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Managing compensation in M&A

Legal Report \ M&A and Securities
|Written By Elizabeth Raymer
Managing compensation in M&A
Faye Rogers

Executive pay is being increasingly scrutinized in corporate deals

As businesses merge and acquire each other and shareholder expectations grow, the compensation of company executives has evolved. Lawyers working in M&A and executive compensation say compensation arrangements are more scrutinized today than they have been in the past, with shareholders, for one, casting a colder and more critical eye on payouts to executives when control of a company changes hands. 

“I definitely think you are seeing both boards and shareholders taking a harder look at change-of-control clauses: when they’re granting them, who they’re granting them to and the nature of the compensation,” says Michael Howcroft, a labour and employment lawyer at Blake Cassels & Graydon LLP in Vancouver.

“I think I’ve seen increased pushback in relation to the generous change-of-control packages as part of a diligence process,” he adds. “I’m hearing from my clients that they’re getting pushback . . . in particular around change-of-control” situations.

Normally, the definition of change of control is the acquisition by someone of 50 per cent plus one of the outstanding or voting shares, explains André Perrault, founder of boutique firm PCI-Perrault Consulting in Montreal, which advises organizations on compensation and designs termination packages.

“Some organizations have change-of-control definitions simply because someone acquires as little as 20 per cent of outstanding shares,” he says, adding that in banks, typically, change of control is triggered by a 20-per-cent change of voting rights.

Executive compensation can be affected differently depending on whether the transaction is among publicly traded companies or if a private equity firm is the purchaser, for example.

Compensation “gets focused on early on in the transaction,” says Lynne Lacoursière, co-chair of the executive compensation practice of Osler Hoskin & Harcourt LLP in Toronto. It begins with developing a good understanding of the equity awards, she says, “so you understand what’s at stake for the executive team.” Negotiating executive entitlements gets pushed off until sign-off or close, as “you don’t want executives to focus on what they’re going to benefit from.”

But while in the public company context awards are more likely to be worked out at a later time, in a typical private equity transaction, the purchaser makes a large grant of equity awards to the management team at the same share price the equity fund bought in at, she says.

Public company awards are more likely to be staggered rather than immediate. 

And, of course, size matters.

“If you were doing a $7-billion  transaction and the change-of-control terms are worth $4 million, no one cares, right?” Howcroft asks rhetorically. “What’s $4 million on a $7-billion deal? I think it’s a bigger issue on small- and mid-sized transactions, where the amount of the change-of-control payout has an impact on the transaction price.”

But shareholder value is always first and foremost the concern for public companies, which can make a CEO’s job precarious. A transaction that is in the best interests of shareholders “will likely lead to the termination of the CEO, because he’ll be redundant in the acquisition,” he says.

So, the aim of the change of control is to provide those exiting employees “with a soft landing so they have an incentive to go out and do a deal to maximize shareholder value, even if it leads to the termination of their employment.” 

There’s a place for lawyers, of course, in protecting the interests of executives and other key staff who find themselves involved in change-of-control situations. 

“I see CEOs getting independent legal advice more and more,” says Bill Hart of Langlois lawyers in Montreal, who acts on behalf of senior management in change-of-control situations, primarily in unlisted companies.

“It used to be that in-house counsel would give advice on the run and also in conflict,” acting on behalf of the company while also advising its employees, says Hart. But, he says, “You must mark the difference: Who’s representing who.” More and more, he says, there is a need for independent counsel for top management.

A CEO will be looking to protect their own personal investment in the company, to see that they are adequately covered by remuneration and that their rights are protected in non-competition provisions and more. “I think the bottom line is that the situation is becoming more complex for CEOs,” says Hart. “There’s more money attached” now. 

And when investment funds and other financial players buy a company, says Hart, they may want to exit after six or seven years at a profit. That means motivating the managers who are there, so that senior management thinks financially, from the profit perspective, as well. 

“Remuneration packages are instruments of motivation,” he says, though that question of motivation may be less crucial for other players in M&A deals; for example, when one company buys another. 

Different approaches are taken to executive compensation packages depending on the structure of the transaction, notes Lacoursière. 

A strategic approach is taken in the context of publicly traded companies that are “a merger of equals,” Lacoursière says. “It’s easier for the equity award of the target employees to be assumed to be substituted, essentially rolling over into the parent company, if it’s a public company,” so employees can keep their stock options. For example, she says, when Loblaw Companies Limited acquired Shoppers Drug Mart Corporation for $12.4 billion in 2014, “some awards [to executives] were assumed or substituted in connection with the transaction.” 

In the public company context, M&A transactions are scrutinized by Institutional Shareholder Services, a proxy advisory firm, which weighs in on pay practices and looks at what the so-called “triggers” are in a change-of-control situation as they affect executive compensation.

Single-triggered acceleration of vesting (meaning the conveying to an employee of unconditional entitlement to a share in a pension fund, stock option plan or deferred compensation plan) occurs simply on the change of control of the target company in an M&A transaction. 

However, in recent years, many public issuers have amended their incentive plans and severance arrangements to provide for “double-trigger” change-of-control provisions, meaning that outstanding awards will be accelerated for a change in control only if an
awardee’s employment is terminated or they resign due to the change in control. Termination of employment includes constructive dismissal, where the terms of employment (e.g., location of work) change so substantially that an employee is effectively dismissed from the job.

This shift to the double-trigger acceleration of vesting pleases institutional investors and proxy advisory firms, as vesting is not automatically triggered in a change-of-control situation and executives are more motivated to act in the best interests of the firm. As Perreault points out, too, “You don’t want all your people to become free agents just on the announcement of a transaction.”

“Double-trigger is viewed as a better governance practice,” Lacoursière says. “The bulk of public company plans assume that there’s a double trigger . . .
And if the buyer is also a public company, you . . . can continue on the same vesting schedule.”

For M&A transactions involving privately held companies or owned by private equity, however, the transaction may be structured differently. “You won’t necessarily roll over entitlements,” says Lacoursière. In this context, vesting is typically on a change of control, meaning that the single trigger is used to pay out equity awards, she says.

Retaining and taking care of talent is always front of mind in a change-of-control situation.

“If I am considering being acquired, what’s of concern is retention of key people,” says Perrault. “You want to make sure that until the transaction is signed, [you] make sure that your team is with you, that they continue grooming the baby. . . . Ensure that executives, if they are going to be terminated, that they have a significant or fair compensation package.” 

Some executives will be linked to the success of the transaction and will get a transaction bonus based on the transaction’s value, Perrault says. “In addition to being able to harvest or cash in my incentives, stock options, etc. if the transaction takes place, the likelihood is there will be significant increase in stock price. You want to make sure key people are motivated to stay before the transaction takes place.”

The cycles of industry — and lower commodity or manufacturing prices — also affect compensation, not surprisingly.

“Everything is cyclical, particularly in B.C.,” says Howcroft, “where a lot of our industries are commodity industries, and commodity industries [e.g., gold, oil, forestry, fishing] are inherently cyclical; they all go up and down. So, when the industry is on an uptick, recruitment is first and foremost: You’re desperate to get the best people.” Sometimes, a premium must be paid to secure the best people, and that often includes generous compensation packages and protections. 

“Now, in some cases, commodity prices are lower than they’ve been, and now that you’re no longer desperate to recruit people, I’ve been hearing a lot of pushback regarding generous packages. . . . The contract hasn’t changed, but now, it’s . . .

‘Why are we stuck with this expensive compensation package when industry is down?’”