COVID-19 and Executive Pay

Joseph E. Bachelder is special counsel at McCarter & English LLP. This post is based on an article by Mr. Bachelder published in the New York Law Journal. Andy Tsang, a senior financial analyst with the firm, assisted in the preparation of the article.

COVID-19 has caused many illnesses and deaths worldwide. It also has caused significant economic loss for many business enterprises and this may impact, in turn, on the compensation those enterprises pay their executives. Today’s column discusses the impact COVID-19 may have on executive compensation.

On March 13, 2020, the President of the United States declared a national emergency beginning as of March 1 based on COVID-19. On March 27, 2020, the President signed into law the Coronavirus Aid Relief and Economic Security Act (the “CARES Act”). COVID-19-related decisions include picking the date to separate pre-COVID-19 and post-COVID-19 periods (the “COVID Start Date”) for compensation or other purposes. For most companies, at the present time, such decisions are at the discretion of the individual company. Exceptions may include companies receiving loans from, or loans guaranteed by, the U.S. Treasury Department. Such loans may be contingent upon agreement by the borrowing company to certain conditions, including the date to be treated as the COVID Start Date.

A. Losses to businesses caused by COVID-19.

Following are illustrations of losses that many businesses have incurred as a result of COVID-19:

  1. loss of revenue due to reduction in business;
  2. losses in perishable inventory that cannot be used because of delays caused by COVID-19;
  3. termination of pending business transactions as a result of delays caused by COVID-19; and
  4. costs incurred due to a company’s failure to perform legally binding agreements in consequence of COVID-19.

B. Adjustments in executive compensation that companies may make to reflect losses due to COVID-19.

Adjustments to reflect company losses due to COVID-19 may include downward adjustments in (or other modifications to): (i) salary, (ii) annual bonus awards, (iii) outstanding performance-based long-term incentives, and (iv) outstanding stock options.

  1. Salary Adjustments. A company might defer or reduce executive salaries commencing with the period following the COVID Start Date. (Many companies adversely impacted by COVID-19 have already made salary adjustments. See, for example, a report entitled “COVID-19 Disruption: Tracking Executive and Director Compensation Changes—Information as of May 15th, 2020,” published by Frederic W. Cook & Co. The report shows that as of May 15 there were 492 Russell 3000 companies that had reported adjustments to executive compensation—the report notes that these adjustments “generally represent decreases to salary.”)
  2. Annual Bonus Adjustments. Annual bonuses at companies adversely impacted by COVID-19 may pay out very little, if anything, based on performance targets set prior to COVID-19 that have become unattainable in the post-COVID-19 economic environment. Some companies may divide the current annual bonus into two parts: the part attributable to the period before the COVID Start Date and the part attributable to the period after that date. For example:
    1. For the portion of the award period occurring before the COVID Start Date, payout of the bonus would be based on actual performance during the pre-COVID-19 period measured against the portion of the original target allocable to that period.
    2. For the portion of the award period occurring after the COVID Start Date, a calculation would be based on actual performance during the portion of the award period occurring after the COVID Start Date relative to the portion of the original target allocable to that period. Some companies may make a downward adjustment in the performance target for this portion of the award in order for the award to have a realistic chance of attainment.

Annual bonuses made in future award periods would, of course, take into account the post-COVID-19 economic business environment.

  1. Performance-Based Long-Term Incentive Award Adjustments. Like annual bonuses, performance periods of outstanding performance-based long-term incentives presumably may be divided between the award period before the COVID Start Date and the award period following the COVID-19 Start Date. However, some companies that have recently made performance-based long-term incentive awards may decide to defer taking any action. For example, an award that was made six months ago may have a three-year performance period. Since there would still be two and one-half years left for the performance target to be attained it might be premature to make any adjustments now to such an award.

Performance-based long-term incentive awards made in future award periods would, of course, take into account the post-COVID-19 economic business environment.

  1. Stock Option Adjustments. Companies whose stock prices have been negatively impacted by COVID-19 may, in some cases, reduce the exercise price of the “underwater” options (e.g., options with an exercise price that currently is above the value of the underlying stock). Alternatively, they may cancel the “underwater” options and grant new options or make awards in a different form such as restricted stock (which would require a fewer number of shares). Whatever actions individual companies take will depend on applicable government restrictions, stock exchange listing requirements, and the company’s plans and award agreements.

C. Issues to consider in deciding whether, and to what extent, to make adjustments in executive pay due to COVID-19.

  1. How significant are the amounts of downward adjustments in executive pay that are being proposed?
  2. Do existing executive compensation plans, programs and agreements permit negative adjustments to be made in salaries or other elements of executive compensation? For example, an executive may have an employment agreement that protects the executive—including the right to terminate employment for “good reason” if the executive’s salary is reduced.
  3. If adjustments are made in one component of executive pay, what will the impact be on other elements of executive pay? For example, if a downward adjustment is made in salaries what will be the impact on contributions on behalf of executives to welfare benefit plans as to which contributions are based on salary levels?
  4. What will the impact be on executive morale at the company if downward adjustment in executive pay at the company occurs?
  5. Are there government restrictions on what an employer can do in making downward adjustments in executive compensation? Statutory limitations may include requirements of the Internal Revenue Code, e.g., Section 162(m) (rules as to deductibility of compensation) and Section 409A (rules regarding deferral of compensation). In addition, the CARES Act, noted above, contains restrictions on executive compensation and severance for companies receiving loans from, or loans guaranteed by, the U.S. Treasury Department.
  6. What must the company disclose regarding the downward adjustment? For example, if it is a public company, what will it be required to disclose in the proxy statement and other SEC filings like Forms 8-K, 10-Q and 10-K?
  7. Have stockholders of the company and/or those advising them, such as proxy advisors, expressed views regarding adjustments in executive pay as a result of COVID-19?
  8. What are peer companies doing with regard to COVID-19-related adjustments?

Conclusion

The current financial statements of many companies will reflect losses in consequence of COVID-19. These companies must consider how to reflect those losses in their financial statements and in other disclosures they may have to make. Examples of such considerations include amounts attributable to COVID-19 losses during a particular fiscal period and how those losses should be reflected in the compensation of the company’s executives. Perhaps the most significant concern, as noted above, will be the impact of compensation reductions on executive morale, especially for those executives whose holdings in their employer’s stock decreased in value as a result of COVID-19. A company that decides to make negative adjustments to the compensation of its executives because of COVID-19 should consider adopting a plan to restore the amount of such reductions to the compensation of its executives when the company emerges from the financial setbacks caused by COVID-19.

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One Comment

  1. rerolle
    Posted Saturday, July 4, 2020 at 5:52 am | Permalink

    a question avoided in this article : what will be the impact on NON-executive morale if executive compensation does not share the pain of Covid-A9 ?

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