This recent Wachtell Lipton memo is a good reference point if you need to quickly summarize the main executive compensation issues that companies & boards need to watch in the coming proxy season. Here are two key items:
Proxy Advisors. Last November, ISS added to its list of problematic pay practices that may result in a negative say-on-pay recommendation “severance payments made when the termination is not clearly disclosed as involuntary.” ISS has historically criticized payment of severance when ISS concludes (whether or not correctly) that the nature of a termination is not a severance qualifying event; the recent guidance raises the profile and significance of 8-K disclosure for NEO separations.
Last December, Glass Lewis revised the threshold for the minimum percentage of a long-term incentive grant that should be performance-based from 33% to 50%, and indicated that it will raise concerns with executive pay programs where less than half of an executive’s long-term incentive grant is subject to performance-based vesting conditions.
Other than the aforementioned items, neither ISS nor Glass Lewis issued any significant compensation-related policy updates for the 2023 proxy season, though both firms announced voting policy updates in a number of other key areas including board diversity. For a detailed discussion of these updates, see our December 6, 2022 memorandum, “ISS and Glass Lewis Issue Final 2023 U.S. Voting Policies.”
Equity Award Considerations in a Reduced Stock Price Environment. Many issuers experienced significant stock price declines in 2022, especially in the tech sector. These declines should be taken into account by compensation committees as they consider 2023 annual equity grants. A reduction in market value will result in awards covering a larger number of shares and may put pressure on individual and aggregate share limits under a company’s shareholder approved equity plan. If plan limits are insufficient to make ordinary course annual equity grants, companies may consider granting cash-settled awards outside of a shareholder-approved plan in the form of phantom equity or stock appreciation rights; however, cash-settled awards will result in variable, or “mark-to-market,” accounting. Companies seeking approval for new equity plans or new share reserves at their annual meetings may also need to re- calibrate the size of their requests to reflect the reduced value of shares.
Many companies experienced a bumpy ride on their “say-on-pay” votes last year. What should companies expect this year? This CAPIntel article says that this year may present some challenges as well:
In 2023, Say on Pay results are likely to be shaped by the unique sociopolitical and economic environment companies face today, the impacts of which have not been felt equally across industries. Amid the threat of recession and a tight labor market, many companies felt obligated to take special actions during 2022 for retention purposes, as stock price declines due in part to the Fed’s anti-inflationary measures negatively impacted executives’ equity holdings. Shareholders and proxy advisors may not view such actions as favorably as in previous years if paired with dramatic drops in stock price, especially towards year-end, given the potential for misalignments in pay-for-performance.
Similarly, some companies may trigger pay-for-performance concerns in cases where above-target bonus payouts based on strong financial metric performance for most of 2022 are coupled with year-end share price decreases. Companies in hard-hit industries, such as technology and financial services, may also draw increased scrutiny from the proxy advisors over their efforts to reign in COVID-era overexpansion with sweeping layoffs. However, as in previous years, we expect pay-for-performance misalignment to continue to be the main driver for ‘Against’ recommendations from proxy advisors in the broader market.
The annual deadlines for filing information returns with the IRS & providing employees with information relating to 2022 ISO exercises and ESPP stock purchases are fast approaching. This Gunderson memo has details on what companies are required to file & the relevant deadlines. This excerpt explains the filing requirements:
Employers must file information returns with the Internal Revenue Service and provide employees with information statements related to incentive stock option exercises that occurred during calendar year 2022. Similarly, employers (typically relevant only for public companies) must file information returns with the IRS and provide employees with information statements related to initial transfers of stock acquired during 2022 under an employee stock purchase plan that complies with Internal Revenue Code Section 423.
The information returns to be filed with the IRS are Form 3921 (for incentive stock option exercises) and Form 3922 (for transfers of shares acquired under an employee stock purchase plan). Employers may satisfy the requirement to provide employees with an information statement by delivering to each employee “Copy B” of the applicable Form 3921 or 3922, or they may use substitute forms for the employee information statements, provided that the substitute forms meet published IRS guidance as to form and content.
Copy B of the relevant information statement must be delivered to employees by January 31, 2023. Paper filers have until February 28, 2023 to file the appropriate form with the IRS, while electronic filers have until March 31, 2023.
The implications of the FTC’s proposed ban on the use of non-competes could have a very significant effect on executive compensation programs. This Morgan Lewis memo considers how the ban might affect equity compensation, tax considerations and other comp-related matters. This excerpt discusses the potential impact of a non-compete ban on golden parachute payments under Section 280G of the Code:
Under Section 280G of the Internal Revenue Code (Code), a corporation will be denied an income tax deduction on any “excess parachute payments” made to certain executives in connection with a change of control, and the executives receiving such excess parachute payments will be subject to a nondeductible 20% excise tax penalty, in addition to regular federal and state income tax. One of the primary exemptions that companies use to exempt compensatory payments from treatment as a parachute payment is by establishing by clear and convincing evidence that such payment is reasonable compensation for services to be provided after the change in control (which includes refraining from providing services due to an enforceable noncompete covenant).
To the extent that covenants based on noncompete clauses are unenforceable under the proposal, a significant tool used to reduce parachute tax penalties will cease to be available, potentially increasing the cost of impacted transactions. This is particularly an issue for public companies that are unable to use private company shareholder votes to cleanse 280G issues with respect to compensation that would otherwise be a parachute payment.
To further complicate matters, the memo highlights the fact that the current proposal doesn’t exempt completed transactions that have relied on noncompete covenants in 280G calculations. So, if the proposal is adopted in its current form, companies that recently closed deals might need to rerun 280G calculations to remove reliance on noncompete covenants to reduce the value of parachute payments and reevaluate their 280G tax position.
Fortunately, I wasn’t one of the thousands of travelers who were stranded by Southwest’s scheduling meltdown over the holidays, but if I was, questions about the structure of the company’s executive compensation programs wouldn’t have been high on my list of things to worry about. I guess that’s why I’m not a Senator, because those questions featured prominently in a letter that Sen. Alex Padilla (D-Cal.) sent to the airline earlier this month. Here are the specific inquiries Sen. Padilla made around executive comp issues:
Is executive compensation in any way tied to flight cancellation rates and consumer satisfaction? What is the estimated impact of this holiday season on top Southwest executives’ compensation? Is the company considering any clawbacks of executive bonuses or other compensation based on the failures that occurred during the 2022 holiday travel season?
In hindsight, my failure to consider the possible executive compensation side of the equation just confirms that I’m pretty clueless. The Southwest situation is just another reminder that any highly publicized corporate crisis is going to result in the media and politicians emphasizing the executive comp side of the equation. There’s just too much raw meat there to expect them to resist.
Tune in at 2pm Eastern today for the webcast – “The Latest: Your Upcoming Proxy Disclosures” – to hear Mark Borges of Compensia and CompensationStandards.com, Alan Dye of Hogan Lovells and Section16.net, Dave Lynn of Morrison Foerster and TheCorporateCounsel.net, and Ron Mueller of Gibson Dunn discuss all the latest issues to consider as you prepare your upcoming proxy disclosures – including how to present newly required pay vs. performance data. Understand what to expect for the upcoming proxy season, so that you can prepare your directors and C-suite – and handle the challenges that 2023 will throw your way.
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This recent article from Directors & Boards highlights anticipated compensation committee priorities for 2023. This excerpt says that one of those priorities is ensuring that incentive comp programs are designed to be recession-proof:
With the prospect of a downturn coming in 2023, compensation committees will have to ensure incentive plan goals are challenging while also ensuring those goals are achievable in a potential downturn. Approaches committees can consider include widening performance ranges around the plan, incorporating relative performance measurement into the plan and adding greater discretion, particularly for short-term incentive plans.
In order to mitigate shareholder concerns, it is better to build any adjustments into the plan design rather than make after-the-fact adjustments for the benefit of management. For example, it is better to widen the performance range at the beginning of the year than to make an adjustment at the end of the year to allow for management incentives when the management team failed to achieve the short-term incentive plan threshold level of performance.
The article also flags ensuring that executives have appropriate equity incentives, addressing new regulatory requirements and dealing with a challenging shareholder environment as other committee priorities for the coming year.
We’ve posted the transcript for our recent webcast – “SEC Clawback Rules: What to Do Now.” Our panelists covered a variety of topics associated with the looming clawback listing standards. Here’s an excerpt from Ariane Andrade’s review of the disclosure requirements that will come into play once an issuer has adopted a compliant clawback policy:
The disclosure requirements affect the annual report on Form 10-K and proxy and information statements where the issuer has to report the information that’s required by Item 402 of Regulation S-K. The new rule requires that the exchange listing standards include a requirement that listed issuers have to disclose their policies. We would expect that a failure to comply would prompt the commencement of delisting proceedings by the applicable exchange.
First, on the annual report in 10-K, the policy itself will have to be filed as an exhibit to the 10-K, and then there will be two new boxes to check on the cover page of Forms 10-K, 20-F and 40-F to indicate if the financial statements that are covered by the filing reflect the correction of an error to previously issued financials, and whether those corrections were restatements that required recovery. The SEC justifies this by saying that the check boxes will provide greater transparency, in particular around “little r” restatements, and they’ll allow investors to more easily identify which restatements triggered a compensation recovery analysis.
The new rule also amends Item 402 of Regulation S-K and Forms 40-F and 20-F to require listed issuers to disclose how they have applied their recovery policies. First, there’s a new instruction to the Summary Compensation Table that requires that any amounts that are recovered pursuant to a clawback policy have to reduce the amount that’s reported in that applicable column in the table, as well as the total column for the fiscal year in which the amount recovered initially was reported. Any of those adjustments have to be identified in a footnote to the table, as well.
Then, there’s new Item 402(w) that kicks in if at any time during or after the last completed fiscal year, the issuer had to prepare an accounting restatement that required recovery of erroneously awarded compensation pursuant to the clawback policy, or if there was an outstanding balance as of the end of the last completed fiscal year of erroneously awarded compensation to be recovered as a result of a prior restatement, then that requires certain disclosure of information pursuant to Item 402.
A recent Willis Towers Watson study highlights the prevalence of ESG metrics in executive comp plans. The firm reviewed public disclosures from more than 800 companies, including S&P 500, FTSE 100, TSX 60 and major European indices. This excerpt summarizes its findings:
In Europe and North America, ESG metrics are used by more than three-quarters of companies when determining executive incentive compensation, ranging from 69% in the U.S. to about 90% in Europe and the U.K. While most companies incorporate ESG metrics into their short-term incentive (STI) plans, measurement of ESG in long-term incentive (LTI) plans has increased sharply over time, especially in Europe (46% of companies) and the U.K. (37% of companies). In the U.S. and Canada, the adoption of ESG metrics in LTI plans remains low (8% and 7%, respectively).
The study found that social metrics feature most prominently in comp plans. Human capital metrics, including talent management, succession planning, DEI, and employee health and safety are the most common. Human capital metrics were used by 68% of European and North American companies.
The survey also reviews how companies incorporate ESG metrics into their comp plans, and observes that they’re used as a separate, weighted metric nearly half of the time. It also provides information on how usage of ESG metrics varies among industries.
An interesting Forbes article recently took a look at what happens at companies when CEOs take a pay cut. As this excerpt notes, the results were striking:
After a large CEO pay cut, financial performance tends to rebound. Among US firms, the median profitability increases from -8% to 10% in the 3 years following a large cut, according to a study by researchers from Nanyang Technological University, University of Washington, and University of British Columbia.
The profitability improvements in CEO pay-cutting firms are larger than in comparable firms that did not cut the boss’ salary, according to the authors’ analyses. In other words, improvements after a CEO pay cut are not just because the industry is recovering, according to the authors. Firms seem to operate more effectively after a CEO pay cut.
Cutting pay can produce almost as much improvement as replacing the CEO, according to the authors of the study. This tends to be especially likely when the board pairs the pay cut with strong incentives for reversing declining firm performance.
The Forbes article points out that other studies have found that a CEO taking it on the chin when it comes to pay also results in shareholders being more likely to approve future CEO pay packages and increase employees’ willingness to bear an increased workload to help improve company performance.