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Many executives of publicly held utility corporations have written severance agreements to protect them in the event of a change in control. However, these severance packages remain vulnerable to attack by acquirers.
Two separate threats are emerging. One involves a direct attack on drafting flaws in the plan documents. The other, more subtle, threat lies in the impact and interpretation of the special "Golden Parachute" rules under the Internal Revenue Code. This second threat warrants attention.
Many severance agreements include lump-sum payments, plus added pension service credit, immediate vesting of stock options, and continued health and life insurance. These benefits could trigger the golden parachute rules, invoking substantial penalties payable out of severance benefits following a change in company ownership. In addition, an acquirer may be able to reduce or eliminate various benefits to avoid making a "parachute payment."
Golden Parachute Rules
The "Golden Parachute" rules can impose penalties against either the acquirer or the outgoing executive, depending on the circumstances. In general, these penalties arise if the value of the severance benefits triggered by a change in control exceeds 2.99 times the executive's average annual compensation during the previous five-year period. If benefits exceed this limit, all severance benefits triggered by the change in control become "parachute payments." Under section 4999 of the Internal Revenue Code, executives must pay a 20-percent nondeductible excise tax on the amount of the "parachute payments" that exceed their five-year average annual compensation. Further, section 280G states that the acquirer cannot deduct these so-called "excess parachute payments."
Consider, for example, an executive who terminates employment following a change in control with a five-year average annual compensation of $100,000. The hypothetical acquirer can pay the executive severance benefits of up to $299,000 without triggering the golden parachute penalties. Now assume that, in accordance with the executive's severance agreement, the acquirer pays $300,000 of severance benefits. By paying an extra $1,000 over the threshold amount, all of the executive's severance benefits become "parachute payments." As a result, the acquirer loses the deduction on $200,000 (the "excess") of the severance benefits paid. Further, the executive must pay both regular income taxes on the full parachute payments plus a $40,000 excise tax (20% of $200,000). Everyone loses. The executive receives a smaller benefit at a greater cost to the acquirer (see Figure, facing page).
Many severance packages for utility executives provide benefits that exceed the golden parachute threshold. Many agreements calculate the executive's severance benefits as a multiple of final pay. The difference between the executive's final pay and five-year annual average compensation can end up as quite substantial, however. In some cases, a severance agreement that provides for two times the executive's final pay may exceed 2.99 times the executive's five-year average annual compensation.
Valuing Severance Benefits
To complicate matters even more, many utility executives retain equity opportunities (e.g., stock options, restricted stock) in their current employment contracts. Typically, severance benefits include immediate vesting of these equity opportunities following a change in control. The executive, naturally, expects to keep existing equity grants after terminating employment. Unfortunately, such expectations may