Key executive compensation issues to consider during an economic downturn

In response to the current health and financial crisis caused by COVID-19, many US-based employers are assessing measures such as employee furloughs, layoffs, and adjusted executive compensation arrangements. In this article, we highlight some of the key risks and issues employers are encouraged to consider as they engage in executive compensation planning strategies, from the impact of furloughs on equity award vesting to changes to compensation and severance policies.

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, equity awards frequently will cease vesting and unvested 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, including whether any amendments or clarifications to existing arrangements may be possible.

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

Private and public companies routinely compensate 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. If 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 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 want to review performance goals for annual bonus, long-term incentive, and performance-based equity awards to understand what planning may be needed to continue incentivizing employees while balancing new economic conditions. Publicly traded companies also are encouraged to take into account any potential disclosure obligations that may arise from making 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 economic impact of COVID-19, including the impact on the company's stock price or fair market value. In addition, given the volatility in national stock exchanges, publicly traded employers may want to consider waiting until later in the fiscal year to establish targets applicable to 2020 performance-based compensation.

In addition, publicly traded companies contemplating changes to performance metrics and goals under long-term incentive plans and multi-year performance-based equity awards are encouraged to consider the proxy statement voting policies of their institutional investors and advisory services. 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.

3. Compliance obligations when paying or adjusting compensation

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

Handling pre-negotiated severance in offer letters and employment agreements: 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," an employer may be limited in its ability to change payment terms. 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 to correct certain types of noncompliance without tax penalty or at a reduced penalty; however, a correction generally must be made prior to separation from service.

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

Deferring salary and reductions in pay: State wage and hour laws, payroll taxes, and Section 409A are all potentially implicated if an employer seeks to have its employees "defer" or reduce wages. 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 because of the complex laws affecting reduced or deferred compensation. Employers should also review existing employment agreements and severance policies.

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 minimum wage requirements and salary thresholds to maintain exemptions. Employers also are encouraged to consider the tax impact of the replacement equity and avoid guaranteeing any particular economic result (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 each country's requirements.

4. Severance plans or policies

Broad-based employee severance plans or policies (even if unwritten) can potentially trigger regulation by ERISA and an annual Department of Labor filing. Importantly, there may be significant planning opportunities to design a severance plan or policy to comply with ERISA and take advantage of its many benefits, such as preemption, waiver of jury trials, limitation of punitive damages, and the potential ability to incorporate arbitration terms and/or non-competition and non-solicitation 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 those who receive a lower exercise price on awards, there are a number of issues to cover with legal counsel, including:

Confirming whether the applicable equity plan and award agreements are flexible;
Assessing the impact of the repricing on incentive stock options (ISOs);
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 waiting period and issuance of an offering memorandum;
Determining whether the repricing triggers any securities requirements for option holders outside the US; and
Preparation of board of directors' resolutions to reflect legal compliance and good corporate governance.

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 if, for example, an employer wants to:

Change the form of equity interest to a different type of award;
Restart the 10-year term of the existing stock options; or
Change to new terms and conditions and get existing awards off of "bad paperwork."

Employers contemplating a stock option exchange are also encouraged 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, publicly traded companies are urged to consider:

Whether the repricing is being 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";
Whether and how to consult with key investors and stakeholders;
The response in the next proxy cycle by institutional investor and advisory services to any repricing or exchange; and Assessing the legal, administrative, and accounting cost for performing a tender offer.

Notwithstanding current economic conditions, ISS has reiterated that it has not changed its approach to option repricing or exchange programs. Employers who have experienced a sharp decline in stock price may wish to consider options, particularly if employee retention and preserving human capital is at a perceived premium. Ultimately, publicly traded companies must determine whether the benefits outweigh any potentially negative reaction of investors and their advisors.

Cisco Palao-Ricketts is co-chair, US Employee Benefits and Executive Compensation practice at DLA Piper. Dean Fealk is managing partner at the firm's San Francisco office and co-chair, International Labor and Employment practice. Rita Patel is co-chair, US Employee Benefits and Executive Compensation practice, and William Hoffman is a partner concentrating on executive compensation and employee benefits.

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