During the COVID-19 pandemic, many public issuers have experienced increased share price volatility and significant share price decline. As a result, the value of their outstanding equity awards and certain cash incentives have decreased, and in some cases, those awards now provide their management teams with little or no value.
As the initial shock and emergency response to the pandemic now transitions to a period of uncertainty—where the pace and stability of business re-openings and market reactions remain in doubt—companies will need to consider how best to incentivize their executives in circumstances of fluctuating share prices and uncertainty in financial performance, while having regard to the long-term best interests of the company and its stakeholders. Since the Supreme Court of Canada's decision in BCE Inc. v. 1976 Debentureholders, boards of Canadian corporations have become accustomed to considering the interests of multiple stakeholders, including shareholders, employees, creditors, and governments, among others, when exercising their business judgment. In the United States, however, although there are a few states with corporate statutes permitting boards to recognize the interests of multiple stakeholders, Delaware (which has a majority of U.S. public companies) and most other U.S. states do not.
For many companies, it won't be until the 2021 fiscal year that their short-term incentives are crystallized, their outstanding equity awards next vest, and their next annual equity awards are granted. In the meantime, boards and compensation committees have an opportunity to begin analyzing and addressing the impact of COVID-19 on their compensation programs.
Taking a proactive approach to executive compensation, even in the face of this uncertainty, will be important to ensure the board and management team are properly aligned.
Boards and compensation committees will want to understand the current and potential effects of COVID-19 on the financial health of the company—and, by extension, compensation performance targets and payout potentials. Given the volatility in the capital markets, the uncertainty surrounding re-opening the economy, and the uneven impact of COVID-19 across industries and geographies, such assessments at any given time may be weak predictors of year-end results. Nevertheless, boards and compensation committees should model various year-end scenarios, including scenarios in which outstanding stock options are underwater, cash flow is a concern and incentive plans may require modifications. Taking a proactive approach to executive compensation, even in the face of this uncertainty, will be important to ensure the board and management team are properly aligned and have a shared understanding of the company's near and long-term goals.
Boards and compensation committees should adopt a pre-meditated and well-informed approach in dealing with compensation decisions. Their plan too should have regard for the company's long-term compensation philosophy, and include consultation with external tax, accounting, legal and other experts and advisors as necessary.
What leaders should think about
Assessing performance and adjusting payouts
The impact of the pandemic will likely mean that some short-term and long-term performance measures may be impossible to achieve, and consequently awards may no longer have any incentive value. Boards and compensation committees should revisit the performance measures underlying their short-term and long-term incentive arrangements, consider how the current environment has impacted these measures and assess how company performance may recover over the coming months and years. Consideration must also be given to the overall health of the business, the effects of COVID-19 on employees and shareholders and potential stakeholder reactions to compensation decisions in the current environment.
Adjustments to outstanding performance-based awards are generally viewed negatively by investors and proxy advisors. Boards will need to carefully balance the views of investors with the long-term best interests of the company and the need to incentivize and retain key members of management. As a result of the uptick in global stock markets and the gradual reopening of the economy through the second quarter of 2020, we expect many companies will wait until later in the year or after year-end before making any final decisions regarding performance targets and whether any exercise of discretion by the board to modify targets or plan terms may be warranted.
If adjustments to performance measures are pursued, moving to relative performance measures may be more palatable to shareholders and other stakeholders.
As many companies particularly hard-hit by the pandemic have announced pay reductions at the senior management level and have implemented mass layoffs, consideration should be given as to what extent paying out annual bonuses would be appropriate for 2020. While reduced or deferred annual bonuses may be appropriate and prudent in the short-term, for performance measures that span a period of 3 years or longer, some adjustments may be worthy of consideration.
Whether to proactively adjust targets, revisit targets following year-end or acknowledge that targets aren't expected to be achieved depends, in part, on the nature of the targets. For example, if targets are based on relative total shareholder return or other performance metrics relative to a company's peers, the targets may still be appropriate. However, if targets are based on operating metrics compromised by the pandemic, or on share price appreciation or return multiplies which are impossible to achieve, some companies may consider supplementing or replacing current performance targets with targets that track pandemic-driven business conditions, operating initiatives and crisis management plans. These changes could help compensate executives, employees and boards that are engaged in extraordinary efforts in response to the pandemic.
If adjustments to performance measures are pursued, moving to relative performance measures may be more palatable to shareholders and other stakeholders as opposed to lowering or removing certain performance thresholds in their entirety.
Underwater stock options
A precipitous drop in share prices may mean a company's recent option grants are significantly underwater (i.e., when the exercise price of the stock option is above the current share price). For these stock options, there is no incentive value in the short term. However, as stock options typically remain outstanding for upwards of ten years and given the recent rally in the stock markets, there is a possibility that they will recover in the longer term. For stock options approaching their expiry date, share prices may not recover in time.
In addition to management incentive considerations, having a large number of underwater stock options outstanding for a long period of time creates overhang, which may put pressure on a company's equity plan share reserve. As a result, some companies are considering whether repricing options may be necessary or desirable.
Option repricing is typically met with considerable scrutiny from investors and other stakeholders. Stock options are intended to be long-term incentives that align the interests of management with shareholders. Option repricings, however, provide relief to option holders while shareholders are required to wait until the share price rebounds. Boards considering option repricing will therefore need to carefully balance appropriately incentivizing management and encouraging retention with acting more broadly in the best interests of the company, including all stakeholders.
Companies that are looking at some form of option repricing will need to consider:
- who will be eligible to participate in the repricing, including senior management and directors, and how that may impact whether shareholders approve the repricing as well as the results of a company's say-on-pay vote;
- which outstanding stock options are eligible for the repricing (e.g., only stock options with an exercise price above a pre-determined share price, or only those that have been outstanding for a minimum amount of time);
- the views of proxy advisory firms regarding repricings and the potential negative reactions from its shareholders, employees, creditors and other stakeholders; and
- if a stock option repricing is effected through an exchange on a value-for-value or other basis of lower priced stock options for the underwater stock options (as opposed to a unilateral reduction in the stock option price), it could implicate the U.S. issuer tender offer rules if the exchange offer is extended to persons in the United States.
Stock exchange requirements and shareholder approval
- Shareholder approval is generally required under stock exchange rules for any amendment to an equity plan that contemplates the potential issuance of shares from treasury, unless the plan permits such amendment without shareholder approval.
- Equity plans typically specify that shareholder approval will be required for any repricing of stock options but generally provide flexibility for the board to adjust vesting provisions (including adjustments to performance thresholds). For TSX and TSX-V listed issuers, disinterested shareholder approval (majority approval) is required for any repricing of stock options held by insiders. Insiders who hold stock options that will benefit from the repricing are not eligible to vote any securities they hold in respect of the shareholder approval.
- A cancellation of stock options followed by a new grant of stock options with different terms within three months will be viewed as a repricing by the TSX.
- A cancellation of stock options followed by a new grant of stock options within one year will be viewed as a repricing by the TSX-V. In addition, among other conditions, TSX-V issuers may only reprice stock options that have been outstanding for at least 6 months and must obtain TSX-V approval of any repricing.
- Under the NYSE and Nasdaq rules, a stock option repricing would generally require shareholder approval unless the equity plan specifically permits repricing. A plan which is silent on repricing will be deemed to prohibit it. However, in the case of foreign private issuers, both the NYSE and Nasdaq will defer to home jurisdiction stock exchange rules.
Proxy advisory firms and public perception
Adjustments to outstanding awards and amendments to equity plans will generally trigger shareholder disclosure obligations in an issuer's next annual proxy circular, regardless of whether the adjustments require shareholder approval. This disclosure would include a description of any changes made and any discretion exercised by the board or compensation committee in assessing performance measures or otherwise adjusting compensation arrangements for its senior management team. Accordingly, it will be important for issuers to provide a clear and compelling rationale for any such changes.
Proxy advisory firms
Glass Lewis recently noted that1: i) effective disclosure and rationales provided by issuers will be particularly critical in determining whether changes made as a result of the COVID-19 pandemic are justified and address material shareholder concerns; ii) it will assess the reasonableness of proposed changes and outcomes by considering if they are consistent and in proportion to the impact on shareholder interests and employees; and iii) particularly with regard to executive pay, Glass Lewis expects boards and compensation committees to proactively seek changes that align with employee and shareholder experiences, recognizing that executives might need to take a pay cut.
Institutional Shareholder Services (ISS) is encouraging boards and compensation committees to provide contemporaneous disclosure to shareholders of their rationales for making adjustments to their 2020 compensation programs in advance of their 2021 annual general meetings2. It believes this disclosure will provide shareholders with greater insights now and next year into the board or compensation committee's rationale and circumstances when the changes are made. ISS is generally not supportive of changes to outstanding long-term awards. It will evaluate any changes made to outstanding long-term awards on a case-by-case basis to determine if appropriate discretion was used and if adequate explanation was provided to shareholders of the rationale for the change.
Glass Lewis and ISS will generally recommend voting against any proposals to reprice stock options. Proxy advisors take a broad view of what constitutes a repricing but will address every situation on a case-by-case basis. Any time an underwater stock option is cancelled prior to expiration and effectively replaced, they will assess whether to apply their repricing policies.
Companies, particularly in sectors that have been hit hardest by the pandemic, will need to be mindful of public perception, potential reputational damage and overall scrutiny that could arise from compensation decisions that are perceived as protecting executives' interests relative to employees and shareholders. The Government of Canada has indicated that recipients of its Canada Emergency Wage Subsidy will be listed on a public database. As a result, companies that are in receipt of public funds may want to consider whether executive compensation adjustments are appropriate in the circumstances.
In Canada, certain companies will be eligible to access loans under the Government of Canada's Large Employer Emergency Financing Facility (LEEFF), which aims to provide financing to large employers whose needs are not being met through conventional financing. The government has noted that companies accessing the LEEFF program will be subject to certain operating requirements, including executive compensation restrictions. Companies seeking loans under this program may need to make more significant changes to their compensation programs to comply with these restrictions.
Organizations that need to preserve cash may also consider changing their director compensation programs going forward to provide less cash and more long-term equity-based awards, such as deferred share units.
Similar considerations apply in the United States. Most notably, employers receiving certain federal loans, loan guarantees or other investments or support may be required to freeze or even cut back compensation (including severance) above certain thresholds to officers and employees for the period of the applicable loan, guarantee or other investment plus an additional twelve months (or longer in certain industries).
Shifts in compensation approach
Companies that anticipate that the pandemic will have substantial, long-term impacts on their business may need to consider adjusting their approach to executive compensation more significantly. Performance targets that are measured relative to peers are adjustments worth considering, if it is in-line with market practice to do so. Companies looking to preserve cash may consider shifting a larger percentage of total compensation to longer-term programs and equity-based awards. Future performance-based equity grants may incorporate different performance targets to reflect a company's revised mid-term and long-term priorities in response to COVID-19.
Companies may also be contemplating changes to their director compensation programs. Some companies that are going through particularly challenging times have begun to announce cuts or freezes to the annual retainers for their directors. Organizations that need to preserve cash may also consider changing their director compensation programs going forward to provide less cash and more long-term equity-based awards, such as deferred share units.
With no sign as to when markets and business conditions will stabilize, boards and compensation committees may benefit from taking a "wait-and-see" approach before implementing any significant changes to their compensation programs. However, it would be prudent for boards and compensation committees to begin reviewing their compensation arrangements, what impact the pandemic has had, and what alternatives may be pursued if adjustments are found to be necessary or desirable. Any decisions with respect to executive compensation should be made holistically, with consideration given to all stakeholders—and with a view to the long-term best interests of the company.
1. Glass Lewis, Everything in Governance is Affected by the Coronavirus Pandemic. This is Glass Lewis' approach.
2. ISS, Impacts of the COVID-19 Pandemic - ISS Policy Guidance.
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