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What's Market: Negotiating Executive Employment Agreements: Elements of Severance
Practical Law Legal Update 4-545-5205 (Approx. 10 pages)
What's Market: Negotiating Executive Employment Agreements: Elements of Severance
by Practical Law Employee Benefits & Executive Compensation and Practical Law Labor & Employment
| Published on 22 Oct 2013 • USA (National/Federal) |
A discussion of the severance payments and benefits in executive employment agreements, including a What's Market comparison report with summaries of severance provisions from recent executive employment agreements.
Severance provisions of an executive employment agreement are typically some of the most heavily negotiated provisions of the agreement. Reaching mutually agreeable terms requires each party to understand current market trends and the legal and tax implications of each severance payment and benefit.
Before negotiations begin, employers should determine the types of:
- Termination that will trigger severance payment obligations.
- Severance payments and benefits that will be payable on each event.
In addition, to avoid shareholder dissatisfaction and adverse tax consequences, employers must carefully consider:
- The amount of each severance payment and benefit.
- The manner in which each severance amount will be paid.
Failing to take these steps exposes the employer and the executive to the risk of negative publicity and significant tax penalties.
This Legal Update discusses severance provisions commonly found in executive employment agreements and contains a chart summarizing the severance provisions of several recent executive employment agreements.
Severance Provisions in Executive Employment Agreements
The severance provisions included in executive employment agreements vary based on each employer's circumstances. However, executive employment agreements generally address the circumstances under which severance will be triggered, which may include:
- The executive's termination due to death.
- The executive's termination due to disability.
- Termination by the employer without cause.
- Termination by the executive for good reason.
- The employer's failure to renew the term.
Each termination event should be carefully defined to ensure that severance is not inadvertently triggered and that the definition does not raise any issues under Section 409A of the Internal Revenue Code (IRC). For more information on defining each of the severance triggering events, see Practice Note, Negotiating and Drafting an Executive Employment Agreement: Termination Events Triggering Severance. For more information on Section 409A as it applies to severance arrangements, see Practice Note, Applying Section 409A to Severance Benefits.
After determining the severance triggering events, employers should consider what the executive will receive on each event. Elements of severance may include:
- Cash severance. This is the most common form of severance, which is typically based on either a multiple of annual base salary and annual target bonus or base salary for a specified duration, in either case, payable in either a lump sum or in installment payments over a specified duration. To avoid adverse tax consequences, Section 409A must be considered when structuring cash severance payments. If structured properly, severance payments can often qualify for an exception from Section 409A, such as the "short-term deferral exception" or the "severance pay exception." For more information on Section 409A, including these exceptions, see Practice Note: Section 409A: Deferred Compensation Tax Rules: Overview. If an exception does not apply and the severance payments are nonqualified deferred compensation subject to Section 409A, payments to "specified employees" in connection with their separation from service must be delayed for six months. For more information on specified employees, see Practice Note, Specified Employees under Section 409A.
- Post-termination health care coverage. Employment agreements frequently provide executives with post-termination health care coverage through either employer-subsidized coverage under the Consolidated Omnibus Budget Reconciliation Act of 1985 (COBRA) or continued participation in the employer's health plan on the same terms as active employees. In either case, employers must consider the possible adverse tax consequences that depend in part on whether the employer's group health plan is:
- a self-insured health plan, which requires compliance with non-discrimination requirements under IRC Section 105(h); or
- an insured health plan, which may be subject to non-discrimination rules under the Patient Protection and Affordable Care Act (PPACA) when additional guidance is issued.
- Additional post-termination benefits. Employment agreement severance provisions can also include certain additional post-termination benefits, such as:
- outplacement services for a specified period or up to a specified value;
- continued coverage under the employer's life insurance plans for a specified period; and
- continued coverage under the employer's disability insurance plans for a specified period.
In addition, employers must consider whether to include provisions in the employment agreement addressing how the following compensation amounts will be treated on termination:
- Bonuses. Employment agreements should specify how the executive's eligibility for a bonus is affected by any termination event, such as whether the executive must be employed on the bonus payment date to receive any earned but unpaid annual bonus on termination and if the executive will be eligible to receive a pro-rated bonus for the year in which termination occurs. IRC Section 162(m) must also be considered when structuring these provisions if the employer intends for the bonuses to qualify for the exemption from the $1 million deduction limit for qualified performance-based compensation. For more information on IRC Section 162(m), see Practice Note, 162(m): Limit on Compensation and Section 162(m) Performance-based Compensation Exception Checklist.
- Equity grants. Often, employers prefer not to address the treatment of equity awards on termination of employment in the employment agreement. However, if the parties agree to include this information, then employers must confirm that the specified treatment is permitted under the terms of the employer's equity plan and should include consistent provisions in each equity award agreement.
Further considerations include whether to:
- Provide change in control protection in the employment agreement in the form of enhanced severance payments and benefits if an executive's employment is terminated (including a constructive termination) in connection with a change in the employer's ownership during the employment term. For a discussion of why companies offer executives change in control protection, how practices are changing in the current economic climate and when change in control payments and benefits are typically triggered, see What's Market: Change in Control Protection in a Say on Pay World.
- Require the executive to:
- sign a release of claims against the employer in exchange for the severance payments and benefits provided in the employment agreement (for state-specific issues to consider when drafting release agreements, see Employment Claims in Release Agreements: State Q&A Tool and for a standard separation and release of claims agreement, see Standard Document, Separation and Release of Claims Agreement); and
- comply with post-termination restrictive covenants, such as non-competition, non-solicitation of employees and customers and non-disparagement provisions (for state-specific issues on drafting post-termination non-competition provisions, see Non-compete laws: State Q&A Tool and for an overview of issues related to non-compete agreements between employers and employees generally, see Practice Note, Non-compete Agreements with Employees).
It is also important to stay current with market trends. Public company employers in particular risk negative media attention and shareholder dissatisfaction if severance payments appear excessive. Reviewing recent executive employment agreements can help ensure that the severance provisions are in line with market practice and can be a valuable negotiating tool for obtaining favorable terms.
Recent Severance Provisions in Executive Employment Agreements
The following is a sampling of recent executive employment agreements contained in What's Market, with summaries of some of their respective severance provisions. To view additional summaries, visit What's Market.
EMPLOYMENT AGREEMENT | President and Chief Executive Officer October 1, 2013 | Chief Executive Officer and Executive Chairman of Calvin Klein, Inc. July 1, 2013 | President and Vice Chairman May 2, 2013 |
SEVERANCE ON TERMINATION WITHOUT CAUSE | Lump sum payment in an amount equal to the cash portion of the pro-rated annual bonus for the year in which termination occurs (30% of the pro-rated bonus amount), subject to actual achievement of applicable performance criteria. Accelerated vesting of all outstanding equity awards subject to time vesting. If the termination occurs after the effective date but on or before the second anniversary of the effective date, then the executive receives cash severance payable in installments over two years in an aggregate amount equal to $5,160,000. If the termination occurs after the second anniversary of the effective date, but on or before the fourth anniversary of the effective date, then the executive receives cash severance payable in installments over two years in an aggregate amount equal to $5,160,000, minus $215,000 for each full month the executive remained employed following the second anniversary of the effective date (provided that the severance amount will not be reduced below zero). Reimbursement of the following expenses if they are incurred by the last day of the second calendar year following termination: Reasonable moving expenses incurred in relocating to Canada following the executive's termination of employment. Reasonable personal tax preparation costs for the tax year in which the executive relocates to Canada following his termination of employment. Severance on termination without cause is the same as severance on termination for good reason. | An aggregate amount equal to 1.5 times the sum of annual base salary and target bonus under the employer's annual bonus plan (if any) for the fiscal year in which termination occurs (or the prior fiscal year if bonus levels have not been established for the year in which termination occurs), payable in 36 substantially equal installments according to the executive's base salary payment schedule. Employer-subsidized medical, dental, life and disability insurance coverage at active employee rates at a level that is at least as favorable as the coverage carried by the employer immediately before the executive's termination until the earlier of 18 months following termination or the date on which the executive obtains comparable coverage through subsequent employment. If the termination occurs following the executive's transition to the position of Executive Chairman of Calvin Klein, Inc., then the severance payment will be calculated according to the executive's compensation in effect while employed as Executive Chairman. The executive is not entitled to any other severance payments or benefits. Severance on termination without cause is the same as severance on termination for good reason. | Installment payments for 12 months following termination in an aggregate amount equal to the sum of annual base salary and annual target bonus. If the executive accepts subsequent employment during the 12-month period following termination, then the employer's severance obligation immediately terminates (see Mitigation and offset). Severance on termination without cause is the same as severance on termination for good reason. |
SEVERANCE ON EXPIRATION OF THE TERM | If the executive's employment terminates because the term expires, then the executive receives: Pro-rated annual bonus for the year in which termination occurs, subject to achievement of applicable performance criteria. 30% of the pro-rated annual bonus is payable in cash and 70% is payable in fully vested equity awards covering shares of employer common stock. If the equity award cannot be granted under the terms of the long-term incentive plan, then the executive receives the entire pro-rated annual bonus in cash. Accelerated vesting of all outstanding equity awards subject to time vesting. Reimbursement of the following expenses if they are incurred by the last day of the second calendar year following termination: Reasonable moving expenses incurred in relocating to Canada following the executive's termination of employment. Reasonable personal tax preparation costs for the tax year in which the executive relocates to Canada following his termination of employment. | None specified. | None specified. |
SEVERANCE ON TERMINATION DUE TO DISABILITY | Pro-rated annual bonus for the year in which termination occurs, subject to achievement of applicable performance criteria. 30% of the pro-rated annual bonus is payable in cash and 70% is payable in fully vested equity awards covering shares of employer common stock. If the equity award cannot be granted under the terms of the long-term incentive plan, then the executive receives the entire pro-rated annual bonus in cash. Accelerated vesting of all outstanding equity awards. Reimbursement of the following expenses if they are incurred by the last day of the second calendar year following termination: Reasonable moving expenses incurred in relocating to Canada following the executive's termination of employment. Reasonable personal tax preparation costs for the tax year in which the executive relocates to Canada following his termination of employment. In the event of the executive's disability, and while the executive remains employed, the executive receives certain vesting benefits (see Other points of interest). | None | Any disability benefit available under the employer's normal procedures and policies for its most senior executives. Pro-rated annual bonus or other bonuses for the year in which termination occurs. |
SEVERANCE ON TERMINATION DUE TO DEATH | Pro-rated annual bonus for the year in which termination occurs, subject to actual achievement of applicable performance criteria. 30% of the pro-rated annual bonus is payable in cash and 70% is payable in fully vested equity awards covering shares of employer common stock. If the equity award cannot be granted under the terms of the long-term incentive plan, then the executive receives the entire pro-rated annual bonus in cash. Accelerated vesting of all outstanding equity awards. Reimbursement of the following expenses if they are incurred by the last day of the second calendar year following termination: Reasonable moving expenses incurred in relocating the executive's dependents to Canada following the executive's death. Reasonable personal tax preparation costs for the tax year in which the executive's dependents relocate to Canada following the executive's death. | None | Continued payments of base salary for 12 months following termination. Pro-rated annual bonus or other bonuses for the year in which termination occurs. |