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A Fresh Take

Insights on M&A, litigation, and corporate governance in the US.

| 12 minutes read

Compensation-related considerations for the 2021 proxy season

Companies poised to enter into the upcoming annual report and proxy season should start disclosure preparations early in order to address the complexities that will have inevitably resulted from an unprecedented 2020. In particular, companies will need to take proactive steps to evaluate the impact of the COVID-19 pandemic on executive compensation, the role of new human capital management disclosure requirements and continued focus on diversity and inclusion, knowing that this year’s disclosures are likely to be heavily scrutinized by investors, proxy advisors and other stakeholders given the volatility and ethos of the preceding months. This post identifies several key executive compensation and related governance issues to keep in mind:

1. Compensation discussion and analysis (CD&A) disclosure for compensation decisions made in connection with COVID-19

 As has always been the case, companies should continue to strive to present the CD&A in a clear, well-detailed and balanced manner. This will be of increased importance as companies prepare to communicate executive compensation program changes prompted by the COVID-19 pandemic, and particularly the case for companies whose boards revised performance metrics or exercised discretion in determining incentive payouts. Compensation committees that have not already done so should develop a process and framework for reviewing the appropriateness of changes to compensation programs or in exercising discretion to determine 2020 annual incentive payouts. This process and framework will allow companies to explain the rationale behind the compensation committee’s decisions in the CD&A. For example, the CD&A may discuss whether the compensation committee reviewed the Company’s performance relative to its peers, its ability to meet cost cutting measures or liquidity objectives, or its ability to stage a recovery or prepare for one when approving compensation changes. A similar framework should be used in designing 2021 incentive programs and setting 2021 performance targets. For example, if an e-commerce company outperformed in 2020 due to COVID, is it appropriate to set 2021 financial targets below 2020 attainment levels? This is an issue that ISS has scrutinized in the past. Other design considerations compensation committees are assessing include using a range rather than a single target financial metric, increasing the use of relative rather than absolute performance measures and increasing the use of non-financial targets, such as strategic or sustainability goals. Moreover, while the CD&A requires only a discussion of compensation decisions related to the named executive officers, companies may choose to include a summary of the impact of COVID-19 on the broader workforce to provide context for executive pay decisions.

In preparing their compensation related disclosures, companies should also carefully consider policy guidance released by Institutional Shareholder Services Inc. (ISS) earlier this year that will inform its voting recommendations on say-on-pay proposals. For example, ISS indicated that COVID-related changes to annual incentive programs would not be viewed negatively “so long as the justifications and rationale are clearly disclosed, and the resulting outcomes appear reasonable.” In general, this flexibility will be reserved for cases where ultimate payouts are below target. ISS has stated that above-target payouts under changed programs will be closely scrutinized. In addition, while ISS will generally not support modifications to long-term incentive programs (positing that these programs should be designed to smooth performance over a multi-year period and not be altered because of short-term market shocks), the guidance indicates that ISS may still view more “modest alterations” as reasonable provided that companies offer clear disclosure related to the compensation committee’s action and rationale.

2. Recent guidance on perquisites disclosure and related Securities and Exchange Commission (SEC) enforcement actions

On September 21, 2020, the SEC’s Division of Corporation Finance issued Compliance and Disclosure Interpretation (C&DI) Section 219.05 addressing whether benefits provided to executive officers because of the COVID-19 pandemic constitute perquisites for purposes of identifying named executive officers and related proxy disclosures. Although the overall analysis of what constitutes a perquisite continues to apply, the SEC acknowledged that certain benefits previously considered perquisites, such as enhanced home technology, may no longer be considered as such when provided as a result of COVID-19 stay-at-home orders. On the other hand, new items prompted by COVID-19 such as health-related or personal transportation benefits will continue to be perquisites unless provided to all employees on a non-discriminatory basis.

The SEC has also continued to bring enforcement actions relating to the failure to properly report or disclose executive perquisites over the past several months, resulting in significant penalties. The improperly excluded disclosures related to, among other things, personal use of company aircraft, housing and hotel costs, and other personal travel and transportation expenses. Notably, the SEC has underscored that even if a benefit satisfies a business purpose, it may still be a perquisite and therefore require disclosure under the relevant SEC rules. The enforcement actions were generated by the SEC’s use of “risk-based analytics” – data analytics tools used to detect possible violations and trigger enforcement leads. The Director of the SEC’s Division of Enforcement has indicated that the SEC remain[s] focused on ensuring companies provide required disclosures, including those relating to travel-related perks and personal benefits and will continue to use risk-based analytics to identify companies that fail to comply.

Companies should periodically seek to evaluate their internal control practices for identifying, tracking and calculating perquisites and continue to apply the two-factor test noted below, being mindful of any new benefits that were provided in response to COVID-19.

      (i) an item is not a perquisite if it is integrally and directly related to the performance of an executive’s duties.

      (ii) otherwise, an item that confers a direct or indirect benefit and that has a personal aspect, without regard to whether it may be provided for some business reason or for the convenience of the company, is a perquisite or personal benefit unless it is generally available on a non-discriminatory basis to all employees.

Notably, even the two-factor assessment ultimately turns on judgment and can be difficult for company personnel to apply consistently in practice. As a result, companies are encouraged to err on the side of caution given the risk of significant cost and potential reputational harm that can result from being the target of an SEC enforcement action.

3. Revisiting CEO pay ratio calculation and disclosure in light of COVID-19

Companies should start calculations for the pay-ratio disclosure earlier than usual this proxy-season, particularly if they have faced significant workforce and compensation changes or volatility this year. The pay-ratio rule, which requires companies to disclose the total annual compensation of their median employee as compared to their chief executive officer, permits companies to identify the median employee only once every three years unless there has been a change in the employee population or employee compensation arrangements that the company reasonably believes would result in a significant change to the pay ratio. For companies that have used the same median employee since the rules were enacted in 2017, this year will require re-identification of the median employee. However, even companies that identified a new median employee in the last two years will need to evaluate whether referencing last year’s median employee is still appropriate if they have faced significant workforce changes due to COVID-19 (or otherwise). If a company determines that it is not necessary to re-identify its median employee, it will be required to briefly disclose the rationale for its conclusion. 

In addition, companies may need to confront additional complexities when defining the employee population from which the median employee will be identified. Under SEC rules, companies are required to consider all employees engaged by the company as of a “determination date” selected by the company that falls within the last quarter of its fiscal year. This includes all full-time, part-time, seasonal and temporary employees around the globe, subject to limited exemptions. Companies may annualize total compensation for full-time and part-time employees engaged for less than the full year (including employees on unpaid leaves of absences) but may not do so for temporary or seasonal employees.

The rules themselves do not however address the treatment of furloughed populations. Subsequent guidance released by the SEC acknowledges that the concept of a “furlough” may have different meanings for different employers and leaves it up to companies to determine whether furloughed populations will be regarded as employees depending on the facts and circumstances (CD&I 128C.04). In making these determinations, companies with furloughed populations should consider factors such as whether the furloughed individuals are still acting as employees (albeit on reduced workweek schedules) or if they have been on leave for several months with no clear prospect of return. If a furloughed individual is identified as an employee, the company must take the additional step of determining the appropriate subset of classifications and calculate total compensation accordingly.

Although the pay ratio rules do not require narrative explanations of the resulting figure, companies that experience significant change in the year-over-year ratio may nonetheless elect to offer disclosure to provide additional context around the unique circumstances brought to bear this year. 

4. Annual compensation risk assessment considerations

As is normally the case, companies should continue to ensure that an effective annual compensation risk assessment is conducted in connection with the preparation of their CD&A disclosure. Given the far-reaching economic impact of COVID-19 in 2020 and corresponding uncertainty regarding the severity and length of the pandemic in the long run, great care should be taken by companies to ensure that existing compensation programs, any modifications and future incentive designs are reviewed from a compensation risk assessment perspective in order to enhance the potential for incentive arrangements to produce desired business results and reward employees appropriately relative to performance.

5. Human capital management (HCM) disclosure 

On August 26, 2020, the SEC adopted final amendments under Regulation S-K as part of a Disclosure Effectiveness Initiative to modernize and improve corporate disclosures, which became effective on November 9, 2020. One of the key revisions is the addition of a new disclosure topic that will require SEC reporting companies to provide a description of their human capital resources to the extent such disclosures would be material to an understanding of the company’s business. This topic is required disclosure in annual reports on Form 10-K and certain registration statements.

Historically, the only specific business disclosure requirement directly related to human capital has been a rule that companies disclose the number of people they employ. The new regime calls for an expanded, in-depth evaluation of human capital as a source of sustainable value for the business by expanding the business disclosures under Item 101(c) of Regulation S-K. Companies will be required to disclose their human capital resources, including any human capital measures or objectives that they focus on in managing their business, to the extent material to an understanding of the company’s business taken as a whole.

The rules identify potential measures or objectives that address the attraction, development, and retention of personnel as non-exclusive examples of subjects that may be material, depending on the nature of the company’s business and workforce. In addition, companies should also give careful consideration as to whether some or all of the following potential HCM areas of focus and disclosure could be relevant, subject to the company’s materiality assessment: diversity and inclusion; workforce compensation and pay equity; talent acquisition and retention; employee engagement and wellness; development and training; company culture; and/or oversight and governance.

In connection with the newly required HCM disclosure, companies should proactively identify human capital objectives that are strategic drivers of their performance and long-term value creation, determine how to measure progress consistently over time and decide how collected information will be utilized within the organization (e.g., to drive specific strategy or guide resource allocation). In doing so, companies should determine the respective roles and qualifications of the board, compensation committee or other committees in the oversight of HCM and the manner in which HCM efforts will be communicated both through public disclosures and shareholder engagement efforts. Any such authority delegated to a committee of the board or subcommittee thereof should be adequately reflected in any charters or other applicable governance documentation, as appropriate.

Notably, while not all information or efforts will be material to the understanding of a business as a whole, there may be information that is nonetheless compelling to various stakeholders. This information may be better suited as disclosure in the proxy statement, sustainability reports and company websites. As a result, companies should develop a carefully planned and thoughtful strategy to enable stakeholders to develop a clear understanding of the company’s HCM efforts. In light of the recent prolonged social unrest and continued focus by investors and other stakeholders, human capital issues are expected to continue to be at the forefront of shareholder engagement matters.

For additional information regarding HCM disclosures, please refer to our additional post here.

6. ISS board gender and diversity requirements

Citing recent social unrest and a greater societal spotlight on racial and ethnic inequalities, ISS announced in its release regarding policy updates for 2021 that it will adopt a new voting policy with respect to U.S. boards that lack racial and ethnic diversity. This policy is in addition to the voting policy ISS previously announced in 2019 with respect to U.S. boards that lack gender diversity.

The racial and ethnic diversity policy provides that, effective for stockholder meetings of companies in the Russell 3000 or S&P 1500 indices occurring on or after February 1, 2022, ISS will generally vote against or withhold from the chair of the nominating committee (or other directors on a case-by-case basis) where the board has no apparent racially or ethnically diverse members. However, ISS indicated an exception will be made if there was racial and/or ethnic diversity on the board at the preceding annual meeting and the board makes a firm commitment to appoint at least one racial and/or ethnic diverse member within a year. Although ISS will not use any lack of racial and/or ethnic diversity as a factor in its vote recommendations for directors in 2021, ISS will identify in its reports when a board lacks racial and ethnic diversity for the benefit of investors.

The previously-adopted gender diversity policy also covers companies in the Russell 3000 or S&P 1500 policies, but provided that 2020 would be a transitional year. Effective for stockholder meetings of such companies occurring on or after February 1, 2021, ISS will generally vote against or withhold from the chair of the nominating committee (or other directors on a case-by-case basis) where there are no women on the company’s board. However, ISS indicated an exception will be made if there was a woman on the board at the preceding annual meeting and the board makes a firm commitment to return to a gender-diverse status within a year.

Companies in the Russell 3000 or S&P 1500 indices should plan ahead to reach compliance with ISS’s policies regarding board gender diversity and racial and ethnic diversity on or before each respective policy takes effect. In addition, in order to improve the diversity of their boards, companies (regardless of whether or not they are in the Russell 3000 or S&P 1500 indices) should consider implementing a number of proactive measures, such as using broader networks to recruit directors, expanding director search criteria to ensure a wide pool of diverse candidates, and developing forward-thinking plans to address upcoming director vacancies. As focus on diversity and inclusion matters continues to be a key item among investors at all levels, companies should also be prepared to address broader workforce diversity concerns in connection with their overall human capital management strategy as noted above.

Public companies may choose to revisit their directors’ and officers’ questionnaires to seek information regarding the board’s diversity, and permission to disclose such information in public reports. 

7. California board gender and diversity requirements

On September 30, 2020, California Governor Gavin Newsom approved Assembly Bill 979, an act that amended Section 301.3 of, and added to Sections 301.4 and 2115.6 of, California’s Corporations Code (AB 979). AB 979 requires public companies headquartered in the state of California to appoint to their boards “directors from an underrepresented community” (i.e., individuals who self-identify as “Black, African American, Hispanic, Latino, Asian, Pacific Islander, Native American, Native Hawaiian, or Alaska Native” or as “gay, lesbian, bisexual, or transgender”).

AB 979 requires an NYSE- or Nasdaq-listed corporation headquartered in California, including a California-headquartered corporation that is incorporated in Delaware or elsewhere, to (i) by December 31, 2021, have at least one director from an underrepresented community on its board, and (ii) by December 31, 2022, have:

  • At least three directors from an underrepresented community if the board has nine or more directors;
  • At least two directors from an underrepresented community if the board has five to eight directors; and
  • At least one director from an underrepresented community if the board has four or fewer directors.

AB 979 comes on the heels of California’s Senate Bill 826, an act that added to Sections 301.3 and 2115.5 of California’s Corporations Code (SB 826). SB 826 was passed in September 2018 and required public companies headquartered in the state of California to have had at least one female director by December 31, 2019 and requires such companies to have, by December 31, 2021:

  • At least three female directors if the board has six or more directors; and
  • At least two female directors if the board has five or fewer directors.

Noncompliance with AB 979 or SB 826 may result in a fine of US$100,000 in the first violation and US$300,000 for each subsequent violation, with a separate US$100,000 fine for failing to provide required information to the State of California.

For additional information regarding AB 979 and related considerations, please refer to our additional blog post here.


corporate, executive compensation, corporate governance