How COVID-19 Is Impacting Equity-Based Incentive Compensation

April 21, 2020

Written By Anu Nijhawan, Brent Kraus and Jordan Fremont

The COVID-19 pandemic has had an unprecedented impact on the financial markets and stock prices. Through the spring of 2020, share prices have experienced extreme volatility and, in some cases, have traded at unforeseen historical lows. These factors raise the issue of whether equity-based incentive compensation awards continue to serve the function for which such plans were implemented, particularly where employee stability is often critical to a corporation's ability to weather the current economic storm. Within that context, employers may need to consider available alternatives for addressing the impacts of the COVID-19 pandemic on equity-based incentive compensation plans, taking into account both employee retention (i.e., ensuring that an equity-incentive award continues to have a retention and motivation effect) and financial optics (i.e., ensuring that executives are not seen to be unduly benefitting from the pandemic).

This blog offers a compilation of various issues to be considered, focusing, in particular, on the three principal equity grants made by Canadian corporations—stock options, restricted and performance share units, and deferred share units.

Stock Options

A stock option entitles the employee holder to acquire a share of his or her employer for a set exercise price. The ultimate benefit is achieved where the share price increases, thereby aligning the interests of the employee with the interests of shareholders. From a tax perspective, stock options are typically designed to avoid any tax liability until the time the employee exercises the option and to achieve capital-gains like treatment at that time. The latter is achieved through a deduction of 50 percent available where a number of conditions are met, including, most notably, for the present purposes, ensuring that the exercise price of the option is at least equal to the fair market value (FMV) of the share at the time the option was granted.

A number of issues need to be considered with respect to stock options:

• Setting the Exercise Price for Current Grants: Most stock option plans require that stock options be granted with an exercise price at least equal to FMV, a requirement of both tax rules and of stock exchanges. Given the volatility of the markets, corporations may wish to review their stock option plans to determine whether there is flexibility in determining such FMV—for example, in current circumstances, a 30-day average trading price may be more appropriate that using a one-day closing price. For companies listed on the Toronto Stock Exchange (TSX), the TSX generally considers a five-day VWAP to represent market price, but will also consider alternative bases in exceptional circumstances. From a tax perspective, the Canada Revenue Agency (CRA) has indicated there is flexibility in approach, although any chosen formulation of FMV, particularly if different from historical practice, should be reviewed carefully to ensure compliance with tax rules.
• Use of Performance-Based Vesting: A common concern is that a grant of stock options with a current (low) FMV exercise price may, when viewed in hindsight following the COVID-19 pandemic, create an impression that employees (particularly, senior management) were unjustifiably enriched, because the stock options were granted at a time when the share price was temporarily (and perhaps artificially) low. One potential way of addressing such concerns could be to include, in addition to standard time-based vesting, performance criteria as a prerequisite to the vesting of options, if such performance vesting is permitting by the terms of the corporation's incentive plan. The general concept is that an employee is granted a number of options that will vest or become exercisable only if particular criteria are met. The performance criteria can be set flexibly given current circumstances, including targets relating to recovery after the pandemic has passed.Performance-based vesting of options does, however, raise a number of legal and tax issues which should be considered carefully prior to proceeding.
• Share Pools: Given the drop in share prices, many corporations are in a position where the "typical" value of stock option grants (based on target equity value at time of grant) would lead to a circumstance where the corporation does not have sufficient room in its share pool reserved for the stock option plan. Absent seeking approval for amendments to that plan, a corporation in this situation could consider alternatives to stock option grants, such as restricted stock units or deferred cash awards.
• Extension of Expiry Date: Where underwater options may expire in the midst of the COVID-19 pandemic, corporations may wish to extend the expiry dates so as to permit employees to hold on to their options and exercise them once market conditions have improved. Shareholder and, for public companies, stock exchange approval may be required for such extensions, particularly where extensions impact options held by insiders. Alternatively, corporations may choose to grant a one-time "stop-gap" of additional awards to replace the incentives lost by expiring options, or to limit term extensions to options held by persons other than insiders.
• Repricing: Options granted in the past with a FMV exercise price may now be "underwater", in the sense that the exercise price is greater than the current FMV of the underlying share. The concern is that this situation no longer provides an incentive for employees who hold those options to remain with the corporation. In such circumstances, consideration may be given to the pricing of options where the exercise price would be adjusted to represent current value. Repricing is essentially a business decision involving competing philosophical theories, and may be looked upon disfavourably by proxy advisory firms and institutional advisors. Approval by shareholders or applicable stock exchanges may also be required, particularly where the repricing includes options held be insiders. From a tax perspective, repricing can generally be accomplished while ensuring that the option holder continues to be eligible for capital-gains like treatment upon the exercise of the option, provided that the "in-the-money" amount of the option is not increased.
  
  There are two common mechanisms to accomplish a repricing (the selection of which will depend on the particular facts):
  • A repricing can be accomplished by cancelling the original options and granting, in consideration therefore, new options with a repriced exercise price. Such an option exchange should generally be tax-deferred, so long as the in-the-money amount of the new options is not greater than the in-the-money amount of the original options. Where the new exercise price is equal to the FMV of the underlying securities at the time of the option exchange, this requirement will be met.
  • It is also possible to effect a repricing simply by amending existing option agreements to provide for the reduced exercise price. Such an event should also be non-taxable and preferential tax treatment retained so long as the in-the-money amount of the adjusted options is not greater than the in-the-money amount of the unadjusted options.
  
  From a public markets perspective, the TSX generally treats a straight repricing or an option exchange where the repriced options are granted within three months of the cancellation of the old option in the same manner. Repricing requires TSX approval in advance, and shareholder approval is required where option holders include insiders. A repricing that is accomplished by way of option exchange may, however, raise adverse accounting issues, not to mention the administrative burden of cancelling and reissuing options that are, in essence, the same options as those originally granted except for the reduced exercise price.
  
  It is also important to note that some proxy advisory firms have updated their policy guidelines concerning stock option repricing in light of the COVID-19 pandemic. For example, Institutional Shareholder Services (ISS) has indicated that, where issuers seek shareholder approval or ratification of option repricing at 2020 meetings, ISS will continue to apply its existing case-by-case approach to the review of such proposals. Factors considered will include: whether the design is value neutral; whether surrendered options are added back to plan reserve; verifying that replacement awards do not vest immediately; and whether executive officers and directors are excluded. As such, existing standards have not been relaxed due to the existence of the COVID-19 pandemic.

Restricted and Performance Share Units

A restricted share unit (RSU) or performance share unit (PSU) represents a future conditional entitlement of the employee holder to a payment (which may be paid in cash or in shares) equal to the value of one share of the employer corporation, determined as of a future vesting date. From a tax perspective, in order to ensure that an employee is not taxable until he or she receives a payment, RSUs and PSUs (other than those that can be settled solely in treasury shares) are generally structured so that they are granted as a bonus for services rendered in a particular year and such that a payout cannot occur after December 31 of the third year following the calendar year of service.

Because share units are "whole-value" awards (i.e., the employee receives a payment equal to the whole value of a share), they do not raise the same issues as stock options in terms of being underwater. That said, a decreased share price clearly means that share units have less incentivizing effect. The following issues should be considered with respect to these types of awards:

• Grant Value and Vesting Conditions: Typically, share units are granted having a set "grant value", based on the current FMV of the shares of the corporation. As a result of reduced share prices, this may mean that employees are granted more share units than is typically the case, which may result in a concern (similar to those described above in respect of stock options) that management is being enriched due to a grant occurring at a time when the share price is temporarily low. Corporations facing this concern may wish to consider avoiding a set "grant value" and, instead, granting only a specified number of share units.Corporations may also wish to consider performance-based vesting conditions to try to bridge the gap, such that share units would not vest until a certain share price is achieved.
• Amendment of Performance Conditions: Market conditions and measures undertaken by a corporation in response to the COVID-19 pandemic may have resulted in approved performance metrics either ceasing to be capable of meaningful evaluation in the near term, or ceasing to have a reasonable prospect of being satisfied. Corporations considering amendments to performance metrics in respect of outstanding grants again need to the potential effect of stock exchange rules or proxy advisory firm policy. For example, ISS is generally not supportive of the amendment of performance metrics for outstanding grants. Where such amendments are proposed, ISS will evaluate the proposal on a case-by-case basis, considering whether the applicable board exercised appropriate discretion and provided adequate explanation to shareholders of the rationale for the revisions.
• Extending Payout Date Not Permitted: Where share units ordinarily vest and would be paid-out during the COVID-19 pandemic, many corporations may wish to extend the payout dates so as to preserve cash during the pandemic. As described above, however, tax rules generally require that RSUs and PSUs be paid out no later than December 31 of the third year following the calendar year of service. Extensions beyond this date are not permitted.
• Determining Payout Value: Where share units ordinarily vest during the COVID-19 pandemic, payments equal to the FMV of the shares underlying those share units will be required. Where the date of payout cannot be extended (as described above), the payout value may be artificially low. In such circumstances, corporations should consider whether there is flexibility in their plans and with any applicable stock exchange for the determination of FMV. As described above, for example, a 30-day average trading price may be more appropriate that using a one-day closing price. Another alternative may be to grant one-time additional awards to replace the incentives lost by low payouts.

Deferred Share Units

Deferred share units (DSUs) operate in a similar manner to RSUs and PSUs, but are based on a different tax regime which requires, amongst other things, that DSUs not be paid out until the termination of the employee's employment (or retirement or death) and that the payout occur not later than December 31 of the calendar year commencing after the termination of employment. DSUs are typically granted to directors of a corporation and many DSU plans include a provision for directors to elect, irrevocably and in advance, to receive DSUs in lieu of cash retainer fees.

Corporations which offer DSUs also face a multitude of issues in relation to the COVID-19 pandemic, particularly with respect to directors, including:

• Grant Value: Typically, DSUs are granted having a set "grant value", based on the current FMV of the shares of the corporation, with the grant value being the amount of ordinary retainer fees being satisfied. As a result of reduced share prices, directors may be granted more DSUs than is typically the case, which may raise a concern that directors are being enriched due to a grant occurring at a time when the share price is temporarily low. Corporations facing this concern may look to a variety of alternatives, including:
  • reducing directors' fees so that the number of DSUs granted corresponds more closely to prior year grants;
  • in establishing grant value, consideration can be given to alternative mechanisms for establishing FMV; or
  • if permitted under the terms of the plan, corporations could consider not granting DSUs and instead paying all retainers in cash. Where directors have previously irrevocably elected to receive DSUs, great care will need to be taken in this approach in order to avoid adverse tax issues.
• Extending Payout Date Not Permitted: Where a director ceased to be a director in 2019 (prior to the COVID-19 pandemic), tax rules will require the DSUs to be paid out no later than December 31, 2020. Extensions beyond this date are not permitted.
• Determining Payout Value: Where the date of a DSU payout cannot be extended (as described above), the payout value may be artificially low. In such circumstances, corporations should consider whether there is flexibility in their plans for the determination of the quantum of the payout. Tax rules require that the DSU value depend on the FMV of the shares of the corporation within the period that commences one year prior to the director's termination and ends at the time of payment. This provides some flexibility to use a different approach to FMV, if permitted by the plan.
• Additional Compensatory Awards not Permitted: Above, we described the possibility of the corporation granting additional awards to compensate for the lost value of stock options, RSUs or PSUs. This approach is, however, not permitted for DSUs, as tax rules mandate that the DSU holder not have any actual or contingent right to any compensation for the purpose of reducing the impact of a drop in the FMV of shares. In addition, many corporations will have limited or precluded independent director participation in other security-based compensation arrangements to comply with proxy advisory firm policies.

Next Steps

While there is no "one-size-fits-all" approach, there are several potential alternatives in dealing with equity-based incentive compensation during the pandemic, and we recommend that boards and management consult with their legal, tax and accounting advisors on these issues. Equity-based incentive plans will continue, in our view, to be of significant importance in maintaining businesses throughout the pandemic and in the recovery process thereafter.

In addition, please visit our COVID-19 Resource Centre for other COVID-19-related materials.

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