10 Questions You Need to Ask About Change Of Control Provisions

ACTUAL CASE HISTORY: Thomas, 51, was the Chief Operating Officer of a New England-based manufacturer of electronic switches used primarily in the defense industry. He'd been recruited to the position three years earlier from a large defense contractor that was a large customer of the company. Though the company was publicly owned, with its shares traded on a major exchange, most of the company's stock rested in the hands of the grandchildren of the company's original founder.

Prodded by the grandchildren, who felt their holdings were underachieving, the company's Board of Directors retained an investment banking firm to consider various "strategic alternatives." To Thomas, the future was pretty clear: the company would likely be merged with a larger competitor, or sold to a more diversified defense contractor. And he knew, too, that with a change in the ownership or control of the company, it was likely he'd be either replaced or his role would be severely diminished.

Thomas wasn't too concerned about his own situation, though, because his employment contract contained a "Change of Control" (commonly referred to as "COC") provision that provided that, should the company be sold or otherwise experience a major change in its ownership, control or Board composition, he would be entitled to receive a generous separation package including two years' severance pay, full benefits, and immediate vesting of his considerable stock options. That package would permit him to consider his next career move without concern for his family's financial well-being. Though he saw nothing to be concerned about, Thomas nevertheless consulted us to have his employment contract reviewed, with particular focus on the intricacies of his "Change of Control" provision.

It was a good thing he did, for the convoluted manner in which his contract was drafted hid certain potential pitfalls; in fact, Thomas's COC provision did not provide him with the protections he thought it did. First, it defined a Change Of Control very narrowly; we reviewed with Thomas the many other types of corporate transactions that might take place, some of which were not covered by his contract provision. Second, our review revealed that his COC protections were not triggered by mere Change Of Control, as Thomas thought, but required, in addition, the occurrence of a second event, as well, from a list that included his termination, a reduction in his compensation, a decrease in his overall responsibilities, and a relocation of his primary office. Third, the second "triggering" event had to take place within six months of the initial Change Of Control.

Four months later, the deal was struck: the company was acquired by Thomas's former employer, and through a successful tender offer of the outstanding stock, it was to become a wholly-owned subsidiary. Thomas had no desire to return to his former employer in this way, and saw his COC arrangements to be far more attractive an alternative. A problem arose, though: no second "triggering" event was scheduled to take place: his office was not to be relocated, and his responsibilities were, in fact, expanded, now to include two other subsidiaries. However, Thomas's new compensation program was arguably less remunerative, as the acquiring company didn't have a stock option program, and future bonuses were not going to be on scale with his former bonuses.

Through a simple memo to the acquiring company's senior management team, carefully drafted to follow the terms of the COC provision in Thomas's contract, transmitted within the necessary deadlines, he achieved his goal: an amicable separation, two years' compensation and substantial stock option acceleration. But attention to detail, and careful analysis, of his COC provision did make the difference.

LESSON TO LEARN: Businesses change hands in many different ways and for many different reasons, including mergers, acquisitions, going public, being taken private, sales of subsidiaries, strategic combinations, Board re-compositions, and entry of new management, among others. These days, "Change Of Control" takes place more and more frequently. When "Change Of Control" takes place, other changes inevitably follow: for example, you can almost bet that a new CEO will, over time, bring in a new team of his or her own. It's important to know how a "change of control" may affect your employment, your compensation, your stock and stock options, and your career.

WHAT YOU CAN DO: If you have an employment contract, or have ever been offered stock options or restricted stock, or have been offered a retention agreement, or been given an "offer letter" when hired, you may have certain "change of control" rights and benefits. It's important to know what the terms, provisions and conditions of those benefits are. In addition, we have found that deleterious terms and provisions of existing COC agreements can be removed, or reduced in effect, in negotiations at time of COC, if identified and understood.

These are the ten most important questions to answer, or to have answered for you by qualified counsel:

1. Do you have a COC provision? Change of Control provisions may be found in an employment contract, an agreement providing you stock or stock options, in an offer letter, in a retention agreement, in a separate change of control agreement, in corporate policies, or even in employee handbooks. Review everything you have signed or received from HR to determine, first, if you have COC rights and benefits. If not, you may consider asking for them, especially if you're aware others have been given COC protections.

2. If you do have COC protection, how is "Change of Control" defined? Change Of Control is defined in many different ways. These include (i) change in ownership of a majority of outstanding shares; (ii) change in ownership of a stipulated percentage of outstanding shares; (iii) change in ownership of a "controlling interest" defined in some other way; (iv) a transfer of a substantial portion of the company's assets; (v) a sale, transfer or closing down of a specified division; (vi) change in composition of the Board of Directors; (vii) a change of the company's Chief Executive Officer or Board Chairman; (viii) the offering of a portion of the company to the public in an initial public offering; (ix) a financial restructuring giving effective control to bondholders.

3. Does your COC provision require one - or two - "triggers?" Don't assume, once a "Change Of Control" has taken place, that your COC protections are in effect. Perhaps two-thirds of COC provisions require a second "trigger" to take place in order to become effective, usually within a specified period of time after the COC takes place. These so-called "second triggers" include (i) employment termination without "cause"; (ii) reduction in responsibilities or authority; (iii) diminution of compensation; (iv) change in lines of reporting; and (v) change in primary office location.

4. Once COC is fully triggered, do you have a deadline for election of benefits? After the "trigger(s)" have occurred, you will probably have a specified time period in which to elect to take COC benefits, or they will be lost. Read and calculate carefully, for there is no valid excuse for missing a deadline, and requests for flexibility if you are tardy may fall on deaf ears.

5. What are the COC benefits you've been provided? Take stock of the COC benefits you may become entitled to. The most common COC protections include the following: (i) continued salary payments and benefits for one, two or three years; (ii) alternatively, salary, benefits and target bonus for the remainder of the employment term; (iii) pro rata bonus for the year of COC; (iv) acceleration of vesting of all forms of equity; (v) immediate payout of deferred compensation; (vi) pension credits or payments into a supplemental executive retirement policy ("SERP").

6. How are COC payments to be made to you? Generally, there are three alternative ways to be paid your COC monies: (i) in a lump sum, upon a specified date; (ii) over time, as you would receive salary in the normal course of business had you remained in your position; and (iii) "mitigated," which means only until you become employed elsewhere. Don't be afraid to request that these be modified, especially if you have tax, estate, family, health or relocation concerns to support your request.

7. Are your COC benefits conditioned on a non-compete agreement? This question is perhaps the one most overlooked by those who are negotiating or reviewing COC provisions. This is because COC provisions often don't expressly mention non-competition agreements, but instead state that they are conditioned on "your compliance with all agreements with the company," one of which may be a non-compete found in your employment agreement, in a stock option plan, even in an employee handbook. Special attention needs to be given to this question, as it can make the difference between collecting COC benefits and not collecting them, and this should never happen in error. In addition, this can sometimes be ameliorated, or even removed, through negotiation.

8. Is a "parachute payment" excise tax "gross up" provided? IRS Code Section 280(G) generally requires that, if severance payments equal or exceed three times an employee's annual salary, then the employee must pay a special, additional "excise" tax on the payments, and companies may have to pay related penalties. Perhaps half of the COC provisions we've negotiated provide that, if the employee has to pay this additional tax, then the employer will reimburse the employee enough to pay all such obligations (as well as the tax on this reimbursement.)

9. Does your COC provision give you accelerated vesting of unvested stock and stock options? From a financial viewpoint, this is perhaps the most important of the COC benefits. Extreme care and prudent planning are necessary to ensure that (i) no awards or tranches of awards are overlooked; (ii) if accelerated vesting is provided, exercise deadlines are taken into account; and (iii) tax considerations are reviewed with tax counsel or your accountant.

10. Are you certain that your COC agreement is binding on the successor company? This is the most obvious and most overlooked concern about COC provisions: after a COC, is the "new" company bound by what the "old" company promised you? Sometimes, after a sale, there is no "old" company left. Sometimes, after a sale of assets, the "old" company is an empty shell, with nothing left to pay you. While problems arise on this basis only rarely, you don't want to be the exception to the rule.

A "Change Of Control" provision is a perfect example of what we call a "risk-limiter," a way you can limit the inherent risks in your employment relation. In understanding your COC provision, there's no substitute for careful analysis and attention to detail. Taking time now to consider the effects "Change Of Control" might have on you can only help prevent, or minimize, later pain. It can empower you to better navigate and negotiate for what you seek: financial stability in a world of employment uncertainty.

A note about our Actual Case Histories: In order to preserve client confidences, and protect client identities, we alter certain facts, including the name, age, gender, position, date, geographical location, and industry of our clients. The essential facts, the point illustrated and the lesson to be learned, remain actual.