The coronavirus crisis is causing unprecedented, negative economic impacts in an accelerated fashion.  From the stock market losing substantial value in just a few weeks, to widespread travel and business disruptions, the crisis is dramatically impacting many sectors. Many experts, furthermore, believe that the coronavirus crisis is just getting started, and that the countermeasures that are causing such negative economic impacts may last not for weeks, but for months or longer.  Whether engaged in the airline, hotel, restaurant, physical fitness, cruise line, retail, oil and gas, or other industry, significant impacts will flow through all sectors, with few, if any, insulated from the downturn.

These circumstances present significant challenges to companies from an executive compensation standpoint.  While many companies will survive the downturn, for many others, conditions will push them into a restructuring and perhaps, even into bankruptcy.  Even for companies that survive, the crisis will generate circumstances that make it difficult to motivate and retain their best executive talent.

Initially, the negative economic impact of the crisis is causing business results in many cases to fall far below estimates.  As a result, payouts under annual incentive plans will be negatively impacted. This, of course, may not be due to any actions (or inactions) of the executives themselves, but because of the negative economic impacts of the coronavirus crisis.

Flowing from the negative economic situation is also a marked reduction in the value of company stock.  This is reflected in the precipitous fall that the public stock markets have witnessed over the past few weeks.  Because of the declines, many executives are in a situation where their long-term incentive awards—most often provided in the form of stock or stock-based awards—are losing value or have already become worthless.

Faced with these conditions, executives will find little motivating value in their existing compensation programs.  Annual bonus payouts will be reduced or eliminated by the negative short-term economic climate, and LTIP awards will be handicapped at best, and in many cases, rendered completely worthless. Employers may also be facing a restructuring or bankruptcy. Therefore, it is imperative that organizations find alternative methods to motivate and retain key executive talent, or else they may not be able to fight through these tumultuous times.

Annual Incentive Plans

Many companies undoubtedly will have already set performance targets under their annual incentive plans for this year.  Consideration should be given to whether and to what extent performance targets should be reestablished, taking into account the impact of the coronavirus crisis. Since the scope and extent of the current crisis is unknown, companies may wish to adopt a “wait and see” approach as opposed to taking swift action to adjust performance metrics too quickly, to avoid the need for multiple revisions to the performance criteria, which would undoubtedly be viewed negatively by shareholders and shareholder advisory firms alike.

Some factors to consider when determining whether or how to modify the performance criteria include, among other things, SEC disclosure requirements (to the extent the revisions apply to a pubic company’s named executive officers); the accounting impact of any changes; how the press might portray changes to performance metrics; and the message that such changes might convey to employees and investors.

Equity Compensation

Just as the unmodified annual incentive plan may be perceived as a disincentive by executives, current economic conditions have undoubtedly had a negative impact on equity awards, which typically constitute a majority of executives’ compensation.  For example, full-value awards (such as restricted stock) will have a greatly diminished value, and appreciation awards (such as stock options or stock appreciation rights) may be completely worthless.  Companies will need to consider measures to create value for executives, and to realign their interests with those of shareholders generally.

For appreciation awards, companies may want to consider resetting the awards based on the current, lower stock value.  When doing so, the accounting impact and SEC reporting requirements should be considered, not to mention the backlash this might create with institutional shareholders.  Another option would be to issue new awards based on the current share price.  Keep in mind, however, that in the event of a significant reversal in stock price due to economic recovery, this approach could result in an unintended windfall for the executives.  Therefore, companies may want to consider this possibility when determining the number of supplemental awards to grant.

For full value awards, companies may want to consider issuing additional awards, so that the intended long-term incentive (“LTI”) value is achieved. Furthermore, with the uncertainty surrounding the duration of the crisis and the ultimate low point of the stock market, companies may consider granting cash-settled units to ensure the intended value of the LTI award is able to be realized by the executive.

Whether the company elects to reset existing awards or issue additional awards, in either case negative factors are at play.  For example, due to a depressed stock price, the “burn rate” of shares authorized for awards may be too great, resulting in premature exhaustion of shares under the plan.  Furthermore, issuing additional awards will have the negative impact of diluting the interests of the other shareholders to a much greater extent than in healthy market conditions.

Restructuring or Bankruptcy

While addressing annual incentive and stock compensation as discussed above may help to alleviate immediate executive compensation concerns, if a company finds itself heading toward a financial restructuring or bankruptcy, the considerations and strategy change substantially. Companies in bankruptcy want to retain key executives because their substantial industry experience and company-specific knowledge are necessary to continue the operation of the company's business and to support the company's turnaround. On the other hand, such executives have very little incentive to remain with the company during bankruptcy amid job instability, especially where annual bonuses and other compensation may no longer offer attractive payouts. As the key executives' LTI awards often rendered worthless as a result of the bankruptcy, it is generally accepted to target executives' bankruptcy compensation higher than compensation actually realized pre-bankruptcy.

To address these conflicting interests, prior to 2005, companies typically retained executives by implementing key employee retention plans (“KERPs”) whereby executives were paid for simply remaining on the job through specified dates during the bankruptcy process. However, as a result of perceived abuses involving substantial payments to executives in bankruptcy, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“BAPCPA”) added restrictions on payments to "insiders." Bankruptcy Code Section 503(c)(1) generally prohibits payments "to an insider of a debtor for purposes of inducing such person to remain with the debtor's business" unless certain very stringent restrictions are met.  The restrictions are of a nature that, for practical purposes, retention payments to insiders are no longer possible.  However, KERPs still work for those who are not considered insiders.

KERPs

KERPs help organizations motivate, reward and retain critical talent when the organizations are experiencing financial distress. In most cases, remuneration under KERPs is in the form of cash offered to executives, key corporate function leaders and, in some cases, the broader employee population.

At the backbone of KERPs are “stay” bonuses designed to incent employees to stay with the company through a future date. The payment of stay bonuses is typically staggered throughout the expected duration of the corporate transition period, with the final (and usually the largest) payment linked to the completion of the process (e.g., emergence from bankruptcy, liquidation of assets). Stay bonuses are most often expressed as a percentage of the employee’s base salary.

Additionally, it is fairly common for a discretionary pool to be set aside for unanticipated needs that may arise. Funds in the pool are often reserved for use by the CEO to resolve unforeseen issues, such as signing bonuses for new employees, rewards for “above and beyond” efforts, and retention grants for critical employees at high risk of departure.

However, as mentioned above, while KERPs are a good tool for retaining critical workforce members, such arrangements are not permitted to include “insiders” within the meaning of the bankruptcy code. 

Insiders—Key Employee Incentive Plan (“KEIP”) Candidates

In formulating a KEIP, one of the first issues to understand is which company executives are "insiders."  Section 101(31)(B) of the Bankruptcy Code provides the definition of "insider," which includes a director, an officer, a person in control or a general partner of the debtor, or a relative thereof, as well as a partnership in which the debtor is a general partner. However, the list in Section 101(31)(B) is not exhaustive and the terms "director" and "officer" are not defined.  Therefore, a bankruptcy court's determination of insider status is often based on the facts and circumstances of each case.

Some courts have found that a person with an officer title is, per se, an insider as he or she satisfies the definition, while other courts have found that a person's title is not determinative and it is necessary to investigate the extent to which the individual exerts control over the company.

Once a company determines the identity of its insiders, the company should move toward implementing a KEIP for that group of executives.

The KEIP Plan

KEIPs covering "insider" participants are intended to avoid the restrictions of Section 503(c)(1) by being designed in such a fashion that they primarily incentivize such persons, and do not simply induce them to remain employed. Courts have found that a KEIP that is shown to be primarily incentivizing will not be subject to Section 503(c)(1) restrictions even if it has some retentive effect.

Thus, KEIPs should be structured to pay out based upon the achievement of performance metrics and goals determined by the company. Common performance metrics used by companies include:

• Financial metrics (EBITDA, cash flow, operating income, liquidity);

• Sale of assets;

• Confirmation of plan of reorganization/emergence from bankruptcy (usually by a specified time);

• Cost reduction/expense control;

• Creditor recovery; and

• Product sales.

Such performance metrics, however, must be carefully chosen and structured to be sufficiently challenging based on the circumstances of the particular company. Bankruptcy courts have denied KEIPs where performance metrics are too easy to satisfy, and have also required that performance metrics be closely tied to any payout under the plan.

Alvarez & Marsal Says:

Companies experiencing financial distress due to current economic conditions must carefully consider whether and how to modify their compensation programs to ensure that executives stay engaged and motivated through these trying times.

In the unfortunate event that a company is facing a restructuring or potential bankruptcy, additional challenges arise. KEIPs and KERPs, when properly structured, can help bridge the compensation gap between the time in bankruptcy and the successful go-forward organization.

If you or your company find yourself in need of assistance to retool existing executive compensation programs due to the current crisis, or in the unfortunate event your company is facing a restructuring or bankruptcy filing and you need assistance addressing executive compensation issues in that context, please reach out to the author or the other professionals listed here.