By Brent Longnecker and Kevin Kuschel

Change-in-control (“CIC”) provisions for public company executives have re-emerged on radar screens of shareholder activists and regulators due to recent executive pay legislations, such as December 16, 2009, increased Securities and Exchange Commission (“SEC”) disclosures and Troubled Asset Relief Program (“TARP”) regulations. These have intensified the need for companies to review their CIC agreements to ascertain they are aligned with market competitive practices and determine whether changes are necessary. Additionally, shareholder activist groups are pushing proposals that seek to limit payments under CIC arrangements, designating certain CIC arrangements as “poor pay practices.” Understanding the logic behind and the effects of CIC agreements is imperative to the Company and more importantly, the Compensation Committee.

Change-in-Control Triggers

The purpose of change-in-control agreements, also known as golden parachutes, is to safeguard executives during mergers and acquisitions that could potentially threaten the executives’ post-transaction employment. Change-in-control arrangements are structured to be either single-trigger, requiring only a change-in-control to take place, or double trigger, which requires a CIC and a resulting termination. In 2009, 9% of the 125 top companies on the Fortune 500 list moved from a single-trigger to a double-trigger change-in-control structure (Fred Cook 2009 CIC Practices), whereby a total of only 14% of Fortune 200 companies have single-trigger change-in-control provisions (Alvarez & Marsal).

Single-Trigger

Single trigger CIC provisions are heavily criticized for providing executives the benefit of payment for the CIC without the resulting termination. Typically when a company is acquired, there is a subsequent change in management that leaves many executives without a job. As long as the CIC meets the Internal Revenue Code (“IRC”) 409A definition, stating that the resulting payment can be made without a six-month delay for payments triggered by a termination of employment, the real advantage is that the CEO can negotiate in good faith without worrying about losing his position.

Double-Trigger

As indicated, double-trigger CIC agreements are more prevalent than single-trigger. They require both the change-in-control, as well as a resulting qualified termination of employment. Double-trigger CIC arrangements lend protection to executives following a CIC. For a specified period of time, the executive will receive payment if terminated not-for-cause or if the executive terminates for viable reason such as a career change, compensation decrease, title change, required relocation, etc. Also, as this structure necessitates a resulting termination, the six-month payment delay required under 409A takes effect, unless the termination is involuntary or the CEO resigns with good reason which negates the need for the CIC to be 409A compliant.

Benefits Received in the Event of a CIC

Cash

An executive with change-in-control protection is typically given a multiple of base salary and bonus to shield the executive should he be terminated in connection to a change-in-control. Specifically, companies are concerned executives may leave before a transaction date, which may be detrimental to completion of an agreement. Likewise, an executive without change-in-control protection may fear a job loss and take the next best offer regardless of timing. Therefore, companies commonly offer a cash multiple of base salary and bonus in the event of a change-in-control and a qualified termination. The multiple of base salary and bonus offered depend upon the industry and the level of executive. It’s worth noting, between 2007 and 2009, 10% of the top 200 companies on the Fortune 500 list reduced the multiples for the CEO and other executives in response to increased oversight. The multiple should not be based on the highest salary or bonus, or have a time period so short that the perception of manipulation is suspected.

Equity

The accelerated vesting of stock awards and stock options is also a frequent benefit of the CIC arrangement. Upon a CIC, any unvested equity awards held by the executive are commonly immediately vested, giving the executive ownership of those awards and removing any handcuffs the Company held on the executive. The rationale for acceleration of unvested equity follows that of cash severance payments.

Continuation of Medical and Other Benefits

The majority of CIC arrangements provide an amount for the continuation of medical coverage for a period of 18 to 36 months following the CIC (usually the same period of coverage as the cash payment). This amount is calculated from the Consolidated Omnibus Budget Reconciliation Act (“COBRA”) cost that the executive would incur over that period of time. According to Alvarez and Marsal’s Executive Change In Control 2009-2010 Report, since 2007, 10% of the Fortune 200 companies reduced their continued coverage from three years to between two and three years, consistent with a drop in severance multiple.

Excise Tax Gross-Ups and 280(g)

Under section 4999 of the IRC 280(g), an excise tax must be paid by an individual if total parachute payments exceed the “safe harbor limit” or $1.00 less than 3x Base amount. The Base amount is calculated as the average of the last five years of compensation listed on the W2 Form. The excise tax amount is 20% of all parachute payments in excess of 1x the base amount. Additionally, the Company loses the associated tax deduction for what is now considered an excess parachute payment. Regardless of the extra expense and pressure of shareholder activists, 61% of CEOs and 58% of other Named Executive Officers (“NEOs”) at the Fortune 200 companies are entitled to a gross-up in connection with a CIC. In response to the excise tax, companies have a few alternatives to consider:

· Restrict all payments to the safe harbor limit, also known as a cut-back. All payments in connection with a change-in-control are restricted to the safe harbor limit, thereby removing the individual excise tax liability from the executive, but reducing the executive’s payment.

· Provide a modified tax gross-up. The Company decides on an amount over the safe harbor limit that it is willing to pay the excise tax on. If that limit is exceeded, the Company will reduce the CIC payment to the safe harbor limit.

· Provide the best net effect, also known as the Valley Provision. The Company will cut-back the payments to the safe harbor limit only if the executive will receive a better net effect than if they were to pay the excise taxes on the excess parachute payments.

· Provide a performance provision. The Company provides a gross-up to the executive’s excise tax based on the Total Shareholder Return (TSR) since the severance plan has been in place (e.g., if the TSR to shareholders has been 50% from the inception of the plan, the corresponding gross-up to the executive’s excise tax will be 50%). Structuring a gross-up in this manner provides the executive a performance-related incentive that is directly tied to the value created for shareholders.

· Provide no tax gross-ups to the executives in connection with a CIC. The executive will be responsible for the additional taxes on the excessive parachute payments.

· Provide the executive with a full tax gross-up. In an effort to offset the excise tax and keep the executive whole, the Company will calculate the executive’s excise tax burden and pay the individuals tax on their behalf. The Company will only pay the amount of the excise tax, not federal or state taxes. This practice is itself considered an excessive parachute payment and is considered a poor pay practice by shareholder activists. In hopes of combating this issue, shareholder activists (RiskMetrics in particular) are recommending a withholding of votes for Compensation Committee members, and potentially the whole board.

While 280(g) was developed with good intention, the practice of 280(g) is sometimes counter-productive and punitive to executives. Oftentimes, executives who have been historically under-compensated to conserve cash in the interests of shareholders will consequently have a low base amount. In return, they are penalized by 280(g) and the corresponding excise tax for serving in the best interests of the Company. On the other hand, executives who have historically received competitive, or in some cases, excessive compensation, a higher base amount that provides coverage for a higher safe harbor limit is created. Additionally, multi-year, long-term incentive awards, typically implemented to motivate outstanding performance and/or make up for a lack of prior awards, are often accelerated. This constitutes a 280(g) payment that works against the 2.99x base amount safe harbor limit, again potentially penalizing an executive (via excise tax) and company (via lost tax deduction) for making the ethical choice.

Additional Alternatives to Maintain 280(g) Safe Harbor Limits

Upon a CIC, companies ensure compensation provided to executives is appropriately classified. Specifically, IRS 162 defines what should be reasonable compensation and not compensation in connection with a CIC subject to 280(g). As such, a reasonable compensation classified under 162 keeps a company from losing a corporate tax deduction and prevents an executive from being charged with an onerous excise tax liability. The following are examples of compensation that may be classified as reasonable compensation under IRS 162:

Under-Compensation for Prior Years Service

If a company determines an executive will exceed the safe harbor limit, they have the option of performing under-compensation for prior years of service analysis. This analysis reviews the historical compensation of an executive to resolve whether that executive has been reasonably compensated for their services to the Company over the course of the executive’s employment. In the case of a CIC, if it is determined the executive in question has been under-compensated; the Company has a basis, under IRC 162, to reclassify the under-compensation amount out of the CIC calculation and into reasonable compensation. If under-compensation is determined, the amount can be reclassified as equal to what is necessary to reduce the CIC payment to $1.00 less than 3x the base amount.

Reasonable Compensation following a CIC

Similar to the under-compensation classification, the Company can categorize earnings that work against the safe harbor limit as consulting fees or investment banker activities, or use the alternative of increasing the time limit on the executives non-compete which in turn has a value that can aid in reducing the CIC payment to within safe harbor limits. Under any of these alternatives, a company must prove the compensation under consideration is truly reasonable under IRC 162 and not considered a payment contingent upon change-in-control under IRC 280(g).

It is the responsibility of the Compensation Committee and the Board to fully understand the effects of a CIC on each executive and the Company. With the regulatory environment targeting executive compensation on unprecedented levels and shareholder activists pressuring the stability of corporate boards, there is no better time for companies and boards to take proactive steps to further protect the Company, executives and shareholders.

Sources:

“Changes in Change-in-Control Practices” prepared by Frederic W. Cook & Co., Inc. on September 30, 2009.

“Executive Change in Control Report 2009 - 2010: Analysis of Executive Change in Control Arrangements of the Top 200 Companies” prepared by The Compensation and Benefits Practice of Alvarez & Marsal Tax, LLC.

By Brent Longnecker and Todd Henke

One of the biggest challenges in companies today is how to successfully motivate employees.  No other time in modern history has the corporate landscape been as diverse as it is now with multiple generations coming together in the workplace.  There are four unique generations that make up today’s corporate culture: Traditionalists, Baby Boomers, Generation X, and Generation Y.  Each generation brings unique attitudes, expectations, and values that companies must be sensitive to in order to cultivate job satisfaction, retention, and ultimately, productivity. Understanding what makes each generation distinctive will prove positive when selecting the method or vehicle of motivation.

Traditionalists, born on or before 1945, became the definition of “America’s Values” based on their hard work, honesty, and dedication.  They are reliable, value job titles, like to think they contributed toward the company’s overall success, and expect recognition for their loyalty.

Baby Boomers, born between 1946 and 1964, are often referred to as the “Me” generation. Work is a high priority for them, perhaps the highest, which translates into long hours and stressful lives.  They value teamwork, prefer a structured work environment and expect others around them to put in the same amount of effort and time.

Generation X, born between 1965 and 1980, have been credited by some as bringing work-life

balance to the workplace creating a shift from the Baby Boomers work ethic as they transition into managerial roles.  They prefer to work independently with minimal supervision, purpose to get fast results and thrive on opportunities to grow.

Generation Y or Millennials, born after 1980, are technologically savvy and desire to be recognized for their performance as a strong asset to the company.  Unlike previous

generations, this group is interested in change, prefers flexibility and thrives on having continuous short-term goals and deadlines.  For some Millennials, the labor market is seen as a place to sell their skills to the highest bidder and they don’t mind moving from one company to another.

In the past, there has been an unspoken employment agreement between the worker and their employer.  In return for job security, employers were guaranteed loyalty and commitment from their employee.  In the new economy, this is a rare relationship to find.  As employers announce layoffs, employees often leave for better opportunities.  Ironically, as companies are declaring people as the most important asset, they are still treating them as disposable.  Companies must focus on motivational practices that meet every employees need, regardless of age.  This will allow for effective development, sustainability, and alignment of the overall objective, profitability.  To ensure that employees of every generation are effectively engaged and integrated into a company’s culture, employees need to know and feel that they are welcome, wanted, and there for a purpose larger than themselves.  The following mechanisms are designed to achieve those goals.

Attract to retain.  For longevity, get the right candidate in the right position.  Look beyond the candidate’s skill set to ensure that their work style and personality fit in the culture of the company.

Provide meaning and purpose in work.  Employees need to understand the reason for the

organization’s existence.  Create a mission or simply a vision statement that each employee

finds exciting and stimulating.

Provide work-life balance.  Work with your employees to give them flexibility.  Companies

must recognize that employees have lives outside of the workplace.  Whether you are talking about the single employee, married employee or the employee with a family, everyone is looking for the right balance between work and social life.  The smartest companies will allow employees to manage their lives and their work schedule as long as goals are being met.

Share the rewards.  Traditionally, the employee was paid for hours worked and not for what

they produced, created or serviced.  Today, value lies in the employee’s knowledge and skill set

that makes a company’s innovations essential in the market place.  Develop a compensation system that rewards the employee for individual goals met as well as company

goals reached. Annual incentives and long-term incentives both play a vital role in attracting, retaining, and motivating employees of all generations. Employees want to be compensated for the value they deliver not just the hours they invest.

Engage the employee with customized rewards.  Learning what motivates employees of different generations is a necessary process to keeping employees engaged in the company.  Not all employees, especially those that are from different generations, have the same interests outside of work.  Take time out to know what your employees enjoy doing; that way you can reward them with a meaningful non-cash award for a job well done.

Offer benefits for everyone.  Health and welfare benefit plans come in all shapes and sizes.  Make sure you offer benefit plans with everyone in mind.  Every generation has different priorities and needs, encourage employees to assess every benefit option offered by the company to find the best one for them.

Build relationships to last.  The key to a successful work environment is the trust and confidence that you have in your fellow employees.  There is no better way to foster trust than to develop personal relationships with other team members.  Employees need to feel valued and happy working with those around them.  Without internal support and strength throughout the organization, employee morale and even corporate performance can suffer.

Since every workplace is unique, there is certainly no exact formula to retaining employees. However, in an ever-changing corporate environment, it is important to recognize that there is much more than monetary motivation for this multigenerational workforce.  Employees need to feel they are part of an organization that challenges, stimulates, and values them.  By taking steps to establish a successful relationship with open communication between employer and employee, employees will be enriched as will the companies.

By Brent M. Longnecker and Christopher Crawford

On June 25, 2010, the U.S. House and Senate passed the Dodd-Frank Act.  The Act proposes major reform to all U.S. public companies.  The final bill is to be approved by President Obama before July 4, 2010. While there are numerous financial reform provisions in this Act, executive compensation is a central piece. A brief summary on the executive compensation provisions of the proposed Act and L&A commentary follows.

SAY ON PAY

The Say on Pay resolution will give shareholders the opportunity to cast an advisory vote annually, biennial, or triennial on disclosed executive compensation for the top five executives of a public company. “Small Issuers”, companies with less than a $75mm market cap or less than $50mm in annual revenue will be exempt from Say on Pay. Over the past several years, approximately 50 public companies have voluntarily adopted shareholder advisory votes on executive pay – excluding those companies that have received government assistance via TARP.  At least three companies to date have already experienced shareholders’ rejection of executive pay packages in voluntary Say on Pay votes, including Motorola, Occidental, and KeyCorp. While the merits of Say on Pay including articles L&A has authored have been hotly debated, the discussion is now over and companies must deal with the reality (See previous articles on the topic - A Different Say on Executive Pay and Frankly Speaking Say On Pay Is No Way To Act).

L&A Commentary:

Yes or No Vote.  The Say on Pay system as provided in the Act, does not create a forum for shareholders to say what they like or don’t like about executive compensation, rather it requires a yes or no vote, pressuring compensation committees and advisors to make determinations on their own.

More Proxy Advisor Power.  Adopting Say on Pay will likely create more power and influence for the few proxy advisor firms such as RiskMetrics Group (“RMG”) and Glass Lewis.  Many shareholders may not understand the complexities of executive compensation as disclosed in a proxy statement and as such, will rely on the advice of such firms.

RMG.  As RMG influences companies with a majority of shareholders that adhere to RMG’s policies and voting recommendations, there may be an increased trend in the following: use of performance vested equity awards, a movement to cash based long-term incentive awards in light of RMG’s artificial dilution cap formula (Shareholder Value Transfer), fewer excise tax gross-ups in the event of a change of control, and fewer perks. It should be noted that most companies and outside advisors disagree with RMG’s policies and so tensions will continue to increase.

Companies Will Scrutinize Institutional Shareholders. A result of this increased power for proxy advisor firms will likely be public companies scrutinizing who holds the majority of shares.  Specifically, when a company solicits capital in equity offerings, board members are likely to determine if the institutional money comes with strings attached via proxy advisor votes creeping in against executive compensation.

Directors Potentially Not Re-elected.  A majority vote against a compensation program will pressure the company to make corrective changes. If a compensation committee fails to modify executive compensation to shareholder satisfaction, it will likely mean withheld votes or votes against directors in the next election.

Increased Voting Power to Institutions.  The potential re-election problem for directors is compounded by the elimination of the broker discretionary vote in uncontested board elections, thus further strengthening the position of institutional votes, and proxy advisor firms that serve the institutions.

Congressional Say on Pay.  While we are on the subject, if Congress believes Say on Pay is a necessary check and balance for public companies, then L&A contends U.S. citizens should get a vote on pay and pension for Congress members.  In short, there should be accountability for breaking down the economic or moral fabric of our country.

COMPENSATION COMMITTEE INDEPENDENCE

The proposed Act will require the SEC to direct the securities exchanges to add a listing requirement that executive compensation be set by “independent” directors. In defining independence, the stock exchanges would be required to identify factors impacting independence which could result in definitions that exceed those currently required under NYSE and NASDAQ listing standards. This would include whether the director derived any income from the issuer through consulting, advisory fees, or otherwise, and whether the director is affiliated with the issuer or one of its subsidiaries or affiliates. Depending on how such standards are implemented, they may result in an “independent” director more closely resemble  an “outside” director, as defined under Section 162(m) of the federal income tax code.

CONSULTANT INDEPENDENCE

Compensation committee members would also be responsible for considering the independence of compensation consultants, outside counsel and other advisors retained by the committee. This would include considering the provision of other services provided to the issuer, the advisor’s policies and procedures regarding conflicts of interest, business and personal relationships, and stock ownership of the issuer by the advisor. Finally, the retention of compensation consultants would need to be disclosed, as would any conflicts of interest raised by such inquiries and how they were addressed.

Increase Demand for Independent Consultants.  The request for detailing any conflicts of interest among consultants will need further clarification. Given the definition of conflict of interest, and the required disclosure, this provision will likely force many of the multi-service companies with executive compensation practices to make difficult decisions based on whether to retain the executive compensation practice business line. Many public companies are likely to reassess their relationship with their outside compensation advisor to ensure no conflict of interest. Lastly, the many public companies that do not engage an executive compensation consultant may decide to do so.

L&A Commentary:

Reinforced SEC Policy.  This proposal further strengthens the SEC guidelines provided on Dec. 16, 2009, as well as previous guidelines detailed by each of the stock exchanges (See L&A white paper, Immediate Compliance Changes With New SEC Regulations). Companies will need to ensure they are electing independent compensation committee members.

Clarify Independence definition. This provision will need further clarification as to relationships that have a conflict of interest.  Specifically, several board members of public companies are also executives of companies in similar industries to bring the appropriate expertise required for the position.  However, there is a concern these board members could be deemed not independent due to any number of business relationships.

COMPENSATION CLAWBACKS

In further response to shareholder outcry over executive compensation, the Senate bill strengthens Sarbanes-Oxley Act (SOX) Section 304 to require the clawback of incentive-based executive compensation, including stock options, in the event of an accounting restatement due to material noncompliance with financial reporting requirements even if no one, including the executive whose compensation is at issue, engaged in misconduct. The provision would require the clawback of amounts paid based on overstated results for the three years preceding the restatement date. Compensation would be recalculated according to the restated performance.

L&A Commentary:

Broaden SOX. Clawback policies have been in place for the CEO and CFO since SOX was enacted in 2005. However, the Act’s proposed provision will seek to broaden the scope of potential clawbacks, including who would be subject to pay monies, the time period to return monies, the amount to pay back, and what triggers a clawback (poor performance, etc).

Previously Uncontested. Clawbacks have been largely uncontested in the U.S. court system outside the standard SOX definition and the ability to enforce clawbacks will be an initial battle.

Devil in the Details. L&A believes that clawbacks are appropriate when financial statements are restated to the detriment of the company, as with SOX.  However, as clawbacks are extended to a much broader scope, there will be real difficulty in application. For example, how do you collect money that has already been taxed?

Congressional Clawfoward. Additionally, L&A believes that if Congress believes corporate America should be subject to clawbacks, so too, should the government officials.  If it is found that a member of Congress lies, cheats, steals or otherwise is responsible for poor economic performance (e.g. job losses, increased debt, etc.) then a portion of their guaranteed retirement benefit is subject to “claw forwards.”

ILLUSTRATE PAY FOR PERFORMANCE

The Act will require the SEC to amend Item 402 of Regulation S-K to require disclosure of how executive compensation relates to financial performance, taking into account changes in the value of stock and dividends and any distributions. The Act mandates the SEC to issue rules that require disclosure of how median employee compensation compares to CEO compensation.

L&A Commentary:

Window Dressing. The SEC has struggled with forcing companies to report a connection to pay and performance, specifically as it relates to short-term incentives.  While the proposed Act seeks to strengthen the transparency between pay and performance, the provision will be more of a window dressing than reality, as performance can be measured in a variety of ways.

PROXY ACCESS

The proposed Act amends Section 14(a) of the Securities Exchange Act of 1934, to provide for shareholder access to proxies to nominate directors. The House bill requires and the Senate bill authorizes, the SEC to prescribe rules and regulations granting shareholders such access. Senate supporters and shareholder activists have pushed for proxy access for years, arguing that it will help remedy a perceived lack of management accountability. Current Senate considerations include a 5% ownership standard and a two-year holding period on shareholders who wish to nominate directors. Under either provision, the SEC is likely to enact rules for shareholder access.

SEPARATION OF CEO AND CHAIR

Under the proposed Act, the SEC must require companies to explain in proxy statements why the positions of chairman and CEO are separate or combined. This provision reflects a view among some shareholder advocates that “best practices” requires separation of the roles of CEO and Chair. Currently, Regulation S-K requires companies to disclose their leadership structure and why they believe the structure to be appropriate.

COMPENSATION COMMITTEE ACTION

Big changes are coming in executive compensation. As a result, L&A recommends compensation committees and management to consider the following action items:

Review the Compensation Committee charter for sound governance practices.

Review the process for determining executive compensation.

Conduct an analysis of institutional shareholders to determine who follows RiskMetrics or Glass Lewis versus those institutions that have their own voting guidelines.

Start a dialogue with institutional shareholders to solicit feedback on the company’s executive compensation practices.

Review the role and independence of the company’s compensation consultant.

Consider appointing the VP HR as a secretary to the Compensation Committee to ensure open lines of communication between management and the compensation committee, but reinforcing the committee’s overall authority.

Review the new SEC guidelines issued December 16, 2009, for proxy disclosures (See L&A white paper, Immediate Compliance Changes With New SEC Regulations).

Review RMG’s 2010 compensation policy guidelines to at least be aware of them.

Review the total direct compensation provided to the Named Executive Officers to ensure a connection between pay and performance.

Consider conducting a compensation risk assessment.

Review the Compensation Discussion & Analysis (CD & A) to ensure the company is disclosing compensation appropriately and telling the right story.

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Linked Text References

Brown, Tyler and John Christmas. “A Different Say on Executive Pay.” Dallas Business Journal ( 2007): 37.

http://www.longnecker.com/research/authored/a_different_say_on_executive_pay.pdf

Longnecker, Brent, and Chris Crawford. “Frankly Speaking, Say on Pay Is No Way To Act.”  Houston Business Journal  (2007): 61A.  http://www.longnecker.com/pdfs/say_on_pay_final2.pdf

Longnecker, Brent, Joshua Henke and Chris Crawford. “Immediate Compliance Changes With New SEC Regulations.” (2010)

http://www.longnecker.com/research/hottopics/Compliance_Update.pdf

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Brent M. Longnecker is Chairman and CEO of Longnecker & Associates and Chris Crawford serves as Executive Director. Longnecker & Associates is an executive compensation consulting firm based out of Houston, Texas. L&A is a core management team of dedicated professionals that has spent the past two decades working on a variety of corporate governance, board of director compensation and executive compensation solutions. L&A’s personal experience with public, private, and not-for-profit companies provides their consultants with the unique capability to counsel clients with expert knowledge. Additionally, Longnecker & Associates consultants have the ability to draw upon a wide range of experiences ranging from high-growth, bankruptcy, shareholder and employee litigation, IRS audits, spin-offs, mergers, and acquisitions.