Strategies for Executive Compensation. Blake, Cassels & Graydon LLP Willis Towers Watson

Transcription

1 Strategies for Executive Compensation Blake, Cassels & Graydon LLP Willis Towers Watson

2 Recent CRA Developments Affecting Compensation Design Presented by: Elizabeth Boyd

3 Deductibility of Equity Awards Prior to Transalta decision was generally accepted that no employer deduction was available where an award was settled in treasury shares Non-deductibility based on s. 7(3)(b) of the Income Tax Act and presumed the existence of an agreement to sell or issue shares In Transalta, court found no agreement by employer to sell or issue share under PSU plan that permitted employer to choose to settle in cash or treasury shares and plan purported to make pay out discretionary 3

4 Deductibility of Equity Awards (cont d) CRA has issued guidance on the deductibility of equity awards and when an agreement to sell or issue shares will be considered to arise CRA focusing on existence of legally binding agreement Question of fact whether a particular arrangement results in a legally binding agreement to sell or issue shares 4

5 Deductibility of Equity Awards (cont d) Where employer is free to choose the form in which payment of an equity award will be made (cash or shares), there is no legally binding agreement for purposes of s. 7(3)(b) Absent a legally binding agreement, CRA has indicated that: employer may deduct the settlement value of the award, whether provided in cash or treasury shares; and SDA tax rules will apply to award unless structured to fit within an exemption 5

6 When is Agreement to Sell or Issue Shares Made CRA has also commented on the timing of an agreement to sell or issue shares If employer retains discretion to issue shares or pay cash up to time pay out of award is authorized by Board, there is no agreement to sell or issue shares 6

7 When is Agreement to Sell or Issue Shares Made (cont d) If employer grants equity awards subject to a discretionary vesting condition (such as employer consent), an agreement to sell or issue shares does not arise until the vesting condition has been satisfied Discretionary allocation of shares from trust to employees will not result in employees being deemed by s. 7(2) to have acquired shares when they were issued to the trust 7

8 Montminy Decision Stock Option Prescribed Share Rules Decision deals with 50% stock option deduction under s. 110(1)(d) where option shares were repurchased by an affiliate of the issuer Repurchase rights can preclude deduction due to prescribed share requirements in ITR 6204 Federal Court of Appeal (FCA) overturned decision of Tax Court of Canada regarding interaction of s. 6204(1)(b) and s. 6204(2)(c) of Regulations 8

9 Montminy Decision Stock Option Prescribed Share Rules (cont d) Under s. 6204(1)(b), prescribed share status can be lost if it is reasonable to expect that the issuer of the option shares or a person who does not deal at arm s length with the issuer will purchase the option shares within two years of exercise Under s. 6204(2)(c), a share that is subject to repurchase can be a prescribed share provided that the principal purpose of the repurchase right or obligation is to make a market for the share (or protect the shareholder against loss) 9

10 Montminy Decision Stock Option Prescribed Share Rules (cont d) Per FCA, s. 6204(1)(b) is relevant as an anti-avoidance measure aimed at ensuring compliance with the requirement that an employee not be able to require the repurchase of their option shares, and is subject to override where s. 6204(2)(c) applies 10

11 Shareholder engagement and related opportunities and challenges for directors 11

12 Say on Pay in Canada remains strong in 2017, with 91% average shareholder support so far # of companies / # of votes actually held * 193 / / 189 Avg. shareholder support 92% 91% ISS against vote recommendations 5% (9) 5% (10) Failure rate (< 50% support) 1% (2) 2% (3) * 2017 results as of July 31, 2017 Less than 50% shareholder support 90% 85% 80% 75% 70% Say on Pay Support Above 90% 86% 81% 74% 72% 73% 80% 78% 77% Support above 90% decreased from 2010 to 2013, gradually increased from 2013 to 2015 and is on a steady decline in 2016 and Primero Mining Eldorado Gold 29.5% 43.1% TransAlta 47.3% CP Rail 49.9% Crescent Point Energy 31.0% Misalignment between CEO pay and TSR due to $3M grant given to retiring CEO despite share price decline Misalignment between CEO pay and 3-year TSR High CEO pay and special one-time award despite share price decline High CEO pay amidst share price decline of 21% Misalignment between CEO pay and 3-year TSR # of Companies TSX Adopters of Say on Pay Total Sample

13 Say on Pay in the U.S. is also stable in 2017, with 91% average shareholder support and only 28 failed votes * Avg. shareholder support 90% 91% ISS against vote recommendations 13% 13% Failure rate (< 50% support) 2% (35) 1% (28) * 2017 results as of September 18, 2017 Areas of ISS High Concern Categories Board Responsiveness 23% 39% Executive Contracts 20% 7% Peer groups 5% 4% Non-performance-based pay 3% 7% Pay for performance 71% 86% Most Common Issues for Companies with High Pay for Performance Concern Rigor of incentive plan metrics 48% Substantial compensation increase 31% Discretionary nature of awards Majority LTI not performance-based Outsized long-term compensation 21% 23% 25% Payout despite failing to meet target 18% 13

14 Proxy advisors continue to raise the bar on executive compensation designs and governance Problematic practices cited by ISS and Glass Lewis in 2017 reports Pay quantum Excessive internal pay disparity CEO compensation more than 3.5x higher than next NEO and 4x average of active NEOs STI design Annual bonus targets lower than prior year Unclear targets and rationale for STI decisions Similar metrics for STIP and LTIP PSU design Lack of long-term performance-based equity compensation Lack of relative performance metrics Lack of long-term performance-based equity compensation Under PSU plan (e.g., TSR), vesting of relative metrics when performance is below the 50 th percentile of peers Special awards Termination / CIC Consultant Independence Special one-time awards outside regular programs Modified single-trigger CIC agreement Performance-vesting of awards upon termination based on target vs. actual performance Consultant independence, where non-ec related fees are higher than EC fees Consultant independence, where non-ec related fees are higher than EC fee 14

15 Areas of best practice 2017 disclosure among TSX 60 companies early findings (n = 49) 71% 57% 57% 55% Peer Group Selection Description Compensation Committee Letter to Shareholders (front of CD&A) Illustration of Compensation Elements Diversity Policy for Executives 53% 43% 41% 37% Summary of Past Vote Results Link Between STI Metrics and Business Strategy Governance Checklist Decision-making Process Diagram 15

16 Influencing the governance landscape Governance is a system of structures a company puts in place to ensure it is effectively directed and controlled Ontario Teacher s Pension Plan Influencers of Policy Regulators Institutional Shareholders Proxy Advisors Often in response to company outcomes or plan designs, e.g., Dodd Frank Oversight & Compliance Regulators Board of Directors In response to regulatory changes and pressure from shareholders, proxy advisors and media Design & Implementation Senior Management External Advisors Balanced with other influences including business strategy and competitive labour market 16

17 Sharing the corporate governance responsibility The Canadian Coalition for Good Governance ( CCGG ) believes that corporate governance is a shared responsibility between boards and shareholders New for 2017 Institutional shareholders are encouraged to follow the CCGG s seven stewardship principles, meant to ensure investors are effective stewards of their investments Principles 1. Develop an approach to stewardship Guidance (WTW Summary) An approach to stewardship should be developed and disclosed Stewardship should not be outsourced; if outsourced, ensure consistency with approach 2. Monitor companies Monitoring includes reviewing public disclosure, researching the organization and sharing this research with other investors, and attending shareholder meetings 3. Report on voting activities 4. Engage with companies 5. Collaborate with other institutional investors 6. Work with policy makers 7. Focus on long-term sustainable value Institutional shareholders should disclose proxy voting guidelines, and vote on all shares in their portfolio Institutional investors should develop an engagement approach that considers the appropriate level of engagement and with whom to engage Investors must communicate that they do not want non-public material from organizations Consider activities that would warrant an escalation of engagement (e.g., voting against) The CCGG encourages collaboration between investors to develop widely-held principles and more effective engagement By engaging with policy makers, investor perspectives are more likely to be considered during the policy setting process, and shareholder rights are better protected Institutional investors should understand the strategies of organizations in which they invest to ensure emphasis is being placed on long-term sustainable value Investors should understand systematic and unsystematic risks associated with investments 17

18 What is your strategy for shareholder engagement? As proxy advisor expectations and their influence on investor voting increases, organizations are left with two choices align with expectations or engage directly with shareholders Strategy Ongoing / Proactive Reactive Catalyst Shareholder relations Unique pay practices Anticipated against vote recommendation (based on simulations) Message Context and rationale Open forum, collecting feedback Medium Meetings, in advance of the proxy season Investor surveys (limited use) Enhanced proxy circular Subsequent meetings as necessary Negative media attention Against vote recommendation (documented in ISS / GL reports) HRCC Chair, CEO reputation Explaining and rebutting Soliciting shareholder support Embedded comments in draft ISS report Meetings, between time ISS / GL report is distributed and AGM (time sensitive) Supplemental disclosure, emphasizing key messages 18

19 Institute of Corporate Directors (ICD) Guidance for Director- Shareholder Engagement Know your most significant investors Recognize the key benefits of engagement Tailor a process that works for you Set topics of discussion Invite the right participants Review and consider what you learn Do they outsource voting to a proxy advisory firm? What are their policies with respect to executive compensation? What issues have they raised in the past? Directors Board oversight of strategy, risk and controls Executive compensation & succession planning Board composition and decision-making process Management Corporate strategy and financial performance M&A and new products, etc Changes in management Dividends and repurchase plans Board Chair and one director (perhaps Committee Chair) Management representation (with an in camera session) Investor representation from both the portfolio management and governance teams 19

20 In our experience, shareholder engagement is NOT one-size-fits-all Process Steps Decision Points Purpose Define what you hope to accomplish, for example: Collect insights on drivers of shareholder votes (positive and negative) Educate investors on company practices and rationale Establish a relationship with proxy decision makers or influencers Timing Off season best to avoid the spring proxy season. Earlier is better Company participants Audience Documentation Feedback Strategy and talking points Typically up to 3 key individuals, including leaders of Human Resources and Legal functions Preference of institutional investors to include Board / HRC representation No advisors shareholders typically looking to hear from decision makers Identify the key investors and proxy advisors with whom you wish to engage (e.g., X% of votes) Large / institutional investors attendees vary but often governance team reps. and a portfolio manager Proxy advisors may have compensation, governance and industry sector representatives Most companies do not distribute materials in advance, but may use a short presentation in the meeting to facilitate discussion, or create a summary of talking points for internal preparation only Each party will have unique perspectives and feedback may not be consistent across the shareholder base Develop an engagement strategy based on the audience and areas of concern Prepare talking points, even if you do not plan to distribute them Determine who will speak on the company s behalf based on talking points Prepare questions you will ask of your audience given your expectations 20

21 Disclosing shareholder engagement early insights from S&P 500 A closer look at shareholder engagement provides insights into the level of detail appearing in proxy disclosures, including actions taken by companies Engagement process details disclosed by issuers Prevalence of changes made Number / percentage of shareholders engaged 77% Enhanced CD&A disclosure Changed metrics 46% 57% Timing of outreach 68% Adjusted LTI mix 32% Participants involved in outreach Disclosed specific feedback received 44% 27% Extended LTI performance period Set more aggressive targets Modified bonus plan structure 14% 11% 21% Method of contact 14% Adopted/amended clawback 7% 0% 20% 40% 60% Source: Willis Towers Watson s Global Executive Compensation Analysis Team research on S&P 500 as of March 31,

22 Next Generation of Executive Compensation Design 22

23 ISS and Glass Lewis are have an increasing influence on executive compensation design A compliant EC design would include (exaggerated) Peer Group Base Salary STI LTI P4P Same industry and similar size ISS Canada only GL consistent with other peers Aligned to median of the select peer group Little change year-over-year Denominated in Canadian currency Indifferent to measures but should be well disclosed and distinct from PSU metrics Year-over-year targets to encourage growth Formulaic awards no application of discretion 100% PSUs, but 50% weight at a minimum Some form of relative performance Preference to exclude stock options (dilutive and encourage risk-taking) SCT disclosed compensation to vary based on past performance Would imply that LTI values should vary year-to-year 23

24 Rethinking disclosure of performance-based LTI grants Align Disclosed Compensation with Performance Period Discloses grants made at the start of the compensation year (e.g., March 2017 grants in respect of 2017 compensation) Name and Principal Position Year Salary Share- Based Awards Option- Based Awards Non-Equity Annual Incentive Plan Comp. Total Comp. Yearoveryear Change Traditional Alex P. Keaton CEO, Primrose Corporation 2017 $375,000 $375, $750,000 $562,500 $562,500 $750,000 $2,625,000 21% 2015 $725,000 $362,500 $362,500 $725,000 $2,175,000 4% 2014 $700,000 $350,000 $350,000 $700,000 $2,100, Alternate Alex P. Keaton CEO, Primrose Corporation 2016 $750,000 $375,000 $375,000 $750,000 $2,250,000-13% 2015 $725,000 $562,500 $562,500 $725,000 $2,575,000 21% 2014 $700,000 $362,500 $362,500 $700,000 $2,125, Alternatively, disclosed grants made after year-end (e.g., March 2017 grants in respect of 2016 compensation, passed on performance Likely reflects closer alignment between pay and performance (-13% vs. +21%) 24

25 There is an increasing focus on the performance alignment of longterm incentives Proxy advisors and governance policy makers require a minimum of 50% of long-term incentives to be performance-linked Typically options are not considered to be performance-linked They push for either: The introduction of performance conditions to options as best practice Limiting nonperformance linked LTI (options and RSUs) to less than 50% of total LTI Highly Dilutive Reduces Long Term Performance alignment 25

26 Performance stock options the UK experience By meeting shareholder demands, options evolved in unforeseen ways As performance conditions became more complex and tougher Option values fell and dilution increased Eligibility was restricted in an effort to manage total dilution Options became riskier less likely to vest but with higher payouts when they did Over time, companies struggled to issue sufficient options to provide competitive values within strict dilution limits By satisfying shareholders demands, options ceased to provide long-term alignment and became: Riskier More dilutive and expensive Potentially dysfunctional rewarding volatility more than sustainability, and short-term timing more than long-term alignment Today options are rare as executive incentives because of the design requirements and the unwanted impacts that they have 26

27 If options are to continue to play a role, what is needed to keep them relevant Stronger performance conditions will not result in better aligned incentives Care required to ensure options do not become dysfunctional Consider longer option terms and vesting periods? Consider alternative valuation approaches to supplement Black Scholes? Consider changing the frequency of grant from annual grants? Change the design on issues such as late career grant/vesting Financially accountability for decisions made during tenure which pay out after retirement

28 Aligning executive compensation with the future of work Pay Philosophy Pay Design Expanding market with greater mobility (broader peer groups) Greater emphasis on attracting and retaining certain skill sets (segmentation) Higher pay positioning (65th percentile) Aggressive use of LTIs with significant differentiation of grant values (power law theory) Periods of investment impacting earnings / profitability and greater use of strategic milestones Shorter performance cycles aligned with pace of change Agile target setting in response to market and business dynamics Greater focus on long-term performance alignment and value creation Long-term performance alignment (>3 years) Total variable compensation with portion subject to time restriction Market purchased shares at grant (with discounted income tax paid on grant) Market purchased shares at vest (with hold period) Longer vesting shares (settled in treasury shares) Refer to Appendix for further details 28

29 Appendix 29

30 Other Approaches to Long Term Performance Alignment Total variable design with portion of value subject to time restriction Illustration Annual Performance 25% Cash 50% Revenue Growth 50% ROIC (5% hurdle rate) Minimum 75% After-tax Cash Value to Purchase Shares Restriction Period Share held in escrow for an average period of 4 years Shares Retained or Sold for Cash Advantage Disadvantage Time Horizon: longer-term focus Tax: Post restriction period, shares sold for cash taxed as capital gains / loss Ownership: encourages ownership; 75% of the after-tax value used to purchase common shares on the open market (non-dilutive) Retention: promotes retention through the restriction period (details not disclosed) Simple / easy to understand Tax: up front at the time of cash awards Governance: would not be considered performance-based LTI as there is no backend performance vesting condition Significant emphasis on annual performance, used to determine cash award and value of longer-term incentive component 30

31 Other Approaches to Long Term Performance Alignment Market purchased shares, with discounted income tax paid on grant Illustration Units purchased on open market and held by custodian Award ⅓ of RSU ⅓ of RSU ⅓ of RSU Vesting 1 st anniversary 2 nd anniversary 3 rd anniversary (4 th ) (5 th ) (6 th ) Hold Redemption 6 years following grant date Long hold restrictions allow for potentially deep tax discounts Grants vary somewhat based on performance Advantage Time Horizon: longer-term focus Tax: tax discount to employee (due to risk of forfeiture at grant as a result of long vest) Dilution: no dilution Dividends: paid to employees during vesting period Ownership: enhances ownership (real shares / units) Retention: promotes retention Disadvantage Performance: difficult to put additional performance measurement and leverage on back-end Tax: some risk of forfeiture on tax spent (can qualify for tax offset if loss realized) Governance: not considered performance by institutional investors Administration: some effort and cost to set up employee benefit trust / custodian 31

32 Other Approaches to Long Term Performance Alignment Performance-based grants, market purchased shares at vest, hold-period Illustration Performance Assessment Grant Grants vary significantly based on corporate performance (scorecard) Phantom shares and dividends reinvested first 3 years 1 st 2 nd 3 rd Restriction Period (held by custodian no access to dividends until end) Value of after-tax dollars (full tax) used to purchase shares from open market Payout at termination or retirement Advantage Time Horizon: longer-term focus Tax: Capital gains post purchase (year 3+) Dilution: no dilution Dividends: typically credited / reinvested to participants and paid upon vesting Ownership: enhances ownership Retention: promotes retention Disadvantage Performance: no performance consideration after grant (i.e., no additional performance measure or leverage at back-end) Tax: payouts taxed in full as employment income at 3 year vest (can be accommodated somewhat with large grants) Time Horizon: Term potentially too long (could be shortened). Will not realize value until retirement / termination (can be a reverse handcuff) 32

33 Other Approaches to Long Term Performance Alignment Longer-term vesting RSUs, settled in treasury shares Illustration CEO Vesting: Grant NEO Vesting: 50% 50% 50% 1 st 2 nd 3 rd 4 th 5 th 6 th 7 th 8 th 9 th 10 th 10 th year or Grants vary significantly based on level and individual performance 50% retirement (whichever is later) Advantage Time Horizon: longer-term focus Tax: No upfront tax liability required Ownership: enhances ownership Retention: promotes retention Accounting: Fixed accounting treatment Simple / easy to understand Disadvantage Tax: no preferential tax treatment for participants; no corporate tax deductibility Governance: not considered performance by institutional investors (unless performance added) Administration: must settle in shares (requires a treasury reserve); dilutive 33

34 Thank you Ryan Resch Amanda Voegeli Michael Thompson

35 Legal Considerations Associated with Plan Design Changes Presented by: Sean Maxwell

36 Introduction Changes to outstanding plan awards tax issues employment issues disclosure requirements/shareholder approvals Changes to plan design affecting future grants only employment issues application of corporate policies 36

37 Prospective or Retroactive Changes? Certain changes may obviously be intended to be retroactive in nature e.g., a conversion of a SAR into an option Other changes may not necessarily be intended to have retroactive effect e.g., imposition of a double trigger change in control to satisfy ISS may not automatically apply to outstanding grants Need to carefully consider and define impact of plan design changes on outstanding awards e.g., application of a corporate clawback policy to outstanding grants or interplay between existing plans and share ownership guidelines 37

38 Modifying Outstanding Grants If intention is to modify outstanding grants, care needs to be taken to ensure tax efficiency of award is maintained consider impact of repricing options in preserving s. 110(1)(d) deduction CRA has ruled favorably on SARS-to-options conversions, but note that s. 110(1)(d) deduction may not be available need to consider whether SDA exempt awards may become taxable if converted to a s. 7 award 38

39 Modifying Outstanding Grants (cont d) Award agreement typically cannot be modified without participant consent if amendment materially impairs the award need to consider whether this threshold has been triggered issue of consideration for amendment to award agreement should not be overlooked Need also to consider whether shareholder approvals are required under TSX rules or terms of the plan (as may be the case with private company plans) Need also to consider disclosure requirements as well as any insider reporting requirements 39

40 Changes to Future Grants Only More typical approach to plan design changes Simpler, but can nevertheless create legal complexities Consider necessity of shareholder approval to plan changes as a result of either or both TSX rules and plan amendment language timing may be an issue if changes to be made prior to AGM date may be necessary to make awards conditional on shareholder approval 40

41 Changes to Future Grants Only (cont d) Review existing employment agreements for conflict between commitments and proposed plan design ideally, employment contract defers to plan terms relating to granting practices, termination events, change of control, vesting periods, etc., but may be a conflict consider whether amendments required to employment contracts to support plan design changes, and if so, determine valid consideration Need to assess whether changes to plan design may lead to constructive dismissal risks 41

42 Non-Contractual Changes Plan design/value may also be impacted by corporate policies related to grant practices or compensation philosophy e.g., clawback policies introduced to promote good governance or satisfy proxy advisors Consider ability of corporation to unilaterally impose new policies (e.g., conflict with existing employment agreements or creation of constructive dismissal risk) Consider mechanisms available to enforce policies how is previously paid compensation to be recouped in the event of a clawback? what are the consequences of a breach of the share ownership guidelines? 42

43 Q&A 43