1. Cash Conservation, Salary Reductions and Deferral Arrangements
In this time of financial distress, an employer may wish to conserve cash for operations or to try to avoid layoffs by implementing a broad-based salary reduction program. Generally, an employer is not prohibited from reducing the base salary of an “at will” employee (as opposed to an employee who is party to an employment agreement, which is discussed further below). However, there are several considerations that must be taken into account.
First, under most state laws, an employer must pay all wages due to an employee during any work week in which work was performed, on the applicable payroll date, so a reduction may only be applied prospectively and at the beginning of a work week. Second, in order to maintain overtime exempt status, an employee must be paid at least a minimum salary. Note that most states follow the Department of Labor standard of $684 per week, although some states have adopted higher minimum amounts. Third, if possible, an employee’s compensation should not be reduced below an amount which will enable an employee to pay his or her portion of applicable employee benefit costs (for example, health insurance premium payments). Finally, an employer should take into account the effect that a salary reduction will have on other compensation programs in which an employee participates, such as incentive or bonus arrangements, or on an employee’s future potential entitlement to severance pay or state unemployment insurance benefits.
For an employee who is party to an employment agreement with the employer, there are additional considerations and impacts of implementing a salary reduction arrangement. First, virtually all employment agreements will require the employee to consent to a modification of the employment agreement, so a reduction may not be implemented unilaterally. Second, if an employment agreement has a “good reason” termination definition that includes salary reduction as a triggering event, then the employee may have a right to resign and receive severance pay unless the parties agree otherwise.
Ideally, a salary reduction arrangement should not include a commitment or guarantee on the part of the employer to pay the foregone amounts in the future. Likewise, care should be taken before an employer offers an employee the choice to defer base salary (as opposed to a unilateral reduction) or to receive compensation in a form other than cash (such as an equity award). Otherwise, careful structuring will be required to avoid creating phantom income for the employee (resulting in tax liability prior to an employee’s receipt of the compensation) under the constructive receipt doctrine, triggering tax penalties under Internal Revenue Code Section 409A, or violating state wage payment laws (potentially resulting in enhanced damages and personal liability for individual officers of the employer).
Please see our Client Alert entitled “Labor Cost Reduction Options for Employers in a Distressed Economy: The CARES Act and Other Considerations,” for more details, including regarding the Paycheck Protection Loan Program (“PPL Program”) introduced by the CARES Act. If an employer receives a loan under the PPL Program, certain salary reductions could prevent the loan from ultimately being forgiven, unless restored by June 30, 2020.
2. Stock Option Repricing Programs
Extreme volatility in the financial markets caused by shelter in place advisories and general uncertainty regarding the course of the COVID-19 pandemic have adversely affected the stock price of many public and private companies. An employer who grants stock option awards to employees, particularly if such awards represent a significant portion of an employee’s total compensation, may be considering an option repricing program.
A stock option repricing program may be implemented when the exercise price of an outstanding option is higher than the value of the underlying employer stock (often referred to as an “underwater” option). Options that are significantly underwater may cease to provide appropriate incentives for the retention and motivation of executives and other employees. Option repricings may take a variety of forms, including: (i) a simple reduction in the option’s exercise price; (ii) an option-for-option exchange in which the old option is surrendered and a new option is granted, which may include the same terms or which may include different terms such as a new vesting schedule; or (iii) an option-for-stock exchange. An option repricing may be structured as a one-for-one exchange in which the exercise price is reduced but the replacement option covers the same number of shares as the cancelled option, or a value-for-value exchange in which the replacement option covers a smaller number of shares based upon a less than one-for-one exchange ratio.
In considering whether to implement a stock option repricing program, an employer will need to consider a number of issues. First, an employer will need to determine the structure and parameters of the program. The feasibility of different repricing structures is often determined simply based on whether the employer is private or public, with private companies having more flexibility in determining repricing terms. Second, shareholder approval of an option repricing program may be required. For example, stock exchanges such as NASDAQ and the New York Stock Exchange require shareholder approval of an option repricing unless the equity plan specifically permits repricing without shareholder approval. A public company that needs to secure shareholder approval will likely need to work not only with its legal advisors but also a compensation consultant and a proxy solicitor to design and implement the program. Third, an option repricing program may be subject to securities law tender offer rules, whether the company is public or private, if the conditions of the offer require an employee to make an investment decision with respect to the purchase, modification or exchange of the option. For example, a value-for-value option exchange will generally implicate the tender offer rules because the employee must decide whether to accept the replacement option covering a smaller number of shares than the original option. Finally, a stock option repricing program will have accounting consequences and may also have tax consequences, such as the loss of favorable tax treatment for incentive stock options.
3. Impact on Performance-Based Compensation Arrangements
The COVID-19 pandemic and its economic consequences are presenting special challenges for employers with performance-based compensation arrangements. In particular, many public companies that operate on a calendar year basis have recently established their company performance goals for 2020 and, thus, are faced with the prospect of having set performance targets that may now seem unlikely to be achievable, and which may not provide the performance incentives for executives and management employees that were originally intended. As proxy advisory firms have continued to focus on alignment between company performance and executive compensation, many public companies have moved toward providing a greater portion of their executives’ compensation in the form of performance-based cash or equity awards. It is common for cash awards to be earned on an annual basis, while equity awards may be earned over a multi-year period.
For an employer that has already set its 2020 performance goals, consideration should be given to whether the terms of the existing compensation plans or individual agreements provide flexibility for the employer to make adjustments and, if so, under what circumstances. Note that whether, or to what extent, an adjustment may be warranted also depends on the nature of the performance goals. Some metrics, such as share price or EBITDA, may be more obvious candidates for adjustment in contrast with comparative metrics, such as relative TSR, which may not need to be adjusted if an employer’s peer group companies are being similarly affected.
An employer that has not already set its 2020 performance goals has some flexibility to decide how to address the market volatility and uncertainty being caused by the COVID-19 pandemic. An employer may choose to postpone setting its performance goals until later in the year, or to forego granting performance-based awards altogether. An employer can also adopt performance goals that are more advisory than strictly prescriptive. However, for a public company, either approach may attract a negative response from Institutional Shareholder Services (“ISS”) and other proxy advisory firms as not providing a sufficiently formulaic connection between performance and compensation.
4. Furloughs, Layoffs, and Benefits Continuation
Employers should be aware that the difference in the common interpretation of two terms frequently used in employment law, “layoff” and “furlough,” may have important consequences in the employee benefit plan context. For employment law purposes, “layoff” generally means a termination of employment (and, thus, benefit plan participation), while “furlough” means that an employee is in unpaid, non-active status where no duties are performed, often with an expectation that he or she will return to employment at some future date. The furloughed employee, in the employment law context, retains his or her status as an employee and may continue to be employee benefit plan eligible unless applicable contracts and plan terms dictate otherwise.
This caveat is critical as insurance contracts (and related plan terms) often define eligibility for coverage by “active” employee status (typically based on the number of hours per week worked). Unless an insurance contract specifically provides that furloughed (non-active) employees will be covered, an employer that promises furloughed employees health insurance benefits may find itself self-insuring those benefits when the insurer refuses to cover furloughed (i.e. nonactive) employees. An employer that maintains a self-insured plan should review its contract terms with its stop-loss insurer for the same reason. (We note, however, that in light of the COVID-19 crisis, many insurers are now routinely approving benefit continuation during furloughs.)
In addition to obtaining necessary consents to cover furloughed employees, both the written insurance contract and plan documents (e.g. plan document and summary plan description) may require amendments. Finally, an employer should be aware that its decision regarding continuing health insurance coverage for furloughed employees necessarily also impacts an employee’s COBRA rights and the employer’s obligations with respect to those rights (although an employer may elect to subsidize the cost of such COBRA coverage).
To be eligible for federal COBRA coverage*, there must be both a triggering event and a loss in coverage. A reduction in hours, even without a termination of employment, is a triggering event for COBRA purposes, but a furloughed employee will not be eligible for COBRA coverage unless and until he or she loses coverage within the COBRA 18-month maximum coverage period. The timing of COBRA election notices, the commencement of the maximum coverage period, and the impact of Affordable Care Act requirements are complex issues that should be considered in consultation with an employer’s service provider(s) and/or counsel.
*Note: employers with under 20 employees must be aware of state “mini-COBRA” laws; certain states also provide continuation rights that supplement federal COBRA.
5. Section 125 Plan Election Changes
In ordinary circumstances, an employee may elect the health and welfare benefits offered by his or her employer during an open enrollment period and pay for many of the benefits on a pre-tax basis under the provisions of a Section 125 “cafeteria plan.” Such cafeteria plan elections must generally be irrevocable for the plan year, but a plan may include exceptions to this irrevocability rule and permit midyear election changes. During the current COVID-19 pandemic crisis, an employee may wish to make election changes by reason of being furloughed, having hours reduced, or due to the closure of a daycare center or other dependent care facility.
Common exceptions to the irrevocability rule that are most pertinent to the current crisis include:
- Changes in Status. This includes a change in employment status from full-time to part time that affects eligibility for the cafeteria plan or underlying benefit, as well as (i) a termination or commencement of employment; (ii) a commencement of or return from an unpaid leave of absence; and (iii) and a change in worksite. The election change must be consistent with the event.
- Cost Changes. A reduction of hours could result in an increased cost of coverage where an employer contributes a smaller portion of the premium for part-time employees, potentially permitting an election change.
- Reduction in Hours. Agency guidance on cafeteria plans permits an employee to revoke an election for employer sponsored health coverage due to a reduction in hours, provided that (i) the employee is expected to average less than 30 hours of service per week after the change (even if the employee doesn’t cease to be group health plan eligible); and (ii) the election revocation corresponds to the intended enrollment in another plan that provides minimum essential coverage no later than the first day of the second month following the month in which the original coverage is revoked. This would include, for instance, coverage under a state exchange or other employer health coverage.
- Becoming COBRA Eligible. If the employee becomes eligible for continuation coverage under the employer’s group health plan (including due to a reduction of hours resulting in a loss of coverage) under federal COBRA (or any similar state law), a cafeteria plan may permit the employee to elect to increase payments under the plan in order to pay for the continuation coverage.
- FMLA Leave. An employer may (i) allow an employee going on unpaid FMLA leave to either revoke or continue health coverage (including health FSA coverage); or (ii) require that health coverage continue, but allow the employee to discontinue contributions. If the employer continues coverage during an unpaid leave, the employer may recover the employee's share of the premiums when the employee returns to work.
- Dependent Care Election Changes. Dependent care flexible spending account elections may be changed, consistent with the change in costs, by employees who have a significant increase or decrease in qualified dependent care costs due to school closures.
Cafeteria plans can generally be selective in whether to include the permitted election changes, so the plan document should be reviewed and amended to the extent an employer wants to provide additional flexibility during the COVID-19 pandemic. Finally, an employer may wish to consult with service providers and counsel as the permitted change regulations and guidance can be conditional and complex, as well as subject to new legislation promulgated in reaction to the pandemic.
6. Retirement Plans and Relief Provisions in the CARES Act
In times of economic uncertainty employees often look to retirement plan savings as a source of emergency funds. The two standard means of accessing retirement plan savings while still employed are through hardship distributions and plan loans. Both are discretionary features, and an employer may want to review its plan design to see if loans and hardship distributions are currently permitted. If not, an employer may want to amend its plan to permit one or both features. Hardship distributions that are taken before a participant reaches age 59 ½ are typically subject to a 10% early withdrawal penalty (though note recent changes to the law, described below). Plan loans must be repaid on a fixed schedule, and if not repaid are also subject to the 10% early withdrawal penalty.
The CARES Act revised these rules as they related to the COVID-19 pandemic, and it implements a number of provisions that employers can make available in their retirement plans. The CARES Act has made the following discretionary options available effective immediately that can be incorporated into existing plans:
- Coronavirus-Related Distributions. An employer can permit “qualifying individuals” to take a distribution of up to $100,000 from plan accounts. Any such distribution is exempt from the 10% early distribution penalty that would normally apply. “Qualifying individual” is defined as a participant who meets any of the following:
- Is diagnosed with SARS-CoV-2 or COVID-19 with a test approved by the Centers for Disease Control and Prevention;
- Has a spouse or dependent diagnosed with SARS-CoV-2 or COVID-19; or
- Experiences adverse financial consequences from being quarantined, furloughed or laid off; having work hours reduced; being unable to work due to lack of child care; closing or reducing the hours of a business owned or operated by the individual; or from other factors, as determined by the Treasury secretary.
An employee must be able to self-certify that the distribution is related to the COVID-19 pandemic. The amounts may be re-contributed to a retirement plan within three years, and are eligible for amortized taxation over a three-year period.
- Larger Plan Loans. For qualifying individuals, the CARES Act temporarily increased the participant plan loan limit from $50,000 and 50% of vested benefits to $100,000 and 100% of vested benefits.
- Suspension of Loan Repayments. For qualifying individuals, new and existing loan repayment due dates before December 31, 2020 are extended by one year under the CARES Act. This delay period is not included in the maximum 5-year repayment period for plan loans.
- Required Minimum Distributions. The CARES Act has waived the required minimum distribution rules for 2020 in defined contribution plans for all participants.
An employer who is interested in taking advantage of these provisions may implement its decision immediately. The deadline for an employer to adopt plan amendments reflecting any changes is the last day of the first plan year beginning on or after January 1, 2022. Any employer wishing to adopt such changes should consult with its legal counsel and plan recordkeeper or other advisers on implementation.
7. Suspending Employer Contributions to Retirement Plans
Many employers are considering whether to suspend or eliminate company matching or profit sharing contributions to defined contribution retirement plans (e.g., 401(k) plans). An employer’s ability to make this change depends on plan design. One common design is a safe harbor plan, which requires an annual employer contribution in exchange for being exempt from certain nondiscrimination testing requirements. Generally, safe harbor plan contributions may only be suspended if the employer is operating at an economic loss, or if the annual safe harbor notice contains a provision regarding the employer’s ability to make such a suspension. Safe harbor plans require a 30 day notice to participants prior to making such a change, and a mid-year suspension will subject the plan to ADP and ACP nondiscrimination testing for that year. A plan that is not a safe harbor plan has more flexibility to implement a change to the employer contribution provisions. If the employer contribution is purely discretionary then a plan amendment may not be required. Otherwise, employer contributions may be adjusted via plan amendment. Note, however, that ERISA and the Internal Revenue Code contain strict provisions regarding the elimination or cutback of benefits that may have accrued to participants. It is important to consult with legal counsel prior to making any employer contribution changes, as additional consideration may apply regarding impermissible cutbacks and mid-year vested benefits.
8. RIFs and Partial Plan Terminations
Large-scale reductions in force may have unintended consequences for an employer’s retirement plan (e.g., a defined contribution plan such as a 401(k) plan or ESOP, or defined benefit pension plan). Under the Internal Revenue Code, a “partial plan termination” occurs when there is a sharp decline in the number of participants in a retirement plan. While the Code doesn’t define partial plan termination, it is generally considered to occur when more than 20% of a plan’s participants terminate employment. Upon a partial plan termination, affected participants must be fully vested in all amounts credited to their accounts, and in all benefits accrued up to the date of the partial termination. Further, the rules draw a wide net when it comes to determining affected participants. An affected employee includes employees who terminated for any reason during the plan year in which the partial termination occurred, including those who voluntarily quit. An employer should work with its legal counsel and plan recordkeeper or other advisers to determine whether the retirement plan has had a partial plan termination, and if so, which participants require an acceleration of vesting.
9. Plan Terminations
Whether as a result of a shutdown, bankruptcy, or corporate transaction, an employer may find itself needing to completely terminate a retirement plan. The IRS does not consider a plan to be fully terminated unless the company sets a specific date for termination, determines plan benefits and liabilities as of that date, and distributes all plan assets as soon as administratively feasible. All participants must also be 100% vested in their accounts as of termination. An employer should designate a responsible plan fiduciary who can manage the termination process, including the preparation of a final Form 5500, working with the recordkeeper to distribute accounts, and managing plan service providers during termination. It is important to understand that the termination process may not be fully complete until well after the designated termination date. Also note that this is a general description of plan termination considerations and that special issues arise if an employer is considering terminating a defined benefit pension plan (rather than a defined contribution plan, such as a 401(k) plan).
10. Plan Fiduciary Considerations
In light of the significant market volatility caused by the COVID-19 pandemic, plan fiduciaries should review plan investments and investment policies. Any decision-making should be documented by the plan committee, and fiduciaries should consider working with their plan investment advisors to determine whether any changes to the plan’s investment line-up or investment policy should be implemented. Any changes that were in-process prior to the outbreak may need to be revisited. Plan sponsors should also be monitoring recordkeepers and other service providers.
Contact Goodwin ERISA + Executive Compensation team members Natascha George, Jennifer Miani or Rachel Smith for any questions related to the impact of economic changes and workforce reductions on your compensation and benefits arrangements.