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Change-in-control (“CIC”) provisions for public company executives have re-emerged on radar screens of shareholder activists and regulators due to recent executive pay legislations, such as December 16, 2009, increased Securities and Exchange Commission (“SEC”) disclosures and Troubled Asset Relief Program (“TARP”) regulations.  These have intensified the need for companies to review their CIC agreements to ascertain they are aligned with market competitive practices and determine whether changes are necessary.   Additionally, shareholder activist groups are pushing proposals that seek to limit payments under CIC arrangements, designating certain CIC arrangements as “poor pay practices.”  Understanding the logic behind and the effects of CIC agreements is imperative to the Company and more importantly, the Compensation Committee.

Change-in-Control Triggers

The purpose of change-in-control agreements, also known as golden parachutes, is to safeguard executives during mergers and acquisitions that could potentially threaten the executives’ post-transaction employment.  Change-in-control arrangements are structured to be either single-trigger, requiring only a change-in-control to take place, or double trigger, which requires a CIC and a resulting termination.  In 2009, 9% of the 125 top companies on the Fortune 500 list moved from a single-trigger to a double-trigger change-in-control structure (Fred Cook 2009 CIC Practices), whereby a total of only 14% of Fortune 200 companies have single-trigger change-in-control provisions (Alvarez & Marsal).

Single-Trigger

Single trigger CIC provisions are heavily criticized for providing executives the benefit of payment for the CIC without the resulting termination.  Typically when a company is acquired, there is a subsequent change in management that leaves many executives without a job.  As long as the CIC meets the Internal Revenue Code (“IRC”) 409A definition, stating that the resulting payment can be made without a six-month delay for payments triggered by a termination of employment, the real advantage is that the CEO can negotiate in good faith without worrying about losing his position.

Double-Trigger

As indicated, double-trigger CIC agreements are more prevalent than single-trigger.  They require both the change-in-control, as well as a resulting qualified termination of employment.  Double-trigger CIC arrangements lend protection to executives following a CIC. For a specified period of time, the executive will receive payment if terminated not-for-cause or if the executive terminates for viable reason such as a career change, compensation decrease, title change, required relocation, etc.  Also, as this structure necessitates a resulting termination, the six-month payment delay required under 409A takes effect, unless the termination is involuntary or the CEO resigns with good reason which negates the need for the CIC to be 409A compliant.

Benefits Received in the Event of a CIC

Cash

An executive with change-in-control protection is typically given a multiple of base salary and bonus to shield the executive should he be terminated in connection to a change-in-control. Specifically, companies are concerned executives may leave before a transaction date, which may be detrimental to completion of an agreement. Likewise, an executive without change-in-control protection may fear a job loss and take the next best offer regardless of timing. Therefore, companies commonly offer a cash multiple of base salary and bonus in the event of a change-in-control and a qualified termination. The multiple of base salary and bonus offered depend upon the industry and the level of executive. It’s worth noting, between 2007 and 2009, 10% of the top 200 companies on the Fortune 500 list reduced the multiples for the CEO and other executives in response to increased oversight.  The multiple should not be based on the highest salary or bonus, or have a time period so short that the perception of manipulation is suspected. The following chart by Alvarez & Marsal details an analysis of Fortune 200 companies cash severance multiples for the CEO.

Equity

The accelerated vesting of stock awards and stock options is also a frequent benefit of the CIC arrangement.  Upon a CIC, any unvested equity awards held by the executive are commonly immediately vested, giving the executive ownership of those awards and removing any handcuffs the Company held on the executive. The rationale for acceleration of unvested equity follows that of cash severance payments.

Continuation of Medical and Other Benefits

The majority of CIC arrangements provide an amount for the continuation of medical coverage for a period of 18 to 36 months following the CIC (usually the same period of coverage as the cash payment).  This amount is calculated from the Consolidated Omnibus Budget Reconciliation Act (“COBRA”) cost that the executive would incur over that period of time.  According to Alvarez and Marsal’s Executive Change In Control 2009-2010 Report, since 2007, 10% of the Fortune 200 companies reduced their continued coverage from three years to between two and three years, consistent with a drop in severance multiple.

Excise Tax Gross-Ups and 280(g)

Under section 4999 of the IRC 280(g), an excise tax must be paid by an individual if total parachute payments exceed the “safe harbor limit” or $1.00 less than 3x Base amount. The Base amount is calculated as the average of the last five years of compensation listed on the W2 Form.  The excise tax amount is 20% of all parachute payments in excess of 1x the base amount.  Additionally, the Company loses the associated tax deduction for what is now considered an excess parachute payment.  Regardless of the extra expense and pressure of shareholder activists, 61% of CEOs and 58% of other Named Executive Officers (“NEOs”) at the Fortune 200 companies are entitled to a gross-up in connection with a CIC.  In response to the excise tax, companies have a few alternatives to consider:

• Restrict all payments to the safe harbor limit, also known as a cut-back. All payments in connection with a change-in-control are restricted to the safe harbor limit, thereby removing the individual excise tax liability from the executive, but reducing the executive’s payment.
• Provide a modified tax gross-up.  The Company decides on an amount over the safe harbor limit that it is willing to pay the excise tax on.  If that limit is exceeded, the Company will reduce the CIC payment to the safe harbor limit.
• Provide the best net effect, also known as the Valley Provision. The Company will cut-back the payments to the safe harbor limit only if the executive will receive a better net effect than if they were to pay the excise taxes on the excess parachute payments.
• Provide a performance provision. The Company provides a gross-up to the executive’s excise tax based on the Total Shareholder Return (TSR) since the severance plan has been in place (e.g., if the TSR to shareholders has been 50% from the inception of the plan, the corresponding gross-up to the executive’s excise tax will be 50%).  Structuring a gross-up in this manner provides the executive a performance-related incentive that is directly tied to the value created for shareholders.
• Provide no tax gross-ups to the executives in connection with a CIC.  The executive will be responsible for the additional taxes on the excessive parachute payments.
• Provide the executive with a full tax gross-up. In an effort to offset the excise tax and keep the executive whole, the Company will calculate the executive’s excise tax burden and pay the individuals tax on their behalf.  The Company will only pay the amount of the excise tax, not federal or state taxes. This practice is itself considered an excessive parachute payment and is considered a poor pay practice by shareholder activists.  In hopes of combating this issue, shareholder activists (RiskMetrics in particular) are recommending a withholding of votes for Compensation Committee members, and potentially the whole board.

While 280(g) was developed with good intention, the practice of 280(g) is sometimes counter-productive and punitive to executives.  Oftentimes, executives who have been historically under-compensated to conserve cash in the interests of shareholders will consequently have a low base amount.  In return, they are penalized by 280(g) and the corresponding excise tax for serving in the best interests of the Company.  On the other hand, executives who have historically received competitive, or in some cases, excessive compensation, a higher base amount that provides coverage for a higher safe harbor limit is created.  Additionally, multi-year, long-term incentive awards, typically implemented to motivate outstanding performance and/or make up for a lack of prior awards, are often accelerated.  This constitutes a 280(g) payment that works against the 2.99x base amount safe harbor limit, again potentially penalizing an executive (via excise tax) and company (via lost tax deduction) for making the ethical choice.

Additional Alternatives to Maintain 280(g) Safe Harbor Limits

Upon a CIC, companies ensure compensation provided to executives is appropriately classified. Specifically, IRS 162 defines what should be reasonable compensation and not compensation in connection with a CIC subject to 280(g). As such, a reasonable compensation classified under 162 keeps a company from losing a corporate tax deduction and prevents an executive from being charged with an onerous excise tax liability. The following are examples of compensation that may be classified as reasonable compensation under IRS 162:

Under-Compensation for Prior Years Service

If a company determines an executive will exceed the safe harbor limit, they have the option of performing under-compensation for prior years of service analysis.  This analysis reviews the historical compensation of an executive to resolve whether that executive has been reasonably compensated for their services to the Company over the course of the executive’s employment.  In the case of a CIC, if it is determined the executive in question has been under-compensated; the Company has a basis, under IRC 162, to reclassify the under-compensation amount out of the CIC calculation and into reasonable compensation.  If under-compensation is determined, the amount can be reclassified as equal to what is necessary to reduce the CIC payment to $1.00 less than 3x the base amount.

Reasonable Compensation following a CIC

Similar to the under-compensation classification, the Company can categorize earnings that work against the safe harbor limit as consulting fees or investment banker activities, or use the alternative of increasing the time limit on the executives non-compete which in turn has a value that can aid in reducing the CIC payment to within safe harbor limits. Under any of these alternatives, a company must prove the compensation under consideration is truly reasonable under IRC 162 and not considered a payment contingent upon change-in-control under IRC 280(g).

It is the responsibility of the Compensation Committee and the Board to fully understand the effects of a CIC on each executive and the Company.  With the regulatory environment targeting executive compensation on unprecedented levels and shareholder activists pressuring the stability of corporate boards, there is no better time for companies and boards to take proactive steps to further protect the Company, executives and shareholders.

Sources:

“Changes in Change-in-Control Practices” prepared by Frederic W. Cook & Co., Inc. on September 30, 2009.

“Executive Change In Control Report 2009-2010: Analysis of Executive Change in Control Arrangements of the Top 200 Companies” prepared by The Compensation and Benefits Practice of Alvarez & Marsal Taxand, LLC.