Nearly five years ago, the Dodd-Frank Act tried to force Corporate America’s previously opaque executive pay practices into the light of day. Five years on, all that change to disclosure in the Compensation Discussion and Analysis is still a work in progress.
“This single, critical document must address increasingly complex compliance issues, and at the same time connect the dots between compensation strategy, business performance, and pay outcomes,” Richard Goeglein, chairman of the board at Pinnacle Entertainment, said in a recent Webcast, exploring strategies on how companies can tailor their CD&A to strike the right balance of compliance and communication.
The good news for companies is that compliance with compensation-related disclosure has improved significantly since 2007, the year say-on-pay votes really began to take root. Whereas the Securities and Exchange Commission used to condemn companies left and right for not providing enough disclosure, or not providing any clear explanation or rationale behind their pay practices, today “our regulatory audience at this point is satisfied,” Deborah Lifshey, a managing director at independent compensation consultancy Pearl Meyer & Partners, said.
Now the focus shifts to what investors expect from companies for good CD&A disclosure.
Ever since the Dodd-Frank Act gave shareholders an advisory vote on executive pay, companies are “at a bit of a disadvantage because investors, proxy advisers, and the media have all become pretty adept at tracking executive pay issues,” said Sharon Podstupka, a vice president at Pearl Meyer & Partners. Even employees are paying more attention to how executives are being rewarded, she said.
“Say-on-pay results do have meaning, and they send signals about the way boards are making decisions about pay,” Podstupka added. From a practical standpoint, that means the pressure to develop “really good CD&As is at its highest since the inception of Dodd-Frank,” she said. The expectation is that a CD&A will include not only SEC-required information, but also an explanation, in easy-to-read format, of how a company’s business strategy and results align with the compensation committee’s decisions on pay.
According to a survey conducted by Pearl Meyer looking to executive pay disclosure in 2015, one common theme is that companies continue to expand the content in their CD&As. Most companies (94 percent) include an executive summary in their CD&A. Most companies (81 percent) also go into significant detail about their engagement efforts.
“This single, critical document must address increasingly complex compliance issues, and at the same time connect the dots between compensation strategy, business performance, and pay outcomes.”
Richard Goeglein, Chairman of the Board, Pinnacle Entertainment
One new development to emerge from the report is that 29 percent of respondents said they are tying feedback they’ve received from investors to how they’ve responded. Others said they plan to add enhanced descriptions of their compensation committee’s decision-making process, as well as discussions around goals and performance.
“The good news here is that companies have a very good opportunity to make their CD&A narratives their own,” Podstupka said. “The bad news is that it adds to the complexity of the drafting process. If not done in a carefully planned way, you could end up with very long CD&As that make it hard for readers to find the information they’re looking for.”
Podstupka cited Honeywell as an example of one company that has done a good job at illustrating how it makes pay decisions. Another example is ExxonMobil, which has “set the bar very high” at how CEO pay aligns with Total Shareholder Return.
United Technologies is a third example of a company that does a good job with its CD&A, in particular when using bar charts to show how TSR compares to its peers. “They use sound bites, short sentences talking about engagement efforts, what they’ve heard, and how they’ve responded,” Podstupka said.
Pay Ratio Disclosure
Last year the SEC issued proposed regulations for the so-called CEO pay ratio disclosure rule, that companies disclose the ratio of CEO pay to median pay for employees (one of the more controversial, and disliked, parts of Dodd-Frank). “We thought by now these rules would be final and cover proxies issued in 2016, so it would cover compensation for 2015,” Lifshey said. To date, the SEC still hasn’t issued final rules. It recently pushed back its adoption target to the end of 2015, and nobody knows whether that goal will stick.
The good news is that the proposed pay-ratio disclosure rule offers companies a lot of flexibility, since it doesn’t include any a specific methodology. Companies can decide how they’re going to select the employee population covered, and how wide to cast the net when looking at different groups of employees.
Guiding Principles for Developing Meaningful CD&As
Sharon Podstupka, vice president in the New York office of Pearl Meyer & Partners, shares a few crucial guiding principles for how companies can develop clear and meaningful content in their Compensation Discussion and Analysis disclosures.
Link business and leadership strategy to pay philosophy. “It’s critical to make the connections between what the business strategy is; why the leadership team is critical to executing on this strategy, in particular when you’re dealing with retention issues; and how the executive pay program supports these fundamental business imperatives,” Podstupka said.
Highlight performance results (tied to plan metrics) and resulting pay outcomes. “Companies really do need to be clearer about the metrics and strategic initiatives on which executives are focused and held accountable—the ones that are expected to drive shareholder value, in particular,” Podstupka said. Be clear about milestones achieved and how those achievements were considered in pay decisions.
Be transparent about responses to shareholder feedback in your shareholder engagement process, or ongoing dialogue with institutional shareholders. Even if not all feedback is addressed in a way that makes everyone happy, shareholders still deserve a clear explanation of actions that were taken, or not, and why, Podstupka said.
Strike that perfect balance between compliance and communication. We are just now at a point in where we’re coming to terms with audience expectations, who don’t want to be weighted down with technical and legal jargon. “We need to ensure that people are grasping what we mean, and how what we’re saying reflects a broader business and leadership strategy,” Podstupka said.
Source: Pearl Meyer & Partners.
Under the proposed rules, companies at a minimum have to disclose CEO pay, median employee pay, and the ratio between the two. They must also briefly explain the methodology and estimate for calculating the ratio.
“This is not always an easy exercise, because if you have a vast population that is global, and you really need to hone in on certain groups of employees that you think more fairly represent the median employee, you’re going to have a lot of explaining to do as to why you’re carving out those international employees or those part-time employees that you don’t think should be part of this discussion,” Lifshey said. “So, while simple on its face, the proposed rules and guidance almost complicate because there are a lot of decision-making points.”
Companies should decide who will be involved to figure out where employees are located, how much they make, how that’s calculated, and what access you have to information. In certain countries with data privacy rules, for example, you might not be able to get the compensation data that you need, Lifshey said.
Pay-for-performance has been a hot topic ever since say-on-pay emerged. As a result, companies that care about proxy advisory firm input already are putting some sort of pay-for-performance analysis into their proxy by following the ISS model, tracking CEO pay to Total Shareholder Return, Lifshey said.
Clawbacks are another big item in CD&A disclosure. Clawbacks under the Sarbanes-Oxley Act are narrow: They only allow a company to recoup incentive compensation given to the CEO or CFO within the last 12 months, in the event of bad acts. “It was a very limited clawback provision,” Lifshey explained.
The Dodd-Frank Act, in contrast, covers current and former executives and includes a three-year look back. In addition, only a material mis-statement is needed, not the showing of deliberate bad acts. As a result, many companies have begun disclosing that they have a clawback, or will enact one following final enacted rules under Dodd-Frank. “You also score some ISS points in some of their testing models for the presence of a clawback,” Lifshey said.
“The compensation committee’s role has certainly changed over the years,” Podstupka concluded. “Effectively managing messages about executive pay has become a lot more intricate than it was five years ago, and the drafting and development process has become more complex.”