The Problem with Today's Severance Payments: Conflicts of Interest and More

Paul Hodgson is Senior Research Associate of The Corporate Library

Recent objections to the merger between the two health insurers Anthem and Wellpoint Health Networks have focused on the excessive severance arrangements in place for all of Wellpoint's officers should they be terminated following the merger. Estimates of the potential termination costs range from just over $170 million to more than $600 million, thought the company estimates them to be closer to $200 million.

There are two issues to be dealt with here. The first is that high levels of "transaction payments" result in a severe conflict of interest for executives. The second is that change of control severance payments at their current levels mean that all mergers waste some of stockholders' money, whatever the cost savings in the long term.

The conflict of interests engendered by such payments is disclosed in the proxy/prospectus in the Form S-4, filed recently by Anthem (http://www.sec.gov/Archives/edgar/data/1156039/000095012304006164/c81091a1sv4za.htm#121). It indicates that Wellpoint's directors and executives have financial interests in the merger. This is an understatement. The proxy/prospectus goes on to describe them:

"WellPoint's directors and executive officers have interests in the merger as individuals that are in addition to, and that may be different from, their interests as WellPoint stockholders. Each of the Anthem board of directors and the WellPoint board of directors was aware of these interests of WellPoint directors and executive officers and considered them in its respective decision to approve and adopt the merger agreement.

These interests include:

An employment agreement with WellPoint's Chief Executive Officer and a severance plan covering certain officers of WellPoint and its subsidiaries that provide these officers with various severance benefits if their employment is terminated following the merger;
Certain cash payments upon the completion of the merger and, if employment continues through specified periods following the merger, cash payments after the merger under the employment agreement with WellPoint's Chief Executive Officer and the severance plan covering certain officers of WellPoint and its subsidiaries;
Acceleration and vesting of options and restricted stock for executive officers of WellPoint if the executive officer terminates employment under certain circumstances after the merger; and
The right to continued indemnification and insurance coverage by the combined company for events occurring prior to or at the time of the merger."

"Certain cash payments" is a euphemism for (1) guaranteed bonuses in the year of the change of control and (2) change in control completion bonuses. The guaranteed bonuses ensure a high level of reward in the year the change of control takes place, whatever the performance of the combined company. Change in control bonuses are made up of 100 percent of salary and bonus. These benefits cover all officers of the company, numbering almost 300. In addition, if these officers are terminated through no fault of their own, they will receive 300 percent of salary and bonus, with continuation of welfare benefits, credited pension service, financial counseling (as in help with answering the question: "what am I going to spend all of this money on?") and outplacement services.

Such arrangements do not so much create a conflict of interest between Wellpoint management and Wellpoint stockholders, as they create a climate whereby it would hardly be surprising if officers had not spent most of their time searching for a company – any company – to merge with.

In addition, all equity awards vest immediately on a change of control. There is some justification for equity awards to vest immediately if an officer is terminated without cause; but for them to vest immediately, whether there has been a termination or not, does not make sense. Equity awards for continuing employees should simply be assumed by the surviving entity.

Of course, the largest share of the employment-related transaction costs will go to Wellpoint's CEO, Leonard Schaeffer. Schaeffer's employment agreement was amended and restated in December 2002 and has a fixed five-year term (http://www.sec.gov/Archives/edgar/data/1013220/000104746902008794/a2097358zex-99_1.htm). The proxy/prospectus indicates that he will continue as chairman of the new company until the second anniversary of the merger and then will retire. Such a retirement would not seem to be a termination without cause or a constructive termination. But Schaeffer's new employment agreement only defines "without cause" by saying it is not "for cause". So under virtually any termination that is not for cause, Schaeffer will receive severance benefits.

The clause says if "within 36 full calendar months after a Change in Control Executive is subject to a Constructive Termination or an involuntary termination (other than by reason of Cause, death or Disability)" he will receive the payments. Retirement would seem – to a common sense view – to be a voluntary termination, but no doubt another view will be taken. Indeed, it would appear from statements by the company that severance payments will be made because Schaeffer is relinquishing his position as CEO, therefore a constructive termination has taken place. Given management's full support and recommendation of this merger, it would seem to me that Schaeffer is voluntarily relinquishing his post, but again, no doubt another view will be taken.

In any case, it is certain that Schaeffer will receive a "guaranteed bonus" in the year of the merger, and a "completion bonus" in two stages after that; the final payment being made, conveniently, just before he "retires". The calculation of the bonus element of the completion bonus is one of the most convoluted I have ever read, but it roughly translates as "the highest amount we could possibly come up with." The guaranteed and completion bonuses could lead to payments of up to $13 million, depending on the date of the merger. And that is before any severance amounts are included.

Severance on a change of control will amount to three times salary and bonus (approximately $22 million), outplacement services and three years credit under 401(k) and non-qualified retirement plans, with full matching contributions. For the purposes of the supplemental retirement plan, Schaeffer will be deemed to have at least five years' vesting service, as well as three additional years of service, and – in the curious logic of executive compensation – he will be "deemed to be three years older than his actual age". Other benefits that may also be provided under the regular severance plan continue for even longer, four and five years in most cases. These are:

". . . continued medical and dental coverage, for 48 months following termination (or longer in certain circumstances), full title and ownership of the automobile then provided to Mr. Schaeffer, continued financial counseling benefits for five calendar years following the year of termination, office space and clerical support for 60 months following termination, such other benefits as are determined in accordance with the Company's employee benefit plans and retiree health benefits (in addition to any other health benefits) in accordance with Mr. Schaeffer's current "grandfathered" arrangement status."

And, of course, all equity awards will vest immediately on the change of control. In addition to all this, if the entire golden parachute is liable for excise tax because it is deemed excessive by the Internal Revenue Code – hardly an unlikely occurrence – Schaeffer will have the tax paid for him. Of course, Schaeffer is no stranger to tax gross-ups. On two separate occasions in the last fiscal year, he has received tax gross-up payments.

First, in February 1999 Schaeffer received an interest-free loan to pay taxes on vested restricted stock. That loan was forgiven this year. Second, again this year, he received a $2,000,000 "special bonus" "to assist Mr. Schaeffer in paying income taxes with respect to performance-based compensation earned under the agreement". With compensation in excess of $32.5 million in 2004 alone, not including the loan forgiveness and other tax gross-ups, it might be expected that Schaeffer could take care of his own tax bill. Evidently another view was taken.

Wellpoint at one time estimated Schaeffer's entire severance costs at a total of $76 million, but has since used other figures.

A recent press release from Wellpoint (http://ir.wellpoint.com/phoenix.zhtml?c=82476&p=irol-newsArticle_general&t=Regular&id=581468&) sheds some clarity on the situation, but also contains a justification of the severance arrangements at the company.

"WellPoint's executive compensation program, including change-in-control severance benefit and stay bonuses, that was adopted by the Board of Directors based on independent expert advice, has been in place for years, has been fully disclosed and is consistent with market practice."

This would be all right if 1) the age of severance benefits, 2) disclosing severance benefits and 3) the fact that everyone else is doing it were acceptable excuses, but one of the claims is not even true. While change of control severance payments of three years' salary and bonus are standard market practice, the level of completion bonuses at the company is now far from common. Furthermore, while severance is in line with the market, it ignores the fact that the market is out of line with both good business and common sense.

I have said it before, and I will keep saying it, severance payments should offer financial protection if employees are terminated through no fault of their own. More than adequate protection is offered by the payment of a single year's salary. Multiples of this, and the inclusion of so-called incentive payments in the calculation, have no place in such protection. Furthermore, if employment is gained elsewhere during the first year following termination, payments should cease immediately. Such moderate severance and a complete ban on transaction or completion bonuses, would remove any suspicion of a conflict of interest between stockholders and management in most mergers.

So why are objections being raised against this merger on account of the high cost of severance? Until the modest severance benefits outlined above are standard market practice, every merger with typical change of control severance benefits – not just this one – represents an unnecessary waste of stockholders' money. It is not enough to say, as Wellpoint's CFO does, that "over $2.0 billion will be achieved in savings, versus the one-time severance costs of $200 million." Stockholders would far rather see savings of over $2 billion, and severance costs at a fraction of their current levels.