How to Devise and Utilize the Appropriate Tally Sheets (10/12/06)

1. Tally Sheets and the New Proxy Rules
   1. The new proxy rules require disclosure of “Total Compensation” in the Summary Compensation Table and “Other Potential Post Employment Payments” in a narrative discussion.
      1. The Company should modify its tally sheets to support the SEC disclosure requirements.
      2. The Compensation Committee should be provided with updated tally sheets when approving changes in the executives’ compensation.
   2. The new disclosure rules also require disclosure of the present value of pension benefits and non-qualified deferred compensation balances at yearend.
      1. We believe the tally sheet termination scenarios should also include a “total amount owed the executive as he or she walks out the door” (see Attachment).
      2. Thus, in addition to the payment of severance, acceleration of equity and continuation of benefits, this summary should include the value of vested equity, retirement benefits and deferred compensation owed an executive upon termination.
      3. 1. In addition to summarizing the Company’s total obligation to the executive, this analysis will also serve to raise questions about the need for certain programs and policies.
         2. For example, if an executive has $15 million in vested equity incentives, $6 million in pension and another $5 million in deferred compensation, what further post-employment arrangements or obligations should the Company have with the executive?
   3. The SEC has also requested that companies disclose the extent to which past compensation amounts are considered in setting other elements of compensation.
      1. This suggests that a tally sheet capturing prior gains from incentive plans will be necessary to allow the Committee to fully consider the impact of past compensation on current pay decisions.
      2. We also believe that projecting values on outstanding awards is also appropriate to help the Committee (and management) understand the level of incentives already “baked into” existing incentives.
2. Are the Tally Sheet Amounts Reasonable?
   1. One of the most common questions from Compensation Committee members and executives alike is “are these amounts reasonable?”
      1. For example, one of our clients was worried that a $50 million change-in-control tally for the CEO might be viewed as unreasonable, and asked me what was “typical.”
      2. The $50 million included $12 million in severance (based on a 3x salary and target bonus multiple); $5 million in accelerated time vested restricted stock and stock options; $2 million in enhanced pension benefits; $15 million in vested stock options; and $10 million in vested pension and deferred compensation. In addition, the excise tax grossup for Section 280G purposes was estimated to be $7 million.
      3. None of the specific CIC provisions (e.g., 3x severance multiple, excise tax grossup, accelerated equity vesting) was out of line with competitive practice, the executive was a long service employee (thus, the pension was built up over a full career) and the Company performed quite well, hence the considerable equity value.
      4. What “stuck in the Committee members’ craw” was the fact that the CEO had $25 million in equity and pension benefits, and he had previously cashed-in another $25 million in option gains over the last few years. The Committee felt the payment of severance of $12 million, enhanced pension of $2 million, and excise tax grossup of $7 million seemed unnecessary (they were okay with accelerating the previously awarded equity incentives valued at $5 million).
      5. Several alternatives were discussed:
         1. Ask the CEO to relinquish his severance contract. (Due to poor drafting of the agreement, a notice of contract cancellation gave the executive good reason to quit and collect 2x salary and bonus in severance.)
         2. Eliminate the excise tax grossup and limit the severance amount to the golden parachute safe harbor.
         3. Grant future equity awards with double trigger vesting.
         4. Amend the contract to include a covenant-not-to-compete to help mitigate the excise tax.
         5. Establish a policy that severance will be reduced $.50 for $1 for every dollar over $20 million the executive has earned through pension and equity incentives throughout his career. (Since he already earned $50 million, the $12 million in severance would be reduced to zero.)
         6. Do nothing for now, and benchmark his payments to amounts reported by peers in their 2007 proxy.
      6. As you might have already guessed, the Committee chose 5(f) above.
         1. While anecdotal, this experience confirms what many commentators fear will lead to a new round of benchmarking. For example, what if the CEO’s peers are entitled to more severance? How likely is it that the executive will agree to scale back?
         2. The Committee was very reluctant to “change the deal,” fearing the executive might quit.
         3. Personally, I like the “lifetime achievement” limitation cited in 5(e) above. Some will argue it penalizes executives for success and perversely pays the greatest amount of severance to the least successful, shortest service executive. On the other hand, it phases out severance for executives that do not need the payments to maintain their lifestyle, (and in all likelihood the lifestyle of their children, grandchildren and beyond). It also initiates a dialog with the Committee on how much wealth the executive compensation program should be targeting under different performance scenarios, as opposed to a year by year analysis of how pay compares to the survey data.
3. Action Items
   1. Update tally sheets to support proxy disclosure requirements.
   2. Carefully review termination scenarios for unusual or large payments:
      1. Severance multiples are applied to highest or maximum bonus rather than target or average bonus.
      2. Excise tax grossups, especially where the incremental after tax value to the executive is modest compared to scaling payments back to the safe harbor.
      3. Outstanding awards are paid out at maximum performance or are not prorated for time worked during the performance cycle.
      4. Final average earnings in the pension calculation is significantly increased due to the inclusion of the severance pay.
      5. Additional years of credited service or age unreasonably increase the present value of the pension.
      6. Pension formula includes equity gains in the final average earnings calculation.
      7. Lump sum pension is based on an artificially low discount rate.
      8. Retirement provisions result in full vesting of equity incentives at time of grant.
      9. The Company is obligated to provide all benefits, even in a for cause termination.
   3. Look at all payments, past and present when reviewing the reasonableness of the termination scenarios.
   4. Consider the potential value of existing awards in making current compensation decisions and evaluating the reasonableness of termination payments.
   5. Make sure the Company gets value in return for severance payments (e.g., covenant-not-to-compete, non-solicitation of employees and customers, waiver of claims against the Company) and can recoup or stop payments if the executive violates those covenants and restrictions.
   6. While “benchmarking” termination payments to peers to test the reasonableness of your arrangements is inevitable, avoid the temptation of using the data to justify expanding benefits.
   7. Consider including “lifetime achievement caps” in all severance arrangements.