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The COVID-19 Test for Compensation Committees

April 24, 2020

Compensation Committees are addressing whether compensation should be adjusted to reflect the effect of the coronavirus (COVID-19) pandemic on companies’ businesses and how to correlate executive compensation with changing company priorities. Here is how compensation committees can approach this challenge in the coming months.

Compensation committees of US-based public companies (Compensation Committees) will have important decisions to make in the coming weeks and months due to the coronavirus (COVID-19) pandemic’s effects on companies’ businesses. The current economic environment caused by the COVID-19 pandemic, with enormous uncertainty and significant daily and weekly changes in a company’s cash flow and stock price, has created new and unprecedented challenges in balancing key executives’ compensation with the long-term goals and priorities of the company. A Compensation Committee has at its disposal a number of different ways to offer key executives compensation in order to maintain a balance that will lead to the best result for the company and its shareholders, but will also provide appropriate incentives and retention tools to retain and motivate key executives in the current environment. The Compensation Committee may need to reconsider, and in some cases renegotiate, compensation previously offered. This LawFlash discusses how Compensation Committees can approach these decisions to help companies navigate these uncertain and rapidly changing times.

This LawFlash addresses various considerations for Compensation Committees against the backdrop of COVID-19, and is one of a series focused on COVID-19’s impact on corporate governance, including the duties and actions of boards and committees.

Cash Compensation and Bonuses

Many companies are reducing key executive salaries and bonuses temporarily, to save costs and to show solidarity with the business. If 2019 bonuses have not been paid, the Compensation Committee may want to review the bonus plan and bonus communications to determine whether the Compensation Committee retained discretion to reduce or defer 2019 bonuses based on current conditions. If the Compensation Committee determines to defer payment of all or a portion of the 2019 bonus, any deferral must comply with the requirements of Section 409A of the Internal Revenue Code (Section 409A).

As a general rule, a 2019 bonus could be deferred to a date not later than the end of the short-term deferral period (i.e., for a company with a calendar fiscal year, March 15, 2020) under Section 409A, unless it can be demonstrated that the payment would jeopardize the ability of the company to continue. In such case, payment of the deferred bonus would have to be made as soon as the financial impediment ceases to exist. Similar Section 409A considerations apply if the Compensation Committee determines to defer a portion of a key executive’s 2020 base salary.

For 2020 year bonuses, many Compensation Committees are considering whether an adjustment of 2020 bonus performance metrics and goals is possible and appropriate. The Compensation Committee should check the bonus plan and communications to determine whether there is an ability to adjust the performance metrics and goals. If the plan allows it, performance metrics and goals can be adjusted during the year based on expected outlook, or the Compensation Committee can wait until the end of the year to make an adjustment. Where 2020 performance metrics and goals have not yet been set, many Compensation Committees are delaying setting the metrics and goals until the company has a better sense of how the COVID-19 pandemic will affect the business for the year and what performance metrics and goals will be appropriate.

The proxy advisory firms Institutional Shareholder Services (ISS) and Glass Lewis scrutinize mid-year adjustments to performance goals and metrics. In this regard, ISS recently issued guidance indicating that it understands that many companies will likely adjust annual performance metrics, goals, and targets in light of the COVID-19 pandemic, and while such decisions will be reviewed at next year’s annual shareholders meeting, ISS encourages companies to provide contemporaneous clearly articulated disclosure of the rationale for the changes to shareholders, in addition to discussion in the Compensation Discussion and Analysis in next year’s proxy statement.

Depending on the structure of the 2020 annual bonus program, it may be possible for the company or the executive to elect to defer the 2020 bonus under the Section 409A rules for “performance based compensation.”

Equity Awards

If Compensation Committees are considering adjusting performance goals for outstanding equity awards with performance-based vesting, Compensation Committees will need to take into account the same considerations described above for cash bonuses in connection with any changes to performance goals. Before adjusting performance goals, the Compensation Committee should consider whether it retained discretion to make adjustments to payouts based on unusual circumstances in the equity grant documents, in which case it may not be necessary to adjust the performance goals. However, note that ISS looks less favorably on adjustments to performance goals for long-term equity awards than with respect to annual bonus plans. With respect to long-term performance plans, ISS noted in its recent guidance that its policies do not support changes in the middle of the performance period and ISS will review any changes to performance goals for long-term plans on a case-by-case basis to determine whether appropriate discretion was exercised.

Prior to making any changes to equity awards, the company should consider whether any outstanding equity awards continue to be grandfathered from the $1 million deduction limitation under Section 162(m) of the Internal Revenue Code (Section 162(m)) as performance-based compensation. Any changes to the performance goals could cause the loss of such grandfathering.       

For Compensation Committees that are in the process of making 2020 equity awards, careful consideration should be given to the amount of equity to be granted as a result of currently low share prices. If the Compensation Committee determines the number of equity awards based on a dollar value that is converted into shares based on stock price, a currently low share price may result in a significant increase in the number of shares that the executive is awarded, compared to prior years. If the value of the stock quickly rebounds, this could result in a potential windfall of value to the executive. Because of the elimination of the performance-based compensation exception under Section 162(m), much of the value of equity awards may not be tax deductible by the company. Conversely, if the Compensation Committee limits the number of shares that are granted to avoid a potential windfall, but the company’s stock does not rebound to its prior level quickly, this could result in potential retention issues and diminished incentive value.

When making equity awards, the Compensation Committee should take into account the terms of the equity plan under which the grant will be made. In particular, many plans continue to include per person limits on the number of shares that may be granted each year. Also, if the number of shares that will be granted in 2020 is significantly greater than in prior years, this could impact the number of shares that the Compensation Committee will have available for annual grants in future years, as well as for promotions and new hires.

Consideration should also be given to delaying annual equity awards until later in the calendar year, when stock prices may have stabilized and realistic performance goals may be set. Alternatively, the Compensation Committee could use a stock price based on a trailing average for purposes of setting the number of shares or the exercise price of options (subject to compliance with Section 409A with respect to options).

Another option for Compensation Committees to consider is granting retention equity awards in situations where the performance goals of existing equity awards are unlikely to be met. ISS and Glass Lewis scrutinize retention awards and expect to see fulsome disclosure of the rationale for retention awards in the Compensation Discussion and Analysis of the proxy.

The Special Case of Stock Options

With the drop in the stock market as a result of the COVID-19 pandemic, outstanding stock options for many companies are likely to be underwater (i.e., the exercise price of outstanding stock options is greater than the current fair market value of the underlying stock). Compensation Committees may consider repricing or replacing underwater stock options. Prior to taking any action, the Compensation Committee will need to take into account a number of considerations, including:

  • Stockholder Approval: The NYSE and Nasdaq each require that the stockholders approve an option repricing, unless the underlying plan specifically permits otherwise. Most plans do not permit option repricing without shareholder approval because of ISS guidelines, so stockholder approval will likely be required prior to any repricing action.
  • ISS Guidance: The recently issued ISS guidance on COVID-19 confirms that if companies seek shareholder approval of an option repricing, ISS will apply its existing policy approach for the relevant market. Under this policy, ISS will generally recommend against any repricing that occurs within one year of a “precipitous drop in the company’s stock price.” ISS will examine whether the repricing plan is value neutral, whether the surrendered shares are added back to the equity pool for future grant, and the vesting of the replacement shares. ISS requires that executive officers and directors be excluded from a repricing, which often defeats a primary purpose of repricing options.

Severance

The Compensation Committee should consider whether a reduction of base salary or target bonus could give rise to an executive’s ability to terminate employment for “Good Reason” and collect severance under his or her employment agreement. If so, it will be important to have the executive consent to the reduction and, if necessary, confirm that the reduction does not trigger “Good Reason.” If terminations occur following a reduction in compensation, a Compensation Committee will need to consider how severance benefits will be calculated in light of the change in compensation. If severance benefits are to be paid in a lump sum to an executive, Section 409A may limit the ability of the Compensation Committee to change the form of severance to installments. Section 409A may also require the delay of payment of severance benefits for six months from termination of employment to an executive, to the extent the severance benefits constitute deferred compensation subject to Section 409A.

CARES Act Loans

If a company receives a loan or a loan guarantee under Section 4003 or 4116 of the CARES Act, certain restrictions will be imposed on the company, including restrictions on executive compensation. If a company is considering such a loan, the Compensation Committee will need to consider the impact and limitations on its executive compensation program, since the company will need to limit total compensation and severance pay to certain employees during the applicable restriction period. Imposing these restrictions may raise contractual issues with executives. There are a number of unanswered questions relating to how the restrictions will be implemented. For more detailed discussions about the restrictions tied to loans under the CARES Act, see our recent LawFlashes: Loans Under Section 4003 or 4116 of the CARES Act: Beware of Executive Compensation Limits, and CARES Act Brings Compensation, Benefits, and Payroll Tax Changes.

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The foregoing discussion is not intended as an exhaustive list of the compensation-related considerations that a Compensation Committee will need to consider in connection with the COVID-19 pandemic. Any decisions that a Compensation Committee makes relating to compensation matters will need to be carefully considered and should take into account the various tax, contractual, accounting, and disclosure implications that may result, as well the retention and short-term and long-term incentive consequences of any decision.

CORONAVIRUS COVID-19 TASK FORCE

For our clients, we have formed a multidisciplinary Coronavirus COVID-19 Task Force to help guide you through the broad scope of legal issues brought on by this public health challenge. We also have launched a resource page to help keep you on top of developments as they unfold. If you would like to receive a daily digest of all new updates to the page, please subscribe now to receive our COVID-19 alerts.

Contacts

If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:

Boston
Laurie Cerveny
Michael Conza
Bryan Keighery
Carl Valenstein
Julio Vega

New York
Mary (Handy) Hevener
Gina Lauriero
Gary Rothstein
Jill Weintraub
Thomas P. Giblin, Jr.
John T. Hood
Christopher T. Jensen
Howard A. Kenny
Jeffrey A. Letalien
Christina Melendi
Finnbarr D. Murphy
David W. Pollak
Kimberly M. Reisler

Palo Alto
Albert Lung

Philadelphia
Amy Pocino Kelly
Robert Lichtenstein
Erin Randolph-Williams
Mims Maynard Zabriskie
David Zelikoff
Justin W. Chairman
James W. McKenzie
Alan Singer
Joanne R. Soslow

Pittsburgh
Randall (Randy) McGeorge
Celia Soehner

Princeton
David C. Schwartz

San Francisco
Heather Brookfield

Silicon Valley
Zaitun Poonja

Washington, DC
Rosina Barker
Althea Day
Patrick Rehfield
Jonathan Zimmerman
Sean Donahue
Keith E. Gottfried
Linda L. Griggs
David A. Sirignano
George G. Yearsich