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Traps for the Unwary: A Look at Employees and Benefits in M&A Transactions

    Client Alerts
  • May 13, 2015

Employees drive the success of a company.  In fact, in some industries (technology, for example) talent acquisition can be a primary motivation for a transaction.  From identifying the target’s key employees, to assessing the potential liabilities and obligations associated with the target’s entire workforce, to integration and retention, business combinations give rise to a variety of complex employment and benefit issues that should be carefully addressed by the parties.

An initial and fundamental consideration is how to structure the transaction.  In addition to tax, general allocation of liability and other considerations, a transaction’s structure also dictates the specific liabilities and obligations a buyer will assume with respect to employees.  For example, in a stock-based transaction like a merger or stock acquisition, the buyer automatically becomes the employer of the target’s workforce and generally assumes all of the target’s liabilities related to those employees, including compensation and employee benefits.  On the other hand, the buyer in an asset transaction has more flexibility to negotiate the employees it will hire and the liabilities it will assume from the selling company.

In analyzing the employee-related consequences of a business combination and conducting due diligence, it is important to consider a multitude of issues, with some of the more challenging areas highlighted below.  Depending on the circumstances, these can be thorny issues that warrant negotiation to reallocate potential risk and liabilities and/or a purchase price adjustment.

Benefit Plans
For many benefit purposes under the Employee Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code, and therefore also in an M&A scenario, the “controlled group” rules come into play.  Under these rules, all trades or businesses under common control and corporations within the same “controlled group” are considered a single employer.  These rules can be implicated in a number of areas, such as benefit plan compliance, COBRA obligations, and health care reform.  Joint and several liability among members of a controlled group can apply for some benefit plan liabilities, particularly for defined benefit plans and multiemployer (union) plans.

Defined benefit plans, such as traditional pension plans, often carry significant liabilities that can adversely affect a buyer post-closing.  This can be true both in the case of an on-going plan and in the event such a plan is terminated post-closing.  Defined benefit plans generally require minimum annual funding contributions that can constrain a buyer’s cash flow, and many defined benefit plans are significantly underfunded.  The Pension Benefit Guaranty Corporation (PBGC) also monitors defined benefit plans (particularly underfunded plans) and could intervene to secure additional contributions to the plan which could delay or hinder the transaction.  For underfunded plans, the PBGC may attempt to assert liens on assets.  Defined benefit plans can pose risks to a buyer even in an asset transaction.

Multiemployer defined benefit plans also usually raise a cautionary flag.  Typically established by a union, multiemployer plans cover employees of unrelated participating employers based on each employer’s collective bargaining agreement with the union.  Significant underfunding of multiemployer plans has left many participating employers with significant annual contribution obligations and even more daunting withdrawal liability if the employer wants to cease participation (for example, following a stock-based transaction).  In an asset-based transaction, withdrawal liability may be automatically triggered upon closing and is generally assessed on the participating company unless the buyer specifically agrees to continue contributions in accordance with detailed ERISA requirements.

A more common component of a target’s employee benefit offerings are defined contribution plans, such as a 401(k) plan.  Sometimes a buyer may consider continuing or assuming the target’s 401(k) plan – for example, if the buyer does not already have established benefit plans, if the buyer wants to minimize disruption to employees, or if the seller’s existing plan has significant advantages.  Thorough due diligence should be undertaken before making such a decision.  Often, however, a buyer in a stock-based transaction may not want the risks associated with assuming the target’s 401(k) plan or merging the target’s 401(k) plan with its own.  In such case, the buyer would want the target to terminate its 401(k) plan prior to the closing date because IRS rules regarding 401(k) plans and controlled groups likely will prevent the buyer from doing so post-closing.  In an asset-based transaction, many buyers will not want to assume another company’s defined contribution plan, and the target will need to terminate the 401(k) plan.

Retiree benefits, including health and life insurance benefits for retirees and their dependents, are another area of concern.  For example, whether the target can reduce, modify or terminate such benefits is a hot button issue and has been the subject of class action litigation in both union and non-union settings.  The answer generally hinges on whether the target has reserved the right to unilaterally modify benefits in the plan documents.  In addition, in some cases, retiree health benefits are a significant liability on the balance sheet.

More recently, health care reform has become another area of consideration for corporate transactions, particularly due to the significant penalties for non-compliance.  Some of the Affordable Care Act requirements also hinge on the company’s number of employees and the number of employees in the controlled group, and can be affected by the transaction.

Change in Control and Parachute Payments
Certain employees may participate in a nonqualified deferred compensation plan subject to Section 409A of the Internal Revenue Code which imposes strict rules on the terms and conditions for such plans.  In addition to evaluating such a plan’s past and current compliance with Section 409A, if a transaction constitutes a “change in control” under Section 409A, participants in a nonqualified deferred compensation plan may be able to receive payments under such plans.

Executives and other key employees of the target may be parties to employment agreements, change in control agreements, severance arrangements, deferred compensation plans, restricted stock and stock option agreements, and other arrangements for which a change in control triggers payments, accelerated vesting and other benefits to the employees either at or after a closing.  These potential payments should be considered in evaluating liabilities.  In addition, if a transaction constitutes a “change in control” of a corporation under Section 280G of the Internal Revenue Code, payments and benefits that exceed a specified threshold are nondeductible by the corporation and subject the recipient (e.g., the executive) to a 20% excise tax.  Although privately-held corporations can avoid Section 280G penalties if they meet shareholder approval requirements, publicly-traded companies do not have that option.  While no longer the norm, companies sometimes have some form of “gross up” agreement with their executives to cover some or all of the Section 280G penalties – these gross up agreements significantly increase the costs of the change in control payments.

IRS regulations allocate COBRA responsibility in mergers and acquisitions.  In either a stock or asset sale, if the seller or any member of its controlled group continues to maintain a health plan after the sale, the seller (or that related company) is responsible for providing COBRA.  If neither the seller nor any related company has a group health plan following the closing of a stock sale, the buyer must make COBRA coverage available.  To the surprise of some employers, in an asset sale where the seller (or related company) continues to maintain a health plan, all terminating employees who lose health coverage  are entitled to be offered COBRA, even if hired by the buyer and offered coverage under the buyer’s plan.  If neither the seller nor any related company has a group health plan following an asset sale, and the buyer continues the business operations associated with the purchased assets without interruption or substantial change, the buyer is considered a successor employer and responsible for  COBRA coverage.

While the parties are free to deviate from the regulations to contractually allocate COBRA responsibility, if a party breaches its contractual obligation, the obligation belongs to the party that otherwise would have been responsible under the regulations.

Compliance Issues and More
Employment, executive compensation and employee benefits are areas that are riddled with compliance requirements and other business obligations that could result in liability post-closing if not identified and appropriately addressed.  A buyer typically attempts to mitigate this risk by obtaining detailed representations and warranties from the target and the right to seek indemnification from the target if liabilities arise.  There is no substitute, however, for thorough pre-closing due diligence as way to quantify and manage liability.  Close attention should be paid to:

  • Employee classification, including overtime practices
  • Collective bargaining agreements
  • Workplace safety
  • ERISA and Internal Revenue Code compliance, including COBRA compliance
  • Securities laws, including NYSE and NASDAQ rules related to executive compensation and equity awards
  • Federal and state tax implications for the companies and the employees
  • Litigation related to employees or former employees
  • Potential WARN obligations

Public companies must also consider whether and when they will need to register with the SEC or list with a stock exchange the securities to be issued post-closing under surviving target plans.

International Employees
Cross-border transactions further complicate employment issues.  In most areas of the U.S., absent a unionized work force or provisions in an employment agreement or purchase agreement that say otherwise, employees are generally “at-will” and buyers are able to conduct necessary post-closing layoffs and reorganizations.  In many jurisdictions outside of the U.S., however, the doctrine of “vested rights” is recognized.  The vested rights doctrine essentially regulates, restricts or prohibits an employer’s ability to terminate employees without good cause and without following mandated dismissal procedures, including certain severance obligations in some cases.  For example, in a stock-based transaction, from the moment the transaction closes and the buyer becomes the employer of the target’s employees, the buyer is subject to the doctrine of vested rights.  These vested rights may reach beyond actual termination and protect an employee from “constructive termination”, which may be a major obstacle for a buyer that wants to realign workers, reduce benefits or transfer workers to new locations.

While the astute practitioner may attempt to side-step the doctrine of vested rights by structuring the transaction as an asset-based transaction, some jurisdictions outside the U.S. have passed laws that provide employees with “acquired rights”, which require the buyer to assume the existing workforce along with the target’s vested rights obligations.

In most cases, it is essential that parties to an international transaction engage experts in the local jurisdictions to help them navigate these obstacles from the initial planning stages through integration.

Retaining Employees
Retaining key employees can be critical to the success of a deal.  A 2014 survey by Towers Watson, a global professional services company, found that nearly nine of ten companies that had retention rates of over 60% deemed the transaction to have met their strategic objectives.  In comparison, only 67% of companies that had retention rates of less than 40% expressed the same sentiment.

Typically, the target wants to retain key employees until closing and the buyer wants to retain key employees post-closing.  One way to incentivize a key employee to stick around (and to keep the employee from competing with the acquired company post-closing) is to enter into a retention agreement with that employee, also referred to as a “pay to stay” agreement.  Under this arrangement, the buyer or seller pays an employee in exchange for that employee agreeing to stay on for a certain period of time post-closing.  Retention agreements sometimes also include a performance condition (“pay to perform”) in addition to a purely time-based service requirement for payment.

Depending on the key employee’s position with the buyer post-closing, such arrangements may trigger proxy statement (for example, in the CD&A section) and other disclosures in SEC filings. Buyers should consider how any such arrangements might fit within their existing compensation structure or be perceived by their shareholders.  Such agreements also could constitute deferred compensation so they should be structured to comply with or be exempt from Section 409A of the Internal Revenue Code.

Significant employee-related considerations and benefit related issues arise in M&A transactions.  Involving employment and employee benefit/executive compensation counsel early in the process is critical to understanding and addressing potential liabilities and obligations, structuring compensation packages that entice key employees to stay and ensuring that the transaction is a success.