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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In August 2019, the Business Roundtable (BRT) released its new stakeholder model of the revised purpose of the corporation, stating explicitly that businesses exist to serve multiple stakeholders — including customers, employees, communities, the environment, and suppliers — in addition to shareholders.[i] This new model was publicly supported by 181 CEOs of major corporations. It could have a substantial impact on corporate incentive designs, metrics, and other governance areas as corporations continue or begin to operationalize this stakeholder model into their long-term strategies, as incentive plans are core to reinforcing and communicating business strategy. While there are many opinions on the BRT statement, the stakeholder model is evolving in both importance and sophistication.[ii]
Further, the COVID-19 pandemic, the associated economic impacts, and increased focus on social justice illustrate the increasing expectations on — and willingness of — corporate leaders to address social issues that may extend beyond a traditionally narrower view of the business purpose of the corporation. Given these circumstances, some companies are taking a fresh look at their impact on numerous stakeholder groups and their reinforcing impact on company success. For example: Will increased focus on employee wellness initiatives enhance the resilience of corporations? Will sustainable supply chains and real estate differentiate a company in both the consumer and talent markets, or are these practices rapidly becoming baseline expectations of employees, investors, customers, and the broader community? The answers to these questions are beyond the scope of our expertise, but these and similar questions are at the center of the discussion on ESG metrics and their applicability to incentive compensation.
If the stakeholder model represents an emerging model for the strategic vision of a company, ESG (Environmental, Social, and Governance) metrics can be used to assess and measure company performance and its relative positioning on a range of topics relevant to the broader set of company stakeholders in the same way that financial metrics assess company performance for shareholders. This Viewpoint will address, at a “conceptual” level, key questions and guidelines for assessing a company’s readiness for — and potential approach to — implementing ESG metrics and goals in executive incentive programs. We are applying our significant expertise in the design of executive incentive programs to the emerging paradigm of ESG-focused goals in the context of the evolving stakeholder model.
The BRT statement drew significant interest from the press and corporate governance community as it was viewed by many — some investors, the media, academics, and some legal commentators [iii] — as a social and economic enhancement to, or replacement of, the concept of “shareholder primacy” as popularized by Milton Friedman and supported by many institutional investors and their advisors.[iv] Others viewed it as a contradiction to, or a distraction from, the very successful shareholder model which has created prosperity over decades for shareholders and many other stakeholders.[v]
Pragmatically, the BRT’s statement may be a continued evolution of corporate culture and strategy that seeks to place more direct focus on the role that stakeholders have long played in the corporation from the corporate governance, management, and board perspectives. This sentiment is reflected in the member quotes included in the BRT’s release as well as a recent Fortune CEO survey in which a majority of CEOs surveyed (63%) “…agree with the [BRT’s] statement and believe most good companies always have operated that way.”[i] ,[vi] In this context, the BRT’s statement serves to enhance, clarify, and substantially debate the sometimes-counterproductive dichotomy of “stakeholders versus shareholders.” ESG metrics, applied to this clarified purpose of the corporation, provide the quantifiable and generally accepted means to measure this more nuanced view of company performance.
The “Stakeholder Value Creation Chain” below is a model developed by Pay Governance to illustrate the intersection of ESG strategy, the stakeholder model, and the creation of firm value. The model captures the reinforcing carryover effect of stakeholders’ contributions to the economic success of the company. An example of a “positive externality” is that many employees want to work for environmentally friendly companies, and the increased engagement of those employees may also increase productivity, customer satisfaction, etc. All companies need to balance their stakeholders’, including shareholders’, long-term interests. It may be a greater challenge for economically stressed companies to make long-term investments for other stakeholders than it is for top-performing companies to do so. However, our research and others’ find that, overall, companies manage both short- and long-term performance trade-offs efficiently. [vii], [viii] These findings support optimistic outcomes for this Stakeholder Value Creation Chain.
These developments, and interest in this model of value creation generally, have prompted an increase in questions about whether and how to include ESG metrics in incentive plans. Below, we provide some key questions and guidelines for assessing a company’s readiness and potential approach for implementing ESG metrics in executive compensation incentive programs.
ESG incentive metrics are like any other incentive metric: they should support and reinforce strategy rather than lead it. Companies considering ESG incentive metrics should align planning with the company’s social responsibility and environmental strategies, reporting, and goals. Another essential factor in determining readiness is the measurability/quantification of the specific ESG issue.
Companies will generally fall along a spectrum of readiness to consider adopting and disclosing ESG incentive metrics and goals:
1) Companies Ready to Set Quantitative ESG Goals: Companies with robust environmental, sustainability, and/or social responsibility strategies including quantifiable metrics and goals (e.g., carbon reduction goals, net zero carbon emissions commitments, Diversity and Inclusion metrics, employee and environmental safety metrics, customer satisfaction, etc.).
2) Companies Ready to Set Qualitative Goals: Companies with evolving formalized tracking and reporting but for which ESG matters have been identified as important factors to customers, employees, or other stakeholders. These companies likely already have plans or goals around ESG factors (e.g., LEED [Leadership in Energy and Environmental Design]-certified office space, Diversity and Inclusion initiatives, renewable power and emissions goals, etc.).
3) Companies Developing an ESG Strategy: Some companies are at an early stage of developing overall ESG/stakeholder strategies. These companies may be best served to focus on developing a strategy for environmental and social impact before considering linking incentive pay to these priorities.
We note it is critically important that these ESG/stakeholder metrics and goals be chosen and set with rigor in the same manner as financial metrics to ensure that the attainment of the ESG goals will enhance stakeholder value and not serve simply as “window dressing” or “greenwashing.” [ix] Implementing ESG metrics is a company-specific design process. For example, some companies may choose to implement qualitative ESG incentive goals even if they have rigorous ESG factor data and reporting.
The business case for using ESG incentive metrics is to provide line-of-sight for the management team to drive the implementation of initiatives that create significant differentiated value for the company or align with current or emerging stakeholder expectations. Companies must first assess which metrics or initiatives will most benefit the company’s business and for which stakeholders. They must also develop challenging goals for these metrics to increase the likelihood of overall value creation. For example:
There is no one-size-fits-all approach to ESG metrics, and companies fall across a spectrum of needs and drivers that affect the type of ESG factors that are relevant to short- and long-term business value depending on scale, industry, and stakeholder drivers. Most companies have addressed, or will need to address, how to implement ESG/stakeholder considerations in their operating strategy.
For those companies moving to implement stakeholder/ESG incentive goals for the first time, the design parameters range widely, which is not different than the design process for implementing any incentive metric. For these companies, considering the following questions can help move the prospect of an ESG incentive metric from an idea to a tangible goal with the potential to create value for the company:
1) Quantitative goals versus qualitative milestones. The availability and quality of data from sustainability or social responsibility reports will generally determine whether a company can set a defined quantitative goal. For other companies, lack of available ESG data/goals or the company’s specific pay philosophy may mean ESG initiatives are best measured by setting annual milestones tailored to selected goals.
2) Selecting metrics aligned with value creation. Unlike financial metrics, for which robust statistical analyses can help guide the metric selection process (e.g., financial correlation analysis), the link between ESG metrics and company value creation is more nuanced and significantly impacted by industry, operating model, customer and employee perceptions and preferences, etc. Given this, companies should generally apply a principles-based approach to assess the most appropriate metrics for the company as a whole (e.g., assessing significance to the organization, measurability, achievability, etc.) Appendix 1 provides a list of common ESG metrics with illustrative mapping to typical stakeholder impact.
3) Determining employee participation. Generally, stakeholder/ESG-focused metrics would be implemented for officer/executive level roles, as this is the employee group that sets company-wide policy impacting the achievement of quantitative ESG goals or qualitative milestones. Alternatively, some companies may choose to implement firm-wide ESG incentive metrics to reinforce the positive employee engagement benefits of the company’s ESG strategy or to drive a whole-team approach to achieving goals.
4) Determining the range of metric weightings for stakeholder/ESG goals. Historically, US companies with existing environmental, employee safety, and customer service goals as well as other stakeholder metrics have been concentrated in the extractive, industrial, and utility industries; metric weightings on these goals have ranged from 5% to 20% of annual incentive scorecards. We expect that this weighting range would continue to apply, with the remaining 80%+ of annual incentive weighting focused on financial metrics. Further, we expect that proxy advisors and shareholders may react adversely to non-financial metrics weighted more than 10% to 20% of annual incentive scorecards.
5) Considering whether to implement stakeholder/ESG goals in annual versus long-term incentive plans. As noted above, most ESG incentive goals to date have been implemented as weighted metrics in balanced scorecard annual incentive plans for several reasons. However, we have observed increased discussion of whether some goals (particularly greenhouse gas emission goals) may be better suited to long-term incentives. [x] There is no right answer to this question — some milestone and quantitative goals are best set on an annual basis given emerging industry, technology, and company developments; other companies may have a robust long-term plan for which longer-term incentives are a better fit.
6) Considering how to operationalize ESG metrics into long-term plans. For companies determining that sustainability or social responsibility goals fit best into the framework of a long-term incentive, those companies will need to consider which vehicles are best to incentivize achievement of strategically important ESG goals. While companies may choose to dedicate a portion of a 3-year performance share unit plan to an ESG metric (e.g., weighting a plan 40% relative total shareholder return [TSR], 40% revenue growth, and 20% greenhouse gas reduction), there may be concerns for shareholders and/or participants in diluting the financial and shareholder-value focus of these incentives. As an alternative, companies could grant performance restricted stock units, vesting at the end of a period of time (e.g., 3 or 4 years) contingent upon achievement of a long-term, rigorous ESG performance milestone. This approach would not “dilute” the percentage of relative TSR and financial-based long-term incentives, which will remain important to shareholders and proxy advisors.
As priorities of stakeholders continue to evolve, and addressing these becomes a strategic imperative, companies may look to include some stakeholder metrics in their compensation programs to emphasize these priorities. As companies and Compensation Committees discuss stakeholder and ESG-focused incentive metrics, each organization must consider its unique industry environment, business model, and cultural context. We interpret the BRT’s updated statement of business purpose as a more nuanced perspective on how to create value for all stakeholders, inclusive of shareholders. While optimizing profits will remain the business purpose of corporations, the BRT’s statement provides support for prioritizing the needs of all stakeholders in driving long-term, sustainable success for the business. For some companies, implementing incentive metrics aligned with this broader context can be an important tool to drive these efforts in both the short and long term. That said, appropriate timing, design, and communication will be critical to ensure effective implementation.
According to a recent Bank of New York Mellon survey, some the most prevalent questions from investors fielded by corporate investor relations professionals surveyed concern board composition and structure, diversity and inclusion, climate change and carbon emissions, executive compensation, and energy efficiency.[xi]
The illustrative table below provides Pay Governance’s generalized perspective on the alignment between ESG initiatives and the directly impacted stakeholders. The matrix below is illustrative and is not exhaustive of all ESG metrics and stakeholder impacts.
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