According to ISS, Emerson Electric (the Fergusson, Mo. – based electrical equipment manufacturer) was the first U.S. company to which ISS applied its new Equity Plan Scorecard policy. On February 3rd, Emerson held its shareholder meeting, at which time, it put its 2015 Incentive Shares Plan up for shareholder approval. Based on a recently filed Form 8-K, Emerson’s shareholders resoundingly approved the plan.
In general, the new ISS policy analyzes equity plan proposals pursuant to three pillars:
- Estimated Cost – total potential cost relative to industry/market cap peers, measured by estimated Shareholder Value Transfer in relation to peers.
- Plan Features – review of problematic plan terms (e.g., single-trigger change in control vesting, discretionary vesting authority, liberal share recycling, minimum vesting periods).
- Equity Grant Practices – relative burn rate, vesting terms in most recent CEO grants, estimate plan duration, portion of CEO’s most recent equity grants subject to perfomance conditions, clawback policy, post-exercise/vesting holding requirements.
Emerson’s shareholder proposal to approve the plan, which can be found here, seems drafted with an eye to the Equity Plan Scorecard. In particular, the proposal points out that:
- The plan will have enough shares to last through the next two performance cycles (October, 2015 and October, 2018).
- The company has reduced it’s weighted average diluted shares via share repurchases.
- The plan incorporates key ISS best practices concerning minimum vesting periods, clawbacks, double-trigger change in control provisions.
- The plan does not allow liberal share counting or contain a liberal change in control definition.
- The company’s grant practices should be viewed favorably under ISS standards.
It will be intersting to see if companies use the ISS Equity Plan Scorecard as a rubric of sorts when drafting equity plan shareholder proposals. Emerson’s proposal certainly touched on many ISS key issues and appears to have been embraced by shareholders.
The CD&A is a required part of a public company’s annual proxy statement. Its stated purpose is to give shareholders material information about a company’s compensation objectives and policies for the named executive officers (NEOs). It also provides perspective for investors about the compensation numbers and narrative that follow. As such, the CD&A’s real purpose is to explain the “compensation numbers.” As everyone knows, this has become increasingly important in the last few years, primarily due to the mandatory “say on pay” shareholder vote on executive compensation. While the vote is not binding, it can get very embarrassing if shareholders do not approve executive compensation practices and policies.
We believe the CD&A provides an excellent opportunity to educate shareholders about the company’s business strategy and to highlight how stated compensation practices best support the company’s goals.
So this year, let your CD&A tell your story by using some of these helpful tips:
• Year in Review – explain the decisions made during the year and the resulting payouts, if any; describe the context for decision making;
•Business Strategy — describe strategy and how compensation practices support it;
•Executive Summary — include succinct “summary” of good governance and best practice policies upfront and early in the document;
•Charts & Graphs — use lots of these to illustrate elements of pay, mix of pay, variable vs. fixed, and to chart performance against goals;
•Simple Direct language — use simple plain English and write from the investor’s perspective; assume your reader knows nothing about executive compensation;
•Financial Performance – ensure the company’s performance story frames the discussion of executive compensation; don’t keep the reader guessing how performance impacts executive pay – show them how through a chart or graph; and
•Realized or Realizable pay – consider using if appropriate (e.g., if TSR or say –on- pay support are low)
Finally, keep it short (but be thorough) so that shareholders and proxy advisory firms may easily understand how your compensation programs support your business strategy.
The Securities and Exchange Commission recently indicated that further rule-making would not likely occur until October of 2015 with respect to:
- Pay for performance rules;
- Compensation clawback requirements;
- Hedging rules; and
- CEO pay ratio rules.
You can access the SEC’s regulatory agenda here.
Previously, the SEC had targeted the end of this year for action in each of these areas. Many issuers will likely be relieved by the delay of these Dodd-Frank requirements, especially the pay ratio rules, whose proposed regulations were the subject of significant comment.
In other areas of rule-making, such as compensation clawbacks and (to a lesser extent) hedging, market forces and institutional shareholder pressures have already led many publicly-traded companies to adopt policies that address these issues.
Of course, the SEC’s priorities may change at any time, but it appears that issuers will have a break from new proxy requirements related to these Dodd-Frank rules, at least for now.
A new Conference Board report on proxy voting in 2014 reports a decline in shareholder proposals on executive compensation matters. Among Russell 3000 and S&P 500 companies, the 70 compensation-related proposals was down from 86 proposals in 2013. Almost 70% of the proposals involved either requiring equity retention periods or limits on golden parachute payments. A couple of notes:
- There was majority support for 5 of the golden parachute proposals and 1 of the equity retention proposals.
- Support increased for clawback and SERP limit proposals, but measured on a small number of proposals (3 clawback and 2 SERP proposals).
- 2014 saw a complete lack of proposals on tax gross ups (consistent with the decreased use of gross ups).
- The major area of new proposals (6) related to director compensation, however, these were all part of a single director election proxy fight.
Last Thursday, ISS released its final 2015 proxy voting policy updates. The only significant change in the executive compensation area relates to equity plan proposals. ISS will now analyze these using a “Equity Plan Scorecard” with various factors and weightings that can have a positive or negative influence, similar to how ISS’s Quickscore system works for executive compensation programs generally.
Plan cost (45%) and burn rate/grant practices (35%) are given the largest weightings under the new formula. The remaining category is for “plan features” (20%), which includes many of the same or similar problematic features as identified in prior guidelines, such as liberal change in control definition, option repricing, etc. However, one new feature that will be present for 2015 that was not previously identified as problematic is whether a plan authorizes discretionary vesting of awards in the absence of a change of control (COC).
In our experience, many companies do occassionally exercise discretion to accelerate the vesting of equity awards in non-COC situations, to address legitimate business concerns mainly in connection with employee departures. For example, a company may generally support pro-rata vesting of otherwise cliff-vested equity awards in involuntary termination situations, but may make this feature discretionary instead of mandatory, to give the company flexibility/leverage to address particular terminations on a case-by-case basis. The ISS policy updates appear to be saying, somewhat arbitarily, that while a mandatory vesting acceleration provision in this situation would be fine, discretion to accelerate vesting would be a problem.
With the ISS policy change, the common practice of exercising discretion to accelerate vesting of equity awards may now suddenly factor into negative vote recommendations on a company’s future equity plan proposals. In fact, the mere authority to accelerate vesting outside of a COC context may now factor into a negative vote recommendation, suggesting that companies going forward may need to explicitly prohibit accelerated vesting outside of the COC context in their equity plan documents if they wish to be sure of receiving a favorable recommendation.
ISS is scheduled to issue FAQs addressing the 2015 policy updates later this year and may provide some additional guidance in this area.
Last month, the IRS issued final regulations under IRC Section 162(m)(6) for certain health insureance companies. The final regulations largely track the regulations proposed in 2013, previously discussed here.
For taxable years starting after 2012, the statute (added by the Affordable Care Act) reduces the annual deduction limit for “covered health insurance providers” from $1,000,000 to $500,000, expands the class of covered individuals to include all employees, officers and directors, eliminates the performance-based compensation exemption, extends the limitation to deferred compensation earned after 2009 and applies to private health insurers as well as public, among other things. A “covered health insurance provider” for this purpose is any licensed health insurance company or organization that receives 25% or more of its gross premiums from providing health insurance coverage during a taxable year from “minimum essential coverage,” which generally includes coverage provided under a government program, an employer-sponsored group health plan or a health plan offered in the individual market within a state.
Importantly any direct or indirect 80%-controlled parent or subsidiary of a covered health insurance provider (or any member of an affiliated service group) is subject to the reduced deduction limitation as well, regardless of whether the related entity is in the health insurance business, unless a de minimis rule applies. Under the de minimis rule, an entity will not be a covered health insurance provider if less than 2% of the gross revenues for a taxable year for that entity and its direct or indirect parents or subsidiaries (or affiliated service group members) comes from providing health insurance coverage that is minimum essential coverage.
As mentioned above, one of the changes introduced by Section 162(m)(6) was to apply the deduction limitation to deferred as well as current compensation. This requires covered health insurance providers to allocate deferred compensation amounts (including traditional nonqualified retirement plans, cash and equity-based incentive compensation and severance pay) to the taxable years in which such amounts are earned (or on a pro-rata basis to the year or years in which they vest, if subject to vesting). A summary of these rules is beyond the scope of this post, but suffice it to say the rules are complex and will impose substantial additional tracking requirements on covered health insurance providers.
Many of the innovations introduced by Section 162(m)(6) may ultimately find their way into tax reform legislation that would apply to businesses beyond the health insurance industry. For example, the Camp tax reform proposal for 162(m) would eliminate the performance-based compensation exemption and would apply to deferred compensation as well as current, similar to Section 162(m)(6). Alternatively, the recently proposed CEO-Employee Pay Fairness Act indicates that Congress could end up taking a different tack in its efforts to reform Section 162(m)—by tying the deductibility of certain officer and director compensation in excess of $1 million to whether a company pays a minimum average compensation level to its rank and file employees.
The SEC’s approval of the new PCAOB auditing standards for risk related to material misstatements creates a bridge between compensation committees and the company’s auditors. Chairs of compensation committee should expect to see auditors crossing that bridge with lots of questions, beginning next year.
In the newly revised PCAOB Auditing Standard No. 12 on Identifying and Assessing Risks of Material Misstatement, there is increased focus on financial relationships and transactions with executive officers. In addition to reading employment contracts and proxy disclosures, the auditor is facing several new requirements related to executive officer compensation that will impact compensation committees, including:
- A specific requirement to inquire of the compensation committee chair regarding “the structuring of the company’s compensation for executive officers.”
- Needing to obtain an understanding of executive compensation, including at least two specific matters under the control of the compensation committee:
- Changes or adjustments to incentive compensation arrangements, and
- Special bonuses.
Since the focus is on risk assessment, the auditors may go beyond the executive officers. If the compensation committee is involved in, for example, the incentive plan for all officers, the auditor could also ask about the structure of those incentives.
The revised standards apply to audits of financial statements for fiscal years beginning on or after December 15, 2014, including reviews of interim financial information within these fiscal years.
We expect that companies will want to prepare their compensation committee chairs for these auditor meetings. This ongoing auditor interaction may also be added to the duties of the compensation committee in its charter at the next revision.
In our September 4 post, we discussed the case for eliminating the Section 162(m) disclosures in proxy statements. Here is an alternative view of the subject.
It is worth looking back at the reasons for virtually every CD&A having a Section 162(m) disclosure. Here is a brief history:
- Before the 2006 revamp of the rules, the SEC had required discussion of a company’s Section 162(m) policy.
- The CD&A rules give as an example of possibly material information: “the impact of the accounting and tax treatments of the particular form of compensation”.
- In the adopting release, the SEC stated:
Regarding the example noting the impact of accounting and tax treatments of a particular form of compensation, some commenters urged that companies be required to continue to disclose their Internal Revenue Code Section 162(m) policy. The adoption of this example should not be construed to eliminate this discussion. Rather, this example indicates more broadly that any tax or accounting treatment, including but not limited to Section 162(m), that is material to the company’s compensation policy or decisions with respect to a named executive officer is covered by Compensation Discussion and Analysis. Tax consequences to the named executive officers, as well as tax consequences to the company, may fall within this example.
Most companies interpreted the CD&A rules to apply the prior “presumption” of materiality to the Section 162(m) disclosure and continued their prior practice of making a disclosure.
What is the right approach now? If a company wants to eliminate the disclosure, the question is materiality. As with most materiality questions, there are different ways to look at it.
Virtually all companies where the deduction may be in question will adopt Section 162(m)-compliant compensation plans and then follow the Section 162(m) requirements in paying some compensation. The potentially most material aspects of Section 162(m) from a disclosure perspective are the requirement to use preapproved performance goals and the limits on grant sizes and types. Also, most companies will not give up a deduction without Section 162(m) being a part of the decision process. Does this mean that Section 162(m) was material in the decisions?
On the other hand, the actual tax savings from Section 162(m) as a number is not material for most companies. And it is difficult to maintain that the disclosure continues to be useful to shareholders, particularly given shareholder complaints about the growing length of the CD&A and the SEC’s past statements that the CD&A should avoid boilerplate disclosures.
If a company determines that the Section 162(m) disclosure should be maintained, it is worthwhile to look at the disclosure in light of the shareholder litigation. There may be tweaks to the disclosure that would reduce the likelihood of a Section 162(m) disclosure-related shareholder claim.
Abercrombie & Fitch has negotiated a settlement to a shareholder derivative suit alleging excessive CEO pay for up to $2.78 million in attorneys’ fees and an agreement to make a series of governance-related changes:
Abercrombie agreed to appoint a chief ethics and compliance officer, tie executive pay more closely to performance, bolster anti-corruption compliance training, and limit access to nonpublic data to Jeffries’ partner and other third parties, among other provisions, court papers show.
The suit was filed in the wake of the company’s failed 2013 say-on-pay vote. In March, prior to the suit being filed, the company announced a number of changes to the executive compensation program to address shareholder concerns.
Plaintiffs’ compensation-related demands included: (i) having the chair of the compensation committee meet at least annually with the company’s 10 largest shareholders to discuss executive compensation matters; (ii) making 100% of the CEO’s long-term incentive award dependent on the achievement of performance conditions; (iii) subjecting annual and long-term incentive awards to multiple challenging performance metrics including some non-performance metrics; and (iv) removing language allowing the company to make adjustments to performance metrics to exclude certain costs.
A suggestion from John Kelsh at Sidely Austin which makes a lot of sense:
For many years, a stand-alone section on “Tax Considerations” has been a standard feature of the CD&A. These sections typically focus on Section 162(m) considerations and contain generic statements regarding the desire to maximize tax efficiency while also retaining the need for flexibility. In 2014, some companies omitted these sections. Deletion seems advisable in many instances, particularly given that these sections (i) have sometimes been targeted by plaintiff’s firms, (ii) are generally little more than boilerplate and (iii) rarely contain any material information (and thus are not required to be disclosed under Item 402(b)(2)). Companies wishing to streamline and focus their CD&A on meaningful disclosures may wish to consider doing the same.