Most remuneration committees have thought carefully about their equity-based long term incentive plans and the associated performance metrics and targets. They also typically have a clear idea of how they should operate.
Unfortunately, such plans are often not adequately documented and in some cases, details that may trouble the Board at a later date have not been considered. It is not unknown for disagreements between management and the Board to result in legal action.
Often a dispute may arise when performance is close to the threshold and small variations in the method of calculation may mean the difference between a portion of the incentive vesting or nothing vesting at all.
Some of the detail required when documenting a relative TSR performance hurdle is set out below. At least these details must be clear:
- Performance Period – the exact starting and end dates of the performance periods must be clear – if only the relevant financial years are specified, there may be confusion whether data from 30 June or 1 July is utilised in calculations.
- Vesting schedule – How much equity will vest at each level of performance? It is important to be clear whether vesting occurs at or above the performance levels specified and whether cliff vesting, straight-line vesting, a matrix, or some alternate schedule will be utilised.
- Index as a peer group – Index constituents change over time, so the company must specify what date the index constituents will be determined – this may be the start of the performance period, the end of the period or some other specified date, however, it must be clear. The decision may affect the difficulty of vesting – for example, the index at the end of the performance period may have a survivor bias.
- Dealing with constituents – Some of the companies will disappear due to delisting, mergers or takeovers during the performance period. Should these companies be excluded or treated in another fashion? (For example, companies that drop out of the index because of insolvency might be included with a negative return, while companies dropping out of the index due to acquisition might be excluded.) Some of the companies will not be listed at the beginning of the performance period. Should the companies be included using the pricing data available or excluded?
- Specific Peer Group – Where the peer group is small, there is a risk that changes to the constituent group will reduce it via exclusions until it is no longer sound. What happens in such a case and what rules determine how the peer group can be updated?
- Will smoothing (moving average) be used to calculate TSR? If so, over how many days and will the smoothing occur using the prices before, after or either side of the relevant dates? Will a volume weighted average price be used or simply the share price adjusting for splits, etc? Has the company specified the exact share price to be used, for example the daily adjusted closing price?
Examples of details that might need to be documented for an EPS Growth hurdle include:
- What exactly is meant by EPS growth? Will it be the compound annual growth rate from a base year to the final year, a cumulative growth over the performance period, a continual annual growth rate that must be met each year throughout the performance period, or an alternate calculation? The calculation methodology including any formulas should be documented in detail, with all variables defined as clearly as possible.
- Which earnings figure will be used to calculate EPS? The statutory figure or an underlying figure? In the latter case, what types of exclusions will be accepted?
- Will diluted or basic EPS be used?
- Are the specified growth targets annual or for the whole performance period?
- Details of the performance period and vesting schedule should be documented, as noted above for Relative TSR hurdles.
Despite Boards’ best efforts, there may still be contingencies where calculating LTI plan vesting becomes ambiguous. It is for such cases that there should always be an additional clause in any plan specifying the Board’s ability to use reasonable discretion.
As the use of discretion is always subject to scrutiny, it is always best to have all details documented to the best of the Board’s knowledge at the time of the plan’s creation. Upon updating plan documentation, a copy of each iteration and a record of changes should be kept. This documentation may prevent future disputes, or if disputes do arise, provide a solid foundation that protects the Board’s original intent.