Talking Points: Reconsidering Outstanding CEO Pay Packages and Agreements (10/11/07)

Michael Melbinger, Winston & Strawn LLP

  1. Why must the Compensation Committee fix existing arrangements?

    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. (See, In re The Walt Disney Company Shareholder Litigation, New York Stock Exchange v. Grasso).
     

    1. New Executive and Director Compensation Disclosure Rules make it easier for investors and the media to understand every element of the compensation package. The Committee must understand and demonstrate 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.
    2. Neither the executives nor the compensation committee members are well served by unrecognized components of compensation.
    3. 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. Better late than never. The compensation committee will look great if it eliminates past excesses. Directors should not be embarrassed that they did not (or do not) understand all of the intricacies of an employment agreement, change in control agreement, deferred compensation plan or SERP. These can be very complicated.
       
  2. 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

    (a) SEC disclosure rules

    (b) Recent litigation and SEC enforcement actions

    (c) Tools to facilitate thoughtful and informed decision-making (e.g., tally sheets, internal equity analysis, wealth accumulation targets, etc.)

    (d) Good governance best practices:

    (i) Independent advisor(s)

    (ii) Executive sessions after every meeting

    (iii) Committee composition – independence, competencies, commitment

    (e) Shareholder climate

    (f) Key elements of executive contracts:

    (i) Contract term/renewal provisions

    4. (ii) Cause

    (iii) Constructive termination (e.g., “good reason” and “open windows”)

    (iv) Change in control

    (v) 280G – gross ups, etc.

    (vi) Claw backs

    (vii) Restrictive covenants – non-compete, non-solicit, etc.

    (g) 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. Develop tools to assess executive pay and executive contracts thoughtfully and holistically

    (a) Tally sheets – base, bonus, equity, perquisites, retirement plans (SERPs),

    (b) 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.

    (c) 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.

    (d) Identify, understand and quantify other benefits, such as perquisites, tax gross-ups, special retirement benefits, etc.

  6. 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?

    (a) Understand the circumstances under which benefits are paid:

    (i) Change-of-control – single trigger or double trigger

    (ii) Terminations unrelated to change-of-control

    (iii) Benefit formulas – accelerated vesting, cash payout (multiple of base and/or bonus), continuation of benefits and perquisites, post-employment “consulting” arrangements, etc.

    (iv) Key definitions - “change in control,” “cause” and “good reason”

    (v) Contract term and renewal provisions

    (vi) Treatment of “golden parachute” excise taxes under IRC 280G

    (vii) Restrictive covenants – non-compete, non-solicit

    (b) Review recent SEC filings to confirm accuracy and transparency of existing arrangements

    (c) 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

    (d) Consider the impact of recent shift and/or increased use of restricted stock/units on payouts

    (e) Understand the impact of a change in control (and/or employment termination) on performance awards (e.g., equity awards with performance-based vesting)

    (f) Compare economic benefits and costs (to employee and company) under different stock price assumptions

    (g) Review payouts at the individual and aggregate levels

  7. Work off the new SEC disclosure tables for 2006 fiscal year, or as they will look for 2007. Is there anything we are embarrassed about? What do we wish looked better?

    (a) Understanding the total “value” of compensation to be disclosed to shareholders (and the public)

    (b) 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 “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 gross-up provisions

5. Eliminate executive health and other tax gross-up provisions

6. Eliminate single trigger and open window change in control provisions (in favor of double trigger)

7. Revise severance/change-of-control benefit formulas:

(a) Eliminate/revise bonus payout formula

(b) 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)

(c) Eliminate post-employment consulting provisions

(d) Eliminate "excessive" post-employment perquisite arrangements (e.g., travel, housing, security)

(e) Eliminate SERP enhancements

8. Specific strategies for fixing packages and agreements

(a) The new CD&A process is the perfect time to introduce (or re-introduce) the subject of rollbacks. The process of asking and answering the SEC's questions for Compensation Committees should point to some obvious areas for reform.

(b) The new disclosure rules – leverage new disclosure rules to drive better decision making by highlighting areas of concern and likely shareholder pushback, particularly with regard to perquisites, change in control and severance benefits and 162(m) costs

(c) Amendments for Code Sec. 409A. Leverage this process for improvements.

(d) Annual pay decisions (base, bonus, long-term incentives) are “easier to address” than existing contractual commitments.

(e) 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

(f) Leverage compensation philosophy – pay positioning, performance analysis, internal equity, philosophy around perquisites

(g) Carve out future awards – to mitigate accelerated vesting and/or golden parachute gross-up

(i) Options vs. restricted stock, performance shares

(ii) Modify annual bonus plan

(iii) Condition future awards on contract modification

(h) Negotiate – eliminate gross-up in favor of more vesting, higher salary multiple, etc.

(i) Consider introducing benefit caps – e.g., severance pay, 280G gross-ups

9. Consider substituting more acceptable perks and benefits for egregious ones.