The COVID-19 pandemic dealt an unexpected blow that pushed a number of companies into bankruptcy. The impact of pandemic-related shutdowns was broad: Companies in a diverse range of industries – including retail, oil and gas, consumer goods, restaurants, and entertainment and recreation – filed for Chapter 11 bankruptcy protection in the first half of 2020. While the number of filings has not yet reached the level seen in the 2008 financial crisis, the number of bankruptcies is expected to rise through the remainder of the year.

The 2020 surge in bankruptcies has been accompanied by heightened scrutiny of executive pay in restructuring situations. Bankruptcy filings are often preceded by announcements of executive retention and other short-term performance-based awards. These awards can draw criticism as excessive and even inappropriate given the impact of bankruptcy on shareholders and the broader employee population. However, 2020 is unique. While situations vary by industry, most agree that this flurry of bankruptcy filings is not the result of poor management but rather the inevitable impact of unprecedented and unforeseeable broad shutdowns across the country to contain the pandemic. The companies entering bankruptcy need continuity, stability, and motivated leadership. Carefully designed and communicated retention and performance awards can play an important role in keeping leadership in place and focused on moving the company through the restructuring process.

The Evolution of Prepaid Awards

Corporate bankruptcies cause a significant amount of uncertainty for executives and employees, who can be tempted to leave for more stable work situations with predictable, secure compensation streams. Poor company performance means that annual incentives are unlikely to pay out, and equity holdings lose almost all value. In situations where shareholders need to retain executives through the bankruptcy period, cash retention awards to critical members of management can be effective by providing compensation stability. These programs are often called Key Executive Retention Programs (KERPs).

Executive retention awards in bankruptcy situations today have a unique design: they are paid before the bankruptcy filing and are subject to clawback provisions. Clawback provisions are triggered if the executive terminates employment during a specified time period or is terminated for cause. In addition, some clawbacks are tied to performance goals not being achieved. If triggered, the clawback provisions require executives to pay back the after-tax award value. The fact that the awards are prepaid differentiates them from most other cash incentives and makes them the subject of criticism and misunderstanding.

The unique design for executive retention awards emerged from changes to the U.S. bankruptcy code made through the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA). Prior to BAPCPA, a large portion of executive compensation in bankruptcy situations was delivered through retention awards. Executive retention awards were typically paid out in a lump sum or through several payments based on the executive’s continued employment. Executive retention awards also had special status in the bankruptcy proceedings that ensured payment ahead of many other company obligations. As a result of the special status and lack of performance features, executive retention awards were not viewed favorably.

BAPCPA imposed stringent restrictions on awards to “insiders” implemented during the bankruptcy process that are based solely on retention and that lack performance features (“Insiders” are defined as directors, officers, individuals in control of the corporation, and relatives of such individuals). BAPCPA’s restrictions effectively stopped the use of executive retention awards once companies file for bankruptcy. Despite BAPCPA, executive retention awards eventually re-emerged – as prepaid awards subject to clawbacks. By paying the awards before the bankruptcy filing, companies can generally avoid the BAPCPA restrictions and avoid having the award subject to Bankruptcy Court approval.

Prevalent Executive and Employee Pay Practices during Bankruptcy

CAP analyzed the 8-K filings of a number of companies that entered bankruptcy in 2020. Based on this analysis, companies today often use a mix of compensation programs to retain and motivate executives and employees leading up to, and during, the bankruptcy process:

• Pre-filing, prepaid executive retention awards
• Performance-based Key Employee Incentive Plans (KEIPs)
• Employee retention and incentive programs

Pre-Filing, Prepaid Executive Retention Awards

A number of companies that filed for bankruptcy during 2020 announced prepaid retention awards for executives anywhere from days to months before the legal filing. The 8-K filings indicate that the prepaid retention awards are designed by the board with advice from compensation consultants, as well as bankruptcy and other advisors. Typical design parameters for executive retention bonus awards include:

While less common, some companies, including Chesapeake Energy and Ascena Retail Group, include base-level performance criteria in the clawback provisions to add a performance element to the prepaid retention awards. This improves the overall optics of such awards and helps avoid additional scrutiny during bankruptcy.

Performance-Based Key Employee Incentive Plans (KEIPs)

After BAPCPA, KEIPs emerged to provide incentives to executives without running afoul of the bankruptcy code. KEIPs, which are approved during the bankruptcy process, are performance-based incentives that pay out in cash based on the achievement of financial and operational goals. The goals can be very short-term in nature, such as quarterly performance periods.

Typical design parameters for KEIPs include:

A current trend is to design and implement the KEIP prior to filing. This is especially true in pre-packaged bankruptcies where the financial reorganization of the company is prepared in advance in cooperation with its creditors. Having these programs in place with payouts contingent on performance improves continuity throughout the entire process, incentivizes the management team to perform, and meets the court’s requirement that any variable compensation to executives be performance based.

One recent example of a company announcing a KEIP before the bankruptcy filing is Diamond Offshore Drilling. The company announced a prepaid retention program for executives, as well as a KEIP, a non-executive incentive plan and an additional retention plan. All plans except for the prepaid executive retention program are subject to Bankruptcy Court approval, according to the 8-K. The KEIP, nonexecutive incentive plan and the additional retention plan replace past incentives – including requiring the forfeiture of past restricted stock unit awards and stock appreciation rights – and current incentives that would have been granted in 2020. The KEIP includes nine participants, including the senior executive team.

Employee Retention and Incentive Programs

Retention and incentive programs for employees are also used during the bankruptcy process. The use of employee programs depends on the company’s business needs and other factors, such as size and industry. Retention and incentive programs for non-executives typically replace the value of annual incentives and sometimes long-term incentives. Employee retention programs are cash-based and pay out at specific intervals, often quarterly given the uncertainties associated with companies in restructuring situations. The duration of employee retention programs often mirrors those for executives.

Severance programs, which provide compensation to individuals at termination, are also used in bankruptcy situations. When communicated broadly during bankruptcy, severance can be considered a retention program as it helps employees have some financial security and focus on their current jobs rather than finding new positions. Severance programs tend to be used more commonly for employees than executives because BAPCPA limits the value that can be delivered to “insiders.” However, a recent example of a severance program for executives came from Hertz Global Holdings, which announced amendments to its executive severance programs prior to its bankruptcy filing in May 2020. The severance programs, which were disclosed in the same 8-K filing as a prepaid key employee retention program, cover senior executives and vice presidents, and the payment multiple was reduced to 1X salary and bonus from 1.5X.

Conclusion

Executive compensation programs implemented in conjunction with a bankruptcy should be carefully designed and reviewed with outside advisors to ensure that the company is complying with bankruptcy code. Companies should carefully review the value of executive awards to ensure that they are reasonable while also in line with competitive practices and past incentive opportunities. Executive award amounts should be considered in the context of employee awards and the company’s overall financial situation to ensure fairness and avoid the appearance of excess. Lastly, companies should carefully communicate the rationale for executive awards and what the company is doing for employees in the 8-K current report or other announcement. Clear communication up front can help head off later public relations and optics headaches.

When OPEC meetings in Vienna ended last week without a deal to extend production cuts to counter the drop in demand brought about by the Coronavirus outbreak, Saudi Arabia and Russia initiated a production battle, flooding the market with more oil regardless of the price. As a result, the energy industry is in a tailspin with WTI crude prices at $22.

The impact of this price drop has had an immediate impact. Producers have already announced spending cuts which quickly trigger layoffs and furloughs among the oilfield services and drilling companies. Some companies have already announced these moves and it is inevitable at many others.

CAP has conducted a “pulse” survey within the oilfield services and drilling sectors to get a sense of the impact this is having on executive compensation. 19 companies participated in our survey this week and the findings are summarized below.

Key Takeaways

• While less than 10% have implemented base salary cuts, nearly half of the companies we spoke with are currently considering them and the reductions will be deeper than those made several years ago at the start of the downturn.
• Nearly one-third of companies have not yet established annual incentive goals for 2020.
• Another one-third indicated that discussions to adjust goals approved in the last few weeks have already begun.
• 16% indicated that bonus payouts for 2020 have already been capped or suspended altogether. The vast majority indicated bonus target reductions have not been considered.
• As the first quarter of 2020 comes to a close, 47% of companies already indicate they expect the Compensation Committee will exercise discretion on bonus payouts at the end of the year.
• 21% of companies have not yet made LTI grants with some citing market volatility.
• 79% of companies have already issued grants with 73% of those indicating that grant date award values were equal to or very close to prior year award values. 27% have modest reductions in grant date value mostly attributable to lower stock prices.
• Almost 60% of companies stated that cash-settled long-term awards were (or will be) used. The average allocation of cash awards is roughly 50% of the total value granted.

Base Salary

2020 was not going to be a year for prevalent salary increases in the sector, but within a matter of a weeks it now seems inevitable that executive salary cuts will be widespread. As talk of layoffs and furloughs turns into reality, the optics are not good (internally and externally) if executives are not also impacted. While only a handful of companies have already implemented salary cuts, the topic has come up and is under consideration at nearly half of the companies we spoke with.

Our early read is that the cuts already implemented and under consideration are deeper than those we saw 4-5 years ago. At that time, reductions of 5-7.5% were common. Cuts of 15-20% have already occurred at a couple of companies with a few others indicating 10%-20% cuts are likely.

Annual Incentive / Bonus Program

One of the toughest responsibilities of the Compensation Committee is to establish meaningful performance goals in the midst of great uncertainty. Based on our survey, approximately 32% of companies have not yet established performance goals for 2020.

Of those with approved goals, 31% indicated they already anticipate an adjustment to the performance levels approved just in the last few weeks.

During the extended downturn, we have seen many companies widen the range of performance from threshold to maximum. With these wide performance ranges, the payout levels are typically lowered. For instance, when threshold performance is lowered to 60% or 70% of target the payout might start at 25% instead of the normal 50% of target. Likewise, maximum performance is often stretched further or the payout may be capped at a lower multiple (i.e. 150% vs. the standard 200% leverage).

A few companies indicated that within the last couple of weeks they have already suspended or capped 2020 bonus payouts. While only 16% of companies indicated such actions, it is not an insignificant development at this early stage.

One trend that we think will increase dramatically in 2020 will be the use of discretion by the Compensation Committee. In fact, with Coronavirus adding to the disruption caused by low oil prices, we believe discretion will be widely used across many industries this year. 47% of the companies in our survey already expect the Compensation Committee to exercise discretion over payouts at the end of the year. A little more than one-third (38%) of those expecting discretion indicated the application would only be negative (to lower payouts).

Competing views on the use of discretion are sure to emerge. ISS and Glass Lewis consider positive discretion to be problematic although that view may evolve this year given that global economy is under unprecedented stress. Some will argue that as stakeholders are hurt, executive bonuses should be reduced or even curtailed. On the other hand, executives will work tirelessly and often pick up additional responsibilities in times like these to stabilize and survive and some believe they should be rewarded for doing so.

It will be important for all to document the impact of the oil price decline coupled with the impact of the Coronavirus. These events are so significant that it may be necessary for compensation committees to evaluate an executive team’s performance on executing the adjusted strategic plan.

Whether discretion is applied or more qualitative type goals are used to assess performance, companies should be prepared to provide clear and enhanced disclosure of the decision-making process and the impact of the operating environment.

Long-Term Incentive Program

Stock prices within the sector were already low and many companies had already spent a great deal of time deliberating over grant sizes and values for 2019/2020 cycle awards. To make matters much worse, stock prices have fallen precipitously in the last few days – more than 50% in most cases. For those who have not yet made grants it will likely be impossible at this point to come close to awarding values from last year due to the severely reduced stock prices, burn rate implications, and share availability.

That said, most of the companies responding (74%) have already issued grants. 73% of those companies issued 2020 awards that have a grant date value equal to last year’s award. 27% indicated that award values are less than prior year primarily due to share availability and lower stock prices as opposed to intentional reductions in award value.

Nearly 60% of the sector issued (or intends to issue) cash-settled awards. The average company has allocated 50% of the total award value to cash-settled instruments. The most prevalent practice is to issue restricted stock awards with performance-based awards that pay out in cash. The use of cash alleviates some of the pressure on long-term plans by reducing share usage.

As we move forward, companies will be forced to consider various techniques. These could include dilution caps, using a 30- or 60-day average stock price to determine grants, restricted cash awards at and below the director level of the organization (and possibly higher), establishing stock price hurdles that act as performance conditions for vesting to occur or switching to a fixed share approach, among other practices.

Conclusion

While companies across the globe are in crisis mode, it will be important for compensation committees to strike a balance between stakeholder interests and the interests of their executives. A tremendous amount of wealth has been erased in a week. While retention is a key issue it should not be overplayed at this moment. The focus is to manage through the crisis. Achieve alignment by motivating the team to engage in the achievement of the strategic plan by incorporating milestone measures into the annual incentive plan and make financial performance goals achievable – at least at the threshold level. Use discretion where appropriate to balance outcomes at the end of the year. We are at the front end of an unprecedented year for the oil & gas industry while at the same time the entire world braces for recession due to Coronavirus. However, the recovery, when it comes, will bring opportunity.