How Employee Benefits And Executive Compensation Issues Affect The Sale Of A Business

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1 How Employee Benefits And Executive Compensation Issues Affect The Sale Of A Business A. Introduction Michael A. Lawson Rhan Soh Jeleen Guttenberg Michael A. Lawson is a partner, and Jeleen Guttenberg, and Rhan Soh are associates, in Skadden, Arps, Slate, Meagher & Flom LLP. A complete set of the course materials from which this outline was drawn may be purchased from ALI-ABA 1. Employee benefit plans can be the source of major liabilities that can lead to significant negotiation between the buyer and seller regardless of the type of transaction. The following discussion analyzes employee benefit-related issues in the context of a stock sale (or merger) or an asset sale and methods of dealing with those issues. 2. Types Of Plans. All employee benefit plans are subject to some type of regulation that must be taken into account in analyzing the available alternatives. Employee benefit plans holding company securities are subject to regulatory requirements under the Securities Act of 1933 (the Act ) and the Securities Exchange Act of 1934, as amended (the Exchange Act ). Those plans that are also tax-qualified plans are subject to extensive regulation under the Internal Revenue Code of 1986, as amended (the Code ) and under the Employee Retirement Income Security Act of 1974, as amended ( ERISA ). a. Equity Compensation Plans plans that provide for awards of stock options, stock appreciation rights, stock purchases, other stock-based incentives plans. b. Cash Compensation/Severance Plans plans that provide for bonuses, deferred compensation, incentive compensation, severance, change-incontrol, termination pay. ALI-ABA Business Law Course Materials Journal

2 ALI-ABA Business Law Course Materials Journal April 2007 c. Welfare Plans plans that provide medical, surgical, or hospital care benefits, as well as benefits for sickness, accident, disability, death, unemployment, vacation, or training. d. Pension Or Retirement Plans defined contribution plans (e.g., 401(k) plans or other profit-sharing plans), defined benefit pension plans, single employer or multiemployer plans. 3. Types Of Transactions a. Stock Transactions stock purchase, tender offer, and mergers. Generally, in a stock transaction, the buyer assumes the seller s employee benefit plan liability by operation of law. b. Asset Transactions In contrast, in an asset sale, the buyer generally does not assume any plan liabilities, unless the buyer affirmatively agrees to do so. i. This general rule may not apply where successor liability may be imposed upon the buyer. Factors that may give rise to such liability include whether (1) the successor had notice of the claim before the acquisition; and (2) there was substantial continuity in the operation of the business before and after the sale. See Chicago Truck Drivers, Helpers & Warehouse Workers (Indep.) Pension Fund v. Tasemkin, Inc., 59 F.3d 48, 49 (7th Cir. 1995), and Brend v. Sames Corp., 2002 WL (N.D. Ill. July11, 2002). c. In either event, both the buyer and seller are looking to avoid or minimize their own liability with respect to employee benefit plans and, in addition, each may have specific goals concerning employee benefits. Generally, the costs related to any benefits or compensation related to the transaction are quantified and factored into negotiation of the price of the transaction. B. Compensation Plans 1. Equity Compensation Plans a. General i. Equity compensation plans generally take the form of options to purchase company stock, restricted stock, phantom stock, stock appreciation rights, deferred stock, stock bonuses, or stock purchase rights, the terms and conditions of which may be set forth in plan documents and agreements or in individual employment agreements. ii. Equity compensation plans often contain specific change-in-control provisions that may provide for the payment of benefits (or the enhancement of benefits otherwise payable) to the participant in the context of an acquisition either solely by reason of the transaction or if the individual is terminated within a certain period of time following the transaction (known as a double trigger provision). iii. The golden parachute provisions of sections 280G and 4999 of the Code, however, may impose substantial tax penalties (in the form of loss of a federal income tax deduction to the company and imposition of an excise tax on the executive) on certain excess parachute payments (generally payments that are contingent on a change in control equal to or in excess of three times an employee s average annual compensation).

3 Employee Benefits & Executive Compensation Issues 7 b. Due Diligence i. Plans should be reviewed to determine: (1) The benefits payable under such plans; (2) Whether shareholder approval obligations have been met or will be created in connection with the transaction; (3) Rights and interests of the participants in stock of the buyer/surviving company following any acquisition; (4) Whether golden parachute penalties will be triggered and, if so, whether any actions may be taken to reduce or eliminate such benefits and/or the penalties; (5) Whether all compensation payable is deductible under the Code, including, but not limited to section 162(m) of the Code; (6) Whether all options to purchase the seller s equity and equity granted or issued to participants under the seller s equity compensation plans were properly registered with the Securities and Exchange Commission ( SEC ) (e.g., on a Form S-8) or that an exemption from such registration was available under federal and state law, as applicable. (Some states, California in particular, may have specific substantive and filing requirements that must be focused on by private companies with employees in those states. Any due diligence review would include checking any equity plans or awards for compliance with applicable state law.) (7) Whether deferred compensation plans are in compliance with section 409A of the Code. (8) Whether reporting and disclosure obligations have been met or will be created in connection with the transaction. (9) Whether the plans mandate (as opposed to provide for the discretion to make) equitable adjustments of outstanding equity awards to reflect the transaction in order to avoid adverse accounting treatment. c. NYSE/NASDAQ Rules Regarding Shareholder Approval Obligations. NYSE and NASDAQ rules require that shareholders must generally approve all equity compensation awards. These rules do not require shareholder approval under the following circumstances: i. Shareholder approval will not be required to convert, replace, or adjust outstanding options or other equity-compensation awards to reflect the transaction; ii. Shares available under plans acquired in corporate acquisitions and mergers may be used for certain post-transaction grants without further shareholder approval when the party that is not a listed company following the transaction has shares available for grant under pre-existing plans that were previously approved by shareholders. This would not apply to a plan adopted in contemplation of the merger or acquisition transaction. (1) The number of shares available for grant may be adjusted to reflect the transaction.

4 ALI-ABA Business Law Course Materials Journal April 2007 (2) The time during which those shares are available may not extend beyond the period when they would have been available under the pre-existing plan. (3) The awards may not be granted to individuals who were employed, immediately before the transaction, by the post-transaction listed company or its subsidiaries. d. Code 280G Golden Parachute Payments i. Payments that are considered parachute payments under Code section 280G have two adverse effects. First, excess parachute payments are not deductible by the employer. Second, the recipient of the payments is subject to a 20 percent excise tax under section 4999 of the Code on all excess parachute payments. The following are common methods used to lessen the bite of parachute payments: (1) Ceilings On Payments. Reduce the payments that would be subject to excise tax imposed by Code section (2) Best-Payment Cutback. Under a best-payment cutback, the executive s payments are cut back as above unless, after comparing the value of the payments on an after-tax basis (including excise tax), the executive would be in a better economic position by receiving all payments. The cliff-like nature of the excise tax makes it possible for an executive to receive a greater after-tax benefit by reducing the amount of payments he or she receives because of the change of control. (3) Gross-Up Payments. Gross-up payments are occasionally used to protect an executive from the adverse effects of Code sections 280G and A gross-up payment is simply a cash payment to reimburse an executive for any excise tax the executive would otherwise owe the government. But, because the gross-up payment itself is treated as a payment contingent upon a change of control, it is also subject to the section 4999 excise tax (as well as ordinary income tax). Therefore, a circular calculation is employed to arrive at the proper gross-up number, which may be a substantial part of the executive s total payments, depending on the executive s overall tax rate. Note that gross-up payments are advantageous to the executive but extremely costly to the employer, because gross-up payments are usually large and nondeductible under section 280G. (4) Shareholder Approval. A parachute payment may be reduced upon shareholder approval in certain circumstances. Code section 280G(b)(5) provides that a parachute payment does not include any payment with respect to a corporation that, immediately before a change in control, either (A) was a small business corporation; or (B) was not publicly traded, provided that shareholders who owned (immediately before the change in control) more than 75 percent of the voting power of the corporation approved the payment and there was adequate disclosure of all material facts to shareholders. (5) Reasonable Compensation. Pursuant to Code section 280G(b)(4), the amount of parachute payments is reduced by amounts that can be established as reasonable compensation for personal services actually rendered before, or to be rendered on or after, the change in control date. Facts and circumstances of the particular situation dictate whether payments constitute

5 Employee Benefits & Executive Compensation Issues reasonable compensation. Factors considered in such a determination include the nature of the services rendered or to be rendered, the individual s historic compensation for performing such services, and the compensation of individuals performing comparable services when the compensation is not contingent on a change in control. Generally, payments made under certain nondiscriminatory employee programs constitute reasonable compensation, while severance payments or damages paid for failure to make severance payments do not constitute reasonable compensation. e. Dealing With Equity Compensation Plans In Acquisitions i. Generally, the seller s equity-based plans may be assumed by the buyer in either a stock sale (or merger) or asset sale. (1) If the seller s equity compensation plan provides for the grant of incentive stock options within the meaning of section 422 of the Code ( ISOs ), and the buyer chooses to assume the seller s equity compensation plans, the shareholders of the buyer must approve assumption of the seller s equity compensation plans in order to permit the buyer to make additional ISO grants following the closing. (2) Equity compensation plans may generally provide for the conversion of the seller s equity or options to purchase the seller s equity into buyer s equity or options to purchase buyer s equity, or else such terms are negotiated in the transaction document. (3) Converted ISOs need not lose their ISO status so long as Code sections 424(a) and (h) are complied with. Such compliance generally means that the assumed/converted options must not provide additional benefits to participants or more favorable terms than participants previously had under the old options, except that an acceleration of exercise date is allowable. Moreover, the aggregate spread of the assumed/converted option shares immediately after the assumption or conversion must not exceed the aggregate spread of the old option shares immediately before the assumption or conversion. Finally, the aggregate fair market value of the assumed/converted option shares immediately after the assumption or conversion must not exceed the aggregate fair market value of the old option shares immediately before the assumption or conversion. (4) If the conversion of seller s equity or derivative securities into buyer s equity or derivative securities is negotiated, the seller should have the buyer covenant that the buyer will file a Form S-8, or form required under state law, as applicable, immediately following closing to register shares of buyer s equity subject to the derivative securities and to secure a covenant from the buyer that buyer shall have enough authorized shares to cover any exercise of converted derivative securities following the closing. (5) Whether or not vesting of outstanding options to purchase the seller s equity would accelerate before a conversion may also be a topic of negotiation, if such acceleration was not addressed by the equity plans or agreements under which the options were granted. ii. Altering the terms of equity compensation plans or agreements generally requires the consent of each optionholder whose rights would be adversely affected. The buyer must pay careful

6 10 ALI-ABA Business Law Course Materials Journal April 2007 attention to the specific terms of the plans and agreements to determine what modifications may be made without consent, if any, and whether consent to certain modifications may be obtained through negotiation, if necessary. iii. In addition, the buyer should pay careful attention to the accounting consequences of any proposed adjustment to outstanding equity awards. 2. Other Compensation Plans a. Types Of Plans. Supplemental retirement plans, top hat plans, supplemental pension agreements, annual compensation (bonus) plans, deferred compensation plans, split dollar life insurance agreements, and a variety of long-term incentive plans, which can be either cash-based or equity-based plans. b. These plans are typically unfunded, although some are funded through insurance agreements or rabbi trust arrangements. i. A rabbi trust is a funding mechanism where the benefits remain subject to the claims by the company s creditors and are, therefore, less secure than a plan that is funded through a tax-qualified trust. c. Due Diligence i. All non-qualified plans should be carefully reviewed to determine the effects of the transaction on such plans (i.e., whether such plans could be assumed by the buyer or whether such plans may be terminated without liability to the buyer). ii. Copies of all instruments relating to any non-qualified plan should be reviewed as well as copies of any material communications to participants relating to any such plan. iii. The buyer should review seller s compensation arrangements and non-qualified plans to see if all compensation payable is deductible under the Code, including, but not limited to, section 162(m) of the Code. d. Assumption Of Liabilities With Respect To Compensation Plans i. Sale of Assets (1) Generally, in a sale of assets the buyer will not assume or otherwise be responsible for the payment of benefits under the seller s compensation plans unless the buyer explicitly assumes all or part of such arrangements. (2) Failure to assume such plans or arrangements may trigger acceleration of payouts under the cash-based annual and long-term incentive compensation plans or the acceleration of vesting and exercisability under the equity-based long-term incentive plans. The additional executive compensation created by such acceleration may make it more difficult for the buyer to hire desirable executive officers of the seller. Such acceleration may also give rise to the imposition of the loss of federal income tax deductions for the seller and the imposition of excise taxes on such executives under the golden parachute rules.

7 Employee Benefits & Executive Compensation Issues 11 ii. (3) Assumption of cash-based and equity-based annual and long-term incentive compensation plans by the buyer may avoid the acceleration (or enhancement) of benefits in the context of the transaction and may, thus, avoid (or delay) the impact of the golden parachute rules. Assumption may take the form of the continuation of cash-based plans and the conversion of equity-based plans into plans that are based on the buyer s equity. (4) When the buyer intends to maintain substantial continuity in the operation of the business before and after the sale, it is possible that successor liability may be imposed upon the buyer regardless of whether or not the plans would be assumed. See Chicago Truck Drivers, supra, 59 F. 3d at 49. Under such circumstances, the buyer should factor such possibility into the cost of the transaction or consider assuming the plans to avoid any doubt. Sale Of Stock/Merger (1) In a stock deal or merger, the buyer generally assumes the seller s plans automatically by operation of law. Benefits may still be payable or accelerated or enhanced by reason of the acquisition. (2) Note that, in the absence of any action on the part of the buyer, the terms of the assumed plans will remain in force and may become factors in future transactions. 3. Tax-Qualified Retirement Plans. Tax-qualified plans are plans of general application that are subject to extensive regulation, primarily by the Code and ERISA. The Code and ERISA set forth extensive and complicated rules regarding eligibility, vesting, discrimination, coverage, distribution, funding, and reporting. Tax qualification means that the employer s contributions are deductible when made, but employees are not taxed until amounts are distributed. Such plans are funded through a trust, the assets of which are separate from the assets of the company sponsoring the plan (and, therefore, not subject to the claims of the sponsoring company s creditors). a. Defined Contribution Plans i. General ii. (1) Defined contribution plans are generally tax-qualified plans that hold individual accounts for each participant. In a defined contribution plan, contributions, investment earnings, and losses are allocated to the account of each individual participant. The participant s benefits under the plan are determined solely on the basis of the amounts credited to his or her account under the plan at the time the account is distributed. (2) Defined contribution plans include profit sharing plans, 401(k) plans, money purchase pension plans, stock bonus plans, and employee stock ownership plans. Because the accounts of participants only reflect amounts actually held on their behalf by the plan s trustees, defined contribution plans generally do not contain any unfunded liabilities. Due Diligence (1) The buyer should review the most recent Internal Revenue Service determination letter issued for each plan, recent summary plan descriptions, results of any discrimination testing,

8 12 ALI-ABA Business Law Course Materials Journal April 2007 recent summary annual report, summaries of any material modifications, employee notices, contracts with third-party administrators, actuarial reports, and Form 5500s. (2) The buyer should determine that all contributions are current (or have the seller represent that all contributions due up to the closing date of the transaction will be timely made) and that no non-exempt prohibited transactions have occurred. (3) Additionally, with respect to defined contribution plans that hold company stock, the buyer will need to ensure that the proper securities filings have been timely made, if applicable. It is particularly important to ensure that a Form S-8 (or any other required form under state law, if applicable) has been timely filed for defined contribution plans that allow participants to purchase company stock using voluntary contributions, and that the accompanying prospectus has been distributed to participants. iii. Sale Of Assets (1) Generally, in a sale of assets, the buyer will not assume or otherwise be responsible for the payment of benefits under the seller s defined contribution plans unless the buyer explicitly assumes such arrangements. Just as in the context of non-qualified plans, where the buyer intends to maintain substantial continuity in the operation of the business before and after the sale, it is possible that successor liability may be imposed upon the buyer regardless of whether the plans would be assumed. See Chicago Truck Drivers, supra, 59 F. 3d at 49. Under such circumstances, the buyer should factor such possibility into the cost of the transaction or consider assuming the plans to avoid any doubt. (2) Buyer Does Not Assume Plans (A) Generally, at least some of the employees who are participants in the plan are terminated from employment by the seller and hired by the buyer. This may cause the affected participants to forfeit any nonvested benefits under the tax-qualified defined contribution plan, unless the seller is required to treat such termination of employment as a partial termination of the seller s plan (which, under regulations issued by the IRS, would require all such affected employees to become fully vested) or the seller otherwise agrees to fully vest such employees. (B) Alternatively, if not required to accelerate vesting, the seller may amend the plan to recognize service with the buyer as service with the seller for vesting purposes. (C) Generally, 401(k) plan benefits may also be distributed pursuant to section 401(k)(2) upon severance of employment with the seller (so long as the buyer is not a part of the controlled group encompassing the seller.) (3) Buyer Assumes Plan (A) If the buyer assumes the seller s defined contribution plan, the buyer s assumption can take the form of either the assumption of the entire plan or the transfer of the assets and liabilities under the seller s plan to a plan sponsored by the buyer (either an existing plan or a new plan created for the purpose of accepting the transfer of assets and liabilities).

9 Employee Benefits & Executive Compensation Issues 13 iv. (B) When the assumption is in the form of the assumption of the entire plan, additional due diligence may be necessary to ensure that the plan has been administered properly and that the buyer is not assuming any fiduciary liabilities. (C) When the assumption is in the form of the transfer of assets and liabilities, negotiations with the seller will generally focus on the type of assets to be transferred (e.g., liquid and non-liquid assets, company stock, interests in mutual funds, etc.). (D) If the buyer intends to transfer assets of a seller s plan into a plan sponsored by the buyer, it should be cognizant of the anti-cutback rules of section 411(d)(6) that would require the buyer to preserve certain protected benefits (e.g., accrued benefits, optional forms of benefit, early retirement subsidies) associated with such assets. In this regard, regulations under section 411(d)(6) permit plan sponsors to eliminate certain optional forms of benefit payments (e.g., certain annuities, installment payment options, in-kind distribution rights) under certain circumstances. Purchase And Sale Of Stock/Merger (1) The buyer generally assumes plans by operation of law. Benefits are not payable (and are generally not accelerated or enhanced) by reason of the acquisition. Any seller equity held in trust on behalf of the plan participants is treated in the same manner as other seller equity holders in the acquisition. (2) If the buyer maintains its own defined contribution plan and does not wish to assume seller s defined contribution plan, buyer should require that seller terminate its defined contribution plan as a condition to closing. If the seller terminates its defined contribution plan, the benefits pursuant to such plan will become fully vested and the distributions upon termination of the plan may be rolled over into an individual retirement plan or into buyer s defined contribution plan (subject to the terms and conditions of buyer s plan). b. Defined Benefit Plans i. Types Of Defined Benefit Plans (1) Single Employer Plans ( SEPs ). Under single employer defined benefit plans, a participant s benefits are determined by a formula, which is set forth in the plan. The formula usually involves factors such as the age, length of service, and compensation of the participant at the time of retirement. The employer contributes to the plan amounts sufficient on an actuarial basis to cover the benefits of participants as they become due and payable. Although both the Code and ERISA contain minimum funding standards designed to facilitate such funding, a plan may still have insufficient assets to cover accrued benefits at the time of an acquisition. (2) If a single employer plan is terminated at a time when its assets are insufficient to satisfy all of its liabilities (a Distress Termination ), the employer sponsoring such plan and each member of such employer s controlled group of corporations and each of the trades or businesses under common control with the employer would be jointly and severally liable to the Pension Benefit Guaranty Corporation (the PBGC ) for such insufficiency under Title IV of ERISA.

10 14 ALI-ABA Business Law Course Materials Journal April 2007 ii. (3) If a single employer plan is terminated when the assets are more than sufficient to satisfy its liabilities, such surplus may be distributed to the participants or it may revert to the employer. Any reversion to the employer may be subject to an excise tax equal to up to 50 percent of the surplus assets received. (4) Multiemployer Plans ( MEPs ). A multiemployer plan is a union-sponsored plan that covers more than one unaffiliated employer. These plans are governed by a joint board of trustees, half of whom are appointed by the employers who are making contributions to the plan and half of whom are appointed by the union that sponsors the plan. (5) Each employer s contribution obligation is set by its respective collective bargaining agreement. Under the Pension Protection Act of 2006, the joint board of trustees may be able to impose minimum contributions obligations in certain circumstances. (6) An employer who ceases to have an obligation to contribute to a multiemployer plan is deemed to have withdrawn from such plan and is at that time liable (along with each member of such employer s controlled group of corporations and each of the trades or businesses under common control with the employer) to the plan for its proportionate share (generally based on relative contribution history) of any unfunded benefit liabilities of the plan, which liabilities are to be paid over a period not to exceed 20 years. Due Diligence (1) In performing due diligence for defined benefit plans, it is especially important to review the most recent actuarial reports for the plans in addition to the most recent Internal Revenue Service determination letter issued to each plan, recent summary plan descriptions, results of any discrimination testing, recent summary annual reports, summaries of any material modifications, employee notices, contracts with third-party administrators, and Form 5500s. (2) Information regarding multiemployer plans is usually difficult to find. Some information usually can be found in publicly available Form 5500s filed with the Internal Revenue Service and the Department of Labor. (3) The most recent forms may not be available, but the older forms that are available for public review may provide a prospective buyer with valuable information regarding the funded status of any multiemployer plans. Recent amendments under the Pension Protection Act of 2006 are intended to make information regarding the funded status of multiemployer plans more readily available. iii. Sale Of Assets (1) Generally, in a sale of assets the buyer will not assume or otherwise be responsible for the payment of benefits under the seller s defined benefit plans unless the buyer explicitly assumes such arrangements. (2) Buyer Does Not Assume Plan (SEPs) (A) Generally, at least some of the employees who are participants in the plan are terminated from employment by the seller and hired by the buyer. This may cause the affected

11 Employee Benefits & Executive Compensation Issues 15 participants in a defined benefit plan to forfeit any nonvested benefits under the plan, unless the seller is required to treat such termination of employment as a partial termination (which, under regulations issued by the IRS, would require all such affected employees to become fully vested) or the seller otherwise agrees to fully vest such employees. (B) Alternatively, if not required to accelerate vesting, the seller may also amend the plan to recognize service with the buyer as service with the seller for vesting purposes. (C) Where the seller is required to retain the plan, the seller may choose to terminate the plan under a Standard Termination (if the plan is fully funded) or may choose to freeze the plan (if the plan is not fully funded). Under either option, the participants will become fully vested in their accrued benefits. Under the standard termination, the benefits accrued under the plan would be distributed to the participants through the purchase of annuities or lump sum distributions following such termination. If the plan is frozen, the seller would be obligated to continue to make contributions to the plan until it becomes fully funded, at which time it would be terminated in a standard termination. (3) Buyer Does Not Assume Plan (MEPs). If the sale would eliminate the seller s obligation to make contributions to a multiemployer plan (e.g., because all of the seller s union employees are employed in the business being sold) and the buyer does not assume the collective bargaining agreement and take certain other steps in compliance with section 4204 of ERISA as outlined below, the sale will result in a complete withdrawal by the seller from the multiemployer plan, thus imposing withdrawal liability on the seller (and members of the controlled group encompassing the seller) under Title IV of ERISA. (4) Buyer Assumes Plan (SEPs) (A) If the buyer assumes the seller s defined benefit plan, the buyer s assumption can take the form of either assumption of the entire plan or transfer of the assets and liabilities under the seller s plan to a plan sponsored by the buyer (either an existing plan or a new plan created for the purpose of accepting the transfer of assets and liabilities). (B) When the assumption is in the form of the assumption of the entire plan, additional due diligence may be necessary to ensure that the plan has been administered properly and that the buyer is not assuming any fiduciary liabilities. (C) When the assumption is in the form of the transfer of assets and liabilities, negotiations with the seller will generally focus on the funded status of the plan and the actuarial assumptions to be used in determining the amount of assets to be transferred (e.g., projected benefit obligations ( PBO ), accumulated benefit obligations ( ABO ), the discount rate to be used to determine the present value, the mortality tables to be applied, etc.). (D) Regulations issued by the IRS require that following the transfer, the participants in each of the transferor plan and the transferee plan be in at least the same position that they would have been had the plan been terminated immediately before the merger. Subject to this minimum requirement, it is generally in the buyer s interest to use PBO along

12 16 ALI-ABA Business Law Course Materials Journal April 2007 with other assumptions that would be applicable in the context of the termination of the plan and it is generally in the seller s interest to use ABO along with other assumptions that would be applicable in the context of determining the funding of the plan on an ongoing basis. (5) Buyer Assumes Plan (MEPs). iv. (A) If the sale agreement complies with the requirements of section 4204 of ERISA, the sale of the business and the assumption of the plan and the collective bargaining agreement by the buyer will not result in the imposition of withdrawal liability on the seller and the buyer will inherit the seller s contribution history for purposes of determining the buyer s post-sale withdrawal liability. (B) In general, section 4204 of ERISA provides that the acquisition agreement must contain provisions pursuant to which: (i) the buyer agrees to continue to make contributions to the plan with respect to the same number of contribution base units (e.g., manhours worked) as the seller did prior to the sale; (ii) the buyer agrees to provide the plan with a bond for a period of five plan years commencing after the sale, in an amount equal to the greater of the average annual contribution required of the seller for three plan years before the plan year of the sale, or the seller s required annual contribution for the plan year before that of the sale; and (iii) the seller agrees to remain secondarily liable to the plan for such five-year period. Sale Of Stock/Merger (1) SEP. The buyer generally assumes plans by operation of law. Benefits are not payable (and are generally not accelerated or enhanced) by reason of the acquisition. Any seller equity held in trust on behalf of the plan participants is treated in the same manner as other seller equity holders in the acquisition. (2) MEP. The buyer generally assumes plans by operation of law and the seller does not incur withdrawal liability by reason of the sale of stock or merger. The buyer inherits the seller s contribution history for purposes of determining the buyer s post-closing withdrawal liability. C. Welfare Plans 1. General a. Welfare plans include medical benefit plans, life insurance plans, disability benefit plans, salary continuation plans, medical reimbursement plans, certain vacation plans, and cafeteria plans. b. Welfare plans may be self-funded, funded by insurance contracts, or a tax-exempt trust such as a voluntary employee s beneficiary association and, therefore, may have excess assets. c. The buyer should confirm that any plan documentation requirements are satisfied, that each plan accurately describes the type and level of benefits under the plan, and that each plan expressly reserves the employer s right to amend and/or terminate benefits. The failure to expressly reserve

13 Employee Benefits & Executive Compensation Issues 17 this right could allow participants to allege that they were promised lifetime post-retirement medical and life insurance benefits that can represent large unfunded liabilities for the employer. d. The Consolidated Omnibus Budget Reconciliation Act of 1985 ( COBRA ) requires employers to offer continued medical plan coverage to certain employees and dependents when their coverage would otherwise terminate due to the occurrence of certain qualifying events and to provide notice of such events. e. The Health Insurance Portability and Accountability Act of 1996 ( HIPAA ) requires that certificates of coverage be issued to all employees and beneficiaries losing coverage under certain welfare benefit plans and to reduce the new, standardized pre-existing condition limitation periods by any period of a new enrollee s prior creditable coverage. 2. Due Diligence a. The buyer should carefully review all plan documents and trust documents, including the latest summary plan descriptions of the plans and any material communications to employees. b. Oftentimes, the summary plan description is the only plan document setting forth the rights of the participant and the employer. The buyer should carefully review the employer s right to amend or terminate the plans, especially with respect to retirees. c. The buyer should also be sure that seller has complied with the requirements to provide COBRA and HIPAA notices, because substantial penalties may be incurred for failure to provide such notices. 3. Dealing With Welfare Plans In Acquisitions a. Sale Of Assets i. Buyer Does Not Assume Plan. Generally, in a sale of assets, the buyer will not assume or otherwise be responsible for the payment of benefits under the seller s welfare plans unless the buyer explicitly assumes such arrangements. ii. COBRA liability for M&A qualified beneficiaries generally rests with the controlled group of the seller as long as the selling group continues to maintain a group health plan after the sale. iii. If the selling group ceases to maintain a group health plan and if the buying group continues the business operations of the purchased assets without substantial change, the buying group is a successor employer and thereby becomes responsible for COBRA on behalf of M&A qualified beneficiaries. In general, an M&A qualified beneficiary in an asset sale context is a qualified beneficiary whose qualifying event occurs in connection with the asset sale and whose employment was associated with the assets being sold. iv. Failure to assume welfare plans or arrangements would not generally trigger acceleration of benefits. The seller would generally continue to be responsible for claims incurred (i.e., doctor visits) before the closing date. v. Assuming that the buyer covers the seller s employees that it hires, the buyer would be responsible for claims incurred following the closing date, regardless of when the claim is made.

14 18 ALI-ABA Business Law Course Materials Journal April 2007 vi. The buyer and the seller could agree, however, to split coverage based on claims made before and after the closing date regardless of when incurred. The latter may be easier to administer but may result in significant inequities to the buyer if claims are not made promptly. Such splitting arrangement would generally eliminate seller s obligation to provide COBRA coverage post-closing. (1) Buyer Assumes Plans. Assumption of welfare plans is rare except when (A) buyers and seller s plans differ significantly; or (B) when all of the following conditions are present: the buyer will be offering employment to substantially all the seller s employees, the buyer does not sponsor its own welfare plans, and the seller will no longer be operating as a separate company following the acquisition. b. Sale Of Stock/Merger. In a stock sale, the buyer generally assumes plans by operation of law. i. As with an asset sale, COBRA liability in a stock transaction for M&A qualified beneficiaries generally rests with the controlled group of the seller as long as the selling group continues to maintain a group health plan after the sale. ii. If the selling group ceases to maintain a group health plan, the buying group becomes responsible for COBRA on behalf of M&A qualified beneficiaries. iii. In general, an M&A qualified beneficiary in a stock sale context is a qualified beneficiary whose qualifying event occurs in connection with the stock sale and whose employment was with the organization being acquired. 4. Post-Assumption Modification Of Plans a. The participants rights under the welfare benefit plans are generally set forth in the summary plan description for the plan. Often the summary plan description is the only plan document setting forth the rights of the participant and the employer. The buyer that assumes a plan must pay careful attention to the specific terms of the plans and agreements to determine what modifications may be made, if any. D. Severance Plans 1. General. Severance benefits are usually an unfunded liability of an employer. Severance pay plans may carry significant liabilities even if employees will be terminated only as a technical matter as a result of the transaction. A sale of assets may trigger entitlement to severance under a plan where the employees of the seller are severing their employment relationship with the seller. Although most courts have held that the sale of a business does not trigger a termination of employment where the employees have continued in the employ of the buyer, the specific terms of the severance plan or agreement must be reviewed to ensure that such treatment can be avoided. 2. If a severance plan pays more than two times the terminated employee s compensation or spreads the payments out over more than two years, it may be deemed to be a pension plan (and subject to ERISA s pension funding and reporting requirements).

15 Employee Benefits & Executive Compensation Issues If the severance plan is within this safe harbor, it may be treated as a welfare plan, subject to ERISA (and the requirement that there be a written document, a claims procedure, etc.). Plans for single individuals may not necessarily qualify as plans subject to ERISA. 4. In the case of severance arrangements for key employees, such arrangements may be treated as deferred compensation subject to payment limitations under section 409A of the Code. E. Personal Loans 1. The area of personal loans to executives has gained prominence as an issue following enactment of the prohibition on most such loans by the Sarbanes-Oxley Act and section 13(k) of the Exchange Act. 2. A buyer considering assuming any loans made after enactment of these provisions should perform diligence on the existence of any personal loans to employees and assess whether such loans are prohibited or whether they may become prohibited (e.g., the company was not subject to the prohibition because it was not subject to the Sarbanes-Oxley Act or the Exchange Act at the time a loan was made, but may become so subject during the life of the loan; the employee receiving the loan was not an executive at the time the loan was made, but may become an executive for purposes of the prohibition). 3. A buyer, whether in a stock sale or an asset sale, may not assume a loan that it would be prohibited from making in the first place. Accordingly, the buyer may want to obtain assurance from the seller that either: a. No such outstanding personal loan is or will become prohibited following the transaction; or b. No such outstanding personal loan will be outstanding immediately before the closing date (such loans may be paid off or forgiven). 4. Costs associated with any issues regarding loans to executives also may be factored into the purchase price. F. Additional Securities Considerations 1. Section 16 a. General i. The disposition of stock held by officers and directors in connection with a merger, sale of assets, or liquidation may result in possible liability for short-swing profits under section 16(b) of the Exchange Act, which imposes liability on officers and directors for any profits from the purchase and sale of security within six months. Generally, the grant of options or purchase of shares of company stock is considered a purchase of stock for purposes of section 16(b), and, unless it is an exempt purchase, it can be matched against a sale of that stock within six months before or after the purchase. Rule 16b-3 of the Exchange Act exempts certain transactions between an issuer and its officers and directors from section 16(b). b. The Skadden Letter

16 20 ALI-ABA Business Law Course Materials Journal April 2007 i. On January 12, 1999, the SEC issued a no-action letter to Skadden, Arps, Slate, Meagher & Flom LLP ( the Skadden Letter ) stating that the full Board of the buyer or a committee of two or more non-employee directors ( Committee ) of the buyer may exempt: (1) the conversion of seller nonderivative equity securities into buyer equity securities, debt, cash or a combination of different forms of merger consideration; and (2) the conversion of seller derivative securities into buyer derivative securities or buyer nonderivative equity securities, or the cancellation of seller derivative securities for cash under Rule 16b-3(e) of the Exchange Act, provided that certain approval conditions are met. ii. Additionally, the full Board of the seller or a Committee of the seller may exempt the acquisition of buyer equity securities by officers and directors of buyer through the conversion of seller equity securities in connection with a merger which also constitutes an acquisition from the buyer that is eligible for exemption under Rule 16b-3(d), provided that certain conditions are met. The approval by the respective Boards or Committees must be obtained at the same time as, or following, approval of the merger agreement (but before the closing of the merger). iii. The full Board approval or Committee approval must specify: (1) The name of each officer or director; (2) The number of securities to be acquired or disposed of for each named person; (3) In the case of derivative securities acquired, the material terms of the derivative securities; and (4) That the approval is granted for purposes of exempting the transaction under rule 16b-3. iv. The Second Circuit in Gryl v. Shire Pharmaceuticals Group PLC, 298 F.3d 136 (2d Cir. 2002), cert. denied, 537 U.S (2003), abandoned the requirement set forth in the Skadden Letter that the board or committee resolution approving the grant specify that the approval is for purposes of exempting the transaction under Rule 16b-3 (i.e., requirement (4) above). (1) In Gryl, shareholders of Shire Pharmaceuticals Group ( Shire ) brought suit against certain Board members for disgorgement of short-swing profits under section 16(b) of the Exchange Act. Defendants were option holders and directors of Roberts Pharmaceutical ( Roberts ). Roberts became a wholly owned subsidiary of Shire. Pursuant to the Agreement and Plan of Merger, all outstanding options to purchase Roberts stock became options to purchase Shire stock and certain directors of Roberts were to become directors of Shire. Less than six months following the merger, the Defendants exercised their Shire options and sold the Shire stock for a profit. (2) The district court held that the insiders acquisition of the options qualified for exemption under Rule 16b-3, even though the acquiring company s approval of the option grants did not satisfy the conditions outlined in the Skadden Letter. Upon the request of the Second Circuit, the SEC filed an amicus brief affirming the requirements set forth in the Skadden Letter in certain respects but effectively disavowed the requirement that approval resolutions expressly state that approval is intended to exempt the transactions from Rule 16b-3. The Second Circuit ultimately affirmed the district court and concluded that, contrary to the Skadden Letter,

17 Employee Benefits & Executive Compensation Issues 21 there is no requirement under Rule 16b-3(d) that the board resolutions approving an option grant include a statement of exemptive purpose. c. Subsequent Developments i. In Levy v. Sterling Holding Company, LLC, et al., 314 F.3d 106 (3d Cir. 2002), cert. denied, 540 U.S. 947 (2003), the court stated that its review of rule 16b-3 and the SEC s 1996 adopting release convinced it that rule 16b-3 primarily is concerned with employee benefit plans (though the court acknowledged that the release itself states that a transaction need not be pursuant to an employee benefit plan or any compensatory program to be exempt, nor need it specifically have a compensatory element ) (see 314 F.3d at for citations from the 1996 adopting release that would argue in favor of plaintiff s view). The court distinguished the present case from Gryl on the ground that Gryl involved stock options that had a compensatory nexus (although the Second Circuit, in Gryl, did not make its decision based on whether the securities had a compensatory nexus). The court construed that Rule 16b-3 applied only to transactions having a compensation-related aspect. ii. The SEC amended Rule 16b-3 to resolve any doubt as to the meaning and interpretation of these rules by reaffirming the views [the SEC has] expressed previously regarding their appropriate construction. The amendment provides that any transaction (other than a Discretionary Transaction) involving an acquisition from the issuer (including without limitation a grant or award), whether or not intended for a compensatory or other purpose, will be exempt from section 16(b) if any one of the Rule s three existing alternative conditions is satisfied. Ownership Reports and Trading by Officers, Directors and Principal Security Holders, Release Nos ; ; ; IC-27025; File Bo. S , 70 Fed. Reg (2005). 2. Form S-8 Issues a. With respect to the conversion of options to purchase equity of the seller into options to purchase equity of the buyer following the acquisition, sellers who are subject to the reporting requirements of the Exchange Act should be aware that the options to purchase equity of the buyer held by former employees or directors of the seller who were never employees or directors of the buyer will not be eligible for registration by the buyer on Form S-8. These options must either be registered as part of the acquisition on Form S-4 or be subject to the holding periods set forth in Rule 144 of the Act. To purchase the online version of this article, go to and click on online.