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Issue 17 : Performance Issue


Discretion: How Should Boards Approach its Application within Incentive Plans?


brian robbins

BRIAN ROBBINS
Partner
SIMPSON THACHER & BARTLETT LLP

Brian D. Robbins is a Partner in, and Head of, Simpson Thacher’s Executive Compensation and Employee Benefits Practice. He has extensive experience in the areas of executive compensation, employee benefits, and ERISA, and routinely advises the firm’s corporate clients in connection with compensation and employment matters as well as the firm’s M&A and public company advisory practices. He has represented numerous high profile senior executives with regard to the negotiation of employment and termination agreements.

In the years following the financial crisis, we have witnessed intense focus on performance metrics and risk taking in federal legislation and increased scrutiny of performance metrics, as well as the development and implementation of performance-based compensation arrangements at public companies by corporate governance organizations such as Institutional Shareholder Services Inc. (ISS) and Glass Lewis & Co. (Glass Lewis). In addition, public companies have long operated under Section 162(m) of the Internal Revenue Code, which concerns executive officers who receive compensation in excess of $1 million but fail to meet the requirements of “qualified performance compensation” under those rules. Furthermore, many private companies, particularly those expecting to go public, have adopted performance-based compensation metrics and designs similar to those in place at public companies.

While ISS and Glass Lewis encourage the exclusive use of objective performance metrics and frown on public boards and compensation committees awarding compensation when these criteria are not met, there are circumstances when the use of discretion may be appropriate. Notable examples would include unanticipated market changes, strategic transactions, personnel changes resulting in reallocation of responsibility, or other changes in circumstance that warrant rewarding the management team for increasing shareholder value. Many public companies provide for this ability within the confines of the “qualified performance-based compensation” requirements under IRC Section 162(m), for example, by creating minimum performance goals that must be met to earn a maximum bonus, but with the expectation that the bonus amount will be reduced to reflect actual performance.

While creating performance-based compensation programs designed to pay bonuses only upon the achievement of pre-established objective performance goals is desirable (and clearly a market trend), ultimately, the board and compensation committee may choose to balance this with the desire to retain flexibility to react to unexpected events and even to compensate management for more “subjective” performance criteria.


susan stemper

SUSAN STEMPER
Managing Director
PEARL MEYER & PARTNERS

Susan Stemper is a Managing Director at Pearl Meyer & Partners, advising Boards and management on executive compensation, including strategy, compensation program design, pay-forperformance, IPO/transaction/M&A, communication and disclosure, and related governance. Susan advises public and private companies across several sectors, including emerging and growth technology and biotech companies. In addition to her experience in consulting, she has served in corporate compensation leadership roles.

Applying discretion shouldn’t be a third-rail issue. Even with strong, structured performance and pay alignment, boards regularly use discretion to approve financials, other numeric metrics, or exclude a now-private peer from relative TSR calculations. Discretion is also used for non-quantitative goals, such as succession or organizational effectiveness. In each case, it helps determine results within the plan.

Discretion is also needed to assure appropriate payouts when the plan did not—or could not—anticipate certain events. Perhaps the strategic plan changed and the team refocused. A well-executed spinout may be right for the long term, but cause a significant miss on current-year goals. Further, while a goal may have been achieved on paper, how it was met may undermine other critical objectives. In these and similar cases, discretionary adjustments (up or down) may be needed to align pay with performance.

Boards should develop a process to assess results and determine whether adjustments are warranted. This creates a familiar approach when discretion is needed.

Boards should:

  • Adopt apples-to-apples principles for financials; document treatment of accounting changes, M&A budgets, effect of foreign exchange changes, etc.

  • Understand what events might break the pay and performance link.

  • Monitor the plan throughout the year, and discuss potential issues with management.

  • Deal with the unplanned.

  • Understand facts and circumstances and how well executives addressed the situations.

  • Model alternatives to best align payout with performance, including the loss of tax deductibility.

  • Clearly communicate decisions and rationale to participants, other directors, and stockholders.


sarah goller

SARAH GOLLER
Senior Manager Fund Financial Services
VANGUARD

Sarah Goller is responsible for Vanguard’s corporate governance program and oversees daily operations of governance and proxy voting matters for Vanguard investment portfolios. Her position involves assisting Vanguard’s Proxy Oversight Group with policy decisions, managing a team of governance analysts, and ensuring accurate execution of Vanguard’s global voting and engagement program. Sarah’s team meets regularly with company representatives, including portfolio company directors and executives, on matters such as executive compensation, director elections, and Vanguard’s corporate governance philosophy.

Prior to her current role, she worked as an analyst in the Portfolio Review Department, which is responsible for overseeing Vanguard’s 100-plus mutual funds, assessing fund performance, and monitoring Vanguard’s external advisors. Sarah has also worked in Vanguard’s Corporate Strategy and Advice Services Departments. She is a graduate of the University of Notre Dame and is a CFA charter holder.

Two of Vanguard’s primary principles regarding executive compensation are “pay for performance” and “pay within reason.” These joint principles reflect our expectation of reasonable consistency in compensation among companies that are comparable when considering their size, complexity, industry, and performance. We also expect that most of executive pay will be driven by objective, quantitative goals that will create long-term value for our shareholders.

We’ve also seen a number of boards apply discretion effectively. For example, we’ve spoken to a number of companies that apply limited discretion in response to a company’s risk profile or cyclicality. We’ve also communicated with boards that exercised discretion when a company is in a turnaround situation and goal-setting is more difficult. Finally, a number of compensation committees exercise negative discretion in response to litigation or regulatory matters that may be difficult to predict.

At the end of the day, it’s most important that we understand how the compensation committee approaches these decisions. We expect that pay will generally reflect a company’s performance over time, and this is more difficult to assess when a company doesn’t use quantifiable metrics. As a result, we need to understand how the board assesses performance. Specifically, what are its criteria, agreed to at the beginning of the year, that determine the final pay decision? Companies shouldn’t underestimate the importance of thorough disclosure and other shareholder communications to convey how they’ve prudently used discretion.


robert lamm

ROBERT B. LAMM
Of Counsel
GUNSTER

Bob Lamm is Of Counsel to Gunster, Yoakley & Stewart, P.A., Florida’s Law Firm for Business, and serves as co-chair of the firm’s Securities and Corporate Governance practice. He rejoined Gunster in 2014, having been a shareholder from 2000 to 2002.

In addition to his role at Gunster, Bob is an Advisory Director of Argyle, which advises corporations on the effective communication of corporate governance, and he serves as a Senior Advisor to Deloitte’s Center for Corporate Governance.

From 2008 to 2013, Bob was Assistant General Counsel and Assistant Secretary of Pfizer Inc. His previous experience includes service as Vice President and Secretary of W. R. Grace & Co., Senior Vice President – Corporate Governance and Secretary of CA, Inc., and Managing Director, Secretary and Associate General Counsel of FGIC Corporation/Financial Guaranty Insurance Company.

In most contexts, using discretion is considered a good thing; among other things, it implies trust and the exercise of judgment. However, when used in the context of determining executive compensation, our legal and regulatory system has looked askance at the use of discretion for at least the last 20+ years. In particular, with the enactment of Section 162(m) of the Internal Revenue Code in 1993, compensation committees became increasingly locked into using quantitative metrics and discretion became permissible only when applied negatively—i.e., when the committee reduced compensation below the amount indicated by the application of the metrics in question.

However, particularly at a time when companies and investors alike are increasingly concerned with issues such as diversity, sustainability, and compliance—“softer” issues that are not easily susceptible to quantitative metrics—I would argue that positive discretion is a good thing. Negative discretion may “punish” executives for subpar performance in these softer areas, but it doesn’t incentivize executives to excel, or even to “do the right thing,” where these areas are involved. Rewarding executives for outstanding achievements in diversity, sustainability, compliance, and other areas would give them reasons to exceed expectations and outperform peer companies (i.e., competitors) and might just provide a reason to launch a race to the top.

I’ve yet to find a company that says “we aren’t going to comply with Section 162(m) because we value discretion over deductibility,” but maybe now is the time for some brave souls to go there.


brian holmen

BRIAN HOLMEN
West Region Practice Leader for Board Solutions
HAY GROUP

Brian Holmen is the West Region Practice Leader for Board Solutions at Hay Group in its Los Angeles office. Brian works with Boards of Directors and management to design and implement cash and equity incentive programs for directors, executives, and employees, including deferred compensation arrangements, severance arrangements, change-in-control arrangements, and employment agreements. He also addresses corporate governance issues associated with director and executive programs.

In my experience, it is difficult for a Compensation Committee to establish objective performance metrics that account for all of the variables that may occur over a long time horizon. To comply with Section 162(m) of the Internal Revenue Code, long-term incentive (LTI) grants often include a laundry list of adjustments that will be made to reflect unpredictable events, such as litigation costs, foreign exchange gains or losses, or reorganization and restructuring programs. Despite the effort to account for these events, unforeseen developments may still render an LTI grant worthless, as we all learned in 2008. For this reason, I believe that Compensation Committee discretion to adjust performance awards remains an important tool in LTI design.

To comply with Section 162(m) while giving Compensation Committees flexibility to adjust awards, I am a proponent of 162(m) “umbrella” plans. Under a common umbrella plan design, a Compensation Committee approves one or more objective performance metrics that, if achieved, will fund the bonus pool with a maximum amount that may be paid to each participant. Under the plan, the Compensation Committee establishes separate objective and/or subjective performance metrics that determine the actual amount of the bonus pool that will become payable to each participant. To the extent the actual amount that becomes payable to each participant is less than the maximum amount allocated to the bonus pool for that participant, the Compensation Committee exercises negative discretion to reduce the maximum amount.

For many companies, the flexibility in design makes this an attractive alternative to traditional 162(m) plans. A company that implements such a design must consider how to describe the arrangement in its proxy and how to socialize the arrangement with participants.


ana fluke

ANA M. FLUKE
Senior Manager
ERNST & YOUNG LLP

Ana M. Fluke is a Senior Manager in the Human Capital practice at Ernst & Young LLP. Based in Cleveland, Ohio, she provides advisory services focusing on human resources, compensation/ executive compensation, and benefits issues. With over 15 years of experience, Ana supports both public and private companies on the design, implementation, and operation of their executive compensation philosophy and strategy and the programs to support that strategy. She is a Certified Compensation Professional through WorldatWork™.

With continued scrutiny on executive compensation and the emphasis on pay for performance, boards generally use discretion only if there are unexpected business or market events or a fundamental change in the business. Ideally, the incentive plans should have challenging but realistic goals, which should result in payouts that are reflective of the company’s performance. However, circumstances will arise that require discretionary adjustments to awards, whether positive or negative, and the board has a duty to carefully consider all of the facts to determine if an adjustment is necessary, as well as understand the ramifications of applying that discretion. Those ramifications could include tax and accounting consequences, disclosure requirements, and employee, shareholder, and public perception issues.

As boards consider making discretionary adjustments, they need to consider all elements of performance and the unique facts and circumstances that may require a discretionary adjustment to the award payout. Also, the board may wish to consider applying discretion in a manner that falls outside of the incentive plan to help mitigate the potential ramifications. Regardless, we recommend that boards proactively develop guiding principles outlining those circumstances when discretion may be considered in incentive payouts, as well as outside the incentive plans. The guiding principles should also address how much awards can vary from the calculated amounts when discretion is applied. This will help boards determine when and how to apply discretion to incentive awards in a consistent manner


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