Chemical Industry Stocks are Volatile—Ways Your Compensation Committee Could Respond

2018 was a rough year for chemical companies. Median one-year total shareholder return (TSR) was down 20%. Among 42 chemical companies[1], only a quarter ended the year with positive TSR. Stock prices really took a hit in the fourth quarter, when only one company ended the quarter with positive TSR. While we recognize that chemical stock prices can be highly volatile, it also appears that margins continue to be under pressure and growth may be slowing. Is this a sign of a down cycle? Not necessarily. But it does remind us that the chemical industry is inherently cyclical and a down cycle will come at some point.

From the compensation committee’s point of view, an obvious consequence of a downturn in stock price is that outstanding equity award values will decrease. While that demonstrates alignment with shareholders, boards must also consider employee engagement and retention. In a down cycle, individuals will be tasked with running a business in difficult conditions while salaries are likely stagnant; annual incentives may be tracking below target (or may not pay out); and unvested long-term incentive awards are less meaningful, particularly at lower levels in the organization. Assuming the management team is the right one to lead the company through a downturn, it will be important to ensure stability, engagement, and retention.

So how can compensation committees manage incentive programs in the event of a down cycle? While each company is different and has distinct strategic priorities, there are various actions that warrant review and consideration.

• Maintain stability in the equity plan. Equity awards may have less perceived value in a down cycle, but they are nonetheless the primary tool to deliver consistent compensation through the cycle. During a downturn, the annual incentive plans will likely pay below target or nothing and that may be appropriate. For senior executives, companies should try to maintain target grant date long-term incentive values through the down cycle, which can combat uncertainty elsewhere and serves to recognize that an individual’s job is a lot tougher in a downturn. A greater number of shares will hopefully provide an incentive to stay with the company through the difficult period and avoid the need to provide special retention awards (which proxy advisory firms dislike). However, this approach will increase share usage and potentially deplete the share pool. Companies should evaluate this in the context of overall equity plan participation and consider cash in lieu of equity or cutting back grant values as necessary deeper in the organization.
• Annual incentive plans should be rebalanced. They should reflect the real possibility of poor financial performance over the short term and look to reward modestly for achieving operational goals that move the company forward through the down cycle and potentially leave it stronger for the upturn.
• Be prepared to use discretion. The committee’s judgement during the down cycle will be critical. Annual incentive plans with heavier emphasis on operational performance may result in outsize payouts relative to financial performance. Transparency and trust between management and the board will be important.
• Re-evaluate relative TSR as a long-term incentive plan measure. If relative TSR is an existing measure, reconsider its weight in the plan. Management may have very limited visibility to TSR during an industry-wide downcycle. It is important that equity is used wisely given that it is the primary vehicle to maintain stability through the downturn and share pools could be depleted faster during a down cycle. However, if TSR is a measure in the plan:
  • Consider capping payouts at target if TSR is negative;
  • Confirm that the peer group is appropriate and subject to similar market cycles; and
  • Consider capping total payout value as a multiple of grant date value to manage the potential accounting cost (i.e., Monte Carlo valuation), which is also a positive governor to manage outsized payouts.
• Review the length of performance periods and the ability to accurately forecast performance in uncertain conditions. For performance share plans, a typical three-year goal may be very difficult to forecast. Consider establishing shorter one- or two-year performance goals but maintain similar three-year “cliff” vesting requirements.

We recognize that any of the above actions could result in negative feedback from the proxy advisory firms who are more likely to emphasize pay and performance alignment. They do not consider employee engagement and retention during a down cycle. Shareholder engagement and communication in the CD&A will be critical—as it always is even in normal market conditions!