Compensation Disclosures

Part 2. The Basics of Executive Compensation Design

In the past, the proxy statement disclosure of executive compensation was viewed largely as a legal compliance document. Corporate legal departments generally took the lead in drafting the materials with support from the compensation committee who assembled the information required for the compensation tables. As a result, proxy statements were often challenging to read. Technical jargon was used frequently and the bare minimum level of disclosure required to comply with regulations was often provided.

With the advent of the management Say on Pay vote, companies now view the proxy statement — and particularly the Compensation Discussion and Analysis (CD&A) — as a critical communications document. Rather than a compliance document, the CD&A and supporting materials in the proxy statement are the means for the company to make the case that its executive compensation program is effective in supporting pay-for-performance, aligning management’s interests with those of shareholders, and retaining key executives. As a result, companies have been working to modify their disclosure to make proxy statements more user friendly and better communications documents.

Below is a brief summary of some of the key developments in proxy statements, with a focus on the CD&A.

Use of an Executive Summary

In our view, the executive summary is the most important section of the CD&A. It provides the company with an opportunity to boil down its compensation decisions in the relevant year to the essentials. Even though the SEC does not require an executive summary, most companies have adopted this approach. While each company has a different compensation program, well-written executive summaries of the CD&A share the same structure:

Company Performance: This section provides a written or graphic summary of the performance of the company. It addresses TSR and key financial performance metrics that are used in the annual and long-term incentive plans. Companies can also include important strategic milestones (e.g., product launches or business acquisitions) and operating achievements (e.g., cost reductions or succession planning) from the year.
Incentive Compensation Payouts: This section describes how the company’s performance impacted annual and long-term incentive plan payouts (e.g., above-plan financial performance led to above-target annual incentive payouts). If performance fell short of expectations, it will demonstrate that there was an associated impact on pay.
Target Compensation Levels: This section describes how the committee arrived at target pay decisions for the executive team, referencing the company’s pay philosophy.
Compensation Design Changes: This section highlights any changes to the company’s annual or long-term incentive design, or any other executive compensation changes. It also provides the reason for these changes.
Highlight Positive Program Features (“What We Do/What We Don’t Do”): This section informs shareholders of positive aspects of the program (e.g., ownership guidelines, stock holding requirements, anti-hedging policy, etc.) and negative aspects that are absent from the program (e.g., excise tax gross-ups, single-trigger vesting of equity following change in control, excessive perquisites, etc.).

Assist the Reader

Proxy statements used to read like legal documents and anyone who has ever read a legal document can tell you that the writing is often difficult to understand.

Therefore, the SEC has encouraged companies to use plain English in describing their compensation programs and companies have taken this to heart. There is a lot of jargon specific to the field of executive compensation and should be avoided wherever possible.

As part of the move toward clearer communication, companies have tried to aid the reader by breaking up long blocks of text and calling out the topic under discussion more clearly. In addition, many companies have introduced tables and graphics to enhance the readability of the proxy statement.

Pay Versus Performance Disclosure

The SEC issued final rules on pay versus performance in September 2022. Dodd-Frank 953(a) requires issuers to show “…the relationship between executive compensation actually paid and the financial performance of the issuer…” The SEC has decided to use an approach for equity-based compensation similar to “realizable pay” and essentially “marks to market” outstanding and unvested equity awards on a “fair value” basis from the grant date to the vesting date. This approach effectively accrues the equity value over the vesting period, with the heaviest impact on value likely to be in the year of grant. It is a fundamentally different approach from the proposed rules of 2015 where the value of equity would have been recognized in its entirety upon vesting, similar to existing definitions of “realized pay.”

The final rules require companies to prepare a table disclosing compensation actually paid to the named executive officers (NEOs) next to SCT totals and key metrics, over a five-year history. The metrics required to be disclosed in the table are: the company’s indexed TSR over the period, indexed TSR of peer group, GAAP net income, and a financial metric of the company’s choosing. Companies will need to describe the relationship between compensation actually paid and each of the financial metrics included in the table, using a graphical and/or narrative approach. Furthermore, companies must provide a list of three to seven metrics they deem most important in making executive compensation decisions, which may include non-financial measures if at least three are financial metrics.

The rules require a three-year history in the proxy statement for fiscal year ended on or after December 16, 2022, a four-year history in the 2024 proxy and a full five-year history in 2025 and beyond. Smaller Reporting Companies (SRCs) will have pared-down requirements. The new Pay Versus Performance disclosure may be located anywhere in the proxy or information statement; it does not need to be incorporated into the Compensation Discussion & Analysis.

Key Questions for Committee Members to Ask:

Does the executive summary clearly relay the company’s pay-for-performance story?
Does the CD&A tell the reader why we did what we did, or does it merely say what we did?
Are there opportunities to condense the document?
Can we avoid unnecessary jargon and use plain English?