"Executive Compensation: Avoiding Proxy Litigation and Say-on-Pay Pitfalls in 2014"

by Skadden, Arps, Slate, Meagher & Flom LLP
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The spotlight on executive compensation further intensified during 2013, the third season under the Dodd-Frank Act’s “say-on-pay” rules, with the release of additional disclosure requirements and increased risks of proxy-related litigation. To remain on top of these new developments, companies should consider the following as they head into the 2014 proxy preparation and equity award granting processes:

Proxy Litigation

Fiduciary Duties. As 2013 began, plaintiffs continued to file a wave of lawsuits alleging breaches of fiduciary duties by management and directors in connection with allegedly inadequate proxy disclosure relating to say-on-pay proposals and proposals to increase the number of shares reserved under equity compensation plans. While there has been a slowdown in reported litigation activity, companies should continue to prepare their compensation disclosures with the threat of such lawsuits in mind.

Equity Grant Activity. We also have observed a new wave of lawsuits claiming that companies have failed to meet the requirements of Section 162(m) of the Internal Revenue Code, particularly by granting awards in excess of the compensation plan’s stated per-person limits or failing to get reapproval of performance goals every five years. In a number of cases, companies have voided the grants in question. As companies prepare for their next round of equity grants, they should carefully monitor any equity grant activity by involving internal counsel and equity specialists, as well as external advisers, to maintain compliance with all relevant laws and the terms of the applicable plans and arrangements.

Say-on-Pay

Avoid Complacency. The overall voting results for say-on-pay proposals at Russell 3000 companies have stabilized and even slightly improved. Seventy-three percent of proposals passed with 90 percent support or greater, 24 percent passed with between 50 and 89 percent support and 3 percent failed by obtaining less than 50 percent support.1

Interestingly, of the companies with failed proposals in 2013, the vast majority had passed the year before, with almost half obtaining approval rates between 70 and 99 percent. As such, it is critical that companies approach each say-on-pay vote with a fresh eye and be mindful that past success will not guarantee approval in future years.

Advisory Firms: Traditional Factors and Emerging Themes. As always, companies should be aware of the factors that typically cause Institutional Shareholder Services (ISS) and other advisory firms to issue an “against” recommendation:

  • the determination by ISS that there is a disconnect between the company’s performance and the amount of the CEO’s pay;
  • equity award grants that are time- rather than performance-based, particularly if such grants represent a substantial portion of the company’s equity grant program;
  • retention (or “mega”) equity grants or bonuses, particularly without a rigorous justification; and
  • performance goals that ISS deems to be insufficiently challenging.

As each proxy season unfolds, additional themes emerge from advisory firm reports, and companies should be aware of these recent developments:

  • Outreach Efforts: ISS continued to express concern that certain companies had not conducted adequate shareholder outreach, especially where ISS viewed that the compensation committee had been insufficiently involved. As such, companies should document and describe any shareholder outreach efforts in detail in the proxy and emphasize the involvement of the compensation committee, whether via direct interface with shareholders or through determination of the content and direction of those communications.
  • Nonformulaic Bonuses: Advisory firms have been looking closely at bonus programs that are not entirely formulaic. While a number of companies issued supplemental disclosures following an “against” recommendation explaining the strategic reasoning behind these plan structures, such filings generally do not result in a change in the recommendation. Companies should consider examining these plan designs and set forth their rationale clearly in the 2014 proxy.
  • Mistakes of Fact: A number of companies alleged that the shareholder advisory firms had made mistakes of fact regarding the terms and parameters of compensation arrangements, particularly in the case of incentive compensation plans. While each situation has its own unique characteristics and context, the fact that multiple companies raised this issue is a reminder to be exceptionally clear when drafting proxy disclosure with respect to complex arrangements and to have the disclosure carefully reviewed by multiple parties to check for overall comprehensibility. Charts and graphics also can be useful in this regard. Additionally, companies should carefully review the advisory firms’ descriptions of their compensation arrangements for factual accuracy.

Pay-Ratio Disclosure

The SEC’s proposal to implement “CEO pay-ratio” disclosure requirements under the Dodd-Frank Act has received considerable press attention. The proposed rules would require certain SEC reporting companies to publicly disclose:

  • median annual total compensation of all employees of the company (including all full-time, part-time, temporary, seasonal and non-U.S. employees);
  • annual total compensation of the CEO; and
  • the ratio of the median annual total compensation of all employees to the annual total compensation of the CEO.

Assuming the SEC adopts the final rules in 2014, a company with a December 31st fiscal year-end would be required to disclose pay-ratio information relating to 2015 compensation in its 2016 proxy. Items to watch for in the final rules are any parameters and details provided with respect to the permissible calculation methodology, and any relief provided by the SEC regarding the points that have drawn the harshest criticism from the business and practitioner communities (in particular, the inclusion of part-time, temporary, seasonal and non-U.S. employees). Companies also may want to consider submitting comment letters, even after the official deadline for such letters has passed.

1 All percentages follow the (for/for + against + abstain) formulation.

*This article appeared in the firm's sixth annual edition of Insights on January 16, 2014.

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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