The Dodd-Frank Act was brimming with new disclosure demands regarding executive compensation. Slowly but surely—and emphasis on slowly here—the Securities and Exchange Commission has been issuing proposed and final rules on clawbacks, pay for performance, and the dreaded pay ratio rule.
Indeed, that slow pace of rulemaking has given companies and their boards time to plan for the new disclosures and even a chance to look ahead to compliance issues they might encounter.
The pay ratio rule, for example, was made final by the SEC in August and is the most controversial of all Dodd-Frank compensation disclosures. At its simplest, the rule requires companies to compare CEO compensation to the pay of the median employee and report that data as a ratio.
Corporate America originally feared that the pay ratio rule had an international scope that inaccurately pushed the ratio upward, and also complained about differences in cost of living among various countries and currency fluctuations, plus the lack of centralized payroll information. In response, the SEC’s final rule provides companies with substantial discretion to use estimates and sampling as a means to determine the median employee and the employee’s compensation.
As the rule took shape in the months following its 2013 proposal, Steve Seelig, ?executive compensation counsel at Towers Watson, urged companies to evaluate their approach to compliance. Is year-to-year accuracy and consistency most important to the business? Is having the lowest CEO-worker ratio what matters? How can you minimize the cost of compliance? Is the technology on hand, notably for payroll and other data collection systems, up to the task?
“The fact that clawbacks are coming isn’t really a surprise to anybody. The issue is that the SEC clawbacks are very specific and what companies have done voluntarily is all over the map.”
Doreen Lilienfeld, Partner, Shearman & Sterling
With a final rule now on the table, these questions can be evaluated and answered.
“There is a great demand from compensation committees to not be surprised by their company’s ratio,” Seelig says. “A lot of our clients are actually doing dry runs so that they can provide at least a forecast for management and the compensation committee.”
Seelig advises companies to think about how the data, and how you developed the data, is explained in the Compensation Discussion and Analysis section of the proxy statement. “I don’t necessarily know that companies have really thought much about how their communication strategy needs to change once they see what the number is,” he says.
Because the SEC-mandated disclosures aren’t due until 2018, “there isn’t a mad rush yet”, says Doreen Lilienfeld, a partner at law Shearman & Sterling and group leader of its compensation practice.
“Nonetheless, we’ve seen clients start to think about how they are going to get the data together,” she says. “That’s the most daunting challenge.” While concerns are inevitable about how the pay ratio will affect a company’s image among shareholders and the general public, a big reason for conducting trial runs is to gauge the potential reaction of employees who discover their paychecks don’t reach median pay.
“We have seen quite a few clients who have already run the ratio using 2014 compensation data,” says Josh Agen, senior counsel with law firm Foley & Lardner.
Some of those companies are evaluating whether the SEC’s concession to allow statistical sampling, instead of a person-by-person workforce analysis, is a feasible way forward. “Some are not entirely comfortable with the whole concept of statistical sampling, so they may run the numbers both ways, using actual compensation numbers and a parallel process using statistical sampling to see if they come close to each other before relying solely on statistical sampling,” he says.
A chart from Shearman & Sterling’s 13th annual “Corporate Governance and Executive Compensation Survey” looks at one aspect of how companies conside compensation clawbacks.
Source: Shearman & Sterling.
These early calculations may help companies determine how the pay ratio will be discussed in the proxy, including whether presenting an alternative pay ratio—using full-time employees only, for example—would enhance understanding of the data, says John Trentacoste, a director with Farient Advisors.
Pay for Performance
Proposed in April, this SEC rule would require (it is not yet final) disclosures that explain how executive pay, including annual bonuses and long-term incentives, corresponds to company performance as based on total shareholder return.
“We have not heard a pressing need from compensation committees to see more about what that would look like,” Seelig says. “There is not the same degree of sensitivity as there is on the pay ratio issue.”
That is partly because companies have already been defending executive pay practices to shareholders in say-on-pay votes. That’s not the same as disclosing an exact pay-for-performance metric, but both measures do address that basic point of explaining the logic behind shareholder pay.
And on this point too, some companies have decided to start disclosing this year; Agen has already been called upon to help clients develop mock-up disclosures. “The actual compiling of that table is pretty straightforward and mechanical,” he says. “The decision you have to make is on the comparable TSR. Are you going to use your custom peer group? Or are you going to use the broader benchmark you use for your Form 10-K performance graph?”
Explaining the relationship between pay and performance, a requirement of the proposed rule, can be difficult. “There isn’t necessarily going to be a close relationship because of the way pay is calculated in that table,” Agen says. “You are valuing equity awards when they vest, and that is typically several years after you set the pay level. There is a timing disconnect there, and explaining it in a way that is at all insightful is going to be difficult.”
Another concern companies should consider well ahead of the eventual filing deadline: What if a company believes TSR isn’t best suited to its pay narrative? “The proposed rules have a certain definition of what performance is,” Lilienfeld says. “The challenges come when your compensation committee has decided that a metric other than TSR is what the executives are working for.” Deciding early if this is the case will give companies time to craft voluntary disclosures as a supplement to what the SEC requires.
A recent survey by Towers Watson of 453 corporate executives and compensation professionals found that 55 percent expect to provide additional information and analysis that go beyond what the proposed rules will require.
The SEC’s proposed clawback rules specifically address incentive-based compensation, including stock options that were received by a current or former executive, that must be taken back in the event of a financial restatement.
A recent survey of 100 companies by Shearman & Sterling found that 87 already have clawback policies in place. “The fact that clawbacks are coming isn’t really a surprise to anybody,” Lilienfeld says. “The issue is that the SEC clawbacks are very specific and what companies have done voluntarily is all over the map. It is a necessary step for every issuer to revisit their voluntary policy and make sure they are going to be compliant. In most cases issuers are going to have to review their policies.”
Where clawback procedures differ between rule and practice, she expects companies may decide to run two policies concurrently.
Trentacoste believes we may even see companies decide to go beyond what the SEC requires. “There might be an additional clawback policy that extends further down in the organization,” he says.