The Top Six Employee Compensation Questions in a Downturn

The Top Six Employee Compensation Questions in a Downturn

November 21, 2022, Covington Alert

Multinational companies navigating a global recessionary environment face many questions about their workforce planning and structure, and the potential impact of outside macroeconomic forces on their compensation and benefits programs. This alert explores six key questions that companies and employees may ask about their compensation and benefits programs as they brace for a possible global recession.

1. Should Incentive Plan Performance Targets Be Adjusted?

Many companies grant annual cash bonuses and performance-related equity awards that are based on the satisfaction of pre-determined corporate and individual performance targets. These targets may become harder to achieve as a result of a global recession. Beginning with the widespread impact of the COVID-19 pandemic, it has become increasingly common for companies to consider potential adjustments to corporate-level targets in light of macroeconomic conditions. Before any changes may be made, corporate boards and compensation committees should scrutinize plan documents and award documentation to confirm whether and how changes may be made. In addition, listed companies should be mindful of the impact any performance target adjustments may have on public disclosures, shareholder perception and relations, “say on pay” voting in the U.S., and new SEC guidance on “pay versus performance” disclosures.

2. Can We Unilaterally Reduce Compensation or Benefits?

Outside of pure workforce reductions (which we covered in our earlier series of alerts on Recession Risk and Workforce Reorganizations, many companies will look to reduce compensation and employee benefits in an effort to contain costs while maintaining an adequately-sized workforce. In the U.S., outside of the collectively-bargained context, employees have little recourse against their employers if the company initiates reductions in compensation or benefits. Generally, employers’ concerns are primarily focused on retaining high performers, managing public relations, and preserving as much morale as possible.

Outside the U.S., however, the rules are vastly different. Broadly, if benefits are contractual it will be hard to reduce them unilaterally without risking breach of contract / constructive dismissal claims. If benefits are non-contractual, reduction may be easier but could still depend on having an express power in the relevant plan rules to reduce or amend benefits. Some types of benefits may be protected under statutory regimes (for example, pensions), which may significantly restrict an employer’s ability to reduce them. Where a significant change to terms and conditions is planned, this may also trigger obligations to inform and consult with employee representatives, such as works councils or union representatives, prior to implementing the change.

3. Will We Have Enough Shares to Continue Making Equity Grants?

In a down market, companies that grant equity awards expressed as a fixed dollar value on the grant date will issue more shares pursuant to these grants than anticipated, thus depleting share reserves more quickly. Depending on the circumstances, companies generally have two choices for how to manage an unexpectedly high “burn rate” for share reserves: increase the share reserve or decrease the number of shares issued as employee grants. 

Increasing the share reserve is often the first choice for many companies, but this approach has its drawbacks and complications. Increases to share reserves require shareholder approval, which for listed companies involves disclosures, proxy voting, and the input of institutional proxy advisors. Because shareholder votes are typically tied to the annual meeting cycle, if a company wishes to increase its reserve, planning must begin early to ensure that the request has been properly sized and vetted.

Alternatively, companies might consider mitigation strategies like delaying new grants, offering all or a portion of some awards in cash rather than equity, or granting awards contingent upon future shareholder approval of an increased share reserve. Companies may also consider using a price-averaging mechanism (rather than a one-day spot price) when converting target award values into shares as a way of smoothing short-term price volatility.

4. What Can Be Done About Underwater Stock Options?

Stock options may become significantly underwater in a global recessionary environment. Companies with substantial tranches of underwater options often consider repricing underwater options or implementing a stock option exchange program, whereby underwater options can be tendered to the company in exchange for a lesser number of new stock options at a lower exercise price, new shares of restricted stock, restricted stock units or similar equity awards. Repricings and exchange programs are subject to restrictions in plan documents and, for U.S. public companies, stock exchange listing standards, and shareholder approval is generally required. In addition, a stock option exchange program may also have to comply with the Securities and Exchange Commission’s (SEC) tender offer rules, which among other things, require the filing of a Schedule TO with the SEC and a minimum offer period of 20 business days. U.S. public companies should also consider any disclosure obligations that can arise as a result of these actions. Companies should also confirm whether repricings or exchanges of underwater options granted to individuals outside of the U.S. count as new grants for purposes of local securities or exchange control laws, and/or risk giving rise to employment-related claims under local law if an employee is able to show “detriment”.  

5. Should Employer Contributions to 401(k) Plans Be Reduced or Suspended?

Companies that offer a matching contribution or non-elective contribution under a U.S. tax-qualified defined contribution retirement plan may consider whether to reduce or suspend such contributions as a cost-cutting measure. Companies will need to review their plan documents with their benefits counsel to determine whether any amendment to the plan document is necessary to effect such action, to ensure compliance with IRS rules on the suspension of contributions, and to prepare any required participant notices. Companies with “safe harbor” plans must take care to ensure that any such reduction or suspension is permitted under the tax rules applicable to “safe harbor” plans.

6. What Changes Can Be Made to Non-Qualified Deferred Compensation?

Many global companies issue awards that are subject to the non-qualified deferred compensation rules under Section 409A of the U.S. Internal Revenue Code, or operate non-qualified deferred compensation plans (such as supplemental executive retirement plans or SERPs) that are subject to the same set of rules. These rules heavily restrict a company’s or individual’s ability to change the time or form of payment, particularly in any way that might accelerate or delay payment from when it would otherwise have been made. Due to the broad scope of Section 409A, many compensation arrangements can be implicated, even if they do not look or act like traditional deferred compensation plans. Before making any changes to awards already issued, any non-qualified deferred compensation plans, or any other arrangements that in form or practice provide for payments in a year after the year in which the right to the payment arises, companies should consult with their benefits counsel to determine whether Section 409A will permit the change.

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If you have any questions concerning the material discussed in this client alert, please contact the members of our Global Workforce Solutions practice.