This past week, Attorney Mike Melbinger provided detailed reviews on how Institutional Shareholder Services may deal with the ways in which companies have changed and continue to change both short- and long-term incentive plan targets in response to a global pandemic and the related fallout that has ensued. Published below are Mike’s thoughts on ISS decisions.
Part 1 looks specifically at potential ISS updates as they related to pay-for-performance qualitative evaluation. Part 2 (which also follows below) looks at other related issues including, one-time awards granted as a replacement for forfeited performance-based awards, changes to the Equity Plan Scorecard, Stockholder Say-on-Pay, and option repricing.
Part 1: ISS Preliminary FAQs on COVID-Related Incentive Plan Changes (published Oct 20, 2020)
I have posted several times on companies’ changing their short- and long-term incentive plan targets and metrics in response to the havoc wreaked by COVID-19, including the need to disclose these changes. On October 16, ISS published general guidance as to how it “may approach COVID-related pay decisions in the context of ISS’ pay-for-performance qualitative evaluation.” ISS published this preliminary FAQ ahead of the regular annual FAQ update expected to be published in December, “in order to sooner inform investors, companies, and their advisors on these issues.”
The FAQs also address several issues that are unrelated to short- and long-term incentive plan targets and metrics. In the interest of brevity, I will address those issue in posts later this week.
ISS begins by acknowledging the extraordinary circumstances facing some companies.
It is expected that many companies will be making adjustments to annual incentive programs, which may include changes to metrics, performance targets, and measurement periods. Some companies, particularly those most severely impacted by the pandemic, may suspend their programs entirely and instead make one-time discretionary payments. Other companies may take a combination of these approaches. Such actions would be considered problematic under normal circumstances; however, in the extraordinary circumstances of the current economic downturn, ISS may view such actions to be a reasonable response so long as the justifications and rationale are clearly disclosed, and the resulting outcomes appear reasonable.
Disclosures Necessary for Investors to Evaluate COVID-Related Changes to Bonus/Annual Incentive Programs
According to ISS, investors have indicated that additional disclosure is necessary for them to evaluate annual incentive program changes or discretionary awards, given the pandemic. ISS’ qualitative review will continue to evaluate companies’ incentive programs on a case-by-case basis. The FAQs list key five disclosure items that would help investors evaluate COVID-related changes to a company’s annual incentive program:
- 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. This 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. Generic descriptions (i.e. “strong leadership during challenging times”) are 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. ISS will closely scrutinize above-target payouts under changed programs.
- ISS encourages companies that have designed the following year’s (2021) annual incentive program to disclose information about positive changes, which may carry mitigating weight in ISS’ qualitative evaluation.
ISS’ analysis of Changes That Lower Financial or Operational Targets Below the Prior Year’s Performance Levels
With respect to ISS’ analysis of incentive plan goal rigor, investors have indicated that lower performance expectations that reflect external factors (such as operational impacts due to the pandemic) may be a reasonable explanation for lower goal setting. Nonetheless, a lower performance target should be accompanied by disclosure as to how the board considered corresponding payout opportunities, particularly if such payout opportunities are not commensurately reduced.
COVID-Related Changes to Equity/Long-Term Incentive Plans
As expects (and as we have discussed in previous blogs) ISS generally will view changes to performance cycles that are currently in-progress (e.g., FY2018-20 or FY2019-21) negatively, because these programs should be designed to smooth performance over a long-term period and not be altered after the beginning of the cycle based on a short-term market shock. This is particularly true for companies that ISS judges to exhibit a quantitative pay-for-performance misalignment.
For long-term incentive award cycles beginning in 2020, ISS may view modest alterations to the incentive program as reasonable. “For example, movement to relative or qualitative metrics may be viewed as reasonable in the event of unclear long-term financial forecasting.” However, ISS will view more drastic changes, such as shifts to predominantly time-vesting equity or short-term measurement periods, negatively, unless the company’s underlying business strategy has fundamentally changed. In either event, companies should clearly explain any changes to the program to allow investors to evaluate the compensation committee’s actions and rationale.
Stay tuned for a discussion of other issued address in the FAQs later this week.
Part 2: Other Issues Addressed by ISS’ Preliminary FAQs (Oct 23, 2020)
Earlier this week, I posted on ISS FAQs related to COVID-19 pay changes (above). Today I want to note that the FAQs also addressed certain issues not related to changes to performance targets and metrics.
Evaluation of COVID-Related Retention or Other One-Time Awards
ISS expects that companies that grant one-time awards to address concerns resulting from the pandemic, including awards with a retention component, will clearly disclose the rationale for the awards (including magnitude and structure), as well as describe how the award furthers investors’ interests. ISS will not view boilerplate language regarding “retention concerns” as sufficient rationale. ISS also expects that (i) awards will be reasonable in magnitude, (ii) the vesting conditions will be long-term, strongly performance-based, and linked to the underlying concerns the award, and (iii) the awards will include shareholder-friendly guardrails to avoid windfall scenarios, including limitations on termination-related vesting.
Evaluation Retention or Other One-Time Awards Granted in the Context of a Forfeited Incentive
ISS will look askance at awards granted as a replacement for forfeited performance-based awards. To the extent one-time awards are granted in the year (or following year) in which incentives are forfeited, ISS expects companies to explain the specific issues driving the decision to grant the awards and how the awards further investors’ interests.
Changes to Equity Plan Scorecard (EPSC)
For the 2021 policy year, the passing score for the S&P 500 EPSC model will increase to 57 points. The passing score for the Russell 3000 EPSC model will increase to 55 points. For all other EPSC models, the passing score will remain 53 points. ISS made no changes to EPSC specifically related to the pandemic.
Changes to ISS’ SSOP* Responsiveness Policy in Light of COVID-19
ISS may cut some slack to companies that received less than 70% support on the say-on-pay proposal, but are unable, due to the pandemic, to take actions or make changes to pay programs and practices to address the concerns of ISS and investors. However, in this case, the company’s proxy statement should disclose specifically how the pandemic has impeded the company’s ability to address shareholders’ concerns. If pay program changes are delayed, or do not necessarily fully address shareholder feedback, the company should disclose a longer-term plan on how it intends to address investors’ concerns.
Problematic Pay Practices
ISS’ Problematic Pay Practices policies will be consistent with prior years.
ISS also made no changes on option repricing programs, which case-by-case approach generally opposes repricings that occur within one year of a precipitous drop in the company’s stock price. If boards undertake repricing actions without seeking prior shareholder approval, the directors’ actions will remain subject to scrutiny under the U.S. policies on board accountability.
*SSOP: Shareholder Say on Pay
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. Any tax advice contained herein is of a general nature. You should seek specific advice from your tax professional before pursuing any idea contemplated herein.
Securities offered through Lion Street Financial, LLC (LSF) and Valmark Securities, Inc. (VSI), each a member of FINRA and SIPC. Investment advisory services offered through CapAcuity, LLC; Lion Street Advisors, LLC (LSF) and Valmark Advisers, Inc. (VAI), each an SEC registered investment advisor. Please refer to your investment advisory agreement and the Form ADV disclosures provided to you for more information. VAI/VSI, LSF and CapAcuity, LLC. are non-affiliated entities and separate entities from OneDigital and Fulcrum Partners.
Unless otherwise noted, VAI/VSI, LSF are not affiliated, associated, authorized, endorsed by, or in any way officially connected with any other company, agency or government agency identified or referenced in this document.