News that Arctic Cat is to be acquired by Textron, Inc. is the latest of a number of acquisitions of Minnesota-based companies, including the recently concluded purchase of St. Jude Medical by Abbott Laboratories and the still-pending acquisition of Valspar by Sherwin-Williams. The possibility that these recent transactions may create redundancies may have many Twin Cities executives blowing the dust off their change-in-control (CIC) clauses. The author of Frankenstein, Mary Shelly, wrote that, “Nothing is so painful to the human mind as a great and sudden change.” For workers with a contractual CIC provision, however, a parachute payment can soften the blow and even provide cushion for the worker to go on to a new and even more exciting career opportunity.
The contractual tool known as the “CIC” has been popular since at least the 1980s during that decade’s wave of takeovers. The often-stated purpose of a CIC provision is to protect high-level employees from being fired and replaced in the event of a sale of the company. Typically, the chief executive fears being replaced by the new owners, and mid-level executives fear being replaced by a new CEO who might bring in lieutenants she knows or trusts from previous companies.
There are two potential, but often opposed, motives for such clauses.
- To encourage the executive so that she can concentrate her energies on finding new capital, a potential buyer, or merger candidate without being distracted by the consequence of her success; and
- To discourage potential buyers by acting as a “poison pill” that increases the cost of an acquisition.
The mechanism is basically the same in both circumstances: CIC provisions trigger a windfall for the executive, which is often referred to as a “golden parachute.” This windfall can be in the form of a severance package of one to three year’s base salary, it can mandate an accelerated vesting of stock options, or both.
The Internal Revenue Service has declared that parachute payments in excess of 300 percent (three times) the employee’s previous annual salary are subject to significant tax penalties. This provision, known as Section 280G, has resulted in a practical three-year ceiling on most parachute payments. Section 409A of the tax code, enacted in 2007, may also impose penalties for non-compliant contracts.
The definition of “change in control” should be specifically stated and may include a majority change in equity ownership of the corporation, the purchase of all or substantially all of the assets of the corporation, or a change in majority control of the board of directors. The “effective date” of a change in control should also be clearly defined as the author has been involved in arbitration over this issue. Executives might find themselves pink-slipped immediately prior to a CIC, whether in an effort to avoid the parachute payment, in a last-ditch effort to clean house, by coincidence, or at the request of the new owners even if they have not officially taken control. For this reason, it is helpful on the employee’s side to define the date of a CIC for severance purposes as being 60 days prior to the effective date of a transaction such as a merger, acquisition, public offering, or sale of assets.
Most CIC clauses define a change in control, in part, as a change in the ownership (or “beneficial ownership”) of securities or voting shares of the company representing some percentage of all voting power. From the executive’s perspective, the number should be as low as possible, perhaps 20% or even 15%. For publicly held corporations, 33% or 35% is more common. For small, privately held companies, the trigger is usually 50%. Generally, the larger the company the smaller the percentage of stock necessary to constitute a CIC. Sometimes application of these clauses can be complicated depending on the nature of the transaction from a securities law perspective. For example, venture capital or distressed company financing may create debt which is convertible to equity, such as preferred stock. This can confuse the question of what constitutes “ownership.” Another issue arises if a high-level executive in a very large corporation is the head of a billion-dollar division of the company, but if that division is sold off to a competitor without changing the “ownership” of the company as a whole, it may lead to the termination of the executive’s employment without recourse to a CIC clause.
Change in control clauses may be “single trigger” or “double trigger.” A single trigger clause, which is less common, automatically pays benefits to the executive upon the change in control if he chooses not to remain with the corporation. A double trigger only pays benefits if there is a change in control and the executive is involuntarily terminated within a certain time period following the effective date of the change in control.
Reported court decisions regarding CIC clauses are rare, partly because executive contracts often include confidential arbitration provisions. In a decision last year, however, The Supreme Court of Virginia overturned a $655,000 breach of contract award to Scott Harvard, the former CEO of Hampton Roads Bankshares, Inc. Harvard resigned his employment following the acquisition of Gateway Bank in 2009 and requested a golden parachute payment equal to 2.99 times his base salary. The bank refused to pay due to federal restrictions on executive parachutes imposed on financial institutions as part of the Emergency Economic Stabilization Act of 2008, which was part of the Troubled Asset Relief Program (“TARP”). Although trial court ruled in his favor, the Virginia Supreme Court reversed, holding that federal law barred the payment on the basis of impossibility of performance. Hampton Roads Bankshares v. Harvard, 781 S.E.2d 172, 291 Va. 42 (2016).
Harvard was not so lucky, but Minnesota executives of Arctic Cat and other Minnesota acquisition targets will hopefully have an easier time triggering their golden parachutes.
About the Author
Minnesota executive law attorney V. John Ella has extensive experience representing businesses and executives in negotiating employment agreements. If you have any questions about employment contracts, please contact him at 612.455.6237 or firstname.lastname@example.org. Trepanier MacGillis Battina P.A. is a Minnesota employment law firm located in Minneapolis, Minnesota.