1. Do your homework:
To determine whether (and how) to approach your pay-for-performance message, consider running a simulation of the likely pay-for-performance analysis to be conducted by one or more of the major proxy advisors. This will give you a good sense of how these organizations are likely to view the effectiveness of your executive compensation program (that is, the alignment of your financial performance (as measured by total shareholder return) and Chief Executive Officer’s compensation (as reported in the Summary Compensation Table)).
If the simulation produces a favorable result, it may influence the degree to which you address pay-for-performance in your Compensation Discussion and Analysis. If the simulation produces an unfavorable result, it will enable you to decide how to develop your pay-for-performance message, as well as to evaluate whether any program changes are in order to enhance the likely qualitative evaluation of your executive compensation program.
2. Decide whether your disclosure will be affirmative or defensive:
It may be appropriate to address the effectiveness of your executive compensation program (based on an examination of pay-for-performance) independent of the analysis that will be performed by the major proxy advisors. While, in the event of an unfavorable analysis from a proxy advisor, there may be a tendency to want to use your disclosure to rebut what you believe to be the flaws in the analysis, experience has shown that this will not be a good use of your disclosure.
Numerous institutional investors have indicated that they are more interested in understanding how you evaluate pay-for-performance than receiving a diatribe against the methodology or conclusions of the proxy advisory firms. Save these rebuttal arguments for any supplemental materials that you prepare in connection with reaching out to your shareholders to discuss your executive compensation program.
3. Spend some time framing your message:
All companies say that they “pay for performance,” but investors are looking for evidence to back up this statement. And, how you present this evidence may go a long way to both determining the outcome of your Say-on-Pay vote, as well as how your executive compensation program will be viewed holistically. Since it’s likely that you’ll have one chance to present your pay-for-performance message (which, presumably will constitute the core element of the Executive Summary of your Compensation Discussion and Analysis), it’s a good idea to outline how this message will be presented.
One approach is to state clearly and concisely why you believe that your executive compensation program embodies an effective pay-for-performance alignment, present the information to substantiate that statement, and then tie your approach to the specific executive compensation actions and decisions for the last completed fiscal year. A separate, but equally important consideration, is to make sure that this message promotes a smooth transition to the discussion of your annual and long-term incentive compensation arrangements for your executive officers in the body of your CD&A.
4. Consider using graphics to tell your story:
The most effective pay-for performance presentations use tables, graphs, or charts to illustrate the relationship between a company’s financial performance and its compensation actions and decisions for its Chief Executive Officer. As they say, “a picture is worth a thousand words.”
However, note that when selecting the measure or measures of corporate financial performance against which you will be correlating your executive compensation (as well as the methodology for calculating those measures), you are establishing a precedent that the market will expect you to follow in future years. In other words, you may not be able to significantly change the measures from year to year simply to make your results look good (in the absence of a compelling reason). Thus, it’s important to ensure that you are comfortable with the measures and methodology selected. And don’t use so many graphs that it detracts from the substance of your message. There’s a “happy medium.”
5. Consider using “realized” or “realizable” pay to show your correlation:
Some companies believe that a pay-for-performance discussion is most meaningful when showing the compensation that has been actually realized by their Chief Executive Officer (and other named executive officers) or the compensation realizable by that executives (or those executives) rather than the compensation that is reported in the Summary Compensation Table (which often represents the total compensation opportunity for the covered fiscal year). Of course, in taking this approach, it will be important to determine how “realized” or “realizable” compensation will be calculated and to clearly disclose and explain the methodology that you have selected. Once again, consistency will be an important factor here.
6. Carefully select the appropriate measure of your financial performance:
While the logical starting point to evaluate your company’s financial performance is total shareholder return – since it’s both a favored measure from a shareholder perspective, as well as the measure used by the major proxy advisors for a significant part of their analysis, in any given year it may not be the best measure to explain how your board compensation committee approached its deliberations.
For companies with a long product development cycle, those in a cyclical industry, or where your industry sector is experiencing an economic downturn, TSR may not be the most appropriate way to show how your executive officers were incented to drive the company’s performance in your particular circumstances.
Some shareholders and proxy advisors also incorporate factors other than TSR into their analysis. So you’ll want to figure out which factors are important to your business and shareholder base. There may be several. In any event, we
recommend explaining why and how the measures that you choose feed into the development of sustainable long-term value creation.
7. Don’t lose sight of the Dodd-Frank Act pay-for-performance disclosure
As with many parts of the Dodd-Frank Act, at this time it’s difficult to know how Section 953(a) of the Dodd-Frank Act will operate until the SEC provides rules on what disclosure will be required. Nonetheless, companies should consider doing the following in anticipation of the eventual effectiveness of this provision:
− Review the past disclosure of your incentive compensation arrangements and consider providing greater disclosure about your compensation policies and alignment to financial performance
− Address this relationship in the Executive Summary to your Compensation Discussion and Analysis
− In the absence of SEC rules, consider presenting graphic disclosure showing the relationship between aggregate named executive officer compensation and corporate financial performance over an extended period of time (for example, five years)
− Total shareholder return is one possible corporate financial measure that may be used, or one or more other financial measures that reflect your methodology for gauging financial success
− Consider leveraging financial performance measure already being tracked for purposes of Item 201(e) of Regulation S-K, which contains the requirements for the Performance Graph (based on its cumulative total shareholder return on the class of common stock registered under section 12 of the Exchange Act (see Item 201(e)(1)).
By Mark Borges