Key Employee Terminations: Protecting Your Client and Avoiding Pitfalls

October 28, 2009

Jeffrey R. Capwell Bruce M. Steenjcapwell@mcguirewoods.com bsteen@mcguirewoods.com

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Background• Why is this topic relevant?

– Impact of current economic environment on executive employment– Increased regulatory complexity around termination arrangements– Evolving legal standards

• What is at stake for the employer?– Protection of valuable business interests (trade secrets,

customers/clients, etc.)– Reputation and goodwill– Benefits and compensation costs– Regulatory and accounting considerations (e.g., Section 409A)

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Neal Sadaka was Right:“Breaking Up is Hard to Do”

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“Forget Everything you Learned in High School”“Avoid the Perp Walk at all Costs”

– The Liability Risks– The Relationship Costs– The Reputational Costs

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“Remember Everything you Learned in Kindergarten”

“This is not just about being nice”

It’s about how:

•Your clients perceive you•Your employees perceive you•Your competitors perceive you•The marketplace perceives you

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“The Bucket List”or

“The 3 Questions you should ask before you let a key employee walk out the

door”•What information do I need to do business tomorrow?

•How do I best get that information?

•The “joint statement”

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“The Paper Chase”“Did you do your assignment Mr. Hart?”

•To compete or not compete?

•“Solicitation” is such an ugly word

•I can keep a secret

•If you cannot say anything nice …

•Mutual releases – “not!”

•Integration clauses – do your homework

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“We can still be friends”

•Carefully define the duty to cooperate:•Extent of access•Compensation for access•Compensation for cooperation

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Code Section 409A• Broadly applies to many compensation arrangements

– Post-termination pay and benefits payable over more than a single tax year may be covered by Section 409A

– Exceptions are limited• Strict requirements for compliance

– Covered arrangement must be in writing and include certain specified provisions

– Limited ability to correct errors, particularly document errors• Severe consequences of noncompliance

– Immediate income inclusion– Additional 20% tax– Premium interest tax (underpayment rate plus 1%)– Aggregation rule = amounts under similar arrangements are combined

with those under the noncompliant arrangement into a single “plan” • What’s at stake for the employer?

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Exempt Severance Arrangements• The 2 x 2 exception

– All payments made by end of second year following year of termination– Severance limited to two times the lesser of (1) annualized comp for year

before year of termination or (2) $245,000 (for 2009 and 2010) – Termination is involuntary (or under a qualifying good reason definition)

• The short-term deferral exception– Termination is involuntary (or under a qualifying good reason definition)– All payments will made by no later than 2.5 months following the end of

year in which termination occurs • Benefit-specific exceptions

– Certain deductible expenses reimbursed or provided in-kind – Reasonable outplacement and moving expenses– Certain medical expenses– Benefits with a value not in excess of $16,500 (for 2009)

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Requirements for Non-Exempt Arrangements• Restrictions on employee deferral elections

– Limited exception for entirely new severance promises • Payment requirements

– “separation from service” trigger strictly defined– No acceleration and limited right to defer

• Six-month delay in payments to “specified employees”• Common problems areas

– Healthcare continuation beyond COBRA period – Open-ended release provisions– Time or manner of payment elections– Terminations that don’t qualify as a separation from service

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The Substitution Trap• Substituting a new payment right for an existing Section

409A payment right is treated as payment of the original payment right– Substitution can result in violation of a Section 409A requirement

(Ex. = changing the period of monthly payments from 4 years to 3 years would violate anti-acceleration rule)

– Presumption that new right is a substitution if proximate to a forfeiture or voluntary relinquishment of the original payment right

• Examples– Accelerations or deferrals that comply with timing rules– Reductions or offsets– Loans

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A Template for Applying Section 409A to Separation Pay• Is the target executive already covered under a separation

pay arrangement?– Need to parse out all of the separate payment promises that may

apply • Are pre-existing arrangements covered by Section 409A?

– Strict operational compliance necessary • Will a new separation pay promise be created as a result of

the termination?• If yes, will the new promise replace or modify any existing

promise?– Consider how the substitution rule may apply– Consider appropriate contractual protections

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Other Considerations

• Corporate governance– Which parties need to be involved in developing and approving

the separation pay? (Disney cases and their progeny) – Evolving “best practices” in negotiating termination pay

• ERISA– “Top-hat” plan exception– ERISA claims procedure as a tool to bar state law contract claims

• Golden parachute tax – Relationship of termination to a change in control event (before or

after the change)– Interplay with Section 409A

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Other Considerations• Financial accounting

– Typically an issue with respect to modification of equity compensation

• Public disclosure– Form 8-K triggering events

• Separate trigger for termination and entry into a material compensation arrangement

• Considerations associated with term sheets – Proxy statement considerations

• Effect of termination on NEO status

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Considerations for TARP Employers

• Prohibition on “golden parachutes”– Flat ban on any “departure-related” payment, regardless of amount

or type of compensation – Applies to “senior executive officers” and the next five “most

highly compensated employees” (up to a total of 10 employees) – Bars current or deferred payments– Limited exceptions:

• Payments from qualified plans, etc.• Payments for “services performed or benefits accrued”

• Why this rule may matter even after TARP ends

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QUESTIONS?

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