Late last month, the Vanguard Investment Stewardship team shared a new update about the asset manager’s approach to ESG metrics in compensation plans. This update follows earlier guidance from May 2022.
Vanguard implies that it’s time for more detail because it’s seeing a growing number of U.K. and European companies implementing ESG metrics. However, the insights & suggestions appear to be relevant to all portfolio companies, including U.S. companies.
Vanguard still doesn’t expect companies to use ESG metrics and recognizes there’s no one-size-fits-all approach to executive pay. But if a company does use ESG metrics, those metrics should be transparent, rigorous & well-planned – it’s not a place to “test-and-learn.”
The update explains that pay-for-performance alignment continues to drive Vanguard funds’ say-on-pay votes. The stewardship team gives these examples that may cause concerns & impact voting decisions:
1. The introduction of ESG metrics that are not clearly aligned to company strategy.
2. The inclusion of ESG metrics that are not linked to a financially material risk or opportunity, even where targets are quantifiable or clearly disclosed.
3. The introduction of ESG metrics without the disclosure of comprehensive definitions.
4. Increased weightings placed on ESG metrics or replacing financial metrics with ESG metrics without a disclosed compelling rationale.
5. Year-over-year optimum achievement of ESG targets. This may raise concerns over the rigor of plan design, including the level of rigor in the established ESG targets. This concern may be exacerbated when ESG metrics are not quantifiable or clearly aligned to a company’s annual reporting.
VIS also suggests these “best practices” (see the full 4-page update for more detail on what each of these mean):
1. Focus on materiality
2. Alignment to appropriate time horizons
3. Robust disclosure
4. Stretch targets
5. Use of underpins or modifiers where appropriate
6. Thoughtful approach to external indexes
Lastly, the update shares a few questions that Investment Stewardship reps may ask about ESG metrics during engagements.
Here are a couple of commonly held beliefs on executive pay:
1. Performance-based pay – linked to total shareholder return or other financial metrics – will help executives focus on delivering profits to investors.
2. Investors need a lot of information to assess whether that’s happening to their liking.
Despite all of our hard work on these two topics, executive pay continues to increase, and in some cases ascend into the into the stratosphere. A lot of people – including CEOs! – think it’s gone too far and have suggested pay caps. With all that head-scratching, maybe we should also consider whether “say-on-pay” and “pay versus performance” – and the complex executive pay programs that they spotlight – are part of the problem.
A recent 31-page report from Boston-based non-profit FCLTGlobal makes the case that commonly used pay metrics tend to incentivize short-term results at the expense of long-term performance. Here’s an excerpt:
The most effective remuneration structures are matched to a company’s objectives, strategy, and management. The simplest solution is direct stock ownership by executives, with long-term holding periods. This arrangement is similar to private equity-backed companies’ structures, where the focus is on executive wealth creation over time. This report offers practical tools to aid corporate boards in designing executive remuneration, calibrating long-term equity awards, and effectively communicating remuneration policies to shareholders. These actions include the following:
• Replacing approaches that are counterproductive in the long term, and focusing on rapidly building executive share ownership through restricted stock and share retention policies
• Applying alternative indicators to gauge compensation structure and incentives
• Streamlining corporate disclosure of pay practices, emphasizing the decision-making narrative Investors require simplified approaches to say-on-pay voting that are aligned with long-term remuneration design.
We propose a framework that focuses on five key elements: holding period, quality, targets, instruments, and progress, each of which is broken down into key elements that investors can use to update their proxy voting policies. This is a critical step to take: by clearly stating in writing what criteria are likely to lead to a no or yes vote, investors can lean into a set of principles that drive proxy voting and contribute to positive change at portfolio companies.
The report also says AI could play a role in next-gen executive pay:
We expect that over time, digital technologies like artificial intelligence will revolutionize the process of gathering remuneration data for proxy voting. Tools like pay duration and wealth sensitivity, which we present in this report, have complex data needs. But they need not be so complicated, given currently available technologies. The proxy agencies, who hold significant sway in proxy voting outcomes, could embrace these technologies to help broaden the tools available to companies and investors alike.
FCLT – which stands for “focus capital on the long-term” – also delves into company & investor frustrations with say-on-pay, the shortcomings of TSR as a pay metric, and actions for boards of directors. At the back, there’s a chart with “do’s & don’ts” for improving long-term alignment.
The notion of doing away with performance programs isn’t a new one, especially in Europe. I most recently blogged about it in August, when Norges Bank continued its push for simplified pay structures. This year, Norges voted against say-on-pay at companies that were “most materially misaligned” with the firm’s preferred approach – which worked out to 1 in 10! That said, US investors have been reaping returns right along with executives these past few years. So, there’s probably not consensus on whether US executive pay is “broken” enough to fix.
FW Cook has released its Annual “Top 250 Report” – which examines the long-term incentive practices & trends of the 250 largest companies in the S&P 500. This year’s report gives special focus to design trends that have emerged since the COVID-19 pandemic (i.e., pre-2020 to current). Here are the key findings:
Prevalence of total shareholder return (“TSR”) metrics has increased 7 percentage points since 2019, with most companies combining market-based metrics with at least one other financial performance metric…
• Increased use of TSR metrics is driven by pressure to better align long-term incentive payouts with shareholder outcomes, despite program participants’ limited control over external factors that influence stock price movement.
• Most companies use TSR with at least one other performance metric (85% prevalence), and the prevalence of using it as a modifier of payouts based on other metrics has grown by 50% since the start of the pandemic (38% prevalence now, up from 25% in 2019)
Non-TSR financial goal ranges have widened to account for goal-setting difficulties, while relative TSR award designs have become more rigorous…
• Wider ranges between threshold and maximum goals for non-TSR financial metrics make it more likely to earn at least some portion of the award while making an above-target earnout more challenging.
• For relative TSR, more companies are setting above-median target goals (30% prevalence now, up from 24% in 2019) and implementing caps on payouts if absolute TSR is negative (34% prevalence now, up from 26% in 2019).
Performance measurement using multiple, discrete annual goals has increased in prevalence…
• 12% of companies measure long-term incentives in annual increments, double the rate in 2019, which is most common in the Communication Services (29% prevalence), Information Technology (24%), and Health Care (19%) sectors.
• However, proxy advisors and investors often express concern that annual goals do not incentivize long-term performance and continue to prefer multi-year end-to-end measurement periods, which remain much more prevalent.
• Setting annual performance goals year-by-year (vs. all-at-once at grant) further deleverages performance risk and has increased by 30% in prevalence (46% prevalence now, up from 36% in 2019), despite being subject to more external scrutiny than upfront goal-setting.
Frontline involved a dispute over the effect of a non-competition agreement contained in Equity Incentive Grant Agreements entered into between a parent entity, fund entities of the parent’s private equity owners, and employees of an operating subsidiary of that parent entity. Through the Equity Incentive Grant Agreements the employees received equity units in the parent, and in exchange agreed to certain non-competition covenants. But the operating subsidiary employer was not a party to the Equity Incentive Grant Agreements and the non-competition provision only prohibited the operating subsidiary’s employees from going to work for a competitor of the parent. […] The employees terminated their employment with the operating subsidiary and went to work for what was alleged to be a direct competitor of the operating subsidiary.
Vice Chancellor Will found that the “parent’s business was owning the operating subsidiary, not engaging in the business in which the operating subsidiary engaged.” And, concerning the plaintiff’s argument of mutual mistake:
Vice Chancellor Will acknowledged that what was intended by the non-competition agreement “was to prevent the employees from working for a competitor of its operating subsidiary.” But what was intended and what was said were in this case two different things. According to the court, no showing was made here that the parties had reached “a specific prior understanding that differed materially from the written [equity grant] agreements” that were signed by the parties. And simply failing to properly draft the restrictive covenant in a manner the plaintiff may have intended, to thereby support the equity grant that was given to the employee, was not, according to the court, a mutual mistake.
Troutman Pepper recently released this memo regarding equity award delegations after the 2022 and 2023 DGCL amendments, which we’ve previously blogged about here and on TheCorporateCounsel.net. Here’s helpful background from the memo as a reminder:
Section 152(b) of the DGCL governs the board’s delegation of its authority to issue capital stock (which includes grants of restricted stock awards), and Section 157(c) governs options and rights (most commonly, time-vesting and performance-vesting restricted stock units (RSUs)). Historically, there was a misalignment between Section 152 and Section 157 of the DGCL, which resulted in boards having more flexibility to structure delegations to grant restricted stock awards than delegations to grant options or RSUs.
The DGCL was previously amended, effective August 1, 2022 (the 2022 amendments) to address this issue, giving boards greater flexibility to structure delegations for all types of equity awards. While the 2022 amendments were welcomed by practitioners, the amendments raised certain ambiguities and interpretive questions, as discussed in our prior client alert. The 2023 amendments seek to provide more clarity on the DGCL requirements for structuring a delegation to grant equity awards.
The memo then goes on to review the old ambiguities and the clarifications in the 2023 amendments. Here are excerpts related to two of those ambiguities:
Under the 2022 amendments, the board was required to fix both (i) a cap on the maximum number of options or RSUs that may be granted by the delegate, and (ii) a cap on the maximum number of shares issuable pursuant to the delegation. Clause (i) created interpretive confusion as it was unclear what additional cap was required above and beyond establishing a maximum number of shares issuable pursuant to awards granted by the delegate. The 2023 amendments address this issue by eliminating clause (i) from the DGCL. Therefore, the only cap that is required in the authorizing resolutions is a maximum number of shares issuable pursuant to awards granted by the delegate.
The 2023 amendments seek to clarify that there are two time periods that should be fixed in the authorizing resolution, which may be different: (i) a period during which the delegate is authorized to grant options or RSUs, and (ii) a period during which shares may be issued in respect of those options or RSUs. To fulfill the first requirement, the board must establish a time period during which the delegation to grant awards remains in effect (e.g., the delegate may grant awards for five years following the effective date of the resolutions). To fulfill the second requirement, the board must establish a time period during which shares may be issued in respect of options or RSUs granted pursuant to the delegation.
While setting the time period for delivery of shares is often straightforward for options, the memo discusses complications for RSUs — for example, when settlement can be deferred. It ends with this reminder regarding delegating to a one-director committee:
Sections 152(b) and 157(c) of the DGCL are not the exclusive method for setting up an equity award delegation in Delaware. If a company’s CEO sits on the board, for example, the board may create an “equity award committee” comprised of one director — the CEO — who is authorized to grant equity awards to nonofficers. Because the delegation rules of Sections 152(b) and 157(c) do not apply to the delegation of grant-making authority by a board to a committee of the board, these rules would not apply when establishing the equity award committee. While certain formalities must still be followed and safeguards must be put into place, this alternative delegation method is attractive to many companies whose governing documents allow it.
In a new whitepaper (available for download), ISS Corporate Solutions (ICS) reviewed perk usage for CEOs of Russell 3000 companies (including the S&P 500) from January 1, 2020 to June 1, 2023 with a focus on understanding how perks usage impacts shareholder say-on-pay support. The study found that there is a double-digit decrease in shareholder support when ISS highlights perks as a concern. Of course, perks remain a relatively small portion of a CEO pay package, making it hard to understand to what extent the decreased level of support was caused by these concerns. To drill down, ICS removed from the mix companies with unfavorable overall pay programs, and the impact of perk concerns lessened.
If you’re looking to assess the types of perks your company provides, ICS listed life insurance benefits, financial planning benefits, relocation benefits, home security benefits and personal use of corporate aircraft as the most common. Those last two seem to have increased in usage since the pandemic, while the others have decreased or been consistent.
Late last week, the Corp Fin Staff issued nine new Regulation S-K Compliance and Disclosure Interpretations and updated one existing Regulation S-K Compliance and Disclosure Interpretation to provide guidance regarding the pay versus performance disclosure requirements. Here’s what Dave shared about these CDIs on TheCorporateCounsel.net:
The new CDIs address the following areas:
Question 128D.14 – Awards granted in fiscal years prior to an equity restructuring (such as a spin-off) that are retained by the holder must be included in the calculation of executive compensation actually paid.
Question 128D.15 – The change in fair value of awards granted prior to the date of an issuer’s IPO must be based on the fair value of those awards as of the end of the prior fiscal year for purposes of determining executive compensation actually paid (not based on other dates, such as the date of the IPO).
Question 128D.16 – In accordance with FASB ASC Topic 718, the effect of a market condition should be reflected in the fair value of share-based awards with such a condition. In addition, for purposes of the table required by Item 402(v)(1) of Regulation S-K, market conditions should also be considered in determining whether the vesting conditions of share-based awards have been met.
Question 128D.17 – The fair value of an award that did not meet vesting conditions during the year because the performance or market conditions were not met, but for which there is still potential for the award to vest in the future, should not be subtracted under Item 402(v)(2)(iii)(C)(1)(v) of Regulation S-K because it failed to vest in the current year.
Question 128D.18 – If retirement eligibility is the only vesting condition for a stock or option award, that condition would be considered satisfied for purposes of the pay versus performance disclosures and calculation of executive compensation actually paid in the year that the holder becomes retirement eligible.
Question 128D.19 – A performance-based vesting condition is considered satisfied when the applicable condition is achieved; however, a provision which requires the compensation committee to certify the level of performance attained should be analyzed to determine if it creates an additional substantive vesting condition, such as an employee does not vest in the award unless and until they remain employed through the date such certification occurs, in considering whether the award is vested for purposes of the Item 402(v) of Regulation S-K disclosures at the end of the fiscal year-end.
Question 128D.20 – An issuer may satisfy the requirement in Item 402(v)(2)(iii)(C)(3) of Regulation S-K with respect to the fair value of all equity awards being computed in a manner consistent with the methodology used to account for share-based payments under GAAP by using a valuation technique that differs from the one used to determine the grant date fair value of the equity-based awards that are classified as equity in the financial statements, as long as the valuation technique would be permitted under FASB ASC Topic 718, including that it meets the criteria for a valuation technique and the fair value measurement objective.
Question 128D.21 – To comply with Item 402(v)(2)(iii)(C)(3) of Regulation S-K, the methodology used to compute the fair value amounts of all equity awards must be consistent with the methodology used to account for share-based payments in the financial statements under GAAP. It is not acceptable to value these awards as of the end of a covered fiscal year based on methods not prescribed by GAAP.
Question 128D.22 – If the assumptions disclosure required by Item 402(v)(4) would involve confidential trade secrets or confidential commercial or financial information, the disclosure of which would result in competitive harm for the issuer, the issuer may omit such information to the extent such information would be subject to the confidentiality protections of Instruction 4 to Item 402(b) of Regulation S-K. However, the issuer must provide as much information responsive to the Item 402(v)(4) requirement as possible without disclosing the confidential information, such as a range of outcomes or a discussion of how a performance condition impacted the fair value. In addition, consistent with Instruction 4 to Item 402(b), the issuer should also discuss how the material difference in the assumption affects how difficult it will be for the executive or how likely it will be for the issuer to achieve undisclosed target levels or other factors.
The Staff also updated Regulation S-K CDI Question 118.08, which addresses the approach for satisfying Item 10(e) of Regulation S-K and Regulation G with respect to non-GAAP financial measures that are presented in pay-related circumstances in the proxy statement. The same principles articulated in Question 118.08 continue to apply, where an issuer can refer to annex or cross-reference the non-GAAP financial measure disclosure in the Form 10-K, but the Staff updated the language in the CDI to replace references to “the relationship between pay and performance” with “how pay is structured and implemented to reflect the registrant’s or a named executive officer’s performance.”