Practical Steps to Consider Now on Clawbacks, PSUs, and Executive Compensation Disclosure

Reprinted from The Conference Board’s November 19, 2021 E-Newsletter “ESG Alert”

The road to the Compensation Discussion & Analysis (CD&A) is paved with good intentions.

The Conference Board’s recent webcast It Seemed Like a Good Idea at the Time: From Principle to Practice in Executive Compensation, focused on three key areas – clawbacks, performance-based equity, and compensation disclosures and engagement – where there has been a persistent gap between aspiration and reality.

The webcast, sponsored by Cleary Gottlieb Steen & Hamilton, provided fresh insights on what’s working, what’s not, and what companies should consider doing now in each of these areas.

Here are some of the practical takeaways from the discussion with Audry Casusol, Partner, Cleary Gottlieb; Jared Berman, Partner, Meridian Compensation Partners; and Brit Wittman, CVP, Global Rewards, Applied Materials:

Clawbacks

With the SEC resurrecting its rulemaking process to impose a mandatory, no-fault clawback regime, most firms are taking a “wait and see” attitude when it comes to adopting or updating clawback policies. But even companies that currently have a discretionary policy may still want to refine their policies in a few areas:

• Clarify the process for the board making a clawback determination. No matter the SEC rule, someone needs to decide whether a clawback is justified. Consider what kind of information the board will need and who should provide it. In particular, think about whether it would be helpful to enlist a third party to collect and analyze the information, as well as the evidentiary standard the board will use.
• Establish a mechanism for recouping. You will want to be prepared in the (hopefully) rare instance in which you claw back compensation. Don’t wait until then to think about how, in practice, you’d recover compensation.
• Consider your approach to indemnification. Your executives will likely be quite interested in knowing how you will approach indemnifying them for legal and other expenses in a clawback process that turns out not to have been justified.

Performance-based equity

Even though they have become ubiquitous at large companies, performance share unit (PSU) programs have faced skepticism from investors who are concerned that the performance goals set by the compensation committee are too easy to meet, that the committee approves unjustified adjustments that bring the payout to target or above, or that there’s still a disconnect between payouts and the company’s stock performance. That challenge was compounded by COVID-19, which sometimes made it impossible for executives to meet their three-year goals in their PSU programs. Firms that addressed their underwater programs by changing performance goals, adjusting results, or adopting replacement plans exposed themselves to strong investor opposition and negative say-on-pay votes. What’s a compensation committee to do?

• Use a wider range. Set the performance threshold for a minimum payout at a level that still gives executives a chance of an earnout even when the company has a bad year, but set a high bar for a maximum payout to keep your shareholders happy and to drive superior performance.
• If you’ve moved away from relative total shareholder return (TSR), consider reintroducing it or making it a more prominent feature of your program. Relative TSR has disadvantages as a performance metric because so many factors affect stock performance that are out of executives’ control. But it allows for payouts if your industry or the entire economy are affected by a major negative event, and it clearly aligns payouts with your shareholders. So consider having, for example, 50% of your PSUs linked to a company-specific financial metric, while 50% is linked to relative TSR.
• Simplify and verify the “adjustment” process. If you’ve chosen a metric such as adjusted earnings per share (Adjusted EPS) as your performance target, avoid asking your compensation committee to approve a lot of de minimis Consider having the audit committee approve adjustments to financial performance before they go to the compensation committee. Ensure adjustments can go both ways: don’t just back out the bad news; back out the unexpected windfalls too.
• Keep your performance share plan simple. One way of avoiding having a single bad year putting all of your outstanding PSU plans underwater is by “banking” PSUs on an annual basis as you go along. But keep in mind that you still want these to be long-term plans and don’t want to make your program so complicated that it cannot be understood by investors or by the executives it is intended to motivate.

Disclosure

Some companies still think of the proxy statement as a compliance document, not a communication vehicle. Others abandoned that view years ago. Regardless of where a company is on the spectrum, here are a few suggestions:

• Be sure to include the “why” in your proxy statement. Proxy statements often focus a great deal of attention on the “what,” not on the “why” of executive compensation. Be sure that the lawyers drafting your compensation disclosures understand what the compensation committee was thinking and trying to achieve – and be sure the “why” is featured prominently in your proxy.
• Use supplemental filings to tell a focused story. Proxy statements tend to make executive compensation appear homogenous across companies – not just because everyone has to comply with SEC rules, but because investors and proxy advisory firms are looking for companies to disclose the same kinds of information in their proxy statements. But you want to be able to tell your company’s specific story. Use (and file) a short deck that highlights the main points, and don’t wait until you’re facing a bad say-on-pay vote to do so.

Finally, all the webcast panelists agreed that when it comes to linking executive compensation to ESG performance, the main lesson from the past decades of experience with executive compensation is: proceed with care.