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Sep 16, 2020

Discretionary adjustments to executive compensation call for careful disclosure

Molly Doran explains how to handle executive pay when pre-pandemic incentives may now seem inappropriate

In the wake of uncertainty about the coronavirus pandemic and its impact on public markets, many compensation committees are evaluating how to follow through on incentive compensation for their executive teams. This year has been anything but ‘business as usual.’ In many cases, long-term equity awards granted before March 2020 have lost value and performance goals for annual bonuses have become unrealistic.

Companies still want their compensation programs to motivate and reward executives’ efforts. But when so many are furloughing employees and reducing dividends, pre-pandemic incentive compensation plans may now seem inappropriate.

Companies turn to discretion 

Corporate boards are thinking about how to keep incentive plans motivating, engaging and acceptable. A recent survey of 681 US companies reveals that many have either revised their incentive plans or are considering revisions. This reflects the fact that plans fashioned before the pandemic began will likely not accurately reflect employees’ and executives’ efforts today.

The most common proposed change is adding an element of discretion, which would enable a compensation committee or the full board to adjust incentive awards at the end of the performance period. When discretion is permitted, awards that seem excessive can be reduced, and meager awards can be increased.

But investors will be wary of companies that exercise discretion – especially when awards are increased – so to mitigate ill-will and retain stakeholder trust, companies must prioritize careful disclosure.

Formal disclosure requirements 

SEC rules for the compensation discussion & analysis section of proxy statements call for companies to disclose ‘whether discretion can be or has been exercised (either to award compensation absent attainment of the relevant performance goal(s) or to [alter] the size of any award or payout).’

ISS and Glass Lewis have both addressed the prospect of pandemic-era discretion in updated guidance. Glass Lewis expects ‘[e]ffective disclosure and rationales’ and warns it will look more kindly on companies that had ‘a good track record on governance, performance and the use of board discretion prior to the pandemic.’ ISS’ statement is similar, urging companies to provide ‘adequate explanation’ of the rationale for any changes.

Foster stakeholder trust 

In addition to thinking about the details they are required to disclose, companies should consider how best to communicate those details to foster stakeholder trust. Trust is always important, but as boards make potentially unpopular decisions in the short term to fortify their companies for the future, trust is crucial. Companies can take many steps to boost trust, including evaluating the language they use in their disclosure documents.

Labrador study, in partnership with BVA, released in July 2020 (requires registration) provides statistical proof, on a large scale, of the effectiveness of plain language in corporate disclosure. In particular, plain language delivers the advantages of efficiency, clarity and reader retention by making documents more inviting and easier to read and understand. 

Participants in the study found plain language samples ‘well written’ 64 percent of the time, and ‘well organized’ 66 percent of the time (compared with 48 percent and 49 percent, respectively, for the original copy). Moreover, participants were far more likely to call plain language samples ‘pleasant’ to read (58 percent) than to say favorable things about the original samples (41 percent).

These results are significant because a reader’s positive impressions of a document can translate into positive feelings about the company behind the document. In other words, the study suggests a connection between plain language and trust. The takeaway? Companies that produce corporate disclosure documents in plain language may generate trust.  

Disclosure considerations 

Tying it all together, companies that can exercise – or have exercised – discretion to adjust executives’ incentive awards must explain their decisions precisely and in plain language. Here are some issues to address:

  • Rationale – If payouts increased (or goals decreased), is it still fair to consider the compensation ‘performance-based’? Perhaps pre-pandemic metrics like sales volume or product launches became less relevant, but did executives outperform by retaining employees and ensuring an uninterrupted supply chain?
  • Which plan?  Proxy advisers (and presumably shareholders) are more inclined to accept changes to the annual incentive plan than the long-term plan. A company that reprices underwater stock options should expect extra scrutiny. Explain why each specific exercise of discretion was warranted.
  • Comparability – How are peer companies faring? Are they making similar changes to their incentive plans?

Comprehensive disclosure 

Rather than overwhelming disclosure documents with corporate-speak, companies should divulge their use of discretion in plain language. They will fare better with their audience, and may increase the odds that investors will support discretionary changes to executives’ incentive awards.

Molly Doran is director of advisory and design services at Labrador