This post is part of a 7-part series addressing compensation adjustments that Compensation Committees could consider in order to continue to incent and retain their executive officers in today’s economy. The titles of each of the 7-parts in this series are listed at the bottom of this post. This Part 3 is entitled “Address Outstanding Performance-Based Equity Awards,” and provides some alternatives that Compensation Committees could consider with respect to outstanding performance-based equity awards that have currently unachievable performance goals. Such alternatives include (listed in no particular order, and not an exhaustive list):
Alternative No. 1 – Wait and See
Some Compensation Committees will wait until later in the fiscal year and determine at that time whether it makes sense to apply positive discretion to waive outstanding performance conditions. Whether this approach is sufficient to incentivize and retain the executives will depend on whether trust exists between the executives and the Compensation Committee. Risk exists where there is a lack of trust because, if the executive does not believe positive action will take place in the future, then the executive might leave the company for a better economic opportunity. And too, this approach is only permissible if the equity incentive plan and outstanding performance awards do not contain terms that would limit such future discretion by the Compensation Committee (i.e., though the performance-based exception to the $1mm deduction limit under Section 162(m) was eliminated by the Tax Cuts and Jobs Act, some companies cannot apply positive discretion to outstanding performance-based equity awards because their equity incentive plan still contains terms that prohibit such discretion).
Alternative No. 2 – Maintain the Outstanding Award and Grant a New Award
This Alternative works well for those companies that have a large available share reserve in their equity incentive plan. However, for companies with substantially constrained share reserves in their shareholder-approved equity incentive plan, the Compensation Committee could partially adopt this Alternative No. 2 by having it apply only with respect to outstanding awards that will soon expire, or alternatively, such companies could structure the new award to be settled in cash.
Alternative No. 3 – Replace Performance Goals of Outstanding Awards
Outstanding performance awards could be amended by replacing ill-performing performance goals with new performance goals. However, this approach should not be implemented without first verifying the accounting consequences (i.e., as a gross over-simplification, the company could recognize incremental compensation expense based on the fair value of the modified award). And too, check with legal counsel on whether the contemplated amendment would trigger the SEC’s tender offer rules (which are generally triggered whenever a holder of a security is being asked to make an “investment decision”); important to this analysis is whether the terms of the outstanding award require the executive’s consent before the Compensation Committee could effectuate the amendment (e.g., an investment decision is likely triggered if consent of the executive is required). That all said, some of the doable approaches within this Alternative 3 include:
- Eliminate Absolute Modifiers to Outstanding Relative TSR Awards. Eliminate absolute modifiers within outstanding relative total shareholder return (“TSR“) awards (i.e., awards that compare the stock price of the company to the stock price of its peer group). As background, past best practices would require a downward adjustment to a relative TSR award if the absolute return to the company’s shareholders was negative over the performance period (a.k.a., an absolute modifier). The Compensation Committee could amend such an award to eliminate any absolute modifier and such amendment would typically not require the executive’s consent. But to provide a contrasting example, amending an absolute TSR return to become a relative TSR formula would likely require consent of the executive.
- Kick-the-Can Forward by Adding Another Year to the Performance Period. The Compensation Committee could amend the outstanding performance award by extending the performance period by another year (or months) to the extent that the performance goals are not achieved during the initial performance period, resulting in the executive’s having more time within which to satisfy the performance goals (e.g., if the outstanding award has a performance period of three years and the performance goals are not met by the conclusion of such three-year period, the Compensation Committee could amend such award to have a performance period of four years). However, this alternative is more applicable to outstanding awards where the performance period will expire soon, because, for outstanding awards with two or three years remaining within the performance period, a wait-and-see approach is more shareholder friendly.
- Add a New Performance Goal to Outstanding Performance Goals and Provide the Executive with the “Better of” the Two. The Compensation Committee could amend the outstanding performance award by adding a new performance goal to the preexisting performance goals, and provide in such amendment that the executive would receive a payout based on the “better of” the two performance goals. Typically, such amendment would not require consent of the executive.
Blog posts that are part of this 7-part series include:
- “Considerations with Respect to Upcoming Equity Grants” (Part 1 of 7)
- “Consider Changes to Increase Cash Flow” (Part 2 of 7)
- “Consider Retention Packages to Discourage Poaching” (Part 4 of 7)
- “Revisit Stock Ownership Policy Requirements” (Part 5 of 7)
- “Modifying or Terminating a 10b5-1 Trading Plan” (Part 6 of 7)
- “Does It Make Sense to Consider a Secular Trust for Deferred Compensation” (Part 7 of 7)