It is time to start preparations for the 2023 proxy season. The most significant change this year is the adoption of the final rules to implement compensation disclosure obligations under the new Section 14(i) of the Securities Exchange Act of 1934, as amended (the “1934 Act”), required by Section 953(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The new rules include the addition of Item 402(v) of Regulation S-K, which requires a public company to disclose the relationship between executive compensation and the company’s financial performance. There are also related ongoing developments in environmental, social and governance (“ESG”) disclosures, both mandated and discretionary, which companies should keep in mind when preparing their proxy and information statements. These new rules and developments are summarized below.
Compensation Disclosure Rules
Congress added Section 14(i) to the 1934 Act and directed the U.S. Securities and Exchange Commission (the “SEC”) to adopt rules requiring public companies to provide a comparison of executive compensation to a company’s financial performance. The new requirements are contained in Regulation S-K Item 402(v) and require disclosure of a comparison of executive compensation to a number of specific pay-versus-performance measures (summarized below) in any proxy statement or information statement in which disclosure relating to executive compensation is required under Item 402 of Regulation S-K. The SEC release relating to these new rules can be found here (the “Release”) and a summary fact sheet published by the SEC can be found here.
The new rules, which are effective beginning with fiscal years ending on or after December 16, 2022, apply to all public reporting companies except foreign private issuers, registered investment companies and emerging growth companies. Smaller reporting companies (“SRCs”) are subject to less onerous disclosure requirements as noted below. Such new disclosures will not be deemed to be incorporated by reference into any filing required under the Securities Act of 1933, as amended (the “Securities Act”) unless the registrant chooses to do so.
Pay vs Performance
Item 402(v) requires registrants to provide in a table format similar to the example included below the following pay-versus-performance measures: (a) year; (b) total compensation amount shown in the summary compensation table (“SCT Total”) for the company’s principal executive officer (“PEO”); (c) compensation actually paid to the PEO; (d) average SCT Total for the company’s remaining named executive officers (“NEOs”); (e) average compensation actually paid to the remaining NEOs, (f) cumulative total shareholder return (“TSR”) of the company; (g) the TSR of the company’s peer group; (h) the company’s net income; and (i) the measure chosen by the company and specific to the company as a measure of financial performance (the “Company-Selected Measure”). Non-SRC registrants must provide information for their five most recent fiscal years, while SRCs need only provide information for their two most recent fiscal years beginning in the year in which they first provide the disclosure, and thereafter they must provide such information only for their last three fiscal years. SRCs also need only provide certain metrics of those listed above. The metrics marked in the table below with an asterisk are those which SRCs are exempt from disclosing.
In light of the new disclosure requirements, companies should begin compiling the necessary data and information well in advance of the 2023 proxy statement.
Compensation Actually Paid
Out of the metrics required under the new rules, calculating total compensation actually paid is likely to present the most time-consuming element of the new rules because it encompasses the following three adjustments:
- Pension Benefits. Companies (other than SRCs) must (1) deduct from the SCT Total the aggregate change in the actuarial present value of the executive’s accumulated benefit under all defined benefit and actuarial pension plans and (2) add back (a) the service cost for services rendered by the executive during the applicable year and (b) the entire cost of benefits granted in a plan amendment or initiation during the covered fiscal years that are attributed to services rendered in the period prior to the plan amendment or initiation.
- Equity Awards. Equity awards are required to be disclosed in the years in which they were granted with changes in values disclosed year to year thereafter until the awards have vested or the company determines the awards will not vest. Companies must deduct or add, as applicable, the equity award amounts reported in the SCT Total and then include a specially calculated amount (set forth in Item 402(v)(2)(iii)(C)(1)).
- Deferred Compensation. Compensation actually paid must also include above-market or preferential earnings on deferred compensation that is not tax-qualified.
Tabular Disclosure of Financial Performance Measures
Non-SRC Companies must disclose a tabular list of between three and seven financial performance measures which the company believes to be the most important financial performance measures used to link executive compensation actually paid to company performance. The list may include non-financial measures considered if the company believes them to be among their three to seven most important measures. The list may be broken down as follows: (i) one list for all NEOs, (ii) one list for the PEO and one list for the remaining NEOs or (iii) a separate list for each NEO.
Company-Selected Measure and Additional Disclosures
The information disclosed in the above table under Company-Selected Measure must represent the most important financial pay-versus-performance measure for the company not otherwise required to be disclosed under Item 402(v). Such measure may be a non-GAAP financial measure so long as disclosure is included describing how the information is calculated from the company’s audited financial statements. If a company does not use any financial pay-versus-performance measures or only uses measures required to be disclosed, then the Company-Selected Measure is not required.
Companies may also provide additional pay-versus-performance information beyond those that the new rules require, provided that such disclosure (i) would not be misleading or obscure the information required to be disclosed under the new rules, including by being presented with greater prominence than required information, and (ii) is clearly noted as supplemental.
Graphical Presentation or Narrative Discussion of Relationship of Pay to Performance
Using information from the table above, companies must provide clear descriptions of two key relationships. First, the relationship between compensation actually paid to the PEO and the average compensation actually paid to the other NEOs, and the company’s (A) TSR, (B) net income and (C) Company-Selected Measure. Second, companies must describe the relationship between total shareholder return of the company versus that of the company’s peer group. The presentation may be graphical, narrative or a combination of the two.
The increasing shift from traditional annual shareholder meetings to virtual annual shareholder meetings brought about by the Covid-19 pandemic has continued in 2022 and we believe that it will continue to be popular and remain regular practice for many companies. Virtual meetings may add efficiency to the flow of meetings, reduce travel expenses for both the company and investors, and lower the environmental impact of shareholder meetings. However, companies should take care to avoid any footfalls when opting to go virtual.
If using a virtual meeting format, a company should ensure that its proxy statement disclosure contains all relevant and necessary information for shareholders to attend and vote their shares, including procedural differences for record shareholders and beneficial shareholders to participate. In doing so,it is helpful to indicate whether there will be a telephone number, email address or chat feature available to report and resolve technical problems. Companies should also keep in mind that Regulation FD applies to the virtual meeting context – if there is a glitch, it is important to assess whether material, non-public information was involved, in which case a press release or Form 8-K would be necessary to comply with Regulation FD.
Integrating ESG considerations into strategy, risk management, human capital initiatives, and governance, and communicating ESG performance, have become business imperatives for many companies due to growing support for ESG shareholder proposals and increased demand for ESG reporting.
According to a study released in March of 2022 by the activist group As You Sow with the help of researchers including the Sustainable Investments Institute, 2022 saw a record number of ESG-related shareholder proposals for the annual meetings of publicly traded U.S. companies. As of March 2022, such
proposals were up 22% from the same point in 2021. Of such proposals, the most frequent topics related to diversity, equity and inclusion matters and, in particular, board diversity and climate risk.
In line with the growing support for ESG proposals, demand for ESG reporting has seen increasing attention as shareholders have begun to place greater emphasis on a company’s role as a member of society in addition to its ability to maximize shareholder returns. Today’s investors want to know how companies are addressing these issues from a profitability and risk management perspective. There are now also many organizations that rate companies separately based on their ESG initiatives and commitments.
The SEC has signaled that ESG disclosure regulation will be at the forefront of SEC Chair Gary Gensler’s tenure and, in the time since his appointment, has already announced several proposed rules and amendments relating to ESG disclosure requirements. However, while reporting ESG elements with respect to compensation is required in many jurisdictions around the world, the SEC has yet to require such disclosures. In the adopting release for the new compensation disclosure rules, the SEC addressed requests from several commenters to mandate the inclusion of ESG metrics and acknowledged the growing practice of linking pay to ESG performance but countered that such measures are typically not tied to “specific quantitative goals” and “are generally used in short-term incentive plans” rather than long-term incentive plans. Instead of making such disclosures a requirement, the SEC left the door open by providing a means for companies to include ESG disclosures as supplemental disclosures provided they meet the requirements noted above under “Company-Selected Measure and Additional Disclosures”.
Despite growing demand and awareness, movement toward ESG goals is still a work in process for most companies. For any companies considering including supplemental disclosures relating to ESG measures during this proxy season, care should be taken to avoid exposing the company to liability in the event any named metrics are not achieved. To avoid increasing the scope of potential liability, companies should consider describing ESG policies and commitments as goals rather than expectations and targets for what specific progress the company intends to make. Companies should also make sure that any ongoing disclosures in 1934 Act filings otherwise reflect consistency with such company’s broader goals and policies. As of today, none of this disclosure is required by the SEC, so the substantive legal risk lays in bad disclosure as opposed to no disclosure.
Human Capital Management
Remember too that recent amendments to Regulation S-K explicitly require a discussion of human capital resources, including the number of employees, as well as any human capital measures or objectives that the company focuses on in managing its business in the business section of an annual report on Form 10-K. There were some common themes for human capital disclosures in the annual reports filed in 2021, but companies varied widely in terms of presentation and the level of detail included. Some common topics covered in such disclosures included diversity, equity and inclusion, employee recruitment, turnover, retention and training, as well as labor relations.
When formulating human capital disclosures this year, companies should recognize that institutional investors have made human capital management disclosures a priority. Accordingly, companies should begin preparing this section of their annual report and any related proxy statement disclosure well in advance of the filing deadline to ensure accuracy which may involve review from multiple internal departments and outside advisors.
As we noted last year, proxy statement disclosure of board diversity details has been expanding over the past few years. In August 2021, the SEC approved Nasdaq’s board diversity rule, requiring Nasdaq listed companies to comply with the disclosure rules by the later of (i) August 8, 2022, or (2) the date the company files its proxy statement or information statement for its annual meeting of shareholders (or, if it does not file a proxy or information statement, the date it files its Form 10-K or 20-F) during the 2022 calendar year). Even before the approval of the Nasdaq board diversity rule, the EY Center for Board Governance found that 86 percent of Fortune 100 companies voluntarily disclosed the board’s racial and ethnic diversity in 2021.
Director and Officer Questionnaires
Because companies are required (or may choose) to include self-identified diversity characteristics in their proxy statements and/or on their websites, director and officer questionnaires are an efficient spot to gather such information. You should consider making conforming additions to such questionnaires in order to obtain the needed or desired information. Further, companies should keep in mind that state laws in some cases require disclosure of diversity information. Adding one or more questions to the director and officer questionnaire process may therefore be the best vehicle for gathering diversity information to satisfy both state and federal disclosure requirements.
Compliance with the new compensation disclosure rules will require careful planning and preparation, involving gathering additional peer group quantitative information. As a result, companies may want to start the process of preparing their proxy and information statements earlier than normal.
For more information, contact your CFDB lawyer or: