Background
In early February, U.S. President Donald Trump announced he would impose import tariffs of 25% on goods (excluding energy resources) entering the United States from Canada, and a 10% tariff on energy resources. In response, the Government of Canada announced it would impose tariffs on $155B of certain U.S.-made goods coming into Canada.
Since then, tariffs from both countries were paused for 30 days. In mid-February, President Trump imposed a 25% tariff on all steel and aluminum imports to the U.S., including from Canada. Later in February, President Trump affirmed that tariffs would go into effect as originally proposed.
We do not currently know: 1) if general tariffs will actually be imposed by the U.S. on Canadian goods; 2) how long tariffs will be in place; and 3) whether Canada (or other countries) will impose retaliatory measures/escalations. We do know some economic impacts of tariffs, both short-term and long-term:
In this client alert, we focus on the following executive compensation-related implications of tariffs and considerations for compensation committees as they navigate Q1 meetings:
1. Incentive plan adjustments and principles
2. The impact of a volatile CAD-USD F/X rate on compensation programs
3. Long-term incentive award sizing and equity mix during times of share price volatility and decline
1. Incentive Plan Adjustments and Principles
The most recent widespread economic shock to affect the Canadian economy was COVID-19. This “Black Swan” event was not anticipated and required greater flexibility and judgment on the part of compensation committees. We found that companies that relied on adjustment “principles” rather than defined formulas and rules were able to react most flexibly to the changing environment and ensure pay outcomes aligned with performance outcomes at year-end.
What are adjustment principles?
Incentive compensation is intended to be at-risk. Accordingly, adjustments should be made to:
• Avoid rewarding or penalizing management for unbudgeted events that management is not expected to manage
• Ensure that incentives remain aligned with long-term business strategy and the best interests of stakeholders
• Provide flexibility to deal with unexpected events so that that performance goals can be set on a rigorous basis, rather than on a basis that provides allowances for unexpected events
• Ensure that incentive plan payouts make sense taking into account the organization’s performance viewed holistically
• Avoid penalizing management if “doing the right thing” for the business negatively impacts incentives
How might adjustment principles be used in relation to tariffs?
While not all adjustments can be categorized in advance, it is helpful to develop a framework by which the Committee considers adjustments each year.
2. Weakening Canadian Dollar
Financial metrics
Where a company has sources of revenue from multiple countries, exclusions for currency fluctuation may already be built into adjusted earnings and cash flow definitions – this is a relatively common formulaic adjustment for incentive purposes and rarely causes investor concerns.
Some companies may decide to only adjust for currency at the “extremes”. For example, no adjustment for F/X when the Canadian dollar is within a C$1.35-C$1.45 corridor, but adjustments are made outside these extremes. Companies may choose to take this approach when the overall impact of F/X volatility to financial results is de minimis except outside those extremes and/or management is expected to manage F/X volatility at the business level (e.g., through hedging, pricing negotiations etc.). It is very helpful to set out such corridors/exclusions in the definition of the adjusted financial metric itself, so that adjustments are made as a matter of course and do not need to be considered on an exception basis by compensation committees.
North American compensation peer groups
Many large Canadian companies include U.S. companies in their compensation peer groups out of necessity when:
• There are insufficient publicly traded industry comparators in Canada
• The company actively recruits senior executive talent from the U.S. market or loses talent to the U.S. market
• A significant portion of operations, employees, assets or capital is located in the U.S.
The inclusion of U.S. companies in the peer group raises the question of how to treat currency for benchmarking compensation, specifically when benchmarking pay for Canadian-resident executives.
There are two general approaches to treatment of currency for a North American blended group:
• Meridian’s default “nominal” methodology—treat USD compensation at par with CAD (1 USD = 1 CAD) for USD compensation paid to U.S. resident executives and convert compensation using a 12-month average exchange rate for USD compensation paid to Canadian resident executives
• Convert all pay to CAD methodology—convert USD compensation paid by U.S. companies to U.S. resident executives to CAD using a 12-month or longer average exchange rate
The table below compares these two approaches to currency when U.S. companies are added to the peer group:
The Committee should ultimately rely on its business judgment about the competitive realities of each position in setting compensation relative to those benchmarks (e.g., market data is only one factor in the pay decision making process).
3. Share Price Volatility
LTI grant sizing
While we do not fully understand the impacts of tariffs on the economy, we do expect greater share price volatility. In industries directly negatively impacted by tariffs, a precipitous share price decline may require a company to rethink its approach to long-term incentive grant sizing. Below is a list of common “guardrails” we have seen implemented in prior economic crises, to manage equity spend:
• Award same number of share units as prior years. Materially decreases compensation value and increases retention risk. Prior awards are not re-priced, so lower current award values may be viewed as a double penalty. Generally used when the share price decrease is expected to be short-term.
• Use a long-term volume weighted average trading price. Used to determine the share price for share units. Can be used in all market conditions to moderate underlying share price volatility. If adopted, this approach should be used consistently in all market conditions (e.g., 5-day, 30-day, 60-day average).
• Manage number of share units to be awarded. There may be insufficient shares in the reserve, with no choice but to reduce the number of share units granted or the number of participants who receive equity awards. The value of share units not awarded under this scenario may be provided in another form of long-term incentive awards, such as cash-settled RSUs or PSUs, or forfeited.
• Manage number of share units to be awarded taking into account the annual “burn rate”. Some companies set a maximum burn rate (i.e., 0.5% of the outstanding issue) and manage award levels within that rate.
• Calculate the number of share units as normal and apply an arbitrary reduction. This is, as suggested, an arbitrary solution, but was an approach commonly used in the energy sector when oil prices significantly decreased in the past (reductions in the range of -10% to -30%).
• Set a limit on the percentage increase in the number of share units awarded year over year. Cap the number of share units relative to the number (rather than the value) of share units/options awarded in the prior year, or the average of the 3 prior years. This alternative also arbitrarily reduces compensation.
• Make a portion of the equity awards in early 2025, with the balance 6 months later. Mitigates risks on both sides and helps bridge the gap between Committee/investor expectations on the one hand and executive expectations on the other hand. This reduces leverage and dilution and may mitigate potential windfalls if the reduction in share price is shorter-term.
Companies granting stock options
For companies that grant stock options, share price volatility will have several impacts on the valuation of an option:
• Higher volatility will increase the valuation as a % of face value
• A significant reduction in share price value may lead to a temporarily high dividend yield, which significantly reduces the valuation as a % of face value
Without adjustment, companies may need to grant significantly more stock options to deliver equivalent value. In extreme cases, taking a longer-term average of historical stock option valuations may be appropriate, if the current value is not aligned with historical valuations. Companies may also re-examine the weighting of stock options in their LTI mix, as options continue to fade in popularity in Canada.
Concluding Thoughts
In the coming weeks and months, the efficacy and resilience of compensation plan designs will be tested. While there are many items to think about, first and foremost should be:
• Defining the estimated impacts of tariffs on the business, which will be unique to each company
• Taking care of employees, customers and stakeholders in the face of the continued threat of tariffs
• Running the business to the best of management’s ability, and not letting the incentive plan get in the way of making choices that are best for the business and its shareholders
• Relatedly, not letting concerns over potential proxy advisor reactions get in the way of making the right choices for the business
We stand ready to assist our clients think through these and other challenging compensation problems, in a turbulent time for the Canadian economy.
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This Client Update is prepared by Meridian Compensation Partners, LLC, provides general information for reference purposes only and should not be construed as legal or accounting advice or a legal or accounting opinion on any specific fact or circumstances. The information provided herein should be reviewed with appropriate advisors concerning your own situation and issues.
Questions regarding this Client Update or executive compensation technical issues may be directed to:
Christina Medland at (416) 566-1919 or cmedland@meridiancp.com
Andrew McElheran at (647) 472-7955 or amcelheran@meridiancp.com
Andrew Stancel at (647) 382-7684 or astancel@meridiancp.com
Matt Seto at (647) 472-0795 or mseto@meridiancp.com
Andrew Conradi at (647) 472-5231 or aconradi@meridiancp.com
Rachael Lee at (647) 975-8887 or rlee@meridiancp.com
Kaylie Folias at (416) 891-8951 or kfolias@meridiancp.com
Jason Chi at (647) 248-1029 or jchi@meridiancp.com
Gabrielle Milette at (905) 242-0503 or gmilette@meridiancp.com
Wali Ahmed at (647) 208-0132 or wahmed@meridiancp.com
Steve Li at (437) 451-2710 or sli@meridiancp.com
Krunal Billimoria at (647) 267-5869 or kbillimoria@meridiancp.com
Paakavy Senthamilarasan at (647) 926-5641 or psenthamilarasan@meridiancp.com