Our eighth Annual Survey of Selected Corporate Governance Practices of the Largest US Public Companies (the “Survey”) reflects a year of consolidation, rather than innovation, in compensation disclosure by the largest US public companies. The proxy statements of the Top 100 Companies  continue many of the trends noted in prior years: enhanced attention to the risk profile of compensation strategies; more companies adopting clawback policies; increased acceptance of shareholder say-on-pay votes; and increased use of independent compensation consultants.
Few proxy statements report new compensation strategies or novel approaches to compensation disclosure. One possible reason for the relative stability in compensation practice and disclosure was the absence of significant new legislation during the period covered by this Survey. Companies were not required to assimilate and react to anything nearly as dramatic as the legislation implementing the Troubled Asset Relief Program (“TARP”) of the prior year.
Regulatory developments did, however, have some impact on this year’s Survey results. In particular, on December 16, 2009, the Securities and Exchange Commission (the “SEC”) amended its proxy disclosure rules relating to executive compensation to require disclosure regarding:
The amended SEC rules also mandate new or expanded disclosure on other topics related to corporate governance, including the board’s role in risk management, the board’s leadership structure, and director and nominee disclosure (including how the company considers diversity in the nomination process)—all of which are discussed in our companion survey.
The period covered by this Survey straddles the February 28, 2010 effective date of the revised SEC disclosure rules, but the majority of companies surveyed—80 of the Top 100 Companies—filed their proxy statements after the new disclosure requirements became effective. As discussed throughout this Survey, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Reform Act”) was signed into law by President Obama on July 21, 2010. The Reform Act addresses a number of issues included in this Survey (including say-on-pay, clawbacks and compensation consultant independence) and will likely change practices at all public companies in the future.
The most striking change in this season’s proxy statements is the increased prominence accorded to discussions of “risk.” This year’s Survey indicates that a decisive majority of the Top 100 Companies addressed the impact of the company’s compensation programs on its overall risk profile (see page 18). Regulatory developments, including the applicability of the new SEC disclosure rules, help explain the enhanced emphasis on risk.
For the nine Top 100 Companies subject to the regulations issued under TARP, proxy statement discussion of compensation risk was mandatory.  Financial institutions that participate in TARP must ensure that their compensation programs “exclude incentives for senior executives to take unnecessary and excessive risks that threaten the value of the company” for so long as the institution has outstanding obligations to the government. Compensation committees of TARP entities must conduct semiannual reviews of all employee compensation plans for unnecessary risk and the manipulation of reported earnings. Finally, a TARP entity must certify in its proxy statement that its compensation committee met with senior risk officials and assessed whether their executive compensation programs encourage executives to take unnecessary and excessive risks.
For companies not subject to TARP, compensation risk disclosure is required under the SEC’s new disclosure rules only under limited circumstances. Companies must disclose the relationship between their compensation practices applicable to all employees—not only those applicable to the named executive officers (“NEOs”)—and their risk management philosophy only if the risks arising from their compensation programs are “reasonably likely to have a material adverse effect” on the company. Of the Top 100 Companies that filed before the new rules went into effect, a narrow majority—12 of 20 companies—voluntarily included some discussion of compensation risk. None of the Top 100 Companies concluded that risks were reasonably likely to have a material adverse effect on the company.
Practitioners initially expected companies to shy away from making conclusory statements on risk, absent an affirmative requirement. Experience in the 2010 proxy season has proved otherwise: 61 of the Top 100 Companies voluntarily affirmatively stated that their compensation policies and practices do not create material adverse risk. At least some public companies that omitted an affirmative statement received SEC comment letters asking for confirmation that they have addressed the disclosure requirement, and that the absence of disclosure resulted from a risk assessment process. This may foretell more detailed disclosure requirements in the future.
Indeed, process, as much as disclosure, seems to be the key to the evolving “best practice” on compensation risk. Companies are coming to terms with basic procedural issues, such as who should assess the risks arising from compensation policies and practices. The compensation committee is one obvious candidate, but compensation committees have historically focused on arrangements for executive officers, whereas risk assessment needs to encompass compensation programs for all employees, both to ensure that the SEC requirements are satisfied and as a matter of sound corporate governance. (One of the lingering concerns from the financial crisis is that compensation programs for employees well below the executive level can adversely impact a company’s financial position if they lack appropriate risk mitigants). For a compensation committee to conduct a risk assessment effectively, it must work closely with management and the audit and risk committees of the board and must feel comfortable relying on the information provided by management and its consultants and advisers. Identifying the risk profiles of a company’s various business activities—typically the responsibility of management and the audit committee—is the first step in assessing risk. Once these risks are identified, the compensation committee may examine whether the company’s compensation programs operate to control or exacerbate these risks, or whether they create new risks.
Early experience with compensation risk disclosure suggests that responsibility for the assessment is most typically delegated to the compensation committee. Ten of the Top 100 Companies have formalized this arrangement by including risk assessment as one of the committee responsibilities listed in the committee charter. The results of this year’s Survey, however, do not allow us to generalize about how companies are integrating the roles of the compensation committee, other board committees, management and independent consultants in conducting compensation risk assessments.
What companies say about compensation risk varies widely. A small minority of the Top 100 Companies included no more than a conclusory statement that they had conducted a review and that their compensation policies and practices are not reasonably likely to have a material adverse effect on the company. (As was the case with companies that made no affirmative disclosure at all, some companies that did no more than state the result of their risk assessment attracted an SEC comment asking for a description of the process that the company undertook to reach the conclusion). Most of the Top 100 Companies, on the other hand, explained their positions by pointing out various features of their policies and practices that are designed to discourage excessive risk taking.
The proxy statements of the surveyed companies were remarkably consistent in the factors listed to support a company’s conclusion that compensation policies do not pose a risk to the enterprise. The listed items include:
- providing a mix of cash and equity and of annual and longer-term incentives;
- using multiple metrics to determine payout in order not to put too much emphasis on any single measure;
- caps on incentive award payouts (for example, 200% of target);
- share ownership guidelines that require employees to retain award shares for a specified period, or through retirement, so that they retain the risks of share ownership;
- multi-year vesting periods; and
- implementing and enforcing clawback policies.
Each of these considerations can appropriately factor into a company’s evaluation of its compensation risk profile. We anticipate that a key issue over the next several years will be how companies translate their evolving risk assessment practices into disclosure that will provide shareholders with useful insight into the company’s processes of risk assessment applied to compensation policies.
Another noteworthy development over the last several years has been the dramatic increase in the number of companies that report the maintenance of “clawback” policies. The number of Top 100 Companies that disclose that they maintain a clawback has increased from 35 companies in 2007 (the first year that this Survey tracked the topic) to 56 companies in 2009 to 71 in 2010. In addition, eight more of the Top 100 Companies have stated that they will expand existing policies or implement a new clawback policy in 2010. As the Reform Act will require clawback policies to be adopted by all listed companies, these policies will no longer be optional.
Several factors likely have contributed to the widespread adoption of clawback policies by the Top 100 Companies. Section 304 of the Sarbanes-Oxley Act, adopted in 2002, mandates compensation recovery from a public company’s CEO and CFO in limited circumstances where the issuer is required to prepare an accounting restatement as a result of misconduct. On June 9, 2010, the US District Court for the District of Arizona denied a motion to dismiss a claim by the CEO of CSK Auto Corporation in an action by the SEC to recover compensation under Section 304, notwithstanding the fact that the executive committed no personal wrongdoing.
The TARP regulations also mandate clawbacks. Financial institutions subject to TARP generally are required to recover compensation paid to 25 of their top employees (essentially their NEOs and the 20 other most highly compensated employees) if retention awards, bonuses or other incentives are paid based on materially inaccurate financial statements or any other materially inaccurate performance metric criteria.
The prevalence of clawbacks does not suggest that they have become standardized in operation and as to the types of compensation arrangements they cover. As we detail on page 28 of this Survey, the expression “clawback policy” covers a wide array of practices. When designing compensation recovery policies, companies will need to address the following key variables:
- Who is covered by the policy? Possibilities include NEOs only; all executives; all executives and a specified universe of other highly compensated employees; and all employees. The dominant trend among the Top 100 Companies is to cover all executive officers (40 of the 71 Top 100 Companies with clawback policies), but the practice is by no means universal. Clawback policies as mandated by the Reform Act will need to apply to all current and former executives.
- What are the events that trigger recovery? The narrowest policies provide for recovery only when the individual has engaged in fraud or other misconduct that has resulted in a financial restatement. Other policies allow recovery whenever there has been a financial restatement, even if no misconduct was involved. Still others allow recovery even if the company has not been forced to restate financial statements, but there was error in determining performance against the targets or metrics that were used to calculate the amount of compensation. Yet another approach focuses on activity deemed harmful to the company (e.g., leaving to work for a competitor, or disclosing confidential information) and uses specified forms of misconduct as the trigger for recovery. There are nearly as many variations and combinations of these strategies as there are companies with clawback policies. The Reform Act clawback requirement is triggered upon an accounting restatement due to material noncompliance with any financial reporting requirement.
- How far back should the clawback provision reach? The Sarbanes-Oxley Act provides for recoupment of compensation received within the 12-month period following the public release of the financial information that subsequently has to be restated, while the Reform Act requirement will apply to compensation received during the three years preceding the date on which the issuer is required to prepare an accounting restatement. Proxy statement disclosure does not provide sufficient detail for us to generalize about how the Top 100 Companies have addressed this issue in their clawback policies.
- How is the clawback enforced? Another decision point is whether recovery will be mandatory or discretionary, and, if the latter, who decides when, and against whom, to enforce the clawback. To date, discretionary policies prevail at the Top 100 Companies (80% of the companies with clawback policies).
More clarity on clawback design features may be forthcoming in related SEC regulations to be issued under the Reform Act. However, the Reform Act does not impose a deadline for the implementation of the SEC rules.
As companies make decisions on clawback design and shift their focus to enforcement of these policies, the legal issues raised by compensation recovery can be expected to come to the fore. Companies implementing clawback policies need to consider applicable state wage-deduction laws that limit the circumstances under which an employer may recoup “wages” from employees. Rules also vary from country to country, which may make implementing a uniform global clawback policy challenging.
What Shareholders Are Voting On
In the 2010 proxy season, for a second consecutive year, the number of compensation-related shareholder proposals was lower than the prior year. The Top 100 Companies presented a total of 89 compensation-related shareholder proposals for vote during the 2008 proxy season; the number declined to 77 proposals during the 2009 proxy season and diminished further to 69 in 2010. Page 20 details the compensation-related proposals at the Top 100 Companies.
One factor that at least partially explains the decline is that shareholders have been anticipating the legislative reforms on compensation that are included in the Reform Act. Many of the matters addressed in the Reform Act overlap with the subject matter of many of the compensation-related proposals advanced by shareholders in recent years. It appears, moreover, that some shareholder advocates have focused on the legislative process rather than pursuing ballot initiatives that might be rendered moot or superseded by Congressional action.
The most frequent compensation-related shareholder initiative at the Top 100 Companies this year continued to be a request that companies institute advisory say-on-pay votes. Although the details of say-on-pay proposals vary, the fundamental point of the proposals is to request the company to institute an annual (or other periodic) nonbinding shareholder vote on executive compensation practices. Shareholder initiated say-on-pay proposals sometimes also request the company to establish other mechanisms for the company to consult with shareholders and for shareholders to provide feedback to the company on executive pay.
During the 2010 proxy season, 19 of the Top 100 Companies submitted their executive compensation programs for approval by shareholders, either as required by TARP (eight of the Top 100 Companies) or pursuant to say-on-pay policies that the company adopted even though not legally required to do so (an additional 11 companies).
With the adoption of the Reform Act, say-on-pay will be mandatory for all public companies in the 2011 proxy season. The Reform Act requires a vote to occur at least once every three years (unlike prior proposals which required annual votes). In the first instance, shareholders must be given the opportunity to vote on both (1) the say-on-pay resolution and (2) a separate resolution to determine whether the company’s say-on pay-vote will be held every one, two or three years. Thereafter at least once every six years, shareholders must be given the opportunity to redetermine whether the say-on-pay vote will be held every one, two or three years. The vote is nonbinding and will not be construed as overruling the board’s compensation decisions or imposing additional fiduciary duties on the board. However, if an issuer does not respond to a negative vote, in the future, shareholders may take further action such as withholding votes for members of the compensation committee.
One lesson from this proxy season is that companies cannot assume say-on-pay resolutions will pass. One Top 100 Company—Motorola, Inc., which voluntarily implemented say-on-pay—and at least two other public companies, Occidental Petroleum Corporation and KeyCorp, failed to win majority support for their compensation policies. The defeat of the proposal by Occidental Petroleum’s shareholders is striking since the company had pursued other avenues for shareholder consultation and feedback on executive pay issues, including meetings with shareholders, in addition to voluntarily adopting say-on-pay. On a similar note, shareholders at Abercrombie & Fitch Co. rejected a proposed new long-term incentive plan by a wide majority (Abercrombie has been widely criticized for certain executive compensation practices, including its recent decision to pay its chief executive officer $4 million to forgo his right to use the company’s aircraft for personal travel. The defeat of these proposals illustrates how shareholders are beginning to send a clear message to companies that they will not accept what they have identified as poor pay practices. This trend could gain traction next year as companies implement the say-on-pay vote under the Reform Act.
Only a handful of public companies have voluntarily implemented say-on-pay policies to date. For the 2010 proxy season, brokers were entitled to cast discretionary votes on management say-on-pay proposals, and brokers are believed generally to vote with management’s recommendations. Winning approval for say-on-pay (and other compensation-related shareholder proposals) may prove even more challenging in years to come as the Reform Act will disallow discretionary votes by brokers on these proposals.
What to Expect Next Year
First, all reporting companies will be subject to the new SEC disclosure rules for the 2011 proxy season. Most of the Top 100 Companies will have a year of experience with the new rules under their belts and will have the benefit of SEC interpretations through comment letters (formal) and public speeches (informal). Treatment of disclosure topics that have been addressed this year in varied ways is likely to be more uniform next year as practice trends emerge. In particular, we think that more of the Top 100 Companies will include a more detailed discussion of their risk assessment processes and of the basis for their conclusion that their compensation programs do not present a risk of a material adverse effect on the company. It is not clear, however, how meaningful this disclosure will prove to be to investors.
Second, the presentation of compensation information, particularly their Compensation Discussion and Analysis (“CD&A”), will likely continue to improve. An increasing number of companies begin the CD&A with an executive summary that provides a road map for the ensuing disclosure. Many companies use informative and easy to read graphics, tables or other visual aids to help explain performance metrics or the relationship among different elements of compensation. Although still infrequent, some Top 100 Companies have converted their CD&A to a Q&A format. Many Top 100 Companies continue to take seriously the SEC’s admonition to present their compensation disclosure in a manner that makes it accessible and understandable to the average reader who is not an expert in the field.
Finally, some of last year’s disclosure and governance trends have become this year’s law. Many companies will need to reexamine their compensation policies and procedures over the next year to take into account the requirements of the Reform Act.
In addition to the say-on-pay and clawback provisions detailed previously, the Reform Act includes the following key points:
Disclosure and Vote on Golden Parachutes
The Reform Act requires proxy statements and consent solicitations filed by issuers in connection with mergers, acquisitions and major asset sales to describe, in clear and simple form, the arrangements with any NEOs of the issuer or the acquiring company concerning all compensation (whether present, deferred or contingent) that is related to the transaction. Companies would also be required to disclose the aggregate amount of compensation that will be paid or may become payable to the NEOs (together with the conditions to payment) as a result of the transaction. The SEC is directed to promulgate regulations governing the specifics of this disclosure.
The proxy statement must also provide shareholders the opportunity to cast a separate nonbinding vote to approve these payments unless the arrangements have been previously subject to a say-on-pay vote.
This provision applies to all meetings occurring on or after January 21, 2011.
Compensation Committee Independence
The Reform Act requires the SEC to direct the national securities exchanges and associations to prohibit the listing of securities of any issuer whose compensation committee is not comprised exclusively of independent directors. Compensation committee independence rulemaking must be implemented within one year from the enactment of the Reform Act. Rather than setting explicit independence standards, the Reform Act tasks listing authorities with defining independence. In formulating the definition, factors to be considered include:
- the source of compensation of the director, including any consulting, advisory or other fees paid by the issuer;
- whether a director is affiliated with the issuer, a subsidiary of the issuer, or an affiliate of a subsidiary of the issuer; and
- the compensation committee independence requirements do not apply to certain issuers, including “controlled companies” (e.g., companies where more than 50% of the voting power is held by an individual, a group or another issuer) and foreign private issuers.
Compensation Consultant Independence
The Reform Act provides that a compensation committee (1) may, in its sole discretion, obtain advice of consultants, legal counsel and other advisers and (2) must be directly responsible for the appointment oversight and compensation of these advisers. Any committee that elects to retain a consultant, however, will not be compelled to follow the adviser’s advice and must exercise its own judgment in fulfilling its duties and making compensation decisions. Issuers are required to provide funding for the adviser compensation determined by the committee.
In selecting its advisers, compensation committees must take into account factors affecting independence. The Reform Act directs the SEC to identify independence factors that are competitively neutral among categories of consultants, legal counsel and other advisers and provides the following partial list of considerations:
- provision of other services by the adviser’s employer;
- the amount of fees paid to the adviser’s employer, considered as a percentage of the employer’s total revenues;
- the policies and procedures of the adviser’s employer that are designed to prevent conflicts of interest;
- any business or personal relationship between the adviser and a member of the compensation committee; and
- the adviser’s ownership of stock of the issuer.
Unlike previously proposed legislation, the Reform Act does not require that consultants be independent. In any proxy statement filed on or after January 21, 2011, issuers must disclose (in accordance with rules to be established by the SEC): (1) whether the compensation committee retained a consultant, (2) if the consultant’s work raised a conflict of interest and (3) how that conflict is being addressed.
Within one year following enactment of the Reform Act, the SEC must adopt rules that require the listing authorities to prohibit the listing of securities of any issuer that does not comply with the consultant and adviser independence rules. The listing authorities must also set forth procedures providing companies with a reasonable opportunity to cure any defect before a delisting.
The compensation consultant independence provisions do not apply to “controlled companies.”
The Reform Act directs the SEC to require additional compensation-related proxy disclosure regarding:
- The relationship between compensation actually paid and the financial performance of the issuer, taking into account any change in the stock value and dividends paid. Issuers may use a graph to illustrate the relationship.
- The median total annual compensation of all employees (other than the CEO), the annual total compensation of the CEO, and the ratio of these two amounts. Total compensation would be calculated in the same manner as the summary compensation table.
- Whether any employees (not only executive officers) or directors (or their designees) can hedge against decreases in the value of equity granted as compensation or otherwise directly or indirectly held by the employee or director. Many public companies already prohibit hedging and, in accordance with existing SEC guidance, discuss in their CD&A any policies regarding hedging the economic risk of share ownership.
- Policies on incentive-based compensation that is based on the issuer’s financial reports. The Reform Act does not specify a deadline for the SEC’s rulemaking relating to additional disclosures.
The complete survey is available here.
 For purposes of the Survey, the following companies are considered TARP companies: American Express Company; American International Group, Inc.; Bank of America Corporation; Citigroup Inc.; The Goldman Sachs Group, Inc.; The Hartford Financial Services Group, Inc.; JPMorgan Chase & Co.; Morgan Stanley; and Wells Fargo & Company.