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Davis Polk Discusses Reductions in Executive Pay Due to Covid-19

  • Kyoko Takahashi Lin and David Mollo-Christensen

    • The coronavirus (COVID-19) pandemic and the ensuing market uncertainty, as well as recently enacted legislation, have upended the compensation and benefit programs of many companies. This is the fifth memorandum in a series of client memoranda that we are preparing regarding how companies may wish to consider addressing their compensation programs in this context.[1]

    The recent market volatility has disrupted many companies’ day-to-day operations resulting in economic hardship that has caused companies to consider or implement various measures to reduce personnel costs, including pay cuts, furloughs and/or layoffs. When implementing such personnel cost-cutting measures, a number of companies have reduced executive pay,[2] including reductions in base salary and bonus opportunities,[3] and some have also reduced director retainers. This memorandum summarizes the actions that a number of companies have already taken and provides guidance for companies considering reductions in executive or director pay.[4]

    Do reductions to executive pay need to be approved by the company’s board of directors or compensation committee?

    It depends. Reductions to base salary and bonus opportunities for executive officers are generally, although not always, required to be approved by the compensation committee of the board. Companies should review their corporate governance documents, in particular their compensation committee charter, in order to ensure that any such reductions do not require approval by the full board.[5] The resolutions adopting a bonus program should also be reviewed as they may contain a delegation of authority to take certain actions with respect to the program, including a delegation of administrative authority from the board to its compensation committee.

    Companies should also consider whether to approve salary reductions for an indefinite period, or instead, to approve the reduction for a fixed period of time with the potential to later extend the time frame in which the reduction will apply. In either case, companies may want to consider whether the approval should include a requirement that the base salary being reduced will be reviewed and reassessed in the future (for example, at the end of each fiscal quarter of 2020).

    Are there contractual issues for companies to consider when deciding whether to reduce executive pay?

    Yes. There are a number of potential existing contractual issues that companies should consider prior to implementing a reduction to executive pay:

    What are some other considerations for companies to take into account when deciding whether to reduce executive pay?[6]

    How much of a reduction are companies typically approving?

    It varies. Companies should consider their individual circumstances when determining whether and the amount by which to reduce their executive-level compensation.

    Are public companies required to disclose reductions in executive pay?

    It depends, and, in any case, the timing and the location of the disclosure may vary. We expect that regardless of technical disclosure requirements, many companies will want to make such reductions public, either for internal employee morale or investor relations purposes, to demonstrate that the executive team is sharing in the challenges being faced by its employees and shareholders.

    Can a current reduction in executive pay be exchanged for some other right to future compensation?

    Yes, but be aware of tax considerations. Companies that are primarily concerned with reducing costs in the short term may wish to consider implementing base salary reductions now, in exchange for some other right to future compensation. Such later payment may be in the same form (i.e., cash) and in an amount equal to the base salary reduction amount or in the form of other consideration, such as equity awards. For example, some companies have considered granting restricted stock units in place of the foregone salary. Such grants can only be made in place of prospective salary and not salary that has already been earned (even if unpaid).

    Companies that choose to provide for any such make-up payments, specifically if the make-up payments will be paid after the 2020 calendar year, should do so with caution, because such an arrangement could constitute an impermissible deferral of base salary under Section 409A of the Internal Revenue Code (Section 409A). Generally, in order to be exempt from Section 409A under Section 409A’s short-term deferral rules, payments need to be made by March 15 of the year following the year in which the payments are no longer subject to a “substantial risk of forfeiture.” Although the rules under Section 409A are not entirely clear, if the make-up payments are paid, and in the case of restricted stock units, if such units vest and settle, by March 15 of the year following the year in which the salary reduction occurred , the make-up payments will likely be exempt from the Section 409A requirements under the short-term deferral exception.[15] If the make-up payments are not exempt from Section 409A, then any deferral of base salary would be required to comply with the specific timing rules that govern when deferral elections can be made.[16]

    For deferrals of performance-based incentive compensation, including annual bonuses, there is more flexibility in the timing rules, because deferral elections can be made up to the date that is six months before the end of the applicable performance period, as long as the amount of the performance-based compensation is not readily ascertainable.[17] Companies that have not yet set their annual incentive plans for 2020 may wish to consider the salary reductions in setting threshold, target and maximum performance levels and the amounts that may be earned at each level. However, as noted above, executives often have contractual rights to receive bonuses within a predetermined and pre-negotiated time period, so any deferral of such payments may require the consent of the executive.

    Are companies taking action with respect to director compensation?

    Yes, although a smaller number than those taking action with respect to executive pay. In connection with reductions in executive pay, a number of companies have reduced or have considered reducing annual director cash retainers and equity awards. While a decrease in director compensation is not required to be reported on Form 8-K, as Item 5.02(e) is not triggered by changes in director compensation, a number of companies have chosen to voluntarily disclose this information. So far, nearly 40% of the companies that we have observed disclosing reductions in executive pay have also disclosed reductions in director retainers.

    Companies should review their governing documents to confirm whether there are any approval requirements for reductions in director retainers. Director compensation may be covered by the compensation committee charter or by the company’s corporate governance guidelines and/or the nominating/corporate governance committee charter, depending on which body is responsible for director compensation. In the absence of committee authority, a reduction in director compensation could be approved by the full board.

    Similar to reductions in executive pay, companies will also want to keep in mind that ISS recently adopted a non-employee director “excessive compensation” policy where ISS indicated that it will target companies with director pay in the top 2% of their ISS-determined peer group. We recommend that companies monitor whether their ISS-determined peers are reducing director pay in order to avoid inadvertently falling under the ISS director “excessive compensation” policy by virtue of not reducing their own directors’ pay.

    In Conclusion

    Companies that are, or may be, considering reducing either executive or director compensation should consider the necessary approval and disclosure requirements and requirements under federal, state or local law, along with the implications such reductions may have for existing contractual arrangements and benefit programs and the impact on other related calculations such as stock ownership requirements and computations under the Golden Parachute Rules. Evaluating these direct and indirect impacts can facilitate companies acting in a proactive and thoughtful manner both with respect to the structure and rollout of any pay reduction program, and the manner in which such reductions in pay are communicated to executives and directors, other employees of the company and stakeholders generally.

    ENDNOTES

    [1] Please see our previously published client memoranda:

    [2] Throughout this memorandum, for purposes of public companies, we use the term “executive” to refer to the company’s “executive officers,” as defined by Rule 3b-7 under the Securities Exchange Act of 1934 (Rule 3b-7), but both public and private companies may be considering these actions for a broader group of senior management. Rule 3b-7 defines the term “executive officer” as a company’s “president, any vice president of the [company] in charge of a principal business unit, division or function (such as sales, administration or finance)” or “any other person who performs similar policy making functions.”

    [3] While reductions in annual bonus opportunities are not as common, some companies have already reduced or eliminated executive bonuses for the 2020 fiscal year.

    [4] Companies that receive financial assistance through certain programs established under the Coronavirus Aid, Relief, and Economic Security (CARES) Act are subject to limitations on employee compensation, which are discussed further in Question 3.

    [5] A compensation committee charter may only cover “executive officers” for purposes of Rule 3b-7. Companies that are considering a pay reduction for other members of the company’s senior management team should review their policies to determine the required approvals, if any, for such reductions.

    [6] For other actions that companies have taken in respect of their 2020 incentive compensation programs in response to COVID-19, please see our previously published client memoranda: COVID-19: Considerations for Companies That Have Already Established Their 2020 Incentive Compensation Programs.

    [7] An executive’s base amount is three times the average amount of taxable compensation that the executive received over the five-year period immediately preceding the change in control. This means that a reduction in base salary will also reduce the executive’s base amount, which could negatively impact the company and its executives by triggering the application of the Golden Parachute Rules or increasing the lost deductions and amount of excise tax owed.

    We note that, for public companies, the loss of the tax deduction may be a lesser concern to the company because the recent changes to Section 162(m) of the Internal Revenue Code effectively make all compensation for a calendar year above $1 million for its most senior executives non-deductible and significantly expand the scope of executives that are subject to this deduction limitation. However, the applicability of the excise tax on the executive was not affected by the Section 162(m) changes, so the reduction in the executive’s base amount resulting from a salary reduction could be a real issue, especially for executives at companies that may be a likely takeover target.

    [8] For airlines receiving funds under the payroll support grant program, the limits apply until March 2022. For companies that receive a direct loan or guarantee from the Treasury Department or participate in the Main Street Lending Program, the limits apply until one year after the loan or guarantee ceases to be outstanding. For more information on the Main Street Lending Program, please see our visual memo.

    [9] Beginning in March 2020, we have tracked Securities and Exchange Commission filings that disclose company actions taken with respect to compensation as a result of the COVID-19 pandemic. Our findings are based on a review of those filings that have disclosed executive salary and director retainer reductions, which we discuss in Question 7.

    [10] Named executive officers, as defined by Item 402 of Regulation S-K, typically include any individual who served as the chief executive officer or the chief financial officer of the company in the last completed fiscal year and the next three most highly compensated executive officers who were serving as executive officers at the end of the last completed fiscal year. For companies that are smaller reporting companies or emerging growth companies, named executive officers include any individual who served as the chief executive officer during the last completed fiscal year and the next two most highly compensated executive officers who were serving as executive officers at the end of the last completed fiscal year.

    [11] If an executive’s employment agreement has been filed as an exhibit with the company’s Form 10-Q or Form 10-K, then any amendment to that employment agreement in connection with the reduction in pay is required to be filed as an exhibit with the company’s next Form 10-Q or Form 10-K.

    [12] For a more detailed overview of the ISS Guidance, please see this blog post published on the Davis Polk Corporate Governance blog.

    [13] Companies classified as smaller reporting companies and emerging growth companies are not required to include a Compensation Discussion and Analysis section in their proxy statement.

    [14] One item that companies may want to consider in their communication of executive pay reductions to rank-and-file employees is providing the appropriate amount of information and context so as to assuage any fears that the rank-and-file employees may have of an imminent reduction to their own salaries or other compensation, to the extent the company is not intending to, or does not want to reserve discretion to, reduce compensation for rank-and-file employees.

    [15] If the amount of the make-up payment is “materially greater” than the foregone salary and the executive is required to remain employed through the date of the make-up payment, then it is likely permissible for such make-up payments to be extended past March 15 of the year following the year in which the salary reduction occurred, but the guidance from the Internal Revenue Service on this point is not entirely clear. Treas. Reg. § 1.409A-1(d)(1). The Office of the Chief Counsel of the IRS has issued advice indicating that a 25% increase is “materially greater.”

    [16] Treas. Reg. § 1.409A-2(a). Failure to comply with these specific timing rules can result in adverse tax consequences to the executive. If payments of nonqualified deferred compensation are made in violation of Section 409A, then the employee will be required to pay an additional 20% tax, on top of the ordinary income taxes on the noncompliant deferred compensation amount and underpayment penalties. For more information on deferral elections, please see our previously published client memoranda: COVID-19: Impact on Nonqualified Deferred Compensation Plans.

    [17] Treas. Reg. § 1.409A-2(a)(8).

    This post comes to us from Davis, Polk & Wardwell LLP. It is based on the firm’s memorandum, “Covid-19: Reductions in Executive Pay,” dated May 6, 2020, and available here.

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