The cost of being fired

Investors and analysts were braced for the impact an executive termination package would have on Marsh & McLennan’s (MMC) financial results well before the company released its 2007 fourth-quarter and year-end results on February 12. The company had given some forewarning in announcing on December 21 that Michael Cherkasky, president and CEO since October 2004, would step down after the board of directors ‘determined that a change in leadership will best enable MMC to move forward and enhance shareholder value.’

It’s no news flash that C-level termination packages come with high price tags. But the company did make news by breaking down the costs of Cherkasky’s departure in terms of its impact on earnings per share. Its earnings release estimated that MMC’s fourth-quarter net income of $.16 per share was reduced by approximately $.07 as a result of costs associated with discontinued operations. It went on to state, ‘Additionally, incremental costs associated with the departure of MMC’s former CEO negatively impacted earnings per share by approximately $.02 in the fourth quarter of 2007.’

A double-edged sword

MMC would have been unlikely to take this unusual step had it not fallen so far short of its numbers. If its financial performance had been better, the move might not have seemed necessary. Yet under any circumstances, specifying how big a blow an executive termination package deals to earnings per share has potential benefits and risks. Experts say a board and management team considering this action must be mindful of disclosure standards and the need to reassure investors about the company’s operational health while sticking to SEC guidance regarding the use and misuse of per-share data.

‘The SEC may frown on the use of earnings-per-share numbers in certain cases’ and ‘has periodically expressed concerns about the use of non-GAAP per-share data,’ explains Mary Anne O’Connell, partner in Saint Louis law firm Husch Blackwell Sanders. ‘Although the final version of Regulation G adopted by the SEC generally prohibits the use of cash flow information in per-share terms, it does not prohibit other uses of non-GAAP per-share information.’

Moreover, the SEC has stated its opinion that ‘discussions quantifying the effects of unusual items on net income and earnings per share may be helpful to readers and therefore acceptable,’ adds O’Connell.

Beth Saunders, founding partner and chairman at Chicago-based investor relations firm FD/Ashton Partners, states the case more strongly: ‘Investors have to believe you’re giving them the transparency you have knowledge of.’

O’Connell agrees that, ‘In general, a company’s obligation to disclose factors material to performance should outweigh concerns about use of non-GAAP measures.’ However, she qualifies that principle with two caveats. First, the use of the non-GAAP items must be relevant and helpful. Second, the company must clarify that the non-GAAP information is provided in the specific context of the management discussion and analysis (MD&A) and not as a substitute for the GAAP information.

Legally, timing is also an issue, says Mark Harrington, general counsel and corporate secretary at Guidance Software in Pasadena, California. Expanded SEC requirements for meaningful disclosure and analysis of executive compensation, retention and severance packages also apply to companies’ obligations in the event of the executive’s termination. But Harrington does not believe the earnings release is the best medium for conveying that information. ‘My take is that a company would likely have an obligation to make such disclosures in a proxy statement,’ he said. However, ‘if the financial impact is material to the company … [it] might not be able to wait until the proxy and there may be an obligation to disclose such detail in a quarterly filing or even an 8-K.’

How much information is too much?

Aside from legal and regulatory compliance issues, Saunders cautions that a company must also consider how the news it is delivering will be received by investors. The board and management must ask, ‘Is it worse to pinpoint how much we’re paying an executive to leave or to let investors walk away thinking we have deeper operational issues than really exist?’ The answer to that question can fluctuate with the market’s overall performance, she adds. In a skittish market where investors are dumping positions they believe have too much risk, companies will be more inclined to think ‘it’s better to give that extra data point than have the Street walk away thinking there are operational problems.’

MMC had taken steps before earnings were announced to quell any such fears. By January 30, less than six weeks after Cherkasky’s exit from the company was announced, new president and CEO Brian Duperreault – touted in a press release for ‘his ability to produce results and create shareholder value’ – was at the helm. Two weeks earlier, the company increased its dividend by a penny to $.20 a share, which served as an additional display of MMC’s corporate confidence.

Harrington raises a related point that has to do with investors. Although his legal opinion is that the information is best disclosed in a proxy statement, quarterly filing or 8-K, he notes that ‘this kind of detailed disclosure of the severance package, in a press release, is shareholder-friendly.’ In certain circumstances, that could help a company to offset any potential shareholder ire raised by a costly executive severance package.

A need-to-know basis

What do board members and executives need to consider before deciding whether this is the right move for their company? One question is how much information the company deems necessary to provide with regard to non-operational issues when the core earnings potential is still good, Saunders says. She advises companies to examine their motives. Do they believe investors need to understand the expense in earnings-per-share terms? Is the impact on earnings per share going to emerge as a widespread shareholder concern? The right decision comes down to determining what investors need to know, she says. ‘Ultimately, the board, the management team and the legal counsel need to figure out at any given time what are the material facts that need to be disclosed.’

Saunders also offers thoughts about how to present the information after a company decides to move forward with an earnings-per-share breakdown of executive termination costs.

‘I think all things remaining equal, the more forthcoming companies will put those kinds of expenses under a broader group of compensation expenses,’ she says. Within that context they can offer comments in the earnings release or on the conference call that compensation expenses for the quarter rose because of termination expenses. Including the item in a laundry list of those that affected earnings per share addresses transparency requirements without raising undue investor alarm, Saunders says. It also spares the company from the consequences of calling so much attention to the termination expense that investors wonder whether it is being used as an attempt to distract attention from more serious operational issues.

Presentation is everything

O’Connell agrees that she would urge a company to be sure it will be helpful to investors to describe an expense in earnings-per-share terms. As corporate counsel, she would advise a company that decided to go forward with the move to also be sure the expense is calculated in the same way as fully diluted earnings per share and to explain why it was included.

Another key point is the manner in which the company words its announcement, regardless of where it decides to do so. Harrington advises against saying the severance package ‘negatively impacted’ earnings. ‘If the board, in the proper exercise of its business judgment, determined that such a severance package was necessary to recruit and retain this CEO candidate, then the proper tone of wording the statement is that it was a one-time cost associated with the departure of a CEO and likely necessary to have retained that CEO in the first place,’ he says.

Furthermore, the two lawyers deny the concern that a company, having made this specification once, would be setting a precedent requiring it to frame any future executive termination packages in terms of earnings per share.

Harrington says each executive termination situation is unique and dependent on its own set of circumstances and materiality to shareholders. ‘I really don’t think that [concern] is an issue,’ O’Connell agrees. ‘We have seen other companies delineate various non-recurring expenses in EPS terms and have not seen the market begin to expect this routinely.’

Saunders takes their advice a step further and says the question hinges less on costs than on the market. ‘My gut feeling is, in very good times, this would not be happening,’ she says. ‘I don’t know if it’s a trend. I think it’s indicative of where the market is today.’