Till Wealth Do Us Part - The Truth Behind Executive Employment Arrangements

formerly ACA Journal

Volume 11 Number 2 Second Quarter 2002

Till Wealth Do Us Part
The Truth Behind Executive Employment Arrangements

James F. Reda, Buck Consultants Inc.

The purpose of employment arrangements could be likened to the purpose of marriage. In marriage, two parties trade vows for lifelong stability. In employment arrangements, two parties trade monetary consideration for management stability. Stability in the latter example is derived from:

The improved comfort and reduced distraction of the executive
The certainty of employment arrangements that more clearly define the relationship between the executive and the company
The reduced harm an executive can cause the company by imposing restrictive covenants.

Similar to a prenuptial agreement, if the executive’s employment ends in an untimely manner, the severance benefits are clearly stated. This clarity will significantly reduce the amount of negotiation -- or time in divorce court -- necessary to come to final terms with a departing executive.

And like prenuptial agreements, substantial pitfalls are associated with employment agreements, but the advantages outweigh the risks. Each company should consider its employment arrangements in light of the current situation because what works for one company will not work for all. A careful review of external factors, such as prevalence of companies that compare to your company and their use of employment arrangements, should be completed before broaching such discussions with your board.

Employment agreements with senior management are typical, and usually fall into one or two major areas -- change-in-control (CIC) or employment and severance arrangements. A host of common design problems exacerbates the loss of the retentive power of pre-CIC programs and post-CIC severance. This article emphasizes CIC arrangements and reviews employment and severance arrangements, as well. (See Sidebar) “Defining a Change in Control” offers a brief definition of the basics of a CIC. (See Figure 3)

Also included in this article is a summary of the design features of programs that work in ways counter to what is expected. Most dilemmas cited were in place at mostly large, well-known, publicly traded companies. While the identity of specific situations is confidential, the examples include many high-profile business combinations in recent history.

Examining the “Prenup”
Golden parachutes and other executive compensation payments triggered by a CIC often are an essential part of an executive’s compensation package. The design of these arrangements can save or cost the combining companies’ shareholders millions of dollars. In the past 15 years, CIC arrangements have become standard operating gear for senior executives. The CIC protections also have been extended deeper into the employee ranks and, in some cases, cover the entire employee population. Extreme care and foresight should be applied to these types of arrangements before, during and after the change in control.

An important dynamic regarding CIC severance arrangements is that these programs typically are drafted before a potential business combination and, as such, more likely are weighted in favor of the pre-CIC executive group. While a generous CIC severance program helps to make executives neutral to future business combinations that could reduce or eliminate job opportunities, it creates challenges for combining companies in the pursuit of key executive talent retention.

The ideal result is balanced CIC severance protection that overcomes resistance to potential business combinations, but does not operate as an enticement for executives to jump ship in the middle of a transaction. Thus, the competitive levels of CIC severance protections are effective at ensuring that executives support pending business combinations, along with heightening the post-business combination retention challenges of the new organization.

The design, approval and implementation of CIC agreements are among the most important tasks of the compensation committee. Figure 1 offers a list of provisions to be considered. Some of the items listed require much discussion and thought before the board issues its final approval. CIC agreements should be discussed and approved by the compensation committee, then all outside directors and, finally, by the full board. Furthermore, CIC agreements are at least a “two-meeting” issue. It is very difficult, and perhaps too rushed, to discuss and approve these arrangements all in one meeting.

Figure 1 - Items in a Typical CIC Agreement

Type and number of executives covered

Tiers of coverage

Effective period of the agreement

Protective period of the CIC

Constructive termination definition applicable after the CIC

Trigger definition

Type of trigger initiating severance benefits

Potential CIC or pre-CIC protections

Cash severance payment multiple and components

Annual incentive payable in year of CIC

Long-term incentive payable in year of CIC

Pension enhancement

Continuation of welfare benefits (e.g., life, medical, etc.)

IRS Code Section 280G excise tax treatment

Qualified versus nonqualified benefits

CIC agreements also should be accompanied by cost estimates under various scenarios. Recent experience has shown that such estimates can be very costly. Recent disputes after the transaction argue the appropriateness of certain high-cost arrangements in the face of a CIC.

Because changes in company ownership almost always are followed by changes in staffing, the potential acquisition of one business by another creates tremendous uncertainty among the employees of the acquired company. This uncertainty can:

Distract employees from focusing on business issues. This is especially troublesome when top management should be at their best during a CIC.
Create disincentives for top management to initiate negotiations or even cooperate in negotiations that could result in a CIC that may be in the best interest of shareholders.
Create an incentive to pursue internal or external opportunities that carry lower risk of job loss, but may not offer the best shareholder value premium.

Singly or collectively, these factors can harm shareholder value.

Designing a Plan that Your Betrothed Will Sign
CIC severance benefits typically are provided in one of two ways:

Specific arrangements prescribed by various agreements and plan documents. For example, awards that vest over a period of years, such as stock options, restricted stock or nonqualified pensions, may have provisions to accelerate vesting or payout under certain CIC-related circumstances.

Comprehensive arrangements that cover various classes of employees. These programs couple severance benefits, such as cash payments to cover lost salary and bonuses, plus continuation of health and welfare benefits, with specific plan provisions previously described.

Beast of Burden: Design Considerations
Poorly designed CIC agreements can result in a benefits windfall for executives and a corresponding financial burden to the company. As a result, investors often view such programs with skepticism. The need for fairness to executives and investors increases the importance of proper planning and design of CIC arrangements. The following four general design principles can support these dual goals:

The program should provide compensation and benefits continuation as a bridge to new employment.
Severance benefits should be payable only in the event of involuntary termination or voluntary termination that occurs for “good reason” (i.e., “constructive” termination).
Compensation and benefits during the continuation or severance period should not be enhanced relative to what otherwise would be payable if employment had continued absent the CIC.
Employee rights to equity and other types of grants made and obligations, such as pension and insurance before the CIC, should be protected.

Additionally, several questions need to be addressed when designing a comprehensive CIC program. Figure 2 outlines these questions in general order of importance.

Figure 2 - Designing a Comprehensive CIC Program

Who will participate?

What constitutes a change-in-control?

Will the board have discretion to change the definition of the CIC trigger?

What events will trigger benefits under the program?

How long will the agreement remain effective?

How long will protection remain in place after the transaction is complete?

When will cash benefits, if any, be paid?

What benefits will be covered and what severance multiples will apply?

What is the effect of 20 percent federal parachute excise tax?

How will tax considerations be addressed for both participating employees and the company?

Cold Feet: Pitfalls of CIC Agreements
The pitfalls associated with CIC agreements are numerous, starting with issues that manifest themselves before a business combination (sometimes thwarting a business combination that otherwise would have occurred) and ending with short- and long-term issues that pop up after a transaction is closed.

Waiting at the Altar: Pre-transaction CIC Severance Design Considerations
Lack of CIC executive severance protection, interruption of retention protection before closing and a lack of specific guidance for determining incentive payouts are all features that have either thwarted a business combination, enhanced the likelihood of key executives leaving before the transaction closes, or increased CIC-related liabilities.

Plus, the lack of a competitive CIC severance program can create a significant disincentive to potential business combinations. There have been several large business combinations that were not completed primarily because of a lack of sufficient severance protection for top executives. Similarly, it is likely that the key corporate decision-makers who don’t have a strong CIC severance coverage are less vigilant in their search for business combinations that could jeopardize their roles.

Some companies facing a proposed business combination overcompensate for the lack of an existing program. In some cases, companies hastily adopt a CIC severance program in response to a known business combination. These companies establish protections that exceed median market practices. This is especially true in cases in which the business combination partner has pre-established CIC protections in place that are substantially better than the other business partner.

Many CIC programs fail to effectively describe the methodology for the payout of outstanding incentive-based pay. While most programs provide for full vesting of incentive awards upon a CIC, the determination of the deemed payout levels for the shortened periods is often incomplete and in most cases unworkable. Where specific guidance is lacking, some companies deem that performance objectives have been met. This leap of faith sometimes results in millions of additional dollars of cost, especially where the executive is entitled to a full gross-up for parachute excise tax.

Honeymoon Aborted: Things to Consider at the Close of Ceremony
Issues that arise immediately after the transaction typically relate to the degree of ease with which an executive may voluntarily leave and collect severance benefits. Severance triggers that are too easy to trip can result in millions of dollars of added cost, typically paid in the form of retention incentives. Examples include:

Shift of negotiating power to executives because of “single trigger” CIC arrangements.
Sensitive “good reason” termination triggers
Unintended CIC payments based on size of combining partners.

Heightened executive negotiating power often gets translated into costly renegotiation of CIC protections. Single and modified single trigger arrangements place an enormous amount of negotiating power in the hands of executives -- particularly when severance benefits are grossed up for excise taxes. This is especially wasteful for those executives whose employment was to be continued after
a CIC.

A single trigger arrangement allows an executive to voluntarily quit after a CIC -- for virtually any reason -- and receive severance benefits. A “modified single trigger” is similar, except that the window for leaving for any reason typically is limited to a one-month period that begins sometime after the CIC. At all other times within a modified single trigger arrangement, an involuntary termination (or a constructive termination) is required to receive CIC severance coverage.

In most CIC programs, the definition of a “good reason” for termination by the executive is so loose that the provision essentially becomes a single trigger arrangement. Constructive termination provisions may be designed to be very favorable to the executive by stipulating a very tight definition of duties, responsibilities, reporting relationships, pay and benefits levels and, in some cases, actual place of work. The tighter the definition of constructive termination, the more costly it may be to negotiate away these existing protections.

While it often is desirable to place limits on the types of pay changes that may be made, many “good reason” definitions handcuff the successor organization from making necessary changes. For example, the inability to transition health and welfare benefits programs to one system may negatively affect the integration of the two companies’ programs. Similarly, changes in incentive arrangements and retirement programs often are desirable, but not possible, when doing so would raise the specter of substantial severance liabilities. In some cases, the CIC arrangements would stipulate the executive’s reporting relationship must remain intact. This provision sometimes may be interpreted to include specific executives.

The market practice with respect to the threshold for determining whether a CIC has occurred is established at a point where even the dominant company is deemed to have undergone a CIC. Specifically, if a company’s continuing shareholders (after the business combination) represent less than 65 percent of the total shareholders, a CIC typically will be deemed to exist. Under this system, a business combination of near-equals would result in a CIC not only of the smaller company, but also of the larger company.

Learning to Love the In-Laws: Post-CIC Design
The types of post-CIC design problems are less susceptible of categorization. Some relate to severance protections that are so high they make retention virtually impossible, while others relate to ambiguous drafting and poor planning. For example:

Misguided negotiations out of parachute arrangements
Inadequately defined supplemental retirement provisions
Unclear or inflexible continued long-term incentive awards.

After a business combination has closed, it is common to renegotiate away CIC severance agreements and replace them with less costly programs. Done properly, such renegotiations can result in substantial savings in less gross-up payments. However, if done incorrectly, these negotiations can add to the after-tax cost to the company.

In search of lower after-tax costs, a company may negotiate itself into a position of higher after-tax costs if the negotiated agreement does not hold up to IRS scrutiny. Typically, a company vies for the conversion of a CIC payment arrangement into a much lower CIC payment arrangement, payable at time of CIC, and a reasonable level of compensation for services performed, including consulting arrangements and noncompete agreements.

The challenge of retaining employees after a business combination also may be influenced by the executive’s proximity to retirement age. While it may not be appropriate -- or in some cases legal, considering age discrimination rules -- to tailor the amount of severance benefit to the executive’s age, it should be considered as a design issue to align the severance payments with the type of termination following a CIC. For example, a $5 million benefit may be enough to convince an executive in his or her mid-50s to retire from an active career, whereas the same amount of money may not be sufficient to convince an executive in his or her early 40s to feel comfortable retiring.

Though unintentional, some CIC programs provide for long-term incentives in the payout multiple. Most CIC programs provide for a multiple of base salary and bonus to be paid upon a qualifying termination. However, some CIC severance multiples reflect an ambiguous reference to base pay plus “incentives,” creating uncertainty about whether long-term incentives are intended to be included. In addition to ambiguous language, the inclusion of long-term incentives in the severance multiple are on the rise.

Enhancements to supplemental retirement arrangements often are drafted in ways that are not easily interpreted across the array of typical retirement programs. For example, adding three years of age and service credits to supplemental retirement rights is fairly straightforward with respect to supplemental retirement benefits, but it can create confusion with respect to how the enhancement impacts early retirement programs and the timing of benefit payouts.

Another common source of confusion related to drafting lies in the assumptions to be applied to the addition of future age and service credits. An executive’s assumption that the final average pay calculation is to be extrapolated into the future (rather than relying on the final average pay that exists as of the severance date) can result in a dramatically higher benefit than anticipated by the company.

The trends found in the 70 agreements (See Sidebar) are based on the median of the total base salary, sign-on bonus, stock options, restricted stock and total compensation in the periods 1995-1996, 1997-1998, and 1999-2000. Overall, it was found that total compensation has been on the rise since 1995-1996 when it was at $9,575,000; it has risen to $44,432,585 in 1999-2000.

In addition, the percent of the total compensation devoted to the sign-on bonus and restricted stock has risen as well. The sign-on bonus has gone from 1 percent of the total compensation in 1995-1996 to 5 percent in 1999-2000, while the restricted stock has gone from 0 percent in 1995-1996 to 17 percent in 1999-2000.

Obviously, the percent of total compensation accounted for by base salary and the grant date value of stock options has been decreasing since 1995. The base salary, which once was 8 percent of the total compensation in 1995-1996, has decreased to 2 percent in 1999-2000, while the grant date value of stock options has gone from 91 percent in 1995-1996 to 76 percent in 1999-2000.

The change in how corporations compensate executives is due to the growth of our economy, the increase in the use of employment agreements, and the willingness of companies to pay top dollar for the best skills and experience. As long as the U.S. continues to grow and expand, the amount of compensation and enticements provided to our top executives in their employment agreements will continue to increase as well.

To Have and Disclose: Employment and Severance Agreements

An employment agreement that includes a severance agreement is the other major category of agreements. The primary difference between the two major classes of employment agreement is that a CIC agreement is applicable after a CIC, and the employment agreement is typically applicable before a CIC. In addition, the cash severance benefits pursuant to a CIC agreement are substantially greater than that under a severance agreement.

To assist in the review of employment and severance agreements, senior executive employment agreements will be the focus. In recent years, CEO employment agreements have become fundamental documents that define what is expected from a senior executive and what the executive obtains in return.

The CEO employment agreement is a bellwether for employment agreements as it sets the upper level of benchmark. CEO agreements are more readily accessible for review as publicly held companies must disclose employment arrangements with their named executive officers, including the CEO.

One of the most important functions performed by a board of directors or compensation committee involves selecting the right CEO candidate and establishing an appropriate pay package. The CEO’s pay package sets the tone for overall executive compensation programs. The pay package will be disclosed to the public and will be available for comment by the national press. Finally, as the rate of turnover among CEOs increases, directors must strike a balance between shareholder interests and the need to offer attractive incentive opportunities for a new CEO.

A survey of 70 employment agreements with new CEOsI includes a review of CEO employment agreements for the period. The companies represent a variety of industries, including high technology and transportation.

The survey of CEO pay earned in the first year includes components of compensation as follows:

Salary at the new rate annualized to cover a full year of service

Annual bonus for the most recent year. The annual bonus generally reflects a guarantee for the first year at a new company.

Sign-on bonus for the agreement (cash or unrestricted stock)

Initial long-term incentive award, which usually consists of a large stock option award, but also can include restricted stock or cash-based long-term incentive arrangement.

How Ozzie and Harriet Got Hitched: A History of Agreements
In the 1950s – and earlier – it was very uncommon for CEOs to have agreements with their respective companies; today, roughly 58 percent of CEOs now have agreements based on a sampling of companies reporting in The Corporate Library, 2001 (a review of the employment agreements with S&P 500 companies).II This dramatic rise over the years in the use of employment agreements has occurred due to two reasons:

Asking for an agreement from your company was seen as an act of disloyalty and was therefore unfavorable.

CEOs generally had a long tenure with their company and rose through the ranks, so an agreement was usually unnecessary. Once it became more common for CEOs to be hired from outside the company, employment agreements became more popular.

Reasons for Exchanging Vows
There are various reasons for and advantages of using CEO employment agreements. A recent survey on executive employment agreementsIII listed eight main reasons why companies use employment agreements. They:

Help retain key executives

Provide severance protection

Satisfy the request of the executive

Formalize components of compensation and benefits

Establish non-compete covenants

Help attract new executives

Provide change-in-control severance protection

Formalize roles and responsibilities.

Also, the existence of an employment agreement can in fact accelerate the severance process of a CEO as the severance provisions have been agreed to and are spelled out in the agreement. This substantially reduces the negotiation involved with CEO severance.

There are similar advantages of using employment agreements. These advantages are characterized as:

Agreements help define what is expected from the CEO.

They allow the CEO to have special benefits not offered to other employees.

They help minimize conflict in the case of dismissal or legal matters.

They give the impression that the CEO will be with the company for an extended period of time.

There are several high-profile cases whereby the existence of an employment agreement shrank the period of time necessary to vet out the terms and conditions of employment in the midst of a severance from months to days. The company can hasten the departure of a CEO on friendly terms by allowing the chief executive officer to terminate under the “constructive termination provisions” of the agreement that provides for a higher level of cash payments and benefits.

Figure 3 - Defining a Change in Control (CIC)

One of the most important components of a CIC agreement is the definition of events that trigger benefits under the CIC program. Most CIC agreements require both a CIC to occur and a termination of employment after the CIC. While the definition of change in control varies among companies and industries, it often includes:

Acquisition of a specified percentage of the company’s stock by a single entity or a group of entities acting in concert

The specified percentage typically ranges between 20 percent and 30 percent

An exception that should be included for acquisition by employee benefits plans or shares acquired by the company or with approval by the company or board

A changeover in the majority of outside directors within a specified time period (e.g., two years), unless new directors are approved by a specified percentage (e.g., 50 percent or 66-2/3 percent) of incumbent directors.

Source: © 2001 Mercer Human Resource Consulting Inc.

Wrapped Around Your Finger: Employment Agreement Components
There generally are six key components in a CEO agreement (the percent shown after each component is the frequency of use):

The effective date and term (100 percent)

Salary (100 percent)

Benefits and perquisites (95 percent)

Sign-on or other bonuses (57 percent)

Long-term incentives (stock options - 96 percent; restricted stock - 59 percent; and other incentives - 10 percent)

Severance provisions (95 percent).

Additional incentives such as club memberships and company cars vary depending on the CEO and the company, and the components change in value depending on the agreement. The most common components that are outlined in agreements have to do with the compensation that the CEO will receive. The amount of compensation that a CEO receives is a good indicator of the relationship between the board of directors and the CEO, as well as the performance of the CEO.

The Author

James F. Reda is a principal and compensation practice leader with the Atlanta office of Buck Consultants, Inc. Reda’s areas of specialization are senior executive employment arrangements, change-in-control metrics, business combinations, shareholder rights and corporate governance issues and long-term incentive arrangements, for both public and private companies. He has a bachelor of science in industrial engineering from Columbia University and an S.M., Management, Massachusetts Institute of Technology, Sloan School of Management. Reda has written two books in the field of executive
compensation: Pay to Win: How America’s Most Successful Companies Pay Their Executives (Harcourt: 1999), and Compensation Committee Handbook (John Wiley & Sons: 2001).

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Endnotes

I) Buck Consultants, Inc. Review of CEO Employment Arrangements, 2001.
II) The Corporate Library (2001). Report Year – 2001. Retrieved July 31, 2001 from the World Wide Web: http://fm.thecorporatelibrary.net/update/FMPro.
III) Hewitt Associates, LLC (1998). Survey findings: Executive employment contracts, pp. 1-21.