October 30, 2020

Blog: ISS provides early guidance on changes to executive compensation related to COVID-19

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ISS has provided some early guidance regarding how it will view pandemic-related changes to executive compensation as part of its pay-for-performance qualitative evaluation. According to ISS, the guidance was informed by direct discussions with investors as well as the results of its annual policy survey. The guidance is summarized below:

Salary reductions. Because salary tends to be a relatively small component of total comp, ISS will give temporary salary reductions only “mitigating weight,” but will attribute more significance to the reduction “if targeted incentive payout opportunities are decreased to reflect the reduced salary.”

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In this recent study of how COVID-19 has affected CEO compensation, conducted by Equilar and the Rock Center for Corporate Governance at Stanford, the authors analyzed the compensation disclosures made by companies in the Russell 3000 between January 1 and June 30, 2020. The authors found that 502 companies (17%) disclosed adjustments to CEO salary, bonus or long-term incentive programs or director fees during this period. Predictably, companies that made CEO pay adjustments were also the companies that sustained the biggest stock price declines (average stock price decline of 23.6% compared with 10.2% for non-adjusting companies) and were compelled to lay off or reduce pay for employees (82% compared with 10% for non-adjusting companies). For the most part, the study reported, adjustments were made to CEO salaries (449 companies). however, the biggest proportion of CEO pay is typically in incentive bonuses and equity, not salary. As a result, while the median CEO salary in this group may have declined by 47%, total targeted comp declined by only 8%. (See this PubCo post.)

Changes to bonus/annual incentives. ISS expects that there may well be adjustments to these programs in light of COVID-19, especially among companies severely impacted. Adjustments may even include, in some cases, substitution of one-time discretionary payments in lieu of entire programs. Although normally these practices would be frowned on, in view of the pandemic, ISS may view these actions as reasonable “so long as the justifications and rationale are clearly disclosed, and the resulting outcomes appear reasonable.”

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In this article about annual incentive plans in the context of the pandemic posted on the Harvard Law School Forum on Corporate Governance, consultant Semler Brossy suggests that in “past years, investors have often considered discretion a ‘dirty word.’ However, in this context, discretion can be used to re-focus organizations on those key activities and outcomes that will support a stronger future. Investors and proxy advisors to date have sent a strong message against adjustments to in-cycle long-term incentives, but they have signaled openness to discretionary adjustments to annual bonuses for 2020/2021 fiscal years.”

To provide clarity and incentives, Semler advises, boards should develop criteria for discretion now, including key elements such as “financial performance relative to peers, absolute and relative shareholder outcomes, stakeholder concerns [such as alignment with employee actions and community experience], progress against strategic initiatives (including human capital management and other ESG elements), leaders’ performance in the crisis, and the current macro environment (including the pandemic).” Semler expects that, for the most part, any discretionary awards will be modest, unless the company has recovered on performance or “relative outperformance is extraordinary.” For many companies, protecting employee income and safety will come first, with executives considered “only in the context of the rest of the company.” Semler advocates that boards attempt to

“make awards proportionate to stakeholders’ outcomes, to look at pay programs holistically, to maintain alignment with results, and to consider long-term effects. Cost cutting at many companies has already led to reductions in merit pay, benefits, and retirement contribution, in the midst of sizeable employee furloughs and layoffs. These companies expect to recover eventually, but budgets will be tight for a while. Less generous protections for executives relative to the rank-and-file are likely to be the norm.” (See this PubCo post.)

Disclosure of changes. Key disclosures advocated by ISS include:

“The specific challenges that were incurred as a result of the pandemic and how those challenges rendered the original program design obsolete or the original performance targets impossible to achieve. The disclosure should address how changes are not reflective of poor management performance.
For companies making mid-year changes vs. one-time discretionary awards, the company should explain why that approach was taken (as opposed to the alternative approach) and how such actions further investors’ interests.
One-time discretionary awards should still carry performance-based considerations and companies should disclose the underlying criteria, even if not based on the original metrics or targets. Investors are likely to find generic descriptions (i.e. ‘strong leadership during challenging times’) to be insufficient.
The company should discuss how the resulting payouts appropriately reflect both executive and company annual performance. The disclosure should clarify (or estimate) how the resulting payouts compare with what would have been paid under the original program design. Above-target payouts under changed programs will be closely scrutinized.
Companies that have designed the following year’s (2021) annual incentive program are encouraged to disclose information about positive changes, which may carry mitigating weight in ISS’ qualitative evaluation.”

Reduced bonus/annual incentive plan targets. Reductions in financial or operational targets below the levels of the prior year might be reasonably explained as the result of the impact of COVID-19, but boards will need to explain in the disclosure how they considered the corresponding payout opportunities, especially if they were not similarly reduced.

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In the Equilar/Stanford study, only 92 companies took action with regard to annual bonus programs, including 44 that reduced bonus payments, 17 that deferred payments and 10 that exchanged cash bonuses for equity. Of the 92 companies, 31 changed the structure of the bonuses for the current year in a manner favorable to the CEO by making the award discretionary instead of target-based (three companies), changing it to a retention bonus instead of a performance award (eight companies) or changing the performance metrics by reducing the performance targets (20 companies). In some cases, the reduced goals were to be established later in the year as visibility increased.

Changes to equity/long-term incentive programs. Because these programs are designed for the long term, ISS believes that current in-progress cycles should not be modified “based on a short-term market shock.” ISS will generally view these types of changes “negatively, particularly for companies that exhibit a quantitative pay-for-performance misalignment.” However, “modest” changes to long-term incentives awarded in 2020 looking forward may be viewed as reasonable (e.g., changes to relative or qualitative metrics) in the event of “unclear long-term financial forecasting.” In the absence of fundamental changes to the basic business strategy, “drastic changes,” such as “shifts to predominantly time-vesting equity or short-term measurement periods,” would be viewed negatively. All changes should be explained in the disclosure.

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The Equilar/Stanford study found that only 33 companies changed their long-term incentive plans, including nine that reduced the target value of the LTIP, nine that decreased the portion of performance units and increased restricted units, eight that changed the metrics, seven that changed to a retention award and one to a discretionary award. Together, about 60% of changes to bonuses and LTIPs reflected reductions in value, while 40% “gave the CEO the opportunity to earn value they might otherwise have lost, such as by exchanging cash awards to equity with the potential to increase in value through a stock price recovery, changing structure to discretionary or retention awards, or easing financial targets/ metrics to determine the ultimate value of awards.”

One-time awards. Companies that, to address challenges created by COVID-19, grant retention or other one-time awards should disclose, avoiding boilerplate, the rationale for the award (including magnitude and structure) and how the award furthers investors’ interests. ISS advises that the practice should be “isolated” and that the awards should be:
- reasonable in magnitude;
- contain long-term, strong performance-based vesting conditions tied to the underlying concerns; and
- contain “shareholder-friendly guardrails to avoid windfall scenarios, including limitations on termination-related vesting.”
Forfeited awards. ISS does not favor the grant of one-time awards in replacement of forfeited performance-based awards. Companies that grant one-time awards in the same year or year following forfeiture of incentive awards will need to describe “the specific issues driving the decision” and how the awards further investors’ interests. If one-time awards were granted as a result of forfeited incentives (fairness, lower pay, etc.), companies will need to explain how the awards “do not merely insulate executives from lower pay.”

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The authors of the Equilar/Stanford study also raise the conundrum of whether any change in compensation is appropriate:

“All compensation arrangements have some element of risk embedded in their design. Sometimes a compensation award will not pay out, while other times it will substantially exceed original expectations. While negative exogenous events have a negative impact on performance, positive events can have an unexpected positive impact (so-called ‘pay for luck’). Rarely do we see a voluntary reduction in payout to reduce a windfall payment that was not really merited. Both positive and negative operating environments should be considered part of the risk imposed on executives.”

The authors ask whether CEOs that usually benefit from positive outside events and rising stock markets should “be sheltered from reversals in these same factors? If so, what implications does this asymmetry have on CEO incentives? Does it create a condition in which the CEO benefits from any exogenous event?”

Say-on-pay responsiveness policy. If a say-on-pay proposal receives support below 70%, consistent with current practice, ISS will still consider, COVID-19 notwithstanding, the company’s disclosure of (i) the board’s shareholder engagement efforts and (ii) the specific feedback received from dissenting investors. Typically, ISS also takes into account the company’s actions taken to address investors’ concerns. However, if a company is unable to implement changes due to the pandemic, the company should disclose, in its proxy statement, how the pandemic has impeded the company’s ability to address shareholders’ concerns, and, if changes are delayed or incomplete, a longer term plan to address those concerns.
Other ISS policy changes. ISS is not changing its Equity Plan Scorecard (EPSC) in light of COVID-19; however, it is increasing the 2021 passing scores for the S&P 500 EPSC model to 57 points and for the Russell 3000 EPSC model to 55 points. For all other EPSC models, the passing score will remain 53 points. There are no changes to ISS policies on Problematic Pay Practices (which identify problematic contractual provisions in executive agreements) or option repricing policies (which generally oppose repricings that occur within one year of a precipitous drop in the company’s stock price).

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.