This article is reprinted with permission from the
April 29, 1991
edition of

New York Law Journal.

1991 NLP IP Company.

 


Severance Arrangements

SERIES: Part II

By Joseph E. Bachelder.

 

PART I OF THIS COLUMN on severance arrangements discussed the subject of planning for severance in terms of the agreements, plans and other arrangements entered into in advance of the event. (New York Law Journal, Dec. 31, 1990) Part II. examines circumstances in which prior arrangements have not provided the protection being sought and, therefore a specially negotiated arrangement is worked out.

Frequently a severance negotiation is one that the employer is under no legal obligation to enter into. Instead, the circumstance may be one in which the employer (generally, the board of directors or its compensation committee in the case of a very senior-level executive) wants to be perceived as being fair and reasonable in connection with the termination. There may be concern on the part of other senior management members that someday they might be subject to the same thing. Also, it is not unusual for a senior level executive to have one or more mentors on the board of directors who want to assure fair treatment to him.

The scope of the severance arrangements that the employer may be willing to enter into undoubtedly will reflect the circumstances surrounding the executive's termination. In addition, in some cases the employer may condition the severance arrangements upon the executive's entering into a no-compete agreement or other limitations on his future activities.

Salary Continuation

Unlike a search for competitive compensation data, a search for competitive severance data generally involves a special effort. There are not the numerous public surveys that are available in respect of compensation and long-term incentives, broken down by company and industry. Such data as are available are largely based on payments pursuant to change in control arrangements.

Precedents vary considerably as to the appropriate length of the period in respect of which salary continuation payments are to be made. The particular employer involved may have its own precedents. (A corporate-wide severance policy may be a starting point, although it likely will not be deemed adequate for a very senior-level executive.) In addition, there will be precedents within the industry or at other companies with which the employer may consider itself comparable.

Information regarding severances of very senior-level executives may be available through examination of proxy statements.

Sometimes provisions for salary continuation include provisions for mitigation. 1 In some cases no effort to mitigate is required for the first part of the severance pay period and thereafter it is. In other cases, there may be no duty to mitigate under the terms of the agreement but if employment is found the agreement may require that part or all of the subsequently earned compensation be offset against the severance payments otherwise due.

Frequently the executive seeks to have the severance payment made in a lump sum promptly after the severance. On the other hand, if the employer is seeking a nocompete agreement, it may prefer to have the payments made over time to keep an economic "leash" on the executive.

Sometimes negotiations involve not only salary but also bonus payments. It might seem contradictory to a severance that bonus payments could be involved. If termination occurs late in a fiscal year and if the executive, notwithstanding the circumstances of the termination, made a valuable contribution for the portion of the year he was employed, it is not uncommon for an employer to give consideration to such a request. Another circumstance in which a "severance bonus" may be negotiated is one in which the executive was employed with an understanding that he was guaranteed a "minimum" bonus during employment.

The continuation of cash compensation arrangements could be embodied in a consulting agreement. The reasons for such arrangements vary. The company may want to have the executive available to advise on ongoing business issues, litigation matters, etc. Or, board members may feel more comfortable with a consulting arrangement than with a straight severance arrangement. There may be a tax advantage to the terminated executive in having a consulting arrangement. 2

Long-Term Incentives

These include arrangements such as stock options, stock appreciation rights, restricted stock, phantom stock and performance share or performance unit awards. Usually the most critical issue in negotiating an ad hoc severance arrangement with respect to such awards is the vesting issue (or, in the case of stock options and stock appreciation rights, exercisability).

Usually a stock option plan provides for a period of one to three months following termination without cause in which an executive may exercise the option, to the extent exercisable at the time of termination. Two issues may arise. First, can the period beyond the date of termination be extended beyond that provided in the original stock option award? Second, can the portion of the option not yet exercisable be accelerated, in whole or in part?

In addition to precedents, a careful look must be taken at the plan itself to see whether the employer (usually a special committee of the board such as the compensation committee) has the discretion to modify the post-termination entitlements and whether there are any implications under 16 of the Securities Exchange Act of 1934, applicable stock option rules under the Internal Revenue Code of 1986 (e.g., 422 if an incentive stock option is involved) or other applicable laws or regulations.

Even if the plan, or a rule outside the plan itself, does not permit modification, the company might provide the executive with a cash payment representing the economic equivalent of the rights being forfeited. 3 In the case of other forms of long-term incentives, the usual issue is whether the forfeiture provisions may be waived. Again, not only precedents but the plan document itself and laws and regulations that may be applicable, as noted in connection with stock options, must be considered.

Retirement Benefits

It is not unusual for an employer to modify the terms of a non-qualified supplemental employee retirement arrangement to accommodate an executive whose employment is terminated prematurely. Among the modifications that may be made are (I) acceleration of vesting, (ii) acceleration of payment (in some cases without actuarial adjustment for early commencement of benefits), (iii) enhancement of the amount of benefits (this may be accomplished in various ways including enhancement of the formula granting of additional years of credited service or simply increasing the dollar amount of pension payable) and (iv) enhancing the survivor's benefits without corresponding reduction in the benefit payable during the terminated executive's life. In many instances, this new arrangement is handled by special agreement between the employer and the terminated executive and does not involve any change in a broader-base supplemental retirement plan for executives that already may be in existence. In some cases a special arrangement also is entered into to fund, or otherwise secure, a previously unfunded benefit.

There may be advantages to emphasizing the economic aspect of a severance arrangement through modification of the retirement arrangements. Accounting for the cost of an enhanced pension in some cases may be spread over a longer period than would be the case if the arrangement were exclusively a payment of cash over a relatively short time. Also, board members may feel more comfortable with a pension enhancement than with an arrangement that is exclusively or substantially in the form of cash severance payments. In the case of a public company, there may be concern over the appearance in the proxy statement of a description of a cash-heavy severance arrangement involving a senior-level executive who was previously listed in the cash-compensation table. 4

In some cases continued coverage in a tax-qualified retirement plan may be available. However, the constraints associated with such plans, including discrimination rules, make such continuing coverage unlikely in most cases.

Welfare Benefit Plans

It is typical to provide for continuation of welfare benefit coverage during the period in respect of which salary continuation payments are to be made. These plans include life, disability and health insurance. 5 Existing plans may or may not permit continuing coverage following a termination of employment (except to the extent Consolidated Omnibus Reconciliation Act (COBRA) provides a right to a terminated employee to continue health coverage on a contributory basis). If existing plans to not permit continued participation, it may be necessary to provide the executive with individual coverage or a cash payment with which to purchase individual coverage. This frequently raises the issue of whether the executive should be given a payment that after taxes on the payment is sufficient to purchase the coverage. From the executive's standpoint, if the previously furnished benefit was not taxable, or was taxable at a lesser amount, some form of increase may be necessary in order to keep the executive whole from an out-of-pocket cash standpoint. Generally speaking, welfare continuation arrangements provide for cessation of benefits to the extent the executive becomes covered by a subsequent employer's program.

Some perquisites may be provided during the period of salary continuation. These may include continued use of a car provided by the employer (and/or the right to purchase the car at a favorable price at the end of the period it is leased or provided by the employer), club membership dues, financial counseling including tax planning and income tax preparation.

It has become customary for an employer to pay the cost of outplacement services. In some cases an office and/or secretarial services may be furnished. It is by no means the case, however, that all employers willing to provide severance payments are also willing to provide continued perquisites. Also, as already noted, the extent to which an employer is willing to provide continuing perquisites will be very much affected by the circumstances surrounding the executive's departure.

Indemnification

A terminated executive may continue to be covered under the by-laws of the employer and by indemnification insurance that the employer may have taken out such as director's and officers' liability insurance. To the extent those arrangements do not provide adequate coverage, a terminated executive may seek to have provision made in the severance agreement for indemnification on account of any acts taking place during the period of the executive's employment.

No-Compete Provisions

Obviously an employer providing severance payments and other benefits in a case in which it is not already obligated to do so (or providing severance benefits in excess of previously agreed-to arrangements) will likely seek some consideration for the continued benefits. As already noted in some cases a consulting agreement is entered into pursuant to which the employer may, if it chooses, ask for the services of the executive. With or without a consulting agreement, a no-compete provision is a very typical part of a severance arrangement. Issues that may arise in connection with a no-compete include the geographic scope and the length of the period of the no-compete. Also a frequent issue is the definition given to the business of the employer in respect of which the terminated executive cannot compete. "Definitely a factor in the scope of a no-compete provision is the amount of severance the employer is willing to pay. In addition, the employer frequently requires that the former executive not solicit customers and/or employees for some time.

No-compete arrangements may provide for various remedies. At the very least, the continued payment of cash severance will be conditioned upon not competing. In addition, the no-compete arrangement may provide specifically that the employer may seek injunctive relief for failure to abide by the no-compete. It is in the context of a former employer's seeking injunctive relief that no-compete arrangements are frequently challenged. Such a case may involve not only the geographic, temporal and business scope of the agreement but also the uniqueness of the services of the executive. (In addition, the in terrorem effect of a no-compete provision on both the former executive and prospective employers engaged in the business as to which the restriction applies very well may prevent, from a practical standpoint, the executive from obtaining competitive employment during the period of the restriction.)

Confidentiality

A severance agreement may provide not only for continued confidential treatment of proprietary information relating to the business of the employer but also may provide for confidential treatment of the agreement itself. Exception likely will be made to the extent necessary to obtain professional advice. Confidentiality as to the agreement may be desirable if the employer seeks to avoid establishing a precedent in making severance arrangements. On the other hand, as noted earlier if the company is a public company and the executive is one whose compensation has been required to be reported in the cash compensation table, disclosure of the severance arrangements in the proxy statement likely will be required.

Announcements

Typically the employer and the executive will agree upon the public announcement to be made regarding the executive's termination. Also, there may be provision that neither party, subsequent to the termination, will make unfavorable comments about the other.

Releases

Typically a severance agreement provides for mutual releases although there are circumstances in which employers demand a release but refuse to give one on the ground that the severance arrangement is essentially for the benefit of the executive and that the employer had no pre-existing obligation to provide any severance benefits (or benefits of the magnitude being provided). Each party generally will seek general release from any acts occurring prior to the agreement. From the standpoint of the employer, specific releases will probably be sought in respect of applicable federal and state antidiscrimination laws and, quite possibly, other employment-related laws. 6 From the executive's standpoint, care must be taken not to release the employer from otherwise applicable indemnification entitlements and, of course, each party must remain obligated to perform in accordance with the agreement itself.


FOOTNOTES:

1 New York law requires a discharged employee to use reasonable diligence to seek similar employment to mitigate his damages. Crabtree v. Elizabeth Arden Sales 105 NYS2d 40, 45 (Sup. Ct. 1951), aff'd, 279 A.D. 992 (1952), aff'd, 305 N.Y. 48 (1953); Karas v. H.R. Laboratories, 67 NYS2d 15, 19 (App. Div. 1946); Howard v. Daly, 61 NY. 362, 370 (1875). Salary considerations and degrees of responsibility are factors that may be taken into account in determining whether a new job is "similar employment." Crabtree, 105 NYS2d at 44; Ingrassia v. Shell Oil, 394 F. Supp. 875 (SDNY 1975). It should be noted, however, that a severance provision in an agreement is in essence a liquidated damage provision and thus eliminates the employee's duty to mitigate damages. Musman v. Modern Deb. Inc., 50 AD2d 761, 377 NYS2d 17 (1st Dept. 1975); Boyle v. Petrie Stores, 136 Misc2d 380, 518 NYs2d 854 (1987), aff'd, 519 NYs2d 988 (1987).

2 For instance, severance payments made to a nonresident of New York who had formerly performed services for his employer solely in New York City would be subject to New York State and City income tax. David P. Haskell, N.Y. State Tax Comm'n (TSB-H-83(229)-I; Income Tax, July 29, 1982), if, instead, the former employee were paid a consulting fee for services performed entirely outside of New York while a nonresident, the payments would not be subject to New York tax. Eugene G. Fubini, N.Y. State Tax Comm'n (TSB-H-81(138)-I; Income Tax, April 28, 1981). However, a consulting agreement pursuant to which no real services were to be performed presumably would be ignored by New York tax authorities and payments received under such an agreement would be treated on the same basis as severance payments.

3 A cash payment in lieu of an extension of the stock option privilege would not appear to be substantially adverse to the employer from an accounting standpoint. The employer would be required to charge earnings for the amount of the cash payment. An extension of the option exercise also would appear to require a charge to the extent of the spread in the option determined on the date the option period is extended. (In either case, the charge might be spread over two or more accounting periods it was in consideration for services (e.g., pursuant to a consulting agreement) or for an agreement to forgo certain activities (e.g., pursuant to a no-compete agreement) over such extended period.) See Accounting Principles board Opinion NO. 25, Accounting for Stock Issued to Employees (AICPA, October 1972), paras. 11d and 12.

4 Pursuant to Item 402 of Regulation S-K under the federal securities laws, the proxy for the annual meeting must include a description of any compensatory arrangement with an individual named in the cash compensation table that results or will result from the individual's resignation, retirement or other termination of employment. This requirement extends to individuals named in the cash compensation table "for the latest or next preceding fiscal year." Such disclosure is not required if the amount involved, including all periodic payments or installments, does not exceed $60,000.

5 Consolidated Omnibus Budget Reconciliation Act of 1986 (COBRA) (29 USCA 1161-67 [West Supp. 1991]). Under COBRA, most employees are eligible for group health insurance benefits during an 18-month period following termination, during which the employee pays the insurance premium. COBRA applies to employers with 20 or more employees but excludes churches, certain other tax-exempt organizations and federal employees. Employees not covered by COBRA may be eligible for continuation under state law.

6 In 1990 the Age Discrimination in Employment Act of 1978 (ADEA) was amended to provide that the protection ADEA affords employees may not be waived unless the individual has knowledge of the waiver and releases the employer voluntarily. 29 USCA 626(f) (1) (West Supp. 1991). This statute sets out several criteria that must be met in order for the waiver to be effective. Among other requirements, the individual must be given at within which to consider the agreement least 21 days containing the waiver and at least seven days following the execution of the agreement to revoke it. 29 USCA 626(f)(1)(F) & (G) (West Supp. 1991).