Beginning With the End in Mind
June 14, 2008
Case categories include: M&A
By Kathryn Meier, Esq.
Imagine that your company is seeking to merge or be acquired only to discover that the “change in control” provisions in your compensation agreements are scaring away potential suitors. Internal inconsistencies within your agreements (employment agreements, change in control agreements, severance plans, equity incentive plans, supplemental executive retirement plans, etc.) create substantial financial liabilities that you may not uncover until it is too late. Such unanticipated consequences can adversely impact or kill your deal.
So, summer is a great time to pull out that change in control language (admit it, you “borrowed” it from your last company) and make sure that it is current, competitive and compliant with state and federal laws. To get the juices flowing, here is a basic checklist of the kinds of change in control language to look for in a typical CEO employment agreement:
- Appropriate Triggers: There are three basic types of events that trigger an entitlement to severance payments in the event of a change of control:
- Single Trigger: Requires only a qualifying change in control to trigger entitlement to the severance benefit, so that a non-terminating CEO can be entitled to the benefit. These are used much less often now than in the past.
- Double Trigger: Requires the change in control and the termination of the CEO for “good reason” or by the company without “cause.”
- Modified Single Trigger: Adds a short voluntary termination period to the double trigger, typically 30 days after the one year anniversary of the change in control event.
- The Timing of the Trigger: Current change in control provisions typically have a two to three year period of severance eligibility after the event. The period is often shorter for other executives.
- Definitions of “Change in Control”: Companies should anticipate what types of future transactions would qualify for a change in control specific to the company’s exit strategy. Typical provisions include:
- Any sale, merger or consolidation of the company with another company that involves all or substantially all of the company’s assets.
- The passing of a resolution by the board of directors or the shareholders to liquidate the assets of the company in one or more transactions.
- Any takeover of all or substantially all of the assets of the company by any person or persons other than the current shareholders.
- A sale of a majority of the voting securities of the company by the existing shareholders.
- Definitions of “Good Reason” and “Good Cause”: To be eligible for the severance benefit, the CEO will have to demonstrate that his/her resignation is for “good reason” or that the company terminated him/her “without cause.”
- “Good Reason” Can Include:
- Material adverse change in titles, duties or responsibilities
- Material reduction in budget authority
- Material reduction in compensation
- Material change in employee benefits
- Change in reporting structure (to whom the CEO reports)
- Material breach of other key employment contract terms
- “Cause” Can Include:
- Illegal or gross misconduct
- Material failure to perform duties
- Breach of restrictive covenants
- Breach of company’s code of conduct
- Breach of fiduciary duties
- Failure to cooperate with, or attempt to obstruct, any governmental investigation
- The Amount of Severance and Its Components: CEO severance packages can range from 1 to 3 times “annual compensation” in a cash payment. Annual compensation typically includes base salary and any annual bonus. Fewer companies can get away with “salary only” as the basis for the calculation. Other components can include:
- Pro rata Bonus: This is the bonus “earned” in the prior measuring period.
- Reimbursement of Health Premiums: The employer provides reimbursement of COBRA premiums for a defined period of time.
- Outplacement Assistance: This benefit is a plus if the CEO is not experienced in seeking out other CEO level positions.
- Other Perquisites: Some companies will allow the CEO to purchase a company car, continue club memberships and the like.
- Consideration of 409A and Other Tax Implications: While too extensive to cover in this short checklist, the company needs to understand the substantial tax implications of change in control agreements. The value as well as the timing of a severance plan payment can have tax penalty implications and should be reviewed by experienced counsel. For instance, in an excess parachute situation, some companies include a “gross up” provision in the agreement to cover additional taxes owed by the CEO in the event of a penalty.
- Legal Fees Reimbursement: Some companies include clauses that provide reimbursement of legal fees incurred to assert the CEO’s rights under the agreement. This benefit can be a way to smooth the change-in-control process.
- Release of Claims: More companies are including a release as a part of the severance agreement. It is important to confirm that there has been adequate consideration for the release.
On a final note, remember that there are change in control provisions in other employee benefits documentation (e.g., SERPS and equity compensation plans) that may have different triggers and terms than those found in the employment agreement. It is important to understand why those differences exist and whether the differences create a conflict with other benefits documents. Getting an independent compensation consultant or attorney to audit your overall compensation plan is the best way to assure yourself that you are compliant and your documents are internally consistent.
Kathryn Meier, Esq. is an employment attorney and the President and Managing Shareholder of the law firm of Hoge Fenton Jones & Appel in San Jose, California. Kathy is a frequent speaker on employment law issues for businesses.