Continuing the Conversation with George Paulin: A Second Wave of COVID-19 Executive Compensation Implications

Setting financial goals and granting long-term incentives for FY20 were the COVID-19 issues that received immediate attention. Most companies either have already acted and expect to apply appropriate judgement at year end or are waiting for additional business and stock-market clarity that they hope will come by mid-year. A growing list of companies in hard-hit sectors including airlines, energy, hospitality, and retailing also are freezing or reducing executive pay for liquidity and alignment with rank-and-file employees.

Meanwhile, further implications are emerging. A list of ten follows, along with initial thoughts on the potential impact:

1. Stock ownership guidelines with “hold-until-comply” requirements will be problematic at hard-hit companies. Executives and outside directors who complied with their guidelines at pre-pandemic prices may have fallen below, and companies generally will not want to force them into the market to buy shares or limit personal liquidity at an uncertain time.
2. Adding ESG metrics to performance-based incentive plans will have increased urgency. COVID-19 is a wake-up call that environmental/social issues can trigger huge financial risks and threaten company sustainability. Focus likely will be on immediately actionable shared goals related to human-capital management and disaster preparedness.
3. Pay and performance peer groups will need to be reviewed for ongoing relevance. Dramatic swings in relative revenues and market-cap values will have to be evaluated if sustained, as well as a concentration of peers in hard-hit sectors that are likely to take more recovery time than others.
4. Non-qualified deferrals will cause anxiety at companies where bankruptcy is a possibility. Employees and outside directors with non-qualified deferred compensation (deferred salaries, bonuses and director fees), will be treated as unsecured general creditors in the event of company financial insolvency.
5. Most executive succession plans do not contemplate virus-related quarantine time or worse. To move quickly, companies need to be ready not only with qualified replacements but also compensation policies for emergency interim roles as well.
6. Hard-hit companies and others without formalized change-in-control severance policies are more likely to consider them. Takeover vulnerability is higher for sustainable companies trading at deep historic discounts, and increased activism is a threat.
7. “Shareholder safeguards” that limit performance share payouts to 100% of target if stock price is negative for the performance period could be triggered. These provisions were encouraged by the proxy advisors and are relatively prevalent. Activation that was regarded as remote in the bull market could now be common, especially for three-year performance periods ending with FY20.
8. Black Scholes and Monte Carlo GAAP values will vary from recent history impacting the number of shares needed to deliver competitive grants. In the most-common scenario, these values likely will be higher as a percentage of the grant date share price reflecting a combination of lower interest rates, higher volatility, and higher dividend yields assuming constant dividend rates on lower prices. However, with share prices generally lower, more shares will be granted.
9. Fixed-value formulas for delivering non-employee director equity grants will be impacted by grant timing. At many companies with calendar fiscal years, directors’ grants will be made on the day of upcoming shareholder meetings in April or May. Price averaging over the prior five-to-20 trading days may be appropriate if recent market volatility persists, or if there is perceived inequity versus executives and employees who received grants at higher prices before the pandemic in January or February.
10. Available stock-plan share reserves are being depleted faster than originally assumed, and investors/proxy advisors are unlikely to relax policies for approving replenishments. Equity grants are now almost universally based on value at time of grant, where the number of shares increases at a lower price and vice versa. The market sell-off means more shares for the same value, while investor policies generally cap potential costs in relation to company market-cap-value and/or potential dilution based on a percentage of company shares.

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