Executive Insecurity - No Better Time for Employer Attention. Bloomberg Labor & Employment Law Report. October 6, 2008.

October 16, 2008

Mark Poerio, Eric Keller, Ethan Lipsig, Stephen Harris

Executive Insecurity - No Better Time for Employer Attention Bloomberg Labor & Employment Law ReportOctober 6, 2008

Contributed by Mark Poerio, Ethan Lipsig, Eric Keller, and Stephen Harris, Paul Hastings Janofsky & Walker LLP

The collapse, takeover, or bailout of such Wall Street heavyweights as AIG, Bear Stearns, Fannie Mae, Freddie Mac, Lehman Brothers, and Merrill Lynch has caused a loss of confidence that reaches far beyond the investor community. Job insecurity is rampant. Just this week, CNBC reported a prediction that 1,000 or more banks would fail in the coming months. Within the past few weeks, federal regulators acted to eliminate millions of dollars Fannie Mae and Freddie Mac CEO severance pay.

Employees and executives do not just have their jobs to worry about. They have real reasons to worry about whether their compensation will be reduced, whether their severance pay and deferred compensation promises will be honored, and whether they can survive the precipitous decline in personal wealth many have experienced as their employer stock (and other) holdings have fallen in value. Employers rattled by uncertainty understandably may be paralyzed, but many of them should at least consider taking decisive actions designed to mitigate employee anxiety and preserve employee talent.

So what is an employer to do? Jack Welch said it simply during the sharp 2001 downturn: In bad economic times, you have to take care of your best. Executing of this strategy effectively requires thoughtful employer attention to compensation structures and severance protections, with consideration given to:

Improving morale and productivity.

Defusing unwarranted concerns about a change in corporate control or employer bankruptcy, and addressing those concerns if they are legitimate fears.

Preserving business value, whether for a short-term exit or long-term viability.

Recalibrating incentive plans and awards as appropriate both to encourage award holders and to protect key business interests.

Discouraging key employees from looking for better security or opportunities elsewhere.

Ensuring severance protections are adequate to allow employees to focus on their jobs rather than worrying about what will happen if they are let go.

It is critical for decision-makers to proceed holistically, considering all relevant business, HR, accounting, and legal issues in a comprehensive, integrated matter. There is no one roadmap by which employers may navigate todays challenges. Nevertheless, many employers will have to consider the same or similar issues.

Q-1: What are your most critical workforce challenges e.g., retention, relocation, growth, reduction, or restructuring?

Reason for Concern. Employers need to prioritize in order to act preemptively, and thereby take advantage of the opportunities to retain their talent. The global job market makes this a complex calculus, and existing executive compensation structures may even be creating incentives for unwanted terminations of employment (e.g., to expedite collection of at-risk severance or deferred compensation benefits).

Actions to Consider. Hold an off-site or retreat with experienced advisors to develop an action plan that takes into account the broad spectrum of business, HR, legal, economy, and other workforce planning issues.

Q-2: Who do you need to retain and motivate?

Reason for Concern. In rough economic times, mediocre employees stay put. It is the star performers who have the greatest employment mobility.

Action to Consider. First identify your best talent, and then be sure that they either are unlikely to quit, or that you have at least considered giving them performance-based awards and severance and other retention awards (such as pay-to-stay bonuses, which often are tied to continued service until a critical date) that will enhance their long-term commitment.

Q-3: Are there opportunities to better deploy under-utilized personnel? If not, when and how will you contemplate layoffs, exit incentives, furloughs, forced vacations, reduced hours, or other temporary or permanent work force reductions?

Reason for Concern. Under-utilized workers typically are anxious, unproductive, and less loyal because they generally see their limited long-term future. They may be more likely to adopt a punch the clock attitude as they focus more on other employment opportunities than the dwindling ones they perceive at their present job. They tend to file more disability, discrimination, and other employment-related claims.

Actions to Consider. Employers often have projects that have been back-burnered over the years. Often these projects can be assigned to an otherwise under-utilized workforce. If this is not possible or practical, any downsizing strategy should be structured to optimize the present and future workforce and minimize the harm to the morale of the surviving workforce. For example, one big layoff may be less harmful in the long run than a series of smaller ones over an extended period of time. Employees are less likely to see the latter as a beneficent employers effort to preserve jobs than they are that of an inept employer that cannot get things done right the first time, and the continuing layoffs will keep the remaining workforce roiling with job insecurities. On the other hand, first offering exit incentives before resorting to layoffs may be a gentler and more effective way to achieve a desired workforce reduction.

If layoffs or exit incentives are in the cards, make sure that severance or exit incentive programs are well-documented and optimized, e.g., sensibly designed, Internal Revenue Code Section 409A-compliant, require stateof-the-art releases, etc. In most cases, an ERISA-covered severance plan is preferable to a series of severance agreements, which might be subject to state law or might be ERISA-noncompliant. It is also critical to understand and minimize WARN Act issues, and to consider reducing or eliminating certain benefits for workers notified of future layoff, e.g., disability or vacation accruals.

Q-4: Is your company perceived as being at risk of being sold, taken over, or going bankrupt?

Reason for Concern. The best talent will have the best opportunities for more secure or remunerative employment, and may seize those opportunities (in the absence of employer action to cement their loyalty). The unfortunate result is that an employers workforce may be increasingly comprised of those who are least likely to find alternative employment.

Actions to Consider. If attrition is a concern, consider implementing retention arrangements. Alternatively, pay-to-stay bonuses may reward those who stay employed until a critical date or a targeted corporate event, such as the end of a transition period after a corporate sale.

If a corporate sale, merger, or takeover is the concern, it may be time to finely-tune your severance plan. Special change-in-control incentives might trigger golden parachute penalties, which may make tax gross-up protections (despite investor disfavor) or other lesser safeguards appropriate. Because acceleration of vesting in connection with a change in control normally will result in parachute payments, the shift toward performance-based vesting has increased golden parachute risks in recent years.

For bankruptcy concerns, there are proven stalwarts (secular trusts and letters of credit) for new benefits. Cashing-out (or securing) existing benefits is more problematic, but one last opportunity is available under a special Code Section 409A transition rule that ends on December 31, 2008. Such cash-outs need to be done well before a bankruptcy filing to be defensible.

Employers have many alternatives for quelling employee anxieties. The key is to identify the real concerns, and to promptly implement targeted, responsive countermeasures.

Q-5: Do your incentive bonuses or stock-based awards need recalibration?

Reason for Concern. It is natural for shareholders and investors to want executives to share their pain (in the form of a sense of loss) by holding out-of-the-money stock options and awards with unattainable performance targets (together, underwater awards). Unfortunately, these awards sap morale and leave employers vulnerable to competitors who offer incentives that give executives a fresh start having greater potential for future value.

Action to Consider. Assess potential replacement of underwater awards, but be wary of shareholder and investor reaction, as well as SEC tender offer, financial statement, Code Section 162(m), Code Section 409A, and other issues that may arise. For employers with collapsed stock prices, cash-based incentives are generally the best currency for incentive compensation. If past stock incentives have imploded, or if employer stock is a questionable currency for awards, formula-driven cash bonus plans normally may serve as healthy performance incentives. Deferred bonuses may effectively create golden handcuffs that encourage long-term performance and loyalty, and discourage loyalty (such as non-competition) requirement violations.

Q-6: Do you want to better discourage employees from pursuing competitive employment or improper behavior (such as unduly aggressive financial statement accounting practices that ultimately may require a financial restatement)?

Reason for Concern. Harsh economic times exacerbate the damage that comes from disloyal or dishonest executives. Those who leave for competitors often can steal valuable information and critical customers. Those who cook the financial books can cause a future stock price collapse.

Action to Consider. Impose or strengthen non-compete and claw-back protections. Since the passage of the Sarbanes-Oxley Act of 2002, Boards of Directors and their compensation committees have become increasingly cognizant of discouraging executive misconduct through the inclusion of forfeiture or recapture (aka claw-back) rights with respect to executive officers equity awards and other compensation. The legal consideration for securing such an agreement commonly is provided through new benefits, e.g., retention arrangements, or replacements for underwater awards.

Q-7: How will you effectively communicate the actions taken to advance your workforce goals?

Reason for Concern. In an anxious workplace, employee productivity and morale suffer from uncertainty, such as over their employers financial status, possible reductions in force, or the severance benefits that would be provided if there were reductions in force.

Actions to Consider. Meet with key employees to better understand and address their and the broader workforces concerns. Develop a strategy for communicating with the entire workforce on these issues. Doing so requires well thought out responses that strike an appropriate balance between transparency and discretion. Because well-intended warnings or promises may back-fire, it is best to have legal counsel involved in the communications process.

Conclusion

Job insecurity is rampant, particularly in the hard hit financial sector. It may be tempting to do nothing and hope for a rebound, but it may be better to take prompt and decisive actions It will be tempting to freeze and wait for a rebound, and hope key employees stay focused and loyal. It would seem better to take decisive, prompt action and thereby secure the best talent for the current economic storm.

Mark Poerio is a partner in the Washington, D.C. office of Paul, Hastings, Janofsky & Walker, and co-chairs the firm's global executive compensation and employee benefits practice. Principally for executive and stock-based compensation, he advises corporate boards and officers about relevant business, tax, financial accounting, securities, labor, M&A, severance, and litigation issues.

Ethan Lipsig is a partner in the Los Angeles Office of Paul, Hastings, Janofsky & Walker and founder of the firm's 40-plus ERISA practice group. His practice focuses on institutional investment, employee benefits litigation, workforce restructuring, and executive compensation.

Eric Keller is a partner in the Washington, D.C. office of Paul, Hastings, Janofsky & Walker representing clients in all aspects of executive compensation and employee benefits law. He advises boards of directors and compensation committees on how to design and implement executive compensation arrangements that comply with Sarbanes-Oxley, stock exchange listing requirements, securities disclosure requirements and other corporate governance standards.

Stephen Harris is a partner in the Los Angeles office of Paul, Hastings, Janofsky & Walker devoting his practice to executive compensation, employee benefits and workforce restructuring matters. He advises clients regarding design, administration, and fiduciary matters.

(c) Bloomberg 2008. Originally published by Bloomberg Finance L.P. Reprinted by permission.