COVID-19 and Employee Benefits #3: Considerations for Compensation Committees

May 4, 2020

Even as senior management rapidly shifts priorities in the face of layoffs, volatile stock prices and sharp declines in cash flow, compensation committees must come to terms with the impact of the coronavirus (COVID-19) pandemic on executive compensation. All of this occurs in the midst of annual compensation reviews and approval cycles, when companies determine annual and long-term incentive plan performance targets and prepare proxy disclosures. The COVID-19 pandemic creates unprecedented challenges in how to proceed with 2019 and 2020 compensation planning, given the uncertain depth and length of the current economic and business disruption. Discussed below are some items for compensation committees to consider.

Note: this is the third in a series of McGuireWoods client alerts relating to COVID-19 and employee benefits. For additional details, please see our other alerts:

Cash Compensation

Many companies are considering suspending or reducing key executive base salaries and annual incentives “temporarily” as a show of support for the company. This may take the form of no base salary increase, base salary reductions, voluntary pay waivers or stock awards in lieu of a percentage of base salary. It may also take the form of reduced or suspended payment of cash retainers to non-employee directors. All of these measures are typically taken to preserve precious cash.

Before proceeding with any of these alternatives, a compensation committee should consider the following factors.

  • Employment Agreements, Change in Control or Incentive Plan Language. Review these documents to determine what discretion (if any) is reserved to the compensation committee to adjust base salaries or goals or to defer payouts for executive officers.
  • Executive Consent. Consider whether executive consent is appropriate so the reduction in compensation does not trigger (or is carved out from) any “good reason” termination under any employment agreement or severance arrangement.
  • Deferrals. Annual incentives/bonuses payable for 2019 usually fall within the short-term deferral rule and must be paid on or before March 15, 2020, for calendar year plans; the deferral of such amounts will generally not be available unless the incentive payment would jeopardize the company’s ability to continue. However, for 2020 annual incentive plans, executive elective deferrals may be possible for performance-based compensation so long as the elections are made by June 30 (in the case of calendar year plans) or before the date the performance-based compensation has become reasonably ascertainable. Such deferrals might be valuable if a company needs to conserve cash.
  • Disclosure Implications. Consider whether the changes made are “material” and trigger an 8-K filing with the Securities and Exchange Commission; even if not required, consider disclosing the company’s measures voluntarily in either an 8-K filing or a press release. With respect to cash plans for which goals have been adjusted or waived, those awards must now be reported as bonuses in the summary compensation table of the proxy.
  • Adjustments to Goals/Payouts. Any mid- or final year adjustments to goals/targets or metrics will be scrutinized by proxy advisory groups such as Institutional Shareholder Services (ISS) and Glass Lewis (GL), although ISS recently stated that it anticipates many companies will adjust annual performance metrics, goals and targets as a result of the pandemic. ISS will require clean contemporaneous disclosure of the rationale for the changes to shareholders.
    • 2020 Plans. For 2020 plans already established, consider waiting to make any changes until the proverbial dust settles to evaluate the full impact on the business, and then use discretion to determine how management and employee incentives have been impacted.
    • Disclosure. For 2020 plan adjustments that occur in the future, clearly discuss the rationale for any changes in next year’s compensation discussion and analysis.
  • Stock in Lieu of Base Salary. Consider any unintended consequences associated with granting “at-risk” equity, since in the case of a rebound in stock prices, the executive may be viewed as landing a windfall of excessive compensation when the value of the stock (upon rebound) exceeds the value of original cash compensation. For public companies, stock must also be registered and delivered under a shareholder-approved plan to comply with applicable listing requirements.
  • Board Retainers. Note that the authority to adjust cash board retainers may rest within the purview of the compensation committee or the nominating and governance committee, so a review of governance documents is necessary. In any case, the full board of directors will typically need to approve any change in non-employee director compensation based on the recommendation of the compensation or nominating and governance committee.

Long-Term Performance-Based Compensation

Many of the issues discussed above under “Cash Compensation,” and in particular, those relating to performance-based incentives, also apply to long-term performance-based compensation (e.g., executive consent and disclosure requirements). However, the analysis is a bit more complex in the case of adjusting equity grants whether it takes the form of adjusting goals, metrics or targets, or in the case of future grants, reducing the pool of eligible employees.

Before proceeding with any of these alternatives, a compensation committee should consider a number of factors.

  • Employment Agreements, Award Agreements/Terms and Conditions. Review these documents to determine what, if any, discretion is reserved to the committee to adjust payouts in the midst of extraordinary circumstances.
  • Adjustment to Goals/Payouts. Note that ISS and GL do not look favorably on modifications to long-term equity awards in contrast to annual incentive plans so the committee will need to provide robust disclosure of rationale for the adjustments.
  • Section 162(m). Consider whether an adjustment to an outstanding grandfathered award under 162(m) will be lost due to the modification.
  • Accounting Implications. Consider whether lower equity award goals will trigger incremental accounting expense, to be reported in the summary compensation table and grants of plan-based awards table in the proxy.
  • For 2020 Grants (not yet made):
    • Consider delaying the grant cycle until the impact of the downturn is clearer and make discrete retention awards to select executives.
    • Use a shorter performance period and possible additional service vesting requirements.
    • Build more discretion into award terms to adjust performance targets.
    • Provide less strict leverage in establishment of performance targets (e.g., plus or minus 3 percent of target performance yields payout).
    • Use lower thresholds to ensure minimal payout.
    • Use relative metrics as a percentile rank against peers.
    • Consider using stock prices based on a trailing average for purpose of setting the number of shares or the exercise price of options, subject to 409A compliance.
    • Consider equity award plan terms (e.g., individual limits to a single participant) and be sure not to violate them.
    • Consider the share pool available. The number of shares reserved for issuance may not be sufficient to cover a typical grant; in this case, reduce the number of eligible participants and consider long-term cash for others.

Stock Options

While it may be premature, companies may consider exchanging underwater stock options for in-the-money options, full value equity awards or cash. With the drop in the stock market as a result of the COVID-19 pandemic, many companies may have outstanding stock options that are likely to be “underwater,” meaning that the exercise price of the outstanding stock option is greater than the current fair market value of the underlying stock.

Before proceeding with any option exchange program, a compensation committee should consider several factors.

  • Shareholder Approval Requirements. Both the NYSE and NASDAQ (as do most equity plans) require that shareholders approve any stock option repricing.
  • Proxy Statement Disclosure. The proxy statement will also need to provide for robust disclosure of the repricing in the compensation discussion and analysis.
  • ISS Guidance. ISS recently issued guidance confirming that, if companies seek shareholder approval of an option repricing, ISS will apply its existing policy approach for the relevant market. This means ISS will generally recommend against any repricing that occurs within one year of a “precipitous drop” in the company’s stock price. ISS will also review whether the repricing is value-neutral, whether surrendered shares are added back to the equity pool for future grant, the vesting of the replacement shares, and whether executive officers and directors are excluded.
  • Other Considerations:
    • Percentage of outstanding options underwater
    • Number of shares available
    • History of option exchanges
    • Incremental accounting expense

McGuireWoods has published additional thought leadership analyzing how companies across industries can address crucial business and legal issues related to COVID-19.

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