Talking Points: How to Fix Outstanding CEO Pay Packages and Agreements (10/12/06)

Why must the Compensation Committee fix existing arrangements?

How should the Compensation Committee go about re-examining existing arrangements?

• Step One – Establish a framework and process for thoughtful, informed (and motivated) decision making.

  1. Get it on the calendar – the Compensation Committee should periodically review existing arrangements, allowing ample time for education, analysis and deliberation
  2. Review the Compensation Committee Charter and related decision rights
  3. Education – to help “set the stage” for appropriate action the Compensation Committee needs to be kept apprised of recent developments, trends and best practices concerning executive compensation and Committee operations
     1. SEC disclosure rules
     2. Recent litigation and SEC enforcement actions
     3. Tools to facilitate thoughtful and informed decision-making (e.g., tally sheets, internal equity analysis, wealth accumulation targets, etc.)
     4. Good governance best practices:
        1. Independent advisor(s)
        2. Executive sessions after every meeting
        3. Committee composition – independence, competencies, commitment
     5. Shareholder climate
     6. Key elements of executive contracts:
        1. Contract term/renewal provisions
        2. Cause
        3. Constructive termination (e.g., “good reason” and “walking windows”)
        4. Change-of-control
        5. 280G – gross ups, etc.
        6. Restrictive covenants – non-compete, non-solicit, etc.
     7. Other legislative and regulatory developments – tax, accounting, etc.
  4. Compensation philosophy/guiding principles – from time to time the Committee should review (with management) the company’s compensation philosophy/guiding principles and revise as appropriate.
  5. Understand the competitive environment – historically it was not uncommon for “competitive market studies” relating to executive pay and executive contracts to be developed by management and/or their advisors. Not surprisingly, this led to a skewed, piecemeal and/or anecdotal presentation of the competitive environment. To combat these biases, Compensation Committees should take market data “with a grain of salt” and use such data only as a reference point. Common sense, informed deliberation, good judgment and adherence to the company’s compensation philosophy/guiding principles should drive decision making.
  6. Develop tools to assess executive pay and executive contracts thoughtfully and holistically
     1. Tally sheets – base, bonus, equity, perquisites, retirement plans (SERPS),
     2. Equity profiles – current equity holdings and their associated (intrinsic) value – vested and unvested, as well as recent/historical value realized (option exercises, restricted stock vesting, sales, etc.
     3. Pay/performance analysis – review recent and longer-term pay (by element) against company performance. Confirm that pay is aligned with performance objectives and pay positioning.
     4. Identify, understand and quantify other benefits, such as perquisites, tax gross-ups, special retirement benefits, etc.
  7. Understand existing executive pay arrangements – contracts and other agreements (employment agreements, change-in-control agreements, severance agreements, SERPs) – who is covered and what do they say?
     1. Understand the circumstances under which benefits are paid:
        1. Change-of-control – single trigger or double trigger
        2. Terminations unrelated to change-of-control
        3. Benefit formulas – accelerated vesting, cash payout (multiple of base and/or bonus), continuation of benefits and perquisites, post-employment “consulting” arrangements, etc.
        4. Key definitions - “change-of-control,” “cause” and “good reason”
        5. Contract term and renewal provisions
        6. Treatment of “golden parachute” excise taxes under IRC 280G
        7. Restrictive covenants – non-compete, non-solicit
     2. Review recent SEC filings to confirm accuracy and transparency of existing arrangements
     3. Calculate costs/benefits under executive contracts - cash, equity and other benefits under different scenarios – termination (with and without cause), voluntary resignation (with and without good reason) and change-of-control
     4. Consider the impact of recent shift and/or increased use of restricted stock/units on payouts
     5. Understand the impact of a change-of-control (and/or employment termination) on performance awards (e.g., equity awards with performance-based vesting)
     6. Compare economic benefits and costs (to employee and company) under different stock price assumptions
     7. Review payouts at the individual and aggregate levels
  8. Prepare mock-ups of SEC disclosure tables – presentation of existing arrangements in tabular form as required under the new SEC disclosure rules can be very enlightening and can help to motivate the Compensation Committee to appropriate action.
     1. Understanding the total “value” of compensation to be disclosed to shareholders (and the public)
     2. Post-employment arrangements, such as severance and change-of-control
• Step two - discussion and deliberation. Are the amounts, terms and structure appropriate? Are they consistent with the company’s compensation philosophy Some Boards/Compensation Committees may conclude that the amounts and terms are appropriate and be satisfied that they have discharged their fiduciary duty to shareholders by studying the issue.
• Step three - devise and propose revisions to executive pay/contracts.
  1. Fixing and “cause,” “good reason” and related provisions (employment and all other compensation agreements)
  2. Fixing and adding claw backs (employment and all other compensation agreements)
  3. Reducing or eliminate perquisites, gross-ups, etc.
  4. Eliminate 280G and other tax gross-up provisions
  5. Eliminate single trigger change-of-control provisions (i.e., in favor of double trigger)
  6. Revise severance/change-of-control benefit formulas:
     • Eliminate/revise bonus payout formula
     • Moderate vesting acceleration (e.g., consider something less than 100% acceleration, particularly with regard to full value shares, such as restricted stock/units and performance awards)
     • Eliminate post-employment consulting provisions
     • Eliminate post-employment perquisite arrangements (e.g., travel, housing, security)
     • Eliminate SERP enhancements
• Specific strategies for fixing packages and agreements
  1. The new CD&A process is the perfect time to introduce (or re-introduce) the subject of roll backs. The process of asking and answering the SEC's questions for Compensation Committees should point to some obvious areas for reform.
  2. Annual pay decisions (base, bonus, long-term incentives) are “easier to address” than contractual commitments.
     • Leverage compensation philosophy – pay positioning, performance analysis, internal equity, philosophy around perquisites
     • Disclosure – leverage new disclosure rules to drive better decision making. Mock-ups of required proxy disclosure help to highlight areas of concern and likely shareholder pushback, particularly with regard to perquisites, change of control and severance benefits and 162(m) costs
  3. Dealing with contracts – cannot be amended unilaterally. May be particularly challenging when there are multiple executives and/or automatic renewal provisions; reason by no contract or contract with limited terms are preferable
     • Carve out future awards – to mitigate accelerated vesting and/or golden parachute gross-up
       • Options vs. restricted stock, performance shares
       • Modify annual bonus plan
       • Condition future awards on contract modification
     • Negotiate – eliminate gross-up in favor of more vesting, higher salary multiple, etc.,
       • Consider introducing benefit caps – e.g., severance pay, 280G gross-ups
  4. Consider substituting more acceptable perks and benefits for egregious ones.