As we reminded readers in December, the 2021 American Rescue Plan Act amended the definition of “covered employees” under Section 162(m) of the Internal Revenue Code — currently limited to a company’s named executive officers — to add a public company’s five highest compensated employees (even if they are not executive officers) for tax years beginning January 1, 2027 and thereafter. Earlier this month, the IRS and the Treasury Department issued proposed regulations to implement the change. This Gibson Dunn alert describes the proposal as follows:
The proposed regulations clarify a few points in determining who qualifies as one of the next five highest compensated employees who make up these additional “covered employees.” Specifically, companies will need to consider all of their common law employees and officers, as well as employees and officers of any member of the company’s affiliated group. Employees for this purpose also include employees of related management entities or professional employer organizations who perform substantially all of their services during the taxable year for the publicly held corporation or members of its affiliated group . . . These additional highly compensated employees may change from year to year and will not remain “covered employees” in perpetuity.
In ranking employees to determine who is the most highly compensated, companies must look at compensation that would be deductible in that tax year but for the application of Section 162(m). As a result, compensation that may be granted in 2025 or 2026 but that is includible in income and deductible by the company in 2027 will be counted forpurposes of determining who is an additional “covered employee” for the 2027 tax year. This may have an immediate impact on companies’ annual compensation planning and how they account for tax for financial statement purposes.
The five highest compensated employees for a given taxable year may include individuals who were already among the company’s covered employees by virtue of previously being a named executive officer for a prior taxable year.
FW Cook argues that the proposed rules’ coverage of employees of other organizations who perform substantially all of their services for the public company during the taxable year is overbroad and potentially pulls in situations that the rule is presumably not intended to capture. For example, the memo suggests that the rule could capture outside counsel or outside consultants working on a large litigation or project or even, for the entertainment industry, an actor in a year a movie is being filmed. The comment period runs until March 17, 2025, and FW Cook urges potentially impacted companies to submit comments.
In 2023, the SEC Staff was asked about the application of the first Form 10-K clawbacks checkbox when a company is required to restate interim results. The Staff informally commented that if financial statements included in the 10-K are not required to disclose the correction of an error because the error only existed in interim periods, it would not object to an issuer’s decision not to check the box on the Form 10-K. This Weil proxy season alert has this important reminder that the SEC’s guidance noted that Item 402(w) disclosures may still be required in this situation:
Item 402(w) of Regulation S-K requires proxy disclosure concerning a company’s action to recover erroneously awarded incentive-based compensation in proxy and information statements in which Item 402 compensation disclosure is required . . .
Companies should take note that the SEC Staff confirmed through informal guidance that while the 10-K checkbox does not need to be checked as a result of material corrections to interim financial statements where annual periods are not affected by the errors, companies must still provide the disclosures required by Item 402(w). This suggests the possibility that a correction of interim financials could be an accounting restatement that could require a clawback if, for example, incentive-based compensation is based on interim period financial results.
This brought to mind the “1st half/2nd half” annual incentive plans adopted in response to COVID-19 uncertainty. Some companies may have continued that approach.
Meridian recently published surveys of both CEO and CFO compensation reported by S&P 500 companies for the period 2020 through 2023 (based on proxy statements filed in 2021 through 2024). Here are trends for CEOs:
– Median total compensation in 2023 was $15M – The median compound growth rate of CEO total compensation dropped from 5.4% prior to 2021 to 2.8% since 2021 with the pandemic decreasing pay outcomes. CEO pay grew only modestly above inflation levels over this period.
– Pay growth was volatile, more “saw-toothed” – Compensation fell for many in 2020 due to profound economic downturn, rose in 2021, fell again in 2022 and then increased in 2023.
– Overwhelming majority of CEO pay is delivered in long-term incentives (LTI) – Salaries grew more slowly at ~3% annually while grant values of LTI grew 7%-8% annually; since LTI is reported at its grant date value, realized values can be higher or lower than reported.
– Newer CEOs (much like other roles) earn less than experienced CEOs – Total compensation for CEOs hired in 2021-22 vs. those hired in 2020 dropped, suggesting higher compensation was required to attract a new CEO at the height of the pandemic than in later years.
And here are a few trends for CFO compensation:
– Median total compensation in 2023 was $4.9M – The median compound annual growth rate of CFO total compensation since 2020 was 5.9%, but only 3.2% since 2021 with the impact of the pandemic.
– Pay increased throughout this period albeit somewhat unevenly post-pandemic – Salaries grew at ~3.6% annually while grant values of LTI have grown 6.3% annually.
– Newer CFOs (similar to other roles) earn less than experienced CFOs – Total compensation for CFOs hired in 2021-2023 vs. those hired in 2020 dropped, suggesting higher compensation was required to attract a new CFO at the height of the pandemic than in later years.
With the new disclosure requirements under Item 402(x) coming online for calendar-year companies in the 2025 proxy season, companies are bracing for more scrutiny of equity grant practices. Even if everything is on the up & up, the new disclosures could invite questions and second-guessing that most of us would prefer to avoid.
This DLA Piper memo offers several housekeeping tips to help ensure that awards are granted and structured in a way that avoids MNPI and accounting issues, or other challenges. Here’s an excerpt:
Implement a formal equity grant policy. Adopt a written equity grant policy that outlines the terms and procedures that must be followed when making an equity grant, including authority and delegations, timing, and communication of awards. This should be considered comprehensively with other policies and procedures, such as the insider trading policy and nonemployee director compensation policy, to ensure such policies work together properly and can be disclosed in a clear and consistent manner.
Delegate authority responsibly. To optimize the impact of awards and ease administration, the compensation committee may wish to delegate certain authority to subcommittees, management, or third parties to administer or implement equity grants. Because the purpose of compensation committees, however, is to provide independent oversight of management and compensation programs, any such delegation should be formally approved by the committee and subject to appropriate oversight, limits, and reporting. Confirm that any such delegation is permitted by the compensation committee’s charter, the plan itself, and any applicable laws or regulations.
Mitigate insider trading risks with timing of grant or settlement of awards. Consider utilizing pre-established grant dates that coincide with regular board or committee meetings, or occur shortly after the release of quarterly or annual financial results, to avoid concerns that the company misused material nonpublic information (MNPI) that is not reflected in the grant date fair value of the award. A “spring-loaded” award that enjoys an immediate lift in value when earnings are announced may frustrate investors, create accounting complexity, and prompt legal challenges, while an award that immediately decreases in value after earnings may lose its intended incentivization effect.
Additionally, consider whether the future vesting and settlement of the award could create insider trading considerations. It is common for tax withholding obligations to be funded by “sell to cover” transactions into the open markets, which generally should not occur when there is MNPI. However, companies can develop strategies in advance to address such situations, such as the use of Rule 10b5-1 trading plans, automatic withholding of shares upon vesting with a value equal to the amount of withholding taxes, timing vesting schedules to align with “open” windows, or deferring settlement of vested awards subject to limitations under Section 409A.
As Meredith shared last week, there are some nuances in the disclosure rule that companies should consider even if they don’t grant options or SARs. That was one of the topics that we covered in our recent webcast on upcoming proxy disclosures – which is available on-demand for members of CompensationStandards.com.
About 5 years ago, we started to see compensation committees take on a greater oversight role for “human capital” matters. The expansion followed the #MeToo movement and investors pushing for more disclosure about workforce demographics, corporate culture, and other issues affecting employees. A recent memo from the EY Center for Board Matters says that 51% of S&P 500 companies now expressly disclose in their proxy statements that the compensation committee is responsible for human capital – up from 25% in 2021 – and that compensation committees have continued to rename themselves over the past few years to better reflect their role. Here’s more detail:
While some committee references to human capital management oversight are at a high level, others specify oversight of key strategies and programs, including those related to DEI; talent recruitment, development and retention; workplace safety and culture; health and wellness; and pay equity. Notably, references to culture more than doubled (from 11% in 2021 to 24% in 2024). These changes are significant and reflect the board’s focus on the broader talent agenda and how it connects to the company’s overall transformation and resilience goals.
The memo suggests updating the committee charter to reflect new responsibilities – for the sake of clarity and to get “credit” with investors. But don’t add something to the charter unless the committee is actually doing it. The best way to ensure that discussions actually happen is to add them as an agenda item on the annual governance calendar.
This Aon article says that economic instability and heightened shareholder scrutiny of the use of positive discretion are putting pressure on companies when setting metrics for their LTI plans with three-year performance periods. Greater uncertainty makes it challenging to set “realistic, achievable and suitably challenging” goals.
For this reason, Aon is seeing more and more companies reconsider three-year performance periods in their LTI programs, with some of those companies opting to use a three-year averaging method for performance shares. This “hybrid” approach incorporates averages derived from three distinct one-year performance periods. The article says there are a number of potential benefits to this approach:
– Flexibility: Shorter performance periods enable boards to adjust to shifting market conditions and macroeconomic uncertainties, making goals more precise and achievable.
– Enhanced performance tracking: With realistic and timely internal and external financial data, incentive targets can be set appropriately. The averaging approach requires sustained achievement of long-term performance objectives.
The article says this approach achieves these goals while still demonstrating “to investors that the board has a long-term vision.” For example, the proxy advisors “generally favor cumulative long-term performance metrics,” but “averaging three one-year performance periods helps address their concerns about adopting shorter-term performance periods.” If you’re in this boat, consider your CD&A disclosure carefully since the article notes, “thoroughly communicating the reasoning behind the board’s long-term vision is crucial.”
As you turn to the human capital management disclosures in your 2024 Form 10-K, this Gibson Dunn article may help you with benchmarking disclosures and considering tweaks you may want to make to your drafting this year. “Tweaks” does seem to be the right word here since one of the takeaways noted from the firm’s survey of S&P 100 disclosures over the last four years is that “companies are generally making only minor changes to their disclosures year over year, and these minor changes generally included shortening of company disclosures, maintaining or decreasing the number of topics covered, and including slightly less quantitative information in some areas.” Here are some specific trends highlighted in the alert:
– Length of disclosure. Fifty-seven percent of surveyed companies decreased the length of their disclosures, 34% increased the length of their disclosures, and the length of the remaining 9% remained the same.
– Number of topics covered. Forty-one percent of surveyed companies decreased the number of topics covered, 13% increased the number of topics covered, and the remaining 46% covered the same number of topics.
– Breadth of topics covered. Across all companies, the prevalence of 10 topics increased, nine topics decreased, and nine topics remained the same. The most significant year-over-year increases in frequency involved Culture Initiatives (30% to 35%) and Pay Equity (48% to 50%) disclosures. The most significant year-over-year decrease involved COVID-19 disclosures, which declined in frequency from 34% to 1%. Other year-over-year decreases related to disclosures addressing Diversity Targets and Goals (21% to 14%), Diversity in Promotion (29% to 26%), Quantitative Diversity Statistics regarding Gender (63% to 60%), and Community Investment (28% to 25%).
– Most common topics covered. This year, the topics most commonly discussed generally remained consistent with the previous two years. For example, Talent Development, Diversity and Inclusion, Talent Attraction and Retention, Employee Compensation and Benefits, and Monitoring Culture remained the five most frequently discussed topics. The topics least discussed this most recent year, however, changed slightly from that of the previous year as COVID-19 disclosures, and Diversity Targets and Goals dropped into the five least frequently covered topics.
– Industry trends. Within the technology and finance industries, the trends that we saw in the previous year regarding the frequency of topics disclosed generally remained the same.
Calendar year-end companies will soon be filing their first disclosures addressing new Item 402(x)(1), which requires a description of policies and practices related to the timing of option & SAR grants and the release of MNPI. Companies must address how the board decides when to grant (do they follow a predetermined schedule?), whether the board or compensation committee considers MNPI when deciding timing and terms of the options (and if so, how) and whether the company has timed the disclosure of MNPI to affect the value of executive compensation.
We know that the narrative policies and practices disclosure is required regardless of whether a company has actually made grants of option awards close in time to the release of MNPI, but one interpretive question we’ve heard pop up is what companies need to say — if anything — if they just don’t grant options or SARs at all. Gibson Dunn’s Ron Mueller addressed this in last week’s webcast, “The Latest: Your Upcoming Proxy Disclosures.” Here are a few takeaways from his talking points:
– Item 402(x) is not limited to NEOs. This requires disclosure about any option grant policy generally.
– Item 402(x) has no time limit. A lot of companies stopped granting options in the last few years — moving to performance-based awards — but they still have options outstanding. It’s unclear from Item 402(x) whether those companies need to address their policies and procedures under Item 402(x)(1).
– Item 402(x) does not address RSUs or PSUs. But some companies have written policies that apply not just to options, but also to grants of RSUs or PSUs. Many of these companies — including those that don’t grant options — have elected to discuss these equity grant policies and practices — going beyond what is required but providing helpful information. Per this Gibson Dunn alert, “although these rules apply only to options and similar awards, we expect many companies to include, or expand on existing, narrative disclosures regarding their policies and practices related to the timing of full value awards as well (i.e., restricted stock units, restricted stock, and performance stock units).”
Late last month, I recorded a conversation with Shaun Bisman of Compensation Advisory Partners on ISS and Glass Lewis compensation-related policy updates for the 2025 proxy season. Tune in to this 16-minute episode of The Pay & Proxy Podcast to hear Shaun address:
Executive compensation-related updates to Glass Lewis’s 2025 Voting Policy Guidelines
ISS’s FAQ updates regarding the presentation of realizable pay, evaluation of program metrics and changes to in-process pay programs
ISS’s new FAQ on performance-vesting equity disclosure
Potential changes to ISS’s Benchmark Voting Policies for 2026 relating to the treatment of time-vesting equity awards
Practical implications and action items for compensation committees
As always, if you have a topic you’d like to discuss on a podcast, please reach out to me at mervine@ccrcorp.com!
Back in the 2021, there was a jump in the percentage of companies including individual performance metrics in their annual incentive plans. A number of companies added these metrics during pandemic times in order to provide some flexibility in the midst of uncertainty. A recent analysis from ISS Corporate observes that usage has remained steady ever since – with 34% of companies across the S&P 500 and Russell 3000 using them, compared to 29% in 2020. The memo looks at payouts at these companies compared to companies that do not use individual performance metrics. Here are the key findings:
– Incorporating discretionary components within a company’s Annual Incentive Program has become increasingly common, particularly in the Real Estate and Financial sectors.
– Companies that have individual performance metrics in their Annual Incentive Programs tend to deliver higher payouts and executives are more likely to achieve target than companies that do not.
– Discretionary components in a compensation program generally shift pay more towards the Annual Incentive Program for companies in the Russell 3000, while having the opposite effect for the S&P 500.
– Individual performance metrics may be used as a substitute for discretionary bonuses for S&P 500 companies, but the opposite is true for Russell 3000 companies, where companies with discretionary metrics also award larger discretionary bonuses on average.
Companies may want to prepare to talking points in response to these observations, because the memo offers this advice to investors:
The results also suggest that investors should carefully evaluate programs that lack pre-set quantifiable metrics. While IPMs add needed flexibility to a CEO’s pay package, they can also subtly lead to an increase in short-term pay. Companies with IPMs are more likely to hit their target payout, and short-term payouts may be significantly higher as well. In short, the results suggest an important role for monitoring AIPs with a heavily weighted individual performance metric and it is incumbent on companies to provide adequate disclosure.
Remember that last month, updated ISS FAQs also signaled that companies may face more scrutiny this year around performance metrics and related disclosures, especially for performance-vesting equity when pay & performance aren’t aligned under ISS’s quantitative test.