In the wake of the market disruption caused by the COVID-19 outbreak, a number of employers have announced temporary salary reductions as a means of conserving cash, and thus demonstrating sound stewardship. This memorandum discusses key considerations for companies and boards that are contemplating a salary reduction program for members of executive management.

Existing Contractual Entitlements

Definitions of Good Reason

Companies considering implementing a base salary reduction for executives should begin with a careful review of their existing contractual requirements to determine whether the reduction could trigger the right of an executive to terminate employment for "good reason." "Good reason" (or constructive termination) rights may arise under employment agreements or in severance plans. "Good reason" triggers may also engender consequences under equity or incentive compensation arrangements and deferred compensation plans.

Each arrangement that includes a "good reason" construct should be analyzed to determine whether the contemplated reduction in base salary could trigger an argument of constructive termination. The company ought to consider whether the salary reduction is significant enough to cause a trigger if the "good reason" definition is qualified by materiality and if "good reason" is triggered when the salary reduction is part of an across-the-board program that reduces salaries for the entire company or similarly situated employees. If it is determined that the salary reduction could trigger "good reason," employers should seek consent and waivers from the executives before proceeding.

Employment agreements should also be reviewed to determine whether the salary reduction may give rise to a breach of contract claim because it provides that the executive is entitled to a stated salary that may not be reduced.

Severance Entitlements, Annual Bonus Targets and Benefit Plans

Because severance formulas and bonus targets are often based on a multiple of base salary, base salary reductions may have follow-on consequences on severance payments and bonus plans. Consequently, all arrangements that use base salary as a formulaic input should be reviewed to determine whether any modifications are advisable (for example, by resolving to use the pre-reduction salary or by not using salary at all).

Other considerations include the impact that a base salary reduction would have on retirement plan contribution levels and other benefits that involve payroll deductions under existing company benefit plans. With 401(k) plans for instance, if base salary is reduced to $0, there can be no employee contribution and no employer match; further, plan loans may be affected (for a discussion of how COVID-19 responses generally may affect qualified retirement plans, see our recent publication, Qualified Retirement Plans During COVID-19: The CARES Act and Other Considerations). Company benefit plans, like flexible spending account plans, should be reviewed to determine what effect a salary reduction would have on benefit or contribution levels, and executives should be advised of that impact and whether their elections can be altered.

Share Ownership Guidelines

Share ownership guidelines may provide that executives must own shares of company stock equal in value to a specified multiple of annual base salary. Companies with such guidelines should consider whether the pre-reduction salary multiple remains the proper benchmark if a salary reduction has been agreed. Because many base salary reductions are temporary, companies may choose to retain the pre-reduction salary multiple under their share ownership guidelines. Companies should also take into account that, with lower share prices, executives may be forced to purchase more shares in order to meet the ownership thresholds at a time when they are earning a reduced base salary if no adjustment is made. As a result, it may make sense to adjust the ownership multiple while the temporary salary reduction is in place, set a fixed number of shares as the milestone instead of, or in conjunction with the base salary measure, or temporarily suspend the share ownership requirement while simultaneously prohibiting any sales of shares by a covered executive so as to lock in their current ownership levels. Companies with share ownership guidelines that are not based on a multiple of salary may not face this issue, but should take care in monitoring compliance with share ownership guidelines, especially while market prices are volatile.

Public Disclosure

A material reduction in the base salary of a named executive officer (within the meaning of Item 402(a) of Regulation S-K) will trigger a company obligation to file a current report on Form 8-K, as will a material modification to any such named executive officer's compensation arrangements (for example, executive severance entitlements) that are undertaken in connection with the reduction. Companies can use this disclosure requirement as an opportunity to frame the salary reduction to the market and show their executives sacrificing in tough times and leading by example. This message can also be carried through to communications to employees.

Section 409A Considerations

Companies should consider whether the desired salary reduction program is to be structured as a reduction in base salary for a temporary period or, instead, is actually an intention to defer the salary payments. Deferrals can take the form of delayed salary payments or salary payments replaced with other consideration, such as equity awards. A company that structures its salary reduction program as a deferral to a later date (whether or not payment is dependent on continued service to such date) may unwittingly create a deferred compensation arrangement that is subject to Section 409A of the Internal Revenue Code ("Section 409A").

Deferred compensation arrangements subject to Section 409A must comply with specific timing rules governing when deferral elections can be made. Companies and executives should bear these required deferral election timing rules in mind when structuring changes. Companies should be mindful of any payment that is expected to occur other than in the 2020 calendar year, or the short-term deferral period thereafter.

These and related issues will be discussed in more detail in our upcoming memorandum focused on Section 409A and COVID-19. 

Labor Law Considerations

Companies considering salary reduction programs must consider and comply with applicable federal, state and local wage and labor laws. The points below apply to executive salary reductions, but require special attention if the program will extend beyond the executive management team to rank and file employees.

The first consideration is the Fair Labor Standards Act (FLSA), which requires among other things, the payment of a minimum wage and an overtime premium. Executives are generally classified as "exempt" under the FLSA. However, an executive (or other exempt employee) whose salary is reduced below the minimum salary that is required for exempt status (currently, $684 per week) will lose the exemption. Moreover, states have their own minimum wage and overtime laws with differing exempt salary requirements, so employers will need to verify state minimums to ensure proper classification.

Further, salary reductions must be prospective to comply with FLSA (and state law) requirements on earned wages. As a result, any salary reduction should not go into effect until the beginning of a pay period for which the employee has not performed any work. Relatedly, companies should ensure that payment entitlements accrued prior to the salary reduction are paid out at the salary level prior to the reduction.

Rank and file salary reductions should be applied using objectively defined categories of employees, such as a salary band, so that arguments of disparate impact can be mitigated. Other considerations may arise as a matter of applicable state and local law. For instance, any applicable state constructive termination rules or advance notice requirements should be reviewed.

To the extent that salary reductions are part of a broader program that includes furloughs or layoffs, other laws and considerations may be implicated. Employers considering such programs may see our recent publication, Key Considerations in Employee Terminations.

Our Take

The implementation of a management salary reduction program can serve to both conserve cash and demonstrate to employees that leadership is willing to make personal sacrifices in tough times. Notwithstanding the good intentions behind these reductions, the full impact of these potential changes should be considered and evaluated by any company before undertaking such a change.

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.