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 wind up unfulfilled.
The Internal Revenue Service (IRS) has issued proposed regulations, under the golden parachute rules, that set forth intricate rules for determining the value of an executive's severance benefits. These rules involve subjective judgments and can lead to unanticipated results (em particularly if an acquirer is inclined to interpret the rules to its own advantage.
For example, under the proposed regulations, the IRS treats the immediate vesting of an equity opportunity as a separate right that counts toward the golden parachute threshold. The deemed value of the immediate vesting may turn the severance benefits into "parachute payments," thus giving the acquirer an opportunity to forfeit a portion of an executive's equity opportunity to avoid triggering the golden parachute penalties.
Interpreting Severance Packages
Severance packages for utility executives typically address the golden parachute rules in one of three ways: the cap, the punch-through amount, and the gross-up payment. The amount of after-tax benefits the executive will receive following a change in control can vary dramatically depending on how the agreement is structured. Both the executive and the board of the corporation must clearly understand which approach has been used in the executive's severance agreement.
Golden Parachute Cap. Severance benefits are limited to the maximum amount that avoids triggering the golden parachute penalties. This approach may allow the acquirer to reduce substantially the amount of severance benefits otherwise promised under the severance agreement.
Punch-Through Amount. Severance benefits that trigger the golden parachute penalties will be paid in whole only if the executive would thereby receive a larger after-tax benefit. This type of agreement usually specifies a method for determining the amount at which the executive would "punch-through" the golden parachute cap and receive all severance benefits. While sometimes allowing payment of all severance benefits, this approach does not cushion the executive against the 20-percent excise tax.
Gross-up Payment. The acquirer provides a special "gross-up payment" to make the executive whole for any golden parachute excise taxes. This approach neutralizes the economic impact of the golden parachute rules on the executive. While appropriate under certain circumstances, providing a gross-up payment can cause the acquirer considerable nondeductible expense.
Avoiding the golden parachute rules can be advantageous to the executive and the company, and several actions could reduce potential exposure to the penalties. One approach would accelerate a portion of the executive's taxable income. Done properly, accelerating income will boost the executive's five-year average annual compensation, which determines the golden parachute limit. Another approach would modify the executive's compensation package to include additional equity opportunities in lieu of current salary. Equity opportunities may avoid treatment as "parachute payments," or may receive a lower "parachute payment" value than cash severance benefits. Supplemental pension benefits could also be designed to reduce or avoid "parachute
payment" treatment. The nature of an individual executive's existing compensation package may create additional planning opportunities.
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The merger deals are out there, waiting to be done. Compensation committees and management teams, particularly at publicly traded utilities, should address this issue well in advance of an acquisition offer. Else, the unwary executive may fall prey to a cost-conscious acquirer looking to minimize executive benefits. t
Arthur I. Anderson is a partner in charge of the corporate department of McDermott, Will & Emery, Boston. His practice includes mergers, acquisitions, leveraged buyouts and liquidations, and stock disputes. He has also represented public utilities before the Securities and Exchange Commission in matters regarding the Public Utility Holding Company Act. Stephen C. Ploszaj is a partner in the employee benefits department of McDermott, Will & Emery. He has represented high-technology companies, tax-exempts, health care providers, industrial manufacturers, regulated investment companies and financial institutions.
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