Employee Terminations: Working Through the Consequences

Terminating an executive has multiple consequences, stemming from SEC disclosures, taxes, what it means for the say-on-pay vote, and investor relations in general. All of these impacts relate to, or are driven by, accounting rules. This makes accounting a critical consideration during a termination—and ideally in the planning beforehand.

In a recent presentation with CompensationStandards.com (paywall), I joined Orrick’s J.T. Ho, Pillsbury’s Jon Ocker, and PJT Camberview’s Rob Zivnuksa to discuss best practices surrounding employee terminations. To illustrate the key issues, our panel considered a reasonably typical example of a terminated employee and his proposed severance package. We assumed a severance package of cash, extension of bonus eligibility, allowances for vesting of outstanding time and performance-based restricted stock units (RSUs) after termination, and the extension of vested option expirations.

Two key tenets of equity modification accounting drive financial outcomes in this case. The first tenet is to recognize what’s earned—and don’t recognize what’s not earned. The second is to use the right fair value for each instrument, which is as of the date the award was effectively “granted.” In our example:

• The RSUs were otherwise set to forfeit upon termination, meaning the accelerated shares were granted due to the modification and require new valuations.
• Vested options were extended, resulting in incremental costs due to the extra value of the modifications.
• Other payments were recognized as of the date they were committed to by the company, meaning that severance agreed to this year gets recognized this year, even if the payment is years in the future.

With all of this compensation coming at once, it’s easy for an executive to become a named executive officer (NEO) in the proxy statement for the first time even though they’re leaving the company. This is exacerbated by the fact that awards granted before the termination, and then modified to allow for vesting at termination, are counted twice in the summary compensation table—once at grant, and then again at modification. This matters because once the employee becomes an NEO, the company will need to make additional disclosures:

• Detailed disclosures of compensation amounts across all of the tables in the proxy CD&A
• Proxy disclosures covering change in control and termination benefits
• Disclosure of the severance agreement within the 10-K and/or 10-Q
• Form 4 filings for any new and modified grants

Importantly, with effective planning techniques, companies may be able to delay some of the expense and thereby prevent these extra disclosures. For example, by signing a one-year advisory agreement—provided it’s substantive—one could potentially satisfy the service requirement on some of the RSUs and also delay when the cash payout is earned. Alternatively, companies whose award agreements have conditions that allow vesting after severance will avoid modification accounting altogether—although if not carefully considered, this may result in vesting when the company would prefer it didn’t occur, and could draw negative attention from investors.

Deferrals of some of the payments can not only help from a financial and proxy reporting perspective, but also help companies save money on taxes. Specifically, if the severance causes the terminated employee to become a covered employee by being one of the three highest paid employees outside of the CEO or CFO, the company’s tax deduction for his compensation is subject to a $1 million limitation in that year and every future year. Avoiding covered employee status allows the company to take the full deduction. If the employee is already covered, spreading the payments over more years can also maximize the compensation deduction.

Of course, even with foresight and planning, it’s not always possible or desirable to artfully slide under disclosure thresholds. In these cases, investors will certainly scrutinize any package they see. When a company has to disclose a severance package, it’s important to consider how best to get investors on board.

It’s key to build a compelling narrative by establishing the business need for the severance package and what the company is getting out of the transaction. From an investor perspective, it’s understood that noncompete agreements can be very valuable to a company, and this value could justify the severance payments. Investors may also be more willing to accept the severance if other governance changes are implemented. In any case, if the termination is for cause, investors may be concerned with any severance payments. And in egregious cases—think terminations for “me too” misconduct—we’ve seen such payments hit the headlines.

Importantly, companies may be able to work with investors and proxy advisors to show them what the severance arrangements are and why they make sense. Regulation FD does prevent companies from giving special information to proxy advisers. However, a short supplementary filing can be made explaining the transaction (and addressing any concerns from Glass Lewis or ISS) and then time can be taken to discuss the specific impact with institutional investors.

A final topic of discussion was clawbacks. Clawbacks are often the best way to recoup cost if problems turn up after an employee’s separation, or if the employee violates a noncompete or other covenant later on. While the SEC hasn’t followed up on their 2015 proposed clawback rule based on the Dodd-Frank Act, we see clawback becoming a standard part of the governance landscape.

Although a clawback can be a great enforcement device if things go awry, companies should be careful that they’ll be able to enforce it. In some jurisdictions, such as California, enforcing a clawback without the former employee’s consent may not be plausible.

Terminations are a fact of life for every company. Being proactive is the best way to ensure that the process goes as smoothly and painlessly as possible when the time comes. This means it’s as crucial as ever for cross-functional teams to work through possible scenarios, understand the key business and financial concerns, model the potential outcomes, and have a plan for when and how to communicate with their investors.