Incentive compensation has long been a board’s primary tool to ensure that the interests of management are aligned with the interests of a company’s shareholders. To that end, the ongoing challenge facing compensation committees is choosing metrics that motivate management to optimize shareholder value without incentivizing behaviors that focus on short-term stock price appreciation that can threaten the company’s long-term interests. As a result, traditional incentive compensation metrics measure performance through quantitative shareholder return and financial and operational metrics that reward longer-term performance. Although the traditional metrics still dominate, a number of forces have recently resulted in the incorporation of more qualitative ESG factors. This article discusses the forces encouraging companies to adopt ESG metrics and analyzes how companies are incorporating ESG metrics into their incentive compensation programs.  

THE FORCES OF CHANGE 

A number of forces have led to the increased use of ESG metrics in incentive compensation plans. These include:

1. Institutional Investor Focus on Sustainability  

As Larry Fink, Chairman and CEO of BlackRock noted in his January 2020 letter to CEOs, the failure to focus on the needs of a broad range of stakeholders will damage long-term profitability. This view is widely held by asset managers. According to the 2019 RBC Global Asset Management Responsible Investing Survey, 70% of institutional investors in Canada, the United States and the United Kingdom apply ESG principles to investment decisions, with over half of those investors citing a positive performance impact as the prime motivator. As a sign that ESG investing is an increased priority, reports indicate that the amount of assets invested in sustainable funds in 2019 was nearly four times larger than in 2018.1

2. Shifting Views of the Role of the Corporation  

In August 2019, more than 180 CEOs signed onto a Business Roundtable statement that, for the first time, rejected the view that companies exist principally to serve their shareholders. Rather, the statement asserted that corporations should commit to serving the interests of all stakeholders, including, in addition to shareholders, customers, employees, suppliers and communities. The Business Roundtable’s updated position reflects increasing investor, employee and community pressure on companies to not only advance profits, but to also contribute to addressing societal problems such as income inequality, diversity and environmental sustainability. The incorporation of ESG into incentive compensation plans could become a key measure that observers will use to track whether the signatories’ companies are actually honoring this redefined philosophy with real changes in practices. 

3. Changes to 162(m) of the Internal Revenue Code  

Section 162(m) of the Internal Revenue Code provides that compensation in excess of $1 million paid to certain covered employees of public companies is not deductible. Prior to the passage of the Tax Cuts and Jobs Act, “performance-based compensation” was not subject to the $1 million limitation. To constitute “performance-based compensation,” the compensation was required to be paid pursuant to objectively determinable performance goals, and the corporation was not permitted to exercise discretion to increase amounts payable once performance was certified. With the removal of the “performance-based compensation” exemption from Section 162(m), companies now have greater latitude to use qualitative performance metrics and to implement a bonus “modifier,” which enables companies to increase the payable bonus as a result of a subjective determination, such as a commitment to the company’s ESG principles. 

Proposed DOL Rules on ESG Investing for ERISA Plans 

Although institutional investors are demonstrating an increased desire to engage in ESG investing, a proposed rule from the Department of Labor (DOL) may curtail these efforts. The proposed rule addresses ESG investing in the ERISA context. The DOL holds a longstanding position that ERISA fiduciaries should consider economic returns as of primary importance in selecting plan investments, but as Administrations have changed, the guidance from the DOL with respect to investments that also consider promotion of social, environmental or other policy goals has also changed.  

The proposed rule is viewed as discouraging ESG investing by suggesting that ESG investing raises heightened concerns under ERISA. Pursuant to the proposed rule, ESG factors may be considered only to the extent they present material economic risks or opportunities. In addition, if two alternative investments appear economically indistinguishable, a fiduciary may “break the tie” by relying on ESG factors. However, the breakthe-tie rule is not new, and because the DOL believes true ties rarely exist, a fiduciary must document the basis for concluding that the investment alternatives were indistinguishable. 

The proposed rule is not without controversy, as evidenced by the over 8,000 comment letters sent to the DOL. The overwhelming feedback in these letters is against the proposed rule, with opponents arguing that ESG factors are already integrated into the decision-making processes of asset managers and are considered financially material.

ACTION ITEMS FOR INCORPORATING ESG METRICS INTO INCENTIVE PROGRAMS 

The following is a list of action items for companies looking to consider incorporating ESG metrics into their incentive compensation programs:

2020 SURVEY — COVID-19 & ANNUAL INCENTIVE COMPENSATION 

Under the federal securities laws, public companies are not required to disclose the details of their 2020 annual incentive compensation until they file their next annual proxy statement. For most companies, this means that disclosure is not required until Spring 2021.

Even if not required, companies may elect to disclose COVID19-related adjustments they are making to incentive compensation programs. Further, Institutional Shareholder Services has posited that any COVID-19-related changes to incentive compensation should be disclosed through Form 8-K filings.

Companies have announced that they will reduce annual incentive payouts for executive officers; adjust executive payouts to align with payouts to the general employee population; and lower minimum performance thresholds or otherwise revise performance and payout ranges. Others have offered one-time equity awards to executives in lieu of annual incentive opportunities or divided the year into multiple segments, with  different performance objectives applying to the different parts.

We expect that at many companies, discussions regarding 2020 annual incentive compensation are ongoing. We also expect that approaches to incentive compensation will continue to evolve as the impact of COVID-19 unfolds. The approach to modifications in annual plans versus long-term plans may be of particular interest to watch, and ISS and investors are likely to view adjustments in short- and long-term plans differently, with more flexibility for 2020 plans.