Too often the overlooked part of ESG, the "governance" factor can greatly influence many other aspects of a company's success, including its compliance, sustainability, executive performance, and brand reputation in the marketplace
Environmental issues like the climate crisis and social issues like worker welfare, labor relations, and diversity, equity & inclusion (DEI) are dominating the environmental, social & governance (ESG) issues that currently are animating corporate board agendas and investor conversations.
However, leaving the G — corporate governance — out of the equation can be a recipe for disaster. And that is because governance is what helps ensure that environmental and social issues are managed effectively from the top down.
Simply put, governance covers the system of controls, procedures, and practices that a company adopts to govern itself. Good governance involves business ethics, transparent information disclosure, accountability, effective risk management, and proper financial reporting and regulatory compliance, all the while addressing stakeholder needs.
Getting the governance part of the equation right is extremely important, especially in the context of the pay vs. performance requirements from the U.S. Securities and Exchange Commission (SEC) that went into effect late last year. The pay vs. performance requirements add complexities to existing executive compensation reporting requirements that good governance can help navigate.
Implementing the G in ESG
In August 2022, the SEC issued its final rulemaking release on pay vs. performance, and the rules were intended to make it easier for investors to evaluate a registrant’s decision-making with respect to its executive compensation policies. The new rules require all registrants — except for emerging growth companies, foreign private issuers, and registered investment companies — to disclose in detail the relationship between executive compensation and company financial performance.
In the spirit of clarity, SEC Staff at the Division of Corporation Finance updated its Compliance & Disclosure Interpretations of Regulation S-K in February 2023, responding to certain practical and implementation questions about the new pay vs. performance requirements.
Registrants must begin complying in proxy or information statements required to include such compensation information for fiscal years ending on or after December 16, 2022, meaning as early as this 2023 proxy season for calendar-year registrants.
The SEC wants registrants to align their pay vs. performance disclosures with the agency’s new rules, with an eye toward improving transparency and corporate accountability by providing investors with information that will help them assess registrants’ executive compensation practices when, for example, exercising their right to cast advisory say-on-pay votes.
Practical considerations & best practices
For registrants to provide meaningful disclosures in line with the pay-versus-performance rules that help guide investors’ decision-making process, it is important that corporate management and boards of directors put into place controls and procedures to help ensure that material financial and nonfinancial information required to be disclosed is identified and communicated in a timely manner.
Plan ahead and coordinate internal and external efforts — The pay-versus-performance disclosures require registrants to collect new information and make new calculations unlike those required in prior years for proxy statements. Thus, it would behoove registrants to coordinate with their boards, particularly their compensation and audit committees; with key in-house departments, such as finance and accounting, legal, public relations, and human resources; and with external advisers, such as compensation consultants and legal counsel, to help ensure that all newly required information is captured.
Consider the benefit of keeping new pay-versus-performance disclosures out of CD&A — Many registrants will likely find it worthwhile to keep the new pay vs. performance disclosures separate from those typically used in the Compensation Discussion & Analysis (CD&A) parts of many proxy statements. In the CD&A, especially during the first year, registrants may want to avoid suggesting that the tabular disclosures guided compensation decisions, unless the disclosures happen to align with the narrative in the CD&A.
Consider potential impact of new pay-versus-performance rule on say-on-pay — Given that the new pay vs. performance disclosure requirements are a component of executive compensation disclosure; and, thus, can affect investors’ say-on-pay advisory votes, registrants should consider reflecting on how these disclosures may influence advocacy for favorable say-on-pay results.
Consider proxy advisory firm response to new pay-versus-performance rule — The new pay vs. performance disclosure requirements may eventually lead proxy advisory firms — such as Institutional Shareholder Services, Glass, Lewis & Co., and others — to decide upon an acceptable correlation between company performance and executive compensation and apply it in their say-on-pay recommendations regarding registrants. Although it is unlikely that any meaningful assessment of the impact of the new disclosures on corporate governance ratings and voting policies issued by proxy advisory firms will occur until after most registrants with a December 31 fiscal year-end have filed their 2023 proxy statements, registrants may want to consider in advance how they would respond in light of their particular facts and circumstances.
Consider how new pay vs. performance rules may influence financial analyst assessments — When assessing financial performance measures to be included in the Tabular List and the Pay vs. Performance Table, registrants may want to consider the potential impact of the new pay vs. performance disclosures on financial analyst views, especially since disclosures in the Tabular List could affect the metrics used by analysts in evaluating and predicting a registrant’s financial performance. Further, discussions of the relationship between executive compensation actually paid and company performance measures may impact how analysts evaluate future company disclosures.
While ESG matters are increasingly dominating executive and board agendas, the G — for governance — too often does not receive equal attention, which can rob registrants of the opportunity to leverage the power that comes from embedding risk management systems and other elements of sound governance into their corporate structures.
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