The COVID-19 pandemic continues to inflict economic costs on companies across sectors of the economy. For affected companies with compensation programs that are significantly performance-based, motivating and retaining executive talent when incentive performance targets become unattainable due to the downturn is a significant concern. The heightened level of uncertainty over how long the pandemic will last and how fast the economy can recover further obscures the way forward. In this advisory, we summarize recent proxy advisor guidance on adjusting annual performance goals, and outline a range of strategies for adjusting those goals to incentivize performance and retention while maintaining alignment with shareholder return and fundamental financial performance.

ISS Case Study

On June 8th, ISS Corporate Solutions, the consulting affiliate of proxy advisor Institutional Shareholder Services (ISS), issued the first of four case studies outlining potential frameworks for adjusting annual incentive goals or metrics “to establish a more realistic structure for properly incentivizing executives” in the volatile COVID-19 era. This first case study[1] (Case Study) considers a scenario in which a company adjusts its annual performance goals with a commensurate reduction to its CEO’s short-term incentives.

The Case Study focuses on a mid-cap retail company with stores closed due to the pandemic. The company’s CEO incentives are tied to full-year EBITDA results that will be unattainable because of the shutdown. The company’s CEO performance goals were developed using an algorithm that models the probability of possible outcomes based on certain variables, in this case, growth rate and volatility, together with consideration of historical operating results, peer financial performance and analyst expectations. The company elected to revise the original goals by adjusting the growth rate downward and the volatility rate upward to reflect the likelihood that the economic downturn will have a negative and lasting impact on the company’s finances even if the retail sector rebounds after re-opening. These adjustments resulted in a downward adjustment of the projected range for EBITDA. The CEO’s target incentive award was then reduced by 25% to reflect the decline in projected EBITDA. The Case Study identified the following potential benefits of adjusting full-year goals with a commensurate reduction in CEO incentives:

1. Continued motivation for the CEO to achieve full-year operating results based on clear goals, with an opportunity to earn an award aligned with the interests of shareholders who had suffered a steep decline in share price; and
2. Avoidance of the need for year-end discretionary adjustments, which could give rise to an unfavorable reaction from investors.

The Case Study also identified several potential drawbacks:

1. Difficulty of revising growth rate and volatility assumptions before it is clear how the economy will recover; and
2. Potential negative reaction of shareholders who might consider the revised performance goals too “soft” in the event that the economy recovers faster than expected.

Strategies for Adjusting Performance Goals

While the Case Study is not intended to indicate how ISS will evaluate a company’s compensation decisions, it suggests that an ISS review of mid-year adjustments to annual executive performance incentives is likely to focus on how well such incentives align with shareholder interests and a company’s performance-based compensation philosophy.

Companies with performance targets that are likely to be unattainable given the COVID-19–related downturn will want to identify the best strategy to incentivize executives while continuing to protect shareholder value in an uncertain market. This challenge will be difficult because institutional investors and others are likely to be critical if the selected performance targets are set too low and the market improves. Compensation committees should consider the following alternative strategies for adjusting annual performance targets midstream:

• Wait and see. Although we are well into calendar year 2020, some companies are continuing to wait until the impact of the pandemic is clearer before revising their 2020 performance targets to avoid the risk that the adjusted targets will be deemed too soft by shareholders and proxy advisory firms after the fact. It is possible that institutional investors and proxy advisors may disapprove of targets that are reduced before it is clear that the COVID-19 impacts are long-term and substantial for the company, its industry, or both.
• Revising Metrics. To avoid setting revised targets that could again become unattainable, companies should consider adopting a wider range of metrics for performance targets, provided the company’s incentive plans and agreements allow these adjustments. These revised metrics could include non-financial operational goals focused on process improvement or increased efficiencies, or targeted regional or department-based goals to address disparate impacts of the downturn.
• Replacing full year with second half performance goals. Companies can consider using 6-month rather than 12-month targets to enable executives to receive full incentives for the second half of the year. The performance goals and applicable time frame could be adjusted with or without a commensurate reduction in executive incentives for the applicable period. As noted in the Case Study, a substantial decline in share price would suggest that the award should be reduced to align it with shareholder interest.
• Setting relative performance targets. Companies might consider setting targets relative to peer company performance or current values (e.g., relative shareholder return, net income or total sales) rather than relying on absolute metrics.
• Compensation committee discretion. Awards can be subject to adjustment by the compensation committee with the benefit of some hindsight. Companies should note that because ISS generally views discretion unfavorably, the compensation committee would need to document its discussions leading to any discretionary changes, and effectively communicate these matters to shareholders.

Further Considerations

Prior to taking any action to revise performance metrics, companies should review their compensation plan documents to confirm the extent of the compensation committee’s authority to revise established performance criteria. Amendments that may potentially adversely affect participants may require their consent. Companies should confirm that the proposed modifications will not violate the deferred compensation rules of 409A of the Internal Revenue Code, and also note that any revision to performance targets under compensation agreements or plans in effect on November 2, 2017, which are currently grandfathered under Section 162(m) of the Internal Revenue Code, will result in loss of grandfathered status (meaning that the company will no longer be able to exclude this compensation from Internal Revenue Code Section 162(m)’s $1,000,000 cap on deductible employee compensation). In addition, modification of a performance-based equity award that makes it easier to achieve will result in an accounting charge based on the modified aggregate fair value of the revised award, and a company giving its compensation committee discretion to modify awards based on performance goals should note that such awards may be treated as a liability under accounting rules. Companies should further note that ISS has recommended that material changes to performance targets for short-term incentives due to the pandemic as well as an explanation of the rationale behind these changes should be contemporaneously disclosed to shareholders. An unfavorable reaction from investors could result in a negative say-on-pay vote at the next annual shareholders meeting.

Final Note

Attempting to structure realistic performance-based compensation programs during a period of economic instability and market volatility is a fraught exercise. Despite the uncertainties, companies and their compensation committees will want to continue to incentivize and retain their top talent, and may need to take action to ensure those goals are met. Thoughtful focus on strategies and goals that align personnel needs and the interests of shareholders will help companies navigate the current turbulent environment.
 

Endnotes

_{1 Revisiting Annual Incentive Goals in Light of the COVID-19 Pandemic: https://insights.issgovernance.com/posts/revisiting-annual-incentive-goals-in-light-of-the-covid-19-pandemic/}