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. Last Friday, 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 issues 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 (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.
-Mike Melbinger, CompensationStandards.com October 20, 2020
