Reexamining Executive Compensation Agreements in Difficult Economic Times
Insight Thomas M. White · March 27, 2020
The global pandemic raises a host of concerns for businesses and the executives they employ. Health and staffing issues are paramount but executives are particularly concerned about their job tenure and their compensation and companies have heightened concern about their viability. The typical tension between the interests of the parties is exacerbated by the current economic environment. Because of economic circumstances, the renewed focus will be placed on three critical components of executive compensation arrangements:
- Current cash compensation
- Severance pay
These topics will be addressed in turn.
CURRENT CASH COMPENSATION
When times are difficult and business prospects are uncertain executives will try to diminish the risk they incur by increasing the portion of the compensation and benefits package they receive in salary. From the employer's perspective, tough times necessitate conserving cash. This may result in more protracted negotiations.
With respect to new hires, there may be an increased interest by employers to defer a greater portion of compensation into the future or increase the contingent portion of compensation by emphasizing bonuses. New executives might want to be compensated for the additional risk they would be taking on.
With respect to current employees, some employers may request that they continue to work for reduced compensation. As noted below in the discussion of severance pay, this might cause unintended consequences to employers.
There are several elements of bonus arrangements that should be borne in mind:
- The criteria that are utilized
- The time when those criteria are determined
- When the bonus is paid out
The criteria that are utilized differ from one situation to the next. Sometimes specific criteria are set forth in the agreement, sometimes the criteria are left to the business's unfettered discretion. When an economy slows executives will want to have the greatest assurance that the criteria are spelled out in detail while employers want broad discretion to adjust criteria as business circumstances change.
The time when the bonus criteria are determined is also important. Here again, there are several approaches that may be taken. The employment agreement may establish the criteria for bonuses at the beginning of the employment term or on anniversaries thereafter. On the other hand, if the employer retains the utmost discretion, the criteria will not be determined until the end of the term for which the bonus is earned. Then there is a mid-way position where the parties discuss each year the criteria that will be utilized for that year.
Finally, there will be negotiation over when bonuses are paid. Sometimes bonuses are paid shortly after a period ends, for example after a quarter or year ends. This may be preferred by executives when the economy or business prospects of his employer are at greatest risk.
In other situations, bonus distributions are deferred for a more extensive time.
If payment of bonuses is deferred both the executive and the employer needs to determine if section 409A of the Internal Revenue Code is satisfied. 409A provides rules regarding when deferred compensation may be paid. If the statutory requirements are not satisfied the executive has to pay two taxes in addition to that imposed on ordinary income and his employer has to report and withhold for the amounts paid in violation of the requirements. Under the statute -- as relevant here -- payments are permitted if they are paid within 2 1/2 months after the year in which they are not subject to a substantial risk of forfeiture, or are paid according to a fixed schedule. These standards are set forth in the great majority of executive compensation agreements and should not cause a problem.
However, in difficult economic times some employees may have a need for cash prior to the time set forth in the employment agreement. These individuals may offer to take a "haircut" and accept a smaller cash payment if that payment occurs prior to the time specified in the agreement. Acceleration of deferred compensation is prohibited by 409A and the excises would apply.
The right to severance pay is typically found in most executive employment agreements. This benefit is conditioned on the individual either being terminated by the employer without "cause" or by the employee for "good reason."
"Cause" is typically defined as involving the employees insubordination, performance of his duties in a grossly substandard manner or engaging in conduct that is either criminal or involves moral turpitude. Discharge due to poor business performance or in anticipation of a decline in profitability does not involve "cause" and the individual would be entitled to severance pay in the amount set forth in the parties' agreement.
Alternatively, an employee who resigns due to a "good reason" is typically entitled to severance pay. "Good reason" frequently means that compensation is reduced in a material way. In bad economic times employers may ask executives to take a pay cut. If the employee refuses the modification of his compensation he may be entitled to severance pay. That amount of that benefit may be substantially in excess of the amount requested to be forsaken.
Employers may seek to avoid payment of severance pay by drafting their employment agreements appropriately. This might mean including a provision that severance is not due if similarly situated individuals are also requested to take a salary reduction.
Difficult economic times require careful consideration of all of the terms of executive employment agreements. Negotiations may prove more difficult in bad times than in good ones and this may mean that negotiations take longer in order to result in a document that is mutually satisfactory to both parties.
Thomas M. White specializes in the full scope of human resources management, such as Employee Benefits and Executive Compensation, Healthcare, and Employment Law. He began his practice shortly after ERISA was enacted. In this capacity, he has undertaken a full range of contentious, non-contentious and transactional benefits and employment work, and also has extensive experience in the development, documentation and administration of executive compensation programs. He has worked on behalf of clients ranging in size from start-ups to Fortune 500 enterprises. Read more about Thomas here.
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