Connecting executive compensation with financial performance took a while to implement—and it wasn’t easy.
Toward the end of last year, the U.S. Securities and Exchange Commission voted 3-2 to accept the “clawback” rules, which are intended to discourage senior leadership from making risky corporate decisions for short-term gain, resulting in restated financial statements.
In short, the SEC called out two types of triggering events involving material and non-material changes to financial statements. And the last part, referred to as “Little Rs,” is why the SEC vote was not unanimous.
Two SEC Commissioners, Hester Peirce and Mark Uyeda, voted no because the new rule included non-material changes.
SEC Chair Gary Gensler, however, supported the rule, citing the fact that corporate restatements have increased to nearly 75% from 35% in recent years. “If the financials are inaccurate, why should executives be getting paid incentive comp on financials that were inaccurate,” he said in an interview with Thomson Reuters.
Here are seven insights to ensure your executive compensation is aligned with the Dodd-Frank Act:
Require Shareholder Advisory Vote
Public companies are required to hold a non-binding advisory vote for their shareholders on the topic of executive compensation at least once every three years.
Although the frequency vote gives shareholders four options, including “abstain,” making the vote an annual tradition is the best practice.
At the end of May, Russell 3000 companies have only failed 1.5% on Say on Pay, according to Harvard Law School Forum on Corporate Governance. The current failure rate is 130 basis points lower than last year. In addition, the percentage of Russell 3000 companies receiving more than 90% support (i.e., 78% vs. 75%) is also higher than last year.
Investors are now able to vote on the compensation of the top executives in a public company, which includes the CEO, CFO and at least another three highly paid executives.
Bolster Independence for Compensation Committee
The compensation committee balances investor expectations along with a company’s financials to form employee retention strategies. In recent years, however, the role has evolved. Two-thirds of surveyed companies have expanded the role of their committee by expanding the charter or the name as well as the charter, according to the Center On Executive Compensation.
Institutional investors are driving change with more focus on the environment, talent and diversity and inclusion. New topics like human capital metrics, safety and wellbeing, culture and employee engagement are now falling under the compensation committee’s purview.
Strengthening independence requirements for committee members is more important than ever.
Added Disclosure on Conflicts for Consultants
Compensation consultants can serve as an invaluable resource for up-to-date pay rates, ongoing compensation trends and incentives to foster employee performance.
The Dodd-Frank Act requires more disclosure about the portion of compensation consultants and any potential conflicts. Stock exchanges must have listing standards that create greater independence for all compensation committee members, including consultants.
For example, exchanges must consider the source of all compensation to the director and whether the director is affiliated with the issuer via a subsidiary or affiliate.
Oversight of CEO/Rank Employee Ratio
The Dodd-Frank Act requires public companies to disclose the CEO pay ratio, which compares a CEO’s compensation to pay for median employees.
In 2021, CEOs were paid 399 times as much as a typical worker—a 1,460% increase since 1978. The shift in executive compensation to stock-related investments, which represents roughly 80% of the gains over the decades, is cited as one of the driving forces by the Economic Policy Institute.
Even though the SEC strongly encourages companies to follow generally accepted accounting principles (GAAP) metrics to ensure integrity, companies are only required to provide the CEO pay ratio without context or a long discussion, which can be found, however, in the compensation and analysis parts of a proxy statement.
Disclose Pay Versus Performance
Last summer, the SEC adopted amendments to require companies to disclose information that links executive compensation and financial performance.
For the five more recent fiscal years, the amendments require companies to provide a table of executive compensation and financial performance measures, including total shareholder return, as well as the total shareholder return of companies in the registrant’s peer group, its net income and a financial performance metric of the company’s own selection. Companies are also required to provide a list of three to seven financial performance measures that they deem important for connecting executive compensation and company performance.
Mandate Recovery Policies for Restatements
The SEC requires companies to implement policies to recover awarded, incentive-based compensation resulting from an accounting restatement from past and existing executive officers, no matter the level of involvement. As a result, stock exchanges must have listing standards that require companies to adopt a written “clawback” policy, which they will disclose as an exhibit in Form 10-K and on the cover of annual reports.
All types and sizes of restatements can trigger a clawback, including ones that materially impact the financial statements in the current year and ones that don’t from prior fiscal periods.
Companies must recover the compensation that is erroneously awarded and received by an executive in the three years preceding the date of the restatement.
A company must disclose the ability of employees, officers and directors who can use equity securities granted as compensation to hedge. The company must comply by disclosing the practices in full or providing an accurate summary. If the company doesn’t have any hedging policies, then it must disclose that hedging is permitted.
Companies should review their current hedging policies with an attorney and consider updating or streamlining the document. Does your current policy cover the correct category of employees or enough detail about transactions?
Review these items carefully with an attorney to make sure pay is aligned with the Dodd-Frank Act.
(Joseph M. Pastore III is chairman of Pastore, a law firm that helps corporate and financial services clients find creative solutions to complex legal challenges. He can be reached at 203.658.8455 or firstname.lastname@example.org.)
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