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.

Severance Pay May Be Forbidden, Court Rules

severance-pay-8-31-16.pngNo one wants to imagine bad times for the bank. But it makes sense to plan in advance, just in case. Your bank needs to motivate and keep the executive management team in place during difficult times, and one way to ensure this is to put in place a competitive compensation package when times are good.

A troubled bank can have significant restrictions imposed on its executive compensation programs. In particular, 12 C.F.R. Part 359 (Part 359) broadly prohibits the payment of, or entering into an agreement for the payment of, any golden parachute payment without prior regulatory approval. For an overview of Part 359, see our article dated September 23, 2011.

A decision in July of 2016 from the U.S. Court of Appeals for the 8th Circuit once again confirms the view of the “impossibility” of severance pay under Part 359 and serves as a reminder that prior planning can help a bank to work within those rules.

Overview of Von Rohr
Jerry Von Rohr was a long-serving senior executive at Reliance Bank, serving lastly as chief executive officer before Reliance terminated his employment. At the time, the bank was subject to Part 359. Von Rohr claimed he was entitled to compensation for a year following the effective date of his termination. Because it was subject to Part 359, Reliance asked the Federal Deposit Insurance Corp. (FDIC) whether the claimed payment could be made to Von Rohr. The FDIC advised that the payment would be a “golden parachute payment” under Part 359, which Reliance could not make without prior FDIC approval. Reliance declined to make the requested payment. Von Rohr filed a lawsuit against Reliance and the FDIC. He alleged breach of contract and requested a declaration that federal law does not prohibit the payment. The trial court upheld the FDIC’s determination and granted summary judgment to Reliance on the breach of contract claim. The appeals court affirmed the trial court’s decision.

In granting summary judgment to Reliance, the court affirmed the trial court’s finding that the FDIC’s determination made Reliance’s performance under Von Rohr’s contract “impossible.”

In upholding the FDIC’s determination that any post-employment payment to Von Rohr under his employment agreement would be a golden parachute because it would be a payment “for services he did not render,” the appeals court made clear that whether or not something is called severance or a “golden parachute” is irrelevant to the analysis as to whether it is prohibited under Part 359. Von Rohr had argued that the payment he was due was simply his compensation for the remainder of the term of his contract, not a payment solely and specifically contemplating his termination. The court indicated that, if it accepted Von Rohr’s view, it would “create a giant loophole” in the prohibitions of Part 359. The intent of the regulatory scheme is to prevent troubled banks from draining their already low resources with payments to terminated executives who may have been responsible for the bank’s condition. It would not serve that intent to allow artful drafting to avoid it.

Von Rohr also claimed that the FDIC’s position is in conflict with its consistently held view that Part 359 does not preclude payment of damages for statutory claims (e.g., discrimination, whistleblower retaliation, etc.). The court dismissed this claim by acknowledging the FDIC’s view on statutory claims and noting that Von Rohr was raising a contractual claim, not a statutory claim.

Planning Opportunities
Significantly, exempt from the scope of the prohibition of Part 359 are payments under tax-qualified retirement plans, benefit plans, bona fide deferred compensation plans and nondiscriminatory severance plans, as well as those required by statute or payable following death or disability.

In particular, Part 359 exempts bona fide deferred compensations and nondiscriminatory severance plans only where such arrangements have been in place at least (and not modified to increase benefits within) one year prior to the troubled condition designation.

Between bona fide deferred compensation, nondiscriminatory severance and death or disability benefits, a bank should be able to build the basics of an attractive compensation package for a member of executive management. However, many banks put off current consideration of these types of arrangements for one reason or another. The Von Rohr case should serve as a reminder that Part 359 is inflexible. Therefore, banks should consider today whether to implement such arrangements.

Finally, should a bank find itself involved in litigation related to an executive’s termination, it should remember that Part 359 does not prohibit payment of damages for statutory claims.

Will Your Bank Shoot Itself With a Single Trigger?

Here at Bank Director, we encourage readers to contact us with questions about issues they face as independent board members or members of management. We seek answers from experts and publish them for others in our membership program.

Our first question comes from a director of a privately owned Georgia bank:

“I am on the board of a local bank and the discussion involving change of control came up. We currently have a ‘double trigger’ regarding . . . key executives if a bank sale occurs. We have been counseled by our attorneys to change the document to a ‘single trigger’ in order to simplify the transaction and not put our executives in a difficult position of terminating in order to collect two or three times base earnings. What is the most common ‘trigger’ in banks today?”

BrentLongnecker.pngSo let’s retrace what the difference is: A single trigger is payment upon a change in control regardless of any change in employment status. A double trigger is payment upon a change in control followed by an involuntary termination of employment. Tips: Consider what constitutes a change in control, and consider the likelihood of the executive surviving the change in control. Consider position, age and the cost of severance to the deal. The trend today is double triggers; single triggers are out of favor.

Also, if this is a private bank, a single trigger may be worth considering IF it can get sound and enforceable non-compete and non-solicitation language signed by the departing executives. There is nothing worse than to give out a nice payment to executives—on behalf of the bank and its shareholders—only to see them set up shop “across the street” and begin competing and taking your people. Change-in-control monies have seeded more competition than most people would imagine, especially with banks!

—Brent M. Longnecker, chairman and CEO, Longnecker & Associates

DoreenLilienfield.pngChange-of-control protections can both ensure that executives provide an impartial consideration of strategic alternatives for a company without focusing on their own potential job loss, and serve as an effective retention tool for executives during uncertain times surrounding a potential transaction.

Executives are often eligible to receive enhanced severance benefits (typically a multiple of base salary and bonus) if their employment is involuntarily terminated (e.g., for cause or good reason) within a specified period following a transaction. In today’s market, there is minimal use of single trigger cash change in control payments, as they can undermine rather than foster the purposes noted above. Due to shareholder and shareholder advisor pressures, the use of single triggers for most types of change-in- control benefits has become fairly uncommon; however, notwithstanding plan design, equity awards may often accelerate at the time of a transaction, particularly in cash deals.

Some companies may elect to provide cash retention bonuses in lieu of, or in addition to, change-of- control severance benefits. Retention bonuses incentivize key individuals to remain with the company through the closing date or a specified milestone thereafter, and are also typically paid out on an involuntary termination prior to the payment date. The amount of any severance and other change-in- control benefits should be taken into consideration when determining retention bonuses.

—Doreen E. Lilienfeld, partner, executive compensation and employee benefits, Shearman & Sterling LLP

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.

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.

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.