Companies Should Consider Modifying “Change in Control” Definitions in Executive Compensation Arrangements To Avoid Unintended Payment Trigger

Last year, a federal court considered whether a “change in control” had occurred under the terms of a company’s Executive Severance Agreement (the “ESA”). The court’s decision provides guidance on how a court might interpret a change in control definition under executive compensation arrangements and highlights the need for some companies to consider modifying their definitions for clarity.

Facts of the Case

Under the facts of the case, two investors in the company acting separately began to buy shares of the company, eventually acquiring over 25% of the company between the two of them. Through their position, they were eventually able to acquire three seats on the board of directors of the company—one to be controlled by each individually, and another to be controlled by mutual agreement between the two. In a single month, four board members resigned; three of whom were replaced by the two investors and the fourth of whom was replaced by the board.

Pursuant to the ESA, executive participants were entitled to enhanced severance benefits in the event of a termination following change in control. The ESA defined a change in control (in simplified language) as (i) any person or “group” obtaining 25% or more of the combined voting power of the company’s securities, or (ii) replacement of one‑fourth of the company’s directors without approval of at least two‑thirds of the directors then in office, with the caveat that there is no “approval” where there is a threatened election contest.

Claims and Rulings

The participants made two arguments. First, they argued there was a change in control because the two investors were a “group” who acquired more than 25% voting power. The court ruled in favor of the company on this argument, declaring that the investors were not a “group.” In fact, the investors were hostile to each other and working independently.

Second, the participants argued there was a change in control because a sufficient number of board seats changed, and the change was due to a threatened election contest (nullifying any “approval” of current directors). The court decided in favor of the participants on this argument, ruling that, although there was no explicit threat of a proxy contest, the threat may have been implicit, and the second argument should go to trial.

Recommendations

Based on this ruling, companies with executive compensation arrangements should review their change in control triggers to determine if the definition of change in control therein has the intended result. A company may wish for the actions of separate individuals not acting as a group to trigger a change in control upon certain changes in ownership or voting power; in those cases, references to people acting as a “group” or citations to specific Code sections may need to be removed or clarified. Alternatively, a company may wish for changes in ownership or voting power to trigger a change in control only due to a coordinated effort; in those cases, references to people acting as a “group” or citations to specific Code sections may need to be added or clarified. In addition, companies will want to determine what types of board turnover should trigger a change in control and adjust their definitions accordingly. Finally, it is best practice to include carve-outs, if any, indicating what types of changes should not constitute a change in control (for example, an IPO or a large change in ownership or voting power that still leaves certain shareholders with a large stake) or, if applicable, what types of changes should constitute a change in control.

If you need assistance in modifying your control definitions based on this article, please reach out to a member of the Kutak Rock Employee Benefits and Executive Compensation practice group.