The COVID-19 pandemic continues to inflict financial prices on corporations throughout sectors of the economic system. For affected corporations with compensation packages which can be considerably performance-based, motivating and retaining govt expertise when incentive efficiency targets develop into unattainable as a result of downturn is a major concern. The heightened degree of uncertainty over how lengthy the pandemic will final and how briskly the economic system can get well additional obscures the best way ahead. On this advisory, we summarize current proxy advisor steering on adjusting annual efficiency targets, and description a spread of methods for adjusting these targets to incentivize efficiency and retention whereas sustaining alignment with shareholder return and basic monetary efficiency.
ISS Case Examine
On June eighth, ISS Company Options, the consulting affiliate of proxy advisor Institutional Shareholder Companies (ISS), issued the primary of 4 case research outlining potential frameworks for adjusting annual incentive targets or metrics “to determine a extra reasonable construction for correctly incentivizing executives” within the unstable COVID-19 period. This primary case examine (Case Examine) considers a situation wherein an organization adjusts its annual efficiency targets with a commensurate discount to its CEO’s short-term incentives.
The Case Examine focuses on a mid-cap retail firm with shops closed as a result of pandemic. The corporate’s CEO incentives are tied to full-year EBITDA outcomes that might be unattainable due to the shutdown. The corporate’s CEO efficiency targets have been developed utilizing an algorithm that fashions the chance of attainable outcomes based mostly on sure variables, on this case, progress fee and volatility, along with consideration of historic working outcomes, peer monetary efficiency and analyst expectations. The corporate elected to revise the unique targets by adjusting the expansion fee downward and the volatility fee upward to mirror the probability that the financial downturn could have a damaging and lasting affect on the corporate’s funds even when the retail sector rebounds after re-opening. These changes resulted in a downward adjustment of the projected vary for EBITDA. The CEO’s goal incentive award was then lowered by 25% to mirror the decline in projected EBITDA. The Case Examine recognized the next potential advantages of adjusting full-year targets with a commensurate discount in CEO incentives:
Continued motivation for the CEO to realize full-year working outcomes based mostly on clear targets, with a chance to earn an award aligned with the pursuits of shareholders who had suffered a steep decline in share worth; and
Avoidance of the necessity for year-end discretionary changes, which might give rise to an unfavorable response from buyers.
The Case Examine additionally recognized a number of potential drawbacks:
Problem of revising progress fee and volatility assumptions earlier than it’s clear how the economic system will get well; and
Potential damaging response of shareholders who may think about the revised efficiency targets too “smooth” within the occasion that the economic system recovers quicker than anticipated.
Methods for Adjusting Efficiency Objectives
Whereas the Case Examine is just not supposed to point how ISS will consider an organization’s compensation choices, it means that an ISS overview of mid-year changes to annual govt efficiency incentives is more likely to give attention to how properly such incentives align with shareholder pursuits and an organization’s performance-based compensation philosophy.
Firms with efficiency targets which can be more likely to be unattainable given the COVID-19–associated downturn will wish to establish the perfect technique to incentivize executives whereas persevering with to guard shareholder worth in an unsure market. This problem might be tough as a result of institutional buyers and others are more likely to be important if the chosen efficiency targets are set too low and the market improves. Compensation committees ought to think about the next different methods for adjusting annual efficiency targets midstream:
Wait and see. Though we’re properly into calendar 12 months 2020, some corporations are persevering with to attend till the affect of the pandemic is clearer earlier than revising their 2020 efficiency targets to keep away from the danger that the adjusted targets might be deemed too smooth by shareholders and proxy advisory corporations after the very fact. It’s attainable that institutional buyers and proxy advisors might disapprove of targets which can be lowered earlier than it’s clear that the COVID-19 impacts are long-term and substantial for the corporate, its business, or each.
Revising Metrics. To keep away from setting revised targets that would once more develop into unattainable, corporations ought to think about adopting a wider vary of metrics for efficiency targets, supplied the corporate’s incentive plans and agreements enable these changes. These revised metrics might embrace non-financial operational targets centered on course of enchancment or elevated efficiencies, or focused regional or department-based targets to handle disparate impacts of the downturn.
Changing full 12 months with second half efficiency targets. Firms can think about using 6-month relatively than 12-month targets to allow executives to obtain full incentives for the second half of the 12 months. The efficiency targets and relevant timeframe might be adjusted with or with out a commensurate discount in govt incentives for the relevant interval. As famous within the Case Examine, a considerable decline in share worth would counsel that the award ought to be lowered to align it with shareholder curiosity.
Setting relative efficiency targets. Firms may think about setting targets relative to see firm efficiency or present values (e.g., relative shareholder return, web earnings or complete gross sales) relatively than counting on absolute metrics.
Compensation committee discretion. Awards might be topic to adjustment by the compensation committee with the advantage of some hindsight. Firms ought to be aware that as a result of ISS typically views discretion unfavorably, the compensation committee would want to doc its discussions resulting in any discretionary modifications, and successfully talk these issues to shareholders.
Previous to taking any motion to revise efficiency metrics, corporations ought to overview their compensation plan paperwork to verify the extent of the compensation committee’s authority to revise established efficiency standards. Amendments that will doubtlessly adversely have an effect on members might require their consent. Firms ought to affirm that the proposed modifications is not going to violate the deferred compensation guidelines of 409A of the Inner Income Code, and likewise be aware that any revision to efficiency targets below compensation agreements or plans in impact on November 2, 2017, that are presently grandfathered below Part 162(m) of the Inner Income Code, will end in lack of grandfathered standing (that means that the corporate will now not be capable of exclude this compensation from Inner Income Code Part 162(m)’s $1,000,000 cap on deductible worker compensation). As well as, modification of a performance-based fairness award that makes it simpler to realize will end in an accounting cost based mostly on the modified combination truthful worth of the revised award, and an organization giving its compensation committee discretion to change awards based mostly on efficiency targets ought to be aware that such awards could also be handled as a legal responsibility below accounting guidelines. Firms ought to additional be aware that ISS has really helpful that materials modifications to efficiency targets for short-term incentives as a result of pandemic in addition to an evidence of the rationale behind these modifications ought to be contemporaneously disclosed to shareholders. An unfavorable response from buyers might end in a damaging say-on-pay vote on the subsequent annual shareholders assembly.
Trying to construction reasonable performance-based compensation packages throughout a interval of financial instability and market volatility is a fraught train. Regardless of the uncertainties, corporations and their compensation committees will wish to proceed to incentivize and retain their high expertise, and will have to take motion to make sure these targets are met. Considerate give attention to methods and targets that align personnel wants and the pursuits of shareholders will assist corporations navigate the present turbulent atmosphere.
1 Revisiting Annual Incentive Objectives in Mild of the COVID-19 Pandemic: https://insights.issgovernance.com/posts/revisiting-annual-incentive-goals-in-light-of-the-covid-19-pandemic/
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