Western Independent Banker - May/June 2008 - (Page 27) By: Clark W. Struve Tangle-Proof Parachutes for Your Change in Control Agreements THERE ARE A lot of benefits to being a top executive, but job security isn’t one of them. Especially in a consolidating industry like banking. Career risk continues to be on the mind of bankers across the country. And why not? “The M&A market looks as strong as ever in 2007 as buyers seeking revenue growth look for strategic expansion as well as cost-saving opportunities.”1 Smaller and mid-size banks are most frequently affected. According to the Federal Reserve Board, approximately 90 percent of mergers over the past decade have involved a target with less than $1 billion in assets; three-quarters have involved those with assets of less than $250 million. Once a virtual lifetime position, a community bank CEO’s position is typically eliminated after a change in control (CIC), and concern over job insecurity is trickling down to other officers as well. Having the proper agreements in place not only provides peace of mind for your executives, it can help ensure management is focused on increasing shareholder value. Top leadership is more likely to work toward a deal that’s beneficial to shareholders if they know they are protected in the event of a change in control. CIC Agreements A CIC agreement can be a stand-alone agreement or a provision within an employment agreement. CIC agreements are designed to: • Help protect key executives in the event of a change in control; • Encourage or discourage a potential merger or acquisition. A CIC agreement or provision generally: (1) defines CIC payment triggers, (2) outlines severance payments tied to a CIC, and (3) directs the integration of Section 280G of the tax code. Preplanning is important in order to avoid the potential negative ramifications of Section 280G. This section states that executives who receive “excess” golden parachute payments are required to pay – in addition to regular income taxes on these payments – a 20 percent excise tax on a substantial portion of these payments. Moreover, a portion of these payments will not be deductible for the bank, resulting in increased bank expense. Determining “Excessive” Payments To assess the risk of a golden parachute payment being excessive, calculate the projected total costs resulting from the change in control (including any accelerated vesting of benefits). While benchmarking the total cost of your agreements against what is common practice in peer banks can be helpful in determining what is considered reasonable, you should also review the following IRS guidelines: 1. Is the payment in the “nature of compensation?” The general rule is that payments are considered “in the nature of compensation” if they arise out of the employment relationship or are associated with the performance of services. 2. Is the payment made to a “disqualified individual?” A disqualified individual is an employee or independent contractor of the bank who is also an officer, shareholder or highly-compensated individual. 3. Is the payment “contingent” upon a change in ownership or control, or an event “closely associated” with a CIC? This can be a tricky question to answer, but the general rule is that a payment is considered “contingent” if it would not have been made in the absence of a CIC. 4. Is the parachute payment less than 3X the individual’s “base amount?” “Base amount” is the average annual compensation includible in the individual’s gross income for the five most recent taxable years, excluding the year of the change in control. Remember, you must aggregate parachute payments from all sources (e.g., employment contracts, supplemental executive retirement plans, stock option plans) to determine whether they are excessive. If the answer to all of these questions is “yes,” then the parachute payment is not subject to negative tax treatment by the IRS. However, if the answer to questions 1-3 is “yes,” but the answer to question 4 is “no,” then the parachute payment is excessive, and the executive and bank risk significant tax consequences. Exceptions to the Restrictions Closely held banks are subject to IRC Section 280G restrictions, although there are several exemptions for certain institutions. For example, parachute penalty taxes can be avoided if disclosure is made to all shareholders and more than 75 percent of shareholders approve the payments. Footnotes 1. Bank Director Magazine – The Road to Growth; The Market Overview for M&A in 2007 Clark W. Struve is a registered representative of, and securities products and services are offered through, Clark Securities, Inc., dba CCFS, Inc. in Texas. He can be reached at (831) 373-4614 or clark.struve@clark-consulting.com. Having the proper agreements in place not only provides peace of mind for your executives, it can help ensure management is focused on increasing shareholder value. Top leadership is more likely to work toward a deal that’s beneficial to shareholders if they know they are protected in the event of a change in control. Western Independent Banker May/June 2008 27
For optimal viewing of this digital publication, please enable JavaScript and then refresh the page. If you would like to try to load the digital publication without using Flash Player detection, please click here.