Five years after the Dodd-Frank Act tried to bring more clarity to Corporate America’s executive pay practices, the Compensation Discussion and Analysis is still a work in progress. New disclosure regulations on the horizon promise to make the CD&A even more onerous.
The CD&A is one of few windows investors have to peer into the inner workings of boards’ thoughts about executive compensation and, at a deeper level, corporate strategy. “Whatever you say [in the CD&A] really has to be describing why you pay what you pay, how it relates to the performance targets that you set for the management team, and how it relates to the overall strategy of the company,” says Peter Gleason, president of the National Association of Corporate Directors.
Many institutional investors use the CD&A to better understand how the board aligns compensation to the strategic goals of the company “and using that as a proxy for how the board is exercising its fiduciary responsibility more broadly,” says John Roe, executive director with ISS Corporate Solutions, a subsidiary of Institutional Shareholder Services. “Because of that, investors are looking for additional disclosure, and boards are responding.”
As a result, one new development to emerge in the CD&A is more qualitative disclosure on what’s happening in the boardroom. Compensation committees are including more details, for example, on how decisions about executive pay align with company performance (both financial and non-financial). They’re also providing clearer explanations on how pay philosophy translates into decisions—such as target pay versus peer group, or year-over-year changes to pay levels. Disclosure of the process by which goals are set is another recent development in the CD&A.
That being said, companies still have concerns about confidentiality and sharing too much information about their strategy and how they set goals. “There is still a bit of a push-pull there, but I think we’ve seen a big increase in the transparency on those issues,” says Scott Olsen, human resources services leader for PwC.
One big driver for all this attention, of course, are all the new regulations piling onto compensation committees—particularly the Securities and Exchange Commission’s pay-for-performance rule (already proposed, yet to be adopted) and the CEO pay ratio disclosure rule (yet to be proposed at all). The CD&A continues to get longer, spanning several dozen pages, whereas once upon a time the average company’s entire proxy statement wasn’t that long. “The disclosures that have come in response to the regulations have created information overload,” Gleason says.
Earlier in June the NACD issued a special report on compensation committees, where an NACD-appointed commission recommended that disclosures explain in “plain English” how pay decisions are tied to performance. “You’re not necessarily conveying the best information when you get wrapped up in the jargon,” Gleason says.
“Whatever you say really has to be describing why you pay what you pay, how it relates to the performance targets that you set for the management team, and how it relates to the overall strategy of the company.”
Peter Gleason, President, National Association of Corporate Directors
“Companies started going down the route of making the CD&A more visually appealing, but didn’t necessarily communicate clearly what was happening in the boardroom,” Roe says. “They’ve toned down some of the marketing qualities of the CD&A—and the proxy more broadly—and amped up the clear disclosure on what’s happening in the boardroom and why decisions have been made.”
Compensation committees are more focused now than ever before on the why in disclosures: “Why do you set the pay at this particular level? Why did you decide to use these performance metrics on performance equity?” Roe says. Those are the sort of components in the CD&A that investors look for and that serve as a lens into how the board operates, he says.
As the CD&A has become progressively longer, more companies are now starting to include an executive summary. The NACD report recommends that when compensation committees are drafting the executive summary, they include one or more of the following elements:
KEY CD&A COMPONENTS
Below is an excerpt from the “Report of the NACD Blue Ribbon Commission on the Compensation Committee.”
The NACD report recommends that compensation committees consider the following components in the CD&A:
An explanation of how pay philosophy translates into key decisions—such as target pay versus peer group, and year-over-year changes to pay levels or pay mix;
Explanation of how company performance—including financial, non-financial, or any other key dimension of performance—links to decisions on executive pay;
Disclosure of process for goal-setting and establishing targets and thresholds, including factors considered by the board, and any changes from the previous year;
Explanation of the rationale for peer-group design, including purpose of the peer group (benchmarking compensation or benchmarking relative performance), rationale for the companies included or excluded, and any changes from the previous year;
Instances where discretion was used by the board, including both the cases where this occurred (e.g., one-time payouts, supplemental benefits, upward or downward adjustments to pay that diverge from plan design, etc.) and the underlying rationale; and
Key points related to the company’s shareholder engagement activities on executive compensation matters.
An overview of existing practices and identification of key changes (for example, plan design and compensation committee practices) from the previous year;
Performance highlights (financial and non-financial company and business results);
Graphics that streamline information and call attention to pay philosophy highlights and design;
Graphics depicting pay mix and the relationship between company financial performance and CEO/non-executive officer performance over time; and
Visual representations of compensation committee activities, such as the peer-group selection process and the timing of the committee’s compensation decisions across the year.
More to Come
Much uncertainty still remains about how the SEC’s pay-for-performance and pay-ratio-disclosure rules will further alter the CD&A. Under the pay-for-performance rule, the SEC said it is mulling proposed amendments “requiring registrants to disclose in a clear manner the relationship between executive compensation actually paid and the financial performance of the registrant.”
Those disclosures, mandated by the Dodd-Frank Act, will explain how executive pay (including annual bonuses, and long-term incentives) corresponds to company performance. Disclosures will need to detail how “company performance” is defined and analyzed.
“What you don’t want to do is come out with some voluntary disclosures that are going to be superseded by some of the pending rules that are out there,” Olsen says. “That does have an impact on how far companies want to take some of the disclosure that they’re doing.”
The SEC’s pay ratio rule is another wild card for compensation committees, Roe says. In 2010, the Dodd-Frank Act mandated the SEC to create a rule requiring public companies to disclose the ratio of CEO pay to that of the median paid employee. The SEC issued a proposal in 2013, but more than two years—and 22,860 comments later—the agency has yet to issue a final rule.
In early June, however, the SEC’s Division of Economic and Risk Analysis issued a new memo that weighs the potential effects of excluding different percentages of employees from the pay ratio calculation; the sticking point is who to include in the median. It was the first hint the filing community has had in months that the SEC is still thinking about pay ratio disclosure.
The concern that many commentators have expressed is that excluding some employees—non-U.S. employees, seasonal workers, temporary workers, for example—from the determination of median employee pay “can affect the calculation of that median, and thus change the ratio of the annual total compensation of the principal executive officer to the median of the annual total compensation of employees,” the DERA memo stated.
“The bigger question in year one is, how do companies actually present information? What kind of commentary will they need to put around it?” Roe says. “It’s going to be a dilemma for compensation committees the first year that this is going to be required. It’s a little bit down the road, but it’s something they should be thinking about.”