Many public and private companies utilize employee compensation plans that are designed to deliver employer shares or cash compensation based on share price and/or other financial performance measures, which have been impacted by the effects of the COVID-19 pandemic. This bulletin discusses a number of executive compensation topics arising in an economic environment that is impacted by the COVID-19 pandemic. Those topics are:
Impact of COVID-19 on Performance Awards
Other Performance-Based Compensation Measures
Compensations Plans Impacts of Leaves/Terminations/Layoffs
Income Tax Considerations
IMPACT OF COVID-19 ON PERFORMANCE AWARDS
Equity-based awards, such as performance share units (PSUs) and restricted share units (RSUs) are an important compensation mechanism for aligning the interests of management—and, in some plans, directors—with the interests of shareholders as awards settle in employer shares or in cash payments based on the value of such shares. Incorporating various performance factors into equity-based compensation awards that can provide enhanced returns to employees where target performance relating to shareholder returns and/or financial metrics is exceeded is also common and seen as a means of further incentivizing and retaining management.
With the downturn in the economy, and the stock markets in particular, associated with the COVID-19 pandemic, the intrinsic value of outstanding equity-based awards will have generally declined, and performance multipliers may not be working as intended. In this situation, many companies may be considering whether to make adjustments to outstanding equity awards and whether the terms of future awards should be modified in light of the economic uncertainty created by the pandemic.
The decision to adjust outstanding awards needs to be carefully thought through. Reputational risk, and potentially adverse impacts to employee and shareholder relations need to be considered as well as contractual rights under plan terms and award agreements, including whether the terms of the equity-based incentive plan and the individual award agreements permit the type of changes being contemplated and whether there are any conditions that must be satisfied. If the company does not have the authority under the plan and award agreements to make the type of modifications it believes are desirable, it may be necessary to formally amend the plan and award agreements, which, particularly in the case of a public company, is likely to require consents from various stakeholders.
A company that is considering adjusting performance criteria or exercising a general discretion to provide executives with more shares or a higher payout than would have otherwise been the case under the unadjusted award, or considering extending the term of outstanding awards—particularly relevant to options—to allow time for share prices to recover, will want to be cautious about being seen to insulate senior management from the financial impact of the pandemic when ordinary employees may have been subjected to layoffs or reduced work hours and pay, and shareholders have also seen a material diminution in the value of their investments.
On the other hand, if a company is concerned that executives will receive inappropriately large share awards or payouts in light of the adverse economic impact of the pandemic on shareholders and the general employee population, it may wish to use discretion to reduce the number of shares or amounts provided to executives. In this scenario, consideration will need to be given to contractual obligations under the plan documents and whether employee consent is required in order to reduce the risk of claims arising from a material reduction in incentive compensation.
In the case of new awards, in addition to reviewing performance conditions and making changes where appropriate, companies may wish to consider whether changes should also be made to their typical mix of equity-based incentives for each level in the organization that normally receives those awards. For example, in a down market, awards that are designed to provide a particular grant date value will cover a larger number of shares than when share prices are higher, which is more dilutive to shareholders and, if share prices recover more rapidly than expected, this can result in disproportionately large amounts of compensation being received. In these circumstances, it may be desirable to include more awards that are less volatile and dilutive, such as RSUs or awards that settle in cash.
In addition, consideration should be given to providing the board of directors or board compensation committee with greater discretion to make adjustments to address COVID-19 impacts and/or including more subjective performance criteria, although public companies will generally want to ensure any adjustment powers are still quite targeted and, in combination with subjective performance criteria, do not cause institutional shareholders and the shareholder advisory firms to treat awards that are intended by the issuer to be performance-based as discretionary compensation.
Tax implications of adjustments and amendments should also be considered (see below for an overview of certain potential tax issues), as well as timing of any adjustments, disclosure obligations under securities laws and accounting impacts. For more information on COVID-19 implications for public companies, please see our March 2020 Blakes Bulletin: CSA and TSX Public Temporary Blanket Relief Due to COVID-19 and April 2020 Blakes Bulletin: COVID-19 Checklist: 51 Issues for Public Company Directors and Officers to Consider. Public companies should also consider the views of proxy advisory firms, such as those available from Glass, Lewis & Co. and Institutional Shareholder Services Inc.
Employers who have key personnel holding stock options that are significantly “under-water” (i.e., the exercise price is greater than the fair market value of the underlying shares) as a result of the impact of COVID-19 on the economy may look to amend the exercise price of those options to adjust for market conditions. The restrictions on whether the exercise price of an option can be amended will depend on the specific amendment provision in the option plan, whether the company is private or public, and, if public, the rules of the relevant stock exchange. It is also important to consider the expectations of proxy advisory firms, as well as institutional and other investors.
For companies listed on the Toronto Stock Exchange (TSX), the amendment provisions in the plan will be relevant—but note that specific security holder approval is required for the reduction in the exercise price benefiting an insider of the issuer. Further, the rules of the TSX provide that if a listed issuer cancels options—or similar entitlements—held by insiders, or held by non-insiders where the amendment provision does not permit such amendment, and then re-grants those securities under different terms, the TSX will consider this as an amendment to those securities and will require security holder approval, unless the re-grant occurs at least three months after the related cancellation.
For companies listed on the Canadian Securities Exchange (CSE), the CSE’s policy is that stock options may not be amended once issued and, if an option is cancelled prior to its expiry date, the issuer must notify the CSE and shall not grant options to the same person for at least 30 days. For private companies intending to reprice options to current fair market value, it will be important to be able to support the current valuation of the company in a robust manner.
Stock options granted by public companies and most private companies—other than some Canadian-controlled private corporations—will typically have an exercise price that is not less than the market value of the underlying share on the date of grant. This is to comply with exchange rules and is also a requirement for employees to qualify for the advantageous 50 per cent stock option tax deduction (Stock Option Deduction).
Professional advice should be obtained before amending the exercise price of outstanding options. In particular, in order to preserve the ability of the option holder to potentially get the Stock Option Deduction, assuming the option holder is currently eligible, certain tax rules must be complied with when implementing the amendment. It’s not simply a matter of cancelling outstanding options and issuing new ones—doing so, could result in unintended tax consequences.
As described in our March 2020 Blakes Bulletin: CSA and TSX Public Temporary Blanket Relief Due to COVID-19, the TSX has extended the typical three-year timeframe within which an issuer must obtain securityholder approval of unallocated awards under the issuer’s security based compensation arrangement, and is permitting the exercise of awards under such plans prior to securityholder approval. Security-based compensation arrangements include stock option plans and other forms of equity-based incentive arrangements that are or can be settled in shares newly issued from treasury, such as certain performance share unit and restricted share unit plans. Issuers with “rolling” plans (i.e., plans which do not have a fixed number of shares reserved for issuance) are required ordinarily to have securityholders approve the renewal of such arrangements every three years; issuers required to obtain securityholder approval at their 2020 annual general meeting will be able to continue to grant awards until the earlier of such annual meeting and December 31, 2020. Awards granted during this period may also be exercised prior to being ratified by securityholders. This relief was made necessary by the decision to permit issuers to hold 2020 annual meetings at any time during 2020 (up to and including December 31, 2020), rather than within six months of the end of its fiscal year.
OTHER PERFORMANCE-BASED COMPENSATION MEASURES
Given the unknown longer-term effects of COVID-19 on equity values, which impact performance metrics based on shareholder return, and on the economy in general, and the potential for dilution of shareholders where equity awards are required to be granted over a much larger number of shares to deliver the same amount of target compensation than was required pre-COVID-19, companies may also wish to consider other means of incentivizing and compensating employees.
For example, fixed-amount cash incentive arrangements that use financial metrics other than share value as performance criteria are not dilutive and may—depending on the company’s business and metric or metrics selected—be more predictable as they do not depend on share price. Issuing cash-settled RSUs and PSUs will also help manage dilution, although will not address volatility in award values to share prices. In some cases, companies may wish to provide executives and directors with cash-settled deferred share units (DSUs) that track the value of the company’s shares, but only pay out on termination of employment, rather than actual equity or shorter-term awards; these would be intended to reduce dilution, to allow more time for the value of the company’s shares to recover and provide an even longer-term alignment with shareholders. If desired, vesting terms can be incorporated into a grant of DSUs. As compared to awards settled by the issuance of shares, the granting of cash-settled share-based compensation can have different impacts on the company’s financial statement disclosures that should also be considered.
The ability to use more cash-based awards will, of course, depend on a company’s cash flows and ability to generate revenue to pay out such awards following vesting. While companies may be comfortable that they will be in a position to pay out cash-based awards granted now with a vesting date several years in the future, for awards coming due now, as businesses struggle with financial impact of COVID-19, some companies may wish to delay bonus payouts and even defer salary payments in order to conserve cash. Consideration will need to be given to employment standards legislation and plan terms, as they are likely to limit an employer’s legal ability to postpone earned amounts of compensation without the consent of affected employees. In addition, the “salary deferral arrangement” (SDA) rules under the Income Tax Act (Tax Act) discussed below may also impact the ability to defer salary and bonus.
COMPENSATION PLAN IMPACTS OF LEAVES/TERMINATION/LAYOFFS
Sponsors of various types of incentive compensation arrangements should carefully review the terms of their incentive arrangements to determine the impact, if any, of workforce reductions or periods of reduced pay on outstanding awards. In particular, employers should assess the extent to which any without cause dismissals of employees may result in the full or partial acceleration of outstanding incentive awards, as well as any limitations on post-termination exercises or redemptions and the application of performance criteria where interim criteria must be used to determine the number of awards vesting. Such provisions may not be triggered where employers opt to temporarily layoff a portion of the workforce, but if such layoffs prove permanent, there may be a retroactive termination event that would implicate the plan’s termination of employment provisions.
Incentive plans—and, in particular, short-term incentive arrangements—often contain a requirement that the employee be actively employed at the time of payment for a bonus or other incentive payment to be made. Employers should give consideration to how such provisions will be applied in the event that the employee otherwise eligible for such an award is not actively employed on the payout date due to a temporary layoff or other COVID-19-related reason (such as a requirement to quarantine or self-isolate, or care for another self-isolating individual) and the potential impact of any payment on benefits the employee may be receiving from the government (e.g., the Canada Emergency Response Benefit).
Additionally, certain incentive plans provide for proration of award payouts where there has been a leave of absence or other interruption in employment during the vesting or performance period. Employers should consider whether interruptions in service such as temporary layoffs or leaves of absence might impact award payouts in future years if plan terms provide for pro-ration of awards in such circumstances.
Finally, many plans use base salary as a factor in determining target awards or payouts under incentive arrangements (particularly short-term incentive arrangements). If adjustments are made to salary as a response to the current environment, employers should consider and anticipate any impacts to incentive awards or opportunities and, where employee consent to the salary adjustment is sought, the impact explained to the employee.
INCOME TAX ACT CONSIDERATIONS
The Tax Act contains a number of provisions that may come into play where an employer modifies outstanding awards or that will impact the design of new awards.
For awards that are required to be settled in shares issued from treasury, or in lieu of shares cash at the election of the employee, it will be important to consider the implications of section 7 of the Tax Act and, for stock options, the availability of the Stock Option Deduction in connection with any modifications made to outstanding awards and the design of new awards. A particular concern where awards are adjusted or amended will be whether the changes are sufficiently fundamental as to result in a taxable disposition of the original award, although in many cases, if prescribed conditions are met, a taxable event can be avoided.
For awards that are not required to settle in shares issued from treasury, the principal tax consideration is likely to be whether the awards as modified result in an SDA. An SDA can arise in a wide range of circumstances in which the payment of compensation is postponed beyond the end of the year in which it is earned and the Canada Revenue Agency generally takes a fairly expansive view of when an SDA can arise in connection with performance-based compensation. If an award is caught by the SDA rules, taxation is potentially accelerated to the year of grant and also potentially each year during the performance period. There are some specific exceptions under the SDA rules, including incentive awards that pay out within a three-year window from when the relevant services are performed, and DSUs that meet certain requirements under the Income Tax Regulations, and “emergency” deferrals of compensation to ensure a business remains viable may not result in an SDA, but there is no general exemption, which means that a case by case analysis will be required.