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The COVID-19 pandemic dealt an unexpected blow that pushed a number of companies into bankruptcy. The impact of pandemic-related shutdowns was broad: Companies in a diverse range of industries – including retail, oil and gas, consumer goods, restaurants, and entertainment and recreation – filed for Chapter 11 bankruptcy protection in the first half of 2020. While the number of filings has not yet reached the level seen in the 2008 financial crisis, the number of bankruptcies is expected to rise through the remainder of the year.

The 2020 surge in bankruptcies has been accompanied by heightened scrutiny of executive pay in restructuring situations. Bankruptcy filings are often preceded by announcements of executive retention and other short-term performance-based awards. These awards can draw criticism as excessive and even inappropriate given the impact of bankruptcy on shareholders and the broader employee population. However, 2020 is unique. While situations vary by industry, most agree that this flurry of bankruptcy filings is not the result of poor management but rather the inevitable impact of unprecedented and unforeseeable broad shutdowns across the country to contain the pandemic. The companies entering bankruptcy need continuity, stability, and motivated leadership. Carefully designed and communicated retention and performance awards can play an important role in keeping leadership in place and focused on moving the company through the restructuring process.

The Evolution of Prepaid Awards

Corporate bankruptcies cause a significant amount of uncertainty for executives and employees, who can be tempted to leave for more stable work situations with predictable, secure compensation streams. Poor company performance means that annual incentives are unlikely to pay out, and equity holdings lose almost all value. In situations where shareholders need to retain executives through the bankruptcy period, cash retention awards to critical members of management can be effective by providing compensation stability. These programs are often called Key Executive Retention Programs (KERPs).

Executive retention awards in bankruptcy situations today have a unique design: they are paid before the bankruptcy filing and are subject to clawback provisions. Clawback provisions are triggered if the executive terminates employment during a specified time period or is terminated for cause. In addition, some clawbacks are tied to performance goals not being achieved. If triggered, the clawback provisions require executives to pay back the after-tax award value. The fact that the awards are prepaid differentiates them from most other cash incentives and makes them the subject of criticism and misunderstanding.

The Evolution of Prepaid Executive Retention Awards in Bankruptcies

Executive retention awardsgranted and paid out duringbankruptcy process Favored payment status inbankruptcies Negative opticsSignficantly changed U.S.bankruptcy law Restrictions effectivelystopped executive retentionawards from being grantedafter a bankruptcy filing Pre-2005 ExecutiveRetention AwardsBAPCPA 2005Announced and paid beforebankruptcy filing (BAPCPAworkaround) Retention enforced throughclawbacks Prepaid ExecutiveRetention Awards

The unique design for executive retention awards emerged from changes to the U.S. bankruptcy code made through the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA). Prior to BAPCPA, a large portion of executive compensation in bankruptcy situations was delivered through retention awards. Executive retention awards were typically paid out in a lump sum or through several payments based on the executive’s continued employment. Executive retention awards also had special status in the bankruptcy proceedings that ensured payment ahead of many other company obligations. As a result of the special status and lack of performance features, executive retention awards were not viewed favorably.

BAPCPA imposed stringent restrictions on awards to “insiders” implemented during the bankruptcy process that are based solely on retention and that lack performance features (“Insiders” are defined as directors, officers, individuals in control of the corporation, and relatives of such individuals). BAPCPA’s restrictions effectively stopped the use of executive retention awards once companies file for bankruptcy. Despite BAPCPA, executive retention awards eventually re-emerged – as prepaid awards subject to clawbacks. By paying the awards before the bankruptcy filing, companies can generally avoid the BAPCPA restrictions and avoid having the award subject to Bankruptcy Court approval.

Prevalent Executive and Employee Pay Practices during Bankruptcy

CAP analyzed the 8-K filings of a number of companies that entered bankruptcy in 2020. Based on this analysis, companies today often use a mix of compensation programs to retain and motivate executives and employees leading up to, and during, the bankruptcy process:

  • Pre-filing, prepaid executive retention awards
  • Performance-based Key Employee Incentive Plans (KEIPs)
  • Employee retention and incentive programs

 

Pre-Filing, Prepaid Executive Retention Awards

A number of companies that filed for bankruptcy during 2020 announced prepaid retention awards for executives anywhere from days to months before the legal filing. The 8-K filings indicate that the prepaid retention awards are designed by the board with advice from compensation consultants, as well as bankruptcy and other advisors. Typical design parameters for executive retention bonus awards include:

Participation:

CEO, other key executives and officers

Objectives:

Retain key employees before and during the bankruptcy proceedings

Award Value:

  • Retention award values often range from 1X to 2X base salary
  • Any previously issued retention awards can serve as precedent

Form of Payment and Timing:

Awards are made in cash, prepaid in a lump sum prior to the bankruptcy filing

Clawback Provisions:

Executives must repay the awards, net of taxes, if they 1) Terminate employment prior to the earlier of a specified period or the conclusion of the bankruptcy period, or 2) Are terminated by the company for cause

Clawback Period:

Most often one year

While less common, some companies, including Chesapeake Energy and Ascena Retail Group, include base-level performance criteria in the clawback provisions to add a performance element to the prepaid retention awards. This improves the overall optics of such awards and helps avoid additional scrutiny during bankruptcy.

Select Pre-Filing Retention and Incentive Programs

Company

Revenue FY2019 ($000s)

Industry

Bankruptcy Date

Program

Award Term

Description

J.C. Penney

$12,019

Retailing

5/15/2020

Retention & Incentive

0.6Y

Adopted a prepaid cash compensation program equal to a portion of NEO annual target variable compensation; NEO awards ranged from $1M to $4.5M; clawbacks are tied 80% to continued employment through January 31, 2021, and 20% to milestone-based performance goals

Retention

1.6Y

Accelerated the earned 2019 portion of three-year long-term incentive awards ($2.4M for NEOs); clawbacks are tied to continued employment through January 31, 2022

Hertz Global Holdings

$9,779

Transportation

5/22/2020

Retention

0.8Y

Cash retention payments to 340 key employees at the director level and above ($16.2M in aggregate); NEO awards ranged from $190K to $700K; clawbacks tied to continued employment through March 31, 2021

Chesapeake Energy

$8,408

Energy

6/28/2020

Retention & Incentive

1.0Y

Executives: Prepaid 100% of NEO and designated VP target variable compensation ($25M in aggregate for 27 executives) based 50% on continued employment and 50% on the achievement of specified incentive metrics Employees (retention only): Converted annual incentive plan into a 12-month cash retention plan paid quarterly, subject to continued employment

Ascena Retail Group

$5,493

Retailing

7/23/2020

Retention & Incentive

0.5Y

Executive and Employee Retention and Performance Awards: Six-month cash award for NEOs (NEO awards ranged from $600K to $1.1M), 3 other executives, and employees who are eligible for the company’s incentive programs based 50% on continued employment through Q4 2020 and 50% on performance; award amounts are based on a percentage of annual and long-term incentive targets Earned Performance-Based LTIP Awards: Accelerated earned 2018 and 2019 performance-based cash awards for all employees ($1.1M for 2 NEOs), subject to continued employment through August 1, 2020 for the 2018 award and August 3, 2021 for the 2019 award

Whiting Petroleum

$1,572

Energy

4/1/2020

Retention

1.0Y or Chapter 11 Exit

NEO awards were prepaid and ranged from $1.1M-$6.4M; clawbacks are based on termination of employment before the earlier of March 30, 2021, or Chapter 11 exit; employees receive quarterly cash awards that in aggregate may not exceed that employee’s target annual and long-term incentive compensation

GNC Holdings

$1,446

Food, Beverage and Tobacco

6/23/2020

Retention

1.0Y

Cash exit incentive awards for key employees (including executives) based 75% on the Company’s exit from bankruptcy and 25% on the 60th day following an emergence event that occurs on or prior to June 23, 2021. Prepaid NEO awards ranged from $300K to $2.2M

Diamond Offshore Drilling

$935

Energy

4/26/2020

Retention

1.0Y

Past Executive Long-Term Cash Incentives: Payment of a portion of past three-year cash incentive awards was accelerated for retention; awards are subject to clawbacks based on termination of employment for one year; NEO payouts ranged from $140,208 to $1.75 million. Other Plans: The Company announced a Key Employee Incentive Plan, a Non-Executive Incentive Plan and a Key Employee Retention Plan, which are all subject to approval by the Bankruptcy Court

Performance-Based Key Employee Incentive Plans (KEIPs)

After BAPCPA, KEIPs emerged to provide incentives to executives without running afoul of the bankruptcy code. KEIPs, which are approved during the bankruptcy process, are performance-based incentives that pay out in cash based on the achievement of financial and operational goals. The goals can be very short-term in nature, such as quarterly performance periods.

Typical design parameters for KEIPs include:

Participation:

CEO, other key executives and officers (ultimately those designated as “insiders” in the bankruptcy proceeding)

Objectives:

Incentivize key executives before, but primarily during, the bankruptcy proceedings

Award Value:

  • KEIPs often collapse the annual and long-term incentive opportunities into a single program
  • In most cases, the executives can earn 100% of their target annual incentive and between 50% and 100% of their prior long-term incentive award value
  • The KEIP must be performance based to receive court approval, and payouts are often determined using absolute measures, such as earnings before interest and taxes (EBIT) or earnings before interest, taxes, depreciation and amortization (EBITDA)

Form of Payment and Timing:

  • Awards are paid in cash upon certification of performance in pre-established goals
  • Performance periods range from quarterly to annual

A current trend is to design and implement the KEIP prior to filing. This is especially true in pre-packaged bankruptcies where the financial reorganization of the company is prepared in advance in cooperation with its creditors. Having these programs in place with payouts contingent on performance improves continuity throughout the entire process, incentivizes the management team to perform, and meets the court’s requirement that any variable compensation to executives be performance based.

One recent example of a company announcing a KEIP before the bankruptcy filing is Diamond Offshore Drilling. The company announced a prepaid retention program for executives, as well as a KEIP, a non-executive incentive plan and an additional retention plan. All plans except for the prepaid executive retention program are subject to Bankruptcy Court approval, according to the 8-K. The KEIP, nonexecutive incentive plan and the additional retention plan replace past incentives – including requiring the forfeiture of past restricted stock unit awards and stock appreciation rights – and current incentives that would have been granted in 2020. The KEIP includes nine participants, including the senior executive team.

Employee Retention and Incentive Programs

Retention and incentive programs for employees are also used during the bankruptcy process. The use of employee programs depends on the company’s business needs and other factors, such as size and industry. Retention and incentive programs for non-executives typically replace the value of annual incentives and sometimes long-term incentives. Employee retention programs are cash-based and pay out at specific intervals, often quarterly given the uncertainties associated with companies in restructuring situations. The duration of employee retention programs often mirrors those for executives.

Severance programs, which provide compensation to individuals at termination, are also used in bankruptcy situations. When communicated broadly during bankruptcy, severance can be considered a retention program as it helps employees have some financial security and focus on their current jobs rather than finding new positions. Severance programs tend to be used more commonly for employees than executives because BAPCPA limits the value that can be delivered to “insiders.” However, a recent example of a severance program for executives came from Hertz Global Holdings, which announced amendments to its executive severance programs prior to its bankruptcy filing in May 2020. The severance programs, which were disclosed in the same 8-K filing as a prepaid key employee retention program, cover senior executives and vice presidents, and the payment multiple was reduced to 1X salary and bonus from 1.5X.

Conclusion

Executive compensation programs implemented in conjunction with a bankruptcy should be carefully designed and reviewed with outside advisors to ensure that the company is complying with bankruptcy code. Companies should carefully review the value of executive awards to ensure that they are reasonable while also in line with competitive practices and past incentive opportunities. Executive award amounts should be considered in the context of employee awards and the company’s overall financial situation to ensure fairness and avoid the appearance of excess. Lastly, companies should carefully communicate the rationale for executive awards and what the company is doing for employees in the 8-K current report or other announcement. Clear communication up front can help head off later public relations and optics headaches.

The CAP 120 Company Research consists of companies from ten 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 Stock Ownership Guideline Requirement Provisions of these companies in order to gauge general market practices and trends.

Characteristics of the CAP 120 Company Research Sample

The CAP 120 Research Study consists of companies selected from ten industries intended to provide a broad representation of market practice among large U.S. public companies. The fiscal year revenues of the companies in our sample range from approximately $3 billion to $500 billion (median revenue of $32.7B) and are summarized in the following exhibits.

9%12%13%9%10%8%9%10%10%10%IndustriesAutomotiveConsumer GoodsFinancial ServicesHealth CareInsuranceManufacturingOil and GasPharmaceuticalRetailTechnology
Financial Summary ($M) Cumulative Total Shareholder Return Ending on 12/31/2018
Percentile Revenue Net Income Assets Market Cap 1-Year 3-Year 5-Year
75th $67,103 $6,804 $172,979 $99,181 4% 50% 73%
Median $32,716 $3,183 $61,495 $43,956 -12% 21% 33%
25th $18,762 $1,654 $25,487 $21,535 -23% -4% 1%

Pay Strategy

Among companies in CAP’s 120 Research, 97% disclose using a peer group for pay benchmarking purposes. The median number of companies in a peer group is 18.

Consistent with last year, approximately one-third (31%) of the companies with a peer group use more than one peer group. Companies with multiple peer groups either use two peer groups for pay benchmarking (e.g., an industry specific peer group and a general industry peer group) or use one peer group for pay benchmarking and another peer group for relative performance comparisons.

Peer Group (n = 116)
% of companies with a disclosed peer group % of companies with more than one peer group (among companies with a peer group) Median # of companies in peer group
97% 31% 18

While use of a peer group is almost universal among large cap companies, many use a peer group as a reference point when setting pay and do not disclose targeting a specific pay position relative to market. Only half of the companies in our study disclose a target pay philosophy for total compensation. Of these companies, only 7% target total compensation above median.

Target Pay Philosophy (n = 56)
Element Base Bonus Cash Long-Term Incentives Total Compensation
% Disclosing 32% 22% 22% 24% 47%
% Target Below Median Pay 8%
% Target Median Pay 87% 96% 96% 97% 93%
% Target Above Median Pay 5% 4% 4% 3% 7%

Annual Incentive

Annual Incentive Plan Metrics

A majority of CAP 120 companies (90%) fund their annual incentive plans using two or more metrics. Only 10% of companies use 1 metric, reflecting a decrease from 2009, as companies try to balance overall plan funding. Use of multiple performance metrics allows for annual incentive payouts to be reflective of broader company performance.

10%35%55%18%25%57%1 Metric2 Metrics3+ MetricsNumber of Annual Incentive Metrics2018 (n=110)2009 (n=76)

Operating Income (including EBIT, Pre-tax Income and EBITDA), Revenue, EPS, and Cash Flow are the most common metrics used in annual incentive plans. Since our first study, the use of Operating Income and Revenue has been generally consistent. Over this period, the use of EPS, Return Metrics and Net Income has decreased (by 11, 10 and 6 percentage points, respectively).

47%45%41%36%31%15%10%5%46%47%35%47%n/a25%16%n/aOp. Income/EBIT / Pre-taxIncome / EBITDARevenueStrategic / Non-Financial GoalsEPSCash FlowReturn MeasuresNet IncomeOp. MarginAnnual Incentive Metric Prevalence2018 (n=110)2009 (n=76)

Note: In the chart above, n/a = not available. Percentages add to greater than 100% due to multiple responses disclosed by many of the companies. Return measures category is comprised of the following metrics: ROE, ROI, ROIC, and ROA.

More companies are incorporating non-financial measures in the annual incentive plan as they are unique to a company’s strategy. Overall, approximately 40% of companies in our study use strategic and other non-financial measures, with certain industries (e.g., Health Care and Oil and Gas) having more of an emphasis on these measures. An emerging trend is to incorporate ESG (environmental, social and governance) metrics in the annual incentive program. Overall, 14 companies (12%) in our study disclosed such measures; environmental measures are most prevalent (8 companies) followed by diversity and inclusion (6 companies).

The chart below shows the three most common metrics by industry in 2018:

Industry Metrics
Metric #1 Metric #2 Metric #3
Automotive (n=11) Cash Flow (73%) Op. income / EBIT / EBITDA (64%) Revenue (36%)
Consumer Goods (n=14) Revenue (71%) EPS (57%) Op. income / EBIT (50%)
Financial Services (n=7) EPS (68%) Return Metrics (43%) Strategic Goals (43%)
Health Care (n=11) Strategic Goals (64%) Op. income / Pre-tax Income (55%) EPS (45%)
Insurance (n=12) Op. Income (58%) Op. EPS (33%) Op. ROE (25%)
Manufacturing (n=10) Cash Flow (60%) EPS (50%) Op. Income (20%)
Oil and Gas (n=11) Strategic Goals (64%) Op. Income / EBITDA (55%) ROIC (36%)
Pharmaceuticals (n=11) Revenue (73%) Pipeline / R&D (73%) EPS (64%)
Retail (n=11) Revenue (82%) Op. Income / EBIT / Pre-tax Income (82%) Strategic Goals (27%)
Technology (n=12) Revenue (67%) Cash Flow (50%) Op. income / Pre-tax Income (50%)

Note: Percentages reflect the prevalence of companies disclosing the metric.

Award Leverage

CAP reviewed proxy disclosures to understand how companies establish annual incentive payout ranges (i.e., threshold payout and maximum payout expressed as a percentage of the target award). 45% of companies in our study disclose a threshold annual incentive payout at a defined level other than zero. The most common threshold payout for these companies is 50% of target. Other companies start at a 0% payout for threshold performance with payout levels progressing to target.

A majority of companies (84%) disclose a maximum annual incentive opportunity. Most of these companies (74%) have a maximum bonus opportunity of 200% of the target award; only a handful of companies (7) have a maximum payout above 200% of target. We continue to see a decline in the number of companies with a maximum payout above 200% of target (8 companies in 2017 and 11 companies in 2016).

Threshold Payout as a % of Target (n = 54)
Range % of Cos.
< 25% 24%
25% to < 50% 26%
50% 48%
> 50% to < 100% 2%
Maximum Payout as a % of Target (n = 101)
Range % of Cos.
> 100% to < 150% 5%
150% to < 200% 14%
200% 74%
> 200% to < 250% 6%
250% or more 1%

Long-Term Incentives

Long-Term Incentive Vehicle Prevalence

A vast majority of companies in our study (84%) use multiple long-term incentive vehicles for the most senior executives. Slightly more than half of the companies (55%) use two long-term incentive vehicles, typically delivered through either a long-term performance plan and time-based restricted stock/units (an uptick this year to 58%) or a long-term performance plan and stock options.

The next most common approach is to use three vehicles (29% of companies). A small percentage of companies in our study (16%) use only one vehicle and it is most typically delivered in the form of a long-term performance plan (84%).

16%55%29%Number of LTI Vehicles1 Vehicle2 Vehicles3 Vehicles

Performance-based LTI awards for senior executives is used nearly universally among large cap companies (95%) and the use of stock options has declined to 51% of companies. This contrasts our first study when the use of stock options and performance-based LTI was fairly balanced (79% used performance-based LTI and 73% used stock options). The prevalence of time-based restricted stock/units has remained flat.

95%51%62%79%73%62%Performance-Based LTIStock OptionsTime-Based RS/RSULong-Term Incentive Vehicle Prevalence2018 (n=120)2009 (n=85)

LTI Award Mix

Performance-based LTI reflects the largest portion of the LTI mix for the CEO. For the first time in our large cap company study, time-based restricted stock reflects a larger portion of the total LTI mix than stock options. The decrease in the value delivered in stock options has shifted to performance-based LTI in the overall LTI mix. The value delivered in time-based restricted stock/units has been generally flat since 2011.

46%62%34%16%20%22%20112018CEO Average Long-Term Incentive Vehicle MixPerformance-based LTIStock OptionsTime-based RS/RSUs

Restricted Stock / Units (RS/RSU) and Stock Option Provisions

The majority of companies use ratable vesting over a period of three years for time-based RS/RSU awards. Approximately 30% of companies use a vesting schedule of four years or more.

68%28%4%Time-based RS/RSUVesting ApproachRatableCliffPerf-Based72%17%11%Time-based RS/RSUVesting Years3 Years4 Years>4 Years

For stock options, most companies use 3-year ratable vesting with a 10-year term.

Stock Options
Vesting Approach Vesting (Years) Term (Years)
Ratable Perf-Based Cliff 3 4 > 4 10 < 10
82% 2% 16% 69% 26% 5% 92% 8%

Performance-Based Award Provisions

The payout curve for performance-based LTI awards with upside and downside leverage mirrors the payout curve for annual incentive awards; the most common threshold payout is 50% of target and the most common maximum payout is 200% of target. Unlike annual incentive awards, a large number of companies (41% for long-term plans vs. 26% for annual incentive plans) disclose a threshold payout between 25% – 50% of the target award.

Threshold Payout as a % of Target (n=74)
Range % of Cos.
< 25% 11%
25% to < 50% 41%
50% 46%
> 50% to < 100% 3%
Maximum Payout as a % of Target (n=106)
Range % of Cos.
100% 1%
> 100% to < 200% 32%
200% 62%
> 200% to < 250% 1%
250% or more 4%

Performance Metrics

Total Shareholder Return (TSR) continues to be the most prevalent performance metric in long-term performance plans; 63% of companies use it as a measure in the performance-based LTI plan. Return metrics are the second most common measure (51% of companies) followed by EPS (31%) and Revenue (23%).

In CAP’s first study, EPS was the most common measure followed by TSR. The rise in the use of TSR can be linked to the influence of proxy advisors who have increasingly used TSR as a proxy for performance since our first study (conducted prior to the adoption of the Dodd-Frank Wall Street Reform and Consumer Protection Act which mandated the shareholder Say on Pay vote). Of the companies that use TSR, approximately 30% disclose using it as an award modifier instead of a weighted metric.

The decline in the use of EPS in performance-based LTI plans is consistent with the decline of EPS use in annual incentive plans. Interestingly, the use of return measures has increased significantly from our first study (51% in 2018 vs. 20% in 2009) as companies are aligning executive long-term pay with profitable growth and operational efficiency. Return metrics are also often favored by institutional shareholders.

63%51%31%23%13%35%20%42%22%11%TotalShareholderReturnReturnMeasuresEPSRevenueCash FlowPerformance-based LTI Metrics2018 (n = 115)2009 (n = 65)

Note: Percentages add to greater than 100% due to multiple responses disclosed by many of the companies. Return measures category is comprised of the following metrics: ROE, ROI, ROIC, and ROA.

Performance Measurement – Absolute vs. Relative

A majority of companies in our study balance absolute financial performance goals (based on budget) with relative metrics. This balanced approach has increased substantially since our first study. Today, 52% of companies use both absolute and relative metrics vs. 25% of companies in 2009. This increase is tied to the increase use of relative TSR as a long-term metric.

In our most recent study, only 11% of companies use relative performance metrics only (down from 26% in 2009) and 37% of companies use absolute metrics only (down from 49% in 2009).

60%87%11%52%37%51%74%26%25%49%RelativeMetricsAbsoluteMetricsRelative Metrics OnlyRelative and AbsoluteMetricsAbsolute Metrics OnlyPerformance-based LTI: Absolute vs. Relative Metrics2018 (n = 115)2009 (n = 65)

Perquisites

A majority of companies in our study (87%) provide perquisites to their CEO. Most companies (69%) also provide perquisites to the CFO. These findings are consistent with our study last year.

Personal use of aircraft, personal security, financial planning and automobile allowance continue to be the most common CEO perquisites. Even though the percentage of companies providing perquisites to the CEO has been relatively flat, the percentage of companies providing the most common perks has increased suggesting that when companies are providing perks to their CEO, it is likely a combination of the four most common categories.

69%45%41%38%56%29%24%31%Personal Use of AircraftPersonal SecurityFinancial PlanningAutomobile AllowanceCEO Perquisite Prevalence20182014

The median value of perquisites delivered to the CEO in 2018 ($125,000) is lower than the value five years ago ($143,000). There was nearly a 30% increase however, in the median perquisite value for the CFO in 2018 ($32,000) compared with 2014 ($25,000).

$125$32$143$25CEOCFOMedian CEO and CFO Perquisites Value ($000s)20182014

Stock Ownership Requirement Provisions

Stock ownership guidelines are very common in publicly traded companies and are viewed favorably from a governance perspective. 95% of companies in our sample have requirements in place for the NEOs. For the CEO, the median guideline (expressed as a multiple of base salary) is 6x and for other NEOs it is 3x.

Stock Ownership

Guideline

Median Multiple of Base Salary
CEO CFO Other NEO
95% 6x 3x 3x

Many companies (52%) have a stock holding requirement in place in addition to the stock ownership guideline requirement for senior executives. It continues to be less common for companies to have stock holding policies that are independent of stock ownership guidelines, or that apply after the ownership requirement has been achieved. These holding policies require executives to hold net shares received from equity awards for periods ranging from one year (most common) to post-retirement. These are generally viewed as shareholder friendly, yet their prevalence has remained fairly consistent over the past few years.

Holding Requirement Until SOG is Met Holding Requirement Separate from or After SOG is Met Holding Period for Separate/Post-SOG Requirements (n=26)
1 Year 5 Years Until Retirement Post Retirement
52% 22% 54% 4% 23% 19%

For questions or more information, please contact:

Melissa Burek Partner
[email protected] 212-921-9354

Lauren Peek Principal
[email protected] 212-921-9374

Industry Context

The retail industry is facing challenges, with many companies experiencing stagnant or declining sales, store closures, layoffs and even bankruptcy. The industry is benefiting from favorable macroeconomic factors: consumer confidence index increasing for 8 years in a row with the 2017 index at the highest point in the last 15 years; continued increases in per capita disposable income; a low interest rate environment; and low unemployment. Yet, the downward pressure on revenues and margin deterioration in the industry has continued, driven by the intense competition from e-commerce retailers, such as Amazon, and lackluster performance of brick and mortar stores. The growth in e-commerce has forced many companies to invest in their online sales channels to compete and grow, while the shift to online sales often forces retailers to provide discounts to attract consumers and at the same time face increasing shipping costs. With this challenging environment as a backdrop, our report will focus on pay versus performance and incentive design among 33 companies.

Multi-Line Retail (Median Revenue ~$70B)

  • Big Lots, Inc.
  • Costco Wholesale Corporation
  • CVS Health Corporation
  • J. C. Penney Company, Inc.
  • Kohl’s Corporation
  • Kroger Co.
  • Macy’s, Inc.
  • Rite Aid Corporation
  • Target Corporation
  • Walgreens Boots Alliance, Inc.
  • Wal-Mart Stores, Inc.

Big Box Retail (Median Revenue ~$13B)

  • Bed Bath & Beyond Inc.
  • Best Buy Co., Inc.
  • Dick’s Sporting Goods, Inc.
  • DSW Inc.
  • Home Depot, Inc.
  • Lowe’s Companies, Inc.
  • Michaels Companies, Inc.
  • Ross Stores, Inc.
  • Staples, Inc.
  • TJX Companies, Inc.
  • Tractor Supply Company

Mall-Based Specialty Retail (Median Revenue ~$4B)

  • Abercrombie & Fitch Co.
  • American Eagle Outfitters, Inc.
  • Express, Inc.
  • Finish Line, Inc.
  • Foot Locker, Inc.
  • Gap, Inc.
  • Guess?, Inc.
  • L Brands, Inc.
  • Tiffany & Co.
  • Urban Outfitters, Inc.
  • Williams-Sonoma, Inc.

Financial Results and Total Shareholder Return (TSR)

Among our sample, median revenue was up 2% versus the prior year, while operating income declined versus the prior year (-2%). Financial performance varied by segment:

  • Multi-Line retail had flat revenues with a modest decrease in operating income (-2%). The decrease in profits was partly driven by the increased competition from e-commerce sites.
  • Big Box retail performed better than the other segments on both revenue (+7%) and operating income (+4%) growth. Companies that focus primarily on one product category continued to grow, despite the pressure from e-commerce competition.
  • Mall-Based Specialty retail saw a minor increase in 2016 revenues of +2% (lower than the +4% growth experienced in 2015) and had the largest decrease in operating income between the three segments (-7%). The decrease in profits was in part driven by deteriorating margins and increased pressure to offer discounts to consumers in a declining mall traffic environment.

In terms of shareholder returns, most of the companies in the sample experienced stock price declines during 2016. Dividend payouts offset the declining stock prices resulting in a modest (+1%) TSR. The retail industry significantly underperformed the companies in the S&P 500, where the median TSR was +13% for 2016. Prior to the presidential election, TSR for most retailers was negative. Stock prices reversed course after the win of the Republican ticket. Expectations for a stronger economy and tax reform bolstered stock prices.

1-Year Revenue Growth (2016) 1-Year Operating Income (2016) Median TSR
Pre-Election (1/1/16 – 11/8/16) Post-Election (11/9/16 – 12/31/16) 2016 (1/1/16 – 12/31/16)
Multi-Line (n=11) 1% -2% -3% 6% 5%
Big Box Specialty (n=11) 7% 4% -3% 5% 1%
Mall-Based Specialty (n=11) 2% -7% 4% -10% -5%
CAP Total Sample (n=33) 2% -2% -3% 2% 1%

CEO Compensation

Pay vs. Performance

1% 7% 2% 2% -2% 4% -7% -2% 5% 1% -5% 1% -36% -9% -24% -24% Multi-Line Big Box Specialty Mall-Based Specialty CAP Total Sample Annual Pay vs. Performance Revenue Operating Income Growth TSR Annual Bonus Change

Multi-Line: Highest median decrease in year-over-year bonus between the 3 segments studied; however, performance was almost flat for 2016. The decreases in bonuses were driven by lower than expected growth as 2014-2015 performance was much stronger (e.g., +9% growth in operating income).

Big Box Specialty: Even though this segment performed better than the other two segments, bonuses were down 9%. Similar to the companies in the Multi-Line segment, 2014-2015 performance was also better for these companies (e.g., +9% growth in operating income).

Mall-Based Specialty: Bonus payouts were generally down reflecting weak 2016 performance. Like the other two segments, 2016 performance was weaker then 2015 performance in terms of revenue and operating income growth (e.g., -1% growth in operating income).

Median Change in CEO Compensation (2016 vs. 2015)

Compensation Element Multi-Line Big Box Specialty Mall-Based Specialty Total Sample
Base Salary +1% 0% 0% 0%
Actual Bonus -36% -9% -24% -24%
Long Term Incentive +5% 0% +4% +4%
Total Direct Compensation +1% -3% -1% 0%

Unlike bonus payouts, the median change in total awarded pay (salary, bonus and long-term incentives) was flat compared to prior year, which was generally aligned with the industry performance in terms of Revenue growth, Operating Income growth, and TSR. The decreases in bonuses were offset by modest increases in long-term incentives that, on average, accounted for 65% of total CEO pay.

Actual Bonuses as a Percentage of Target

As discussed above, annual bonus payouts were lower in 2016. At median, across our sample, actual bonus payouts as percent of target was 112% in 2015 compared to only 51% of target in 2016. Additionally, above target payouts declined significantly in 2016 with only one-quarter of companies paying bonuses at or above target.

Summary Statistics Annual Incentive Payout as a % of Target
2016 2015
75th Percentile 98% 145%
Median 51% 112%
25th Percentile 16% 32%
48% 29% 26% 10% 10% 39% 16% 22% 2016 2015 Prevalence of CEO Annual Incentive Payouts as a Percent of Target ≤ 50% 51%-100% 101%-150% ≥151% of target

Target Compensation Mix for CEOs

Overall, CEO pay mix in our sample was aligned with the broader U.S. market. Within the retail industry, the Mall-Based Specialty retail companies tend to place a greater emphasis on annual compensation (salary + bonus) compared to other retail companies studied (i.e., 46% vs. 29% of total pay). This is in part driven by lower long-term incentive levels as these companies are smaller in terms of revenue and market capitalization compared to the other retail companies in our sample.

Average CEO Target Pay Mix
Salary Target Bonus LTI
Multi-Line (n=11) 10% 16% 74%
Big Box Specialty (n=11) 15% 18% 67%
Mall-Based Specialty (n=11) 14% 32% 54%
CAP Total Sample (n=33) 13% 22% 65%
General Industry 10% 20% 70%

Pay Practices

Annual Incentive Performance Metrics

Among CAP’s retail sample, operating income and revenue were the most common financial performance metrics. All companies with a bonus plan used at least one measure of profitability (operating income, net income, EPS, pre-tax income or EBITDA) and 40% of the companies used profitability as the sole metric in the bonus plan.

84% 47% 16% 16% 25% Pre-Tax Income /EBIT / EBITDA Revenue Net Income/EPS Strategic Goals Other Annual Incentive Metrics

Other metrics include: cash flow, inventory turns, SG&A savings, customer satisfaction, cost savings, individual goals, and gross profit.

Long-Term Incentive Mix

Long-term incentive mix varied slightly by segment, particularly in the use of stock options and time-based restricted stock units. Stock options were used by at less than half of multi-line retail companies and were most prevalent among big box retail companies. All three segments provided similar levels of long-term performance plan awards, with an average of at least 50% of total long-term incentive denominated in performance plans for CEOs.

Average CEO LTI Mix
Stock Options RS / RSUs Performance Plan
Multi-Line (n=11) 14% 31% 56%
Big Box Specialty (n=11) 31% 19% 50%
Mall-Based Specialty (n=11) 22% 24% 54%
CAP Total Sample (n=33) 22% 25% 53%

Long-Term Incentive Performance Measures

The most prevalent metrics in long-term performance plans were profitability measures and relative TSR. Approximately 85% of companies used either one or two metrics in their long-term plans with the rest using three measures. Return measures were not as common as other industries, but we believe that they will become more prevalent as institutional shareholders have expressed great interest in including such metrics in long-termincentive plans.

40% 37% 33% 23% 13% 17% Pre-Tax Income /EBIT / EBITDA Net Income/EPS TSR Revenue ROA Other Long Term Incentive Metrics

Other performance metrics include: cash flow, market share, operating margin, and strategic goals.

Outlook

What’s next for compensation in the retail industry? We expect intense competitive pressure to continue, with opportunities for major disruption from the entry of new players and the continued shift to e-commerce. Strategic transformation will be necessary and some retailers will not survive the challenge. All that being said, attraction and retention of key executive talent will be even more important going forward.


For questions or more information, please contact:

Margaret Engel Partner [email protected]
212-921-9353

Matt Vnuk Principal [email protected]
212-921-9364

Roman Beleuta Senior Associate [email protected]
646-532-5932

Matt McLaughlin Associate [email protected]
646-486-9747

Robert Martin and Rebecca Wertman provided research assistance for this report.

Companies use annual bonuses as a tool to reward executives for achieving short-term financial and strategic goals. Setting appropriate annual performance goals is essential to establishing a link between pay and performance. Goals should achieve a balance between rigor and attainability to motivate and reward executives for driving company performance and creating returns for shareholders.

Key Takeaways:

  • Based on our analysis of actual incentive payouts over the past 6 years, the degree of difficulty, or “stretch”, embedded in annual performance goals translates to:
    • A 95% chance of achieving at least Threshold performance
    • A 75% chance of achieving at least Target performance
    • A 15% chance of achieving Maximum performance
  • This pattern indicates that target performance goals are challenging, but attainable, and maximum goals are achievable through highly superior performance
  • The majority of companies use two or more metrics when assessing annual performance
  • Annual incentive payouts have been directionally linked with earnings growth over the past 6 years

Summary of Findings

Plan Design

For the purposes of this study, we categorized annual incentive plans as either goal attainment or discretionary. Companies with goal attainment plans define and disclose threshold, target and maximum performance goals and corresponding payout opportunities. Alternatively, companies with discretionary plans do not define the relationship between a particular level of performance and the corresponding payout. Discretionary programs provide committees with the opportunity to determine payouts based on a retrospective review of performance results.

Annual Incentive Plan Type
Industry Sample Size Goal Attainment Discretionary
Auto n= 8 100% 0%
Consumer Discretionary n= 10 90% 10%
Consumer Staples n= 12 67% 33%
Financial Services n= 12 17% 83%
Healthcare n= 9 89% 11%
Industrials n= 14 71% 29%
Insurance n= 12 67% 33%
IT n= 12 83% 17%
Pharma n= 10 80% 20%
Total 72% 28%

Consistent with the findings from our study conducted in 2014, 72% of sample companies have goal attainment plans. Our study focuses on these companies.

Performance Metrics

Most companies (61%) use 3 or more metrics to determine bonus payouts. This reflects a shift from 2014, where 48% of companies used 3 or more metrics. Companies annually review metrics to ensure that they align with the business strategy.

Many companies use financial metrics such as revenue and profitability, which are indicators of market share growth and stock price performance. Some bonus plans also include strategic metrics, which incentivize executives to achieve goals that may contribute to long-term success, but may not be captured by short-term financial performance. Companies in the pharmaceutical industry often use strategic goals, such as pipeline development. Similarly, companies with large manufacturing operations often use quality control metrics.

  # of Metrics Used in Goal Attainment Plan  
Industry 1 Metric 2 Metrics 3 Metrics 4+ Metrics
Auto 13% 13% 25% 50%
Consumer Discretionary 11% 44% 45% 0%
Consumer Staples 0% 37% 38% 25%
Financial Services 0% 50% 50% 0%
Healthcare 0% 38% 12% 50%
Industrials 20% 40% 20% 20%
Insurance 37% 13% 25% 25%
IT 10% 30% 40% 20%
Pharma 0% 0% 63% 37%
Total 11% 28% 34% 27%

Pay and Performance Scales

Compensation committees annually approve threshold, target, and maximum performance goals, and corresponding payout opportunities, for each metric in the incentive plan. Target performance goals are typically set in line with the company’s internal business plan. Executives most often earn 50% of their target bonus opportunity for achieving threshold performance and 200% for achieving maximum performance. Actual payouts are often interpolated between threshold and target and target and maximum.

Annual Incentive Plan Payouts Relative to Goals

All Companies

Based on CAP’s analysis, companies paid annual bonuses 95% of the time. Payouts for the total sample are distributed as indicated in the following charts:

This payout distribution indicates that committees set annual performance goals with a degree of difficulty or “stretch” such that executives have:

  • A 95% chance of achieving at least Threshold performance
  • A 75% chance of achieving at least Target performance
  • A 15% chance of achieving Maximum performance

From 2010-2015, no more than 10% of companies failed to reach threshold performance in any given year. By comparison, in both 2008 and 2009, which were challenging years, approximately 15% of companies failed to reach threshold performance goals.

When looking back over 8 years (2008-2015), companies achieved at least threshold and target performance with slightly less frequency. Based on CAP’s analysis of this 8-year period, executives have:

  • A 90% chance of achieving at least Threshold performance
  • A 70% chance of achieving at least Target performance
  • A 15% chance of achieving Maximum performance

By Industry

Pharmaceutical and healthcare companies have paid at or above target more frequently than companies in any other industry over the past 6 years. Both industries have experienced significant growth over the period in part due to consolidation. The companies in the IT, Consumer Discretionary and Consumer Staples industries tend to pay below target at a higher rate. Average payouts for each industry are distributed as indicated in the following chart:

Relative to Performance

CAP reviewed the relationship between annual incentive payouts and company performance with respect to three metrics: revenue growth, earnings per share (EPS) growth and earnings before interest and taxes (EBIT) growth. While payouts were generally aligned with revenue and EPS growth, they most closely tracked with EBIT growth over the period studied (2010-2015). Companies may seek to align bonus payouts with operating measures, such as EBIT, as they capture an executive’s ability to control costs and improve operational efficiency.

The chart below depicts the relationship between median revenue, EPS, and EBIT growth and target and above annual incentive payouts among the companies studied.

Conclusion

In the first quarter of 2017, committees will certify the results and payouts for the fiscal 2016 bonus cycle and approve performance targets for fiscal 2017. Given the uncertain economic outlook following the 2016 presidential election, establishing performance targets for 2017 may be more challenging than usual. Companies may choose to use a range of performance from threshold to maximum to build flexibility into their plans given the unpredictable environment. Our study of annual bonus payouts over the past 6-8 years supports setting goals such that the degree of difficulty, or “stretch”, embedded in performance goals translates to:

  • A 90-95% chance of achieving at least Threshold performance
  • A 70-75% chance of achieving at least Target performance
  • A 15% chance of achieving Maximum performance.

Companies should continue to set target performance goals that are challenging, but attainable and maximum goals that are achievable through outperformance of internal and external expectations – therefore, establishing a bonus plan that is attractive to executives and responsible to shareholders.

Methodology

CAP’s study consisted of 100 companies from 9 industries, selected to provide a broad representation of market practice across large U.S. public companies. The revenue size of the companies in our sample ranges from $18 billion at the 25th percentile to $70 billion at the 75th percentile.

CAP analyzed the annual incentive plan payouts of the companies in the sample over the past 6-8 years to determine the distribution of incentive payments and the frequency with which executives typically achieve target payouts. In this analysis, CAP categorized actual bonus payments (as a percent of target) into one of six categories based on the following payout ranges:

Payout Category Payout Range
No Payout 0%
Threshold Up to 5% above Threshold
Threshold – Target 5% above Threshold to 5% below Target
Target +/- 5% of Target
Target – Max 5% above Target to 5% below Max
Max 5% below Max to Max

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:

Approach

Description

Employee

Employee awards are converted to equity in the company where they are employed. The participants of the equity plan who remain employed by ParentCo retain adjusted ParentCo equity awards. The equity plan participants who are employed by SpinCo receive converted SpinCo equity awards with same terms and conditions

Shareholder

Employees are treated like shareholders. Regardless of where the participant is employed following spin-off, outstanding awards of all equity plan participants are converted into both ParentCo and SpinCo equity at the same conversion ratio as shareholders, with the same terms and conditions as the original awards

Hybrid

A combination of the “Employment” and “Shareholder” approaches based on any of the following: (i) when the equity award was granted, (ii) where the equity holder is employed post-spin, (iii) when the equity award will vest, and/or (iv) the type of equity held at spin-off

Adjustment Only, No Conversion Approach

All employees retain adjusted ParentCo equity with same terms and conditions. Continued employment with SpinCo is treated as employment with ParentCo, for purposes of continued award vesting

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.


1 Source: www.spinoffresearch.com

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.

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