Matters to Consider for the 2018 Annual Meeting

Brian Breheny and Joseph Yaffe are partners at Skadden, Arps, Slate, Meagher & Flom LLP.  The following post is based on a Skadden publication by Mr. Breheny and Mr. Yaffe.

Companies have important decisions to make as they prepare for their 2018 annual meeting and reporting season. We have prepared the following overview of key corporate governance, executive compensation and disclosure matters that we believe companies should focus on as they plan for the upcoming season. As always, we welcome any questions you have on any of these topics or other areas related to annual meeting and reporting matters.

Finalize Pay Ratio Disclosures

The rules adopted by the U.S. Securities and Exchange Commission (SEC) that mandate pay ratio-related disclosures have gone into effect and apply to fiscal years commencing on or after January 1, 2017. As a result, companies with compensation payable with respect to fiscal years ending on December 31, 2017, will need to begin providing pay ratio information in their registration statements, annual reports on Forms 10-K or proxy statements filed in 2018, based on 2017 compensation.

As a reminder, the pay ratio rules require companies to disclose the ratio of the annual total compensation of the median company employee to the annual total compensation of the CEO. In addition, companies are required to provide a brief description of the methodology used to identify the median employee, as well as any material assumptions, adjustments or estimates used to determine the median employee or annual total compensation. There are certain aspects of the pay ratio disclosure requirements on which companies have been primarily focused. We provide an overview of those areas below.

Use of Reasonable Estimates, Assumptions and Methodologies

According to guidance released by the SEC and its staff on September 21, 2017, companies have significant flexibility in identifying their median employee and calculating total annual compensation. The guidance acknowledged exercising this flexibility should not provide a basis for an SEC enforcement action, as long as the company uses reasonable estimates, assumptions and methodologies (unless the company lacked a reasonable basis for the disclosure or it was not made in good faith). Several important features of the guidance are addressed below:

  • Certain types of workers are excluded from the pay ratio rules (e.g., independent contractors and leased workers who are employed by, and whose compensation is determined by, an unaffiliated third party). A company should not infer that the explicit exclusion of these workers represents the sole basis for excluding them from coverage under the pay ratio rules. When determining whether its workers are employees for purposes of the pay ratio rules, a company may apply a widely recognized test from another area of law, such as employment or tax law.
  • In identifying its median employee, a company may use existing internal records that reasonably reflect employees’ annual compensation. The records do not need to include every element of compensation, such as equity awards widely distributed to employees.

Calculating the Median Employee

The pay ratio rules permit registrants to calculate the median employee using “reasonable methods,” yet the final rules do not specify what methods are considered reasonable. The SEC’s September 21, 2017, guidance addresses this uncertainty by:

  • Outlining several acceptable sampling methodologies and other reasonable methods, including simple random sampling, stratified sampling, cluster sampling and systematic sampling.
  • Providing examples of situations where a company’s use of reasonable estimates would be appropriate, such as: (i) analysis of the composition of the company’s workforce (e.g., by geographic unit, business unit or employee type); (ii) evaluation of the likelihood of significant changes in employee compensation from year to year; and (iii) calculating a consistent measure of compensation and annual total compensation or elements of the annual total compensation of the median employee.
  • Confirming that companies may combine the use of sampling methods with estimates and other methods.

While the SEC appears to remain committed to the idea of promoting substantial flexibility in the pay ratio calculation, it is important to remember that companies must clearly explain their chosen methodology.

Treatment of Non-US Employees

Unless one of the two limited exemptions discussed below applies, a company must include non-U.S. employees in its calculation of total annual compensation and the median employee.

The first exemption applies if a country’s data privacy laws or regulations prohibit the transfer of compensation data outside a country’s borders, making it impossible for the company to compile the information necessary to calculate the pay ratio. If this occurs, a company may exclude employees located in the specified jurisdiction so long as the company: (i) discloses the excluded jurisdiction and the pertinent data privacy law or regulations; (ii) makes reasonable efforts to obtain the information (including seeking an exemption from the applicable data privacy laws or regulations); (iii) obtains a legal opinion certifying its failure to obtain the requested information; and (iv) attaches the legal opinion as an exhibit to the filing containing the pay ratio disclosure.

Under the second exemption, which is commonly referred to as the “de minimis rule,” a company may exclude all non-U.S. employees when identifying its median employee, if non-U.S. employees constitute 5 percent or less of their total workforce. Utilization of the exemption bars the inclusion of any non-U.S. employees in the median employee calculation; therefore, if a company chooses to exclude any non-U.S. employees under this exemption, it must exclude all non-U.S. employees.

Investors Intend to Use Pay Ratio Disclosures

In its 2017 benchmark voting policy survey, Institutional Shareholder Services, Inc. (ISS) revealed that nearly 75 percent of the 131 investor respondents indicated that they intend to use pay ratio disclosures as one factor in their analysis of compensation issues. The investors intend to analyze a company’s pay ratio by comparing it to that of other companies in its industry, by assessing year-over-year changes in the company’s ratio, or both. These results suggest that, in addition to making the required disclosures, companies should be cognizant of potential investor, employee and media reaction to the disclosed pay ratio. In addition, companies should be prepared to engage with shareholders if their pay ratio substantially departs from that of their peers, or significantly changes from year to year.

Incorporate Lessons Learned From the 2017 Say-on-Pay Votes and Compensation Disclosures

We recommend that companies consider recent annual say-on-pay votes and disclosure best practices when designing their compensation programs and communicating about their compensation programs to shareholders. We have summarized several key areas below that we believe companies should consider.

Results of 2017 Say-on-Pay Votes

Below is a summary of the results of the 2017 say-on-pay votes and some trends over the last six years since the initial adoption of the say-on-pay rules:

  • Average support for the 2017 season was near 92 percent, which is the highest since voting began. The percentage of companies receiving support above 90 percent was also slightly higher than any prior year.
  • Approximately 99 percent of companies received at least majority support, with approximately 93 percent receiving above 70 percent.
  • The 2017 failure rate of 1.3 percent was the smallest ever, down from 1.5 percent in 2016, and 2.2 percent in 2015.
  • While overall support is high, 10 percent of Russell 3000 companies with vote results in each year have failed a say-on-pay vote at least once.
  • There was a sharp decrease in failure rates at smaller companies (those in the Russell 3000 that identify as SmallCap 600 companies). In 2016, the failure rate was 32 percent. In 2017, it dramatically improved to 18 percent. The performance of S&P 500 companies was more consistent, reporting a 15 percent failure rate in 2017, down from 17 percent in 2016.
  • Almost one-third of companies with annual say-on-pay votes have received less than 70 percent support at least once during the preceding six years.

Say on Golden Parachute

Say-on-golden-parachute votes have historically received lower support than annual say-on-pay votes. The 2017 failure rate of 15 percent was the highest since the advent of the vote and more than double the failure rate of 7 percent in 2016. Average support for golden parachute proposals fell to 79 percent, an all-time low. In fact, ISS issued a negative vote recommendation on 44 percent of the proposals, up from 26 percent in 2016, and the difference in average support between “for” and “against” recommendations from ISS was 37 percent in 2017, the highest on record (up from 28 percent in 2016). Notably, the median CEO golden parachute payment rose close to 75 percent, from $5.2 million in 2016 to $9 million in 2017.

Equity Plan Proposals

Equity plans were approved with an average passing score of 89 percent in 2017, an increase from 88 percent in 2016, and higher than the 2012-15 range of approximately 86 to 89 percent. ISS supported 70 percent of the equity plan proposals in 2017, an increase from 68 percent in 2016. ISS issued an “against” recommendation at a rate of 9 percent in 2017, down from 13 percent in 2016. Eight equity plan proposals failed in 2017, compared to the five-year high of nine proposals in 2016. Among the factors resulting in a failed proposal, the cost of the plan was cited most frequently.

2017 marked the third year in which ISS applied its Equity Plan Scorecard (EPSC). This year’s fewer number of “against” recommendations may be a product of companies incorporating more of the scorecard practices, but the impact of the EPSC on the shareholder approval rating is not entirely clear. In December of each year, ISS publishes Frequently Asked Question (FAQ) documents to help stakeholders understand changes to ISS compensation-related methodologies. [1] In November 2017, ISS provided a preliminary set of FAQs highlighting the following updates to EPSC methodology for the 2018 reporting season:

  • For companies subject to the S&P 500 scoring model, the passing score for the EPSC will increase to 55 points. For all other EPSC models, the passing score will remain 53 points.
  • The change in control vesting factor will be simplified, scoring companies on a basis of full credit or no credit. A company will earn full credit if a company’s equity plan contains both of the following provisions:
    • For performance-based awards, acceleration is limited to actual performance achieved, a pro rata of the target based on the performance period, or a combination of both.
    • For time-based awards, acceleration upon a change in control cannot be discretionary or automatic single-trigger.
  • The holding requirement factor will be simplified, permitting a company to earn either full credit or no credit. The timeline for receiving full credit on this factor will change from a 36-month holding period to a 12-month holding period. Any holding period of less than 12 months will result in no credit.
  • The CEO vesting requirement factors also will be simplified to a vote of full credit or no credit. To receive full credit, the vesting requirement threshold will decrease from greater than four years to at least three years from the date of grant until all shares from the award vest.

Companies should continue to pay careful attention to the EPSC and secure ISS support where the company’s equity plan goals are consistent with the EPSC. However, the historically low failure rate arguably makes ISS support less important with respect to equity plan proposals than in the say-on-pay context.

Views of Proxy Advisory Firms and Shareholder Outreach

Below are some of the areas that caused proxy advisory firms to recommend a vote against say-on-pay proposals in 2017. The first two of these areas appear to have been of more significant concern than others:

  • A “pay for performance” disconnect (as calculated using the advisor’s methodology).
  • Problematic pay practices, including, among other examples, renewal of agreements containing excise tax gross-ups, severance payments to an outgoing CEO in the case of a “friendly” termination, and “make-whole” arrangements or off-cycle grants intended to compensate executives for forgone compensation at a prior employer or an unexpected decline in the value of prior grants.
  • Performance goals deemed by proxy advisory firms to be insufficiently challenging, particularly where goals are lower than prior years’ results.
  • Insufficient shareholder outreach and disclosure, including inadequate response to compensation-related concerns raised by shareholders.
  • An emphasis on time-based equity grants, rather than performance-based grants.
  • Special bonuses and “mega” equity grants.
  • Targeting compensation above the 50th percentile of peer compensation groups.
  • Bonuses that are not solely determined by a formula based on achievement of pre-specified performance criteria.

In addition, ISS recently provided a preliminary set of FAQs highlighting quantitative changes to be included in ISS’ 2018 pay-for-performance calculations, including screen thresholds, the calculation of total shareholder return and the inclusion of a financial performance assessment test. [2] ISS plans to release final FAQs on its U.S. compensation policies in December 2017.

When companies have not changed their compensation plans or programs in response to major shareholder concerns, a best practice has included providing in the proxy materials a brief description of those concerns, a statement that the concerns were reviewed and considered, and, if appropriate, an explanation why changes were not made. In addition, many companies incorporate useful features into their executive compensation disclosures, including executive summaries, charts, graphs and other reader-friendly tools. These features help to achieve maximum clarity of the company’s message. A number of companies also have added a summary section to the proxy statement, generally located at the beginning of the document, that highlights, among other things, business accomplishments and key compensation elements, features and decisions.

Companies also should consider whether to make any updates to the compensation benchmarking peers included in ISS’ database. ISS uses these company-selected peers when it determines the peer group it will use for evaluating a company’s compensation programs. ISS will accept these updates until Friday, December 8, 2017. [3]

The complete publication is available here.

Endnotes

1 A copy of ISS’ preliminary FAQs are available at https://www.issgovernance. com/ file/policy/Preliminary-U.S.-Compensation-FAQ.pdf.(go back)

2A copy of ISS’ preliminary FAQs are available at https://www.issgovernance. com/ file/policy/Preliminary-U.S.-Compensation-FAQ.pdf.(go back)

3Information about this process is available at https://www.issgovernance.com/company-peer-group-feedback.(go back)

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