Is Your Parachute Plan Shareholder-Friendly? This is the ideal time for thoughtful managements to ensure that their change-in-control severance packages aren’t excessive windfalls.

Because of the increased scrutiny of executive pay and the slow pace of mergers and acquisitions deal flow, this is a good time for compensation committees of corporate boards to review their change-in-control (CIC) protections to ensure that severance benefits, historically known as golden parachutes, meet their design objectives, pass an external test of fairness, and do not represent undeserved windfalls for postacquisition departures of top managers. CIC protection provides companies with an opportunity to properly align executive and shareholder interests – if programs are designed correctly – and to reinforce behaviors that promote maximum value from merger and acquisition activity. Executive pay, of course, has been under a microscope for the last few years because of seemingly endless reports of top executives betraying the trust of shareholders. The consensus of shareholder advocates, boards, regulators, consultants, and other interested observers is that executives should be paid fairly, based on performance, but not obscenely. This awareness has forced reexamination of many longstanding executive pay practices, including the swing to expensing of stock options, and for the first time in memory, overall executive pay levels may actually decrease. As the many pillars of executive pay packages are revisited, boards and their advisers should consider a variety of issues about each element: * Is it fair and ethical? * What purpose does it play for shareholders? * Does it motivate the desired behaviors? * Does it have the potential to motivate negative behaviors? CIC protections are ripe for review. Many programs were launched during the m&a booms of the 1980s and 1990s and have not been adjusted for more recent conditions. These programs often were designed quickly, with the primary design considerations being typical market practice and the need to focus executives on getting the best deal for shareholders. Market practice is an important consideration, but if it is considered in a vacuum, it can create designs with undesirable outcomes. So a thorough review in the current environment would try to determine whether CIC protections are motivating appropriate behaviors. This article explores the theory behind CIC protection and its purpose and distinguishes between a CIC arrangement that truly aligns with shareholder interests and one that is simply a giveaway to executives. What Is CIC Protection? CIC protection could be as simple as an acceleration of vesting on stock options when a company is acquired to a comprehensive agreement with severance and excise tax gross-up provisions. In general, CIC arrangements provide for severance protection and benefit continuation in the event that an executive is terminated after corporate control changes. In addition, unvested equity incentives typically are vested when control shifts. Each company defines what constitutes a CIC but most firms say that a CIC will result if a merger occurs and its shareholders represent less than 50% of the owners of the surviving concern. A CIC also will generally trigger if the majority of the board changes, a large portion of company’s shares are acquired by an individual or group, or substantially all assets are liquidated. CIC benefits generally are triggered under one of three provisions: * Double Trigger – This is the most common trigger, providing benefits to an executive if his or her employment is involuntarily terminated or constructively terminated within a given time period following a CIC. * Single Trigger – Benefits for a voluntary termination following a CIC. * Modified Single Trigger – This provision gives the executive a window in which he or she may voluntarily terminate and receive benefits, typically in the 13th month following a CIC. At all other times, a double trigger is in place. A final element often present in a CIC arrangement is language specifying the treatment of excise taxes under the Internal Revenue Code (IRC) Sections 280G and 4999. Section 280G denies a corporation a deduction for any excess parachute payment, and Section 4999 imposes on the recipient of any excess parachute payment a nondeductible 20% excise tax. Most companies have chosen to respond to 4999 with either a full gross-up or a cap on payments. A full gross-up pays the executive for the entire cost of the excise tax, including any additional taxes generated by the gross-up. A cap limits CIC payments to the limit specified by the IRS, thereby completely avoiding an excise tax. Why Is CIC Protection Needed? Many executives have been paid handsomely under CIC arrangements but that is not the primary reason that compensation committees have chosen to implement CIC protection. The underlying theory of CIC protection is that by putting sufficient protection in place, top executives will be willing to consider, and even seek out, corporate transactions that are in the best interests of shareholders, regardless of whether those transactions may jeopardize their own employment. In a nutshell, a company would not want a CEO to be concerned about keeping his or her job if a corporate transaction that is beneficial to shareholders is on the table. If designed correctly, CIC protection can become a critical element to ensuring that shareholders achieve sufficient value from an m&a transaction that changes control of the company. Does the typical CIC protection accomplish these goals? Does it motivate executives to pursue transactions that are in the shareholders’ best interests? Does it really keep executives from focusing on their job security alone? Are CIC benefits a giveaway? Do CIC benefits ever motivate negative behaviors? If the goal is to keep an executive neutral between keeping his or her job or jeopardizing it in a merger or acquisition, what will it take to strike this balance without paying too much? To answer these questions, I will systematically explore the typical elements of a CIC arrangement and consider what designs align best with the underlying theory of CIC. Severance Severance is the foundation of most CIC protection. It is directly related to the annual cash compensation of the executive, and typically makes up a substantial portion of any CIC benefits delivered, although when large equity values become vested on a CIC, severance amounts often prove less significant. Severance is almost always expressed as a multiple of annual pay. In considering severance, companies must consider what an appropriate multiple might be and the proper definition of annual pay. First, what is the definition of pay? The definition of pay should closely mirror the annual cash expectation of the executive, or the annual cash amount the executive “reasonably” believes he or she will receive. Obviously, base salary is a part of this, but what about the annual incentive? What figure best reflects what the executive “reasonably” believes he or she will receive? The target incentive level is one possible answer. If the annual incentive is designed appropriately, the target level should reflect the level of performance expected of the executive in a normal year. However, what about a high-performing or low-performing executive? Does the target amount truly reflect what a high performing executive “reasonably” expects to receive in a normal year? The answer is probably no. A high performer likely expects to achieve something greater than the target level. The manager’s history reflects this level of payout, and a company would expect him or her to assume that they will continue to perform above the expectations set for them. For this reason, the target level annual incentive may not be the best way to reflect the annual cash expectation. Instead, a combination of annual base salary and an average of the past three annual incentive payouts would better reflect expected pay. This does not mean a company should “cherry-pick” the annual incentive payouts used in the average calculation. For example, an average of the highest three payouts over the past five years would not properly reflect the de facto cash target. If pay is defined as annual base salary and the average of the past three annual incentive payouts, then what is the appropriate multiple of pay to use in severance? It takes the typical executive a minimum of six to 12 months to find new employment following a termination. Therefore, a minimum of 12 months of pay is necessary to simply bridge the gap between jobs. However, it is uncertain whether the new job will be as desirable as the position that was lost, and the executive may be forced to relocate or to accept a position of less stature. In some industries it may take longer than the typical six to 12 months to find new employment. We must then determine an appropriate risk premium to pay, beyond 12 months of pay, to neutralize these other factors. This is a difficult question to answer definitively. An appropriate or reasonable amount may be at least two years of pay, but probably not more than three years of pay. For most executives, two years of pay should be enough to make them neutral to the idea of losing their jobs. Is it enough to motivate them to do a deal? Many companies have chosen to provide three years of pay to their top executives. At the very top levels, this may be the right balance between motivating beneficial behavior without paying too much. However, companies must consider how much emphasis they want to place on motivating a deal as opposed to simply keeping an executive neutral. The difference between a three-year and two-year multiple can shift this emphasis. If a three-times multiple is provided, companies should consider the inclusion of post-termination restrictive covenants, such as a non-compete or non-solicitation provisions. They not only provide the company with additional consideration for the severance being provided but can reduce any potential excise tax liability. Generally, any reasonable compensation associated with post-termination restrictive covenants is excluded from the definition of parachute payments under IRC Section 280G. Triggers The issue of triggering CIC benefits gets to the core of the protection offered the executive. Based on the previously stated theory, the goal is to try to keep the executive neutral to the possibility of being terminated. This goal prompts questions about the use of a single trigger. A single trigger allows the executive to voluntarily terminate employment for any reason following a CIC and then receive benefits. Such a trigger is not designed to protect the executive from forces outside of his or her control but to give the executive complete control over when and if he or she will receive benefits. If the employment of that executive is truly needed by the company following the CIC, a single trigger puts the company and shareholders at the mercy of the executive’s pay demands. This is obviously not the desired behavior. The modified single trigger has many of the same negative characteristics. It too allows the executive to voluntarily quit and receive benefits. The only difference is that the termination must take place within a specified period. Some may argue that the modified single trigger gives the executive a window in which to negotiate a new employment arrangement with the company or provides the company with services during a transition period, thereby eliminating potential disagreements over the definition of constructive termination. Again, however, this puts the executive in a position to demand more than would be reasonable in a normal employment arrangement. A modified single trigger often causes negotiations for a new contract to begin even before control changes and leads to a payment greater than the original severance multiple. The double trigger most closely aligns with the desired outcomes of this CIC theory. The double trigger only pays the executive for an involuntary or constructive termination following a CIC. This ensures that the executive only receives CIC benefits if forces outside of his or her control require termination. A constructive termination generally includes a voluntary termination by the executive for “good reason,” meaning that the job has been changed in such a way that it essentially is a new position. Since the old position no longer exists, there is good reason to leave and claim benefits. However, one aspect of the double trigger often works contrary to shareholder interests. At many companies, good reason is defined so broadly that virtually any change in the job after a CIC will trigger good reason. Then, the trigger becomes a single trigger for all intents and purposes. Given the loose definition of good reason, most executives can claim a constructive termination, and the same negative characteristics of the single trigger are present. This is compounded by the fact that most companies reimburse the executive for any legal fees associated with challenges to the CIC agreement. To truly align to the theory of CIC, companies should use a double trigger and be certain that their good reason definitions protect the executive without being so open that a single trigger results. Vesting acceleration The vesting of unvested stock options and restricted stock is another benefit often provided in a CIC. Unvested equity compensation potentially represents a large element of compensation that an executive stands to lose in a CIC, and a vesting provision eliminates an unfair surrender. The protection of unvested equity is aligned with this CIC theory but the question is when vesting should be triggered. Historically, the most common practice among companies is single-trigger vesting with all equity vesting on the occurrence of a CIC. While the executive is protected against losing unvested value, the provision also can enrich the executive at the expense of shareholders without the executive actually losing his or her job. A single trigger also can create a problem of retaining desirable managers if very large equity values become vested at once. While far less common, a double trigger on equity vesting is growing in popularity because it strikes a better balance between the needs of shareholders and the needs of executives. A double trigger only vests equity on a qualified termination following a CIC. This avoids the unnecessary vesting of equity and eliminates the retention problem. The double trigger does open the employee to some risk in that the company may wait until after the protection period to terminate employment. But given the length of most protection periods, this is a very small risk. The acquiring company still must decide whether it wishes to convert existing equity into new company equity, but this decision can be made with the best interests of the executive, the company, and shareholders in mind. The conversion of unvested options also creates an accounting expense for the acquiring company similar to a “cash-out.” Thus, many companies may continue to cash-out options at the close of a deal, regardless of whether they have double-trigger vesting. Excise tax considerations The treatment of excise taxes under a CIC arrangement can add substantial additional cost to the company. The question is whether to cap at an arbitrarily set IRS limit or bear the expense of a gross-up and ensure that the executive receives the full value that the program intended. Although the capping of payments at the IRS limit reduces the potential cost of a CIC arrangement, it also may limit the CIC benefits to a level below what may be in the best interests of shareholders. Remember that the aim is for the executive to be neutral, and a cap could pull the benefits to a level that is below what is needed as an incentive to be neutral. A cap also will place an arbitrary limit on payout based on the past taxable income of the executive because of the definition of the IRS limit. This can lead to very different payouts for two similarly situated executives. In contrast, a gross-up ensures that the executive receives the intended benefit, although it adds significantly to the cost of a program. For top executives, the gross-up should be designed to minimize the potential cost to the company. In other words, the company should only gross-up if the amount that the executive would lose is so large that it could alter his or her behavior. This type of design is often referred to as an alternate gross-up and is provided when total CIC payments exceed the IRS limit by a set threshold, usually by 5% to 15%. If payments exceed the IRS limit, but not by the threshold percentage, then the payments are capped at the limit. If they exceed the threshold, they are grossed-up. This ensures that the company only is grossing-up individuals whose desired behaviors may be impacted by capping. At the senior level, the alternate gross-up likely provides the best protection to both the executive and shareholder. Eligibility A final key area of CIC protection is eligibility, or who should be receiving CIC protection. Up to this point, most of the analysis has focused on top executives, i.e., the CEO and his or her direct reports. These individuals should be protected because they are the people most likely to be involved in a transaction that will trigger a CIC. Is there a need to provide CIC protection below the top level that exceeds normal executive severance benefits? Often the next level or even two levels of executives are critical to completing a CIC transaction. They may not be the individuals directly involved in deciding whether the deal will be completed but their assistance is vital to its success, and their resistance could be fatal to its completion. Therefore, providing CIC protection for executives in the first and second levels below the senior team is often in the best interests of shareholders. However, the same analysis previously described must be applied to ensure that appropriate protection matches shareholder interests and ensures executive neutrality. This often means that protection at lower levels has a corresponding lower severance multiple and potentially a different response to the issue of excise taxes. In setting CIC protections, a company also must review many other areas, such as retirement benefit enhancements, welfare benefit continuation, and the appropriate definition of CIC. The process outlined in this article should be applied to these areas as well. You must also take into consideration market practice and competition for talent. Although the theory behind why CIC protections are needed is helpful in reviewing the alignment of a program, in reality, CIC protections often play a critical role in attracting and retaining strong executives. Thus, the CIC program must not only be aligned to shareholder interests but must have the power to attract and retain key individuals. These times of renewed diligence in executive compensation require a critical review of all executive pay elements. CIC protection gives firms the opportunity to align executive and shareholder interests and to encourage behaviors that maximize value from mergers and acquisitions. Ryan C. Harvey is a Management Consultant in the Corporate Restructuring and Change Practice at Hewitt Associates LLC, an international compensation and benefits consulting firm based in Lincolnshire, Ill. Copyright 2003 Thomson Media Inc. All Rights Reserved.