The April board remuneration committee: checklist of COVID 19 responses
06/04/2020
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Companies are adjusting remuneration in response to COVID-19. But COVID-19 touches more aspects of remuneration than many may have considered. And those who have yet to do anything have catching up to do. Guerdon Associates has provided an April checklist for boards who want to make sure they are covering all angles.

Many will look at this checklist and see a full year’s agenda rather than that for an April agenda. However, COVID-19’s evolution will require agile and ongoing response: Guerdon Associates has already identified agenda items for May’s meeting. So best try to handle as many of these as you can.

1 . ESG

Proxy advisers are likely to expect an “ESG” response, whereby there is a balance among the interests of executives, shareholders, employees and customers.

What this means, at least for proxy advisers, is that stakeholder primacy is still winning over shareholder primacy. This is despite the fact that some companies will have been impacted severely by COVID-19, and solvency is their primary focus in order to stay alive.

Nevertheless, even some companies facing solvency issues have still managed to present a considered ESG response, particularly in the airline and hospitality industries, such as agreeing with employers in other industries to take on their laid off employees. Others, such as in banking, have considered ESG matters in framing a response to better position the business post pandemic.

2 . Fixed pay

If employees are being laid off, or required to work a 4-day week for less pay, investors and proxy advisers believe non-executive directors and executives should share the pain by taking pay cuts.

To an extent, this could be taken further with directors and executives agreeing to receive a proportion of their reduced fixed pay as equity to further conserve cash. (But, be careful of the tax trap that limits salary sacrifice to $5,000 – see HERE).

3 . Discretion

Establish a framework for applying discretion in assessing performance .

Given uncertainty about the severity and duration of COVID-19’s impact, many companies will want to use discretion at the end of the year on annual incentive payouts. It will be important to establish a framework for how discretion will, and will not, be applied in order to ensure decisions at year end are fair and consistent with expectations for both employees and shareholders. See HERE .

4 . Annual incentive payments

December financial year-end companies have paid pre-COVID-19 impacted annual incentives, and their COVID-19 impacted AGMs’ remuneration-related resolutions have been supported.

It is likely that many March year-end companies will not have been impacted by COVID-19 on their financial measures to the extent that thresholds for incentive payment will not have been achieved. Given the support for 31 December companies it would be hypocritical of proxy advisers and investors not to support payment of annual incentives. However, if these companies are subsequently suffering a severe cash impact, they could:

  • Pay the incentive if executives have since taken a fixed pay cut
  • Defer payment until the cash position improves
  • Pay all the incentive in equity

For June year-end companies, financial thresholds are less likely to be attained for many companies. A large proportion of companies will have financial or TSR gateways before annual incentives can be paid.

For these companies, proxy advisers and investors are not likely to support the exercise of positive discretion, despite heroic efforts by some executive teams to control cash flow.

This may have included laying off employees. It may not be acceptable, for some investors, to pay incentives on financial outcomes given the growing importance of ESG matters for incentives.

Non-financial KPIs may have been achieved, including key ESG KPIs such as safety. For companies with no financial or TSR gateways, a proportion of annual incentive for these important outcomes will be paid. Nevertheless, some “shareholder primacy” investors will not be pleased, given their own losses in value. To minimise negative reaction, these companies could also consider similar actions to the above, i.e.:

  • Paying the incentive if executives have since taken a fixed pay cut
  • Deferring payment until the cash position improves
  • Paying all the incentive in equity

5 . Annual incentive target setting

In the current uncertain environment, companies could consider one or more of:

  • Setting targets based on what is known, with an acknowledgement that there will be a review and confirmation of targets halfway through the year. While highly unusual, this would also provide a basis for agile responses to a rapidly changing external environment.
  • Enlarging the target “corridor”. That is, set a wider span between the threshold performance requirement and the maximum.
  • Departing from annual incentive KPIs that are aligned with long term strategy, particularly when survival is at stake. Focus on metrics such as cash flow, cost containment and operational efficiencies.
  • Establishing and communicating guidelines for a discretionary end-of-year bonus payment, instead of a traditional STI based on pre-agreed objectives. This is highly unusual, and would require the remuneration committee chair to communicate the intent in 2020 annual disclosures, and/or during engagement meetings. The guidelines need to be well developed.
  • Not providing an annual incentive opportunity, but promising a time-vested equity grant in lieu. This would conserve cash, and encourage executives to be agile and respond to a changing environment in a way to ensure longer-term company sustainability.

6 . Long term incentives

LTIs are particularly problematic. The outlook is so uncertain that longer-term financial targets for most companies cannot be set with any degree of certainty.

Remuneration committee choices could include one or more of:

  • Granting an LTI, but using a relative TSR measure only
  • Granting an LTI, but setting performance requirements some way into the three year performance period when the financial outlook becomes more certain (in effect, setting performance requirement in the second of the 3 year performance period).
  • Granting an LTI, but placing most weight on ESG or scorecard factors.
  • Deferring the grant to the following year, and doubling up the grant, with a truncated performance period (i.e. 2 years instead of three) for one tranche
  • Not granting an LTI, but granting a long term time-vested restricted equity grant in lieu, at a discount of 50% or more to the usual maximum LTI value. These grants were a trend in the UK prior to COVID-19, and are more likely to become a permanent feature of executive remuneration in future.

7 . Equity grant basis of allocation

Some investors have indicated they would not be well-disposed to executive equity grants based on the significantly lower share price arising from COVID-19 impacts, particularly if the grants coincide with dilutive capital raisings. This disposition is understandable in the US where many companies are now stressed as an outcome of over-leveraging for past share buy backs that, coincidentally, increased EPS growth and executive LTI vesting. While this phenomenon was not evident in Australia, overseas investors will be particularly wary of equity grants where the number of instruments granted is based on a depressed share price.

Apart from those few companies that got themselves into trouble from over-leveraging and now have to raise dilutive share capital, there should be little reason for investors to object to grants based on current share prices in most instances.

As has occurred with all downturns, prior executive grants will be underwater and have little hope of vesting based on financial targets. For a CEO, even without a reduction in fixed pay, annual realisable pay will reduce by between 40% (at the lower end of the ASX 300) to 70% (at the larger end). Further, the impact will likely be felt over at least two financial years of LTI grants.

The logic of the above may yet still escape some governance analysts. Hence, it may be worth an extra effort in explaining why the basis for determining the number to be granted has been consistent through cycles.

Remuneration committees could consider:

  • Making grants using a longer VWAP period
  • Make grants using the usual VWAP basis for calculating the grant number, and option exercise prices, and explaining how cyclical swings and roundabouts impact pay both negatively and positively
  • Reduce the grant number to account for lower share prices
  • Communicate that discretion will be exercised on consideration of vesting outcomes to ensure no realisable pay windfall gains.

8 . Minimum shareholding requirements

All else being equal, the value of director and executive shareholdings have reduced by about 30% over 3 months. Because minimum shareholding requirements (MSR) are typically expressed as requiring executives and directors hold a certain value of company shares after a set period, many will fall short.

Alternatives for the remuneration committee to consider include:

  • Extend the time to attain the holding requirements by 12 months
  • Reduce the MSR
  • Change the policy to remove the time-to-acquire requirement with a requirement to hold vested equity
  • Pause the policy indefinitely until the pandemic has passed
  • Provide an opportunity for directors and executives to meet requirements on a pre-tax basis.

9 . Change in control

Many companies will be vulnerable to takeover during the COVID-19 period. Vulnerability may be the result of risky management strategies, or it may be a short-term industry-wide impact (e.g. retail or tourism). While ensuring shareholders receive the best outcome, boards may also need to reconsider change in control provisions in the equity plan and offers.

10 . Retention

The GFC saw many companies approve retention incentives, in the belief that reduced realisable remuneration heightened turnover risk. For most, that belief was ill-founded, given executives in the same industry were in the same boat, and were not vulnerable to loss.

The same applies, in most instances, to companies during the pandemic. That is, no retention incentives are necessary (some exceptions may apply to some industries, such as technology).

The remuneration committee might consider whether the company is within a vulnerable industry where executive demand is high. If so, retention may need to be considered. Most companies, however, will only need to consider post-pandemic retention issues. Most executives will have had their LTIs lapse. There will be no “retention hooks”. This may facilitate a broader consideration of flaws in remuneration frameworks that do not cope with business cycles. There is no space in this article to cover these but, as with most downturns, there are opportunities to reframe and revise frameworks for the better.

© Guerdon Associates 2021
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