The COVID-19 outbreak has had a swift and volatile impact on business operations and the financial markets. Because this is occurring simultaneously with the annual incentive award cycle of many companies, immediately at issue is how companies will address incentive setting and employee retention in this rapidly changing environment.
This memorandum discusses the key considerations for companies and their boards as they navigate common waters in uncommon times.
Annual Equity Grants
Grant Timing
Companies that were planning to make equity grants in the coming days or weeks may currently be considering delaying their annual grants, particularly if company practice has been to make grants based on the grant date fair value of the awards (as opposed to awards over a fixed number of shares). Before taking such an action, companies should review their prior SEC disclosures, grant policies and plan terms to determine whether there are any contractual restrictions on grant timing or whether they have made past public statements on grant timing policy. Any plan amendments that impact awards to executive officers or directors may trigger Form 8-K reporting. Even if no mandatory Form 8-K is triggered, companies may consider voluntarily disclosing grant timing changes.
Delaying grants may be most appropriate in the case of multi-year performance awards and may ultimately preserve the number of shares available for grant over the life of the relevant equity plan. However, delaying grants may be de-motivating to employees at a time of substantial uncertainty and increased commitment. Companies should carefully craft related employee communications to emphasize the importance of, and explain the reasoning behind, any changes in equity grant cadence.
Some boards and compensation committees—particularly those that have weathered significant prior business disruptions—may choose to stay the course and not delay grants. Proceeding with the typical annual grant timing could, when judged in hindsight, create the impression that management received an unjustified windfall, because equity grants were made when the company’s share price was artificially (and temporarily) low. Shifting the grant timing could alleviate some of that pressure, but it could also exacerbate it given current uncertainties. An alternative to consider is staggering the annual equity grant to be made over the year (i.e., semi-annually or quarterly) to reduce the effects of continuing market volatility and supply chain disruption.
Grant Pricing
Related to the issue of grant timing, given the volatility of the market generally, companies that make grants based on the grant date fair value of the awards using a spot price (such as a daily closing price) may want to consider instead using a trailing average price to avoid anomalous pricing on an extreme up or down market day. Publicly traded companies should keep in mind that “fair market value” for establishing stock option exercise or strike prices may not be determined by a trailing average of more than 30 consecutive trading days in order for the options to be exempt from Section 409A of the Internal Revenue Code. For equity awards other than stock options, we recommend companies think about using a longer period (for instance, 60 or 90 days) when setting the trailing average. Companies considering this approach should ensure the governing plan documents allow for alternate valuation methodologies. Companies should also consult with their auditors to understand the accounting impact of any proposed changes.
Other Innovative Design Features
To address the challenge of making grants when business operations and share prices are changing drastically from day to day, companies might consider more novel approaches to their award design for 2020. In addition to the timing and pricing considerations already mentioned, equity grant practice tweaks could include revisiting the mix of equity awards (percentage of full share awards vs. options), performance award minimum and maximum payout ranges and levels of discretionary authority for compensation committees and boards to adjust payouts at the end of vesting periods.
Long-Term Incentive Targets
Setting multi-year performance targets is always challenging, but it is much more so this compensation season. Companies may consider delaying setting long-term performance award targets until the market is somewhat less volatile, while proceeding with other incentive components. If companies choose to set long-term performance targets now, they may consider using relative as opposed to absolute performance metrics and providing the plan administrator with sufficient discretion to adjust awards when ultimately determining achievement levels.
After tax reform was passed in late 2017, the limitations of Section 162(m) of the Internal Revenue Code regarding adjustments to performance targets no longer create an obstacle to such changes for new awards, as all compensation in excess of $1 million is no longer deductible, thus allowing for additional flexibility without causing negative tax effects. However, companies should avoid letting too much of the applicable performance period go by before goal setting. In addition, companies should review plan documents to confirm plans do not still have adjustment restrictions, even where the award is not intended to qualify under Section 162(m).
If the board or compensation committee is thinking of adjusting long-term incentives granted in prior years, consideration should be given to the plan terms regarding adjustments, whether they are grandfathered for Section 162(m) purposes, and the accounting and disclosure ramifications of any changes, which should be balanced against the overhang of the awards and their reduced retentive value. In some cases, it may be more beneficial to terminate longer-term awards and replace them with new grants with more achievable long-term targets.
Repricing
Stock options can pose particular challenges, given the potential for drastic spreads and the risk of outstanding options going “underwater.” After a long bull market, we may begin to see a resurgence in discussions regarding option repricing, which would revive issues last considered broadly during the 2008 financial crisis. Repricing requires shareholder approval under applicable listing rules, unless a company’s equity compensation plans explicitly permit it, which is rare at present. Additionally, repricing is disfavored by proxy advisory firms and institutional investors. We will provide a further update on option repricing shortly.
Dilution
As share values decline, authorized share plan pools may deplete dramatically because grant sizes will necessarily increase as a consequence. For those companies that have not yet filed their proxy statements for this year’s annual meeting, consider whether to include a proposal to amend equity plans to account for higher than expected burn rates. As the effects of COVID-19 unfold, later this year, we may see an increase in equity grants made contingent upon subsequent shareholder approval,1 and special shareholders’ meetings to approve new plans, increases in authorized share pools and repricing of outstanding awards. Companies should review their equity plans if they have upcoming automatic grants—for example, shareholder approved formula director compensation grants—to confirm there are sufficient shares remaining to make these awards.
Sell to Cover
Market volatility can also pose a challenge to ordinary sell-to-cover transactions as awards vest and settle. For example, take a restricted stock unit that vests and settles on a Friday (when the employer’s stock closes at $10). The tax due is calculated based on the price on the settlement date, but the market sales to cover the withholding obligation do not occur until the trading day on Monday (at a time when the stock drops to $7 in intraday trading). When such drastic market swings occur, the broker must sell significantly more shares to raise sufficient funds to settle the tax liability. In times of significant market volatility, companies might consider moving away from broker-assisted sell-to-cover programs for tax withholding and instead use company net share settlement or withhold from other income of the award holder, if possible. Note that companies should maintain consistency with past practice in determining the date on which awards are valued for tax purposes, and should review their plan documents to ensure compliance.
Employee Messaging
Employee messaging is particularly important in times of anxiety and uncertainty. Management should consider what information employees receive about operations, disruption and workplace policies, as well as compensation, with greater than typical sensitivity. Care should be taken in how that information is delivered, and employers should ensure that employees understand why any changes are being made and how their and the company’s interests are being protected.
Annual Bonus Programs
As of this writing, many companies have already adjusted their 2020 forecasts and may need to revisit previously issued guidance. Needless to say, setting annual performance targets in this rapidly evolving landscape is more challenging than under ordinary circumstances. Companies sponsoring annual bonus plans fall into two categories at this point: those that have already set their annual performance targets for 2020, and those that have not yet taken action.
What to Do if 2020 Performance Targets Have Already Been Set?
Those companies that have already set 2020 performance targets under their annual bonus programs may be considering appropriate and necessary adjustments to targets in light of the COVID-19 outbreak and its impact on businesses worldwide. Without making adjustments, companies may render their annual incentive programs fruitless in terms of providing employees with much needed motivation, a sense of possibility of achievement of pre-established goals and retentive hooks. However, adjusting targets too soon may necessitate further adjustments as the impact of COVID-19 on the business is evaluated. Any adjustments should be made in compliance with the applicable plan documents and in consultation with the company’s auditors. Another alternative would be for the board or compensation committee to consider setting new and additional shorter-term goals (such as quarterly goals) relating to COVID-19 response and recovery targets while longer-term impacts on a business remain uncertain.
What if 2020 Performance Targets Have Not Yet Been Set?
For companies that have not yet acted on their 2020 annual performance targets, boards and compensation committees should consider delaying until more is known about the impact of COVID-19. Boards and management may wish to maintain focus on business continuity and emergency preparedness, rather than trying to predict potential outcomes under incentive programs at this time. In addition to the changes on performance target adjustments noted above, the amendments to Section 162(m) allow for more flexibility in the timing of performance target setting. Previously, Section 162(m) required targets to be set within a certain period (for instance, annual targets had to be set by March 31 for calendar year companies) in order for the related compensation to qualify as “performance based,” and therefore be deductible by the employer when paid. Nonetheless, compliance with plan terms, accounting impact and employee reactions should be kept in mind when determining how long to delay target setting.
If companies choose to proceed and to set annual performance targets now, they may consider using relative as opposed to absolute performance metrics to account for uncertain conditions. Companies can also consider individual performance metrics that tie, for example, to effective crisis response. Alternatively, or in conjunction, companies should take steps to provide the plan administrator with sufficient discretion to make adjustments to annual bonus targets. All discretion should be circumscribed as tightly as possible to outline when it can (and cannot) be applied to better align employee and shareholder expectations, and to ensure that investors will view the compensation derived as performance based. Boards and compensation committees should receive updated information throughout the year on the business—such as revenue, inventory, supply chain, human capital issues and geographic disruptions—to ensure that any discretion is thoughtfully applied at year end.
Our Take
Boards and management teams should consult with their legal, tax and accounting advisors before making any decisions regarding changes to their approach to equity and incentive compensation. Further, all actions should be taken with a mindful eye on the potential reactions of all constituents: shareholders, proxy advisors, activist investors and especially employees. To that end, shareholder engagement efforts, in particular during the 2021 proxy season, with respect to say-on-pay voting and whether additional shares will be needed under equity plans, should be considered. We will continue to monitor and provide updates on all guidance that may be issued by regulators, proxy advisory firms, institutional shareholders and other stakeholders.
Footnote
1. Adverse accounting implications may result from granting equity awards subject to shareholder approval. Companies considering this alternative should ensure they review the accounting impact.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
