Time to Dust Off Those Change-in-Control Agreements

January 3rd, 2014

1-3-14-Pearl-Meyer.pngThe best time to address compensation issues related to a potential change in control (CIC) is when you don’t need to: that is, when there’s not an imminent likelihood of being acquired. Too often, CIC provisions that appeared reasonable when written can yield unpleasant surprises for bank shareholders and/or executives in the heat of a potential transaction. From the shareholder perspective, surprises might be significant enough to unwind the deal or lead to unfavorable pricing, while executives may be unpleasantly surprised by net benefits far lower than anticipated, due to automatic cut-backs or excise taxes.

That’s especially true now that we’re in a perfect storm for CIC:

  • Many bank executives during the financial crisis had reductions in compensation in the form of smaller (or zero) incentive payouts and realized value from equity awards. This could result in lower base amounts from which golden parachute excise taxes are calculated (i.e., the individual’s five-year average W-2 earnings);
  • As banks have returned to consistent profitability in the last year or two, they are granting more equity-based awards and bank stock prices are starting to rebound, leading to potentially higher CIC payouts; and
  • merger and acquisition (M&A) activity is heating up in the community bank marketplace.

If your organization has any possibility of being pursued by a potential suitor in the foreseeable future, now would be a good time to review the CIC agreements and related provisions in your equity and supplemental retirement arrangements.

The general rationale behind a CIC agreement is pretty straightforward: to reduce potential management resistance to a transaction that is in shareholders’ best interests. If executives fear losing their jobs (and related future compensation opportunities) as a result of the transaction, they may be more likely to drag their proverbial feet and find reasons not to do the deal. Providing reasonable protection to executives in the form of CIC agreements and related benefit provisions can mitigate this risk. Common benefits promised upon termination following a CIC include cash severance; acceleration of vesting on outstanding equity awards and deferred compensation; and either the continuation of health and other benefits or payment of their cash value.

The unexpected consequences of CIC payments/benefits are mostly attributable to their potentially adverse income tax treatment. Under Internal Revenue Code §280G, punitive excise tax penalties are triggered for the employee and what’s referred to as “excess parachute payments” are not deductible for the company if the present value of all payments related to the CIC totals more than 2.99 times the individual’s base amount. For this reason, most CIC agreements are very clear about how CIC payments will be handled if this limit is exceeded. Historically, CIC payments by the company often included 280G excise tax gross-ups, where the company reimbursed the executive for the taxes owed, to keep the executive whole if the parachute limit was exceeded. As such, the most common bombshells at transactions were the eye-popping, nondeductible gross-up bonuses required to reimburse the executive.

Under extreme pressure from regulators and the investing community, excise tax gross-up provisions at most community and regional banks have been replaced more recently either by a cap on the present value of CIC benefits at the 2.99 limit, or by payout of severance benefits that will result in the most advantageous payout to the executive from an after-tax perspective (often called the best after-tax approach). However, such provisions can create another major challenge—forfeiture by the executive of a large portion of the intended benefits. This is particularly problematic in an environment in which the base amount is already likely to be low given the recent financial crisis.

If addressed far enough in advance of a CIC transaction, banks may be able to make adjustments to CIC provisions to ensure that a much greater portion of the intended benefits is delivered in a tax-efficient manner. At a minimum, reviewing your CIC agreements and performing a few scenario-based calculations can protect against being caught by surprise when a potential deal is in the works.

Don’t wait until a transaction is on your doorstep—dust off those CIC agreements and explore their potential real-life impact now, before it’s too late.

gswanson

Greg Swanson is a managing director with Pearl Meyer in their San Francisco office and for over 20 years has consulted with public and private companies on matters related to board and executive compensation.