Shareholder interest in ESG and the use of executive compensation to incentivize attainment of ESG objectives has this past year accelerated many companies’ desire to incorporate ESG goals into their executive compensation programs.

However, this needs to be done as part of a larger discussion about each company’s strategic priorities – which metrics fall within those strategic priorities? Which metrics does the company want to communicate to its employees and other stakeholders as those it intends to focus on? Once those questions are answered, the next step is to determine if a particular goal is measurable and over what period. Companies should consider a dry run – if the goal had been in place in a prior year, how would it have been measured and how would it have impacted the plan payout? Currently we are seeing ESG metrics used generally as part of cash incentive programs (rather than long-term incentives) and in the form of individual performance assessments or as part of a scorecard in combination with other objectives, rather than as individually weighted goals.

Use of discretion in bonus payouts

During the pandemic, companies have had to use more discretion in determining payouts under their cash incentive programs, due in part to the difficulty in setting goals. For 2021, ISS took a softer approach to the use of discretion in this context. We believe that for 2022, they will take a less flexible approach and will expect companies’ cash incentive programs to return to “normal”, with payouts that are more closely tied to pre-established goals. If a company continues to believe discretion is necessary, disclosure of the rationale behind the determination of compensation levels, including how discretion was applied, will be key.

SEC reopens clawback rule

Section 954 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 directed the SEC to promulgate rules that would require each national securities exchange to institute listing standards requiring issuers to implement a policy to recover incentive compensation from current or former executives in the event of a “material error” in preparing publicly filed financial statements in the previous three fiscal years (the clawback rule).

On October 14, 2021, the SEC announced it would be reopening the comment period for this rule. While the SEC is soliciting comments on all aspects of the clawback rule, it has asked for input specifically addressing, among other things, its proposed expansion of the level of accounting restatement that would trigger a recovery of compensation. The SEC is considering defining “accounting restatement due to material noncompliance” to include not only material mistakes but also any errors that rise to the level of a material misstatement if the errors were left uncorrected in the current financial statements or the correction was recognized in the current period.

The proposed definition of “accounting restatement due to material noncompliance” will significantly expand the situations under which boards will need to attempt a clawback or disclose why attempting a recovery is not feasible.