Economic disruptions resulting from the COVID-19 pandemic have caused many employers to make changes to employee compensation, such as reducing or deferring base salaries, as part of cost-cutting measures.
Bonus programs and other performance-based compensation arrangements are also being impacted, but in different ways. One significant effect is that performance goals that once looked achievable may now be out of reach. Companies are therefore having to decide whether to make changes to the performance goals to reflect the new economic reality.
The decision whether to modify performance goals will be specific to each company, but should be based on a systematic evaluation. A checklist of 10 key questions to ask in deciding whether to modify performance-based compensation is below.
|Question||Factors to Consider|
|1. Which performance-based compensation programs are likely to be impacted?||The programs most likely to be directly affected are:
• Annual bonus
• Long-term bonus
• Equity-based compensation
|2. Are adjustments to performance goals permitted and, if so, what approvals or consents would be needed?||• Whether adjustments are permitted will depend on the terms of the plan documents.
• The level of approval required – Board, Compensation Committee or management – will be determined by the company’s governance structure and practices.
• Participant consent may be required if the performance goals are part of a contract with the participant.
|3. Would an adjustment to performance goals be consistent with the company’s goals for its incentive compensation programs?||• What is the probability of achieving the original performance goals?
• What is the likely magnitude of the miss?
• How was performance trending prior to the economic shutdown?
• How does the company’s performance compare to peers who are also experiencing the economic downturn?
• What would be the retention and incentive impacts of not adjusting performance goals?
• Is there an existing precedent or policy that applies to this situation?
• What would be the precedent-setting impact of adjusting or not adjusting?
|4. What would be the accounting impact of an adjustment?||• For cash-based awards, accruals may need to change.
• For equity-based awards, a modification could trigger an accounting charge.
|5. Would an adjustment affect the participants’ ability to defer compensation?||• If participants would normally be permitted to make an election to defer their incentive compensation until up to six months before the end of the performance period under the special Code Section 409A rule for performance-based compensation, an adjustment to the performance goals may disqualify the compensation for the special rule.
• This could mean that there would be no opportunity to defer any incentive compensation that is earned.
|6. When would be the right time to make an adjustment?||• Making the adjustment early could help preserve employee motivation and avoid the potentially demoralizing effects of unachievable performance goals.
• However, making the adjustment before the full impact of the economic downturn is known could result in unanticipated outcomes or a need for multiple adjustments.
|7. Are there alternatives to adjusting performance goals that may be preferable?||• Alternatives may include granting new or additional awards, making discretionary payments or repricing stock options.|
|For Publicly Traded Companies Only:|
|8. What disclosures would be required as a result of an adjustment?||• To the extent the adjustment results in payment to any of the company’s named executive officers that would not have been made absent the change, current disclosure on a Form 8-K may be required.
• Even if disclosure on a Form 8-K is not required, the adjustments will need to be discussed in the Compensation Discussion and Analysis section of the company’s Proxy Statement to the extent named executive officer compensation is affected.
|9. How will proxy advisors and investors react?||
• Two of the leading proxy advisory firms, ISS and Glass Lewis, have issued guidance addressing how they will evaluate adjustments to performance-based compensation in the current environment.
o ISS provided no general relief from its general policies that are not supportive of mid-cycle changes to performance goals. However, the firm suggested it would evaluate changes and the company’s rationale on a case-by-case basis and encouraged contemporaneous disclosure of the rationale for changes.
|10. Would an adjustment impact the grandfathered status of any performance-based compensation?||• The 2017 repeal of the exception for “performance-based compensation” from the $1 million deduction limit under Code Section 162(m) means that most performance-based compensation is fully subject to the limit and the former deadline of 90 days into the performance period for setting performance goals no longer applies.
• However, some companies may still have grandfathered compensation arrangements, and a change to performance goals under any such arrangements may jeopardize their grandfathered status.
As companies continue to evaluate how to respond to the economic consequences of the COVID-19 pandemic, their approach to performance-based compensation may have important and long-lasting effects on employee retention and motivation. The foregoing checklist is only a summary. Any changes to compensation programs should be undertaken thoughtfully only after comprehensive analysis of the legal, tax and accounting implications.