With the coronavirus pandemic (we hope) tapering off this summer, boards are looking ahead to more normal compensation programs for 2022. They can pull back on the extraordinary measures and structures of 2020–21 and return to their long-term paths to strengthen or transform their organizations. Those paths were already a bit obscured by ongoing disruption in many industries, but then the pandemic pushed them decisively to the side. Companies can now get out of reactive mode and start to control their future again.

Still, it’s important for boards to resist the temptation to pick up where they left off in 2019. The pandemic and other developments have changed the landscape for corporate behavior and strategy. Executive compensation must adapt accordingly for companies to capture fresh opportunities and overcome new challenges.

Taking Stock

2020 was especially difficult for many boards. For their compensation programs, many resorted to new measures, goals, and performance periods, or used discretion. Others introduced special awards to promote retention or maintain motivation. Many of these approaches veered from the typical path but were deemed necessary to administer relevant and fair rewards amid the crises.

(more…)

You’re chair of the compensation committee for the most recent successful initial public offering (IPO). Pre-IPO shareholders and employees are sitting on large unrealized gains. Your visionary leaders, the team that carries the company’s DNA, have just realized wealth beyond all expectations. That’s great!

But now you have a problem: with less financial incentive—plus the added visibility, accountability, and responsibility of a public company—leaders might begin looking for new challenges elsewhere post-IPO.

How does the board keep the magic alive as the company matures? How does the organization keep talent engaged when financial incentives become less effective? How do you keep competitors—whether established or upstarts—from coming for your now-proven talent?

The principle is simple, yet nuanced in practice: Retaining and engaging critical talent is equally important before and after a public listing. It’s just that the forces at play are different.

Here are five “levers” that can facilitate continued engagement and promote retention after public company liftoff:

(more…)

On June 17, 2021, the SEC issued an order (the “Order”) to adjust for inflation the dollar amount thresholds that determine when an investor is a “qualified client” under Rule 205-3 of the Investment Advisers Act of 1940, as amended (the “Advisers Act”). Prior to the Order, Rule 205-3 defined a qualified client as (i) a client who either has at least $1,000,000 under the management of an investment adviser immediately after entering into an investment advisory contract with such investment adviser (the “AUM Test”), or (ii) a client who the investment adviser reasonably believes, immediately prior to entering into an investment advisory contract with such investment adviser, has a net worth of more than $2,100,000 (the “Net Worth Test”). The recent Order increased the amount in each clause by $100,000, creating new dollar thresholds of $1,100,000 for the AUM Test and $2,200,000 for the Net Worth Test, respectively. Qualified clients also include persons who are “qualified purchasers” as defined in Section 2(a)(51)(A) of the Investment Company Act of 1940, as amended (the “Investment Company Act”), as well as “knowledgeable employees” of the investment adviser.

(more…)

Performance metrics in incentive plans are most effective when they reinforce business priorities and initiatives that are already deemed important by leadership. This is as true for ESG metrics as it is for any other performance objectives, although there are also strong external pressures that appear to be influencing the adoption of ESG metrics today.

Our first report of 2021 delved into the different ESG metrics in the S&P 500, parsing important trends and year-over-year changes in prevalence. This post drills down into how these metrics manifest across industries, with differences driven largely by variance in business models and strategy, as would be expected. For example, we see significant emphasis on employee safety metrics in heavy industries such as Energy and Materials, along with measures tied to environmental impact and stewardship. Similarly, human capital metrics such as retention and talent development are most common in industries with a heavy strategic focus on recruiting and retaining high-caliber talent, such as Financials, Technology, and Health Care.

At the same time, the pressures on corporate leadership and boards to demonstrate commitment to broader social responsibility within ESG have only heightened throughout 2020 and 2021, driven in part by increased focus on the impact of the Covid-19 pandemic on stakeholders as well as the spotlight on racial inequality. These pressures are fueling the adoption of newer social sustainability metrics such as Diversity & Inclusion (“D&I”) in incentive plans across all industries. Headlines continue to highlight blue chip companies that are adding environmental and social (“E&S”) sustainability metrics to go-forward compensation plans, and we expect to see prevalence increase even further by next year.

(more…)

Introduction

There is a growing consensus in the global business and investment community that sustainable and inclusive capitalism is vital to society, the environment, and the economy. This paradigm shift is propelling corporate purpose to the top of the agenda for directors and investors.

The first report from the Enacting Purpose Initiative, Enacting Purpose Within the Modern Corporation, A Framework for Boards of Directors, was published in August 2020. This report builds upon that foundation by setting out how directors can work with their investors to leverage corporate purpose to address societal issues and sustain long-term value creation.

This report’s recommendations were informed by extensive dialogue with over 35 board members in the Director Steering Group and over 30 global investors and asset owners and managers in the Investor Steering Group. We remain encouraged by the common ground between investors and directors regarding the value of corporate purpose. This report lays out that common ground in order to produce actionable insights for directors seeking to deepen their collaboration with investors on corporate purpose.

(more…)

Many business thinkers have criticized corporate “short-termism” that discourages crucial long-term investments in intangible capabilities. Executive pay programs get much of the blame, as even “long-term incentives” last only three years, with the goals for each year’s tranche reset annually.

Those brief periods are understandable given that most company strategies in fast-paced markets require agile responses to near-term market developments. But then how can companies carry out long-term investments?

One answer is to realign pay programs to support the company’s larger mission and purpose, rather than a particular strategy. Boards can link a new set of incentives to progress toward achieving the mission, with an eye to promoting sustainable growth. Once executives are focused on and paid for long-term, mission-driven success, they’ll be more inclined to make the necessary investments.

These new incentives could replace existing three-year plans or become an entirely new set of incentives to complement the existing annual and three-year plans. Two incentive programs would be simpler to communicate and would minimize redundancy. But many boards might prefer a separate, third program to ease the transition from current incentive practices.

(more…)

Average support remains high in 2021, currently approximately 90.8% at Russell 3000 companies, reflecting similar averages compared to 2020 in the same period, despite a higher failure rate in 2021 to date compared to 2020 (see below)

Proxy advisory firms continue to have a significant impact on vote results, although current ISS “against rates” are slightly lower in 2021 than in 2020

(more…)

During a recent compensation committee meeting, the CEO expressed some level of frustration with the public discourse on including EESG (Employee, Environment, Social, and Governance) goals—specifically, DEI (Diversity, Equity, and Inclusion)—into executive incentive plans. “Our culture is all about equity, diversity, and inclusion,” she exclaimed. “Why should we be bonusing our culture?”

The impetus for the CEO’s cultural pushback was a compensation committee member’s suggestion that next year’s annual incentive plan include a 10-15% weighted factor with threshold, target, and maximum goals tied to the number of underrepresented employees in management and executive groupings by year end. The compensation committee member had heard that “everyone” was adding an EESG or DEI bonus factor to their incentive plans, so their company needed to do so, too.

Now, it wasn’t that the company hadn’t tracked diversity progress: it had for the past five years. It wasn’t that the succession planning process hadn’t been geared towards providing women and employees of color opportunities for mentorship and new development assignments: it had been doing so for a decade and was proud of their track record in developing and promoting diverse talent at all levels of the organization. And it wasn’t for wont of public recognition about the company being an employer of choice: a number of “Top 50…” and “100 Best…” lists named the company. All of this was accomplished, the CEO reminded the compensation committee, without taking away any of the focus on delivering financial results in the annual incentive plan because EESG and DEI was, and is, so much a part of the company’s culture.

(more…)

Emerging themes from this year’s Say on Pay and proxy voting season suggests a fundamental shift in shareholder and proxy advisor perspectives on compensation. The primary themes of the 2021 proxy season include:

1. S&P 500 companies have received more scrutiny and lower vote results.
   The S&P 500 failure rate is 3.7% compared to 2.8% for the Russell 3000, even though the ISS “Against” recommendation rate is lower for the S&P 500 (10.2%) than the Russell 3000 (11.0%). Last year the difference was minimal.
2. Shareholders have been highly critical of special awards and long-term incentive adjustments.
   Shareholders and proxy advisors maintain that special awards should be granted infrequently and to specific executives, with rigorous performance conditions and not be additive to regular annual pay. S&P 500 companies that made positive adjustments to payouts or in-flight PSUs had a nearly 10 percentage point higher failure rate.
3. Environmental and social proposals received greater support, especially involving matters on EEO, diversity and inclusion, and climate impact.
   The percent of social and environmental proposals that received above 50% support is 18% and 40%, respectively, which is significantly higher than the 9% and 16% rates at this time last year.

Proxy advisors and several institutional investors released guidelines at the onset of Covid-19 to set expectations on how they would evaluate various Covid-related compensation plan adjustments. Most guidance homed in on acceptable adjustments to add discretion in short-term plans, while advising against long-term plan adjustments. Shareholders and proxy advisors held many companies accountable to these communicated guidelines; however, the rules were more rigidly applied to larger cap companies. Elevated scrutiny of the largest companies raises a discussion about how shareholders have evaluated Covid-19 actions in relation to potential long-term compensation changes.

(more…)

Some firms appear to structure their executives’ incentives as strategic weapons, designed to soften competition from industry rivals. In particular, firms incorporate revenue-based pay into their executives’ pay plans when doing so is most effective at making rivals back off. This approach to executive compensation is consistent with the theory of “strategic delegation,” and suggests that executive compensation plans play a key role in firms’ strategic positioning.

Background

How should performance be measured and rewarded? It’s a question that has fascinated economists, educators, consultants, and bosses for decades. Within the economics literature, the dominant perspective is that of a moral hazard framework, first formalized by Holmstrom (1979). Employees (“agents”) want to do whatever is in their best interest—shirk their difficult/unpleasant duties and/or extract personal benefits, all the while garnering as much compensation as possible. In contrast, bosses/owners (“principals”) want the agent to engage in productive activity to maximize firm profits/value—something the agent will only do insofar as it boosts their compensation. Viewed from this perspective, the purpose of a performance measurement system is to differentiate between productive and unproductive activity, so that productivity can be rewarded and encouraged. As such, the best compensation plan is that which elicits productive/profitable behavior as efficiently and effectively as possible. This framework has proven very powerful. In addition to being simple and intuitive, the moral hazard framework has demonstrated remarkable ability to explain observed compensation practices, both for rank-and-file employees, and for top-level managers and chief executive officers (“CEOs”). However, this framework does not fully explain the gamut of observed compensation practices.

(more…)

In our paper, CEO Compensation: Evidence from the Field, which was recently made available on SSRN, we survey over 200 directors of FTSE All-Share companies and over 150 investors in UK equities on how they design CEO pay packages: their objectives, the constraints they operate under, and the factors they take into account. The answers reveal several interesting results that challenge existing academic theories, which we organize into three groups:

Objective and constraints

We first ask respondents to rank the importance of three goals when setting CEO pay. 65% of directors view attracting the right CEO as most critical, while 34% prioritize designing a structure that motivates the CEO. For investors, these figures are 44% and 51% respectively. This reversal reflects a theme that recurs throughout our survey—directors view labor market forces, and thus the so-called “participation constraint”, as more important than investors, who prioritize the “incentive constraint”. Only 1% of directors and 5% of investors view keeping the level of pay down as their primary goal. This is consistent with CEO pay being a small percentage of firm value, while hiring a subpar CEO or providing suboptimal incentives has potentially large effects. (more…)

“I cannot recall a time where it has been more important for companies to respond to the needs of their stakeholders. We are at a moment of tremendous economic pain. We are also at a historic crossroads on the path to racial justice—one that cannot be solved without leadership from companies.”
— Larry Fink, 2021 Letter to CEOs

At the start of the new decade, corporate engagement with environmental, social, and governance (“ESG”) issues was already accelerating—part of a large large-scale shift in corporate purpose toward responsibility to a broad group of stakeholders. 2020 had a profound impact on corporate governance and responsibility, with the pandemic shining a spotlight on health and safety and the national focus on racial justice drawing sharp attention to diversity and inclusion in corporate America.

As a result, ESG has become one of the most prominent set of issues discussed in boardrooms across the country over the past year. As stakeholder and investor focus on these issues continues to increase, corporate leadership has worked to demonstrate their commitment to progress. Inclusion of ESG metrics in incentive compensation is often seen as a key part in publicly demonstrating this commitment. As a result, ESG metrics have proliferated throughout incentive plans.

(more…)

Eager to give greater attention to stakeholders beyond investors, corporate boards have been adding environmental, social and governance (ESG) issues to their agenda. Prompted by institutional investors and proxy advisors—and from other stakeholder groups— they’ve begun considering translating those concerns into their executive pay packages. At Semler Brossy, we’ve seen a dramatic increase in client inquiries on this challenge.

Linking ESG metrics to executive pay is a powerful way to drive change, but compensation is a sensitive instrument, so we urge caution. Compensation real estate is limited. Each new metric may dampen the emphasis on existing metrics. It is important to balance all incentive metrics to gain the most powerful effect. Companies can be most effective with ESG metrics starting with just the most relevant issues for them and their industry or sector, rather than trying to address all ESG elements.

Companies can assess a number of worthy goals against the company’s specific strategy for customers, employees and other stakeholders. Where can you make the biggest impact or where do you have the biggest gaps? What metrics best drive competitive advantage? Are you looking to limit a major risk or capture a big opportunity?

(more…)

A central issue in executive compensation is the methodology employed by boards of directors and compensation committees to determine chief executive officer (CEO) pay. In this study, we focus on the practice of compensation benchmarking, in which a given firm compares CEO compensation with the compensation packages of peer CEOs at comparable companies. Previous empirical research has established that peer pay and benchmarking play an important role in determining total CEO compensation.

We extend the benchmarking research by analyzing the benchmarking of the components of CEO pay. Motivated by the description of benchmarking practices in compensation committee reports, we examine the following three questions: Is each pay component benchmarked separately and differently than other pay components? Is the structure of compensation (weight of each pay component in total pay) benchmarked as well? And, is pay component benchmarking a better description of benchmarking practices in US public firms than total pay benchmarking?

We employ two research strategies (and samples) to answer our research questions, and focus primarily on the benchmarking of three major pay components: Salary, equity-based compensation, and non-equity performance pay. First, we read the compensation-committee reports (Form DEF 14A) of S&P 500 firms in fiscal year 2013 and find that approximately 89% of firms explicitly state that they benchmark at least one pay component. Further, about 75% of firms declare that they benchmark all three major pay components. These figures indicate that these firms examine separately the distribution of salary, equity-based compensation, and non-equity-based compensation among peers to determine the level of each pay component to their CEO. We also examine whether companies target CEO compensation structure (weight of each pay component in total CEO compensation), and find that approximately 30% of firms explicitly declare in their proxy statement that they benchmark the compensation mix.

(more…)

In January 2021, Pay Governance conducted a comprehensive survey of the use of Environmental, Social, and Governance (ESG) metrics in incentive compensation as reported by 95 participating US companies. The survey documented the prevalence of this emerging trend and explored the types of metrics used, the ways in which they were measured, the types of incentive plans incorporating such metrics, and other important incentive design details. The survey revealed that only 22% of the US companies included ESG metrics in their 2020 incentive plans, whereas 29% of the same companies reported they were planning on including ESG measurements in their 2021 incentive plans. In summarizing the data and citing our conclusions about the survey results, Pay Governance stated that there appeared to be significant hesitancy among US companies to adopt such metrics, as companies considered which metrics and goals would be the most meaningful and consistent with their business objectives. Despite the reluctance on the part of many US companies in moving forward on this issue, we noted that “the inclusion of ESG in incentive plans is perhaps one of the most significant changes in executive compensation in over a decade.” [1]

In our desire to further study this issue, Pay Governance examined the use of ESG metrics in the incentive compensation plans of a select sample of companies in the United Kingdom (UK) and European Union (EU). Our research confirmed that UK and EU companies are well ahead of the US in the inclusion of ESG metrics in incentive plans, and their approach to measuring and rewarding ESG achievements could be a harbinger of strategies used by US companies over the next several years.

(more…)

Cash-for-information whistleblower programs have gained momentum as a regulatory tool to enforce corporate misconduct. Yet, little is known about how financial incentives affect whistleblowers’ decisions to report potential misconduct to authorities. Similarly, there is no large-sample evidence on the consequences for whistleblowers under these programs. We study these questions using over 5,000 whistleblower lawsuits brought under the False Claims Act (FCA) against firms accused of defrauding the government.

Effects of Financial Incentives

Proponents of cash-for-information programs point to the large number of tips that regulators receive from whistleblowers and the success in terms of cases and penalties imposed on corporations. They argue that these programs simply compensate whistleblowers for taking the risk of reporting wrongdoing to the authorities. In contrast, critics argue that cash-for-information programs motivate employees to file meritless allegations with regulators that waste resources of regulators and accused firms alike. Further, they argue that these programs incentivize employees to share information directly with regulators, instead of reporting the issue internally, which might be preferable, as firms can better assess tips in the context of their business and better resolve issues than the authorities.

(more…)

I am honored and humbled to continue the column on executive compensation and corporate governance that Joseph E. Bachelder III wrote for the New York Law Journal for over 30 years. Joe was my esteemed colleague and dear friend at McCarter & English, LLP for more than 8 years. His keen analytic mind, encyclopedic knowledge, attention to detail, concise writing skills, dogged work ethic and relentless pursuit of excellence greatly influenced me and all that knew him. He was a wonderful teacher and mentor who was always generous with his time. Joe Bachelder is and will always be sorely missed.

Earlier this year, in connection with Amazon’s public announcement of its record-breaking annual financial results for 2020, Jeffrey P. Bezos, the company’s founder and board chair, CEO or president since its 1994 inception, announced that he would be relinquishing those positions to become Amazon’s executive chairman sometime this autumn. To say Amazon’s 2020 financial results were “record-breaking” understates the matter: assisted by the effects of the global pandemic, Amazon’s sales of $386 billion represented a 38% increase from 2019 and its net income of $21.3 billion amounted to a whopping 84% increase from 2019. What an opportune time to announce an executive transition! In this post I trace Amazon’s spectacular long-term success and examine its unique executive compensation practices.

Amazon went public in May 1997 when it raised $54 million by selling 36 million shares at $1.50 per share on a post-split basis. As disclosed in its prospectus, the company had no specific plan for its initial public offering (IPO) proceeds but was going public “to create a pubic market for its stock to facilitate future access to public equity markets,” and “to provide increased visibility and credibility in a marketplace where many of its current and potential competitors are or will be publicly held companies.” Upon completion of its IPO Amazon’s market capitalization was about $430 million and Mr. Bezos and his family controlled about 48% of the outstanding shares.

(more…)

Incentive pay for top executives is increasingly based on performance measures (“signals”) other than the stock price—financial metrics such as earnings and sales, and sustainability metrics such as carbon emissions and safety. How should performance signals be incorporated into incentive pay contracts?

A simple solution is to give CEOs shares in the firm, because this perfectly aligns them with shareholder value. However, an important lesson from principal-agent models of incentive provision is that top executives should be rewarded not when shareholder value is high, but when they made the (ex ante) right decisions. This subtle difference can have major consequences. For example, an increase in shareholder value due to a booming economy should not be rewarded with higher CEO pay.

Executive pay should thus depend on shareholder value, but only insofar as it provides valuable information about the decisions made by top executives. Similarly, Nobel laureate Bengt Holmström showed that other signals should be used in incentive contracts if they provide incremental information about top executive decisions.

While Holmström tells us whether to incorporate a signal into a contract, he does not study how to do so. Our paper, How Should Performance Signals Affect Contracts? (forthcoming in the Review of Financial Studies) gives practical guidance for incorporating such signals into compensation contracts.

We point out that a signal can affect two dimensions of compensation contracts:

(more…)

Shareholder perks are in-kind gifts or purchase discounts made available to shareholders that do not scale proportionately with the number of shares held. Shareholders of Ford Motor Company, for example, receive “friends and neighbors” purchase discounts on the purchase of Ford automobiles, and Willamette Valley Vineyards shareholders receive discounts on wine. In our sample of Japanese firms, Sony Corporation sends discount coupons for its products to shareholders with 100 or more shares, Yamaha Corporation offers shareholders a choice of a discount on a purchase or a gift item every year, and Suzuki Motor Corporation annually sends shareholders with 100 or more shares an assortment of premium honey and rock salt.

Theoretical arguments can be made that shareholder perks increase firm value, decrease firm value, or are inconsequential. We articulate and test these competing views using data from Japanese firms. We begin by documenting that the initiation of a perk program is associated with an increase in firm value. The announcement that a firm will initiate a perk program is associated with a 3-day average abnormal stock return of 2.06%. In longer-horizon difference-in-difference (DiD) tests, perk-initiating firms experience positive and significant increases in their market value of equity after the perk program begins. These results indicate that perks are consequential for firm value.

(more…)

Since the Business Roundtable’s 2019 call for greater attention to all stakeholders, corporate boards have been elevating environmental, social, and governance issues in their discussions. Last summer’s widespread protests over racial injustice put extra attention to diversity, equity, and inclusion (DE&I) issues. Boards have begun the difficult work of determining which ESG goals are especially important for their company, and how to translate those goals into incentives for executive compensation where appropriate.

General Reflections

ESG has not yet become a mainstream issue for executive compensation. But the level of inquiry from our clients (predominately corporate boards) has increased dramatically. Those clients say they in turn are getting questions from investors. Often these are about ESG-oriented initiatives generally, but they frequently circle back to executive compensation.

One financial services client, for example, met with large institutional investors recently and spent almost a full hour on ESG. A consumer products client had a similar experience. The investors asked some pointed questions:

(more…)