Kudos! Merck "Reforms" Change Of Control Payout Provisions

In an SEC Form 8-K filed yesterday, Merck disclosed actions taken by its compensation committee of the board of directors. Those actions were taken on Monday. In general, the company has reduced the size of the payouts, in a change of control setting, by eliminating extra credit for years of service (under the pension plans), and by reducing the number of executives entitled to such payouts.

These are welcome reforms, to be sure. And Mr. Frazier should be credited for leading the board to start reeling in all of this excessive severance pay, at the top of the house.

Most importantly, though from my vantage point, Merck has redefined what kinds of deals are covered as a change of control transaction. To my eye, it seems reverse mergers between the subsidiary companies (where the putative target acts as the acquiror -- think here of the Schering-Plough transaction) will no longer be covered. That is, if Merck Sharp & Dohme Corp. (currently the operating subsidiary, most akin to old Schering-Plough, in the reverse merger of two years ago) acts as a nominal acquiror, in a transaction where it is actually being acquired by another company -- but just switching shells in the process -- the payouts will not be triggered. I think that's right.

I think the graphic at right may well help explain why Merck is reeling in the merger-time severance plans. It is hard to say that $20 million (should the executive lose his or her seat) wouldn't keep the executive as well-focused on doing the job at hand -- as $200 million might.

In fact, a non-trivial argument can be made that due to the sheer size of the legacy Schering-Plough payouts, its executives were motivated to angle toward a bust-up, rather than fix and run the company independently.

I'll leave that debate to others (though I've argued this before repeatedly), for now. Here is the SEC Form 8-K -- and a snippet -- as well as the revised change of control severance plan document

. . . .Compensatory Agreements and Arrangements


On November 26, 2012, the Compensation & Benefits Committee (the “Committee”) of the Board of Directors of Merck & Co., Inc. (the “Company”) approved an amendment and restatement of the Merck & Co., Inc. Change in Control Separation Benefits Plan (the “Plan”), to be effective as of January 1, 2013. These changes redefine the eligibility criteria and align severance multiples and other plan features with evolving best practices and the Company’s current compensation framework.

The Company’s named executive officers all participate in the Plan, and they may be impacted by certain of the changes that are included in the amended and restated Plan, including the following provisions:

Smaller Covered Population: The amended and restated Plan modifies the group of executives covered under the Plan by narrowing the group of executives who are eligible to participate on or after January 1, 2013.

Reduce Severance Amounts for Certain Participants; Lump Sum Severance: Pursuant to the amended and restated Plan, effective as of January 1, 2013, the multiple used to calculate a participant’s cash severance payment and the formula used to calculate the bonus portion of the total cash severance to which a participant becomes entitled in the event his or her employment is terminated by the Company without “Cause” or he or she resigns for “Good Reason” within two years of a “Change in Control” (as such terms are defined in the amended and restated Plan) have been amended. For the named executive officers and other members of the Company’s executive committee, other than the chief executive officer, if the participant becomes entitled to severance in the circumstances described above, the participant will be entitled to an amount in cash equal to two times the sum of (i) his or her base salary and (ii) the lesser of (a) the participant’s annual target bonus calculated as of the Change in Control date or the termination date, if greater, and (b) the average of the actual bonuses paid to such participant over the last three years in his or her then current position. Previously, a member of the executive committee was entitled to a severance amount in cash equal to three times the sum of (i) his or her base salary and (ii) the participant’s annual target bonus calculated as of the Change in Control or the termination date, if greater. The changes to the severance calculation multiple will not impact the chief executive officer, although the chief executive officer’s severance will be calculated using the amended and restated Plan’s formula for calculating the bonus component of severance, as described above. Severance payments under the amended and restated Plan will be paid in a lump sum.

Modify Subsidized Health and Life Insurance Continuation Benefits. Pursuant to the changes incorporated into the amended and restated Plan, in the termination circumstances described above, the participant is entitled to certain subsidized health and life insurance continuation benefits, which will now be provided concurrently with (and not before) any applicable continuation period under the Consolidated Omnibus Budget Reconciliation Act (COBRA) and before eligibility, if any, for retiree healthcare coverage.

Eliminate Age and Service Credits. Participants will no longer be eligible for any additional years of age and service credit under the Company’s or its subsidiaries’ supplemental executive retirement plans.

Amend Definition of Change in Control and Good Reason: The definition of Change in Control as used in the amended and restated Plan has been modified to raise certain thresholds, thereby increasing the requirements that must be met to trigger the occurrence of a change in control. The definition of Good Reason for the named executive officers was also modified to eliminate one of the triggering events.

Application of Amendments. Any amendments incorporated into the amended and restated Plan that are adverse to any individual who is considered a participant as of the date of the amendment would be null and void, and therefore would not be applicable, if a Change in Control were to occur within one year of the adoption of the amendments. . . .

  We will keep you posted if the popular press picks up on this.

As a footnote, I suppose I ought to also point out that the revised plan prevents the executives from arguing that changing headquarters from Whitehouse Station to the legacy Schering-Plough facility (as announced earlier this year) would trigger a change in control payment. The old plan, I think, specified any more than 50 mile change in office locations. Now, as revised, it is the greater of the 50 miles, or 120 percent of the executive's prior commute from home (measured in miles, not drive time).

That plan provision -- for those of you keeping score at home -- is found at Section 2.17(c)(ii).

Post-Retirement Pay Rising For Many CEOs -- Hassan, Especially: $175 Million Worth

I've been pointing to this topic (inside pharma) for months -- that very few financial reporters, and people, more generally, understand how much public company CEOs are given, once they depart the chief's seat. Reuters has a piece out this morning, discussing the pension component of it, across the Fortune 500. Per Reuters:

. . . .Pensions rose as a result of generous formulas and some little-scrutinized techniques, such as changes in age or interest rates used in calculations, the paper said, citing an analysis of filings from 340 Standard & Poor's 500 companies. . . .

And with the public outraged over lavish pay and big bonuses, the Journal on its website said pensions rose even as stock prices dropped by an average of 37 percent last year.

The chief executive of Merck & Co saw his pension benefit rise by nearly $10 million to $21.7 million last year. . . .

That's a doubling of his pension benefit.

Of course, the pension is only one small part of the overall post-employment pay any public company pharma CEO will receive. It is time to refresh the tutorial on CEO Hassan's departure package, I think. SO. . . here goes:

Lately, Schering-Plough's SEC filings have recited that "stock options granted on or after January 1, 2008" -- will not automatically vest on a Change of Control. That will be true for most pigs -- but CEO Fred Hassan is unlike most pigs. . . .

That is, it may be true as to other executives, but CEO Hassan negotiated "special grandfathering" of stock options, and other forms of equity compensation, for himself, and himself alone, in the event of a Change of Control, back in 2003, when he signed on -- here's his full employment agreement (the below is from Section 3(j) -- on page 4):

. . . .(j) DURING CHANGE OF CONTROL PERIOD

Without limiting the generality of the foregoing, during a Change of Control Period, the incentive, savings and retirement benefit opportunities (measured with respect to both regular and special incentive opportunities, to the extent, if any, that such distinction is applicable) and the other benefits provided to the Executive pursuant to Sections 3(d), (e), (f), (g), (h) and (i) shall in no event be less than the most favorable such opportunities and benefits provided to the Executive by the Company and its affiliates at any time during the 120-day period immediately preceding the Change of Control Date. In addition, notwithstanding anything herein or in the 2002 Plan to the contrary, upon the Change of Control Date, the Shares and the Options shall immediately vest in full, and the Options shall remain exercisable for the remainder of their stated term. . . .

That last bit nullifies any later action taken by the Board or Compensation Committee to limit the immediate, and full-vesting -- should a Change of Control occur, at least as to CEO Hassan.

And when the Merck transaction closes, that is exactly what Fred Hassan will say: all options -- including those granted on May 1, 2009 -- even after the announcement of the proposed merger -- must vest in full as to Hassan, and Hassan alone.

Some pigs are, indeed, "more equal". Let's try to total it up, then:

The Wall Street Journal story correctly pegs his immediate cash portions at $17.7 million, plus pension benefits of $13.2 million, and medical benefits of $130,750 (just this year), or about $31 million.

But that's just small potatoes, compared to the equity portions: Mr. Hassan has various option grants of 1,100,000 shares (at $18.20), 220,000 shares (at $20.70), 880,000 shares (at $20.70), 200,000 shares (at $19.23), 800,000 shares (at $19.23), 167,200 shares (at $18.85), 668,800 shares (at $18.85) and 868,300 shares (at $22.91). So, all of these are exercisable at various prices between $18.20 and $22.91 per share. [I have dropped from the tally, the options that aren't likely to be in the money: they are 236,000 shares, and 944,000 shares, each exercisable at $31.57 -- but do not forget about these, if by some miracle, Schering-Plough trades into the $31.60 range by merger time.]

Don't forget -- he has his 900,000 share option mega-grant from early 2004 -- exercisable at $17.34.

He also has the 2003-era 200,000 deferred stock units, and the February 27, 2009 deferred stock unit grant of 195,610 shares -- free and clear. [So the jet just got gilded!]

Finally -- he has his "all other performance based" stock units covering 672,714 shares -- if just the target amounts are paid out in 2009, and early 2010. Now, to calculate -- [I advise making an Linux spreadsheet!] on the options, it is simply a matter of subtracting assumed NYSE market prices, from exercise prices -- and multiplying by numbers of shares -- to reach his potential gain, at any given NYSE quoted stock price. Similarly, on outright share-grants, one multiplies the full NYSE stock price, times the total number of shares -- all of those share-gains are his to keep. Simple -- and simply dizzying -- given the size of the numbers, and the endless parade of serial grants.

So, tallying up just the incremental effects -- CEO Hassan's ultimate pay-out will rise by over $7.74 million -- for every dollar over $22.91 that Schering-Plough's common stock rises, in NYSE trading, as of the reverse-merger date (click image to enlarge -- as if you'd need to!):



By my reckoning, if the merger were to close tonight, at $28.20 -- Schering-Plough's NYSE intra-day common stock quote -- Mr. Hassan would walk away with a grand total of $174.97 million!

Now, on top of all of this, remember, the company must pay his taxes -- must gross him up -- should he be hit with any so-called IRS Section 280G "excessive (non-performance based) compensation" taxes. I cannot accurately model the size of that gross-up, in any detail -- but it could add an additional 30 percent to his all-in expense to the company. If the tax gross-up clauses were to be triggered, his compensation costs would likely be north of $200 million (as the company accrues, and pays, the compensation -- and the taxes on it).

Astonishing, no? I think so. [Original version was published in April of 2009.]