Fed’s New Control Rule Brings Transparency, Consistency

The Federal Reserve Board has announced its much-anticipated final rule that addresses the often-confusing question of when a company controls a bank and when a bank controls another company.

The rule revises existing regulations that address the concept of “controlling influence” for purposes of the Bank Holding Company Act or the Home Owner’s Loan Act. It goes into effect on April 1.

The control rule is important: any entity in control of, or controlled by, a bank is subject to the same regulatory supervision and limitations as the bank. These limitations have created hurdles for bank investments by private equity firms and other entities, and have made partnerships between banks and fintech firms difficult to negotiate and structure.

Under the current Bank Holding Company Act, an investor is deemed to control another company if (1) the investor directly or indirectly owns, controls, or has power to vote 25% or more of any class of a target’s voting securities, (2) the investor controls in any manner the election of a majority of a target’s directors or trustees, or (3) the Federal Reserve determines, after notice and opportunity for a hearing, that the investor directly or indirectly exercises a “controlling influence” over the management or policies of the target.

Under the Bank Holding Company Act, there is a presumption that directly or indirectly owning, controlling, or having the power to vote less than 5% of any class of a target’s voting securities is not considered control. Where a transaction created ownership that exceeded the 5% threshold, it was necessary to address the question of whether there was a controlling influence. Since that term wasn’t defined, parties relied on the Fed’s interpretations in similar situations or sought informal guidance of Fed staff on a case-by-case basis, which led to uncertainty.

Previously, control reviews have been situation-specific and often followed precedents that were not available to firms or to the public,” the Fed notes in its press release announcing the new rule.

This made business planning difficult, if not impossible. Seeking feedback in the proposal stage often resulted in excessive delays and left the parties with uncertainty as to acceptable structure and permissible relationships going forward.

The new rule seeks to provide more bright-line guidance with a tiered approach to determining  control based on the ownership of voting shares. The indicia of control used for ownership are similar to those applied by the Federal Reserve under the old rule when providing guidance on individual transactions, and vary based on the following levels:

  • less than 5%;
  • 5% to 9.99%;
  • 10% to 14.9%; and
  • 15% to 24.9%.

There are more relationship restrictions as the ownership percentage increases. Those restrictions relate to director representation; officer and employee overlaps; business relationships (including size and terms of relationships); and contractual powers or limitations on operation of the organization. The Federal Reserve outlined the interplay between percentage ownership and restrictions in a chart that was included in the press release

Equity investors will have more power to influence a bank’s business, which may spur the influx of capital from new sources. Banks, however, may encounter that influence and the increased rights of investors through proxy solicitations challenging the board. 

From the perspective of banks investing in other companies, the industry had hoped for more relief from the limitations on business and contractual relationships. Large banks have shown interest in investing in fintech startups and limiting their competitor’s ability to participate.

There are other areas the new rule does not address. It does not impact existing investments that have been approved because the parties have agreed with the Fed not to take certain actions (referred to as passivity commitments). The regulator stated it will no longer require or seek those commitments but will consider relieving firms from any existing commitments. 

The new rule also does not impact the concept of control for purposes of other regulations, including the Change in Bank Control Act, Regulation O and Regulation W. So a person or entity will still be required to obtain approval to acquire control of a bank or a bank holding company with the presumption that the acquisition of 10% or more of voting securities being considered a change in control.

There are other aspects of the rule that will need to be considered, including calculating equity ownership, accounting rules and the impact of convertible securities. While the new rule does not provide the level of relief that some in the industry had hoped for, it does provide much-needed guidance that will allow parties to create business relationships with more certainty and efficiency.

The Dos and Don’ts of Shareholder Recordkeeping for Private Banks


shareholder-5-1-18.pngPublic and private banks are vastly different, but in some areas, they might be more alike that you may think.

Public banks are required to work with a transfer agent for their investor recordkeeping. Private banks, including institutions that are not listed on a stock exchange or regularly file financial reports with the Securities and Exchange Commission, do not have the same obligations as their publicly traded counterparts; however, this does not mean that sound recordkeeping practices are not just as important.

Based on my more than 30 years in the industry, these are the most important Do’s and Don’ts to consider when it comes to managing your investor records:

DO keep a close eye on your overall share balance. It is critical that the shares held on your share register match the number of shares outstanding that your financial reporting office says are there. Changes in shares outstanding (where there is an increase or decrease in this overall figure) don’t happen very often and may not cause an issue in your day-to-day business. But, if shares are not in balance, trouble will arise in the instance of a change-in-control event, such as an acquisition. The need to rehabilitate the list could complicate and delay the corporate event.

DON’T let share issuance discrepancies linger. When a share transfer takes place, the transaction must be recorded for both the transferor and transferee. For private banks, shares are often not liquid and transfers rarely happen. Given their rarity, it’s important to take special care to properly record transfers on the books of the company. Errors can be hard to find later on— especially when the person who had a photographic memory of the list has retired. It’s best not to let discrepancies happen in the first place, but if they do, resolve them now and avoid a messy accounting issue much later on.

DO pay special attention to executive equity awards. It’s usually not a good idea—or a good career move—to keep improper and inaccurate equity award records of your executives and directors.

DON’T underestimate the importance of data security. Keeping accurate shareholder records is important. Safeguarding that information is even more important. This means protecting data from both outside intrusion and weak internal processes that could threaten it. Data security and security breach notifications are also legal matters that need to be addressed to comply with state and federal law.

DO maintain regular communications with your investors. Part of the C-suite’s business is to continue to attract investors to the company—both to help boost the demand for the stock but also to try to attract some liquidity as well. You can make the C-suite’s job easier by delivering timely communications to your existing investors, keeping them happy.

DON’T lose sight of your regulatory obligations. Companies that file with the SEC obviously need to follow its reporting guidelines. But even those that don’t report to the SEC will need to comply with state or federal regulations applicable to the bank regarding governance and investor relations.

DO perform a regular review of your company charter and bylaws. You should have your counsel review these documents from time to time. This gives you the opportunity to make updates that support your business objectives. For example, you should consider the elimination of stock certificates if they are specifically mentioned in the bylaws.

Making this update allows for the use of book-entry statements (much like those one might see if they own a mutual fund or have their own brokerage account) and for more modern communications and proxy voting technology such as the electronic delivery of annual meeting materials and online voting. Your counsel will need to review applicable banking regulations to ensure these options are available.

Proper tracking of your investors and their holdings is as critical to the success of your business as your relationship with your banking customers. Adhering to strong governance and compliance practices will reduce opportunities for mistakes and risk going forward.

Compensation Issues That Can Determine the Success of Your Acquisition


compensation-9-6-17.pngMergers and acquisitions continue to be an important business strategy for many community and regional banks. The compensation areas that receive the most attention are change-in-control (CIC) related severance payments and the equity holdings that typically increase in value upon the change. The CIC severance payments that are covered under employment and severance agreements are often estimated and are frequently a part of the conversation prior to the actual CIC. Equity and deferred compensation programs that have accelerated vesting upon a CIC are also generally reviewed ahead of time. The executive groups that have these compensation programs get plenty of attention from the key parties involved in a transaction. However, there are also many non-executive related compensation issues that can have a big impact on the ultimate success of a merger or acquisition.

Once the transaction is complete and the executive related compensation payouts have been settled, there is a combined organization that needs to operate successfully. It is possible that the two organizations had significantly different compensation philosophies in place and one of the key first steps is to clearly identify and communicate the compensation philosophy of the merged bank going forward. For example, if one organization believes in leading the market and the other likes to “lag” the market on pay, you’ll need to determine the future direction. A strong compensation philosophy that guides the compensation decisions and clearly communicates the preferences of the organization will help accelerate the pace of the transition.

Additionally, the combined organization will need to determine the appropriate market benchmarking data to utilize. The bank is now larger following the the transaction and this creates a situation where new peers may be appropriate and new benchmarking surveys or data cuts may be necessary. The bank may have expanded into new states and/or regional markets, which impacts the external market benchmarking process. It is critical to identify the appropriate market data to use for external benchmarking and market competitiveness.

Another potential challenge after an acquisition is the possible need to combine and/or introduce formal salary grade structures. If both organizations had a salary structure system in place there will need to be a determination on whether adjustments need to be made to the future structure. If one organization did not have any salary grades in place, then they will likely need to be introduced to the concept. It can take some time to educate managers and employees as to how these salary systems work. The bank should have a non-discriminatory, market competitive, easily manageable and communicated salary structure to use.

Another common challenge is the realization that the actual pay ranges for certain positions within the combined organization are significantly different. This could be attributed to the differing compensation philosophies of the organizations, differing market locations and competitiveness, or simply differing pay practices that have developed over time. The first step to resolving these potential issues is to review the various positions and identify the significant pay differentials that exist. After identification, the challenge is to assess why the differences have occurred and if there isn’t a clear reason—for example, a geographical differential like a rural versus urban location–then the tough part becomes what to do about these internal pay differences. For example, should the pay grade be changed and/or different levels created for a job title?

Possibly the most significant challenge after a transaction is the combination and/or introduction of incentive-based pay methodologies. Most likely there are some differences in place between the two organizations. One may have a completely discretionary system and the other a true performance-based system. These differences often lead to cultural challenges, because formal systems generally emphasize the importance of pay for performance more heavily than discretionary systems. If both banks have formal performance-based incentives in place, then the challenge will be combining the plans and identifying the key differences that need to be resolved. Examples of differences would be the award opportunity levels, participants included in the various tiers and plans, types of goals used, documentation of the plans, and the award tracking systems in place. Someone will need to review the various incentive plans and determine how to best mesh the current practices for the future.

There are a number of compensation related challenges that can impact a successful merger. The challenges spread beyond the executive related severance payments, and continue well after the change-in-control event occurs. Careful consideration and planning should be used to harmonize differing compensation philosophies and practices through the compensation landscape of the combined entities. Compensation philosophies need to be reviewed, salary structures and market benchmark methodologies may need adjustment, and incentive plans will need to be combined or revamped. Finally, a timeline and communication strategy will need to be developed to ensure a successful compensation environment going forward.

Bank Compensation: Should You Award a Transaction Bonus?


incentive-pay-10-12-16.pngWhen a bank suddenly finds itself in the midst of a sale, merger, or other strategic transaction, retaining key talent and senior leadership becomes critical. Without proper incentives, executives can be left to wonder whether impending changes align with their own economic interests and long-term career goals. Banks need their key players to remain sharply focused on maintaining and growing the existing business, while simultaneously handling the increased responsibilities of working through a potential transaction.

While banks typically have change-in-control (CIC) severance and equity arrangements in place for senior executives, retention bonuses—and in special cases “transaction bonuses”—may be implemented as a deal is contemplated.

When establishing awards, banks should be mindful of the total retention opportunities for the group, including potential severance and equity vesting upon termination or CIC. Awards approved should be reasonable on a standalone basis, in the aggregate when considering all CIC-related costs, and relative to deal size. When current severance, equity, and other CIC related benefits are sufficient, there may be no need for additional transaction compensation.

Used less frequently than other retention vehicles, transaction bonuses can be used to motivate executives throughout the business sale process. They are usually paid in cash upon or shortly following a deal closing, although some awards are in shares. Terms vary based on the role a key executive will play.

  • For the deal makers, the select group of executives that are responsible for driving deal terms and value, a transaction bonus can be fairly significant and often is determined as a fixed dollar value, a percentage of the equity transaction value, or fixed number of shares. Some awards are hinged on the attainment of strategic performance goals or metrics such as negotiating a threshold transaction price.
  • For key administrators, those senior level executives critical to managing the due diligence and sale process, transaction bonuses are typically used to compensate for the additional work required. These awards tend to be smaller, taking the form of fixed cash bonuses determined based on a percentage of an executive’s base salary with amounts increasing as desired retention periods lengthen.

To understand how banks are using this incentive, we examined public disclosures over the last five years for the acquisitions of 88 public banks.

  • Of those, just a small number (17 percent) disclosed paying transaction bonuses to their named executive officers (NEOs). In contrast, about a third (31 percent) of the banks reported paying retention bonuses with service periods extending beyond closing. When transaction bonuses were paid, over half of the banks (53 percent) disclosed that there would be no further cash severance benefit provided.
  • Transaction award amounts were extremely varied based on the specific circumstances and size of each transaction and each individual’s contribution. When paid, aggregate awards to all NEOs ranged between $55,000 to over $10 million (on an absolute basis). Aggregate awards as a percentage of transaction values ranged from 0.15 percent at the 25th percentile to 1.36 percent at the 75th percentile with a midpoint of 0.78 percent. Percentages in relation to deal size tended to decrease as the deal size increased.

When considered on the eve of deal, legal and compensation advisors should be actively involved in the design and approval process; banks will be under a heightened level of scrutiny to demonstrate the prudence of their decisions. Also, banks should be mindful of institutional shareholder and shareholder advisory services concerns and a number of tax, legal, and accounting potholes. For example, Internal Revenue Code Section 280G applies when the present value of all payments related to a CIC equals or exceeds three times the individual’s base amount (i.e., an individual’s five-year average W-2 earnings). When 280G is triggered, punitive excise tax penalties apply and intended CIC benefits can be significantly eroded.

In practice, transaction bonuses for senior executives are paid much less frequently than compared to standard retention awards and tend to cover a smaller, more senior group of executives. However, for deal makers, these awards can be a significant incentive and worth considering since they are meant to reward value realization. For key administrators, transaction awards are sized to effectively compensate for the additional time and effort needed to bring a transaction to close. Transaction awards may provide the right retention hold and motivation when severance and equity benefits are insufficient to retain senior level executives through or shortly following close and may help your institution get a deal over the finish line.

Avoiding the Excess Parachute Payments Trap in M&A Deals


parachute-payment-11-27-15.pngIn the normal course of M&A events, compliance with Section 280G of the Internal Revenue Code to be an eleventh hour thing. In very general terms, 280G applies to compensation paid to an employee in connection with the employer’s change in control. It’s not that the merger partners don’t care at all about this provision in the tax code, it’s just that there are a lot of other issues—like the merger agreement itself—that need to be settled first. However, waiting until the last minute can have adverse financial implications for the selling bank and its employees, so here are a few ideas for 280G planning.

Specifically, 280G makes “excess parachute payments” nondeductible to the employer and subject to a 20 percent excise tax payable by the employee if the aggregate payments equal or exceed three times the employee’s base compensation. An employee’s “base amount” is the average of W-2 compensation for the five years before the year of the transaction. To avoid 280G’s negative consequences, an employee’s change in control payments must be no more than one dollar less than three times the base amount.

For example, if we assume Employee A has a base amount (i.e., five-year average) of $200,000, the maximum change in control payment she could receive without triggering 280G is $599,999 (i.e., $1 less than $200,000 times three. If payments to Employee A equal or exceed $600,000, then any amount in excess of $200,000 (i.e., the base amount) will be nondeductible and subject to the excise tax.

Cutbacks and gross ups are the most common form of 280G planning. A cutback provision in a contract ensures that no amount will be paid in excess of the 280G threshold. In contrast, a gross up provision ensures that the employee will be made whole for any excise tax.

Another 280G planning method is managing the base amount. The more advance managing that can be done, the better. Still, some planning can be done even in the calendar year prior to a transaction. Any increase in the base amount will serve to also increase the threshold amount. As such, employers can consider (1) increasing base salary payable in the year (or years) preceding the year of a transaction; (2) accelerating calendar year bonuses, which are typically paid in the spring of the following calendar year, to December of the current calendar year; or (3) encouraging an employee to exercise vested stock options in the year prior to the transaction. Any of these three could have an impact on the base amount.

A little more complex approach would be an employer’s affirmative action to accelerate the vesting of restricted stock or accelerate the settlement of restricted stock units to the year before the year of a transaction. Also, keep in mind that payments with respect to certain restrictive covenants can have value that is not counted as a change in control payment.

Finally, employers should note that in certain circumstances, 280G provides for a “cleansing” shareholder vote. If at least 75 percent of shareholders agree to the change in control payments, regardless of amount, they will not be subject to 280G’s bad consequences.

If selling the bank is one of the strategic options you are considering, you should give some thought to these planning opportunities in an effort to avoid 280G problems.

What’s New for Change-in-Control Agreements


10-29-14-Meridian.jpgIn the banking industry, where mergers and acquisitions are common occurrences, change-in-control (CIC) arrangements can be a critical part of executive compensation programs. However, these arrangements are currently under scrutiny from shareholders, institutional investors, the media and most notably, proxy advisory firms. While market practices in this area can be slow to change, as they tend to be part of longer term agreements or contracts, the external pressure has caused many public companies to change their CIC arrangements in a number of areas.

Purpose of CIC Arrangements
CIC arrangements are generally provided to keep executives neutral to job loss while they consider potential transactions, retain key talent during periods of uncertainty, provide a market competitive benefit and be fair to executives in the event of job loss. CIC arrangements generally cover senior executives who seek out and implement corporate transactions, as well as key executives that may be at particular risk of job loss in the event of a CIC.

Current Trends in CIC Arrangements
Meridian’s 2014 Study of Executive Change-in-Control Arrangements, when compared to our 2011 study, revealed key trends in the following areas: 1) the overall structure of CIC protection, 2) cash severance provisions 3) equity vesting acceleration and 4) excise tax treatment.

Overall Structure of CIC Protection: Shift to CIC Plans
Companies are shifting away from individual CIC agreements and towards CIC Plans. CIC Plans, as opposed to individual agreements, cover multiple executives under one plan. Similar to a general severance plan, the plan terms and conditions are the same for all participants with differentiation of severance multiples based on level. A CIC Plan, instead of individual agreements, ensures consistent application and provides easier administration.

Cash Severance: Decrease in Severance Multiples
A large majority of companies provide cash severance benefits upon a qualified termination following a CIC. The amount of cash severance is typically determined as a multiple of pay, which generally includes both base salary and annual bonus (either target or average of recent payouts). Cash severance multiples are trending down, especially for executives below the CEO level. While 3x multiples remain majority practice for CEOs, 2x and lower multiples are becoming more prevalent for other top executives. This decrease in severance multiples is a direct result of shareholder pressure against large payouts or what is commonly known as golden parachutes.

Equity Awards: Elimination of Single-Trigger Vesting
Historically, the vast majority of companies have provided for equity awards to vest in full immediately upon a CIC (single-trigger). Critics have argued that this creates an inappropriate windfall for recipients, and have argued that vesting should not accelerate absent a qualifying termination following the CIC (double-trigger). A double-trigger provision means that equity immediately vests only if there is a CIC and the executive loses his or her job as a result of the CIC.

Pressure from institutional shareholders and their advisors has led to significant change in the treatment of equity awards upon a CIC. While single-trigger provisions were majority practice in our 2011 study, it applied to only approximately one-third of equity awards in our 2014 study. The most common treatment in our study was double-trigger vesting. However, our study indicates that an emerging practice is to include a caveat on double-trigger vesting: equity will vest immediately if the equity is not assumed or replaced by the acquiring company.

Excise Tax Treatment: Elimination of Gross-Ups
Federal tax regulations trigger a 20 percent excise tax when CIC benefits exceed a specified threshold. Because the tax can have disparate impact on executives depending on their past earnings, many companies have provided tax gross-ups to mitigate its impact. However, these provisions have faced tremendous scrutiny and criticism, which has led to a sharp decline in their use. While many companies have been promising to exclude gross-ups from future agreements for several years, we are now seeing some companies remove them from current arrangements. This has accelerated the movement away from gross-up provisions, as they are now present at about only one-third of companies in our survey.

Gross-ups have generally been replaced with a “best net benefit” provision, which is now the most common excise tax treatment. Under a best net benefit provision, an executive will receive the greater of 1) a capped benefit, with the amount reduced just below the threshold for triggering the excise tax, or 2) the full benefit, with the executive personally responsible for paying the excise tax.

Conclusion
Change-in-control benefits continue to provide several important benefits to banks, but it is important to ensure that provisions balance shareholder and executive concerns. As market practices continue to evolve, it is important to periodically assess your CIC benefits and ensure they remain appropriate and effective.

Time to Dust Off Those Change-in-Control Agreements


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.

How Mergers Can Impact Deferred Compensation Plans: Part II


12-9-13-Equias.jpgSome compensation arrangements can cause headaches during a merger or acquisition or even derail a deal if they trigger the golden parachute rule under the Internal Revenue Code and possibly related excise taxes. So how do you know if your bank has such arrangements? It’s best to review compensation plans well ahead of striking a deal with another bank to plan for the possibility of the application of the golden parachute rules, otherwise known as exceeding the §280G limit. This is the second in a two-part series about what constitutes a golden parachute payment and what a bank can do about it. Check out the first article to see what constitutes a parachute payment.

Is there anything the bank can do to avoid the creation of parachute payments in a change of control?

Yes. There are several potential options:

  1. Accelerate vesting prior to the change in control (CIC). The bank can accelerate vesting of a Supplemental Executive Retirement Plan (SERP) or some other non-qualified deferred compensation arrangement at least 12 months in advance of the change in control to avoid triggering the “golden parachute” excise taxes. The downside is that the bank would have to accrue a liability for the increase in the vested benefit. In addition, if the executive terminated employment, the bank would be obligated to pay the executive the increased benefit. (This is a positive to the executive but may be a negative to the bank.)
  2. Classify payments as part of a non-compete. If the executive’s separation agreement provides that the executive cannot compete with the company for a period of time, then a portion of the payments may be attributable to the non-compete and therefore excludable from the parachute payment amount. There is no bright line test for how much can be excluded as it is based on facts and circumstances. The excludable amount will vary by bank and by individual within a bank. Any amount paid that does not represent reasonable value for the non-compete will be part of the parachute payment.
  3. Provide a retention agreement. The buying bank could enter into retention agreements with one or more executives. There is value to the buying bank in retaining key executives for some period of time after the merger to protect its investment. The amount paid to the executive for retention (including salary, bonuses, stock options or other) must represent reasonable compensation for the services rendered or it will be considered a parachute payment.
  4. Accelerate income. If it is anticipated that the bank may experience a CIC in the foreseeable future, it could take steps to increase the executive’s base amount by accelerating income (through bonuses or the exercise of stock options). In addition, the executive may want to discontinue deferrals under any voluntary deferred compensation plans. Lastly, it may be possible to increase the base amount by terminating the bank’s non-qualified deferred compensation arrangements and distributing the proceeds (being careful to follow the guidance under IRC section 409A).

What are the bank’s alternatives, when designing a plan, to address §280G?

There are three basic strategies:

  1. Cutback. The agreement provides that if the total parachute payments exceed the §280G limit, they will be reduced so as not to trigger an excise tax.
  2. Gross up. The executive is to receive the total payments and the bank will pay the executive additional compensation to cover his excise taxes.
  3. Neither cutback nor gross up. The executive receives his payments, even if they trigger an excise tax, but the bank does not cover his excise taxes. This one should include a filter that would cutback the parachute payments if the excise taxes cause the executive to receive less on a net after tax basis.

Do we have to apply the same strategy for all covered executives?

No. As with other nonqualified benefit plans, you can have different CIC provisions for each executive.

What happens after the CIC is completed?

Typically the timing and amount due the executive is paid pursuant to the CIC provisions in the plan agreement. However, Section 409A of the Internal Revenue Code allows the buying bank to terminate the plan and pay a lump sum to each executive in the plan. The buying bank may only do so if it follows the specific criteria detailed in §409A. Boards and executives should take this into consideration in designing or updating their plan.

Equias Alliance offers securities through ProEquities, Inc. member FINRA & SIPC. Equias Alliance is independent of ProEquities, Inc.). IRS Circular 230 Disclosure: As required by U.S. Treasury Regulations, we advise you that any tax advice contained in this communication is not intended to be used, and cannot be used, for the purpose of avoiding penalties under the Internal Revenue Code.

Parachute Payments: Beware of the Tax Hazards


7-3-13_Crowe.pngDoes your employment contract with your CEO offer too much severance pay? If so, there could be significant tax consequences for the bank and the CEO.

Section 280G of the Internal Revenue Code (IRC) contains a rule that can result in punitive tax burdens for both the payer and the recipient of “excessive,” or “golden parachute,” payments, which are generally triggered during a change-in-control. The rule applies to public companies and certain other corporations that do not meet shareholder approval requirements for parachute payments. Parachute payments are considered excessive if they equal or exceed three times a defined base amount, generally the average taxable compensation paid to the recipient from the payer during the five calendar years preceding the year in which the change-in-control occurs.

Benefits such as stock options and restricted stock awards that are vested at an accelerated rate are factored into the calculation.

If the three-times-base measurement is triggered, then all parachute payments in excess of one times the base amount are subject to a 20 percent excise tax at the individual level (required to be withheld by the payer) and the payer must forgo its tax deduction for the same amount. The result is particularly harsh given the retroactive manner in which the tax burdens are applied.

For instance, assume a base salary of $500,000 for an officer of a public company and a change-in- control that entitles the officer to receive parachute payments. Under Section 280G, up to $1,499,999 (three times $500,000 minus $1) of parachute payments can be paid without any tax consequences. However, if one incremental dollar is paid and the three-times-base measurement is triggered, then the officer is subject to excise tax of $200,000 (20 percent of $1.5 million minus $500,000 base), and the payer is denied a deduction of $1 million (excess of parachute payments over base amount). Assuming a 40 percent marginal income tax rate, this amounts to a lost tax benefit of $400,000 to the payer. The one additional dollar of parachute payment results in combined additional taxes of $600,000 to the officer and the payer and represents one of the most expensive tax burdens in the entire tax code.

Planning Ahead
Planning around the application of parachute payments can be difficult and is best addressed in the negotiation stage of the change-in-control transaction. The tax rules are designed to prohibit obvious reallocations of income (such as reducing parachute payments in exchange for large bonuses in post-takeover employment contracts). However, there are some means of effective planning.

Recipients of parachute payments can accelerate taxable income into the calendar year preceding the year in which the change-in-control occurs, effectively increasing the base amount and allowing more room for parachute payments before triggering the three-times-base measurement. Accelerating taxable income can be achieved by exercising stock options, cashing out deferred compensation arrangements, and adjusting incentive plans. However, public companies must be mindful of the $1 million compensation deduction limit for certain officers imposed under IRC Section 162(m).

Payers can address potential golden parachute issues by drafting employment agreements to stipulate who bears the tax burdens should Section 280G be triggered. Under a “cut-back” provision, the employee’s parachute payments are simply reduced until they drop below the three-times-base trigger (leaving the employee to bear the entire tax burden). Under a “gross-up” provision, the employer is required to gross-up the parachute payments for all income and excise taxes until the employee receives the net amount called for in the employment agreement irrespective of the application of Section 280G. Gross-up provisions can exponentially increase an employer’s obligation under the contract, though, as the gross-up payments are subject to excise taxes and are nondeductible to the employer.

There are a variety of common contractual provisions that fall in between the more extreme cut-back and gross-up provisions and that call for a shared burden between the employer and the employee. These provisions often are negotiated as part of an overall transaction and should be considered carefully before offers are made and agreements are signed. The result of not doing so can be costly to all parties involved.

Why It’s Important to Calculate Your Change-In-Control Payouts Now


iStock_000019351044XSmall.jpgBusiness planning is a key bank responsibility, but many institutions fail to adequately address a critical element of planning:  clarifying and understanding the impact of severance and change-in-control benefits in the event of a potential future transaction.  

Deal offers are often unexpected or need to be quickly evaluated. Negotiations go much more smoothly if the bank has already defined and detailed its change-in-control (CIC) terms and fully considered their potential impact on the executive team.  Why? 

Consider this scenario.  Let’s say the bank’s board and management have agreed on fairly standard and, they believed, fair CIC severance packages:  two times base salary + bonus along with equity acceleration and benefits continuation.  In the process of setting terms, however, the bank made what is actually a common error: It failed to consider the potentially significant impact of the golden parachute excise tax.  

When the bank did the tax calculations, it discovered executives would be subject to an excise tax that would reduce their net severance payout by more than half. Only when the deal became real did it become clear that the benefit structure and ultimate payout would be significantly different than what was intended.   

This unplanned outcome forces two negotiations.  First, the target’s management and board will try to resolve the difference between the intended and the actual value.  But with an offer already on the table, there will need to be a second negotiation with the buyer to get agreement on any changes to the terms.  As a result, the target and the buyer are distracted from the primary objective, which is to evaluate and approve a deal that will create value for both banks’ shareholders.

I will be discussing this and other topics impacting mergers and acquisitions at the Bank Director Acquire or Be Acquired conference in Scottsdale, Arizona, Jan. 27 to Jan 29, including the following: 

  • What are banks doing about CIC benefits?
  • What are some of the “hidden” negative consequences?
  • What can banks do to help mitigate these unintended consequences?