset rights in favor of the company. In conducting these reviews, companies should be mindful that significant questions remain as to how to reconcile potential tensions between the Clawback Rules and other applicable laws, including state and local laws that broadly protect “wages” against forfeiture or clawback and limitations in the tax rules for recovery of taxes paid on amounts that are ultimately clawed back. While the Clawback Rules contain limited impracticablity exemptions which include violations of the company’s home country law, the SEC has indicated that inconsistency between its rules and any existing compensation contracts would not be an excuse for failure to recover and noted that companies have had ample notice of the statutory mandate for the SEC’s adoption of the Clawback Rules. A careful review is especially important after a recent case involving the enforcement of a clawback policy emphasized that in addition to having a policy in place, companies would need to follow general principles regarding the enforceability of contracts in order in to claw back compensation, such that ensuring executives sign an acknowledgement as described above is advisable.
- Compensation committees may wish to consider the impact of the Clawback Rules on compensation plan design. We expect many compensation committees to work with their compensation consultants and advisors in structuring or modifying compensation programs with an eye toward enforcement of the Clawback Rules and potential mitigation of the effect of new clawback policies on executives’ compensation. Potential considerations for modification may include:
- Using operational, strategic, or ESG measures as opposed to financial performance measures and/or moving away from a reliance on stock price or TSR as a financial performance measure given the difficulty in determining the impact of a restatement on incentive compensation earned based on the achievement of such metrics.
- Moving from awards with multiple year performance periods to incentive compensation that contains a “banking” element (e.g., awards where performance is measured at one-year performance periods subject to continued employment through the end of the aggregate number of performance periods) to limit the scope of the award that may be covered by the company’s clawback policy if a lookback period encompasses only a portion of the performance period.
- Implementing “plateau” performance metrics where a range of outcomes, as opposed to one point of achievement, may result in the same payout. For example, an annual performance bonus program where attainment of revenues in the range from $X to $Y result in 100% target payout. This sort of structure could minimize the impact of “little r” restatements on incentive-based compensation payouts given the general expectation that “little r” restatements are not likely to create drastic changes in relevant performance payout calculations.
- Requiring deferral of earned incentive compensation through the date it is no longer covered by the lookback period mandated by the Clawback Rules, longer stock ownership periods following settlement of equity awards, or similar steps to extend the period of time before earned incentive compensation becomes payable to covered executives in order to facilitate recovery.
Notably, however, the desire and ability of compensation committees to make any such changes to plan design may be limited by countervailing interests of shareholders and proxy advisory firms.
- The Clawback Rules generally prohibit a company from indemnifying or otherwise economically protecting executive officers from the Clawback Rules. Affected companies may wish to review their executive employment agreements and plans, as well as indemnification policies, to ensure compliance with this aspect of the rules.
Advisory Firm Guidelines
- We recommend monitoring institutional shareholder and proxy advisory firm policies for their guidelines regarding clawbacks. In revising its 2024 guidelines, Glass Lewis explained that in addition to meeting the requirements of the Clawback Rules, clawback policies should also provide companies with the power to clawback incentive compensation from an executive “when there is evidence of problematic decisions or actions, such as material misconduct, a material reputational failure, material risk management failure, or a material operational failure,” regardless of whether the executive is terminated for cause.
New Disclosure Requirement for Option/SAR Awards
On December 14, 2022, the SEC adopted new disclosure requirements under Regulation S-K requiring disclosure of a company’s policies and practices on the timing of option and stock appreciation right (SAR) awards as well as certain tabular disclosure of awards of options and SARs to NEOs that occur close in time to the company’s disclosure of material nonpublic information (MNPI). Companies are required to comply with new Item 402(x) of Regulation S-K (Item 402(x)) in the annual report that covers the first full fiscal year beginning on or after April 1, 2023, which for calendar year-end companies will cover option and SAR grants made to NEOs in fiscal 2024.
- Narrative Disclosure – Item 402(x) will require companies to discuss their policies and practices as to the timing of awards of options and SARs, as well as any other option-like awards, in relation to the disclosure of MNPI. The disclosure must include (1) how the company’s board of directors determines when to grant such awards; (2) whether the company takes MNPI into account when determining the timing of an award, and if so, how; and (3) whether the company has timed the disclosure of MNPI to affect the value of executive compensation. Companies are required to include this narrative disclosure regarding their policies and practices regardless of whether the company has actually made grants of option-like awards close in time to the release of MNPI. This disclosure is not required for full-value awards like restricted stock or restricted stock units.
- Tabular Disclosure – If the company has awarded options or SARs to a NEO within the period starting four business days before filing a periodic or current report (other than an 8-K disclosing a new option award pursuant to Item 5.02(e) of Form 8-K) that discloses MNPI and ending one business day after such filing, the following disclosure is required in a tabular format: (1) the name of the NEO; (2) the grant date of the award; (3) the number of securities underlying the award; (4) the per-share exercise price; (5) the grant date fair value of the award; and (6) the percentage change in the closing market price of the underlying securities between the trading day ending immediately prior to the disclosure of MNPI and the trading day beginning immediately following the disclosure of MNPI.
- Adopt or Update a Formal Grant Policy – Companies should plan to adopt a formal grant policy if one is not already in place or update their existing policy to mitigate the likelihood of triggering the tabular disclosure set forth in the new rule. Companies may choose to implement a grant policy that sets a fixed schedule for the granting of routine option and SAR awards to occur in an open trading window shortly after the release of MNPI but retain flexibility to deviate from this schedule as needed for off-cycle grants (i.e., for new hires or in connection with acquisitions).
- Update Equity Grant Disclosure in CD&A – Companies should review their existing disclosure related to their equity award grant practices in the Compensation Discussion & Analysis section of their proxy and consider any necessary updates to comply with the new requirements as it relates to option and SAR award grant practices and to reflect any changes to their current grant policies implemented as a result of the new rule.
This article has been republished by the Harvard Law School Forum on Corporate Governance.
 The PVP Rules apply to U.S. public companies subject to SEC reporting (other than foreign private issuers, most registered investment companies and emerging growth companies) and generally require disclosure in proxy or information statements in which disclosure under Item 402 of Regulation S-K is required with respect to any fiscal year ending on or after December 16, 2022. For further detail on the PVP Rules, see our September 2022 alert memo, available here.
 FW Cook, supra note 2.
 See Hertz Corp. v. Frissora, 2:19-cv-08927, 2023 U.S. Dist. LEXIS 109846 (D.N.J. June 26, 2023). We note that the case is an unpublished federal district court opinion and would not be binding on companies. However, while the case does not create a binding precedent, it is possible that other courts will follow this approach and it gives a view as to how a judge may rule when it comes to the enforceability of a clawback policy.
 Glass Lewis, supra note 3.