Economic downturn: Key executive compensation issues for employers

In response to the current health and financial crisis caused by the coronavirus disease (COVID-19), many employers have considered measures such as employee furloughs, layoffs, and adjusted executive compensation arrangements. In this alert, we highlight some of the key issues US-based employers are encouraged to consider as they evaluate potential executive compensation strategies, including:

1. The impact of furloughs on equity award vesting;
2. 2019 performance-based compensation and adjustments to 2020 and future year performance goals;
3. Compliance obligations when paying or adjusting compensation;
4. Severance plans or policies; and
5. Stock option repricing or option exchange programs.
   
   

1.  The impact of furloughs on equity award vesting

Equity awards, including stock options and restricted stock units (RSUs) for example, are often subject to vesting based on “service,” “continuous service,” or a similar term that is typically set forth and defined with specificity in an equity plan or an award holder’s agreement.  Employers are urged to consider whether a furlough that is longer than a typical vacation, especially if 90 days or longer, may be treated as a termination of service under the express terms of an equity plan or award agreement.  In the event of such a termination of service for equity plan purposes, equity awards frequently will cease vesting and unvested equity awards may be subject to forfeiture.  In the case of a furlough, therefore, we encourage employers to review the terms and conditions of equity plans and award agreements to ensure the proper, desired economic outcomes occur with respect to furloughed award holders, including whether any amendments or clarifications to existing equity arrangements may be possible.

2.  2019 performance-based compensation, and adjustments to 2020 and future year performance goals

Both private and public companies routinely compensate their employees with performance-based bonus or equity awards, which may include payment terms and goals set in 2019 or in the first quarter of 2020.  In the event that a company wishes to change the form of payment, or to delay the payment or settlement, of performance-based compensation, there are many tax and securities complexities that we encourage employers to review with legal counsel.

For 2019 performance-based compensation that has not yet been paid, employers are urged to first consult with their legal, tax, and accounting advisers due to the potentially complex consequences of altering such arrangements, which are usually assessed on a case-by-case basis.

With respect to 2020 and multi-year performance periods beginning this year, employers may be interested in reviewing their performance goals for annual bonus, long-term incentive, and performance-based equity awards to understand what planning may be needed to continue incentivizing and encouraging employees while balancing new economic conditions.  Employers may want to consider undertaking a careful review and analysis of performance metrics for all employees.  Publicly-traded companies considering adjustments to current year compensation programs also are encouraged to take into account any potential disclosure obligations that may arise from making such adjustments.

We encourage companies that have not yet made 2020 compensation decisions to consider whether to delay decisions on performance metrics until more is known about the impact of COVID-19 and the economic downturn, including the impact on the company’s stock price or fair market value. In addition, given the volatility in the national stock exchanges, many publicly-traded employers may want to consider waiting until later in the fiscal year to establish performance targets applicable to the 2020 performance-based compensation. 

In addition to potential disclosure obligations, publicly-traded companies contemplating changes to performance metrics and goals under long-term incentive plans and multi-year performance-based equity awards are also encouraged to take into account the proxy statement voting policies of their institutional investors and advisory services, such as ISS.  For example, ISS has stated that while it will evaluate in-progress changes to multi-year compensation programs on a case-by-case basis, the COVID-19 environment has not altered its general policy to oppose midstream changes to existing long-term programs.[1]

3.  Compliance obligations when paying or adjusting compensation

Companies are urged to pay close attention to their compliance requirements in the following key circumstances: 

• handling pre-negotiated severance in offer letters and employment agreements

Although not intuitive, severance pay may be regulated by Section 409A of the Internal Revenue Code (Section 409A), particularly if (a) severance extends for 24 months or more, (b) severance is paid in installments, (c) severance is subject to a release of claims, or (d) if the employee has “good reason,” “constructive termination,” “disability,” or voluntary termination rights that can trigger severance pay. 

If severance is characterized under Section 409A as “nonqualified deferred compensation,” then an employer may be limited in its ability to change payment terms at this time, especially with respect to the timing of severance payments.

If an existing arrangement involves deferred compensation subject to Section 409A and is currently noncompliant with Section 409A, there may be an opportunity under IRS guidance[2] to correct certain types of noncompliance without tax penalty or at a reduced penalty; however, a correction of a noncompliant arrangement generally must be made prior to separation from service.

For public companies terminating officers and other senior executives, we strongly recommend reviewing any pre-negotiated severance arrangement to assess whether Section 409A will impose a 6-month delay on the payment of any severance pay or benefit that constitutes nonqualified deferred compensation.     

• deferring salary and reductions in pay

State wage and hour laws, payroll taxes (e.g., FICA and FUTA), and Section 409A are all potentially implicated if an employer seeks to have its employees “defer” or reduce wages in 2020 or later.  Employers considering whether to defer employee salaries in 2020 with a promise to pay those salaries later, especially if in 2021or another future year, are urged to work with legal counsel to assess risk and determine a workable solution because of the several, complex laws affecting reduced or deferred compensation, including tax laws.  If compensation is to be reduced, we also encourage employers to thoroughly review existing employment agreements and severance policies.  Any deferral or reduction in pay for employees outside the US, if permitted, will need to comply with local law, including any consent requirements.

• replacing cash compensation with equity

To the extent replacement of some portion of cash wages with equity compensation is being considered, we urge employers to obtain advice concerning federal, state and local wage and hour laws, including the requirement to pay certain minimum wages to non-exempt employees and a certain salary threshold necessary for an exempt employee to maintain such exemption.  Employers also are encouraged to consider the tax impact of the replacement equity and to be mindful not to guarantee any particular economic result with any replacement equity (i.e., no promises that the equity will “make up” for reduced wages).  In addition, if replacement equity is provided to employees based outside the US, we urge employers to consider international implications and requirements since tax, disclosure requirements, and potential employment-related liability will likely vary country-by-country.

4.  Severance plans or policies

Broad-based employee severance plans or policies (in certain circumstances, even if unwritten) can potentially trigger regulation by ERISA and an annual Department of Labor filing in the US. There are both advantages and disadvantages to ERISA severance plans.

Importantly, there may be significant planning opportunities to design a severance plan or policy to comply with ERISA and take advantage of ERISA’s many pro-employer benefits, including:

• preemption of state law;
• waiver of jury trials;
• limitation of punitive damages on claims;
• potential inclusion of arbitration terms and conditions; and
• the potential ability to incorporate non-competition and non-solicitation arrangements in certain US jurisdictions that might otherwise restrict the use of such arrangements.

5.  Stock option repricing or option exchange programs

            For private companies:

If an employer’s next common stock valuation report will reflect a decline in fair market value, the employer may want to consider a downward option repricing or a stock option exchange program.  Although the reward is potentially fruitful for the employees and service providers who receive a lower exercise price on their stock option awards, there are a number of planning items that should be covered with legal counsel, including:

• confirming whether the applicable equity plan and award agreements are flexible or, if instead, the applicable plan and award agreements prohibit a repricing without shareholder or investor approval;
• assessing the impact of the repricing on incentive stock options (ISOs), which is often adverse to the tax qualification of the option as an ISO;
• assessing the impact of the repricing on taxation for any option holders outside the US;
• contacting the employer’s auditors and assessing the non-cash accounting expense of the repriced options;
• determining whether SEC tender offer rules will require a 20-business day waiting period and issuance of an offering memorandum summarizing the repricing offer;
• determining whether the repricing triggers any securities requirements for any option holders outside the US; and
• preparation of board of directors’ resolutions to reflect legal compliance and good corporate governance.

Generally speaking, a stock option repricing may be more typical than a stock option exchange because of a repricing’s potential for simplicity and less paperwork.  An option exchange program, however, may be more appropriate for employers, for example if an employer wants to:

• change the form of equity interest to a different type of award (e.g., utilize RSUs instead of stock options);
• re-start the 10-year term of the existing stock options, especially if stock options that otherwise would be repriced are in the late stage of their term; or
• change to new terms and conditions and get existing stock option awards off of “bad paperwork.”

In addition to the issues mentioned above, we encourage an employer contemplating a stock option exchange to assess securities law exemption compliance with the reissuance of awards, including the potential availability of Rule 701 under the Securities Act of 1933.

            For publicly-traded companies:

In addition to several of the issues raised above with respect to private companies, publicly-traded companies are urged to consider:

• whether the repricing is being considered too soon or whether it is occurring or timed to occur when the value of the shares have hit “the bottom”;
• whether the repricing may be viewed (for corporate governance purposes) as opportunistic “short-termism,” which could potentially be negatively viewed by investors, if there is a so-called “V-shaped recovery” to the current economic downturn;
• whether and how to consult with key investors and stakeholders regarding the need for a repricing or exchange, which may require special outreach;
• the response in the next proxy cycle by institutional investor and advisory services, such as Glass-Lewis and ISS, to any repricing or exchange, especially if performed without prior shareholder approval; and
• assessing the legal, administrative, and accounting cost for performing a tender offer.

Notwithstanding the current COVID-19 economic conditions, ISS has reiterated that it has not changed its approach to option repricing or exchange programs.[3]  ISS will continue to follow its existing case-by-case evaluation and will generally oppose a repricing that occurs within one year of a precipitous drop in the company’s stock price.  Further, ISS has stated that it will examine whether (1) the design is shareholder value neutral (a value-for-value exchange), (2) surrendered options are not added back to the plan reserve, (3) replacement awards do not vest immediately, and (4) executive officers and directors are excluded.

Employers who have experienced a sharp decline in stock price may wish to consider looking into these issues, particularly if employee retention and preserving human capital is at a perceived premium.  Ultimately, publicly-traded companies must determine whether the benefit of such a program outweighs any potentially negative reaction of investors and their proxy voting advisors. 

If you have any questions regarding the impact of the current crisis on executive compensation, please contact any member of the DLA Piper Employee Benefits and Executive Compensation practice, your DLA Piper relationship attorney, or email us at CoronavirusEmployment@dlapiper.com.

Please continue to visit our Coronavirus Resource Center and our Coronavirus COVID-19 Daily Update for Employers for the latest legal developments and analysis.

This information does not, and is not intended to, constitute legal advice.  All information, content, and materials are for general informational purposes only. No reader should act, or refrain from acting, with respect to any particular legal matter on the basis of this information without first seeking legal advice from counsel in the relevant jurisdiction.