- from the "1st Annual Executive Compensation Conference" (10/04)

Talking Points – Severance Payments

Mike Kesner is Head of the Executive Compensation Practice for Deloitte & Touche LLP

1. Severance Agreements Negotiated At Termination
   1. Great care should be taken when negotiating benefits for a terminating executive where no prior agreement is in place or where the Board wants to go beyond an existing severance arrangement or policy.
   2. Business reasons for doing so should be clearly established e.g.,
      1. Tighten or create restrictive covenants.
      2. Ensure access for transition issues, such as ongoing or potential litigation.
   3. Accounting, tax and reporting implications should be clearly understood.
      1. For example, extending the exercise grace period on outstanding stock options could result in significant accounting charges.
   4. The economic cost of the revised benefits should be quantified – both cash and noncash benefits (more on this below).
      1. For example, the Black Scholes value of stock options that are accelerated or extended is often overlooked, but represent real value.
2. Controlling severance costs
   1. It is essential that the Board/Compensation Committee quantify the cost of severance arrangements prior to approval.
      1. It is also recommended that these arrangements be reviewed periodically and the cost estimates updated.
      2. Companies should consider revising the agreements if costs get out of line with the original estimates due to changes in compensation, stock price, discount rates, etc.
      3. The Committee should always retain the right to terminate the plan without the participants’ consent (except perhaps in a threatened or actual CIC situation).
   2. The best way to control severance costs is through proper plan design.
      1. Benefit multiples (1x, 2x, 3x) should be based on competitive practice and remain within institutional investor guidelines.  Typically two or three tiers of benefits are appropriate.
         1. For example: 
            CEO – 2x
            EVPs/SVPs – 1.5x
            VPs – 1.0x
         2. Benefits should not be so attractive that it unintentionally provides executives with an incentive to be terminated.
      2. The severance formula should be based on salary and a reasonable definition of the annual bonus
         1. Target bonus or
         2. Average of prior two years
         3. Lower of target or average bonus
         4. Use of maximum bonus or highest bonus earned are not appropriate
      3. Long term incentive payouts or the Black Scholes value of past stock option awards should never be used in the severance calculation (however continued vesting of existing awards, which is discussed below may be appropriate).
      4. Continued vesting of stock options during the severance period and prorata incentive payouts based on actual results are reasonable.  Provisions that provide full year maximum bonus payments regardless of performance and time worked should be avoided.
      5. Eligibility for benefits should be strictly limited to executives who are terminated without cause (and if C-I-C, termination for good reason).
         1. Retirees, burnt-out execs looking for a change of scenery and dishonest employees should never be provided benefits
         2. Termination for cause provisions should be more expansive to ensure chronic non-performance is grounds for dismissal.
      6. The Company should receive valuable consideration for providing severance.
         1. Restrictive covenants
         2. Waiver of future lawsuits
         3. Ongoing access to executive for reasonable period of time
      7. SERP enhancements should be capped.  Increases in final average earnings used in pension/SERP calculations, should be limited to 110% of final average earnings.
      8. Benefits and Perquisites
         1. Try to limit benefit continuation to items designed to protect the executive from catastrophic occurrences such as health and life insurance protection.
         2. Avoid continuing to provide perquisites.  The company no longer derives any economic benefit from providing these perquisites to a terminated executive.
            1. If you must include perks, be sure to carefully quantify the cost of each item upfront.
            2. Consider capping at a specific amount.
            3. Avoid promising airplane usage, country club dues, and office and secretary.
      9. Golden parachute excise tax grossup provisions should be used sparingly.
         1. Also, provide for golden parachute cutback provisions if the executives’ payments do not exceed 101% to 120% of their applicable safe harbor.
         2. Be sure to quantify the cost of this provision under a range of possible scenarios, since the cost can be very sensitive to cash compensation increases, stock price changes and progress through the vesting schedule.