US companies doing
business in China are grappling with how to determine bonus payouts for 2019
and incentive plan goals for 2020 given the political unrest in Hong Kong and
the recent coronavirus outbreak that began in the city of Wuhan.
Starting in summer
2019 and increasing in scale and violence over the course of the year, protests
have disrupted businesses in and around Hong Kong, an important financial hub
and consumer market. Additionally, over the last six weeks, the global spread
of the coronavirus has had a significant and far-reaching economic impact.
China is an economic
powerhouse—the second-largest economy in the world. Many US and global companies depend on its
supply chain and manufacturing capacity, and companies also look to China’s
rising middle class as a vibrant market for their products and services,
providing an important opportunity for organic growth.
extraordinary circumstances, Compensation Advisory Partners (CAP) has outlined
approaches that compensation committees can take to determine 2019 executive
bonuses and plan for 2020.
For companies with
operations in Hong Kong, one of two philosophies can help determine 2019 bonuses.
The first is that executives need to manage their
business through various challenges, and political unrest is just one of many risks faced by management. Under this
approach, performance targets are not adjusted, and incentive-award outcomes
align with the goals established at the beginning of the year.
The second philosophy
is that incentive plans should reward the management team for operating performance
that is within its control (i.e., supporting strong line of sight). Under this philosophy,
adjustments to performance targets are allowed for extraordinary, material, and
unforeseen circumstances (and political unrest qualifies). Such adjustments
would neutralize the financial impact of the Hong Kong protests, and management
would be neither rewarded nor penalized for such an extraordinary event.
Given that 2019 is
over, the Hong Kong protests’ financial magnitude and business impact for the
year are quantifiable. With the amendment of tax rules (Section 162(m)) that previously
required establishing goals in the first quarter and did not allow for subsequent
upward discretion, CAP expects to see companies using more discretion and
adjusting for extraordinary items more frequently. In doing so, companies need
to explain the rationale for the adjustments to executives, employees, and
shareholders to maintain the integrity of incentive plans.
Planning for 2020: A Financial
and Qualitative Approach
performance measures and goals for 2020 incentive plans, CAP advises companies to
take an approach that is both financial and qualitative given the potential
impact of the coronavirus and the continuation of the Hong Kong protests. From
a financial perspective, companies are already adjusting financial forecasts
based on what they know now. The list of companies that have cited the impact
of the coronavirus specifically as a risk to previous guidance in the first
quarter is growing daily, although it’s impossible now to know the extent of
the crisis and the potential financial impact.
For incentive plans
based on achieving specific numerical results (for example, specific revenue
or net income
targets), the goalpost is moving—and will probably continue to move—until targets
are approved by compensation committees in February and March. From a planning
perspective, companies can allow for a broader range of outcomes by having a
lower threshold cut-in for bonus payouts (at commensurately lower payout levels);
set differential performance targets based on high, medium, or low scenarios for
the coronavirus impact; or allow for a discretionary modifier (e.g., 10 percent
to 20 percent) based on the compensation committee’s discretionary evaluation.
At the end of the year, any further adjustments will depend on the company’s
philosophy on retroactive
incentive plan adjustments.
From a qualitative perspective,
also can consider whether environmental, social, and governance (ESG) metrics
should be incorporated into the incentive plan in response to the coronavirus.
What specific policies and actions should be taken to ensure that the company
is doing the right thing by its employees, customers, and other stakeholders
given this pandemic? Thinking through the ESG issues mitigates the company’s
reputational and financial risk and may benefit shareholders over the long term.
Ways to incorporate ESG into incentive plans include having ESG as an
independent, weighted, and rewarded performance measure or having ESG as a
modifier (e.g., up to 20 percent) based on pre-established criteria for financially
calculated goals. If ESG is already part of the incentive plan, compensation
can consider whether ESG’s weight should increase if the company’s China
exposure is material.
As US companies
report business interruptions and revise their earnings estimates, the
potential impacts of the coronavirus and Hong Kong protests are truly unknown.
Even when the virus is contained, its economic, financial, and social impact
may linger. As a result, compensation
need to proactively plan and have a playbook for making pay decisions in this
Bertha Masuda and
Margaret Engel, partners at Compensation Advisory Partners, specialize in developing
innovative and practical compensation solutions, with a particular expertise in
short- and long-term incentive plan design and implementation.