Spin-offs have been in the news for several years. Fully 60 spin-off transactions occurred in 2014, followed by another 40 spin-offs in 2015, with 13 involving S&P 500 companies.1 Spin-off activity continued to be newsworthy in 2016 with major spin-offs completed by Alcoa, Danaher, Emerson Electric, Johnson Controls, and Xerox. Spin-off activity will continue into 2017 with a number of pending transactions including major companies like Ashland, Biogen, Hilton Worldwide, and MetLife. The need to create shareholder value during a period marked by low returns from most asset classes is driving the spin-off activity. In some cases, activist shareholders have pushed companies to create value by breaking businesses into their component parts. When a business undergoes a spin-off, the human resource and executive compensation implications for executives at both the Parent Company (ParentCo) and the Spin-off Company (SpinCo) are very significant.

We have advised many companies as they worked through the spin-off process and we want to share some of what we have learned. As a starting point, we have identified four critical work streams for executive compensation in a spin-off:

1. Establishing Transitional Compensation Arrangements (e.g., near-term retention plans)
2. Understanding and/or Modifying Outstanding Compensation Arrangements (e.g., outstanding equity awards, severance and change in control agreements, benefit plans, etc.)
3. Developing Going Forward Compensation Programs for SpinCo, equivalent in many ways to standing up a newly public company in an IPO
4. Modifying Compensation Programs for ParentCo, as necessary to reflect new business focus and business scale

1. Establishing Transitional Compensation Arrangements

After deciding that a portion of the business is going to be spun-off, one of the first compensation decisions that needs to be addressed is how to structure incentive compensation programs for the company in the year of the spin-off. How complex this step is will depend on the timing of the spin-off in the fiscal year and the nature of the company’s annual and long-term incentive plans. A general principle is that if the spin-off has already been announced at the time design decisions are being made, SpinCo incentive compensation should be based primarily on SpinCo performance to provide better line-of-sight for SpinCo employees and to facilitate the transition.

Annual Incentive Plans

If the upcoming spin-off is a known event at the time that the annual incentive award is made, the transitional incentive plan can be simplified by ensuring that the annual incentive for SpinCo executives is tied 100% to SpinCo performance for the entire fiscal year. In this case, SpinCo executives will be paid an annual incentive based on SpinCo’s performance early in the fiscal year following the spin-off.

In some cases, the annual incentive award may already have been granted prior to the announcement of the spin-off. In such a situation, it is likely that the incentive plan for SpinCo employees will be based on a combination of ParentCo and SpinCo performance up to the time of the spin-off and then on SpinCo performance for the remainder of the year. This may require the company to establish SpinCo specific performance goals for the “stub period” from the completion of the spin-off to the end of the fiscal year. The performance measures for the “stub period” are typically the same performance measures used to assess SpinCo performance for the portion of the fiscal year prior to the completion of the spin-off.

Long-term Incentive Plans

Similar to the short-term incentive, if the company knows that the spin-off is going to take place during the fiscal year, there are design decisions that can help to facilitate transitioning the long-term incentive awards. For any performance-based awards (e.g., performance shares/units/cash), SpinCo employees should be granted awards that are based on multi-year performance objectives for the SpinCo. In some cases, companies will avoid making performance-based awards to SpinCo employees in the year of the transition because of the challenges in maintaining a consistent performance measurement approach before and after the spin-off.

If the spin-off is not a known event at the time that performance awards are made, there may be challenges in converting ParentCo performance awards into SpinCo performance awards at the time of the spin-off. In these cases, some companies will truncate the payout based on the ParentCo performance to date, at spin, and establish SpinCo goals for the remainder of the overall performance period. We will address this issue in greater detail in the next section on the treatment of outstanding awards following the spin-off.

Special Transition Compensation Programs

Most SpinCo employees are likely to view the spin-off as a positive event. Staff positions (e.g., finance, legal, human resources, etc.) will often have enhanced roles and responsibilities at the new company, given the stand-alone nature of the business. Line positions (e.g., business unit executives and staff) often feel that the spin-off provides them with a greater ability to impact business performance.

On the other hand, announcement of a spin-off creates uncertainty about the future prospects of the business. In addition, the SpinCo is a potential acquisition target, with the business potentially being sold rather than spun-off to shareholders. In many cases, it makes sense to review the severance protection in place for SpinCo staff in advance of announcing the spin-off. If there is a real chance that the business may be sold, enhanced severance protection may be needed to ensure that staff positions do not “jump ship”.

There may also be employee retention concerns at the ParentCo. While the spin-off is generally a positive event for SpinCo employees, spin-offs can create concerns for ParentCo employees. For ParentCo employees, a spin-off means working for a smaller company in the future, with a less complex and potentially less interesting job. In addition, the spin-off transaction will create additional work for all corporate staff positions as they set up the newly public company and continue to do their “day job”. For select ParentCo employees, a near-term retention bonus or short-term stock retention grant may provide recognition for their additional workload and focused efforts on preparing for a successful transaction, and help to keep them engaged in a stressful working environment. To the extent that certain corporate staff positions will no longer be needed following the spin-off, there may also be a need for enhanced severance for corporate staff.

2. Understanding and/or Modifying Outstanding Compensation Arrangements

As the company approaches the spin-off, a key compensation issue is how to adjust outstanding compensation arrangements to recognize that one company is breaking up into two companies. Decisions need to be made about what will happen to the company’s long-term incentive plans, as well as retirement plans and deferred compensation plans. For purposes of this discussion, we will focus on long-term incentive plans, as it is an area that is particularly critical for executive compensation.

The treatment of outstanding long-term incentives (particularly equity incentives), can be complex following a spin-off. There are several steps that need to be taken to transition awards, including review of the following:

• What provisions are specified in the equity plan and equity award agreements?
• Should the Committee apply discretion to modify the treatment of employees’ awards based on the circumstances of the transaction?
• What is the preferred approach for converting ParentCo equity (i.e., ParentCo post-spin and SpinCo equity)?
• What will be the timing of the conversion of equity?

Existing Equity Plan and Award Agreements

The first step in reviewing outstanding equity is to understand the treatment that the company’s equity plan and the individual award agreements prescribe for outstanding equity awards. A key issue to understand is what will happen to the awards held by employees of SpinCo. In many cases, the spin-off constitutes a termination of employment and, under ParentCo’s plans, unvested awards are forfeited at the spin-off.

It is important to understand the extent to which the prescribed approach impacts the bottom line of both entities. It is also important to work with internal and external counsel to ensure that there is a common understanding of the contractual rights of employees under the equity plan and award agreements.

Another key issue is whether the plan provides for the conversion of outstanding awards in a spin-off transaction. The plan document will likely include a section addressing a change in capital structure and transactions like a spin-off. In most cases, the Committee is required to convert vested awards to preserve value, but is afforded significant latitude in determining the details of the conversion.

Exercise of Compensation Committee Discretion

In our experience, most Compensation Committees do not want SpinCo employees to forfeit outstanding unvested equity as a result of a spin-off transaction. Forfeiture of previously awarded equity could have a serious impact on morale. One way to address this is to accelerate vesting in ParentCo equity or to provide for continued vesting post-spin. Alternatively, if the ParentCo’s Compensation Committee does not take action to keep SpinCo’s employees whole, then SpinCo’s Compensation Committee may need to take action following the spin-off. But it is important to keep in mind that each situation is different. If outstanding awards are underwater, the spin-off may be an opportunity to eliminate overhang on the stock.

Approaches for Conversion of ParentCo Equity

There are several approaches that are used in practice when addressing how to treat outstanding equity upon a spin-off. The following table provides an overview of the alternative approaches:

While several approaches to conversion are used in practice, the Employee approach is the most consistent with the goal of aligning the executives of the company with the shareholders of the entity they support following the spin-off. Other approaches (e.g., shareholder) may attempt to recognize the efforts of employees, prior to the spin, given that such efforts contribute to the future business success of both entities, post spin. The hybrid approach is sometimes used in situations where there is a significant difference in the growth prospects of the SpinCo or ParentCo. (i.e., ParentCo is expected to have modest price appreciation potential and SpinCo has strong growth prospects). And it is sometimes the case that different treatments may apply to employees within one entity. For example, if the ParentCo hires a senior executive for SpinCo from outside the company, prior to the spin, their awards may convert using the Employee approach if they have minimal service at ParentCo, yet the Shareholder approach may be used for other employees.

For outstanding long-term performance share or unit/cash plans (typically with three-year performance cycles), practice is mixed, and the conversion approach used will depend on the length of time remaining in the outstanding award cycle, the performance measures used, whether a new program is put in place in SpinCo, and the type of SpinCo company structure. In many cases, ParentCo prorates outstanding LTI awards held by employees of SpinCo to reflect their time as an employee of ParentCo. The prorated awards held by SpinCo employees are then paid out based on the original performance criteria at the time payments are made to ongoing employees of ParentCo. Once employees have transferred to SpinCo, the remaining stub periods of each outstanding award may be paid out at the target award amount, or, in cases where the Committee of SpinCo wants to preserve a performance-based focus, they may establish new performance goals based on operational or stock performance of SpinCo. There are challenges associated with setting goals for these ‘interim’ performance periods, yet many companies will do so.

Retirement Programs. Agreement on the treatment of retirement programs, non-qualified deferred compensation (“NQDC”) plans and other benefits is a critical administrative decision. If ParentCo has a defined benefit plan, it must determine whether to transfer assets and liabilities of the pension associated with SpinCo employees to SpinCo. A decision on whether any applicable grandfathering of frozen plans/plan benefits will continue is also required. Non-qualified benefit programs are often only partially funded, or unfunded, and the amounts can be significant. Typically, employee accounts in any NQDC plan of ParentCo are transferred to a SpinCo plan for employees of SpinCo. Alternatively, SpinCo could receive a payout of the NQDC applicable balances. Plan provisions will dictate the course of action. Note that distributions in connection with a spin-off are generally not compliant with Section 409A of IRC, since a spin-off is not a separation of service for employees under 409A.

Health and Welfare Benefits. Generally, SpinCo is responsible for setting up new health and welfare programs and both ParentCo and SpinCo are responsible for claims incurred against the respective plans post-spin. Certain programs such as retiree medical, however, may require a determination of how to allocate liabilities to SpinCo (e.g., for current terminated employees, or just future retirees). Decisions on allocating liabilities related to LTD payments, accrued vacation, COBRA, workers’ compensation, etc. may also need to be made depending on the programs of ParentCo.

Severance and Change in Control (“CIC) Benefits. A spin-off could trigger a CIC depending on the provisions of ParentCo’s various plans. While many benefits arising from a CIC are only paid after a “double trigger” (i.e., they are only paid or vested if a termination of employment occurs in connection with the CIC), certain benefits may be accelerated or payments may be triggered immediately. As a result, severance payments could become due to employees transferring to SpinCo. The companies need to determine if any severance obligations apply when employees transfer to SpinCo and who bears the responsibility for such obligations. Note however, that in many transactions, outstanding awards are assumed by SpinCo, in which case, payments would not be accelerated, nor would any benefits be distributed.

3. SpinCo Going Forward Compensation

Developing a going forward compensation program for the SpinCo is a critical process that often evolves over time. While the default approach may initially be to maintain compensation programs similar to those of the parent company, there may be a compelling case to make fundamental changes to the compensation program to address differences between the SpinCo and the Parent. However, depending on the time-frame for completion of the spin-off and the corporate governance structure, the timing of any such changes may be delayed.

Corporate governance of a spin-off can vary and we have seen each of the following approaches used:

• SpinCo Board of Directors is led by ParentCo executives through time of spin-off until ParentCo no longer has majority stake
• SpinCo has Independent Board members appointed prior to spin-off; decisions on compensation for SpinCo may be subject to Parent Company Compensation Committee approval
• ParentCo Compensation Committee reviews and approves programs for SpinCo

Prior to a planned spin-off there is typically a designated subcommittee of the Parent company board that begins planning and making decisions related to the SpinCo’s compensation program. A Lead Director may be appointed to oversee this planning process on behalf of the new Board, working with the company’s HR or designated SpinCo CEO. Prior to the spin-off, coordinated efforts to recruit new directors, develop a compensation committee charter and a Board calendar, etc. are required.

In a one-stage spin-off, where all shares of the SpinCo are distributed to ParentCo shareholders at the time of the spin-off, the involvement of ParentCo executives and Board members in SpinCo corporate governance will cease at the time of the spin-off. In other cases, where the SpinCo is distributed in stages (e.g., partial IPO to public shareholders followed by a completion of the spin-off or incremental sale of shares in the SpinCo to the public), the parent company Board or parent company executives may continue to serve as Board members of the SpinCo up until the time that the parent company has fully distributed its interest in SpinCo.

When ParentCo Board members or executives are involved in the compensation design, they are more likely to fall back on maintaining a compensation approach that is consistent with that of the parent. They may continue to view the SpinCo as akin to a subsidiary. In these cases, the SpinCo’s compensation program may evolve from the timing of the initial spin-off through the year following the parent company fully divesting its interests in the SpinCo.

Pay Philosophy and Target Pay Levels

For the SpinCo, there is typically pre-planning around the desired compensation philosophy, including a defined market or peer group for pay and performance benchmarking. This peer group should be size and industry specific, reflective of the operating characteristics of SpinCo and may or may not include similar peers to ParentCo’s peers.

There is often extensive benchmarking conducted before the spin-off to determine competitive pay levels for executive positions at SpinCo, assuming new position roles/responsibilities as part of a standalone entity (vs. part of a business unit, prior to the spin-off). It is often the case that benchmarking for SpinCo as a standalone entity will support an increase in pay for executive positions. For example, the top finance executive of a subsidiary is a very different role than CFO of a stand-alone public company. Some adjustments to base salaries and bonus opportunities may be made prior to and/or near the spin date, but should be made within the context of an overall compensation framework to the extent possible. The desired pay mix needs to be determined, with the appropriate emphasis on long-term (equity) incentives to ensure equity ownership build up and alignment with shareholders.

Annual Incentive Program

As with any company, the ongoing bonus program is designed so that funding is based on an appropriate mix of corporate, business unit and/or individual performance. The mix depends on the company’s emphasis on line of sight unit results or overall corporate team results. Performance metrics, whether top line, bottom line, or return based, should appropriately support the company’s strategy. Some investors may initially focus on EBIT/EBITDA or cash flow, yet ultimately determine that a balanced mix of metrics is desirable.

It is worth noting that for both short and long-term incentives, based on the tax code rules (IRC Sec. 162(m), the “performance based compensation” tax exemption for select executive officers), if a company gets an annual and long-term incentive plan approved prior to the Spin by the ParentCo board, and discloses such plan documents in any S1 filing, the company is exempt from IRC Section 162(m) rules for one year. Reapproval of such plan(s) by SpinCo shareholders is required prior to Sec. 162(m) transition relief expiring, and is also required under applicable stock exchange rules. Most companies, however, will still construct their plans to conform with “performance based compensation” rules and best in class industry/market practices.

Long-term Incentives

Key objectives of the Long-term Incentive (“LTI”) program for the SpinCo are to build executive/ employee stock ownership and to create excitement, engagement and alignment with shareholder value creation.

An important first step is to determine an overall equity pool to reserve for equity grants at the SpinCo, i.e., the amount of public stock outstanding that will be shared with employees as part of the compensation program. (This amount is generally under 10% of CSO, once initial IPO, has occurred and/or upon completion of the full spin; industry norms should dictate). At the initial IPO, or at full spin-off, it is common to grant a front loaded equity award to ‘jump start’ employee ownership in the new company. Some companies make a broad-based award to employees deeper in the organization, or beyond the executive group. Stock options and restricted stock are used for this type of grant, yet use of options (vs. full value awards) should be balanced with participation, share usage and cost considerations.

The core LTI framework for SpinCo should be designed to accomplish multiple objectives. Emphasis on equity programs helps to build shareholder alignment. Stock-based performance programs are strongly recommended. Not only do they reflect prevalent practice, but they are viewed favorably by large shareholders. Performance-based equity will also serve as a tool for the new leadership team to promote a focus on specific longer term performance results.

Like any LTI program, balance is important. While some specific industries may use more restricted stock than others (e.g., energy companies), most restricted stock is granted at lower levels in the organization, or for special retention/recognition grants. As a new entity, any new design presents an opportunity to assess long term performance goals related to business strategy and those being communicated to the marketplace. Such goals should likely be incorporated into the LTI program.

Vesting, form of payout and termination provisions are also important. The spin-off event is an opportunity for the new company to re-evaluate ParentCo practices. For example, SpinCo may choose to implement somewhat more stringent award termination provisions to support longer term employment of employees. To further align with best practice, companies should include CIC provisions that provide for outstanding award vesting only upon both completion of a CIC and termination of employment for good reason (i.e., a “double trigger”).

Severance provisions should be established as part of a formal severance (CIC/non-CIC) program or through severance agreements, or less common, as part of an employment agreement. These programs should be implemented after careful consideration of potential costs and benefits to the participant and to the company. Recognize that severance benefits are a sensitive issue for many investors. Tax gross-ups for any 280(g) CIC tax liabilities are no longer common and should not be included. Non-compete and non-solicitation provisions should be put in place for the new entity, as standalone policies or as part of LTI award agreements.

Governance Practices

Certain good governance practices that are commonly in place should be implemented, as they are in the best interests of SpinCo and shareholders and have come to be expected.

Stock Ownership guidelines are now very mainstream and expected by shareholders. They should apply to the newly formed executive group. In SpinCo, it may take some time to ramp up ownership in SpinCo stock, particularly if outstanding ParentCo equity awards were converted at spin using the shareholder approach. Keep in mind there should be a phase-in period before executives are held accountable and a ‘soft’ penalty my make sense, to help facilitate ownership, such as a required holding of 50% of net shares (vested or settled), until the guideline is met.

A Clawback Policy for any awards that were based on results impacted by an accounting restatement is a matter of good governance. A majority of companies today have one, with the ability for discretionary recoupment in the case of fraud or earnings restatement. Note that potential Dodd-Frank rules may mandate a “no fault” policy if finalized.

An Anti-Hedging Policy should be in place that prohibits executives from entering into any hedging transactions related to the company’s stock or trading any instrument related to the future price of the stock.

If Dodd-Frank rules are finalized as currently expected, companies may need to modify these provisions to comply with final rules, but on their own merit, these provisions should be put in place as a baseline.

Directors Compensation. The outside directors’ compensation program of SpinCo should ultimately reflect appropriate market norms for companies of similar size and industry, in terms of the amount of pay provided, the cash/equity mix, and overall structure of board and committee service pay. The design should consider the duties required of directors, as well as the company’s executive compensation philosophy. Initially however, the structure of SpinCo’s program will often resemble the ParentCo program.

The directors equity plan, if separate, follows the same rules as executive equity plans. The ParentCo board typically approves the SpinCo plan prior to the spin-off. Shareholders of SpinCo must reapprove the plan prior to IRC Sec. 162(m) transition relief running out, and also to comply with stock exchange listing requirements.

If any directors work on SpinCo activities prior to the spin-off, special equity compensation may be awarded, or pro-rated. If board leadership includes a non-executive chair or lead director, compensation will need to reflect the expected role, responsibilities and time commitment expected at that time.

4. Modification to ParentCo Compensation Programs Post-Spin

After the spin transaction, it is a good time for the remaining ParentCo to review its own compensation programs to ensure that they reflect the company’s new size and business focus. While not inclusive, the following program components may require review and/or potential modification:

Compensation Philosophy and Competitive Market. The company should assess who the appropriate peer companies are in terms of size, business mix, customers, geographic footprint, domestic vs international business, etc. It may be that the company maintains a market median pay philosophy, but that market position means something different now. If the company’s size is significantly smaller than before, pay levels will need to be monitored for alignment with the newly defined market over time.

Annual Incentive Program. The company’s annual incentive plan, in particular, may need revision so that the performance metrics reflect key drivers of the remaining entity and adjustments to the plan should reflect the new adjustments to the plan should reflect the new organization structure as it relates to any Business Unit or Division performance components. If the remaining business has slower growth prospects and lower margins, for example, the performance metrics may need to be redefined and the weightings reallocated. It may also be the case that there is more of a role for strategic goals as ParentCo also embarks on a new business strategy.

Long-term Incentive Plans. The company should reassess the role of various LTI vehicles at ParentCo. For example, in a low growth business, stock options are not the most effective long term incentive and the company may be better served by increasing the role of a three year LTIP. Conversely, the company may want to instill renewed enthusiasm around the ParentCo’s long term stock performance and growth potential. It may be an appropriate time to emphasize the role of equity. It is also a good time to reassess equity award participation as it relates to overall cost and/or share utilization, both domestically and internationally.

From a more technical standpoint, the Parent should review its current equity plans and share reserve, in light of the recapitalization. A spin-off event itself may not necessarily require revisions to plan documents, but it is an appropriate time to review documents to ensure that appropriate terms and provisions are included. It is also a good time to review compliance with IRC Section 162(m) and 409A.

The compensation related programs and provisions that need to be addressed and acted upon in a spin-off are comprehensive. It is important to the ongoing entities that both ParentCo and SpinCo business objectives are supported by appropriate pay design. At the same time, employee perspectives need to be considered as these transactions can present uncertainty. Planning should begin well in advance of any potential or planned transaction. A cross-functional team from HR, legal, finance and possibly outside advisors, should oversee the necessary action steps. This report can be used to help guide the process and compensation decisions that an organization will need to consider in a spin-off.

Certain compensation practices can have a potentially damaging effect on a company’s reputation, which makes determining what constitutes fair director pay no easy task. Daniel Laddin, founding partner of Compensation Advisory Partners, and Martin M. Coyne, II, Chairman and CEO of NACD’s New Jersey Chapter, offer their insights on today’s most critical compensation issues.

This edition of NACD BoardVision goes beyond definitions to break down realized and realizable pay. Join Christopher Y. Clark, publisher of NACD Directorship magazine, and Eric Hosken , partner at Compensation Advisory Partners, as they talk about how compensation regulations affect businesses today.

The CAP 100 Company Research consists of 100 companies from 9 industries, selected to provide a broad representation of market practice among large U.S. public companies. In this report, CAP reviewed Pay Strategies, Annual Incentives, Long-Term Incentives, Perquisites, and Shareholder Friendly Provisions of these companies in order to gauge general market practices and trends.

Click here to download the full report

Setting goals for long-term incentives has been a persistent problem for companies and Compensation Committees ever since the reliance on long-term performance plans has increased. However, the results of the recent election take the uncertainty to an entirely new level, right around the time when companies are starting to think about setting goals for their upcoming long-term incentive cycle. Examples of challenges various industries will face include:

Energy & Utilities

• Volatility of energy prices given the views on natural gas and oil
• Environmental regulations (i.e. carbon dioxide emissions)
• Traditional sources of energy vs. renewables

Financial Services

• Dodd-Frank implications
• Movement in interest rates
• Return of Glass-Steagall

Industrial and Materials Companies

• Investment in large infrastructure projects
• Renegotiation of trade deals and increased tariffs on goods

None of the above even touches on the implications for businesses if the administration implements a broad-reaching immigration initiative which can have implications on labor costs or if President-elect Donald Trump is successful at dramatically lowering the corporate tax rate.

In many ways, it is similar to the level of uncertainty companies and Boards were dealing with during and immediately following the financial crisis. As Compensation Committees and management plan for 2017 and beyond, a challenge will be setting goals in a company’s 1- and 3-year incentive plans. As such, Compensation Advisory Partners (“CAP”) outlines four things to think about when setting goals to avoid unintended outcomes and maximize flexibility and accountability.

1. Scenario Testing – Run scenarios to test sensitivities and potential outcomes. For example, test what will happen if energy prices go up/down/stay flat and what will happen to payouts under the varying scenarios. Discuss this analysis with the Compensation Committee and establish guiding principles for what is a reasonable payout under the varying scenarios.
2. Retrospective analysis – Over periods of uncertainty, companies can meet or miss their goals for many reasons. If the next four years are as volatile as currently expected, Compensation Committees should encourage management to do a retrospective analysis at the end of each performance cycle comparing actual performance to expected performance when goals were set. For example, if the company ultimately delivers $3.00 EPS and the goal was $2.50, did the company get there through true outperformance, because of changes in non-controllable events or because corporate tax rates declined? This retrospective analysis can help guide the Compensation Committee in determining how challenging the goals wound up being and if appropriate, make necessary adjustments to payouts.
3. Wider range – As the ability to predict the future diminishes, it can often be helpful to rethink the range around target that justifies a threshold and maximum payout. For example, if a company has a high level of confidence in the ability to achieve planned performance, then they might set a relatively narrow range around target (e.g., 95% of plan for threshold and 105% of plan for maximum). However, if the company has less confidence in the ability to set its plan, a wider range (e.g., 90% of plan for threshold and 110% of plan for maximum) may be more appropriate such that deviation from plan does not have as much as much of an impact on payouts.
4. 162m Umbrella Plan – With significant uncertainty it may be challenging to predict what, if any, adjustments a Compensation Committee may want to make to their annual or long-term performance plan. This would be a good time to consider implementing, if you have not already, a 162m umbrella plan to provide the Compensation Committee with flexibility to make adjustments and maintain tax deductibility. An umbrella plan is a structure whereby a bonus is effectively “over-funded” for the Named Executive Officers (“NEOs”) such that the Compensation Committee can determine the final payout with some flexibility as long as the final payout is below the umbrella funded amount. For example, in order to qualify as performance-based compensation, a company could establish a maximum to be paid equal to 3% of net income and specify a percentage of the award pool for the each NEO (excluding the CFO). The Compensation Committee then retains negative discretion to pay less than the maximums established. These umbrella plans are very common for annual incentives, but are less common for long-term plans, though this might be a good time to consider whether one might be appropriate.

There are many other ways of addressing uncertainty around goal setting, but these four tips should help maintain a pay for performance structure, hold management accountable and provide Compensation Committees with appropriate flexibility.

In today’s post Dodd-Frank executive compensation market, most companies are familiar with, and many have implemented, “shareholder-friendly policies” such as clawbacks, hedging/pledging, and stock ownership guidelines. Further, companies have grown increasingly savvy on the executive compensation policies of shareholder advisory firms such as Institutional Shareholder Services (ISS) and Glass-Lewis—specifically as they relate to Say on Pay resolutions (SoP). Most executive compensation professionals—ourselves included—do not deny the influence on voting results when a company receives the dreaded Against recommendation from one or more of the proxy advisory firms. Our research shows that when ISS and Glass-Lewis recommend Against an SoP resolution, there is an approximate 20-30% and 5-15% reduction in the voting results, respectively.

Is this causation or simply correlation? Perhaps that question cannot be answered so easily, but it is possible to study how large institutional shareholders vote on SoP in order to try and understand what factors influence their voting. Companies are already aware of who their largest shareholders are, but an understanding of their voting policies and practices can provide insights on potential shareholder reaction to executive compensation program design, program modifications, and company performance.

To gain a deeper understanding of how large institutional shareholders tend to vote on SoP, CAP compiled a list of the top 25 institutional shareholders (in terms of assets under management) that were invested in at least 250 of the companies in the S&P 500 (“Institutional Shareholders”). CAP collected voting data from Proxy Insight, a leading provider of global shareholder voting analytics.

Among these Institutional Shareholders, 92% (23 out of 25) have their own “in-house” voting policies. What that means, is that even if ISS or Glass-Lewis makes a recommendation, the Institutional Shareholder will make the final determination on its voting decision. Based on 2016 voting results, Institutional Shareholders voted Against SoP 6.6% of the time, at median, for S&P 500 companies. When we expanded the scope of our review to all U.S. public companies, we found that Institutional Shareholders voted Against SoP 8.2% of the time, at median.

Source: Proxy Insight

Why do Against votes occur more frequently among all U.S. public companies compared to S&P 500 companies? This outcome could reflect that S&P 500 companies, in the aggregate, are larger and tend to have the resources to develop and maintain more balanced compensation programs. For example, a long-term incentive (LTI) program that is composed of a portfolio of time- and performance-based awards is viewed positively by institutional shareholders and is more common among S&P 500 companies versus all U.S. Companies. S&P 500 companies also have the capacity to lead more extensive shareholder outreach campaigns, which allows them to explain the rationale for their programs.

Although most Institutional Shareholders vote For SoP in most cases, there are some that will vote Against SoP 10% of the time or more. When voting on S&P 500 Companies, 5 out of 25 of the Institutional Shareholders vote Against 10% of the time or more. When voting on all US companies, 11 out of 25 vote Against 10% of the time or more.

Source: Proxy Insight

CAP suggests that companies should track the voting tendencies of their major institutional shareholders, particularly if they vote Against more frequently. Companies may want to look at historical voting on SoP and should review their institutional shareholders’ proxy voting guidelines—particularly as it relates to compensation. For example, BNY Mellon voted Against SoP at 27% of S&P 500 companies and Against SoP at 44% of all U.S. companies. A review of BNY Mellon’s proxy voting guidelines states that they “consider proposals on a case-by-case basis in situations where:”

• There are tax gross-ups or make-whole provisions in CIC/severance agreements
• The company has poor relative stock performance, especially when compensation is deemed excessive compared to peers
• The company fails to address compensation issues identified in prior meetings
• There appears to be an imbalance between performance-based and time-based long-term incentive awards

Therefore, if one of your company’s major shareholders is an institutional investor that supports SoP less frequently, it is important to understand their voting guidelines, especially if your executive compensation program has practices or includes features that are viewed negatively (i.e. tax gross ups, 100% time-based LTI program, etc.).

Although most Institutional Shareholders have in-house voting policies, they do still subscribe to proxy advisory research from ISS and Glass-Lewis. Among Institutional Shareholders, 88% (22 out of 25) subscribe to ISS and 48% (12 out of 25) subscribe to Glass-Lewis. While there is only one out of these 25 Institutional Shareholders that generally automatically-votes with ISS (Principal Global Investors LLC), CAP determined that there is a correlation between an ISS or Glass-Lewis Against recommendation and voting results. When subscribing to ISS or Glass-Lewis, we found that Institutional Shareholders’ voting aligns with an Against recommendation, at median, 62% of the time for ISS subscribers and 31% of the time for Glass-Lewis subscribers. The data exhibits a greater correlation (approximately double) of vote alignment with an Against recommendation from ISS than Glass-Lewis. This may occur because Glass-Lewis recommends Against about twice as often as ISS does (16% of companies receive an Against recommendation from Glass-Lewis vs. 8% from ISS).

Source: Proxy Insight

As mentioned above, it is not easy to confirm whether the alignment of an Against recommendation from ISS or Glass-Lewis and voting outcomes is the result of causation or simple correlation—perhaps it is a bit of both. However, when companies are trying to understand the voting practices of their institutional shareholders, knowledge of how their institutional shareholders vote in relation to an ISS or Glass-Lewis Against recommendation is a valuable input, particularly in cases where the alignment is very consistent. Since the recommendation from ISS and Glass-Lewis precedes voting, companies can predict potential outcomes based on shareholder tendencies—particularly in cases where the institutional shareholders voting tendencies are correlated with an Against recommendation a high percentage of the time.

Source: Proxy Insight

In examples where Institutional Shareholders do not have a high correlation of voting with an ISS or Glass-Lewis Against recommendation, this can generally be attributed to those Institutional Shareholders that vote For SoP a high percentage of the time in line with their own voting policies.

In our view, it is important for companies to develop a compensation program that aligns with the business strategy, promotes shareholder growth while minimizing risk, and attracts and retains key talent. Once a framework is established, companies can then overlay an understanding of the voting practices of their institutional shareholders, including specific proxy voting guidelines, voting history, as well as the alignment of voting results with ISS or Glass-Lewis recommendations. This becomes more important in cases where the institutional shareholder votes Against SoP more frequently than the norm or follows ISS and Glass-Lewis recommendations a very high percentage of the time. While some companies may engage in comprehensive shareholder outreach programs, other companies do not have the resources for large-scale shareholder engagement. For these companies, an understanding of their institutional shareholder voting policies and practices becomes an important consideration when it comes to compensation program plan design.

Appendix

Today, Institutional Shareholder Services (ISS) announced a methodology update to its CEO pay-for-performance assessment for U.S. companies. Beginning February 1, 2017, ISS proxy research reports will include a new standardized comparison of a company’s financial performance relative to its ISS-defined peer group.

This is a departure from ISS’ sole reliance on Total Shareholder Return (TSR) as a metric. ISS will measure multiple financial metrics which may include Return on Equity, Return on Assets, Return on Invested Capital, Revenue growth, EBITDA growth and Cash Flow (from Operations) growth; these metrics will supplement TSR, but only in the qualitative assessment. ISS will calculate a weighted average of select financial metrics; measures (and weightings) will be based on a company’s four-digit GICS industry group. For 2017, the new financial assessment will not be included in the quantitative assessment although ISS may incorporate a company’s relative financial performance in its qualitative discussion.

This is a significant change to ISS’ pay-for-performance methodology which primarily assesses performance based on Relative TSR. While the additional financial metrics will not be included in the quantitative assessment for the 2017 proxy season, it can provide shareholders with additional context of a company’s overall financial performance. The implication is that TSR will still drive a company’s specific level of concern in the quantitative tests. However, if the company’s financial metrics are not aligned with their stock performance, it could weigh heavily on whether they receive a “For” or an “Against” recommendation from ISS on the Say on Pay vote. Examples where this new policy could help a company is if the market has overreacted to news or industry shifts, but the underlying financials are still relatively strong. When ISS releases the details on the definition and weightings of each financial metric, it will be important for a company to model the financial performance relative to the ISS-defined peer group to understand how its performance will be viewed relative to comparators.

With this updated methodology, however, realizable pay will become increasingly more important in a company’s overall pay-for-performance assessment. By taking a more holistic look at stock and financial performance, ISS may more appropriately capture the linkage between actual compensation earned and the underlying financial performance.

Additionally, ISS has historically relied on S&P to provide financial data, which does an effective job at creating comparability across companies financials. However, they are typically limited in the adjustments they can make across companies (ISS will likely use GAAP definitions, where applicable) and, therefore, a company’s view of its relative performance (which may include adjustments) could differ from ISS. This could be true where there are significant differences between a company’s peer group and the ISS peer group, particularly for companies with a cross-industry peer group (which are more commonly used with large cap companies).

In addition to incorporating financial performance metrics, ISS also announced that it will no longer include companies with less than two years of TSR and pay data in the Relative Degree of Alignment (RDA) assessment. This change will only impact newly public companies.