As employers worldwide manage their response to the COVID-19 outbreak, their understandable focus has been on the immediate consequences and the management of their workforce – identifying whether and when employees should be asked to stay at home or come into the office, who must continue to be paid and what employment-related risks must be managed. (You can read more about this in our blog.)
It is, however, the time of year for many employers to set compensation terms for the year ahead and assess previous year performance.
Stock markets have taken a noticeable hit in recent days and the conditions for some businesses are likely to remain tough in the months ahead.
That may have an impact on any share-based employee remuneration (and, in turn, on employee motivation if they see the value of their options and awards on a downwards trajectory).
This may prompt employers to question whether and how to address the impact, either from the perspective of adjusting outstanding awards or in terms of structuring new equity awards.
We have looked at three key questions below.
1. Can performance conditions for outstanding awards be adjusted?
In simple terms, the answer is that most plans do contain a power to adjust performance conditions in certain circumstances. In practice, however, the ability to use that power may be limited.
In the UK, employee share plans usually contain provisions saying that the company may vary or waive the performance conditions applying to awards if any event or circumstance means that the conditions are no longer a fair measure of performance. This is usually subject to the caveat that the amended conditions must not be materially more or less challenging than the original conditions.
Companies will want to understand the impact of the current market on their performance conditions – and may need to speak with their auditors on how significant the impact is.
But there is a risk that using a discretion to adjust performance conditions in the current climate would not be consistent with the spirit or intention of the adjustment mechanism in a share plan’s rules.
In particular, the difficulty here is that COVID-19 has a market-wide effect – poor performance against a performance target is likely to mean that poor performance has also been suffered by shareholders.
Shareholders are unlikely to be sympathetic toward any upward adjustment in these circumstances or any perception that conditions have been made easier to satisfy. They may also question the need for adjustments to address the (hopefully) short-term impact of COVID-19 against a longer term performance period of three years or more, during which period they may expect things to normalise.
That will particularly be the case for awards which are still at a relatively early stage in their performance period.
In addition to general powers to vary performance conditions, some plans may also give the company the power to adjust the ultimate vesting outcome derived from formulaic performance scorecards if it is determined that the outcome does not fairly reflect the actual performance.
However, these discretions are sparingly used and would generally apply only in exceptional circumstances (such as one-off corporate transactions). When they are used, this is most commonly to make downward adjustments.
In the rare case of making an upward adjustment, this would most typically be in response to circumstances that were considered to have produced an outcome that does not reflect the performance actually delivered.
UK-incorporated companies listed on the London stock exchange will also need to consider their remuneration policy for executive directors to assess whether there is a lawful basis for adjusting performance conditions part way through the performance period.
2. What can (or should) the Remuneration Committee do in respect of new equity awards?
There is a question for employers who are about to make grants as to whether or not they should have regard to the current, extraordinary market conditions.
Should they, for example, set performance conditions by reference to a low base which looks appropriate against the most recent share price performance, or in the expectation that the COVID-19 impact will be short-lived?
Equally, at what level should they pitch any TSR comparisons, bearing in mind that the rest of their peer group is likely to be suffering the same difficulties in the current market?
Some employers may even be thinking about disapplying performance conditions altogether, and granting only time-based awards (see the third question below).
As a practical matter, a 'wait-and-see' approach to long-term incentive awards might be appropriate for the time being, if that is permitted by plan rules, ie grant the award as normal, and consider further down the line whether an adjustment to performance conditions is required (bearing in mind there may still be complexities, as outlined above).
Given the lifespan of an average long-term incentive plan award, it may make sense to save any adjustments for the end of the performance period, rather than trying to build them in up-front.
Companies will also want to think about other potential impacts of making awards at a time when share prices may be low. For example, will dilution limits be breached if awards need to be made over a greater number of shares to ensure the award has a particular market value?
And if awards are granted over an unusually large number of shares, is there potential for a significant windfall when the share price recovers?
3. What can I do to incentivise employees in these difficult conditions, if a performance adjustment is not appropriate?
To the extent that the value of any outstanding awards which are further into their performance period is materially affected, possible options to keep employees motivated include:
- increases to short term compensation, eg in the form of retention payments or increased annual bonuses; or
- increasing the proportion of time-based awards granted, rather than performance-based awards.
Again, for UK-incorporated companies listed on the London stock exchange, any proposals in relation to directors must be considered carefully to ensure consistency with the shareholder-approved remuneration policy.
Communication is likely to be key – explaining to employees that any immediate impact on their share-based compensation may level-out over the coming months and/or that the employer is actively considering other steps to incentivise and retain employees whose share-based compensation has been impacted negatively.