Talking Points II - How to Fix Outstanding CEO Pay Packages and Agreements

Learn about obligations to re-examine, modify existing arrangements; fixing and adding "cause" provisions and claw backs; ways to address current excessive compensation and how to have a difficult conversation about rolling back pay; how to implement meaningful holding periods for outstanding equity compensation; and how to avoid traps for the unwary director when negotiating employment contracts and other compensation arrangements.

Here are some action items to consider:

1. Get a comprehensive tally sheet for the CEO's compensation.
2. Get copies of the CEO's employment and other agreements.
3. Determine whether the compensation mix or agreements contain any provisions that are "toxic" or could be improved.
4. Consider and design alternatives and develop bargaining strategy
5. Meet with the CEO.

Why must the Compensation Committee fix existing arrangements?

1. Board Liability Issues. Bad Publicity Issues
2. For the protection of the Board, the compensation committee, the CEO, and the Company's public image, the Compensation Committee should re-examine all existing arrangements. They must understand and be able to write in the minutes and proxy statement that they understand, each element of the CEO's compensation package, the value of the package under expected scenarios, and the potential value of the package under unexpected scenarios.
3. Emphasize their potential liability for not acting. If a court were to find that directors permitted a CEO to receive millions of dollars in excessive compensation by failing to meet minimal standards of due care by not considering basic information, such as the aggregate costs of a pay package, including severance costs, a court might find that the board abrogated its duties to the company and failed to act in good faith. This could mean that each director would have to pay out of his or her own pocket - without being reimbursed by the company or the D&O insurance carrier - several million dollars each.
4. Neither the executives nor the compensation committee members are well served by unrecognized components of compensation. As a best practice, the CEO should meet with the compensation committee and go through the tally sheet, with the assistance of any internal or external experts necessary to fully explain each component.
5. Directors should not be embarrassed that they don't understand all of the intricacies of an employment agreement, change in control agreement, deferred compensation plan or SERP. These can be very complicated. Let's face it, that is why many of us in this room have jobs, because it takes someone who has specialized in looking at, drafting and negotiating these things for twenty plus years. It is the rare compensation committee that has the requisite expertise to make complicated analyses - which now should be more complicated as more performance-based compensation is used - on their own.

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

Step one - a thoughtful, independent and comprehensive analysis of the complete compensation package:

• Tally sheet - base, bonus, equity, perquisites, retirement plans (SERPS), etc. - recognizing that market data is often skewed:
  • Holdover from the 90s
  • Understates true value of perquisites, SERPs, etc.
  • Selective presentation - e.g., showing the prevalence of gross-up provisions looking only to agreements in existence while ignoring situations where no agreements are in place (i.e., ignoring the zeroes)
  • Looking at pay elements separately - e.g., data show that 50% of agreements pay 2x compensation and 50% of agreements provide for accelerated vesting: how many do both?
• Performance analysis
• Understanding of existing agreements (employment agreements, change-in-control agreements, severance agreements, SERPs)
  • What do they say?
    • Promises as to future compensation - base, bonus (guaranteed), equity
    • Term - specified? Automatic renewal?
    • Cause, constructive termination, change-in-control
    • Restrictive covenants - non-compete, non-solicit, etc.
  • How much do they cost under different scenarios - change of control, voluntary and involuntary termination?
• Compensation philosophy - pay positioning, internal equity, comparative framework

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. 

However, many Boards/Compensation Committees find room for significant improvement. For those Boards/Compensation Committees, step three is to devise and propose revisions to the CEO's total compensation and/or the terms of his/her employment and other compensation agreements. 

1. Devise revisions to the CEO's total compensation and/or the terms of his/her employment and other compensation agreements. Where to look?
   1. Fixing and adding "cause" provisions (employment and all other compensation agreements)
   2. Fixing and adding claw backs (employment and all other compensation agreements)
   3. Performance and performance metrics. When we compare the actual compensation to the company's and executive's performance, are we convinced that the amounts are necessary and appropriate to retain and motivate an executive we want to retain?
   4. SERPs, Severance and Change in Control. Have circumstances changed due to the CEO's tenure and/or success with the company, as well as unforeseen external factors (e.g., stock market values)?
   5. What is the actual amount of accumulated wealth, realized and unrealized, resulting from previous equity grants?
2. Why Now? Why Should a Board undertake this Unpleasant Task?

   Better late than never. A compensation committee that takes the bull by the horns and actually fix their past mistakes (which, may require rolling back excessive grants and pay packages) will have a powerful good faith defense, pointing out that it was not until now that someone pulled it all together in one place and made clear what needs to be looked for and addressed by every diligent compensation committee.

   Note that the former SEC Chairman Breeden's report on his special-committee investigation into alleged wrongdoing by ousted CEO Conrad Black, other departed executives and certain directors of Hollinger International concludes that the Board should be judged on its "entire record" including its attempt to clean up the mess.

3. Strategies for fixing packages and agreements

   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 - push enhanced disclosure - perquisites, change of control and severance benefits, 162(m) costs

   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

   • · Negotiate - eliminate gross-up in favor of more vesting, higher salary multiple, etc.