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2015 Compensation & Governance Outlook Report

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Each year, Equilar highlights critical topics that will affect those dealing with compensation and governance issues in the upcoming year. The Compensation & Governance Outlook Report aims to cover an assortment of relevant and developing trends in the fields of executive and director compensation, equity trends, and corporate governance.

There were a number of noteworthy stories in 2014, including an intensifying climate around shareholder activism, high-profile initial public offerings, increased shareholder engagement efforts, and a strengthening market that led to a further resurgence in M&A activity.

Developments such as these will continue to shape the corporate landscape well into 2015 and beyond. Continuing discussions with shareholders will drive more changes as companies ensure their compensation efforts are communicated through a variety of mediums and methods. Concerns around fairness in a number of areas, including pay equity, will only increase the focus on board decisions and processes. Topics featured prominently in this year’s report include board diversity, shareholder engagement initiatives, Say on Pay responses, and pay for performance disclosures. The topics covered are organized into one of three categories: Disclosure & Governance, Executive Pay, and Board of Directors.

Key Findings

  • Peer group disclosures continue to evolve. Many companies have moved beyond the traditional peer group disclosure of listing the peer companies, instead opting to provide additional financial and industry context regarding the selection of peers through charts and tables.
  • Shareholder engagement and company outreach are becoming standard. Disclosure of shareholder engagement has increased in frequency over the past six years among S&P 100 companies. In 2014, 65 companies disclosed some form of engagement with shareholders in the proxy statement, up from only seven companies in 2008.
  • Alignment between pay and performance is becoming increasingly visual. In addition to the increased use of the phrase throughout the CD&A, companies are also demonstrating “pay for performance” alignment through innovative graphs and tables.
  • Pay ratio disclosures are already beginning to emerge. While the SEC has yet to finalize rules on the CEO pay ratio disclosure it proposed last year, a handful of companies have begun including similar ratios within proxy statements.
  • Companies are finding new ways to communicate director qualifications. Several leading companies have included director skills matrices that provide a comprehensive overview of both the skills the company seeks and the representation of those skills by each board nominee.

Disclosure & Governance

Disclosure Enhancements in Peer Group Selection

When selecting peers, companies aim to provide justification to shareholders for why certain companies were included in the comparator group. While explanations vary, companies often reference the peers’ industry classifications, financial metrics (such as market capitalization or revenue), or competition for talent. It is important for companies to communicate through disclosure that the selected companies are in fact appropriate for benchmarking purposes and have not been “cherry-picked,” or selected with the intent of increasing compensation for executives through the inclusion of aspirational peers. The peer companies will often operate in similar industries and, where possible, have similar cost structures or business models. The stronger the fit in these key areas, the more robust and informative the ensuing compensation and performance data will be for the company. Many companies have moved beyond the traditional peer group disclosure of listing the peer companies and selection criteria used. Instead, these companies are opting to provide context around the selection of peers through additional charts and tables.

Say on Pay Votes Prompt Significant Responsescsuite16_compensation_and_governance_outlook_chart1

As has been the case since the implementation of Say on Pay, approval rates remained high across the Russell 3000 index with 97.7% of companies passing in 2014. Of companies holding annual meetings through November 15 of this year, only 67 received less than majority support. For the first time, more than half of the Russell 3000 companies received greater than 95.0% support.

The majority of companies that failed their 2013 Say on Pay vote made efforts to address the issues raised by shareholders. More than 85% of companies who failed in 2013 included disclosure about their efforts to alter their compensation strategy in their 2014 proxy. Half of these companies reached out to proxy advisory firms, such as ISS and Glass Lewis. With so few companies receiving less than majority support, public scrutiny and shareholder pressure can become focused on them.

Companies that failed their Say on Pay in 2013 faced pressure to engage their shareholders and proxy advisors alike and make changes in order to avoid a repeated failing vote. The companies that disclosed a consultation with proxy advisory firms attained an increase in approval rate, with an average change of 32.8 percentage points.

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Shareholder Engagement and Outreach Efforts

Shareholder engagement can take a number of forms, including distributing written materials, hosting virtual meetings or webcasts, and even convening in-person meetings. Disclosure of shareholder engagement has increased in frequency over the past six years among S&P 100 companies. In 2014, 65 companies disclosed some form of engagement with shareholders in the proxy statement, up from only seven companies in 2008.

Companies failing a Say on Pay vote or those that exhibit poor performance will often disclose shareholder engagement undertaken to address any shareholder concerns. The effective communication of any adjustments made to align company policies and programs with the interests of shareholders is critically important. Of the companies that failed their 2013 Say on Pay vote, 20 disclosed shareholder outreach as a response. On average, the voting results of the 2014 Say on Pay of those companies increased by 22.6%.

While shareholder engagement is a tool that can help companies that are experiencing issues concerning the alignment of pay and performance, it is no longer used solely by companies as a reactionary measure. In addition to generating goodwill, proactive engagement with shareholders allows boards to assess any potential disconnects between parties prior to the annual meeting. An increasing number of companies are recognizing that disclosure of shareholder engagement is generally perceived to be good corporate governance practice and are proactively engaging with shareholders as a result.

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Executive Pay

Emphasizing the Alignment between Pay and Performance

With the value of their investments derived from the underlying performance of the companies in which they invest, it is no surprise that shareholders pay close attention to how a company’s performance aligns with the compensation of its executive team, particularly in the wake of Say on Pay. “Pay for performance” has emerged as one of the key phrases in executive compensation over the last several years. As such, many companies do what they can to assure shareholders that they make this link between pay and performance as strong as possible. This linkage is critical for companies in demonstrating that the long-term interests of shareholders are being considered in the context of compensation decisions. Whether by simply stating within the CD&A that pay for executives is in line with the performance of the company, or by including entire sections and graphs about “pay for performance,” companies are committing larger portions of their proxy statements to addressing the alignment.

The phrase “pay for performance” was disclosed in 84 out of the S&P 100 companies’ proxies in 2014, up from 60 of the S&P 100 companies in 2009. In addition to the increased use of the phrase, companies are also demonstrating a “pay for performance” philosophy through alternative graphs and tables. By comparing company performance to compensation within a graph, shareholders are able to easily discern a clear relationship, or lack thereof in some cases. The frequency of “pay for performance” graphs has increased from four S&P 100 companies in 2009 to 23 in 2014.

Renewed Focus on Incentive Plan Metrics

Incentive plans often have set threshold, target and maximum amounts that pay out depending on the performance of the plans’ metrics. In addition, each metric often has its own threshold, target and maximum values that determine percentages of plans’ payouts. When setting the metrics for incentive plans, the ability for the targets to be achieved has become a focal point for issuers, shareholders, and proxy advisors. Companies frequently have disclosure regarding the rigor of selected performance metrics that are featured in both the annual and long-term incentive plans. In the event that the metrics are not perceived to be rigorous enough, companies can subject themselves to criticism from shareholders or proxy advisors.

Several companies address rigor in some form within the proxy statement in an effort to combat the possibility of criticism. Increasing targets or changing companies used in performance peer groups are common ways to increase the rigor within incentive plans. For example, United States Steel (X) increased the threshold, target, and maximum relative TSR for its long-term incentive plan.

Including disclosure about the rigor of the performance metrics may only partially satisfy shareholders wishes. Quantitative evidence provides a complete picture that the metrics set were rigorous, but this can be difficult to convey to shareholders. An interesting case involving the rigor of performance metrics is Apple (AAPL). Although Apple received a great deal of attention resulting from mega-grants of equity within its compensation program in recent years, the company also has an annual cash incentive plan which includes specific annual performance metrics. The plan’s metrics are net sales and operating income, which have been consistently selected for its plan over the past several years. Despite more than a $6 billion decrease from actual operating income in Fiscal 2012, the maximum payout was paid out in fiscal 2013 with an operating income of $48,999 (millions). This was the third consecutive year that Apple was able to achieve a maximum payout through its annual incentive plan. The rigor of the performance metrics in Apple’s annual incentive plan would presumably be an area of concern for shareholders, yet Apple’s Say on Pay vote percentage increased from 59.7% in Fiscal 2012 to 95.7% in Fiscal 2013.

The Pay Ratio and Internal Pay Equity Considerations

Under current SEC rules, companies are required to provide extensive information about the compensation of their CEO and other named executive, or Section 16, officers. Companies have not, however, been required to disclose the same compensation information for employees outside of the C-suite. Section 953(b) of the Dodd-Frank Act directed the SEC to amend existing rules to require companies to disclose the median of the annual total compensation of all employees of a company along with a ratio of that median to the annual total compensation of the company’s CEO. On September 18, 2013, SEC proposed a rule in accordance with the Dodd-Frank mandate that would require companies to begin disclosing this new ratio within company proxies as early as 2016. Among other details included in the proposal, the SEC outlined a summary of the new pay ratio rule, discussion of methodology for identifying the median employee as well as those covered by the rule, and direction as to how total direct compensation should be calculated.

The forthcoming adoption of this CEO-to-median-worker pay ratio by the SEC again brings the discussion about pay equity to the forefront. While the vast majority of companies are awaiting final guidance from the SEC before implementing processes and systems to comply with the pay ratio rule, a small number of companies have already included such a ratio within their proxy statements.

Board of Directors

Director Qualifications and Skill Matrices

An SEC rule finalized in 2010 required companies to disclose, for each director and nominee, the particular experience, qualifications, and attributes or skills that led the board to conclude the individual should serve as a director of the company. Companies have approached this disclosure requirement in a variety of ways. To facilitate shareholder understanding of director skills and qualifications, many are now frequently opting to clarify directors’ skills by providing separate sections to highlight this particular area. Whereas previously, qualifications and skills were listed in director bios, disclosure methods have evolved in the way by which director qualifications are presented. A number of companies now disclose qualifications in their director bios in a separate section labeled “Qualifications” or “Skills.” This cleaner approach allows shareholders to more easily identity relevant skill sets of each director. Rather than reading through large paragraphs, their eye is drawn to a separate section.

Tackling the Issue of Board Refreshment

While the issue of gender diversity on corporate boards has rightfully gained greater attention in recent years, another equally critical issue is beginning to emerge in boardrooms. Board refreshment and planning for director succession are key tasks that are starting to be examined more closely in the context of optimal board performance. The argument against long-tenured directors is that service beyond a certain number of years may compromise a director’s independence from management and his or her ability to be objective. A multitude of long-tenured directors at one company may indicate a lack of refreshment of the skills and perspectives required by the board. At the same time, many long-tenured directors offer invaluable experience and intimate knowledge of a company’s operations within a particular industry that would not be easily replaced.

Earlier this year, State Street Global Advisors unveiled its new policy around its evaluation of director tenure. The State Street policy is more nuanced than a strict limit on tenure in that it considers average board tenure, the pervasiveness of very long-tenured non-executive directors, and whether the company has a classified board structure. Although ISS does not currently use director tenure as a key factor in its recommendations for director elections, it does weigh director tenure in its Governance QuickScore. ISS examines whether a company has “excessive” director tenure (measured at more than 9 years) as a governance factor within its QuickScore rating. Glass Lewis, on the other hand, explicitly states within its voting guidelines that director age and term limits typically are not in shareholders’ best interests. The renewed focus on board refreshment and succession planning appears poised to stay, and as such, many companies are finding ways to highlight the issue within the proxy. 


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