At the end of August, the Securities and Exchange Commission (SEC) announced that it had approved final amendments to its pay for performance disclosure rules. Pay for performance has been considered a governance best practice for years, but disagreements over “what is considered fair pay” and “what is accepted as “good performance” have frustrated investors who are concerned about the accelerating pace of executive compensation. Corporate directors may consider reviewing current pay for performance metrics with management to come to agreement on how justification of the company’s executive compensation plan will be communicated in compliance with the new disclosure rules.
According to a press release, the new rules require all publicly traded companies registered with the SEC to:
• Provide a table disclosing specified executive compensation and financial performance measures for the company’s five most recently completed fiscal years;
• Report the company’s total shareholder return (TSR), the TSR of companies in its peer group, its net income and a financial performance measure of their choosing;
• Describe the relationships between the executive compensation actually paid and each of the performance measures used, as well as the relationship between the company’s TSR and the TSR of its peer group; and
• Provide a list of three to seven financial performance measures that the company believes are its most important performance measures for linking executive compensation actually paid to company performance.
While the new rules may feel like the SEC is “piling on” to the added responsibilities that corporate boards have taken on in recent years, these disclosures have been under consideration since 2015. “Pay for performance” in executive compensation has generally been accepted as “governance best practice,” and the best way to achieve that has largely been left up to companies and their board of directors. Disclosing the company’s reasoning behind doing something that is largely considered good governance should not be viewed as a punitive.
In fact, compliance with the new rules could be viewed as positive for several reasons:
1. Companies can re-examine whether they have the right incentives in place to drive future growth. A little self-reflection never hurt anyone. If making sure future growth is at optimal levels is the primary goal for a company, gaining a better understanding of how the current executive pay plan is achieving or failing to achieve that goal is valuable information. These new rules encourage boards to determine the impact of their current pay plans on growth and make changes that will allow for better overall outcomes. Why would a board that values good governance be opposed to that?
Companies already track total shareholder return, so disclosing TSR shouldn’t be seen as a negative. Fluctuations in TSR are to be expected, but a three- or five-year decline in TSR should be addressed by the board. The point is, if TSR is declining but executive pay is climbing, then pay is likely not aligned with performance.
If pay and performance are in alignment, then announcing that achievement to investors is a net positive. If pay and performance are not in alignment, then quickly announcing a well thought out plan to fix the problem should also be presented as a positive development that will bear future benefits. Knowing there is an imbalance and not openly disclosing will eventually displease investors. Share price results and periodic say-on-pay votes tell investors whether pay is in alignment with performance, so being opposed to disclosure could appear deceptive.
2. Transparency on executive compensation builds trust with investors. This higher level of transparency should strengthen the board and management’s relationship with shareholders. When management, the board and investors all agree on the meaning of pay for performance and the incentives most likely to achieve it, more of what the management team proposes will likely be approved. Greater trust from shareholders may cut down on potential shareholder actions.
3. Gives the board and management an opportunity to reestablish corporate culture. The requirement that companies disclose three to seven financial performance measures most important to executive compensation speaks directly to the type of corporate culture the company wants to promote. Incentives for improving certain performance measures can lead to employee misconduct, misguided business strategy, cutting corners on quality, or lapses in safety and security measures. The right incentives tied to performance measures can improve sales of certain product lines, improve compliance with other governance measures (carbon emissions, diversity initiatives), and help improve the hiring and retention of executives at the company.
In many cases, incentives speak to values and corporate culture. These days, what the board decides to reward financially says a lot about the company’s idea of fairness. These days, incentives that promote a culture of unfair compensation that favors executives is not viewed positively by investors. Furthermore, if companies continue to value incentives that have not produced shareholder value in the past five years, that may indicate a corporate culture in need of change. Asking the board and management to explain why they believe the incentives they value most will produce positive results for the company in the future is not unreasonable. Shareholders and employees will appreciate the transparency.