In this Viewpoint, we focus on companies that have faced severe impairments due to the pandemic and are grappling with highly volatile stock prices resulting in substantial incentive plan design challenges. This continues our series of pay actions taken or considered among companies impacted by the pandemic.
Based on Securities and Exchange Commission filings and other public disclosures, ~600 companies implemented temporary base salary reductions or deferrals as of mid-2020—many of whom were severely harmed by the pandemic. Many companies stated or implied the reductions were for an undefined period and would be reevaluated during the year while others set specific end dates for the reductions. Executive base salary reductions ranged from 10-100%, while salaried employees’ base salary reductions typically ranged from 10-25%. Nearly 300 companies also disclosed that the Boards of Directors reduced their cash retainers from 25-100% to demonstrate their alignment with the salaried workforce in reducing expenses and cash outflows during these unprecedented times.
For those companies that committed to reducing executive base salaries for an undefined period, to date a few have announced the partial or full restoration of base salaries to pre-pandemic levels due to improved business performance. For those companies that continue to have a significant number of furloughed employees and/or expect additional layoffs, it may be difficult to fully or partially reinstate base salary levels for top executives without attracting criticism of leadership as being “tone-deaf.” At some point, however, the compensation committees and leadership teams at these companies must weigh the risk of de-motivating or losing key talent needed to execute the path to recovery if these base salary reductions are extended too long.
Severely harmed companies are forecasting payouts ranging from 0-50% of target based on pre-established financial goals approved before the pandemic. Many of these companies are taking a “wait and see” approach whether to exercise discretion at year end due to the ongoing uncertainty created by the pandemic and to fully assess the impact of the company’s performance on all of its stakeholders ( i.e., shareholders, employees, communities served, suppliers). As discussed in Pay Governance’s recent Viewpoint, “ Considering Resilience When Assessing FY 2020 Incentive Plan Performance ,” we believe the compensation committee and management should determine how best to apply discretion by assessing and documenting the actions that management has taken to help the company survive and emerge from the pandemic.
Based on publicly available information, some severely harmed companies have already implemented changes to the 2020 annual incentive plan that are intended to strike the right balance between rewarding and motivating employees while recognizing the experience of all stakeholders. These companies have taken various approaches that best fit their situation: setting revised annual goals, splitting the year into multiple measurement periods, adding new incentive plan metrics based on the achievement of critical financial and strategic measures (e.g., reduce expenses, improve balance sheet, open facilities safely, etc.), and more. Most companies applying these approaches are striving to maintain directional P4P alignment through below target incentive payouts and lower than expected financial results, which balances the severe financial impact to the company with the criticality of maximizing results through year end. In many cases, shareholders appear to have supported these changes based on the Say on Pay voting results reported so far. The chart below summarizes the most common approaches and rationale for each approach.
Severely harmed companies are also reviewing the status of outstanding LTI awards and evaluating potential approaches for performance shares / cash LTI plans (LTIPs), which, in many cases, are currently forecasted for low or no payments. We expect many companies to take a “wait and see” approach and decide the most appropriate action for outstanding performance awards at cycle end.
Modifying performance shares / cash LTIPs for the pandemic can be far more complex than adjusting the 2020 annual incentive plan. In addition to the LTI mix, plan design can have a significant impact on the types of adjustments that might be appropriate. For example, the company may be using a relative metric, in which case no adjustments may be needed as the use of a relative measure—in theory—adjusts for exogenous factors. Other companies use three 1-year performance periods, and only the 2020 portion of the award may be adversely impacted. Another plan design feature may measure the final year of the 3-year cycle to determine performance—in which case the plan ending in 2020 is likely to pay zero—whereas it may be too early to evaluate how performance cycles ending in 2021 and 2022 will be affected. The timing of when the cycle ends may also be a factor (e.g., March 31 compared to December 31).
Summarized below are three approaches companies may consider when determining if outstanding performance share / cash cycles should be adjusted after evaluating if other pay elements (unvested RSUs, next year’s regular LTI awards) will be sufficient to achieve talent needs. In our experience, many companies are focused on the first approach (adjust for the pandemic) for the 2018-20 cycle; they will wait until the end of the 2019-2021 and 2020-2022 performance cycles to allow for a real-time assessment of performance (e.g., resilience in response to the pandemic, full 3-year financial and total shareholder return results, impact to shareholders, etc.) in determining if adjustments for the pandemic will be made and, if so, the appropriate amount. Similar to adjustments to annual incentives, shareholders appear to have supported well-reasoned changes based on the reported Say on Pay votes.
In considering potential changes to outstanding incentive awards, it is critical to take a holistic perspective and review the accounting, legal, and proxy disclosure implications with the company’s legal and accounting teams. Shareholder engagement—either prior to or after the changes are made—may also be necessary to understand and respond to shareholder concerns. Shareholder engagement is particularly critical during a year of lower financial results and volatile, generally lower, stock prices. Each company’s situation is unique, and how to best balance the company’s talent objectives, align executive pay with other company actions (dividend and stock buyback policies, base salary reductions, annual and long-term incentive plan treatment, special awards, and changes to /next year’s incentive plans), manage external optics (including the societal impact of the pandemic, company performance on all of its stakeholders, and likely reactions of key investors and proxy advisory firms) must be decided on a case-by-case basis.
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On August 26, 2020 the Securities and Exchange Commission (SEC) took steps to modernize the disclosure requirements under Regulation S-K by adopting amendments to the reporting of the business, legal proceeding, and risk disclosure descriptions in public company filings. Regulation S-K is a prescribed regulation under the U.S. Securities Act of 1933 which sets forth various SEC reporting requirements for public companies. Generally, Regulation S-K deals with narrative disclosures whereas Regulation S-X deals with financial statements. The specific amendments to Regulation S-K pertain to Item 101 (description of business), Item 103 (legal proceedings), and Item 105 (risk factor disclosures). The amendments are the first actions taken by the SEC in more than 30 years to update and streamline Regulation S-K disclosure requirements. [1]
The updating of the human capital disclosure requirements as set forth in Item 101(C)(1) has been one of the most widely anticipated changes based on increased investor interest. SEC Chairman Jay Clayton stated in the release, “I am particularly supportive of the increased focus on human capital disclosures, which for various industries and companies can be an important driver of long-term value.”[1]
The rule amendments promulgated by the SEC are principles-based as opposed to prescriptive, as the SEC wanted to provide registrants with the flexibility to tailor their disclosures to the unique circumstances of each company — all in an effort to modernize, simplify, and update public disclosures for the benefit of registrants as well as investors. The amendment to Item 101(C)(1) revises three areas for reporting human capital. The first area is the general description of the registrant company’s human capital resources. Item 101(C)(1) requires — to the extent such disclosure is material to an understanding of the registrant’s business taken as a whole — a description of the registrant’s human capital resources, including any human capital measures or objectives that the registrant focuses on in managing its business. The final amendments identify various human capital measures and objectives that address the attraction, development, and retention of personnel as non-exclusive examples of subjects that may be material to the company’s business and workforce. The SEC clarifies by stating that the human capital measures and objectives cited are to be considered “examples of potentially relevant subjects, not mandates.” [2]
The second area of Item 101(C)(1) addressed by the amendment is the SEC’s decision to not formally define the term “human capital” for reporting and disclosure purposes. Although many organizations commented that they would prefer a definition of human capital in the reporting guidance, the SEC has decided that the term “human capital” may evolve over time and may be defined by different companies in ways that are industry-specific. The SEC further notes that “there are many definitions of human capital and that the concept … is often tailored to the circumstances and objectives of individual companies.”[2]
The third area of Item 101(C)(1) in the amendment is the registrant company’s need to disclose the number of persons employed by the company. The SEC stated this disclosure requirement can provide important and useful information that is material to an understanding of the registrant company’s business. The SEC indicated the disclosure of the number of persons employed by the registrant can help investors assess the size and scale of a registrant’s operations as well as changes in the business over time. However, the SEC is not requiring disclosure of additional metrics regarding the number of persons employed, such as data regarding full-time versus part-time or turnover statistics; rather, the SEC has indicated that such additional disclosures would be inconsistent with the principles-based approach adopted with the new disclosure requirements.
The SEC’s principles-based approach to human capital disclosure allows companies to determine the employee demographic information and human capital management policies it believes will allow investors to better understand the company and assess the strength of its human resources. We expect a number of companies that have been waiting for the final SEC rule will begin to expand their current disclosures, and many companies will provide relevant information to help investors better understand the most valuable asset not reported on company’s the balance sheet.
The amendments to Regulation S-K will be effective 30 days after publication in the Federal Register.
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re·sil·ience
/rəˈzilyəns/
noun
1. the capacity to recover quickly from difficulties; toughness.*
2. the ability of a substance or object to spring back into shape; elasticity.*
3. actions taken to survive the pandemic and to thrive afterwards.
*from the Oxford Dictionary of English
The pandemic continues to wreak havoc on the economy despite trillions of dollars in federal support. Infection rates and COVID-19-related deaths continue to mount, and unemployment remains at levels not seen since the “Great Recession.” The reversal in the U.S. economy has been stunning. In early 2020, most companies set annual and long-term incentive goals following a year of record financial results and predictions of a strong future. The pandemic has made those goals unachievable, and participants face FY2020 payouts that are a fraction of prior levels — especially if payouts are formulaically generated. This is all at a time when management teams are working frantically to serve the needs of customers, employees, and shareholders.
As a country, we have never been in this place before, not during the financial crisis of 2008-2009, and not after 9/11. There is no modern precedent upon which to rely.
As a result, by now, most companies have followed the advice of “everything should be on the table” as they attempt to figure out the right path forward with respect to 2020 incentive programs. A few have simply announced that 2020 incentive plans would pay zero, either by formula or by plan override. Some lowered goals from where they were originally set. Some set new goals for the remaining quarters in the fiscal year. But most companies will be relying on compensation committee discretion to “right-size” incentive plan payouts so that they balance performance and retention needs in the context of a pandemic where tens of millions of people continue to hurt in one way or another. Indeed, a recent survey indicates 77% of companies have considered exercising discretion at the end of the performance year when determining final incentive awards.
The Oxford Dictionary of English’s definition of discretion is “the freedom to decide what should be done in a particular situation.” Compensation committees currently exercise discretion at the beginning of the performance period when they review and approve incentive plan performance metrics, the targets for those metrics, and the width of the performance curve. In addition, discretion is often exercised at the end of the performance period when certain one-time adjustments are approved in calculating the performance — however defined — that is used for incentive plan purposes.
The exercise of discretion to override pre-established performance metrics, or to add new metrics during an open performance cycle, has been rare and generally unnecessary. However, the pandemic has made those performance metrics, targets, and performance curves an unreliable gauge of management’s performance over the last several months.
In anticipation of the compensation committee’s exercise of discretion to adjust for the effects of the pandemic in 2020, some institutional investors and proxy advisory firms have already issued policies that serve as both a guide and a warning that the use of discretion is not unfettered:
We expect additional institutional investors to publish their policies well before year end. But to answer the question “Is discretion forbidden?”, Pay Governance argues “no” while also acknowledging there is a high bar for justifying its application.
By mid-April 2020, most companies were in some level of crisis. Management teams raced to solve liquidity issues, analyzed and implemented plans to adjust costs as revenue slowed, took action to protect their employees, modified supply chains and manufacturing processes to keep delivery commitments to customers, balanced payables and receivables so that cash flow requirements were met, launched new products that served the needs of those impacted by the pandemic, and — for some — sought government assistance where it was appropriate and available. Over 20% of Russell 3000 companies announced executives’ and board of directors’ pay reductions to make it clear to all stakeholders that the effects of the pandemic impacted everyone.
In short, just as it was dawning on everyone that recently-set FY2020 incentive plan goals were hopelessly obsolete, management teams were already showing their resilience in the face of the pandemic. There was a concerted effort to do everything possible to survive the pandemic and to be in a position to thrive once the pandemic eased. Sadly, easing seems to be a long way off, so continued resilience actions from management teams are a must.
Resilience-based discretion allows the compensation committee to motivate and properly reward management teams that mustered an effective response to the unique challenges of the pandemic. Resilience-based discretion necessitates that the compensation committee conduct a rigorous assessment of performance prior to applying discretion, which can then be clearly communicated to shareholders.
To illustrate how to apply resilience-based discretion, let’s take a common example. The company is forecasting a 10%-30% of target formulaic payout against adjusted goals set prior to the pandemic and could easily slip to zero by year-end. The compensation committee is resolved that such an outcome would not fairly reward the extraordinary efforts of the management team.
The projected payout already adjusts for higher direct costs associated with the pandemic, such as personal protective equipment, higher shipping costs, and disruptions in capacity due to supply chain issues. These adjustments represent the exercise of discretion, as these higher costs were not one of the “normal” adjustments built into the plan.
The compensation committee has also considered the maximum possible incentive plan outcome it could envisage approving after the formulaic outcome, any exception for direct costs of the pandemic, and the application of resilience discretion. As early as our March 23, 2020 Viewpoint “Everything Should Be On The Table,” we believed — and continue to believe — that a target award will be an unusual outcome for FY2020 annual incentives for most companies significantly impacted by COVID-19. [4]
The compensation committee and management identified a number of resilience actions that should be evaluated. Those actions are summarized in a template that can be used to guide the compensation committee in evaluating management’s performance holistically, which in turn can be used to communicate its rationale to shareholders. Below is an example of a resilience scorecard the compensation committee plans to use in finalizing incentive awards for FY2020. The results of a scorecard help determine how much discretion is applied, up to the maximum level that will be used to guide year-end discretion. It is important to note that a reduction in payouts (i.e., negative discretion) is also possible when applying resilience-based discretion.
The final pool funding is then based on the application of the resilience scorecard against the amount that the Committee determines is appropriate and affordable (e.g., between the formulaically derived amount of the pre-COVID goals and the maximum possible outcome the committee could envision).
We have been asked many questions about resilience-based discretion.
1. Is there a guarantee that shareholders will agree with resilience ? There are few guarantees in life. But, clearly, a strong rationale and proof supporting discretion is far better than undefended or opaque explanations of discretion.
2.Is a scorecard necessary? No. However, a quantitative approach to the application of discretion may be helpful to shareholders who wish to understand the operational process and helpful to management teams that want to communicate to employees that they are thinking about this issue and about expectations for completing the year strong.
3. Should named executive officers participate in resilience discretion? Every compensation committee needs to make their own decision, but we would argue “yes.” If resilience-based discretion is the right decision, it should be applied to all participants.
4. Is there such a thing as too much discretion? Probably, yes. The pandemic has taken a substantial toll on society at large. Vanguard said it well: “Boards should…be thoughtful about the reputational risks that may be associated with awarding large payouts at the wrong time.” [1]
General questions about this Viewpoint can be directed to John D. England at john.england@paygovernance.com or Mike Kesner at mike.kesner@paygovernance.com.
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