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Mar 31, 2007

Finding the right Remedy

Boards have tools to control CEO pay and severance packages

The New York Times has been running a series on CEO compensation that is the stuff of directors’ nightmares. On Tuesday, March 6, 2007, it was how AT&T had ‘stonewalled’ shareholder attempts for more say on pay; on March 7, about BP halving the bonus for its outgoing CEO; on March 9, Boston Scientific cuts its CEO’s bonus; four days later, Bristol-Myers begins requiring a three-fourths approval by independent directors for CEO pay, and the day after that, there was focus on Marriott’s CEO pay and how Citigroup’s CEO did well despite company performance falling behind many of its peers’.

Boards dislike such attention. But with new SEC compensation disclosure requirements and growing shareholder activism, they can expect even more scrutiny, particularly when the company head rakes in lots of cash on the heels of significantly disappointing corporate performance.

Companies, though, can avert unwanted notice surrounding compensation. According to many experts, boards have a range of tools available to help them control CEO compensation, particularly when it comes to granting what can be huge severance packages in takeovers or other less auspicious circumstances.

The cure involves better planning and preparation as well as more imagination in structuring compensation deals and more adroitness in negotiation. But before boards can address a problem, they have to realize that it exists. For directors, the first step is to understand the situation they are actually in and how they get themselves and their companies stuck.

The difficulties of a big severance pay-out don’t start with the departure of a CEO; they are the result of everything that the board has previously done – particularly regarding planning ahead for the inevitable departure of any CEO.

Preparation prevents problems

‘Some of those big [severance] packages have to do, in part, with board not doing a very good job with CEO succession planning,’ says Beverly Behan, managing director of the board effectiveness practice at Hay Group. A board with fewer alternative candidates, internal or external, will have a comparably weaker hand during negotiations.

Without effective succession planning, a board can feel pressure to do something quickly, because Wall Street isn’t patient with long searches and delays in appointing new leaders. Unfortunately, the greater the haste, the less strength the company has during negotiations with a candidate. Also, directors may feel that they have to impress large investors or that the institutions will second guess the choice of an internal candidate. The board may over-estimate the degree of talent and experience the company needs or simply want to distract criticism from major investors.

When a company has to recruit a successful executive from the outside, that inevitably means a person who already has a position. Prying the person loose is guaranteed to be expensive. ‘They’re walking away from a company where they may have been for ten or 15 years,’ says Hays’ national practice leader for executive compensation, Irv Becker.

At these times, boards look for ‘rock stars,’ according to Ed Harmon, a partner with law firm Thorp Reed & Armstrong, which means the board must ‘be prepared to pay abundantly.’ Beyond salary, that will include significant payments for severance if the company goes through an acquisition and there is a change of control.

On the surface this is completely reasonable, and companies don’t want to have people at the helm who are not savvy enough to watch for their own self-interest. Yet when they find the candidate, even if the directors are hard to please, they’ll find themselves smitten. ‘You’re always optimistic at that point of time,’ says Jack Dolmat-Connell, president of DolmatConnell & Partners. ‘Every couple that gets married thinks it’s going to last forever as well. Guess what? Approximately 50 percent of them don’t last. Everyone knows the statistics, but everyone goes into it thinking it’s not going to be me.’

Whether out of rapture or habit, when recruiting a new CEO, companies seldom remember that the average chief executive’s tenure is now between two-and-a-half and three years, says Chuck King, a managing director at Korn/Ferry. ‘Boards are much less reluctant to pull the trigger than they used to be,’ he says.

Avoid unpleasant surprises

This greater turnover means it is likely that a severance package will go into effect. ‘Unless you do some modeling to see what numbers may spit out down the road, these numbers can certainly sneak up and surprise you,’ says Sheldon Blumling, a partner with law firm Fisher & Phillips.

Dolmat-Connell agrees: ‘[The directors] usually do approve the terms and conditions … at X period of time, but they haven’t been modeled out so you see what they would be at [a later] point of time.’ Unless the board specifically examines what the compensation would be under different business scenarios at various times, the directors won’t see the cumulative results and that final figure could ultimately drive investors and the press into a frenzy.

Furthermore, the formation of the basic numbers is often flawed. Dolmat-Connell says there are problems with how corporations and even experts form the peer-group samples that are supposed to provide a baseline comparison of benefits, including severance. ‘We’ve walked into, I bet you, a dozen situations taking over executive compensation from other firms and I just shake my head at the peer group [comparison],’ he says. ‘It’s built for a company twice your size or it’s built against another industry or with companies you hope to compete against instead of companies you actually do compete against.’ In addition, when setting benchmarks for performance, boards often base pay on the company’s own budgets and forecasts rather than shareholder return of direct competitors.

Even when the board is reasonably careful, ‘the way a lot of these programs get approved is that they’re brought to the compensation committee separately,’ says Kathy Bonneville, a principal of PayCraft Consulting. ‘A tally sheet is something that a lot of institutional shareholder activists and other advisors use. It really is a summary of all the different pieces of [the CEO’s] compensation. It seems common sense that it would be information the compensation committees would have, but I don’t think it’s really been true. It takes a lot of time and effort to put together.’

Finally, at the end of the long list, comes the negotiation of the package with the future CEO. Most people in business think of themselves as good at making deals, but smart negotiation involves a number of factors: the ability to say no, inventiveness in structuring new approaches to reach agreement, knowledge of the subject in contention, and experience doing that particular type of negotiation. Many companies ultimately are not at their sharpest at this type of thing. As already indicated, either they haven’t done the right planning and homework or they don’t listen to the recommendations of the experts they retain. Additionally, they often approach the actual negotiation process ineffectively.

‘When someone from the general counsel’s office is involved, they’ll be knowledgeable, but they may be looking at it from a legal perspective and not from a total compensation perspective,’ Bonneville says. The lawyer might not be aware of new ways to structure severance or bonuses to mitigate the result of a CEO leaving under poor circumstances, or might not really know what the market might bear.

Boards could also negotiate harder. ‘[CEOs and their lawyers] really come through asking for the moon,’ says Dolmat-Connell. ‘What I think they’re hoping for is that we’ll meet somewhere in the middle, but they more often than not get what they’re asking for. I’ve often seen 80 to 90 percent of the proposed contract terms and conditions go through without any change or push back.’

Taking the right steps

Boards can take steps to significantly improve the CEO pay situation. It’s not a lost cause. After all, McDonald’s was able to replace two CEOs following health issues, with few significant problems. One key step is to start the planning process early. Other moves include anticipating severance issues with modeling, correctly structuring a peer group and working with professionals to develop a strategy. Bringing in outsiders helps reduce the problem when ‘one of the members of the board or compensation committee who is setting up the whole search holds himself out to be a compensation expert when nothing could be farther from the truth,’ says Chris Sues, an executive compensation specialist at law firm Pryor Cashman.

Be sure to benchmark real measures of performance and not personal preferences that may have no bearing. Behan remembers a Canadian company that had a strong turnaround CEO who had a falling out with the board at contract renewal. ‘The guy who he brought in as a successor wore cufflinks with big dice on them,’ she says, while the board was ‘aristocratic.’ The uncomfortable directors literally went around the world looking for someone else to hire, but they were all too expensive, so they bit the bullet and hired Mr. Big Dice. He ended up being the company’s highest performing CEO.

Also consider using emerging approaches to limiting compensation, such as sunset clauses, where cash severance phases out. ‘I’m starting to recommend that and no one has taken me up on it yet,’ say Ira Kay, an executive compensation consultant at Watson Wyatt Worldwide and author of the upcoming book Myths and Realities of Executive Pay. ‘We’re saying … after five years that you’ve either done well on your stock or haven’t and you shouldn’t be entitled to cash severance in addition.’

Kay also suggests setting the severance plans at the industry average at most, so shareholders don’t end up paying a premium for average (or below) performance; limiting supplemental pensions and redirecting that part of compensation on a pay-for-performance basis; and not targeting the 75th percentile for compensation and severance, but instead tying increases over the median to increased performance.

There are many things a board can do to improve control over CEO compensation. The even better news is that much of the work can happen ahead of time with no driving rush, so when the day for replacing the chief executive comes, directors will find that the best news really is no news.

Erik Sherman

Erik Sherman regularly covers business and technology for national and international magazines and is also a book author and playwright