Compensation Policies that Support Good Governance

Since the financial crisis of 2008, US public companies have made great efforts to improve corporate governance. The corporate governance reforms included in the Dodd-Frank Act of 2010 accelerated this movement by requiring shareholders to approve executive compensation on a non-binding advisory basis, beginning in 2011. Companies worked to strengthen their compensation policies as a way to increase shareholder support for Say on Pay proposals. Certain executive compensation program elements quickly evolved from “nice-to-have” status to “expected.” In this section, we summarize five common policies that enhance the alignment of executives with shareholder interest and support strong governance.

Stock Ownership Guidelines

CEOs and other senior executives receive the majority of their compensation in the form of company stock. Stock ownership guidelines have been established by 98% of companies in the CAP 120 to ensure that executives hold onto a pre-defined level of the company’s stock over the course of their tenure with the company. Shareholder advisory firms and institutional shareholders support ownership guidelines, viewing ownership of company stock as a way to align management with shareholders. Most compensation committee members also support the use of stock ownership guidelines but recognize that executives may have some desire to diversify their interests out of company stock over time.

Most stock ownership guidelines share certain characteristics, as summarized below:

*Stock Ownership Guideline Feature*	*Market Approach*
Basis for Requirement	A majority of companies (95% of CAP 120) define ownership as a multiple of base salary A minority of companies (5% of CAP 120) define ownership as a number of shares
Requirement	CEO: 5x-6x salary is most common (56% of CAP 120) Other NEOs: 3x-4x salary is most common
Time to Comply	Five years to comply is the most common (from date of hire or promotion to executive role or for any increase in guideline)
Shares Counted Toward Compliance	Shares owned outright Shares held in company benefit plans Unvested, time-vested restricted stock or restricted stock units (in some cases on a net of tax basis) Unvested performance shares and unexercised stock options typically do not count toward compliance
Assessment of Compliance	At least annual testing of compliance Many companies use an average stock price over a period of time (e.g., average for the year)
Consequence if not in Compliance	Most companies expect executives to comply, but do not have formal consequences for noncompliance Most common “penalty” is to require that all or a portion of shares (net of taxes) vesting be held until guideline is achieved

In practice, most executives are able to comply with ownership guidelines over a five-year period without making any purchases in the open market. This is particularly true for companies that deliver a substantial portion of their long-term incentives in restricted stock or performance shares. Companies that use stock options as the primary long-term incentive may inadvertently encourage early exercise of stock options if they require executives to comply within five years.

When a company experiences a severe decline in the stock price, executives may fall out of compliance with the ownership guidelines. Committees are often lenient in assessing compliance as long as executives do not fall out of compliance due to the sale of shares.

Key Questions for Committee Members to Ask:

Are our stock ownership guidelines consistent with the levels of peers?
Do our compensation programs deliver adequate shares so that executives will not need to purchase shares to achieve the guidelines?
Are our executives all in compliance with the ownership guidelines? If not, do the noncompliant executives still have sufficient time to achieve compliance?
What are the consequences of failing to achieve the ownership guidelines within the specified compliance period?

Stock Holding Requirements

Stock holding requirements are similar to stock ownership guidelines. They require an executive to hold all or a portion of the shares delivered at vesting of full-value shares or at exercise of stock options for a defined period of time. Stock holding requirements first arose out of concerns that executives may have incentives to “pump and dump” a company’s stock. That is, they may take actions that lead to a short-term increase in the company’s stock and immediately sell shares before the market recognizes that the shares are overvalued. In theory, this makes sense for stock options, since the executive could time the stock option exercise, but it is harder to make the case that stock holding requirements are necessary for full-value shares, where executives do not control the timing of vesting.

Key features of stock holding requirements include the following (based on the CAP 120):

*Stock Holding Policy Feature*	*Market Practice*
Shares to be Held	Typically applies only to net shares (i.e., net of any shares used to satisfy the option exercise price or taxes on the shares)
Application	Most include option exercises Some include vesting of restricted shares Some also apply to payouts of performance shares
Percentage of Shares Held	100% is the most common; 50% of net shares is also common
Period of Time	Most companies have a 1-year holding requirement 28% of companies require the shares to be held until retirement

Similar to their treatment of stock ownership guidelines, shareholder advisory firms view stock holding requirements as an effective shareholder alignment tool, preferring that companies adopt these policies, even if they already have stock ownership guidelines. However, many committee members and executives view stock holding requirements as redundant if ownership guidelines are already in place. Approximately 66% of CAP 120 companies disclose a holding requirement. Among the CAP 120, 28% of companies have a holding requirement that is separate from stock ownership guidelines or comes into effect after stock ownership guidelines are met. Some shareholders and advisory groups have promoted the concept of holding requirements until retirement. While this concept has not caught on to date, there is a minority of companies — particularly in the financial services industry — who have implemented this approach.

Key Questions for Committee Members to Ask:

Will stock holding requirements encourage executives to retain company stock beyond current holding levels?
Will stock holding requirements improve shareholder advisory views on our compensation program?
How are our stock holding requirements viewed by executives? Would adopting guidelines meaningfully change executive behavior?
How do our stock holding requirements align with our stock ownership guidelines?

Clawbacks

A clawback provision provides the company with the ability to recoup previously paid compensation to executives if a triggering event takes place. Sarbanes-Oxley mandated that incentive compensation for CEOs and CFOs be subject to clawback by the SEC in the event financial results are restated due to misconduct. Dodd-Frank includes a clawback provision that applies to all executive officers in the event of a financial restatement that would reduce incentive payments. A key distinction between the Sarbanes-Oxley and the Dodd-Frank clawbacks is that the latter does not require executive misconduct to trigger the clawback.

*Clawback Policy Feature*	*Market Practice*
Triggering Event	Most common approach is financial restatement (approximately 83% of CAP 120 companies) and/or misconduct that would have impacted incentive payments (74% of companies) Many companies have expanded their policy to include behavior or activity (e.g., violation of company policy) that results in a material financial or reputational impact to the company. Some companies include violation of restrictive covenants (e.g., non-solicitation or non-compete agreements) as a triggering event
Application	Among larger companies, typically applies to both annual and long-term incentive plans
Period of Time	1–3 years is the most common lookback period that companies use when seeking to reclaim compensation

The underlying rationale for a clawback is that incentive payments based on inaccurate financial statements have not been earned fairly by executives and should be returned to the company, particularly in cases where the restatement was due to executive misconduct. This rationale is compelling and is accepted as reasonable by most compensation committee members. In addition, most shareholder advisory firms support the use of clawbacks.

While the rationale for clawback policies is sound, in practice they are seldom used to recoup compensation from executives. It is often challenging to determine how much an executive was overpaid due to a financial restatement, particularly when the value of equity-based compensation is not directly linked to a company’s financial statements. There may also be legal barriers to recovering compensation from executives.

Clawback Policy Requirement

Effective December 2023, the SEC issued final rules that require all companies listed on the NYSE or NASDAQ to adopt and enforce a clawback policy in compliance with the following provisions mandated by the SEC.

According to the final rules, clawbacks are triggered by all accounting restatements, including both “big R” and “little r” restatements. A “big R” restatement occurs when an issuer is required to prepare an accounting restatement that corrects an error in previously issued financial statements that is material to the previously issued financial statements. This requires an 8-K disclosure. A “little r” restatement corrects an error that would result in a material misstatement if the error were not corrected in the current period or left uncorrected. This type of restatement is frequently deemed not to be material and does not require 8-K disclosure. This was the largest departure from the proposed rules, which only required a “big R” restatement to trigger a clawback.

Current and former executives are subject to the new rules. Compensation received by former executives will be subject to the clawback policy. Companies are not allowed to indemnify executives against the loss of erroneously awarded compensation. The clawback applies to incentive compensation that is determined based on financial measures (including TSR or stock price). Time-vested restricted stock/RSUs and stock options are not subject to clawback.

Boards generally do not have discretion in applying the clawback. They can determine not to pursue it if the direct cost of seeking it will be greater than the amount to be recovered. There are exceptions if the clawback is deemed to violate the executive’s home country law or if it would negatively impact a qualified retirement plan.

The company is required to look back to the three most recently completed fiscal years before the date that the issuer is required to prepare an accounting restatement.

The policy must be disclosed in any information statements that call for Item 402 disclosure, including the proxy statement and as an exhibit to the 10-K. If the policy is applied, the company must disclose in its proxy statement how the clawback policy was applied and amend SCT amounts for any named executives impacted by the recoupment.

Many companies maintain a broader clawback policy than that mandated by Dodd-Frank.

Key Questions for Committee Members to Ask:

Should we adopt a clawback policy beyond the Dodd-Frank requirements? If so, what triggers are best? Do we require misconduct, or should it apply to violations of employment covenants?
If we adopt a supplemental clawback policy, who will be responsible for informing the committee of the occurrence of a triggering event?
Who will be responsible for determining the amount of incentive compensation that needs to be clawed back?
How much discretion will be available to determine how a clawback will be applied?

Hedging

Hedging is a sophisticated technique where an investor attempts to limit losses created by movement in the stock price of a given security by taking an offsetting position. Common examples of hedging vehicles include short sales, put options, and futures. Only a few years ago, hedging of company stock by executives was mentioned rarely when discussing executive compensation. This has changed since Dodd-Frank was implemented and the proxy advisory firms began focusing on hedging.

Most committees have assumed that executives would not hedge equity-based compensation by selling company shares short or using other strategies to protect themselves from decreases in the value of the company’s stock. However, Dodd-Frank requires that companies disclose whether or not their employees or directors were allowed to hedge their interests in company stock. Companies that have implemented policies have generally taken a broad approach in prohibiting all hedges on the company’s stock.

Committees have generally embraced anti-hedging requirements as they help ensure that equity-based compensation aligns the interests of management with those of shareholders. Most agree that allowing executives or directors to hedge their positions in company stock undermines this goal.

Hedging Policy Disclosure Requirement

In December 2018, the SEC adopted new rules requiring disclosure of a company’s hedging policy. The hedging policy was initially proposed by the SEC on February 9, 2015 under Section 955 of the Dodd-Frank Act. It requires companies to disclose in the proxy (or information statements relating to the election of directors) any practices or policies regarding the ability of employees or directors to engage in certain hedging transactions with respect to company equity.

Per the final rules, companies are required to describe any practices or policies they have adopted regarding the ability of employees, officers, or directors to hedge. The SEC made clear that companies could satisfy the disclosure requirements by either providing a fair and accurate summary of the hedging practices or policies that apply, including the categories of persons they affect and any categories of hedging transactions that are specifically permitted or specifically disallowed, or, alternatively, by disclosing the practices or policies in full. If the company does not have any such practices or policies, the company must disclose this fact or state that hedging transactions are generally permitted.

Key Questions for Committee Members to Ask:

Do we have a policy prohibiting the hedging of company stock? If not, why?
Does our hedging policy apply to all employees and directors? If not, which employees does it apply to?

Pledging

Pledging of company shares occurs when an executive uses shares as collateral for a margin loan or other financial transaction. In its 2025 policy statement, ISS indicated that significant pledging of company shares could serve as the basis for recommending a withhold vote for directors. ISS’s concern stems from a risk that executives may need to sell pledged shares to satisfy their obligations, and that could undo the positive incentive effects of using equity as a shareholder alignment tool or limit executives’ ability to comply with ownership guidelines. Forced sales of company stock could also cause the executive to violate insider trading rules.

While pledging of shares was not a widespread practice, several high-profile cases involving company founders who owned large blocks of stock have received negative publicity. In addition, the prospect of a withhold vote for executives encourages companies to take share pledging seriously.

Key Questions for Committee Members to Ask:

Do we have a policy prohibiting the pledging of company stock? If not, why?
Do any executives or directors currently engage in pledging transactions?