2014-Issue 32—As shown by the results of Alvarez & Marsal’s recent survey of public company change in control agreements (“golden parachutes”), the reaction to the heavy criticism leveled at such agreements over the last decade has been to continue the trend towards either eliminating them or reducing the amount payable under them, often substantially. We understand this response but believe that golden parachutes can actually act to protect or even enhance (rather than diminish) shareholder value in certain circumstances, making their elimination ill-advised in those circumstances
Background: Origin of Parachutes
The late 1970s and early 1980s was the era of hostile tender offers by one public company for another. In this climate, two simultaneous worries arose: the worry of chief executive officers that an acquirer would have no need for them after the transaction was consummated and the worry of boards of directors that CEOs who were concerned about losing their positions would not act effectively to complete a favorable transaction. Agreements that provided the executives with a golden parachute in the event of a sale were the answer. These agreements provided executives with a specified level of compensation in one of two circumstances:
1. There was a change in control of their company, even if the executives did not lose their position (a “single trigger” agreement); or
2. A change in control occurred, followed by their termination of employment (a “double trigger”).
Eventually, a third alternative, a “modified single trigger” came into play; this required an executive to remain employed for a specified period following a change in control, after which he or she was free to terminate and receive the promised compensation. In most cases, the amounts promised were a significant multiple of the executive’s compensation in the years preceding the change in control.
Critics contended that these agreements provided executives with excessive benefits, and Congress responded by enacting Section 280G of the Internal Revenue Code of 1986. This provision imposed a 20 percent excise tax on executives who received an “excess parachute payment” (i.e., a payment in excess of three times their average compensation in the five years preceding the change in control) and denied the payor corporation a deduction for that amount. After Section 280G, some companies began to limit the amount an executive could receive to the maximum allowed under Section 280G without penalty. Others continued to provide an uncapped amount, often also including a provision to “gross up” the executives for the excise tax for which they would be liable if the Section 280G limit was exceeded. Still others implemented a so-called “best of both worlds” or “valley” provision whereby the executives received the full parachute payment if it would net them more income than would imposing the 2.99 cap. Provision of an uncapped amount and the promise of a gross-up payment continued to draw criticism but remained in significant use until the last few years, when companies became far less willing to ignore criticism.
Much of that criticism came from Institutional Shareholders Services (ISS) and Glass Lewis, proxy advisory firms whose recommendations have carried significant weight with institutional investors in Say on Pay and other votes. These firms saw the gross-up as a corporate giveaway that should be eliminated and the valley provision as potentially as bad (because the result could be the same as with the gross-up). While many companies might have disagreed with this assessment, few chose to do battle with ISS and/or Glass Lewis over the issue. The predictable result has been that very few new employment or change in control agreements include gross-ups, while the promise has been eliminated from many existing arrangements, on renewal or otherwise. Use of valley provisions has also declined, though not quite as dramatically.
Even though the day of hostile tenders has passed, the concern that prompted the creation of golden parachutes has not and should not be ignored. For example, consider a CEO in his mid- to late-50s whose company is a potential target for an acquirer, who believes it highly likely that he will be terminated if a transaction is successfully completed, and who has only normal corporate severance to cushion a loss of employment. Looking at the reality of the marketplace, a CEO of that age could well conclude that finding a comparable position will be difficult, perhaps even virtually impossible. Under such circumstances, shareholders could well question whether, absent additional protection, the executive will do everything in his power to ensure that a proposed transaction is completed, thereby maximizing value for them. A 2.99 cap is unlikely to fully ensure against such an outcome, inasmuch as three years’ compensation could still leave the above-described CEO unemployed (and unemployable) at an age when he wants to keep working.
Another situation where the lack of any parachute or even a 2.99 cap also may not be appropriate is when a CEO is being recruited by a company that is seen as a potential target. In such circumstances, it will be the rare executive who will agree to accept the position without substantial protection. In the past, some companies attempted to solve this issue by providing for compensation above the 2.99 cap for a specified period after employment begins, after which the cap would come into effect. We believe this is a sound strategy that should be acceptable to ISS, Glass Lewis and large institutional shareholders. In the current climate, however, there continues to be resistance to any provision that even theoretically can provide a payment above the cap, and the use of such provisions has declined.
Alvarez & Marsal Taxand Says:
We wish to make it clear that we are not proposing a return to the days of single trigger agreements with no cap and a gross-up. Nor are we suggesting payments sufficient to cause a dollar-for-dollar adjustment in the purchase price. As with many things, however, the pendulum can sometimes swing too far in the opposite direction from a perceived abuse. Our view is that this has happened and that it is time for public company boards to assert their authority and use the provision they believe will bring about the best result for the company’s shareholders, even if the order of magnitude of the payment is nearly certain to bring outrage from some quarters.
For More Information
Managing Director, Dallas
+1 214 438 1013
Managing Director, Dallas
+1 214 438 1028
Senior Director, Dallas
+1 214 438 1037
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The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.
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