July 21, 2020

Many companies are wrestling with whether to adjust in-progress performance share awards, where goals were set before the global pandemic and economic downturn began and awards may no longer motivate and retain key employees. Given continued economic uncertainty and broader workforce concerns, it may be inappropriate or premature to take action. But companies that want to explore alternatives to address “nonperforming” performance shares, should consider strategic factors and shareholders’ and proxy advisers’ perspectives, as well as accounting, disclosure and tax implications.

 

Assessing the situation

Performance shares are important to many companies’ pay programs. Typically, at the end of a multi-year period, employees earn a number of shares based on meeting predetermined goals, such as growth in earnings per share (EPS) or relative total shareholder return (TSR). If it’s not likely that goals will be met, performance shares may no longer motivate and retain employees but will continue to contribute to stock plan dilution because shares typically are reserved even if they are unlikely to be issued.

 

Companies considering action should evaluate the business case, including the following:

 

  • Number of shares remaining in stock plan reserves
  • Number of performance cycles affected and their scheduled end dates
  • Likelihood of achieving at least threshold performance under various performance scenarios
  • Whether current performance goals are absolute or relative, and whether awards already include a discretionary component
  • Level and number of employees affected
  • Status of other outstanding equity and cash awards
  • Whether broader workforce actions have been taken, such as pay cuts, layoffs, furloughs
  • Likely reaction of proxy advisers and investors
  • Regulatory implications

Strategies for nonperforming awards

Several alternatives to address nonperforming performance shares are shown in the following table:

 

Proxy adviser views

Investors and proxy advisers favor clear connections between performance and incentive plan payouts and generally take a dim view of making executives whole in an economic downturn.

 

ISS

Institutional Shareholder Services (ISS) generally doesn’t support midstream changes to long-term incentive awards but will review changes case by case to determine if directors exercised appropriate discretion and provided an adequate explanation. ISS will assess structural changes to long-term incentive plans under its existing benchmark policy frameworks. The proxy adviser urges real-time disclosure (e.g., on Form 8-K) of the changes and supporting rationale.

 

Glass Lewis

Glass Lewis cautions against executive pay changes that are inconsistent with the challenges workers are experiencing and is most likely to support changes that “take a proportional approach to the impacts on shareholders and employees”. The proxy adviser warns against “maintaining or even increasing executive compensation levels” and cautions that trying to make executives whole is a “certainty for proposals to be rejected and boards to get thrown out — and an open invitation for activists and lawsuits onto a company’s back for years to come.”

 

Regulatory considerations

Before changing in-progress performance shares, companies should consider the following plan document, accounting, disclosure, tender offer and tax issues.

 

Plan documents

Plan documents and award agreements typically specify the types of events that automatically trigger adjustments to goals. Companies should review these provisions although it’s unlikely they will cover pandemics and, even if they do, companies might find it difficult to isolate the impact of COVID-19 beyond direct costs (such as those related to disinfecting facilities, employee relief funds, increased sick leave, and hazard pay).

 

Companies should also review documents for the following:

 

•       Are there any restrictions on discretionary modifications or replacements?

•       Is participant consent required?

•       Will cancelling awards or converting stock-settled awards replenish the share reserve?

•       Will additional grants exceed the available share reserve or any plan individual limits?

 

Accounting

The accounting treatment of discretionary performance share cancellations, modifications, and replacements differs for awards with nonmarket (e.g., EPS or sales targets) vs. market performance conditions (e.g., TSR).  Automatic adjustments that are set out in the plan (“the committee shall adjust for …”) generally have no impact on compensation expense.

 

Nonmarket conditions. Companies recognize no cost for performance shares that are improbable of vesting or cancelled. Instead, companies must recognize any incremental cost associated with a modified or replacement award. The incremental cost is calculated by comparing the fair value of the award immediately pre- and post-modification. If an award is improbable of vesting or cancelled, the pre-modification fair value is zero and the post-modification value equals the new number of shares expected to vest (typically target) multiplied by the per-share fair value on the modification date. The final cost is trued up for the number of shares that actually vest.

 

Market conditions. The cost of a performance share with a market condition must be recognized regardless of the outcome or whether the award is cancelled, as long as the employee completes the award’s original service requirement. In addition, companies have to recognize any incremental cost associated with a modified or replacement award. The incremental cost is calculated by comparing the fair value of the award (using a Monte-Carlo simulation incorporating the probability of achievement) immediately pre- and post-modification.

Disclosure

All of the strategies (except do nothing) would trigger executive pay disclosures.

 

Proxy statement. Generally, the proxy statement Summary Compensation Table (SCT) presents equity awards using the accounting grant-date fair value. Any incremental accounting cost arising from a discretionary modification to, or cancellation and replacement of, awards held by the proxy named executive officers (NEOs) is reported in the SCT and Grants of Plan-Based Awards Table in the year in which the change is made. If the original grant and the modification occur in the same year, this will result in “double” disclosure because the grant date fair value of the original award must also be reported — reflecting two compensation decisions made in the same year (CDI 119.21). (If the original award was granted in a prior year, the original grant date value would already have been reported.) Any action taken should be explained in the Compensation Discussion and Analysis section of the proxy.

 

Financial statements. Under ASC Topic 718, material modifications in any year presented in the P&L must be discussed in the notes to the company’s financial statements.

 

Real-time disclosure. If NEO awards are affected, a Form 8-K filing might be required or prudent. While modifying performance goals generally doesn’t require a filing, ISS urges real-time disclosure of the changes and supporting rationale.

 

Section 16 Form 4 filings. Generally performance shares don’t need to be reported by Exchange Act Section 16 officers until vesting. However, the award must be reported at grant if it vests based solely on achievement of an absolute (not relative) stock price goal or, for a company that pays no or nominal dividends, a TSR goal. If an award with a stock price goal is modified (or an award is modified to add a stock price goal), the modification might trigger a filing.

 

Employee consent, tender offer rules

Unlike stock option repricings and exchanges, modifying or replacing performance shares generally won’t require shareholder approval. But if employees are asked to give up existing rights, modifications or replacements may require their consent. In such cases, companies should consult counsel to determine whether they must comply with the tender offer rules of the Securities Exchange Act of 1934.

 

Tax

The 2017 tax law changes to Section 162(m) have given companies more flexibility to adjust awards without adverse tax consequences. But companies still need to consider the following:

 

Loss of Section 162(m) grandfather. If the original awards are grandfathered (granted under a written binding contract in effect on Nov. 2, 2017 that hasn’t been materially modified), modifying goals or replacing awards might be a material modification. If so, amounts earned by “covered employees” would be subject to the $1 million deductibility cap.

 

Section 409A. Assuming the time and form (e.g., installment or lump sum) of payment originally in place isn’t changed, simply modifying performance goals shouldn’t have 409A implications. But, for example, if the modified award has a longer performance period than the original award, there may be some 409A risk even if each award was designed to meet the short-term deferral exemption. Under 409A, a replacement award could be treated as extending the original forfeiture period (creating a “rolling risk” of forfeiture), with the net effect an impermissible 409A deferral.

 

Tread carefully

The global pandemic and economic downturn have created challenges for companies in many industries, and affected a variety of stakeholders — including executives, rank-and-file employees, and shareholders. When shareholders and proxy advisers engage with companies and vote proxies, they will assess whether company responses to the crisis balance profitability and sustainability, and consider broader workforce and community concerns. Against this backdrop, companies should carefully weigh the different strategies for addressing nonperforming performance shares, resist acting too quickly, avoid windfalls, and be forthright in explaining the rationale for pay and governance decisions.

Mercer is not engaged in the practice of law or accounting, and this article does not constitute and is not a substitute for legal, tax or accounting advice. Mercer recommends securing the advice of legal or tax counsel or accounting firms regarding any such matters related to this article.

Carol Silverman
Carol Silverman

Partner, Senior Legal Consultant

Amy Knieriem
Amy Knieriem

Senior Principal, Senior Legal Consultant

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