Overview

To help companies prepare for 2023 proxy statements and annual shareholder meetings, we summarize below the key elements of the final rules, how key stakeholders (activists, investors, proxy advisors) may use them and key considerations for companies subject to the new disclosure rules.

Executive Summary

• The new rules require the following qualitative and quantitative disclosure in the company’s 2023 Proxy Statement (or similar disclosure) regarding the relationship between executive pay and company performance:
  • A table including certain executive compensation measures (including
    a new measure: Compensation actually paid) and certain financial performance measures (company total shareholder return or TSR peer TSR, net income and a financial metric of the company’s choosing), covering five years of data.
  • A description (narrative, graphical or both) of the relationship between executive compensation actually paid and the measures included in the table.
  • A description of the relationship between the company’s TSR and the peer groups’ TSR as a whole.
  • A list of three to seven performance metrics (in no particular order) that are deemed the most important in determining executive compensation for the most recently ended fiscal year (the covered year).
  • Companies with a calendar fiscal year end are required to implement the disclosure in their 2023 proxy statements.
  • Details of the rule are described in greater detail in the Appendix on page 4.
• Investors and proxy advisors are very likely to utilize this new disclosure to inform their analysis of the company’s 2023 “Say on Pay” vote, potentially flagging companies with higher compensation actually paid during years of declining performance or those that frequently change performance metrics.
• Given this potential impact on investors and proxy advisors, ensuring an effective narrative in your company’s proxy statement and engagement materials will be essential heading into the 2023 proxy season.

How will stakeholders use this new information?

Proxy Advisors

• In their quantitative pay-for-performance analysis. It is likely that proxy advisors will
  incorporate elements of “Compensation Actually Paid” into their quantitative analyses to determine pay-for-performance outliers at some point in the next several years. Compensation actually paid includes elements of both realized and realizable pay. It includes the value of equity vesting in the year as well as the change in value of outstanding awards (including the addition of new grants) as
  of year-end.
• While ISS and Glass Lewis display realizable and realized pay in their analyses, respectively,
  their quantitative P4P models currently consider granted pay only. Using the new information,
  they could build more nuanced models that incorporate elements of compensation actually paid and performance. For instance, companies with a “low concern” of a granted pay-performance misalignment could be flagged for further analysis if compensation actually paid increases significantly during periods of declining performance. Conversely, the quantitative model could consider strong alignment of compensation actually paid and performance as a factor that reduces the initial P4P concern level, similar to how ISS currently incorporates operating financial performance in its model.
• In their qualitative analysis of pay. Proxy advisors are also very likely to consider the new information in their qualitative analysis of pay, which presents both challenges and opportunities for companies. For instance, frequent changes of the “company selected measure” will likely raise concerns of cherry picking. On the other hand, companies have the opportunity to explain their key performance indicators or any anomalous performance at a high level. This is information that proxy advisors, who have thousands of companies to assess and limited bandwidth, might not otherwise know of or consider in their analyses.

Institutional Investors

• To inform their engagement with issuers
  and 2023 “Say on Pay” votes. In addition to performing their own analyses of the new information to identify outliers, we believe investors will likely use this information to
  inform their engagement strategy. Investors are likely to reach out to companies where pay and performance appear to be misaligned or for additional information, particularly if there
  is limited explanation in the proxy or if such companies received negative recommendations from proxy advisors on the basis of compensation actually paid. Managers of active funds are likely to reach out for discussion if they feel the “most important” performance measures disclosed by the company are not actually the key drivers of growth.

Activists

• In rankings of highly paid executives. Groups that put out rankings of high executive pay packages, such as As You Sow, are likely to use this information to continue to “name and
  shame” high paying, low performing companies. Companies at the tops of these lists are often
  subject to negative media attention.
• In “Vote No” campaigns. Similar to companies with a granted pay-performance misalignment, companies with a significant misalignment between performance and compensation actually paid would be vulnerable to vote no campaigns against the say-on-pay proposal and compensation committee members.
• In proxy fights. Activist investors frequently reference executive compensation in proxy
  battles and could make use of this new information. As with the CEO pay ratio disclosure requirements, more pay information provides more opportunities for criticism and anything a company says may be used against them. In many cases, executive pay is criticized without
  context, even for companies that aren’t outliers. In each of these cases, one of the best defenses is to take ownership of the story in the proxy narrative.

Conclusion

While potentially challenging to implement, particularly for companies with multiple equity tranches to value or those that do not use TSR or net income as performance metrics, the rules do present opportunities for companies to tell their story in the proxy. Companies are invited to explain anomalous performance, showcase the alignment between compensation paid and performance and educate investors on the key performance factors that drive pay decisions.

Taking advantage of this opportunity is important given the likelihood that proxy advisors and investors will incorporate the new data into their say-on-pay recommendations and votes. Further, as with any new disclosure, activists are likely to use this information against companies in proxy fights and vote no campaigns. The best defense is clear and descriptive disclosure that showcases the thoughtfulness of the compensation committee’s pay-for-performance approach.

Given the near-term time frame for implementation, companies will need to work closely with legal counsel to interpret and implement the disclosure requirements and move fairly quickly to gather the necessary data and perform assessments to determine the selected performance measures.

We recommend that companies consider the narrative disclosure accompanying this information through an investor lens, take ownership of their story and use this as an opportunity to inform and educate their shareholders.

The complete memorandum is available for download here.