COVID-19 Impact – Considerations for Applying Discretion
For most companies, the application of discretion in determining incentive payouts in recent years has been limited to reductions in award values or rare occasions when a committee/board determined that management should not be penalized for unforeseen and/or unanticipated events outside of its control. Citing pay-for-performance concerns, proxy advisory firms and institutional investors have put pressure on companies to play by the rules established at the outset of the performance period and avoid the use of discretion that is not tied to any criteria for determining awards. These organizations’ policies largely have been formed in the last decade during a time of steady financial and shareholder investment performance that provided a favorable landscape to utilize incentive plans that are largely formulaic. The rest of 2020, and possibly beyond, will be a very different time due to the COVID-19 pandemic as companies withdraw earnings guidance, take operational measures to preserve cash flow, and adjust incentive plans (see www.paygovernance.com/compensation-in-volatile-times ).
For companies that implemented incentive plans and goals before March and are now being negatively impacted by the pandemic, a key issue is how to make these plans relevant and motivational, recognizing the uncertainty regarding the depth and length of the economic and business disruption. Mid-term adjustments and/or a reset of performance goals may not appear feasible at this point given the current lack of clarity in the business and economic outlook. In fact, it may be difficult for some companies to isolate the impact of COVID-19 on financial results, thereby making an adjustment for “extraordinary” events impractical, if not impossible. Thus, it seems that many companies will proceed with caution and evaluate alternatives while allowing time to develop an appropriate response. Some have, in fact, indicated that they intend to wait “until the music stops” before evaluating the impact of the pandemic on their business and then use discretion to determine how management and employee incentives are impacted.
That said, proxy advisors and institutional investors expect that good governance and pay-for-performance principles will be maintained, even during this unfamiliar and unusual time. In a recent update on COVID-19 and compensation governance, proxy advisor Glass Lewis stated that “companies with strong pay structures will be challenged to abide by them, and firms with less robust programs will be forced to choose between lying in the bed they’ve made or changing arrangements and all but guaranteeing shareholder ire.” [i] But how can companies achieve this balance when pre-established performance goals are no longer relevant?
Discretion: A Balancing Act
Now, more than ever, compensation committees and management teams may feel as if they are walking a tightrope without a net. While many committees generally may use discretion as a tool in determining incentive award payouts (note: as a matter of due diligence, companies should review plan documents to determine whether plans allow for discretion), this year the application of discretion will require the balance of a range of potentially competing issues, including:
- Employee motivation and the impact of COVID-19 on in-cycle incentive plans and equity holdings: Compensation committees and management are already discussing the potential negative impact of COVID-19 on in-cycle annual and long-term incentive plans; they recognize that performance goals set prior to the onset of the pandemic may no longer be attainable and that employee morale and motivation have taken a hit on several fronts. For some, this is compounded further by losses on equity holdings due to the impact of COVID-19 on company stock price. Certainly, discretionary payments provided in the face of performance challenges caused by extraordinary circumstances outside of management’s control would go a long way to help with motivation and morale.
- Experience of all stakeholders: Any consideration of discretionary payments must also be made through the lens of key stakeholders. Shareholders have experienced significant losses in stock values; employees may have been laid off, experienced salary cuts, or suffered declines in 401(k) balances; and the community at large has experienced sickness, death, and economic catastrophe. Any discussion of discretion should consider how such payments would be perceived by these constituencies. With this in mind, Glass Lewis recently warned “trying to make executives whole at even further expense to shareholders and other employees is a certainty for proposals to be rejected and boards to get thrown out—and an open invitation for activists and lawsuits onto a company’s back for years to come. Even those companies who project a “business as usual” approach to executive pay will face opposition if employees and shareholders see their own “paychecks” cut. Companies would be wise to avoid this.”1
- Incentives aren’t guarantees: A common rule of thumb regarding a well-designed incentive program is that awards ranging around target should have a probability of achievement of about 50%-60%, and that the probability of paying threshold or maximum awards should be about 15%-20% each. Recognizing the strong payouts over the past decade, where does this year fall on the spectrum?
- Executive pay history with shareholders. Shareholders may be more receptive to the use of (reasonable) discretion in an unusual year if the company has a history of good governance and/or responsiveness to shareholders. However, a history of citations for poor practices or unresponsiveness to shareholders doesn’t bode well for making discretionary adjustments when performance falls below expectations.
- Proxy advisor perspectives As noted earlier, proxy advisors — ISS and Glass Lewis — will have a keen eye on incentive programs and pay-for-performance alignment in the year of COVID-19. Their stated preference is for formulaic outcomes and an intolerance for individual/discretionary performance in excess of about 30% of the annual incentive scorecard. Applying discretion on annual incentive awards, while not straying from a rigorous pay-for-performance approach, may be more acceptable than modifying outstanding long-term incentive awards which still have two to three years to improve performance before payouts are determined and have potential disclosure and accounting implications.
- Disclosure implications. Any decision regarding the application of discretion should contemplate the potential disclosure in the company’s Compensation Discussion & Analysis and associated tables to provide institutional investors and proxy advisors with an understanding of the decision-making process. For example, Glass Lewis indicated that “effective disclosure and rationales provided by companies will be particularly critical to our exercise of discretion in making judgements about whether changes made as a result of this crisis are justified and address material shareholder concerns,”1 and BlackRock similarly stated that “as we describe in our approach to executive compensation, BlackRock believes compensation committees should have discretion to make adjustments to executive compensation plans. Where discretion has been used, we expect disclosure relating to how and why it was used and further, how the adjusted outcome is aligned with the interests of shareholders.”[ii] Thus, it will be critical that companies have a sound business rationale and defensible approach for determining discretionary awards.
Guiding Principles for Applying Positive Discretion
If the decision to apply positive discretion is reached after thoughtful consideration, then guiding principles and/or a framework for applying discretion will be needed to guide decisions and ultimate proxy disclosure. Committees generally prefer some parameters/guidelines to use when applying discretion as opposed to an unstructured approach. Some key considerations are as follows:
- Affordability: Will company cash flows be sufficient for business operations to accommodate bonus payouts between threshold and target? If accruals are expected to be below threshold, what level of pool is affordable for allocation? Should other forms of payout delivery be considered to manage the expense?
- Participation: Which group of the employee population should be considered for discretion? Is there a group that should be excluded from the discretionary awards?
- Performance: A discretionary assessment of performance should be grounded in the company’s preparation for and ability to return to normal operations post-COVID-19. Specifically, how well a company was set up to succeed in the face of adversity and actions taken during the pandemic to minimize recovery time will be important factors to consider. While specific criteria will vary by company and circumstance, some of the protective actions and performance factors might include:
- Award Amounts : After evaluating affordability, participation, performance, and key stakeholder implications, the actual discretionary award amounts may be considered. While it is too early to understand what potential discretionary bonus amounts or adjustments might look like, for plans that miss threshold, the expectation is that the discretionary payout will be well below target and most likely will be a fraction of target award levels, depending on specific company circumstances. For plans that achieve threshold funding, the application of discretion will likely be modest and within the range historically tolerated (less than 30% of award amount) by the proxy advisory firms.
- Payout Delivery: Another consideration is the form of discretionary payment, which may vary based on the employee population under consideration. For example, it may be best to deliver any discretionary award in the form of company stock to strengthen retention, demonstrate commitment, and align with shareholders (assuming sufficient shares exist). This may best be reserved for more senior executives that have greater visibility, higher cash compensation, and to make more efficient use of shares in the plan, with cash awards delivered to other participants.
- Exclusions: Consideration should also be given to any positive financial outcomes that might be excluded (e.g., insurance settlements related to COVID-19) in addition to the normal course of business exclusions from incentive plan performance to ensure there are no unintended windfalls.
While for some companies the immediate-term compensation actions are focused on cash conservation, incentive plan accruals and year-end decisions for companies considering the possibility of some level of incentive payout will be soon upon committees. Early discussion and preparation for the potential use of discretion will allow for appropriate deliberation, accounting accrual adjustment, and sound year-end decision-making.
This Viewpoint is one in a series of ongoing articles Pay Governance will be publishing regarding the impact of COVID-19 on compensation programs. All of our Viewpoints can be found on our website at www.paygovernance.com.
[i] Aaron Bertinetti. “Glass Lewis’ Approach to Governance in Times of the Coronavirus Pandemic.” The Harvard Law School Forum on Corporate Governance. April 1, 2020. https://corpgov.law.harvard.edu/2020/04/01/glass-lewis-approach-to-governance-in-times-of-the-coronavirus-pandemic/.
[ii] Investment Stewardship Group. “Commentary: Investment Stewardship’s approach to executive compensation.” BlackRock. January 2020. https://www.blackrock.com/corporate/literature/publication/blk-commentary-our-approach-to-executive-compensation.pdf.