End of the line

CEO severance bonanzas did not end with the likes of Dick Grasso and Robert Nardelli. Already this year the SEC, citing Sarbanes-Oxley legislation, has prevented Gemstar-TV Guide International from paying $29.5 million to former CEO Henry Yuen, who was then charged with securities fraud. That came after the news that CEO Angelo Mozilo, of mortgage disaster Countrywide Financial, has a severance package valued at $110 million after his stock sales as the company’s share price slid by more than 80 percent and nearly 11,000 employees lost their jobs.

Critics might be shocked, but few are surprised. Watson Wyatt Worldwide examined 70 CEO severance cases last year between April and December, comparing SEC-mandated severance proxy disclosures with the associated 8K filings. In more than three quarters of the cases – 54 out of 70 – companies spent exactly what they reported. The remaining corporations paid a weighted average premium above planned severance of 224 percent, in some cases citing additional quid pro quos such as extended non-compete periods or future consulting services.

Within budget or not, severance payments have come under increasing scrutiny, whether from consultancies, regulators, investors or the public. Done badly, the practice underscores perceptions of corporate waste. At its worst, millions of dollars go to people just for screwing up. Boards must balance the need to recruit executives, which often requires the promise of a healthy severance package, with shareholder and employee interests in the event that an individual needs to be dismissed. Leading businesses are looking at severance as a new frontier and are recognizing that better compensation can create better corporate governance and better performance.

The pressure on severance is understandable. Many investors, directors and experts in executive compensation are concerned about skyrocketing pay for top management and whether it is badly disconnected to corporate performance.

‘I think shareholders had a rough year in 2007 watching several high-profile CEOs walk away with tens of millions of dollars after their companies had lost significant value,’ says David Wise, a senior consultant with Hay Group. ‘Shareholders want CEOs to take home value if they create value. That applies to severance just as it applies to long-term performance plans.’ That concern helped the SEC decide to demand a clear view of all parts of executive pay, including severance, in proxy disclosures.

‘The SEC was … trying to help shareholders get an understanding of the total compensation package including what is euphemistically called pay for failure,’ says Ira Kay, director of Watson Wyatt’s compensation practice. ‘The investors who pushed the SEC in this direction were trying to use disclosure to get control over – and hopefully try to reduce – executive pay levels in general and severance in particular. One of the ways to try to get control was to have the company declare what the executive would be receiving at a moment in time, and therefore hopefully lock the company and executive into that amount.’

Some argue that much anger over severance has been misplaced because the vast bulk of the payouts is not severance per se but rather the payment of equity that had been previously granted, compared to which the actual severance payout pales. However, the severance agreement provides the acceleration of grants making the equity payout possible. Previous compensation becomes part of the glaring severance problem.

Other payments such as golden parachutes and tax gross-ups (to cover the additional excise taxes that come into play for ‘excessive’ compensation), often triggered by a change-of-control clause, also become part of the problem. ‘These packages are very large, and under a gross-up … the number can be very significant,’ says Irv Becker, Hay Group’s national practice leader for executive compensation. ‘The compensation committees knew they had these features, but hadn’t necessarily calculated the magnitude.’

The easy way out

To most of the public, a few million dollars is money to last a lifetime, not a consolation prize. A golden parachute, accelerated equity grants or some other scheme can make for an eye-popping total. Why would boards then authorize even more, particularly after an agreement was already in place?

‘Now you’re in sociological and human behavior,’ Kay says. ‘I think the board members are part-time. There’s a lot of aggravation [in the position]. They want this behind them and don’t want 10 more phone calls or meetings. [So] they spend another 10 to 20 percent to get rid of the problem.’ And then there is the potentially severe damage that an ex-CEO can cause, which can send a company reeling. ‘[The directors] are really afraid of these people, and they don’t want them to do a billion dollars of damage to a $10 billion company,’ he adds.

When directors increase severance beyond the amount in the agreement, it might be to gain some consulting time from a departing CEO to aid a transition. But when there is an involuntary termination, ‘all of these payments are simply attempts to legitimize ways to put money in somebody’s pocket in ways that we don’t have to answer for it or describe it,’ says Theresa Gallion, a managing partner of labor and employment with law firm Fisher & Phillips. ‘This is very commonplace. Maybe sadly, but it is.’

‘What it allows for is a quick fix without any bad publicity and any kind of black cloud hanging over them,’ says Robert Lowe, a partner with Mitchell Silberberg & Knupp. ‘Also, they may feel when they want to hire the next guy [that] it’s easier when the last guy left under relatively easy terms.’ A prospective CEO would be wary if the last departed in circumstances that could be called ‘World War III’. In conflict with this are directors’ concerns about their own reputations challenged with such questions as: ‘Why didn’t the board watch this closer?’ and ‘Why didn’t it act sooner?’

For those left behind

As is true of any compensation element, severance should be in place to elicit behavior that is beneficial to the corporation as a whole, though the most common rationale currently touted for severance is that it is necessary to attract new talent to the company. Two to three years of salary and bonuses provides security to executives who would not otherwise leave established positions to work for a new company. Some maintain the argument that the real intent behind severance is to benefit the other employees.

‘The real theory of severance is that it’s for the non-severed employees, and it is basically a retention plan,’ says Kay, who compares it to leaving a tip in a restaurant. ‘If I think I’m going to be whimsically or cavalierly terminated [without financial protection], I’m going to look for another job.’

At one time, that might have been the biggest reason, but there are others as well. One is deterring termination: a board is less likely to hastily dismiss an errant CEO if it knows a major cost will be involved. ‘[CEOs] want to make sure that a board member or two don’t have a bad hair day and decide to blow them away,’ says Charley Polachi, managing partner of executive recruiter Polachi & Co. Given that the average tenure for executives is less than three years, the concern seems valid. There is also the ‘everybody else is doing it’ argument; other companies offer plump severance packages, and with the public availability of information, any CEO will demand from his company at least the equal of what is on offer at its peers.

For the vast majority of corporations, the issue of severance clearly is not disappearing anytime soon. ‘The advice we are giving our clients is if you want to protect the core cash and stock incentives that are a source of great success for American companies, you need to be disciplined and flexible about your severance and other tangential programs,’ Kay says.

Planning ahead

A board first should see what the company’s total exposure might be. If directors are not using a tally sheet to understand the total amount that would be due, whether for termination, retirement, voluntary departure or change in control, they should start. Although that might seem like advising someone to pay heed to the law of gravity when walking along a sheer cliff, no SEC requirement exists to calculate and disclose the entire amount, so nothing is forcing the board to do the math.

‘You have to show what is triggered by one of these events,’ says Laura Thatcher, head of executive compensation at Alston & Bird. ‘You don’t have to show a person’s already awarded equity grants. Similarly, you don’t have to show what he or she gets in deferred compensation payoffs or pension benefits.’ However, wise companies are putting all the information in one place to make it obvious both to the board and to investors.

Any tally sheet requires frequent updating to remain relevant, even if a total would be disclosed annually. But any tally is only as good as the numbers and assigning a value to severance is a complicated process, especially when stock options are involved. ‘At the end of the day, what you have is a Black-Scholes evaluation,’ says Thomas Twedt, a partner in the corporate securities practice of law firm Dow Lohnes. ‘I’ve seen differences in [stock value] numbers from last year to this year because of the volatility assumptions and just the overall stock prices have gone down.’

One positive result of making everything as clear as optical glass is that the SEC proxy disclosure requirements become a major negotiating tool in a severance situation. The compensation committee can make it work for the company when a departing executive wants more. As explained by Megan Gates, co-chair of the securities practice group at law firm Mintz Levin, this is a convenient way out. The board can say, ‘It’s beyond our control; we don’t want to expose ourselves and the company to a potential lawsuit by stockholders who say, You guys have mismanaged our assets.’ Small and mid-sized corporations might find this tack the most useful, as they were the ones who most often pay more-than-planned severance, according to the findings in the Watson Wyatt study.

A further negotiating tool is the personal circumstances of the individual being hired. Someone with significant personal wealth might not need the security of hefty severance, and a board should keep this in mind when establishing compensation terms.

‘[Boards] are not going to the max anymore,’ says Jack Dolmat-Connell, CEO of DolmatConnell & Partners. ‘They are not going to the 3X salary, full acceleration, full gross-up. You may be seeing 2X base and bonus. You may be seeing partial acceleration of equity.’ Tax gross-ups and other bells and whistles are also coming under a great deal of scrutiny and are even being phased out in some cases.

Of course, the circumstances of an executive departure have a significant impact on the amount of severance. ‘In the recent terminations I’ve seen, if the company doesn’t have any real evidence of malfeasance but decides that the company is going in a new direction and the CEO doesn’t have the skill set to go in that direction, then the CEO has considerable leverage,’ Gates says. ‘[The mindset is], I brought the company this far, so if they want me to go, then I’m owed something in addition to what we negotiated. But if there’s a hint of malfeasance or some other bad act, the board has the leverage to say what it negotiated at the outset is more than sufficient.’

Sunset clauses are becoming much more important for boards. Instead of having benefits fixed for all time, severance can gradually reduce with the time the executive spends at the company. ‘You’ve either done well, started to accumulate wealth in the equity plans you’ve been given and don’t need that protection any more, or you haven’t done well,’ says Becker. The severance benefits can begin to wind down after about two to three years and can then completely phase out in five years.

Companies should be careful to very clearly define what payments will be made in the event of a change in control and also should define what constitutes a change. ‘Does it change when 30 percent or 50 percent or 51 percent is acquired by someone else?’ Polachi asks. A further consideration is: what happens if the board that negotiated your employment changes? If the terms of the agreement are vague, a CEO might take advantage  of the ambiguities and push the new board to change the conditions. The more specific the severance agreement is, the less chance it has of being accidentally triggered or renegotiated.

Multiple triggers relating to a change in control can help to clarify severance conditions. ‘There has to be a change of control and then a subsequent termination or diminution of responsibilities,’ rather than just the change in control, Becker says. Some of the double-triggers can include lowered responsibilities, lowered compensation or a demand for the executive to move more than some fixed distance from his or her current home.

‘There are some interesting things going on out there,’ Dolmat-Connell says. ‘JC Penney, which filed [its disclosure in 2008], took a look at getting rid of the tax gross-ups if executives had been there for five years. Cardinal Health also has a declining severance multiple based on tenure. I think it starts at three years and goes down to 18 months, if the executive has been there for more than two years. What this says is that events that might lead to a departure generally happen in the first couple of years.’

A company might even suggest dropping severance altogether. Don’t laugh, it happens. Particularly when a company sees a change of control is likely in the near future. ‘I’ve seen two or three times when [there has been no severance agreement],’ says Barbara Schlaff, a partner with law firm Venable. ‘It was the executives who were forward-thinking and knowing what’s going to happen down the line with shareholders and [proxy advisory services]. The board loves it. The shareholders love it.’ It makes for a universally happy ending.