The Advisors' Blog

Here’s something that my colleague John Jenkins blogged recently on TheCorporateCounsel.net: We’ve previously blogged about Covid-19 related securities litigation, but this Proskauer blog flags something a little different – derivative litigation targeting comp awards that the plaintiffs essentially claim were “spring loaded” due to the pandemic-related market volatility:

While we are growing accustomed to pandemic-based shareholder actions relating to improper health and safety disclosures or misrepresentations relating to COVID-19 treatments and tests, this month brings a novel variant of the COVID-19 lawsuit. A Universal Health Services Inc. investor has filed a derivative suit against company officers and directors, claiming they took advantage of a pandemic-related drop in the company’s stock price to grant and receive certain stock options that were unfair to the company and its stockholders.

The plaintiff investor claims that “company insiders took advantage of the temporary drop in the company’s stock price to grant and receive options to buy the company’s stock at rock bottom prices, thereby showering themselves in excessive compensation.” The complaint alleges that the drop in stock price was “not caused by any changes in the company’s fundamentals or business prospects,” but instead was entirely attributable to the effect of the pandemic on the markets writ large.

The blog points out that the timing of the awards was pretty terrific from the recipients’ standpoint. The stock popped 25% the day after they were granted and by 47% within a week. According to the complaint, in just twelve days, the defendants reaped over $30 million in gains. The complaint alleges that the officers who received the grants unjustly enriched themselves and that the comp committee committed waste in making the awards.

– Liz Dunshee

You might’ve thought that executive “mega grants” disappeared a decade ago, along with new episodes of Jersey Shore. But this Pearl Meyer memo says they could be making a comeback. The memo defines “mega grants” as awards that have at least some of these characteristics:

– A grant date value of more than 10x the CEO’s (or other executive’s) salary;

– Represents a significant percent of common shares outstanding (e.g., 3% to 12% or more of common stock outstanding [CSO]);

– A one-time multi-year award, with an expectation of no further equity awards being provided to the recipient for several years; and/or

– Extended vesting/performance horizons, often seven to 10 years.

While proxy advisors and investors tend to dislike outsized awards, there may be situations where the benefits outweigh the risks. This Aon memo walks through ways to align mega grants with stakeholder interests – and gives examples of terms & conditions. Here are a few suggestions:

– Expressing the award’s ultimate value as a percentage of the value created for shareholders helps to articulate the value sharing between executives and shareholders. Targeted values of the award often range between 1-5% of total company value, with the majority on the lower end of the spectrum. Going above this range comes with substantially more risk, and in turn, should be accompanied with more performance rigor and justification.

– It is not uncommon for executives to forgo other compensation during the performance period of awards like this to help justify the quantum.

– Even if shareholder approval is not required, we recommend seeking approval to help mitigate risks.

– Some companies have chosen to roll out special broad-based programs at the same time to allow others to share in the success of the company, such as an employee stock purchase plan.

– There are also the optics to manage if the award does not ultimately payout, potentially impacting retention of key executives. Even entertaining a modification if the award becomes unlikely to pay out can make the problem worse. This may also tie up compensation plans for the executives over that timeframe, limiting flexibility to a changing environment. These risks should be weighed carefully during the design phase, so the company is comfortable with this potential outcome.

– Consider including design features that help to create even stronger alignment with shareholders, such as a post-vest holding period.

– Explaining directly to shareholders why this program is necessary and why you believe in it can be very impactful to getting shareholder support.

– Articulating explicitly why this program aligns with the company’s goals and is valuable to all stakeholders helps with the qualitative review of these programs and gaining shareholder support. Companies should make sure the rationale behind the award is one the company believes and can support publicly.

– Liz Dunshee

There’s no “one size fits all” with ESG metrics. They have to be carefully tailored to support the specific ESG strategies & priorities that the board has directed. For that reason, metrics vary across industries. This 16-page Semler Brossy memo dives into emerging trends in different sectors. Here are some takeaways:

– Heavy industries – such as Energy & Materials – place significant emphasis on employee safety metrics, along with measures tied to environmental impact and stewardship. The Energy, Utilities & Materials industries have the highest prevalence of ESG metrics, with safety being the most common metric.

– Industries with a heavy strategic focus on recruiting & developing high-caliber talent – such as Financials, Technology & Healthcare – tend to emphasize human capital metrics such as retention and talent development

– Customer satisfaction is common among Health Care, Financials, Information Technology, Industrials, and Utilities companies. Somewhat unexpected is the low prevalence of customer satisfaction metrics in incentive plans among direct consumer businesses in the Consumer Discretionary and Consumer Staples industries, although these industries also have the lowest prevalence of ESG metrics overall.

– All industries are continuing to face pressure to demonstrate a commitment to social responsibility, which is fueling the adoption of newer “social” sustainability metrics such as Diversity & Inclusion. Blue chip companies are announcing the addition of E&S metrics to go-forward plans.

– D&I is a prevalent metric in Financials, Health Care, Information Technology, and Communication Services, which are all industries that would be predicted by SASB. However, we also find high prevalence of D&I in incentives in Energy, Utilities, and Materials businesses, which is not as intuitive and perhaps a reflection of the higher level of social scrutiny of these companies given their overall environmental footprint. Perhaps most surprising is the relatively low prevalence of D&I incentives in consumer-oriented businesses – Consumer Staples and Consumer Discretionary.

– Environmental metrics are still relatively rare. They’re most prominent by far in the Energy, Utilities and Materials sectors, where emissions is the most prevalent, followed by carbon footprint. We would not be surprised if the combination of stakeholder pressure and financial materiality (e.g., under the SASB framework) will cause environmental metrics to grow in prevalence across industries over time.

– Liz Dunshee

The capuchin monkey experiment is often trotted out as an example of how pay inequity demotivates employees. If we’re anything like the monkey in the experiment, we’re happy to be paid in cucumbers until we see that our colleague is getting delicious grapes. Well, directors are pretty convinced that CEOs have the same tendencies, according to a recent study from Alex Edmans and other business school profs.

In the UK-based survey of over 200 non-executive directors and 159 investors, people seemed to agree that an astronomical level of CEO pay isn’t important to execs because it “finances consumption,” but because it makes them feel like they’re being treated fairly in comparison to their counterparts. In other words, they want to feel special – which means making at least as much as their peers and getting recognized for accomplishments. In the absence of an across-the-board change (and/or a breakthrough in non-monetary ways to motivate execs), that makes it difficult to depart from the “tyranny of the 75th percentile” and ever-increasing peer-based pay – even though investors keep saying they won’t stand for it.

Here’s what else the study showed about pay decisions:

1. Directors and investors consider intrinsic motivation and personal reputation to be the most important sources of incentives for CEOs.

2. While the primary reason for variable pay is to motivate the CEO to improve long-term shareholder value, this is not because the CEO obtains utility from consuming the additional pay from good performance. Instead, variable pay provides ex post recognition of good performance, addressing the CEO’s fairness concerns and boosting her reputation.

3. How much the CEO can affect firm performance is the main determinant of pay variability. Directors view peer firm practice and investor or proxy advisor expectations as important constraints, hindering them from tailoring pay – even though investors themselves do not consider following peer practice as important. Firm risk and CEO risk aversion are not important determinants.

4. Investors strongly believe that lengthening the horizon of CEO incentives would improve decision making, with few adverse consequences. Directors disagree. Some directors are concerned about the attraction/retention effects of such a change; others believe that incentives would become less effective.

5. The majority of directors and, in particular, investors, believe that benchmarking of CEO performance measures should not be universal. One reason is that it is fair for CEO pay to mirror the shareholder experience. A second is that, for many companies, it is difficult to define an appropriate peer group or obtain information on peer performance.

– Liz Dunshee

I’ve blogged before about resale restrictions on equity awards to private company employees – but it’s been a few years. Trading in pre-IPO shares has taken off since then – and Nasdaq just announced that it’s spinning off its private company trading platform in a deal with several big banks. If you’re working with private companies, it’s worth considering whether this affects the value or terms of employee awards. This WSJ article gives some info on who’s using the service:

Nasdaq says its private-market platform is already the leading venue for private-company tender offers. In such transactions, the holders of private-company shares are allowed to sell them within a specified window of time, usually to a large investor or to the company itself.

Cryptocurrency exchange operator Coinbase Global Inc. and cloud-software provider Asana Inc. are among the companies that used Nasdaq Private Market before their IPOs.

In the first six months of 2021, Nasdaq Private Market facilitated a record 57 private-company secondary transactions, according to the exchange operator. The platform handled $4.6 billion in total transaction value in the period, the highest level in three years, Nasdaq said.

– Liz Dunshee

As I blogged last week on TheCorporateCounsel.net’s Proxy Season Blog, ISS has opened its “Annual Benchmark Policy Survey” – as well as a separate “Climate Policy Survey.” The proxy advisor is gathering feedback that could affect how it’ll analyze say-on-pay and whether it will favor ESG metrics being added to comp plans. Here are the specific pay-related questions:

Non-Financial ESG Performance Metrics in Executive Compensation

The inclusion of non-financial environmental, social, and governance (ESG) performance measures and incentives in executive pay plans has become more prevalent in the past few years. For example, as of June 17, 2021, almost 30 percent (27.6%) of publicly traded companies across Europe, North America and Asia-Pacific had incorporated at least one E&S-related incentive metric into their compensation plans, against only 8.5 percent in 2017 (source: ISS-ESG Executive Compensation Analytics database).

Proponents argue that companies will take ESG issues more seriously and have better business outcomes if executive pay is linked to achievement of ESG performance measures such as its environmental footprint or social impact. Critics and skeptics are concerned that many ESG outcomes may be hard to quantify and that the more widespread use of such performance metrics could reward executives for vague and poorly-defined outcomes that should already be considered part of the executive’s job. The upward trend of companies incorporating non-financial ESG-related metrics into compensation programs appears to have been fortified by the recent pandemic and social unrest, which have led a number of companies to make public statements about their human capital, employee safety, environmental, and community support records and incorporate metrics related to these areas into their executive compensation plans.

Do you believe incorporating non-financial Environmental, Social, and/or Governance-related metrics into executive compensation programs is an appropriate way to incentivize executives? Please select the answer below that most closely reflects your view.

– No, non-financial ESG performance metrics are not usually relevant or effective as compensation program measures. Compensation programs should only use traditional financial performance measures, for transparency and to maintain alignment with shareholders’ financial interests.

– Yes, but such metrics should only be used in compensation programs if the metrics selected are specific and measurable, and their associated targets are communicated to the market transparently.

– Yes, when chosen well, even ESG-related metrics that are not financially measurable can be an effective way to incentivize positive outcomes that may be important for a company.

– Other (please specify)

If you answered “Yes” to the question above, which pay components do you consider to be the most appropriate for inclusion of non-financial ESG-related performance metrics if a company chooses to use them?

– Short-term incentives

– Long-term incentives

– Both short-term and long-term incentives – either can be appropriate, depending on circumstances

– Other (please specify)

Long(er)-term Perspective on CEO Pay Quantum

CEO pay quantum is an increasingly important factor for many investors in evaluating executive compensation programs. ISS’ quantitative pay-for-performance screen currently includes a measure that evaluates one-year CEO pay quantum as a multiple of the median of CEO peers.

Does your organization believe that ISS’ pay-for-performance screen should include a longer-term perspective (for example, a three-year assessment) of CEO pay quantum beyond the one-year horizon currently utilized in the ISS pay-for-performance quantitative screen?

– Yes, a longer-term perspective is relevant and would be helpful

– No, the most recent year’s CEO pay is the relevant measure for the quantitative model.

– Other (please specify)

Mid-cycle Changes to Long-term Incentive Programs

For the 2021 proxy season, mid-cycle changes to long-term incentive programs were generally viewed by ISS and many investors as a problematic response to the pandemic, given that many investors consider that long-term incentives should not be adjusted based on short-term (i.e. less than one year) market disruptions. However, some industries continue to incur severe negative economic impacts since the onset of the pandemic more than a year ago.

What is your organization’s view on mid-cycle changes to long-term incentive programs for companies incurring long-term negative impacts?

– Mid-cycle changes to long-term incentive programs should continue to be viewed as a problematic response to the pandemic

– Mid-cycle changes to long-term incentive programs may be reasonable for companies that have incurred long-term negative impacts from the pandemic

– Other (please specify)

These surveys are the first step in formulating 2022 voting policies. They’re open until August 20th at 5pm ET. As usual, ISS also will solicit more input in the fall through regionally-based, topic-specific roundtable discussions. There will also be a public comment period in October for all interested market participants on key proposed changes to voting policies, before the new policies are finalized.

– Liz Dunshee

Although only 7% of shareholder proposals this year have related to executive pay (and none have passed), proposals for compensation linked to environmental performance metrics have increased by 29%. That’s one of the takeaways from this new Sullivan & Cromwell memo, which takes a deep dive into shareholder proposal trends. Here’s an excerpt from page 26:

There was a steep decline in the number of compensation-related proposals between 2012 and 2017, in large part a result of mandatory say-on-pay votes becoming the primary mechanism by which shareholders express concerns over executive compensation. The number of compensation-related proposals leveled out between 2018 and 2020. Proposals submitted this year dropped by approximately 20% from full-year 2020 numbers (48 proposals compared to 58).

Consistent with 2019 and 2020, around half of these proposals reached a vote in 2021, although more avoided a vote as a result of withdrawals and fewer through the SEC no-action process this year. Compensation-related proposals tend to receive relatively low support (averaging 20%), and none passed this year (compared to one in 2020 and two in 2019, each of which were related to clawbacks, which remains the compensation proposal topic with the highest relative shareholder support). ISS supported 50% of the proposals on executive compensation that reached a vote this year, representing a decrease from 76% in 2020 and 70% in 2019, respectively.

The memo goes on to note that shareholder support has dropped for comp-related proposals, including ESG-type proposals, over the last few years. It attributes that to companies being proactive in adding ESG metrics to pay plans, and says that the lower prevalence of environmental metrics in plans (compared to “social” metrics) may be what’s causing proponents to hone in on that aspect with proposals.

As I blogged today on TheCorporateCounsel.net’s Proxy Season Blog, ISS just opened its annual policy survey – and it seeks feedback about including non-financial ESG performance metrics in executive compensation plans, among other executive pay topics.

– Liz Dunshee

Do you find yourself at a loss when it comes to the “share-based payments” note to financial statements? This 500-page KPMG Handbook has everything you want to know (and more) about FASB ASC Topic 718.

The Handbook includes a section on whether to classify awards as equity versus a liability, as well as info about the accounting consequences of award modifications, etc. While I would never attempt to give accounting advice, it’s at least helpful to have a resource to go to when questions arise.

– Liz Dunshee

With a tight labor market and executives & employees reconsidering the “nature of work” as we know it, compensation committees are now dealing with much more than “business as usual.” This memo from Tapestry networks recounts conversation themes from a recent meeting of over a dozen comp committee chairs. The directors are paying attention to how management understands and responds to changing employee expectations:

1. Companies are assessing workplace models for the post-pandemic future. Comp committees should encourage management to be transparent & maintain consistent messaging, and to focus on principles-based training for managers on the ground.

2. A tight labor market empowers employees to ask more of their employers. Companies need to gain insights into the needs & preferences of employees and implement narrowly tailored solutions, which may vary based on industry, regulatory & tax issues, and the specific employee base. The current emphasis on DEI initiatives is just one example of employees using their voice to shape corporate actions.

3. Greater expectations for DEI offer opportunities and raise questions. Board members should look beyond diversity training and coaching to more fundamental steps to improve performance. Have realistic expectations about the pace of progress.

4. Measuring DEI performance and linking it to compensation remains a challenge. One compensation chair said, “If you benchmark DEI against your industry, you’re not necessarily aiming high enough. Identify
New realities for the modern workplace the companies that are doing it right and hold them up as the standard.”

5. Directors want boards to drive DEI initiatives and results. Several members emphasized that directors must set DEI expectations, prioritize them at the board level, and demand results. To start, diversity in the C-suite helps set a tone of inclusion for the entire organization.

– Liz Dunshee

Under the EU’s existing “green taxonomy,” economic activities that meet certain conditions will be incentivized as “environmentally sustainable” investments across the Union. The European Commission is also looking at whether to expand the taxonomy to address “social” objectives. As this Linklaters blog points out, one issue being considered is whether businesses that want to qualify as “sustainable” in the EU will be required to link executive pay to ESG metrics.

Linklaters explains that a group of experts called the Platform on Sustainable Finance are helping the European Commission with its decision. They’ve published a draft report for comments (this fall, the PSF will make a recommendation to the European Commission, which will then publish its own report by year-end).

The PSF folks seem to conclude that while tying pay to ESG could make sense in light of the strategic importance of E&S goals, there are lots of challenges. The blog summarizes the findings:

The PSF report says that that ESG issues now sit at the heart of good business practice, and for some companies this has become a central strategic pillar. As a result, many companies around the world are linking executive remuneration to ESG goals: reducing carbon emissions, customer welfare or workforce diversity.

So the PSF conclude that executive pay linkage to ESG should be part of the EU taxonomy as it is a reflection of what is happening in the real economy.

The PSF say that businesses are concerned that linking EGS to pay could interfere with companies’ autonomy, but they suggest that companies could choose their own sustainability targets and would not need to incorporate a fixed list of indicators. An option would be to link ESG factors to the long term incentive (LTIP) structure and performance measures, possibly along with malus and clawback (withholding pay at the point of vesting, or recovering after payment). It would also be necessary to manage any unintended consequences of linking ESG to LTIPs, which might lead to, for example, greenwashing or gamification.

The PSF draft report identifies some challenges to this linkage:

1. The difficulty of developing criteria to increase diversity on boards because, for example, in some countries gathering information on employees´ ethnicity or sexual orientation is unlawful.

2 How this initiative would fit alongside the upcoming European Commission proposal on sustainable corporate governance, which is expected to address issues related to sustainability expertise in boards and make it compulsory to include sustainability metrics.

3. How this initiative would fit alongside the proposed regulatory technical standards for the Sustainable Finance Disclosure Regulation (SFDR), which already obliges financial market participants to take into account and disclose board gender diversity. This means that all financial products would have to report on diversity anyway.

4. Setting criteria on executive remuneration may prove to be extraordinarily complex due to the variety of long and short term variables and schemes, and could lead to unintended consequences. All this interlinks with companies’ own business models.

5. It is tricky to compare companies on sustainability-linked remuneration, especially if the targets vary between companies.

The PSF identify an alternative option of having rules around compensation structure, transparency and policy that responsible investors already apply when deciding whether or not to approve executive compensation at AGMs. But they say that this could be perceived as disproportionate and infringing national corporate governance models.

– Liz Dunshee