This article is reprinted with permission
New York Law Journal.
© 2006 NLP IP Company.
Severance Arrangements: A Road Map of Issues
Senior executive severance arrangements frequently involve a variety of economic and legal issues. Today's column discusses these issues in the context of what is customarily called a termination by the employer without "cause."
A voluntary termination by the executive for "good reason" often has consequences that are similar to those associated with a termination by the employer without "cause."
When Does Termination Occur?
A "firing" of a CEO or other senior executive does not necessarily mean his or her employment is immediately terminated. Most often when a CEO is fired it means that the executive has been removed as an officer (and sometimes as a director if the executive is serving in that capacity as well). Notwithstanding his removal as an officer, the executive may continue for a period of time as an employee (sometimes providing consulting services, sometimes simply on "inactive status" but still on the payroll). Among the ways in which a departing executive may avoid forfeiting unvested compensation and benefits is by remaining on payroll (that is, on employee status) long enough to vest.
Economic issues often associated with a severance package include the following:
a. Salary continuation.
b. Bonus continuation (generally for the same period as the salary continuation).
c. Pro-rata bonus for the year of termination.
d. Treatment of equity and other long-term awards:
• accelerated or continuing vesting versus forfeiture of unvested portion of award.
• for stock options, period of continuing exercisability after termination of employment (modifying stock options in this respect may have tax and accounting implications as discussed further below).
e. Treatment of retirement benefits:
• additional accrual (versus none) of pension credits under any defined benefit plans.
• additional vesting (accelerated or continuing) versus forfeiture of unvested portion of pension (applies to defined benefit and defined contribution plans).
f. Treatment of other forms of deferred compensation:
• additional vesting (accelerated or continuing) versus forfeiture of unvested portion of deferred compensation.
• entitlements as to interest or other forms of earnings.
• timing of payout.
(Tax implications of such issues affecting deferred compensation are noted in connection with discussion of Code §409A below.)
g. Continued coverage under welfare benefit programs (most frequently the period of continued coverage is the same as the period covered by severance payments).
Entitlements such as the foregoing may be governed by a pre-existing agreement or other arrangement or they may be agreed upon at the time of termination. Absent a pre-existing agreement, in some cases, it may be necessary to come up with a significant severance package in order to convince a majority of the board of directors to vote in favor of termination.
Continuing indemnification protections are very important to a departing CEO or other senior officer. Existing protections can be found in the employer's certificate of incorporation, corporate bylaws and sometimes in a separately adopted indemnification policy for management and, in some cases, individual indemnification agreements. In addition, directors and officers (D&O) liability policies often provide protection.
Nonetheless, continuing indemnification is often an important issue in connection with a severance. Certificates of incorporation and bylaws get changed over time, as do employer management indemnification policies (if they have them). D&O policies generally provide protection for a limited period (year to year, in some cases) and generally cover only claims made during the limited period covered by the policy. For these reasons, a separate provision often is negotiated in connection with a severance in order to protect the departing executive (a) as to areas of exposure not covered by corporate documents or the current D&O policy and (b) to assure the executive that if corporate document protection or D&O policy protection is modified, or ceases, in the future, he or she has a specific contract entitlement to such protection.
Releases have become typical parts of senior management severance arrangements. In some cases, there is only one releasor, the departing executive, who releases the employer (in consideration for the economic benefits of the termination). In many cases, however, the release is mutual. Also, from the perspective of most executives, it is preferable that the release be limited to claims arising from the employment or its termination. In some cases (fewer than half in the author's experience) the employer requires a general release.
Post-Termination Restrictive Covenants
Covenants that may be required of executives in connection with their separations include: (i) protection of confidential information, (ii) noncompetition, (iii) nonsolicitation of employees and (iv) nonsolicitation of customers. In addition, a provision typically is included for return of company property including documents and other accumulation of information proprietary to the employer (with exception generally made for materials that are essentially personal to the executive such as diaries, calendars and rolodexes). Confidentiality generally is without time restrictions (but with exceptions for information that becomes publicly available through no fault of the executive). The other three restrictions (ii-iv) are typically limited in time, frequently to one year or to a period coterminous with the period in respect of which severance is paid.
Another restriction, nondisparagement, often is mutual with exceptions for responses needed to correct an incorrect public statement by the other party. Generally, the nondisparagement period is limited, as in the case of other restrictive covenants as noted above.
Statutes and Regulations
a. SEC Severance Disclosure.
1. Form 8-K. Within four business days of the termination of a "principal executive officer, president, principal financial officer, principal accounting officer, principal operating officer, or any person performing similar functions, or any named executive officer" from such position, an employer subject to the Securities Exchange Act of 1934 must disclose the termination event on Form 8-K. In addition to the disclosure of the date and the event, the employer must disclose, as a part of the requirement to disclose all material compensatory arrangements with named executive officers (NEOs), the material terms of the severance arrangement, but only for the NEOs. (Details of the arrangements for the other officers that are not NEOs do not need to be disclosed.) Such material terms must be filed as part of the original Form 8-K filing unless such terms are not yet agreed to, in which event they must be filed in a subsequent Form 8-K (filed within four business days of such terms being agreed to).
2. Exhibits to Forms 10-Q and 10K. A filing of a copy of an executed separation agreement continues to be required, as an exhibit to a Quarterly Report on Form 10-Q filed by the employer following the quarter in which the agreement is entered into, and as an exhibit to all subsequent Annual Reports on Form 10-K. This requirement applies to agreements with NEOs and other executive officers, unless, in the case of a non-NEO, the agreement is immaterial in amount and significance.
3. Proxy Statement.For a fiscal year in which the termination of an NEO occurs, compensation relating to the termination for the applicable year must be reported. Amounts paid to or accrued by the departing NEO for the fiscal year, whether paid before or after leaving, must be reported in the summary compensation table. In addition to the disclosure required in the summary compensation table, entitlements to future termination payments and benefits are required to be reported in narrative form. (In this connection, see discussion in the following paragraph as to future compensation and benefits.)
• Note as to annual disclosures of future post-termination compensation and benefits. In years prior to the year of termination of an NEO, under the new rules, the proxy statement must disclose in detail the amounts and other material aspects of compensation and benefits that would become due upon a termination of the NEO. These disclosures are made in the narrative set forth in the executive compensation section of the proxy statement (some employers may choose to report quantifiable severance entitlements in tabular form). Thus, in the year of termination, reporting as to entitlements associated with a termination in most cases will be made in the summary compensation table and possibly in other tables as well as in narrative form. The employer's rationale for providing such payments and benefits should also be explained each year in the proxy statement's compensation discussion and analysis.
b. Tax Issues.
1. Internal Revenue Code §409A. Section 409A of the Internal Revenue Code (the code), a complex code provision enacted in 2004 and affecting executive compensation, provides for an additional 20 percent tax on "nonqualified deferred compensation" not meeting the requirements of that provision. In Proposed Regulation §1.409A-1(b)(9), the Internal Revenue Service (IRS) has taken the position that nonqualified deferred compensation includes severance payments. There are a number of exceptions to the application of this rule to severance payments which should be carefully reviewed to determine whether a particular severance arrangement is excepted or whether there is a way in which the application of code §409A could be mitigated or avoided. Following are some of the issues arising under code §409A that may impact on executive severance.
• The "Six Month" Rule. Code §409A(a)(2)(B) provides that, in order to avoid the additional tax, a six-month period must elapse from the date of termination of employment (the term used in the statute is "date of separation from service") until the payment to a "specified employee" of any nonqualified deferred compensation (including severance payments covered by code §409A, but subject to the exceptions noted above and in footnote 17) resulting from the termination. For this purpose most senior level executives will be treated as "specified employees." This means, for example, that unless the "short-term deferral" rule (see footnote 17) or other exception applies, a severance payment to a specified employee must be delayed for six months.
• Other issues under code §409A. In connection with modifications, if any, of existing entitlements upon a termination, care must be taken not to cause an adverse consequence to an existing plan or award. For example, a modification to an existing severance or other deferred compensation right following a termination might cause the plan or the individual executive's entitlements thereunder, to lose "grandfathered" status under code §409A. In the case of a stock option, an extension of the post-termination period for exercisability may cause loss of the exempt status for the stock option under code §409A.
2. Constructive Receipt of Income. In some cases, there may be an issue whether giving an executive a choice as to when to receive a severance amount may result in current taxability under general principles of constructive receipt. (These continue to exist quite apart from the specific new rules as to the additional 20 percent tax under code §409A.)
c. Accounting Issues.
These issues may include the following:
1. Acceleration of Expenses. These issues will arise in cases of accelerated vesting of stock options, accelerated pay-out of long-term awards and accelerated vesting of deferred compensation arrangements including supplemental pensions. Each of these accelerations may result in charges being accrued over a shorter period.
2. Extension of Exercise Period for Stock Options. An extension of the exercise period for a stock option may in some cases result in an increase in the charge against earnings.
In connection with the process of entering into a severance arrangement with a terminated senior level executive, the compensation committee or other group or persons involved in the separation process should keep in mind the following points:
What has been done in similar circumstances at the company and what are "best practices" at other companies in the industry and across industries? This information will become increasingly available under the new proxy statement reporting rules.
b. Independence of Committee Members.
Care should be taken that each compensation committee or other board member approving a severance package for a senior level executive is independent, taking into account, for example, the rules as to independence adopted by self-regulatory organizations (SROs) such as the New York Stock Exchange and NASDAQ.
c. Compliance with Applicable Employer Plans.
Any action involving existing agreements, plans, programs or other arrangements at the employer should be examined carefully to be sure there is no violation of the terms of such an arrangement and that nothing is done that might be a violation or other triggering event under the rules of the applicable SRO (such as a change requiring shareholder approval).
1. The discussion does not address the consequences associated with a termination in connection with a change in control, an event that generally has its own set of agreements, economic rewards and regulatory considerations. Nor does it cover the several other types of terminations that have their own sets of consequences: a termination by the employer for "cause," a voluntary termination by the executive, a termination due to death and a termination due to disability. The media reporting of terminations, frequently based on employer press releases, adds to the confusion over the nature of a termination by reporting a termination as a "resignation" or a "retirement" when, in fact, the termination is a termination by the employer without "cause."
2. The accelerated vesting or accrual of benefits noted in connection with the treatment of retirement benefits may not be possible under tax qualified plans due to the discriminatory effect when applied to a single executive. Accordingly, such acceleration or accrual ordinarily is handled through a supplemental executive retirement plan (SERP), or similar arrangement.
3. The Age Discrimination in Employment Act of 1967 requires that employees covered by its provisions be given a period of at least 21 days within which to consider the agreement and at least an additional 7 days following the execution of the agreement to revoke it. 29 USC §626(f).
4. At least from the executive's standpoint, exceptions to the release should be made for (i) any associated separation agreement, (ii) provisions of any employment agreement or any compensation or benefits plan, program or arrangement that should survive the release and (iii) any right to contribution as to any liability for which the employer and the departing executive are held jointly liable. The release also should make clear that it does not apply to any claims that arise after the release becomes effective.
5. In addition to the restrictive covenants, future cooperation by the departing executive may be important to an employer undergoing investigation or litigation. Because it may be a significant imposition on the executive, a requirement of future cooperation frequently is limited as to the amount of time that can be required in a prescribed period. Also, the period to which it applies frequently is limited as in the case of most of the restrictive covenants noted in the text.
6. Form 8-K is the form used for current reports under §13 or §15(d) of the Securities Exchange Act of 1934.
7. For the purposes of Form 8-K reporting, the term "named executive officer" refers to those executive officers for whom disclosure was required in the registrant's most recent filing with the SEC (normally, the proxy statement.) NEOs consist of any person serving as the principal executive officer (PEO) and principal financial officer (PFO) during the last completed fiscal year as well as the three most highly compensated executive officers serving as executive officers at the end of such fiscal year other than the PEO or principal financial officer (PFO) and up to two additional individuals for whom disclosure would have been provided but for the fact that the individual was not serving as an executive officer of the employer at the end of such fiscal year. Reg. S-K, Item 402(a)(3).
8. In many cases the terms of the separation will be agreed to in advance of the termination (i.e., in an employment agreement, a change of control agreement or a severance agreement). In such event, the Form 8-K filings would be in a different order: the material terms of the agreement would be filed on Form 8-K at the time the agreement is entered into (with additional filings at the time any material amendment is made) and the filing as to the termination event occur subsequently.
9. Regulation S-K, Item 601(b)(10)(ii)(A) requires that "any contract to which officers . . . named in the registration statement or report . . . are parties" (other than certain contracts involving sales of current assets) must be disclosed in Form 10-Q covering the fiscal quarter in which the contract is entered and in any Form 10-K filing as an exhibit. Regulation S-K, Item 601(b)(10)(iii)(A) specifies the management contracts and compensatory plans, contracts and arrangements that must be filed as such exhibits. (In practice, some companies may choose to file such agreement with Form 8-K and incorporate it into the applicable Form 10-Q or 10-K exhibit by cross-reference.)
10. NEO compensation, including severance arrangements, is required to be reported in the proxy statement, pursuant to rules of Regulation S-K, Item 402, as recently revised by final rules of the SEC as published in "Executive Compensation and Related Person Disclosure," 71 FedReg 53,158 (Sept. 8, 2006) (to be codified at 17 CFR pts. 228, 229, 232, 239, 240, 245, 249 and 274). Effective date: Nov. 7, 2006.
11. Regulation S-K, Item 402(c)(2)(ix)(D) requires reporting in the summary compensation table (in this case, for the year in which the NEO is terminated) of "the amount paid or accrued . . . pursuant to a plan or arrangement in connection with . . . any termination . . . of such executive officer's employment . . . ." Thus, for the year of termination, amounts of severance attributable to that year must be reported.
12. Pursuant to the Instructions to Item 402(j) of Regulation S-K, the employer "must provide quantitative disclosure under these requirements, applying the assumptions that the triggering event took place on the last business day of the registrant's last completed fiscal year, and the price per share of the registrant's securities is the closing market price as of that date . . . .Where a triggering event has actually occurred for a named executive officer and that individual was not serving as a named executive officer of the registrant at the end of the last completed fiscal year, the disclosure required by this paragraph for that named executive officer shall apply only to that triggering event."
13. As indicated in footnote 1, today's column is not concerned with severances associated with changes in control. This includes tax consequences under code §280G (the so-called "golden parachute" rule). Nonetheless, it should be pointed out that in the event a change in control occurs and a termination of employment occurs or is deemed to occur in connection with the change in control, numerous technical points under that code section will need to be considered for the purpose of avoiding excise tax treatment to the executive under code §4999 and possible adverse consequences to the employer, including loss of deduction for certain parachute payments and possible gross-up requirements under arrangements with the executive involved. Finally, a possibility exists that, if a change in control occurs shortly after a termination of an executive, code §280G and §4999 may apply and consideration should therefore be given to providing such executive with protection in light of the presumption created by code §280G that it applies, for example, to a payment made under an agreement entered into within 12 months prior to a change in control.
14. See discussion of code §409A in this column, NYLJ, Oct. 21, 2004.
15. In conformity with the statute, the Proposed Regulations in respect of code §409A exclude from the definition of a nonqualified deferred compensation plan any tax-qualified employer deferred compensation plan and any bona fide vacation leave, sick leave, compensatory time, disability pay, or death benefit plan. Prop. Treas. Reg. §1.409A-1(a)(2), (5). Elaborating on the definition of a "nonqualified deferred compensation plan" as provided in code 409A(d)(1), Proposed Treasury Regulation §1.409A-1(b)(1) defines a nonqualified deferred compensation plan as a plan that "provides for the deferral of compensation if, under the terms of the plan and the relevant facts and circumstances, the service provider has a legally binding right during a taxable year to compensation that has not been actually or constructively received and included in gross income, and that, pursuant to the terms of the plan, is payable to (or on behalf of) the service provider in a later year. A service provider does not have a legally binding right to compensation if that compensation may be reduced unilaterally or eliminated by the service recipient or other person after the services creating the right to the compensation have been performed."
16. The Explanation to the Proposed Regulations states that severance is included in nonqualified deferred compensation because "[i]t appears that Congress intended that severance payments could constitute deferred compensation under §409A . . . these regulations generally refer to such arrangements as separation pay arrangements." 70 Fed. Reg. 57,930 at 57,939.
Proposed Treasury Regulation §1.409A-1(m) defines "separation pay" for this purpose as follows:
For purposes of this paragraph (m), the term separation pay means any amount of compensation where one of the conditions to the right to the payment is a separation from service, whether voluntary or involuntary, including payments in the form of reimbursements of expenses incurred, and the provision of other taxable benefits. Separation pay includes amounts payable due to a separation from service, regardless of whether payment is conditioned upon the execution of a release of claims, noncompetition or nondisclosure provisions, or other similar requirement.
17. One exception that may allow certain severance payments to avoid code §409A treatment is called the "short-term deferral" rule. Some severance payments, if paid during the year of termination or within 2 and one-half months following the end of that year, may in certain circumstances not be treated as deferred compensation under code §409A. There are, however, technical aspects of this issue that need to be studied carefully before concluding whether the "short-term deferral" rule applies to particular payments and benefits. Prop. Treas. Reg. §1.409A-1(b)(4).
Another exception relates to severance pay plans meeting certain requirements as to timing and amount of payment. Prop. Treas. Reg. §1.409A-1(b)(9)(iii). However, due to limitations on the amounts that can be excepted under this rule, it would appear to have limited applicability to senior level executives at major corporations.
18. Proposed Treasury Regulation §1.409A-1(h) defines a "separation from service" as follows:
An employee separates from service with the service recipient if the employee dies, retires, or otherwise has a termination of employment with the employer. Prop. Treas. Reg. §1.409A-1(h)(1)(i).
The Proposed Regulation goes on to provide that "[w]hether a termination of employment has occurred is determined based on the facts and circumstances." In this connection, it also provides certain guideline levels of service and compensation above which a separation from service will not be deemed to have occurred. Prop. Treas. Reg. §1.409A-1(h)(1)(ii).
19. Code §409A(a)(2)(B)(i) defines a "specified employee" as:
. . . a key employee as defined in [Code] section 416(i) . . . of a corporation any stock in which is publicly traded on an established securities market or otherwise.
A "key employee" is defined in code §416(i) as an employee who, at any time during the plan year, is
(i) an officer of the employer having an annual compensation greater than $130,000,
(ii) a 5-percent owner of the employer, or
(iii) a 1-percent owner of the employer having an annual compensation from the employer of more than $150,000.
20. This raises the question of whether the employer should pay interest or an earnings factor for the period for which such payment is delayed. Many employers have agreed to this since they continue to have the use of the money during such six-month period. Also, frequently at issue is whether the employer should "gross up" the departed employee for the amount of any tax incurred under code §409A.
21. Under code §409A, certain amounts deferred before Jan. 1, 2005 are not subject to the rules of code §409A. The Explanation to the Proposed Regulations, reflecting IRS Notice 2005-1, Q&A-16, provides as follows:
An amount is considered deferred before January 1, 2005, and thus is not subject to section 409A, if the service provider had a legally binding right to be paid the amount and the right to the amount was earned and vested as of December 31, 2004. Expl. to Prop. Treas. Reg. at 70 Fed. Reg. 57930 at 57,952.
Such grandfathering will be lost in the event there is a material modification to the plan or other agreement pursuant to which the amount is deferred. "[A] modification of a plan is a material modification if a benefit or right existing as of Oct. 3, 2004, is materially enhanced or a new material benefit or right is added, and such material enhancement or addition affects amounts earned and vested before Jan. 1, 2005." Prop. Treas. Reg. § 1.409A-6(a)(4)(i).
22. Modification of an otherwise exempt stock option may cause the exemption to be lost. Among the modifications that will disqualify a stock option is "the granting to the holder of an additional period of time within which to exercise the stock right beyond the time originally prescribed . . . ." The proposed regulation goes on to provide that "it is not an extension if the exercise period of the stock right is extended to a date no later than the later of the 15th day of the third month following the date at which, or Dec. 31 of the calendar year in which, the stock right would otherwise have expired if the stock right had not been extended, based on the terms of the stock right at the original grant date." Prop. Treas. Reg. §1.409A-1(b)(5)(v)(C).
23. As noted in the text in connection with the discussion of proxy statement disclosure, new SEC disclosure rules require discussion of post-employment rights such as severance and will afford a good deal of information as to what other employers are doing in connection with executive terminations. This will make it substantially easier for employers to collect current competitive severance data.