Compensation Season 2019

Boards of directors and their compensation committees will soon shift attention to the 2019 compensation season. Key considerations in the year ahead include the following:

Dodd-Frank Act Regulations

Final Hedging Disclosure Rules. New Item 407(i) of Regulation S-K requires a company to describe any employee or director hedging policies or to state that it does not have any such policies. The required disclosure covers equity securities of the company, any parent or subsidiary of the company, and any other subsidiary of the parent. Companies must comply with the new rule in proxy statements for the election of directors during fiscal years beginning on or after July 1, 2019. Now is an opportune time for a company to review and update its existing hedging policy or to consider adopting a hedging policy if it does not have one.

CEO Pay Ratio Disclosure. We are entering year two of CEO pay ratio disclosure and, while the 2018 disclosures generated less fanfare than anticipated, companies should continue to exercise prudence in this sensitive area. Context was the key to good disclosure in 2018. Where anomalous facts result in a high ratio, companies should explain those facts and consider including a supplemental alternative ratio. In addition, for 2019, companies should consider whether to revise the methodology for choosing the median employee based on changes in their business, operations, compensation programs, or employee population. Finally, companies should be sensitive to the fact that 2019 disclosures will invite comparisons to prior year and peer company disclosures.

Other Compensation-Related Regulations Not Yet Finalized. We continue to await final regulations regarding clawbacks, disclosure of pay for performance, and financial institution incentive compensation.

ISS

ISS remains an influential voice in the compensation arena. The most important ISS compensation policy developments include the following:

• For shareholder meetings occurring on or after February 1, 2020, ISS may issue a negative recommendation for board members responsible for approving non-employee director pay if it identifies a pattern (two consecutive years) of excessive non-employee director pay. Based on its most recent policy update, ISS may consider director pay excessive if it exceeds pay received by the top 2–3% of directors within the same index and sector.
• Excessively dilutive equity compensation plans (20% for S&P 500 companies) may trigger an automatic negative recommendation for plans presented for shareholder approval.
• ISS has identified shifts away from performance-based compensation to discretionary or fixed pay elements as a problematic pay practice.
• ISS disfavors equity grants that cover more than four years. In the case of such grants, ISS requires firm restrictions on future grants and will apply heightened scrutiny to performance criteria with an eye to limiting “windfall” outcomes.
• Insufficient executive compensation disclosure by externally managed issuers is a new basis for a negative say-on-pay recommendation.
• There has been no change to ISS policy regarding pay ratio disclosure. Under existing policy, the CEO pay ratio does not impact vote recommendations, though ISS continues to assess the usefulness and application of the disclosure.

As we have stated in prior years, management and compensation committees should understand the potential consequences of their decisions under applicable ISS policies, but should not waver in their commitment to attract and retain talented personnel who will contribute to the long-term success of a company.

Manage Say-on-Pay Proactively

The single biggest reason for a negative ISS recommendation is a perceived pay for performance disconnect. The absence of detailed disclosure of performance criteria and/or “weak” performance goals are two common ISS criticisms. One way to head off this type of criticism is to include thoughtful disclosure regarding the degree of difficulty of goals and the reasons for setting specified performance criteria. If a company anticipates a challenging say-on-pay vote, it should proactively reach out to large investors, communicate the rationale for company compensation programs, give investors an opportunity to voice any concerns and describe its investor outreach in the annual proxy.

Be Prepared for Shareholder Activists

Companies remain vulnerable to activist threats and executive compensation matters are a frequent target in activist campaigns, even more so with the increasing ease of obtaining and manipulating compensation data. Companies should ensure that they understand how their change-in-control protections function if an activist obtains a significant stake in the company or control of the board. Appropriate protections ensure that management will remain focused on shareholder interests during a period of significant disruption; inadequate protections can result in management departures at a time when stability is crucial. A company under fire needs to coordinate its internal and external investor relations teams to ensure that they have the facts at hand to effectively rebut activist criticism.

Share Price Volatility and Equity Plan Considerations

Recent months have witnessed heightened stock market volatility and stock price declines for many public companies. If a company determines the number of equity awards granted to employees by reference to a specified dollar value, strict application of a formula may accelerate depletion of a plan’s share reserve. A company with limited available equity plan shares may wish to consider granting new awards subject to shareholder approval or granting cash-settled awards outside of shareholder-approved plans, recognizing that cash-settled equity awards may have adverse accounting consequences.

Companies that have experienced significant stock price declines should also monitor whether their existing incentives remain effective. Stock options that are heavily out-of-the-money or share price targets that appear unattainable, for example, may not serve their intended retentive and incentive purposes.

New Section 162(m)—One Year Later

It has been more than a year since Congress all but eliminated the performance-based exception to Section 162(m) other than with respect to certain limited grandfathered arrangements. The change in law remains an opportunity for companies to simplify compensation design, while maintaining a strong link between pay and performance. For a more detailed discussion of key considerations relating to Section 162(m), please see our October 29, 2018 memorandum, One-Year Checkup for the New Section 162(m), and our August 23, 2018 memorandum, IRS Issues Initial Guidance on Section 162(m) Amendments.