As we move into proxy season, BDO’s Richard Smith and Judy Canavan discuss notable areas to watch for – including scoring, incentives and contractual payments and arrangements – and they reflect on how COVID-19 is affecting things.
As proxy season enters full swing, proxy advisory firms and institutional investors are closely watching corporations’ responsiveness to their recommendations and concerns. As in any historical periods of extreme market volatility (such as the dot-com bubble burst of 2000 or the financial crisis of 2008), the volatility caused by the novel coronavirus (COVID-19) pandemic will add additional levels of complexity for this year and will likely result in a rebalancing of priorities in the future.
The CEO pay ratio was viewed to be of limited value. It is unlikely that it will hold much relevance this year in the face of much more pressing issues. When it comes to executive pay, what will continue to be important to investors and advisory firms is how compensation policies are helping a company advance key objectives. Proxy advisory firms Institutional Shareholder Services Inc. (ISS) and Glass Lewis are asking for greater specificity around contractual payments and discretionary incentives. However, for this year, it is likely that the conversation around executive pay will be more complex than ever. We believe there to be three areas of focus for this proxy season that boards will need to address as part of their fiduciary responsibilities:
Scrutiny over Excess Pay
Every year, proxy advisory firms find areas where they need to tighten their grip on excess pay. The current financial situation will put this priority center stage. Several focus areas were already targeted by Glass Lewis: It stated that certain executive “entitlements,” such as excessively broad definitions of “change in control” in employment agreements or inadequately explained sign-on agreements, could trigger a negative recommendation. Disclosures of sign-on agreements should include information about how the compensation amount was determined. Glass Lewis also clarified that severance payments should not exceed market practice or generally deviate from predetermined payouts.
ISS notified companies that a negative recommendation can result when they see a recurring pattern of excessive pay over two or more consecutive years for a non-employee director. When that does occur, a “compelling” rationale must be provided. There are instances in which their concerns could be mitigated — for example, payments related to corporate transactions or one-time onboarding grants.
In response to the COVID-19 pandemic, companies will need to make it clear that they are thinking beyond just their own executives. Glass Lewis made their guidance very clear:
“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 [that] 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.”
Clarity on Short- and Long-Term Incentive Policies
Proxy advisory firms and institutional investors have indicated that detailed disclosures are expected regarding any discretionary incentives used in executive pay plans. Even prior to COVID-19, Glass Lewis specified that any upward discretion applied to short-term incentives should be reported in proxy statements, accompanied by a robust rationale.
While discretionary incentives do exist, it’s rare to see companies use them. Incentive plans with clearly established metrics and goals have no need for a discretionary tool except in the event of extraordinary circumstances. That said, the COVID-19 pandemic is an extraordinary event that has rocked the stock market and dramatically and fundamentally impacted everyday work environments. It will certainly affect incentive performance-based pay (including the use of stock grants, given the unknown projected value of shares). If pandemic concerns continue to rattle the economy for an extended period, then compensation committees and compensation plan administrators will need to consider building flexibility into their plans. While it will likely be necessary to build the flexibility of discretion into annual incentive programs, it is much harder to apply discretion to long-term equity incentive programs without impairing the fixed accounting of equity programs.
Reductions (in pay, in staff, or both) will likely be necessary to keep executives and the broader employee-base engaged and paid. Other compensation-related changes could include modifying goals or changing payout schedules. For companies impacted by closures resulting in reduced cash flow, a deferral arrangement may be considered. Glass Lewis expressed concern that we may see “‘crocodile tears’ for maintaining, or even increasing, executive pay.” As such, for named executive officers (NEOs), any pay increases should be delayed indefinitely.
The bigger issue for most companies going forward is whether short-term and long-term incentive plans are using the right metrics to drive performance in the right areas under these extraordinary circumstances. Adjustments will need to be made at least temporarily, considering the economic environment. It is likely future long-term incentive (LTI) performance plans will be adjusted to use industry-related total shareholder return (TSR) metrics given that it is one indicator of performance during a crisis.
BDO’s analysis of 600 middle market companies across eight industry sectors found that some industries do a better job of aligning pay and performance than others. For most industries, there was a statistically significant correlation between certain financial metrics in long-term incentive plans and TSR. For example, in health care, companies typically use revenue and EBITDA in long-term incentive plans, but the analysis found that net income and earnings before interest and taxes (EBIT) growth are better indicators of three-year TSR growth. The focus on linkages between executive pay and performance continues to grow. Companies should take extra care to provide details that can alleviate investor and shareholder pressures.
Increasing Environmental, Social and Governance (ESG) Pressures
The COVID-19 pandemic has likely added critical ESG issues to the agenda for this year and underscored the importance of specific ESG issues for both 2020 and beyond.
Investors are demanding greater detail around ESG issues, and this year’s proxy season will test just how much influence investors, advisory firms and shareholders have on changing corporate practices on issues ranging from leadership diversity to climate change to gender-pay equity to sustainable governance. With the immediate impact of COVID-19 threatening the very existence of some companies, boards and management have been given a crash course on the linkage between many of the ESG issues and financial viability.
Even before the COVID-19 crisis, major investment management firms, including Blackrock and State Street Global Advisors, were expressing commitments to put ESG matters front and center. Cyrus Taraporevala, President and CEO of State Street Global Advisors, stated the firm’s intention “to use our proxy voting power to ensure companies are identifying material ESG issues and incorporating the implications into their long-term strategy.” He stated that despite their efforts to engage with companies on ESG matters for years, fewer than 25 percent of the companies they’ve evaluated have “meaningfully identified, incorporated and disclosed material ESG issues into their strategies.”
While companies have come a long way with reporting ESG matters in recent years, one of the primary challenges has been the lack of a consistent framework. A McKinsey report found that 75 percent of investors agree there should be one sustainability-reporting standard and 82 percent believe companies should be required by law to issue sustainability reports; most believe that these moves would help companies more effectively allocate capital and manage risk. In the meantime, there have been disparate efforts to create frameworks:
- Major investors (including State Street Global Advisors) are creating their own scoring systems to evaluate companies on material ESG issues.
- The California State Teachers’ Retirement System (CalSTRS) developed its own list of 25 ESG-focused risk factors to regularly discuss with companies. CalSTRS’ ESG risk factors include “human health,” but fails to address protection of the supply chain or risk management — two critical factors in protecting employees and customers from pandemics, war or acts of terrorism.
- The Sustainability Accounting Standards Board created a Materiality Map, which lists and defines key elements of sustainability and links them to accounting metrics. Some of those that that are most closely intertwined with COVID-19 include: customer welfare, employee health and safety, supply chain management, materials sourcing and efficiency, critical incident risk management and systemic risk management.
- ISS also examined how executive incentives might affect environmental and social (E&S) performance. Their analysis found that more companies disclose E&S metrics related to their short-term incentive plans versus their long-term plans. As a result of this research, ISS changed its governance-scoring methodology, adding two new compensation-related factors that evaluate whether companies disclose any E&S performance measures within their short-term and long-term executive incentive plans.
Investors and advisory firms continue to demand companies provide more transparency around executive pay. They also want to see companies taking their concerns around connecting pay to performance seriously. Recent events will likely lower their tolerance level for any compensation decisions that appear to be out of line with the costs borne by shareholder and other stakeholders (including employees). To match these demands, governance and compliance professionals should ensure they include detailed disclosures on compensation and strive to put ESG issues at the fore.