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It has been a hot topic in the news for the last two years, and it has been the subject of several high-profile corporate lawsuits, executive compensation. The metrics that companies use in creating executive compensation packages that exist today are coming under increased scrutiny, requiring the attention of General Counsel throughout the country.
In that vein, ask yourself:
- Are the metrics for executive pay at your company applied uniformly?
- Do you know what factors are used to measure the performance portion of your CEO or COO’s executive pay?
- Do you see a need to have an independent committee oversee the issue of executive compensation at your organization?
Below, we will touch upon the latest trends impacting executive compensation and give you a few takeaways from recent litigation surrounding executive compensation.
A. The Relationship Between Pay and Performance
Now more than ever, public companies in the United States are relying on performance-based stock awards. Among the Russell 3000 companies, performance-based stock awards were at 51 percent in 2017, and at 57 percent in 2018. This recent trend flows from the fact that performance-based equity awards are seen as being vital to coupling executive pay with company performance.
With the recent change in the tax law, compensation committees are able to use a broader assortment of metrics, and have greater discretion, with the number of performance-based shares paid to executives. Taking advantage of that added flexibility, however, might be met with disapproval by investors. That is particularly problematic if investors perceive any change as a move to un-couple an executive’s pay from performance.
Accordingly, compensation committees should be advised by GCs to be very careful to use metrics that investors will view as accurate indicators of corporate performance. The kinds of problems that result from an institutional investor’s loss of confidence in those metrics can be costly for a corporation, as described in the cases discussed below.
B. The Power of Non-Financial, ESG Factors
Alongside the public’s increasing attention on executive compensation is the public’s increasing attention on corporate citizenship. One form that corporate citizenship takes is a company’s environmental, social, and governance (ESG) stewardship. Accordingly, companies are beginning to use ESG factors as part of an executive’s performance-based compensation.
In fact, in 2018, 71 of the Russell 3000 companies used some form of ESG-related performance goals in executive pay. While that is still a relatively small number, the trend is solidly there. Chevron, for example, has adopted a plan that links its greenhouse gas emission targets to 15 percent of its short-term incentive plans. Similarly, Verizon recently announced a plan that connects annual bonuses to its target to have at least 58.9 percent of its workforce made up of women and minorities.
Therefore, when you are advising a compensation committee, you may want to suggest exploring the use of ESG, and other non-financial performance metrics, as a way to modify executive compensation packages. One point of caution, however. It is important to ensure that the measurement of success on ESG factors is as objective as possible. It can be difficult to quantify improvement with regard to non-financial ESG factors. You want to be sure that you minimize the risk that investors will perceive ESG-related compensation incentives as arbitrarily given.
C. Recent Legal Developments on Executive Pay Metrics
Now having discussed a few recent trends, it is worthwhile to look at two recent legal developments related to how courts are handling shareholder challenges to executive compensation.
- Potential Change in the Applicable Legal Standard
Over the years, executive compensation lawsuits were typically judged using the board-of-directors-friendly business judgment standard of review. However, it appears that courts are beginning to apply the entire fairness standard of review instead.
For example, in the case of Stein v. Blankfein in Delaware, the plaintiff claimed that the non-employee directors of Goldman Sachs received compensation that was grossly excessive. (The difference in pay was $600,000 per year at Goldman Sachs, compared to a peer average of $350,000 per year.) In response to the directors’ motion to dismiss, the Delaware Court of Chancery applied the entire fairness standard, rather than the business judgment standard. Consequently, the court denied the motion to dismiss, despite acknowledging the weakness of the plaintiff’s argument.
The Stein court, in using the more forgiving standard of review, followed the Delaware Supreme Court’s decision in In re Investors Bancorp Inc. S’holder Litig. In that case, the Delaware Supreme Court overruled a lower court’s use of the business judgment standard in a challenge to a $51 million equity award granted to the company’s board of directors.
- Use of the Novel Theory of Wrongful “Tone at the Top”
In the case of The Hertz Corp. v. Frissora, Hertz shareholders sued on the novel theory that its former executives, including the CEO, CFO, and GC, fostered an aggressive company culture, which led to a restatement of Hertz’s financial statements in 2015. The company alleged that the defendants breached their duties to the company because they created an inappropriate “tone at the top.” Accordingly, the company sought to recover $70 million in incentive payments, and another $200 million in damages from the executives, arguing that their gross misconduct triggered the company’s clawback policy.
The case is still in litigation. Yet, it serves as a catalyst for GCs and compensation committees to take a close look at a company’s recoupment and clawback policies. Indeed, to avoid costly “tone at the top” litigation, boards should ensure that whistleblowers have meaningful avenues within which to express concern about top executive conduct. In addition, executives should be put on alert that their management style could be used as a basis to start costly clawback litigation.
As GC of a corporation, by keeping a finger on the pulse of executive compensation trends, you may avoid lawsuits and more astutely advise the executive management team and Board of Directors. The information above will hopefully help you consider how best to tie performance to executive compensation, and to avoid some of the pitfalls that could arise when executive compensation is not designed carefully.