Golden Parachute Compensation Practice Pointers

For a variety of practical and legal reasons, compensation to be paid in connection with the sale of a public company (which this article will refer to as “golden parachute compensation”) is best addressed well before an M&A transaction is being contemplated. There are a multitude of issues that are raised when designing these sorts of compensation arrangements, which generally focus on protecting a company’s executives if their employment is involuntarily terminated following a change in control, and below is a checklist to assist companies in approaching many of the important considerations.

1. Timing and Process:

Establish These Arrangements When They are Not Expected to be Needed Soon

Boards and compensation committees can establish the best possible record if golden parachute compensation is established at a time when a deal is not in the offing. They can act in a more deliberate manner over multiple meetings. They can ensure that they have time to direct the collection of and evaluate the peer group data. They can obtain the advice of independent experts, usually compensation consultants and attorneys. For Delaware corporations, they can avoid the “heightened scrutiny” that is generally applied when evaluating the prudence of decisions made in anticipation of a particular transaction. Demonstrating a prudent process will better protect the Board against potential liability for allegations that they breached their fiduciary duty by providing this type of compensation.

Allow for Periodic Re-Evaluation of Substantive Benefits

Circumstances change. Golden parachute compensation packages should be re-evaluated periodically in order to ensure that they are still serving their intended purpose beneficial to preserving the value of the company for stockholders, which is to protect key employees against the risk of involuntary job loss without overpaying or underpaying. Overpayment is a less efficient use of corporate assets and underpayment raises the risk that the retentive qualities of these packages will not work as intended. In effect, these sorts of arrangements act as a form of insurance for key employees, and the amount of coverage needed can change with the passage of time. A typical cycle for re-evaluation would be every 2-4 years.

2. Triggering Events:

No Single Triggers

In the public company context, payments are rarely made simply because a company has been acquired. So-called “single trigger” payments are not consistent with the purpose of golden parachute arrangements that support value to stockholders, which is to retain key employees through a possible sale without having them distracted by personal concerns or encouraging them to leave. Accordingly, they are viewed unfavorably by institutional shareholders and their advisory shareholder voting services (such as ISS and Glass Lewis).

Carefully Crafted Double Triggers

Golden parachute payments are generally paid only upon the occurrence of both of two distinct events: (1) the sale of the company and (2) an involuntary termination of employment. Therefore these payments are frequently referred to as “double trigger” payments. The second trigger is usually pulled upon the occurrence of one of two types of events: (1) termination without “cause” and (2) resignation for “good reason”. Most attention is generally paid to the “good reason” trigger, since it is more subjective and its presence raises a greater concern regarding compliance with Section 409A of the Internal Revenue Code. (“Good reason” definitions that are concluded by the IRS to be overly broad in scope raise concerns regarding whether an employee might become taxable on a portion of the golden parachute payments prior to actual receipt, and be charged with supplemental income taxes on top of regular income taxes.) In order to minimize those compliance issues, many companies use either a “safe harbor” definition for “good reason” specified in the Treasury regulations under Section 409A or a close relative of that safe harbor definition. While there are many issues that arise in the drafting of the definition of “good reason”, here are two examples.

(1) Distance from current job. Often an employee may become entitled to leave for good reason if his or her principal job location significantly changes. Many agreements just use a stock number of miles; 35 or 50 miles are popular numbers. But where a job is located can dramatically affect the appropriate number of miles. While movements of less than 50 miles may not be too disruptive in smaller headquarters cities, such as Kansas City or Pittsburgh, such a move can be extremely disruptive in a major metropolitan area. It may be feasible to commute from Kansas City to Lawrence, KS but getting from Greenwich, CT to Newark, NJ or from Vallejo, CA to Silicon Valley (San Jose) can be a nightmare. So a reasonable distance depends on where the employee lives and works.

(2) Retention of same job. If an employee retains the same job, is that a “good reason”? Most definitions allow for “good reason” if there is a material diminution in position. A line manager may be able to continue to perform his or her job in a basically unchanged fashion both before and after a sale. But what about a CEO, CFO or GC? They are no longer responsible for the direction of an independent entity, but are now performing their jobs for a controlled subsidiary. So no change in an employee’s position doesn’t necessarily mean that there has been no adverse impact. Depending on how the good reason definition is drafted, some executives (typically the CEO, CFO or GC) may have good reason upon the occurrence of the sale itself by virtue of the diminution of their duties because they are no longer employed by a publicly traded company.

3. Definition and Scope of Change in Control:

Be careful when defining “Change in Control”

There is no such thing as a standard definition for “Change in Control”. This definition should be tailored to the company and for the intended use.

For example, what percentage of a company’s stock should an acquiror possess in order to be said to have obtained “control”? For small public companies, it may make sense to require majority ownership. But for larger public companies with widely-held stock and fragmented ownership, a lower percentage ownership can allow an acquiror to exercise effective control. Percentages in the 30-40% range can be entirely appropriate for larger companies.

Generally, “change in control” will have a number of prongs intended to identify the various ways in which control of the management of the corporation can change. They typically include (1) stock purchases (including through mergers, consolidations and similar mechanisms), (2) asset purchases, (3) material changes in board composition over a limited period of time (e.g., in connection with a hostile tender offer), and (4) liquidations. Any good definition will include as much detail as is necessary to ensure that the definition fits its intended use.

Length of the Protection Period

A related issue deals with how closely related the change in control needs to be to an involuntary termination. A usual period of time following an acquisition is 1 to 2 years. We recommend that the post-acquisition protection period be no shorter than 13 months in order to provide an acquiror some flexibility in minimizing the potential adverse impact of golden parachute taxes (discussed in more detail below). While an involuntary termination within one year of a change in ownership is considered to be materially related to that change (and therefore all payments made on account of termination generally are taken into consideration in calculating the golden parachute tax liability), an involuntary termination more than one year afterwards generally is not. That means that payments made on account of a termination more than one year after an ownership change can enjoy reduced or perhaps even no inclusion in the calculation of potential golden parachute taxes. Some periods also include a short period of time prior to the acquisition or provide that the termination will trigger “double trigger” payments if directed by the acquiror, even if it occurs before the deal closes.

4. Elements of Golden Parachute Payments

Each company will need to determine the appropriate composition of golden parachute payments. Here is what we generally see, and what is less common or rarely seen.

Commonly Seen Elements

• Cash salary continuation (for specified period), often paid in a lump sum
• Estimated cash bonus replacement (for specified period)
• Stock award vesting acceleration (often 100%)
• Continued paid benefits (esp. medical) for specified period
• Pro rata bonus for year of termination
• Confirmation re: indemnification

Less Commonly Seen Elements

• Outplacement
• Retirement benefits accrual continuation
• Continuation of selected perquisites (e.g., tax and financial planning, car allowance, etc.)

5. Approach to the Golden Parachute Tax

Section 280G (and its companion, Section 4999) of the Internal Revenue Code provide for adverse tax treatment of payments made in connection with a change in ownership of a corporation that is deemed by the law to be excessive. In general, payments are considered excessive if they exceed three times the executive’s “base amount”, which is his or her average taxable compensation from the prior five years. Golden parachute arrangements need to deal with how to address this law. Since the employee may under certain circumstances be required to pay a supplemental excise tax, in years past many companies provided employees with a tax reimbursement (a “gross-up”) to compensate them for this additional liability. Since gross-ups can get extremely expensive for companies (especially since the application of Section 280G results in these payments being non-deductible to the company), many institutional investors and their advisors have heavily criticized the use of tax gross-ups in this context. In response, golden parachute gross-ups are now rarely seen, and then almost always only in arrangements that the company cannot amend unilaterally.

The most favorable approach for companies is to reduce so-called “golden parachute” payments to a level at which the adverse tax consequences are not levied, known as a “cutback”. However, employees are not generally supportive of cutbacks since they could result in dramatic reductions in benefits. Therefore the most commonly-seen approach today is the so-called “best after-tax results” or “best net” approach. In this alternative, the employee pays the excise tax if that would produce a superior after-tax result for the employee. If not, then the employee’s golden parachute payments are reduced. This approach is superior to not dealing with the issue at all, since if an employee and the company would both be better off if the employee receives reduced benefits, failure to address the issue doesn’t allow for that possibility. And trying to reduce benefits shortly before payment may create other tax problems, such as constructive receipt.

There are some planning opportunities available to reduce or avoid golden parachute payments even once a sale has been agreed upon. If a sale agreement is signed before year-end but does not close until the next year, executives may be able to increase their “base amounts” by accelerating income into the prior year, such as by exercising stock options. Companies on a calendar year will sometimes calculate and pay annual bonuses in the prior year. There may also be an ability to use noncompetition agreements to reduce the amount subject to the golden parachute rules. Any agreements that a key employee may enter into with the acquiror will generally be finalized after the closing.

6. Validation by Independent Compensation Consultants

The company’s compensation committee will generally have retained a third party compensation consultant. That consultant should be asked to advise the Board regarding the reasonableness of the golden parachute payment packages, especially those provided to senior executives. The consultant should be estimating the value based on a reasonable estimation of the sale price for the company (i.e., not necessarily the current stock price) so that the Board can best understand the estimated value of the packages under consideration.

7. Single Plan or Individual Agreements?

Some companies prefer to provide golden parachute payments through the vehicle of a plan document that provides for more standardized terms for all participants. The belief is that the use of a plan document deters individual employees from trying to negotiate separate packages and that plans are easier for a company to amend. Executives generally prefer individual agreements because of the greater contractual guarantees that individual agreements generally provide. Much of this debate is more a matter of style and communications, but the company should ensure that whichever approach it takes, the company will retain the ability to re-evaluate the golden parachute packages it provides periodically. One common approach is for individual agreements to have fixed terms (e.g., two to four years) that “roll over” annually after the expiration of the initial term unless the company provides notice that it is terminating the agreement. If such notice is provided, a new arrangement can be implemented.

8. Payments Should Require a Release of Claims

When employment is terminating and the company is making payments in connection with that termination, a release of claims should be obtained. This should also include a covenant not to sue or to support any action by another regarding a released claim. The scope of the release can vary, with many agreements limiting the release to employment-related claims while some releases are designed as a broad general release of all claims. The release should include not only the company, but also all of the company’s personnel (officers, directors, etc.) and affiliates (subsidiaries, etc.).

9. Payments May be Tied to Compliance with Restrictive Covenants

In addition to obtaining a release, payment of many golden parachute arrangements is tied to compliance with various restrictive covenants designed to ensure good behavior for a period of time following departure. Here is what we generally see, and what is less common (depending on where the employee is located).

Commonly Seen Restrictive Covenants

• Protection of company’s confidential information
• Non-solicitation of employees, and sometimes other service providers
• Non-disparagement of the company

Less Commonly Seen Restrictive Covenants

• Engagement in a competitive business/nonsolicitation of customers/suppliers
• Prohibition on hiring employees for a new business (even if not solicited)
• Regulated contact with the media on matters related to the company

10. Protective springing funding of estimated benefits

Some acquisitions may not be friendly. Employees may rightly be concerned that an acquiror might dispute their entitlement to golden parachute payments, especially if triggered by resignation for “good reason”. So in some unfriendly situations, we have seen Boards consider making arrangements to place funds in a segregated trust or escrow arrangement in order to assure employees that sufficient assets will be available to satisfy the company’s contractual obligations. Under these circumstances, selection of the person or group to make decisions regarding entitlement to benefits becomes of paramount importance. Common approaches are to engage (by then) former members of the Board or an independent institution. Care should be taken to ensure that the accelerated funding does not trigger income tax for employees before the benefits are actually paid.