Episode #10: Cost-Effective Strategies for Preserving Employees (Jessica Lutrin)

Joel Simon: Jessica, with so much uncertainty and volatility in the economy and the stock market, how are you seeing this play out with clients in your practice?

Jessica Lutrin: It’s an interesting time in executive compensation, and we’re seeing companies respond in a variety of different ways to the pandemic. For many, this is reminiscent of what happened in 2008 and 2009. The difference between then and now however is that companies have fresh experience to draw from, which is incredibly helpful as they navigate the challenges presented by these events. In fact, a lot of companies have been very thoughtful in the way that they are treating and communicating with their employees because this is, unfortunately, not their first rodeo.

Simon: You make a good point Jessica, because all too often past lessons are forgotten. But 2009 was recent enough that many of the same business leaders from then are still around.

Lutrin: Absolutely. Especially for private companies that don’t have access to the capital markets, cash preservation is critical and cutting personnel costs is often a quick way to accomplish that. On the positive side, I guess, changes in personnel have actually caused some companies to reevaluate their organizational structure and streamline their operations. Additionally, because of market volatility, companies stock prices have declined, meaning that their equity awards may not necessarily be the most effective tool for incentivizing and retaining employees. This has caused companies to explore ways to restore value to the equity awards, or in some limited cases, grant cash bonuses to employees.

Simon: That’s a really interesting way to break it down. Outsiders probably would just think it was all chaos and panic, but that’s why we have colleagues like you to take companies through things step-by-step. What are the cash preservation techniques your seeing?

Lutrin: As I’m sure you’ve seen in the media, companies are preserving cash by furloughing employees and/or conducting layoffs, which could be conducted on a companywide basis, or limited to a specific division such as advertising or marketing, which has been particularly impacted by the pandemic. The layoffs could be involuntary—the company identifies which employees to terminate—or voluntary, where a company invites a select group of employees to volunteer to resign. These types of voluntary termination programs are often referred to as window programs, and it’s critical that they are structured so that they do not disproportionately impact protected classes. Some companies are also deferring compensation, but there are tax implications to watch out for here. I’m referring to the dreaded rules under Section 409a of the Internal Revenue Code, which I’m sure many of our listeners have encountered. Companies are also implementing hiring freezes which are unlikely to have a material impact on a company’s bottom line and are generally used with another cash preservation technique. Finally, companies are reducing salaries. This may be a useful tool to avoid having to fire employees. In other words, companies are choosing to keep all of their employees employed but have them share in the sacrifice.

Simon: I’m wondering if legislation such as the CARES Act, for example, offers any relief to businesses that take these types of actions?

Lutrin: Under the CARES Act, employers that are subject to a full or partial closure order due to COVID-19 or that experience a significant decline in gross receipts are eligible for a refundable tax credit in connection with retaining their employees. However, employers that received a paycheck protection loan under the CARES Act are not eligible for this credit.

Simon: I know an important part of your practice Jessica is advising businesses in M&A transactions. Have you seen some more developments there?

Jessica: As a matter of fact, yes. These changes in workforce and compensation need to be addressed and are being addressed in M&A transaction agreements. Acquisition agreements often include a covenant under which the buyer agrees to maintain the preclosing compensation and benefits provided to the target company employees for 12 to 18 months, plus closing. We are now seeing some buyers insert a carve-out from this covenant, which provides that they may make across-the-board compensation and benefit reductions to the extent those reductions impact similarly situated employees of the buyer. These changes and the cash preservation techniques that we talked about earlier also need to be addressed in other provisions of the transaction agreement, such as the representations and the interim operating covenants that govern the actions a target company can take between signing of the transaction agreement and closing of a deal.

Simon: All of that sounds like a “you have to take your medicine” approach. Let’s move on the step 2 where a company’s choices are hopefully more positive. Retaining and incentivizing executives.

Lutrin: Right. There are many companies that are focused on making sure their employees feel appreciated and motivated. These companies are generally conducting comprehensive reviews of all the elements of their compensation programs to evaluate whether and how they should be adjusted. For starters, companies can consider whether the performance metrics that they are using in their cash and equity incentive plans are meaningful. For example, given the volatility in the market a stock price metric may no longer be appropriate. Also, certain companies, especially public companies where there is a focus on environmental, social and governance metrics known as ESG metrics should evaluate whether to replace some of the more traditional performance metrics, like EBITA and revenue, in their incentive plans with nontraditional performance metrics such as health and safety and diversity and inclusion. We’ve typically seen ESG metrics being used in annual or short-term incentive plans, but it’s possible that we may now start to see them being used in long-term equity incentive plans. Other companies, however, have adopted a wait-and-see approach before they adjust their performance metrics.

Simon: What if a company does not want to change its performance metrics. What else can it do?

Lutrin: Companies can adjust existing incentives or issue new ones. One major incentive with revisiting is stock options, many of which are underwater or out of the money. Which means an options-exercised price exceeds the fair market value of the stock covered by that option. Companies with underwater stock options may want to consider whether to restore value to those options through repricing, an option exchange program or a cash-buyout program, which basically allows the company to reduce the exercise price of the options or grant a new type of equity award with an exercise price of value equal to fair market value. But before implementing such a strategy, companies and their counsel must evaluate some complicated tax, accounting and tender offer considerations that arise from these types of programs, and of course there’s no guarantee that an option with a reduced exercise price will not again become underwater in the future. Other strategies that a company can consider include granting employees additional equity awards now with the hope that the value of the underlying shares will rebound at some point in the future, or granting cash retention bonuses to key employees to help them stay motivated.

Simon: Those are all great ideas Jessica, but I guess companies must also be ready for departures and transition. What can companies do to try to make that as smooth as possible?

Lutrin: For companies that cannot avoid employee terminations, it’s critical that they are properly protected. There are two main ways companies can ensure this. First, by having the departing employees sign a release of claims against the company. The company will need to offer the employee consideration above and beyond what the employee is otherwise entitled to—severance with service consideration for release—but this might not be feasible for cash-strapped companies. Second, companies should ensure that employees are bound by appropriate restrictive covenants such as noncompetition, non-solicitation and nondisclosure clauses and that all intellectual property has been assigned to the correct legal entity. If an employee is not already subject to these covenants, then the company should build these covenants into any Separation and Release Agreement that the employee signs at the time of their departure. Lastly, if a company expects to see turnover in their executive management team, they should dust off any leadership succession plan, or if they don’t have one, they should consider whether it’s time to draft one.

Simon: Thank you, Jessica, for providing some great insights into what’s happening in the world of Executive Compensation.