Think Carefully Before Rewarding Executives Who Cut Their Salaries

During the early stages of the pandemic, we have seen many executives take salary cuts, especially in industries substantially closed down by travel restrictions or shelter-in-place orders. These cuts are consistent with past economic crises, as they reduce expenses, preserve cash, and demonstrate compassion for employees and customers who are suffering economically—or even physically in this case.

In past crises—the 2008 financial crisis, for example—we saw many instances of compensation committees “reimbursing” executives for their salary cuts with outsized equity grants. Some also made up for unearned annual bonus plans with equity grants in the name of retention and alignment with shareholders. Grants came at times of depressed stock prices and were usually for a larger number of shares than normal since grants were generally determined according to the then-current stock price of the underlying equity.

As the market recovered, these grants accrued significant value. With the proxy statement reporting the dollar value at the time of grant, these later gains were not apparent until executive officers reported their gains upon disposition of their shares (often, years after the grant). While there were a few academic studies of these gains, they attracted no lasting attention from investors or the press.

Given the market’s tepid response to executive gains from equity granted at the time of salary cuts and zero bonus payouts, why not do it again? After all, those arguments about retention and shareholder alignment are very appealing. And the recovery of any particular company is not a slam dunk, particularly in the current unique market circumstances.

Despite what a jaded investor might say, an equity grant today is not a sure road to riches. Still, we urge caution in approaching a decision to make such a grant and some care in determining the size of the grant if you choose to make one.

Many directors will remember the uncertainty of the financial crisis and the circumstances under which they were making compensation decisions. This time, there are weighty differences in both the economic situation and the social background against which we will be making these decisions.

How COVID-19 Is Different
First, to set the context: COVID-19 is truly an exogenous factor impacting businesses. In the 2008 financial crisis, many people in a number of industries related to mortgage finance and homebuilding had participated in or benefited from the overheated housing market—it was a systemic outcome.

From these facts, one can argue that we should be more protective of executive interests today than we were back then. But that claim is countered by a much bigger factor—people are facing potential illness and death, in addition to job losses. This is a level of threat far beyond not being able to pay your bills. Although executives can and will die, too, the broader workforce is especially affected, particularly those in essential services.

Second, the pandemic has been compared to war, and war profiteering is one of the behaviors most repugnant to our societal conscience. We have already seen it in the public reaction to people buying up face masks to resell at outrageous prices in order to make a quick buck. Combine this with changes in social media, which is a much greater factor today than it was 10 years ago: Perceived offenses by corporations and their executives light up the Internet like never before, and we all know that perception can quickly become reality.

Third, we have known from the outset that entire industries are going to be transformed after the recovery due to consumer experiences shopping from home, people remaining reluctant to attend large gatherings, and reduced recreational and business travel. These transformations are going to seriously impact a very large proportion of the workforce. For others in less directly public-facing sectors, working from home may become more permanent, which will also significantly alter those businesses and workers and will likely then have ripple effects on transportation, commercial real estate, and other industries.

Finally, societal and investor demands are different today than they were a decade ago. In the United States, the increasing demand for social support services, especially health care and unemployment protection, will be accelerated by the nature of this crisis and the uneven governmental response.

Even prior to this crisis, investors have increased their demands for corporate action on sustainability, social, and environmental issues over the past several years. The economic impact of COVID-19 will probably result in a slowing of the pace of these broader demands as investors worry about earnings and stock prices, but this movement is not going away and may become sharply focused on the social services element.

What This Means for Equity Grants
Looking ahead three to five years, when the economy has fully recovered and stock prices are again robust, the executives who have been given extra equity grants today will begin cashing in on their gains. Data relative to these transactions are easy to obtain, and studies about them will be published.

Unlike similar studies published in the middle of the last decade, these reports are likely to attract major attention. Investors are likely to hold the directors who gave out those equity grants, and the executives who are still active, accountable. The consequences for both individuals and organizations could be much greater than they were the last time around, especially if those studies are published in an election year when the political climate is even more turbulent than normal (and there is little reason to expect that is going to settle down). While it is human nature to forget quickly, it is risky to rely on that happening a second time.

So, back to our original question: How does a director approach the issue of equity grants in an environment of salary cuts and zero bonuses? Here are some questions to ask.

1. Was our stock price in early March truly reflective of our economic value? Just as today’s price may be too low, the high price was probably on the generous side relative to performance—so what is an appropriate “normal” price for the stock?

2. What is your estimate of how much cash the executive will lose in foregone salary and unearned bonus?

3. If you make an equity grant now (whether a regularly scheduled award or a special grant), how much will the executive gain when the stock price gets back to “normal”? After all, the investor is only breaking even when “normal” is achieved, so asking whether the executive wins in that scenario is appropriate. A typical dollar-value grant made when the stock price is unfairly depressed can make up for a lot of foregone cash compensation (putting aside the temporary stress of the executive’s reduced cash flow).

4. What else are you doing for the executives in terms of adjustments to incentive award calculations or using discretion in determining awards?

5. Is the retention argument compelling in your case? Relatively few executives are truly vulnerable in the best of times, and in the worst of times, few competitors have an appetite for poaching due to their own problems. True retention issues in reasonably performing companies are almost always individual-specific and do not apply to the executive population as a whole.

By answering these questions, you can better determine whether you need to do something to compensate executives for their salary cuts and, if so, what a reasonable, well-thought-out approach is to doing so. Further, in being purposeful about how you determine if it’s appropriate to “make whole,” you have already established a solid basis for the next action: creating a proactive public communication plan.