Choppy waters ahead – long-term employee incentive plans in a recession

In the recession that is inevitably coming, businesses operating long-term incentive plans (LTIPs) will need to navigate between retaining and motivating key staff and keeping a tight control on costs.

Listed companies will also have to ensure that their shareholders are on board with any proposed approach. This will require the company to demonstrate that executive pay remains commensurate with the business’s performance. Fully listed companies will need to consider the guidance on executive pay issued by the various bodies representing institutional shareholders, including the influential Investment Association (IA) which recently issued a statement on the implications of Covid-19.

Can LTIP pay-outs be deferred, reduced or cancelled?

Companies which have suspended or cancelled dividend payments and/or sought additional capital from shareholders should be considering whether to defer, reduce or cancel LTIP pay-outs. So should businesses that have furloughed staff or reduced employees’ pay. Other businesses may in any event be considering doing this in order to reduce costs.

Performance-adjustment provisions are common in many LTIPs and are compulsory for certain firms in the financial services sector and fully listed companies. These allow the business to operate “malus” - that is, to reduce or cancel unvested awards if they are no longer justifiable or sustainable, including where there has been a significant deterioration in the financial health of the business. In some circumstances the performance-adjustment provisions also allow or require businesses to claw back vested awards, but this is generally only where the participant is at fault.    

Businesses with performance adjustments in their LTIP will need to consider whether those provisions have been triggered and, if so, the process for exercising the relevant powers. It is crucial to document the performance-adjustment process so that, if challenged, the business will be able to show that the process followed was in line with the LTIP rules and that you exercised any discretions in good faith and not in an arbitrary or perverse way.  

In the absence of specific performance-adjustment provisions, businesses may be able to use the general powers under the LTIP rules to amend the rules and/or suspend or terminate the plan. Normally, however, no action may be taken that would adversely affect participants’ existing awards without their written consent (see below). Shareholder agreement may also need to be obtained.  

An important issue in relation to deferral of LTIP pay-outs is ensuring that participants are not subject to income tax on the deferred amount until they are actually paid that sum. This generally requires a participant who is not a director to give up or waive their right to the deferred amount before the date on which they would have become entitled to the full pay-out. It is essential to document the waiver. For participants who are directors, there are anti-avoidance rules to consider and specialist advice should be sought.

Is it possible to cancel commitments to grant share options or awards?

Companies whose share price has fallen significantly but which have previously committed to grant share options or share awards of a specific value - rather than over a specific number of shares - will have to use substantially more shares to honour those commitments. Again, in the absence of any express right to amend the award unilaterally, companies will need to seek participants’ written consent (see below).  

Listed companies will need to consider whether they have enough headroom under their share capital dilution limits to honour the commitments. If not, they will need to consider whether any alternatives are available, such as replacing market-value options with nil-cost options or performance shares, or potentially cash-settling awards. It is likely that shareholders will need to agree the way forward.

If a company honours its commitment to grant share options or awards of a specific value, this should be on the basis that it has the power to reduce the unvested options or awards to reflect actual performance. This will avoid participants receiving a windfall when share prices recover (see below).

What happens if participants don’t agree to changes to LTIP rules or cancellation of share options or awards?

As mentioned above, unless the business has a unilateral right to amend the LTIP or LTIP awards, participants’ consent will be required. As LTIPs are generally used for the most senior members of a business, and given the unprecedented impact of Covid-19, participants may be willing to make changes or cancel awards to help secure the business’s future, or as “the right thing to do”.  Businesses may also consider offering something else in return for (or making something contingent on receiving) consent.   

Another possibility might be not to change the rules or cancel awards, but instead look ahead to future awards or rules for any new LTIP scheme and consider appropriate adjustments. Other options, such as unilaterally imposing new terms, are likely to be high risk and could also create a situation where the business is in conflict with its senior management.

Can we still make a pay-out notwithstanding the business’s performance?

For some businesses, it may be clear that the performance conditions set out in the LTIP will not be satisfied so participants will not receive a pay-out. In these circumstances, in order to retain and motivate participants, businesses may want to amend the performance conditions to allow a pay-out.

The degree of flexibility that businesses have in this respect will once more primarily depend on whether the LTIP rules specifically allow the performance conditions to be disapplied and/or altered – or, if not, whether the rules can be suitably amended to do so. Listed companies will need to consider whether shareholder approval is required.

Businesses may be considering amending the performance conditions in any event because of Covid-19, but this is unlikely to be the right approach for listed companies. The IA’s statement recommended that companies wait to see how the economy performs before amending performance conditions. It also emphasised the need for businesses to have the power to adjust LTIP pay-outs downwards to ensure there is a link between pay and performance.  

How do you deal with “underwater” options?

Where share options were granted at market value, the exercise price or option price may now be below the current market value of the shares, meaning that the options are worthless.

Despite the effect on participants’ morale, companies would be well-advised to wait and see whether the share price increases.  If it is unlikely that the share price will increase, the company may want to consider granting new options in exchange for the underwater ones. The company would need to consider whether any amendments to the LTIP rules would be required, including the exercise periods and performance conditions, and if so whether shareholder consent is needed.

Shareholders of listed companies, especially those which are fully listed, traditionally reject proposals to surrender and re-grant underwater options as inappropriate. Such companies will need to try to persuade their shareholders that the approach is in the best interests of the company in these unprecedented times. One possible compromise may be to set the exercise price on the re-granted options at a premium to the current market value (but lower than the original exercise price).

Adjusting the exercise price of an HMRC tax-advantaged plan will be regarded as the grant of a new option (see further below).

Should we grant new LTIP awards?

This depends on the circumstances. In the current situation, it is likely to be difficult for businesses to decide on the level of grant or award and set appropriate performance conditions. They may want to adopt a wait-and-see approach, either by delaying awards or granting awards but delaying the setting of performance conditions. Flexibility will be the key to ensuring that the ultimate pay-out reflects performance.

Some fully listed companies may have already made share awards this year, when share prices are low. They will need to ensure, in accordance with the IA’s statement, that they have powers to adjust unvested amounts so that participants do not receive a windfall when share prices recover and that any gain is in line with performance.   

What are the consequences for EMI options and other tax-advantaged schemes?

There are a number of issues to consider for enterprise management incentive (EMI) options, as we have previously reported.

For all tax-advantaged option schemes - EMI, company share option plans (CSOPs) and save as you earn (SAYE) - there is clearly a risk of the options being underwater, with the exercise price payable being higher than the current market value of the shares. Employees buying partnership shares in a share incentive plan (SIP) may well find that the value of the shares they have purchased is now less than the price they paid.

With EMI options there was concern that furloughed employees would find their options disqualified because they no longer met the committed working-time requirement (25 hours a week or 75% of total working time if less). The Finance Bill 2020 amends the EMI legislation so that there is no disqualifying event if an employee is furloughed, takes leave or works reduced hours as a result of the pandemic as long as they otherwise meet the eligible employee requirements (broadly that they or their associates did not have 30% or more of the shares when the option was granted).  HMRC have also confirmed that the EMI valuation agreement period (during which the agreed and unrestricted market values agreed with HMRC will apply to options granted) is automatically extended to 120 days in the case of agreements where the 90 days would have expired after 1 March 2020.  Valuation agreement letters issued after that date state that the agreement will be valid for 120 days.

HMRC have confirmed in the case of CSOP options that as long as directors and employees met the working hours requirements when the options were granted (25 hours a week in the case of directors) being furloughed will not affect the qualifying status of their options.  

In the case of SAYE options, employees can already stop making contributions for up to 12 months without their savings contracts being cancelled.  HMRC have confirmed that contributions can be postponed for a longer period if they are missed because of the coronavirus (such as being furloughed or unpaid leave) but the amounts cannot be changed.  It should be pointed out that when contributions are postponed the maturity date of the savings contract is correspondingly pushed back which could cause employees to miss out on a new SAYE invitation offered before the existing contract has matured.  Furloughed employees are still eligible employees for the purposes of new SAYE invitations and Coronavirus Job Retention Scheme payments can be treated as salary and payments deducted from them.

Employees who are buying partnership shares under a SIP can already change the amounts they invest and/or stop and re-start deductions from salary at any time.  Payments which are missed because of the coronavirus cannot be made up but many companies  already offer a ‘top-up’ or lump sum facility which gives employees flexibility.  As with SAYE, furloughed employees are still eligible employees for the purposes of new SIP participation invitations and SIP contributions can be made from Coronavirus Job Retention Scheme payments. It should be noted that payments still need to within the £1,800 annual limit or 10% of salary if lower, and adjustments may therefore need to be made fir furloughed employees or employees working reduced hours.

How should we plan forward?

Companies should review their current LTIP rules and consider whether they require any amendments to provide flexibility. Bear in mind that you will need to seek to agree the next steps both with participants and shareholders in order to steer the business through to calmer waters.

Looking further ahead, fully listed companies will need to rethink their approach to implementing new LTIPs. We understand that the IA will require companies to consider whether an LTIP is right for their business and, if so, the type of LTIP required. Rather than using “off-the-shelf” LTIPs, companies will have to ensure that their LTIP is bespoke to their business and specifically designed to support the company’s long-term strategy. 

HMRC are intending to publish a bulletin on the effect of Covid-19 on (company and SAYE share option plans and share incentive plans as well as EMI options) so we will let you know more about that as soon as we do.

If you want to reduce, defer or cancel pay outs under your LTIP (or potentially still make pay outs under your LTIP notwithstanding that the performance conditions are not satisfied) we are currently offering a fixed fee review of LTIP plans. Please contact Sara Cohen or Victoria Goode for more information.