On August 10th, Elon Musk made national headlines due to a lawsuit that Business Today heralded as “Former Twitter executive sues Elon Musk’s X for $20 million in unpaid shares.” The article reports that X is alleged to have reneged on paying stock-based severance, and continues as follows with a story of disappointed expectations:
“This latest legal action follows a similar lawsuit filed by former Twitter CEO Parag Agrawal and three other executives, seeking approximately $128 million in unpaid severance. The lawsuit claimed that Musk displayed ‘special ire’ towards these executives, publicly vowing to withhold their severance payments after acquiring Twitter.”
Those claims add to a long line of lawsuits with a common origin, namely, after a merger or acquisition closes, the buyer contests or refuses to pay, severance to the target company’s executives. The business reason is understandable: buyers – such as X – consider severance to be a transaction cost that they would rather not pay’ especially if the severance event occurs after the closing.
Precautions are nevertheless available for the executives of target companies, and they generally come through a mere document … at no cost to the target company. This is possible by either amending an employment agreement or creating a simple stand-alone agreement. In either case, a core protection involves approving what is known as a springing rabbi trust. Commonly, the trust is created right away, for a limited future purpose, namely, paying any severance or other benefits that may later become due after a change in corporate control. In this way, the rabbi trust sits on the shelf (unfunded), and springs into full funding only when triggered by a change in control event. Under this approach, the selling (target) company must determine before a change in control closes, how much severance and other deferred compensation could become payable on a post-closing basis to all of the protected executives, and then must fully fund the trust at the closing with assets sufficient to cover all of those post-closing potential liabilities.
Why does this matter? Note the adage: those who have the gold rule.
A springing rabbi trust may be constructed to require that its independent trustee, normally a bank, pay benefits from the trust upon the receipt of a certification from the executive that (1) his or her employment has terminated, and (2) a severance amount designated by the executive is therefore due and payable from the trust. Under this mechanism, the executives collect their severance, and the former employer is faced with suing to recover. That flips the usual narrative which involves forcing outgunned executives to face years of litigation and legal fees in order to pursue collecting from their former employer, such as X in the cases described above.
Note that the funding of a springing rabbi trust could include a legal defense fund. That is just one of the nuances to consider when contemplating a springing rabbi trust and related change in control protections (such as golden parachute provisions).
Note also that although such trusts are most commonly suitable as a form of surety for severance arising from a change in control, a rabbi trust may also be suitable under other circumstances, especially when significant deferred compensation benefits are accumulating. For rabbi trusts having that genesis, funding does not normally “spring” in the future but instead corresponds to the accrual of those deferred benefits.
It is worth reiterating that a target company’s executives cannot always be confident that a future buyer will honor (or not dispute) the post-closing payment of severance and other deferred benefits. Interestingly, executives often underestimate — or dismiss — the value of rabbi trusts. That usually occurs because the most notable characteristic of a rabbi trust may be its inability to protect executives against the employer’s bankruptcy or technical insolvency. Indeed, U.S. tax laws require that rabbi trust assets remain subject to the claims of the employer’s general creditors until the executive receives payment. It is common as a result to say, as noted above, that rabbi trusts merely provide “change of heart” protection. Severance protection can, however, be invaluable for an executive if significant severance, deferred compensation, or supplemental retirement benefits are not scheduled to be paid coincidentally with the executive’s termination of employment.
Overall, it is reasonable for an at-risk executive to ask that the employer fund a rabbi trust with an amount sufficient to pay any severance, deferred compensation, or non-qualified plan benefits that are not paid in full at the time employment terminates. To make a long story short, the old saying “you don’t ask; you don’t get” may not date back to Confucius, but it is worth considering when executives face an exit from employment, or a possible merger or sale of their employer.
