Top 10 Topics for Directors in 2016: Executive Compensation

by Akin Gump Strauss Hauer & Feld LLP
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Executive and Director Compensation

Perennially in the spotlight, executive compensation will continue to be a hot topic for directors in 2016. But this year, due to the SEC’s active rulemaking in 2015, directors will have more to fret about than just say-on-pay. Roughly five years after the Dodd-Frank Wall Street Reform and Consumer Protection Act was enacted, the SEC finally adopted the much anticipated CEO pay ratio disclosure rules,i which have already begun stirring the debate on income inequality and exorbitant CEO pay. The SEC also made headway on other Dodd-Frank regulations, including proposed rules on pay-for-performance,ii clawbacksiii and hedging disclosures.iv We highlight below some of the matters that directors should be considering as they craft executive compensation for 2016, particularly in light of the SEC’s recent rulemaking.

Just when companies thought the spotlight on CEO pay could not get any brighter, here come the SEC’s CEO pay ratio disclosure rules. These rules require companies to disclose the annual total compensation of the CEO, the median of the annual total compensation of all employees other than the CEO and the ratio of these two numbers, arguably to give shareholders more context on how a company pays its executives. Although this disclosure does not kick in for most companies until their 2018 proxy statements (relating to compensation for the 2017 fiscal year), companies should not unnecessarily delay consideration of the significant steps that will be required to ensure compliance with the new rule.

The SEC generously provided companies with certain latitude regarding how the median employee is identified, including allowing statistical sampling of the employee population and providing exemptions for certain non-U.S. employees, as well as flexibility on choosing a testing date. But despite this latitude, compliance with the new rule likely will be burdensome and costly, particularly for large or multinational companies where the information to be collected will be extensive. To take advantage of the flexibility that the rules provide, companies need to determine which methodology will work best for their organizational structure and what assumptions and adjustments will need to be made, whether any non-U.S. employees will be exempt, and also what testing date might be most advantageous.

CEO pay ratios are already making headlines, with Discovery Communications topping the charts at a hefty 1,951-to-1 ratio, and the average CEO earning 204 times the median employee based on a recent study by Glassdoor.v Because pay ratios will attract extensive media coverage, the sooner companies have a grasp of what their pay ratio will look like, the better. Directors need to think about how they will explain the pay disparity between their CEO and employees, including any assumptions or adjustments the company may need to make. Being able to explain why the CEO’s compensation is what it is will be paramount. Not only will this explanation be important for investors, but boards also need to be concerned about how company employees will react to this information. Disclosing the median worker’s salary could create tensions among workers, who will now realize how their salary compares to others, not only within their organization, but with competitors as well. Citing various distinguishing factors, such as the fact that the company employs a significant number of minimum wage employees or that its competitors outsource low-paying positions, may help dispense any unintended rifts within the organization.

With the pay ratio rules center stage, companies should remain mindful of certain other Dodd-Frank rules that the SEC proposed over the past year, which, if adopted in the near future, could very well take effect before the pay ratio rules. Companies need to start planning how they will implement and comply with these rules once adopted:

  • Pay for performance. The SEC proposed pay-for-performance rules in April 2015, which call for companies to disclose in their annual proxy statements the relationship between executive compensation and the company’s financial performance. Although final rules have not yet been adopted, most companies are already paying closer attention to pay-for-performance alignment. Nearly 60 percent of public companies have conducted an executive-pay-for-performance analysis comparing the company’s performance and executive pay with those of its peers in the marketplace, but only one third of such companies have disclosed the findings of their analysis.vi
  • Clawbacks. The SEC proposed clawback rules in July 2015, which call for stock exchanges to require listed companies to adopt clawback policies for the recovery of excess incentive-based compensation if the company is required to prepare an accounting restatement resulting from material noncompliance with any financial reporting requirement. The proposed rules are broader than the clawback provisions in the Sarbanes-Oxley Act, which apply to only the CEO and CFO, have only a one-year lookback and require misconduct. While some companies are waiting to see what the final rules look like before adopting a policy, those companies that have a clawback policy should review it for changes that are likely to be required. Companies should also take inventory of their compensation plans or arrangements that may be subject to clawbacks and consider whether amendments to such plans will be necessary to address clawbacks.
  • Hedging. The SEC proposed hedging disclosure rules in February 2015, which call for companies to disclose in their annual proxy statements whether the company permits its employees, officers or directors to hedge or offset any decrease in the market value of the company’s equity securities. With the negative light that ISS and Glass Lewis have cast on hedging (and pledging) by executive officers, an increasing number of companies already have adopted policies that prohibit hedging and, pursuant to existing CD&A requirements, disclosed such policies in their proxy statements.

Directors are also reminded to take extra care when determining their own compensation. Earlier this year, the Delaware Chancery Court, in Calma v. Templeton,vii declined to dismiss a claim against members of Citrix Systems, Inc.’s board that they breached their fiduciary duties by awarding themselves equity grants that the plaintiffs claimed were “excessive” in comparison to compensation received by directors at Citrix’s peers and amounted to corporate waste. The defendants argued that awards were made under an equity plan that had been approved by stockholders and that the board should be given the deference of the business judgment rule. The plan, however, did not set forth specific compensation to be granted to nonemployee directors, but rather gave the board broad discretion to determine the amounts and terms of awards, subject to certain general annual limits. Relying on Seinfeld v. Slager,viii the court held that, although stockholders approved the equity plan under which the equity was awarded, the plan did not include enough specificity on the amount or form of compensation to be issued to the nonemployee directors for stockholder ratification to occur. There must be some meaningful limit imposed by the stockholders on the board of directors for the awards to be evaluated under the business judgment rule. Because there were no such limits, the board’s decision was subject to review under the more exacting entire fairness standard, which requires the board to prove the fairness of the awards to the company.

This post was excerpted from our annual Top 10 Topic for Directors in 2016 alert. To read the full alert, please click here.


i See Akin Gump Corporate Alert on SEC Adopts Final Pay Ratio Rules (August 13, 2015).

ii See Akin Gump Corporate Alert on SEC Proposes Pay Versus Performance Disclosure Rules (May 5, 2015).

iii See Akin Gump Corporate Alert on SEC Proposes New Compensation Clawback Rules (July 9, 2015).

iv See Akin Gump Corporate Alert on SEC Proposes Rules Requiring Hedging Disclosures (February 12, 2015).

v Dr. Andrew Chamberlain, “CEO to Worker Pay Ratios: Average CEO Earns 204 Times Median Worker Pay,” Glassdoor Economic Research blog (Aug. 25, 2015).

vi Joe Mont, “SEC Eyes ‘Pay for Performance’ Rules Next Week,” Compliance Week (April 24, 2105). See also, Towers Watson, “Many U.S. Companies Performed Executive Pay-for-Performance Analyses but Did not Disclose in 2014 Proxies, Towers Watson Survey Finds,” (October 30, 2014).

vii Calma v. Templeton, C.A. No, 9579-CB (Del. Ch. April 30, 2015).

viii Seinfeld v. Slager, et. al., C.A. No. 6462-VCG (Del. Ch. June 29, 2012).

 

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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