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Does Your Parachute Know When to Open?

As 2014 proves to be a buoyant year for merger and acquisition activity, many companies continue to rely upon change of control definitions in executive compensation plans and arrangements (including employment and severance agreements) that do not adequately address increasingly complex forms of business transactions or protect completely against hostile proxy battles. In particular, we have set forth below two types of change of control prongs that we occasionally encounter which may create traps for the unwary, and we have highlighted language which should be considered for inclusion.

The first provision, which often requires modification, is the merger or business combination definition. The provision often states that a change of control will occur if shareholders of the company no longer own more than 50% of the voting power of the surviving entity in a merger.  In many cases, the merger trigger event definition does not provide that such ownership must be in “substantially the same proportions” as ownership immediately prior to the transaction.  The absence of this clause could create a situation in which a minority entity shareholder merges with the company and does not trigger a change of control because the shareholders immediately prior to the merger (including the former minority shareholder) continue to own over 50% of the surviving entity (although in significantly different proportions than prior to the merger). In our view, such construct should be deemed to constitute a “change of control” under executive compensation plans and arrangements because control of the company, as a practical matter, has changed. This problem may be particularly acute in instances where more than one private equity firm owns an equity stake in a non-public company (or a private equity firm has an equity stake in a public company) and such stakeholder transitions from a minority interest to a controlling interest. Accordingly, we would suggest the language highlighted below:

  • “a merger or consolidation of the Company in which the Company’s voting securities immediately prior to the merger or consolidation do not represent, or are not converted into, securities [owned by stockholders in substantially the same proportions as their respective ownership immediately prior to such merger or consolidation] that represent a majority of the voting power of all of the voting securities of the surviving entity immediately after the merger or consolidation”

Another change of control triggering event which, when improperly drafted, does not adequately protect management is the clause referencing a hostile change in the board of directors. The provision generally dictates that a change of control event will be deemed to have occurred if the members of the board of directors cease within a specified period (typically two consecutive years) to represent a majority of directors who were either (i) on the board as of the effective date of the plan or agreement, or (ii) succeed the original board members and whose appointment was approved by a majority of directors (these “good” directors are typically referred to as “incumbent directors”).  The potential issue with this provision is that, in many hostile board contests, directors who serve as representatives of an activist shareholder may be nominated for election to the board or appointed to the board as a result of a settlement with the activist shareholder. Under such circumstances, the then current board would be approving the newly selected directors. Our view is that such directors should not be treated as “good” or “incumbent directors” because the approval resulted from an attempted hostile takeover of the board.  Accordingly, we would suggest the language highlighted below:

  • “individuals, who, as of the effective date of this Agreement, constitute the Board (the ‘Incumbent Board’) cease for any reason to constitute at least a majority of such Board; provided that any individual who becomes a director of the Company subsequent to the effective date of this agreement whose nomination for election by the Company’s stockholders or appointment to the Board was approved by the vote of at least a majority of the directors then in office shall be deemed a member of the Incumbent Board [provided, further, that no individual initially nominated for election or appointed as a director of the Company as a result of an actual or threatened election contest with respect to directors or as a result of any other actual or threatened solicitation of proxies or consents by or on behalf of any person other than the Board shall be deemed to be a member of the Incumbent Board]

There are many provisions in a typical change of control severance plan or agreement that require careful scrutiny, but it is paramount to ensure that the transaction or event triggers contained in the change of control definition are drafted properly to encompass all potential transaction or event scenarios that signal a change of control of the entity has occurred, and must be tailored to the specific circumstances relevant to such entity. Without such proper set of triggers, the benefits or compensation provided under the plan or agreement may never become payable and the original intent behind its implementation may be thwarted.


Michael S. Katzke
Henry I. Morgenbesser