Since March 2020, the worldwide pandemic has derailed expectations for businesses and their employees with respect to everything from how to continue or adapt operations to how to keep employees safe. While the past few months have been unprecedented, the future seems to be just as unpredictable. Having an engaged and committed executive team may be the key to a company’s survival and recovery. In light of this situation, companies must strategize as to how to conduct business while adapting executive compensation programs in light of current circumstances.
Several factors come into play when addressing executive compensation in the midst of a crisis. On one hand, the COVID-19 pandemic has caused companies to experience the depletion of cash as a result of negative impacts on operations which has led some companies to furlough employees and reduce compensation packages and others to freeze compensation altogether. On the other hand, now more than ever, some companies may need to retain and incentivize top talent. Some companies may not only be surviving, but thriving, as a result of new demands for their businesses and services, especially those deemed “essential businesses.” While there is no one-size-fits-all approach for handling executive compensation, it is important to understand the legal ramifications for any modification of executive compensation programs to account for the current climate.
Legal Considerations for Compensation Adjustments
- Reductions in Executive Pay
Companies desiring to free up cash flow may look at reducing or deferring payment of executive compensation for an interim period. The following are just two considerations, among many, to take into account when contemplating options. First, determine whether there are any employment agreements governing the relationship between an executive and the company. Executive employment agreements usually have severance provisions triggered by items such as termination by the company without ‘cause’ or termination by the executive for “good reason.” While on its face, such provisions may appear to be inapplicable, most employment agreements define termination for good reason to include a pay reduction, including one that is calculated as a certain percentage of the salary. It is imperative to review employment agreements to ensure that any proposed cuts will not trigger the right of the executive to collect a severance payment which would further deplete company resources. It is also important to document any voluntary or agreed upon compensation reduction appropriately to avoid future undesired ramifications.
Second, be careful that any true reduction in compensation is not a disguised deferral compensation that could trigger negative ramifications under Section 409A of the Internal Revenue Code (Section 409A). For example, there may be an instance where a company may negotiate a temporary reduction with a promise that additional pay will be provided in the future. Delaying payments earned in one year to a future year requires consideration of Section 409A requirements. Section 409A requires that companies and executives comply with a regulatory scheme for delayed payments or executives face immediate income tax and a 20% excise tax penalty. A commonly recognized exemption under Section 409A is the “short-term deferral” exemption. The short-term deferral exemption allows payments earned in one year to be paid later in that year or paid in the first two and a half months of the following year (such as an executive deferring compensation from June 2020, until February 2021). This may be an option for companies only seeking a short delay in payment; it may not, however, be enough relief for companies during the pandemic. In circumstances where deferred compensation cannot be paid, guidance under Section 409A contains a mechanism for delaying payments of deferred compensation if payment would jeopardize the company’s ability to continue as a “going concern.” Unfortunately, it is unclear what factors would meet the standard of jeopardizing the status of the company as a “going concern.” Regardless, documentation should be retained to support any position taken. The exception generally supports delaying payments until a point that the company is solvent enough to make the additional payments, thus protecting against negative tax consequences.
- Reductions in Bonuses
In the case of annual performance based bonuses, companies may find the need to adjust performance targets that had been set earlier in the year which may no longer be applicable as a result of the impact of the pandemic. Similar to adjusting base compensation, take care to confirm that any changes in performance targets are compliant with controlling employment agreements or arrangements. Often such changes are within the purview of the compensation committees or boards of directors. However, it is important to carefully document and communicate any changes or adjustments to protect against future misunderstandings or claims. To the extent that companies are adjusting bonus performance criteria based on effective “responses” to the pandemic, such criteria should be defined clearly.
Companies may also consider adjusting equity awards which have generally been embraced as a way to allow employees to link their personal efforts to resulting appreciation of the company’s overall value. As a result of the pandemic, executives are experiencing significant fluctuations in the value of their equity, and may be holding underwater options. While companies may take a “wait and see” approach hoping that stock prices will rebound, some companies have considered repricing options. Assuming that a company’s equity plan permits repricing, the company can either reduce the exercise price to reflect the current fair market value through an amendment to the grant agreement or can cancel existing options and replace them on a one-for-one basis. There are several significant ramifications, however, when repricing options including tax, accounting, and corporate governance concerns. For example, if a series of repricings occur then there may be an implication that the grant had a floating exercise price which would cause penalties under Section 409A. Similarly, for public companies, repricings may incur unwanted accounting charges depending on how they are structured. Outside of these concerns, repricings may require shareholder approval. Accordingly, any actions to adjust bonus compensation whether in the form of cash or equity must be carefully considered before being implemented.
- Requirements Related to CARES Act Loans
Companies may be subject to other restrictions that apply to executive compensation programs. To address adverse business concerns resulting from COVID-19, the U.S. Congress passed the Coronavirus Aid, Relief, and Economic Security Act of 2020 (CARES Act). Under Title IV of the CARES Act, companies were able to receive loans from, or guaranteed by, the U.S. Treasury. The loans are subject to certain restrictions with respect to compensation for officers whose total compensation in the 2019 calendar year exceeded $425,000. Generally, from the date of the loan or guarantee agreement until one year after the loan is repaid, an executive’s total compensation may not exceed the 2019 compensation for any consecutive 12 month period. Additional restrictions also applied with respect to executives earning greater than $3 million or those receiving severance payments the definition of compensation under the CARES Act is quite broad and includes “financial benefits.” As a result, companies must carefully work through the definitions and restrictions to address compensation matters under the CARES Act if they have secured loans under the program.
- Considerations for Companies Doing Well
Although the pandemic has been devastating for many sectors of the economy, some companies are thriving and exceeding performance forecasts by wide margins as a result of substantial and sudden shifts in consumer behavior. The demands on these businesses to adjust to the challenges of meeting dramatic increases in business may warrant upward adjustments in bonus compensation. In the case of a company where cash flow, revenue or other financial metrics used to measure bonus performance have exceeded maximum targets, the compensation committee may need to approve an increase in the maximum potential bonus payout. Although the repeal of the stringent requirements of Internal Revenue Code Section 162(m) has negated the performance based compensation requirements for tax purposes, there may be other implications from adjusting or eliminating caps or recalculating the maximum attainable bonus. In some cases, the compensation committee may have discretionary authority on which to rely; however, previously shareholder-approved plans may still contain absolute maximum cash or equity provisions. In some cases, compensation committees may be able to turn to provisions related to extraordinary events as a basis for bonus adjustments. In certain situations, it may be more appropriate for compensation committees to adjust performance criteria to take into account relative industry outcomes. Regardless, careful consideration should be given to the impact of such decisions on company accounting as well as reports from proxy advisory firms and future disclosures in the annual proxy statements.
This article provides just a small number of examples of considerations regarding changes to executive compensation programs as a result of the COVID-19 pandemic. Companies and their management teams, including general counsel, must carefully consider the legal ramifications of adjusting compensation programs, even in light of the business’ need to maintain adequate cash flow to address immediate operational issues. Moreover, to the extent that a company is public, any actions taken with respect to executive compensation may most likely require public disclosure. All actions should be carefully considered by boards of directors with management teams and their general counsel to ensure adequate adherence to compliance requirements, disclosure rules and ultimately investor and public reaction.
Katayun I. Jaffari is chair of the corporate governance and securities group at Cozen O’Connor. She counsels public and private companies in the areas of corporate governance and securities law and compliance, including capital-raising transactions and reporting requirements under SEC, NYSE and Nasdaq regulations, as well as providing general corporate advice and execution with respect to executive compensation, mergers and acquisitions transactions and board and business counseling. She can be reached at [email protected] or 215-665-4622.
Diane Thompson focuses her practice on providing advice and counsel on matters pertaining to executive compensation and employee benefits. Her clients include public and private companies, as well as tax exempt organizations, and she regularly works with board of director’s compensation committees and company executives in finance, human resources, legal, and accounting. She can be reached at [email protected] or 213-892-7939.
Anne Greene is an associate in the firm’s labor and employment department and advises clients on various employee benefits and executive compensation topics. She can be reached at [email protected] or 412-620-6507.