Articles

CONSIDERING CHANGE - IN - CONTROL CLAUSES

"The prince who relies entirely upon fortune is lost when it changes."

Nicolo Machiavelli

V. John Ella
(jella@mansfieldtanick.com)
Mansfield, Tanick & Cohen, P.A.
1700 U. S. Bank Plaza South
Minneapolis, MN 55402
Tel: 612.339.4295
FAX: 612.339.3161

The recent resurgence of merger and acquisition activity, as marked by the combination of the St. Paul Companies with Travelers, should cause many executives to blow the dust off of their change-in-control ("CIC") clauses.

The contractual tool known as the CIC has been popular since at least the mid-1980s during that decade's wave of takeovers. The oft-stated purpose of CIC provisions 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 lower-level executives fear being replaced by the new CEO who may bring in lieutenants he or she trusts from previous companies.

There are two potential, and diametrically opposed, motives for such clauses. One is designed to encourage the executive so that they can concentrate their energies on finding new capital, potential buyers, or merger candidates without being fearful of the consequence of their success. The other variation is meant 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, often referred to as a "golden parachute."

This windfall can be in the form of a severance package of one to three years of pay, it can require an accelerated vesting of stock options, or both. The Internal Revenue Service has declared that parachute payments in excess of 300% (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.

Most executives lucky enough to have a CIC clause in their employment contract or stock option agreement probably do pay close attention to its specific terms in the drafting and negotiating stage, but this may be a mistake. From the executive's perspective, it makes good sense to ask for a CIC clause that has as broad a definition as possible of what will constitute a change-in-control, as well as a large parachute payment. Here are a few CIC drafting considerations:

Publicly held companies

What is the Percentage? Most CIC clauses define a change-in-control as based on the change in ownership (or "beneficial ownership") of securities or voting shares of the company representing some percentage of all the voting power. From the employee's perspective, this number should be as low as possible. Although 20% is the general starting point, it could be as low as 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.
Sale of a Subsidiary or Division. High-level executives in very large corporations may be 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 employee's termination without recourse to a CIC clause. Consider including the sale of your particular division as one of the definitional triggers.
Bridge Financing. Watch out for waves of venture capital or distressed company financing that includes debt convertible to equity, such as preferred stock, and consider how that fits in to your company's definition of change-in-control.
Anti-Golden Parachute Provision. Publicly-held corporations incorporated in Minnesota are subject to a state law provision, section 302A.255, subd. 3, which prevents corporations from amending or entering into agreements that directly or indirectly increase the current or future compensation of an officer or director during a tender offer. This means that a poison pill or CIC clause cannot be drafted after a firm offer to acquire the company is received. Because of the narrow scope of this law, it rarely comes into play. Nevertheless, it highlights the importance of securing such protections as early as possible.

Private companies

Realization Reality. Many executives join small, privately held companies with the hope that they will help grow the enterprise to a point where it can be either sold or taken public. In today's financial climate, however, IPOs are rare and Minnesota only saw two or three all of last year. It is more likely that your company will sell out to a larger entity and this is in fact the realization point at which entrepreneurial executives plan to cash in on stock options issued by a closely held corporation, and in this regard the CIC clause can be the most important component of a stock option plan.
Pre-CIC Termination. Mid-level executives often 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 to define the date of a CIC for severance purposes as being 60 days prior to the effective date of any transaction such as a merger, acquisition, IPO, or sale of assets.
Be Wary of Heirs. Before accepting a position with a closely held company with one major shareholder, inquire what happens if that person should pass away and who will inherit the company. Consider including a CIC clause for the inheritance or transfer by operation of law of a controlling interest of the shares of the company to a third party, in addition to the "sale" of a controlling interest.

The only thing constant in the corporate world is change, but being prepared for change might convert a catastrophe into a windfall.