Four Principles to the Application of Board Discretion

All businesses are inherently uncertain, which complicates business planning and makes target-setting and year-end decision-making for incentives a challenging endeavor.

In these times of volatile national and global markets, caused by Covid and more recently by Russia’s invasion of Ukraine, companies have tried to delay goal setting while waiting for more certainty. However, these efforts are often futile as the year wears on and certainty continues to be in the future. 

Inevitably, committees will more likely have to consider year-end discretionary adjustments. To provide Compensation Committees some guidelines for using discretion, we offer a series of four principles to help guide Committee deliberations. The principles in aggregate suggest that Committees should not be too quick to accede to management’s requests, and if the decision is made to do so, to proceed deliberately. The limited use of discretion is further affirmed by the fact that the forces responsible for uncertainty (e.g., macroeconomics, political actions, weather, technology, commodity prices) generally affect results both positively and negatively and tend to balance out over time.

Accountable Management, Infrequent Adjustments

Principle 1: Management should be accountable for the actual results delivered and adjustments should be made only in exceptional circumstances (i.e., they should be small in number)

Four key points should be considered here:

• Adjustments should generally only be made for non-recurring items, that were unplanned, uncontrollable, and material in amount. 
• Adjustments should only be made when actuals differ materially from original assumptions. So, if actuals fall outside of an assumed “collar” (say more than 15%) only then should adjustment be considered. 
• Adjustments for unplanned items should only be made to the extent that they could not have been reasonably anticipated, planned for (i.e., planning failures are not items for adjustment) and/or mitigated on a timely basis. 
• Adjustments should be symmetrical—in some cases, adjustments will be positive, and in others, they will be negative. A balanced approach is needed to ensure that adjustments are not just driven by unplanned factors that adversely affect payouts, although these are naturally the most likely raised.

Balancing Stakeholder Interest

Principle 2: All adjustments should balance the interests of shareholders and management. Generally, if shareholders are experiencing poor results, then management should share in the burden, and vice versa.

Avoiding Frequent Forgiveness

Principle 3: Adjustments that forgive management for making “bad bets” should be avoided—frequent forgiveness can create ‘moral hazards.’ If such moral hazards are created, management may be motivated to take imprudent risks to obtain upside, under the belief that they will not be held accountable if they fail. 

Avoiding Adjustments with Good Design

Principle 4: Adjustments are not needed if the factors under consideration are already adequately addressed by other design elements.

Companies can mitigate some of the uncertainty by creating a more balanced approach. For example, they can use a combination of relative and absolute goals or use measures that are more directly controlled by management (e.g., sales unit volume vs. sales dollars, profit margins vs. profit dollars). 

If the Committee does decide that action is appropriate, then the Committee needs to decide who should participate in any adjustments and how large the adjustments should be. For example, we believe the following approaches could be used to address these questions: 

• If retention is the primary concern and the other grounds for an adjustment are weak, then the Committee should consider the use of targeted retention awards that are meaningful in amount and thoughtfully deployed using well-thought-out criteria.
• If the Committee believes that senior management should bear a loss in line with the shareholders or because management has primary responsibility for what transpired, then consideration should be given to excluding senior management from the adjustment.
• Finally, the size of the adjustment should be determined, where possible, based on thorough analysis.
  

We understand the difficulties Committees face when having to use discretion. Based on our experience, we believe the ideas outlined above can make the process easier and more thoughtful.