Addressing the Impact of COVID-19 on Performance-Based Compensation
In just a few months of 2020, novel coronavirus (COVID-19) has permeated every aspect of business and society. Initially, it seemed like a tragic but localized health matter abroad, then it sent reverberations to the global supply chain. Now, with virus outbreaks in virtually every country, COVID-19 is a global pandemic that may be the catalyst to a global recession. Since matters are changing daily, so too are our viewpoints. We’re happy to connect live given the rapid change unfolding.
Every business discipline is asking how it can help support the smooth progression of commerce amid chaos and uncertainty. In executive compensation this question is particularly acute with the ubiquitous use of performance equity.
To be effective, performance awards need to have realistic goals so that the recipients perceive a high line of sight between their actions and their ultimate pay. COVID-19 is now making it virtually impossible to set performance goals on new long-term incentive awards and annual short-term cash plans. In addition, outstanding performance equity awards hang in jeopardy based on the impact COVID-19 may have on current year (or even multi-year) results.
In this article, we discuss how companies are taking COVID-19 into account when setting new performance goals and evaluating progress on outstanding performance awards. We’ll cover the various alternatives available and the implications they have for financial reporting and the proxy.
Goal-Setting and Goal Measurement During Economic Turbulence
Let’s start by defining the problem. And there are really two:
- When setting performance goals for a new equity grant under the long-term incentive plan (LTIP) or the annual bonus plan, how can companies arrive at realistic stretch goals amid extreme economic uncertainty? If that uncertainty is ignored, the goals could be altogether meaningless and their incentive impact lost.
- What should be done if the current realizable pay on outstanding performance equity awards is depressed as a result of an unplanned secular shock that has nothing to do with executive decision-making? If realizable pay plummets, retention risks may amplify.
Both problems are important and directly impact the effectiveness of incentive programs. These challenges have always existed, but our view is they are much more acute today given how award designs have evolved and given the much stricter corporate governance climate.
Why Depressed Equity Values Are Dangerous During Economic Turbulence
Compensation committees, CEOs, and CHROs are right to be deeply concerned. The way executive poaching works is that competitive firms target excellent leaders in the C-suite or immediately below and approach them with a more attractive compensation package, a larger role, and an offer to buy out their unvested and outstanding equity.
When equity awards are depressed due to secular shocks that are entirely outside one’s control, the cost of that buyout is low and the interest in exploring one’s options is high. Key person turnover during periods of turbulence can create a negative feedback loop where setbacks beget more setbacks. That’s why retention and incentive alignment are arguably even more important during troubling economic times.
The Current Executive Compensation Climate is More Complex Than Ever
The current market turbulence is much different from prior bear markets. During the dot-com bust of the early 2000s, there was virtually no corporate governance framework to block companies from repricing their stock options and taking similar measures to restore lost incentives. Then, during the financial crisis of 2008, stock options were still in wide use and stock option exchanges became the vehicle through which many companies took decisive action to maintain clear incentives.
Today, approximately 60% of companies use relative total shareholder return (rTSR) awards. Relative performance metrics provide the best insulation against secular shocks. However, 40% of companies still lack relative performance awards and nearly every company maintains an annual bonus plan tied to absolute internal metrics. Long-term incentive plans consist of performance awards with 3-year measurement periods, giving much less time to recover from a negative shock than something like a 10-year stock option would afford. And finally, proxy advisors and institutional investors play a dominant role that usually curtails the range of strategies available to companies.
What Strategies Exist—and What Are the Implications?
Let’s look at solutions for setting new performance metrics and then for dealing with outstanding and underwater performance goals. We’ll also highlight the pros and cons of each strategy, with most of the downsides relating to technical accounting and financial reporting. We’ll see why—more than ever—it’s critical to maintain a close partnership among compensation, corporate accounting, and legal.
Designing New Awards
We’ve spoken with dozens of companies and the strategies being employed are numerous. Here are the key points, along with our recommendations:
1. Do nothing (no changes).
- It’s simple and easy.
- Performance goals already embed uncertainty; changes are not merited just because we now know the flavor of that uncertainty.
- There is nothing wrong with incentive programs not paying out sometimes, especially if shareholders are equally suffering.
- Threshold, target, and stretch goals embed bounded uncertainty linked to known strategies that may under-deliver or over-deliver—unless specifically contemplated, global shocks aren’t factored into goals.
- Therefore, with knowledge of a global shock underway, it’s fundamentally flawed to ignore its occurrence and expected impact on the business plan driving proposed goals.
2. Make the awards in the present but delay setting goals for a reasonable time (e.g. several months).
- It doesn’t make sense to lock down goals while there is great uncertainty around the ultimate impact of the COVID-19 pandemic.
- It’s generally tougher to modify a goal once it’s formalized.
- For a large recipient base that extends past the C-suite, too much delay can trigger skepticism and negative spin.
- Delaying goal-setting presupposes there will be better information in two to three months, which there very well may not be. Instead, why not just use relative goals?
- Not establishing goals delays the accounting grant date, which alters the normal pattern of expense recognition in the financials.
3. Reduce goals by a factor in contemplation of the impact of COVID-19.
- It explicitly acknowledges that business operations have already been affected and attempts to reasonably incorporate those effects.
- It’s too much of a dart-throwing exercise given the uncertainty is still not understood adequately.
- Risk accommodation may be too little or too much and therefore create a different problem in the future.
4. Select different performance metrics or award designs that offer better insulation against a secular shock like COVID-19.
- It’s an organic solution that addresses the root of the problem.
- It delivers a superior story to participants who are naturally concerned with the awards they’re receiving.
- It’s potentially a drastic decision-making adjustment in a relatively short amount of time.
- It may change the underlying incentives employees are accustomed to, and risks disconnect with business strategies.
5. Set goals using the best available information and softly communicate a willingness to modify goals based on how COVID-19’s ramifications unfold.
- It allows the compensation strategy to unfold as planned in the short term while providing reassurance that the “black swan” event of 2020 is being monitored and considered.
- When and if an adjustment is applied, it will be based on better information than what’s available today.
- When and if such an adjustment is made, it will constitute a modification under ASC 718 with incremental cost.
- It assumes that an objective method will exist to quantify the impact of COVID-19 when determining how to modify goals.
6. Draft performance goals to give the compensation committee discretion to adjust actual results based on the identifiable impact of COVID-19.
- It sends a clear message to participants that they won’t be harmed as a result of a secular shock that’s outside their control.
- It will most likely trigger a deferred accounting grant date.
- It assumes that an objective method will exist to quantify the impact of COVID-19 when determining how to modify goals.
Our recommendations depend on the context, but in general we’re skeptical that a “do nothing” strategy is appropriate. Delay is one option, but proceed with care and over-communication. We tend to favor efforts to immunize awards from secular shocks via the use of relative performance metrics. If that’s either impossible or inadequate, we’re cautiously open to introducing either the fifth framework (being prepared to modify goals in the future) or the sixth (adding discretion today).
Addressing Outstanding Awards
There are fewer choices available to outstanding performance awards that are mid-cycle, but these are potentially even more important to deal with appropriately. The specific risk is that COVID-19 results in share price and financial shocks that were never contemplated years ago when setting performance goals. As a result, these awards may fail to pay out—or pay out at low levels.
1. Do nothing (no changes).
- “A deal is a deal” and recipients most likely benefited from positive surprises in the past such that negative shocks simply come with the territory.
- Modifying outstanding awards has major accounting implications that can be highly undesirable.
- Depressed realizable pay levels create a ripe environment for executive poaching, which would cause current performance challenges to escalate and trigger a viciously negative cycle.
- Adjusting performance targets to ensure a reasonable payout is unlikely to be material to the financial statements.
2. Reduce (modify) the goals by a factor in contemplation of the impact of COVID-19.
- It’s necessary to restore incentives if outstanding awards are underwater due to external shocks that weren’t contemplated in upfront goal-setting.
- It triggers an accounting modification that may lead to significant incremental cost with no guarantee that new targets will be met.
- Premature modifications may result in incremental cost and a new target that still cannot be achieved due to ongoing uncertainty.
- Proxy advisors and institutional investors have generally not given clear guidance on suitable performance target resetting approaches.
3. Replace existing metrics with one or more relative metrics.
- Relative awards, when designed thoughtfully, neutralize the impact of macroeconomic volatility and turbulence.
- Modification charges may be subdued or more manageable than a pure goal reset like the second approach.
- Some modification charge will still be incurred.
- It assumes an appropriate relative performance scheme is available that participants would understand and value.
- It may require consent in the form of a tender offer (similar to an option exchange program).
4. Implement an option exchange if a large portion of the LTIP portfolio consists of stock options and stock prices remain subdued.
- Materially underwater stock options serve as a disincentive and represent unproductive overhang.
- Option exchanges can be structured to be accounting neutral and generally garner proxy advisor support.
- Smaller public and pre-IPO firms can implement an option exchange much more easily than large public firms can.
- It’s premature unless stock prices materially plummet and there’s reason to believe they won’t recover anytime soon.
- Option exchanges require a tender offer, which can be costly and time-consuming to complete.
Again, our recommendations vary based on the context. The easiest option is to do nothing. But depending on the extent of COVID-19’s impact, employees may expect the company to make reasonable adjustments to account for such an event outside their control. Upsetting employees may even compound business woes by prompting them to look for greener pastures elsewhere. If modifications are considered, knowing the exact ramifications on financial statements and the proxy is then critical.
Understanding the Accounting Implications of Bold Actions
Approaches that involve modifying performance goals, or affording the committee additional discretion, are bold because they allow wholesale resolution of incentive breakdowns introduced by exogenous macroeconomic shocks. However, they also trigger intricate considerations under ASC 718, the governing accounting standard that also impacts proxy disclosures.
Modifications to Previously Set Performance Goals or Strike Prices
In contemplating a future modification, the objective is to secure an accounting grant date upfront and then monitor realizable pay levels and the factors that cause volatility. However, to avoid surprises and conflict when a modification actually becomes warranted, it’s important to set expectations upfront and educate your compensation committee on what to expect.
To that end, there are three important considerations:
- Types of modifications available
- Accounting ramifications of a modification
- Proxy disclosure implications of a modification
Let’s examine them one by one.
In an economic downturn, modifications can do any of the following:
- Adjust the performance target. In the simplest form, an EBITDA or ROIC target at a particular level is decreased by, let’s say, 20% in contemplation of the impact of COVID-19. Another version of this approach could be to adjust report results in light of the disruption posed by COVID-19. Flavors of these modifications are the most common in practice.
- Extend the time to achieve a target. Although not particularly common, one approach is to allow an extra six months or year to achieve a target in recognition of how COVID-19 disrupted the global economy. An especially practical version of this approach shows up with stock options when terminating executives. An option generally has 90 days post-termination to be exercised, which many would say is not appropriate in the midst of an economic disruption like COVID-19.
- Replace the award with something else. A classic example is option exchange, which replace a bundle of underwater options with a smaller quantity of at-the-money options or restricted stock. Another approach we expect to see is replacing performance share units that have an absolute metric with comparable awards that have a relative metric. One benefit to the replacement strategy is you gain additional control over how much incremental cost is incurred.
All of these actions are considered modifications under ASC 718 because they revise award terms and conditions in a way that increases the value or alters the timing of vesting.
Accounting for a Modification
ASC 718 modification accounting involves a test to see whether the modification creates incremental cost that should be recognized in addition to the upfront grant-date fair value. In a down market, modifications to reset performance targets that are not on track to be achieved typically constitute a Type III, improbable-to-probable modification. This means a series of metrics that are deemed improbable of being achieved are being adjusted to now become “probable” of being hit (to use accounting parlance). It’s equally possible for there to be both a Type III modification for a portion of the award that wasn’t expected to be earned and a Type I, probable-to-probable modification for a portion that was expected to be earned.
Each type of modification is therefore handled differently. For example, extending the performance period may similarly be a combination of a Type I and Type III modification. If the condition being modified is a market condition and employees were expected to provide the requisite service, then there would functionally only be a Type I modification because any drop in performance is not taken into consideration in the accruals. The same goes for extending the term of an option and an option exchange.
Both Type I and Type III modifications require a test for incremental cost. As the name suggests, the objective is to measure how much value the employee receives as a result of the modification. This is the difference in value measured immediately before the modification and immediately after the modification. For shares that were improbable to vest (Type III), the pre-modification value would be zero and the total post-modification value is simply the current fair value of the modified design. This quantity is recognized prospectively over the remaining service period.
The incremental cost for Type I modifications is recognized in addition to any remaining expense from the grant-date fair value. If the vesting period is extended, which is not uncommon to do when creating a benefit for the employee, the incremental cost can be recognized over the longer service period or the original one. Option exchanges and related approaches that swap one instrument for another can be structured to have no incremental cost, in which case there is no accounting charge.
Proxy Implications of a Modification
Under Reg S-K, the incremental cost associated with a modification hits the proxy tables in the year of modification. The idea is that the award that was originally granted to the employee has lost value and the modification is not economically different from simply issuing a new award. It’s a matter of form and not function that this is done by revising the original award, perhaps even by maintaining the same grant ID in the stock administration system. The incremental cost shows up in the Summary Compensation Table and Grants of Plan Based Awards Table.
The impact of Type III modifications in the proxy can be counter-intuitive. In financial reporting, a Type III modification often entails a true-down of expense as the original targets get classified as improbable and the fair value of the modified award is lower than what initially was set up on the original award. However, a Type III modification is by its nature a cancellation and re-grant of the award, which means the new value hits the proxy and there is no mechanism to reflect the true-down in cost that otherwise takes place in the financials.
Modifications are extremely complex given the near-infinite possibilities and the nuances of accounting for them. This is especially true for awards with market and/or performance conditions. Please consult our modifications white paper or contact us with specific options you are considering.
Compensation Committee Discretion to Adjust Goals
The other overarching approach toward dealing with broken incentives involves giving the compensation committee formal discretion to adjust performance results in order to exclude or minimize the effect of COVID-19. This of course only works on new grants since any action taken on an outstanding award is automatically a modification. If instituted on a new grant, the idea is that when the committee does exercise discretion, then it’s not modifying the award because it’s operating in a manner consistent with the upfront specifications.
On its face, adding discretion related to COVID-19 may seem no different from the standard language that allows compensation committees to adjust performance results for accounting standard changes and corporate transactions. However, broad discretion that doesn’t offer prescriptive adjustments is far more likely to result in a deferred accounting grant date and therefore mark-to-market accounting.
ASC 718 provides five criteria to establish an accounting grant date, and only once there is an accounting grant date can there be fixed accounting. An award that’s issued and has required service but no accounting grant date is marked-to-market until the grant date occurs. This is generally problematic because it means the actual cost of the awards granted is unknown. It depends on how the value fluctuates over the period leading up to the specification of an accounting grant date, which is when the discretion ultimately is exercised and put to rest.
We think that language giving the compensation committee open-ended discretion to adjust goals due to COVID-19 events will not meet the ASC 718 criteria for a grant date. The clause violated is the one stating there must be a mutual understanding of the award’s key terms and conditions in order to have a grant date. The performance targets that an employee is being asked to sign up for may be materially different by the end of the performance period, and it’s unclear how, or to what extent, the targets will be changed due to the subjective discretion afforded to the committee.
Before dismissing this alternative, though, consider the silver lining. For one, if stock prices continue to stumble, then the mark-to-market accounting will actually be favorable to the financial statements as fair values decrease. Additionally, if the discretion is only present for a small batch of awards to executives, then even if stock prices soar and result in additional financial statement charges, the total impact may not be overly material. In short, don’t be too quick to conclude that mark-to-market accounting is unacceptable. Potential volatility and complexity are merely important considerations.
What to Do Now
There’s never a good time for a crisis the likes of the novel coronavirus. The upheaval to peoples’ lives and the economies they live in has already reached catastrophic levels and none of us know what the next few weeks and months will look like. Perhaps Covid-19 will prove to be nothing more than a “pause button” on commerce, one that vacuums revenue and profit out of the economy for two months before things resume as normal. Then again, perhaps it will be the catalyst that sends the world economy into its next recession and bear market.
After preserving the safety of our families, friends, colleagues, and business partners, the next imperative is to help our precious economic system continue. We believe that equity compensation is a critical component of the global commercial model because it aligns incentives, helps retain top talent, and supports innovation. Proactive organizations use periods of turbulence to play offense in their talent acquisition strategy, approaching executives and up-and-comers with buyout packages and expanded roles.
To this end, here are strategies we suggest you employ in the near-term. If COVID-19 escalates and the economy deteriorates further, new actions may be needed—but let’s start here:
1. Make sure you have a dynamic model for measuring and scenario-modeling realizable pay.
At any given time, you need to be able to assess how the pay opportunity—by employee and level—is changing. Similarly, you need to be able to quickly gauge how realizable pay could change if circumstances were to deteriorate further.
2. Form an assessment as to how recession-proof your long-term incentive program is.
If you maintain three-year goals linked only to absolute performance hurdles, then we suspect the LTIP may not be adequately recession-proofed. For companies that have not yet made their annual grant, this may support revisiting the overall design and metrics in use.
3. Begin socializing incentive restoration alternatives with your CEO and compensation committee.
As experience has taught us, compensation committees like multiple bites at the apple so that they do not feel forced to make a sudden decision. Now is the time to begin presenting them with alternatives. We have helped many management teams frame out the pros and cons in a way that is simple but effective at quickly preparing committee members for proposals that may soon be coming down the pike.
4. Model the financial reporting implications of your incentive restoration alternatives.
Understanding this is a complex problem without silver-bullet solutions, we presented several diverse alternatives above. The next step is to assess which one could make sense in your organizational context and why. As with most analytical topics, speculation fails and data wins, making the present a key time to begin pro-forma modeling each scenario.
5. Look for offensive maneuvers that could be advantageous.
During turbulent economic times, a defensive posture is essential. That said, as we’ve argued, some firms are able to play offense as well. Begin forming assessments of competitors who may have depressed realizable values and consider whether this can support your own talent acquisition strategies.
We began discussing the possibility of a global recession about a year ago. Whether COVID-19 leads us into a recession or is just a blip, nobody knows, but it will undoubtedly send far-reaching ripples throughout the economy. For more on recession-proofing your LTIP, we encourage you to watch a replay of our recent webcast on LTIP award design. We’re also happy to speak with you about any of these topics. Stay educated and, above all, stay safe.