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Crafting Human Capital Goals for Executive Comp in an ESG World

April 7, 2021, 8:01 AM

As the stakeholder theory of corporate governance continues to gain traction and the core values of the investor population evolve, the focus on EESG matters—employee, environmental, social, and corporate governance—seems here to stay.

The human capital management disclosure requirements issued by the SEC in August 2020 can be expected to strengthen this trend and may shift some of the investor spotlight from a company’s top executives to its broader employee base.

It is no surprise, then, that some companies are beginning to tie executive incentive compensation arrangements to specific human capital goals. For example, McDonald’s Corp. announced in February that 15% of the 2021 annual bonuses for its top executives, including the CEO, will be based on human capital metrics.

Although specific details were not disclosed, we would expect that the metrics have been tailored to incentivize top executives to help McDonald’s reach its board-approved goals of increasing leadership roles held by underrepresented populations and achieving gender parity at its top ranks by 2030.

Practice Is Expected to Grow

It is still somewhat uncommon to tie incentive compensation to human capital metrics; however, we anticipate that this practice will grow. The pandemic has shined a light on issues of equity in society and in the workplace, and there is an expectation that corporate America should respond to and address social imperatives.

Moreover, asset managers and institutional shareholders want disclosures that demonstrate a plan of action. In late summer 2020, State Street Global Advisors released a letter announcing its expectation that the companies in which it invests provide additional disclosures regarding “risks, goals and strategy as related to racial and ethnic diversity.”

State Street said that it expects companies to disclose metrics and data about a company’s workforce diversity, its goals related thereto, how those goals factor into the company’s strategy, and the board’s role in the company’s diversity and inclusion efforts.

Tying executive incentive compensation to human capital metrics can be a powerful way to show that a board is exercising oversight of corporate strategy around any such goals.

Craft Goals With Objectives in Mind

Performance goals have long been tied to a brief (and uniform) list of financial and shareholder return measures, in line with the shareholder model of corporate governance. But the absence of a set market practice in this area and the repeal of the Section 162(m) qualified performance-based exception means that there is room for real creativity to tailor unique performance goals to your employee population.

We recommend that human capital performance goals be crafted with the company’s offensive and defensive objectives in mind:

Offense: What is the company’s most pressing human capital-related need? Is it diversity on the executive team, employee engagement, a holistic compensation review? Then, identify a target goal appropriate to the issue and metrics that would support the achievement of that goal.

Defense: Choose metrics bearing litigation risk in mind. For example, performance metrics should not expose the company to employment discrimination claims by presupposing that the metrics were created to remedy intentional disparate treatment of employees based on protected characteristics.

Adopt Process-Oriented Goals

One strategy to balance the ledger would be to adopt process-oriented, rather than results-oriented, goals.

Assume that a company wants to achieve gender parity among its senior leadership and decides to partially tie executive incentive compensation to that goal. Rather than tying the incentive compensation to an outcome (e.g., at least X% of the company’s SVP positions shall be held by women), tie it to a process (e.g., at least 50% of candidates considered for a role shall be women).

Another example of a process-oriented approach to a gender parity goal would be awarding incentive compensation for programmatic initiatives such as developing gender affinity groups or mentorship programs.

We also recommend being mindful of the disclosure of human capital information, including any performance goals related to it. Identify the disclosures that would be triggered or required in connection with the adoption of human capital performance goals.

Assuming the company is a public company and the named executive officers’ incentive compensation is tied to such goals, the goals would generally need to be disclosed in the company’s proxy statement covering the year to which the goals relate.

Use Care in Drafting Disclosures

Think about how the disclosures would sound from a shareholder’s or an employee’s perspective. Consider drafting shell disclosure language describing the proposed HCM goals and how they would be measured as they would appear in the executive compensation disclosure for the following year’s proxy statement.

Remember that any proxy statement disclosures should be consistent with any HCM disclosure that may be in the company’s annual report, if such disclosure is deemed material to the business. It will be important for a company to tell the entire story about how the performance goals relate to the company’s human capital management strategy.

Keep in mind that any new claims or data may come under heightened scrutiny. A July 2020 shareholder lawsuit brought against Oracle and its board members asserting that they breached their fiduciary duties by making misleading statements about the company’s commitment to diversity serves as a warning against making statements about a company’s culture or human capital imperatives without evidence to support such assertions.

Taking proactive steps in support of a company’s human capital-related EESG imperatives is not a simple task; doing so, however, in a measured and thoughtful manner can meaningfully benefit the lifeblood of the company— its workforce—and demonstrate a sincere devotion to corporate social responsibility.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

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Author Information

Robin Melman is a partner in the New York office of Baker Botts whose practice is focused on executive compensation matters and all issues considered by the compensation committee.

Christina Andersen is a special counsel in the New York office whose practice is focused on advising clients on employment matters, including hiring and promotion practices, company culture, and diversity and inclusion.