This Post will begin a series of blog entries focused on the topic of linking executive pay to a publicly-traded issuer’s diversity and inclusion (“D&I“) initiatives.  As background, there has been a recent push to hold executives accountable for the effectiveness of an issuer’s D&I initiatives by linking their executive pay to the success of such initiatives.  Pretty straight forward (i.e., the success of the D&I initiative becomes one of the metrics in the issuer’s performance-based compensation strategy).

But how should the “link” be designed from an SEC disclosure perspective in situations where the issuer has more than one compensatory performance metric?  For example:

• If the D&I target made up 10% of the executive’s performance-based compensation package, would 10% open the issuer to criticism that such percentile is not enough?
• If the D&I target made up 90% of the executive’s performance-based compensation package, would that open the issuer to criticism from its long-term shareholders that not enough incentive is focused on the issuer’s financial performance and financial return to the long-term shareholders?
• How will the issuer explain a missed D&I target in the proxy statement (i.e., missed financial targets can be explained and softened in CD&A disclosure, but it will be awkward to explain why a D&I target was missed)?

Success of the D&I initiative should be the goal, and focusing the executives on the initiative by tying their compensation to its success is a good strategy (i.e., best way to win the heart and mind of an individual is through his or her stomach).  But avoiding awkward proxy disclosure should also be considered when designing the D&I performance targets.  To that end, consider having the D&I metric designed to act only as a downward pay modifier to a financial performance metric (similar to how absolute shareholder return can downward modify the pay outcome of an otherwise successful relative total shareholder return formula).  That way:

• The status quo of financially incentivizing the executives towards the success of the D&I initiative is maintained.
• Positive proxy disclosure results if both the financial target and the D&I target are satisfied.
• Positive enforcement disclosure results if the financial target is satisfied but the D&I target is not satisfied (i.e., this outcome is not good from the perspective of the D&I initiative or from the executive’s compensation expectations, but from a proxy disclosure perspective the CD&A would disclose that failure of the D&I initiative resulted in a downward adjustment to the pay formula).
• Semi-positive disclosure results if the financial target is not satisfied but the D&I target is satisfied (i.e., this outcome is not good for long-term shareholders, but is good from a social policy perspective), though the answer is that the performance-based pay formula resulted in a $0.00 payout.
• But more importantly, negative proxy disclosure can be softened if both the financial target and the D&I target are not satisfied because, depending on design, only the missed financial target needs to be disclosed.  To this point, if the sole purpose of the D&I metric was to act as a negative modifier to a financial metric (i.e., the D&I metric can only downward adjust a payout and in no circumstances act to upward adjust a payout), then awkward disclosure of the missed D&I target might be avoided.

The situation in the above bullet is similar to the design of a relative total shareholder return program where absolute shareholder return acts as only a downward pay modifier (i.e., cannot be used as an upward pay modifier).  In that situation, if the relative total shareholder return formula produced a payout of $0.00, then such would be the sole disclosure and the CD&A would not have to address whether absolute shareholder return was also negative.   But . . . if absolute shareholder return could act as an upward pay modifier to a relative total shareholder return formula and the relative total shareholder return formula produced a payout of $0.00, then the CD&A would still have to address whether absolute shareholder return was negative or positive.

For the above reasons, consider whether D&I targets should only act as a downward modifier to a financial performance payout, thus avoiding awkward disclosure in situations where both the financial performance target and the D&I target are not satisfied.  More posts on this topic coming!