Executive Severance Practices

Michael Powers is a Partner of Hewitt Associates

• Area of keen interest for board members, institutional shareholders, and the media
  • Each constituency may have differing views on what is "appropriate and reasonable"
  • Facts and circumstances around the termination of employment are very important
• Topic includes both "regular" and change-in-control severance policies/practices

"Regular" Executive Severance Protections

• Objective
  • Provide reasonable transition pay to retirement or next employer, following involuntary termination without "cause" or voluntary termination for "good reason"
• Typical marketplace practice
  • Provide 1×–2× "pay" for senior-most executive officers. Pay generally defined as annual base salary plus target bonus, but not long-term incentive grants.

Areas Where Some Have Gone Astray

1. Going beyond what is reasonable transition pay to retirement or future employment
2. Severance multiples that go beyond 1×–2× pay
3. Pay definition based on highest bonus
4. Lack of caps, particularly where annual bonus is major component of total pay (e.g., financial services sector)
5. Severance pay for remainder of an employment contract term
6. High severance pay for very short-service executives
7. High severance pay for poor performance/failure
8. Vague standards for "good reason" and "for cause" termination provisions
9. Accelerated vesting on SERPs or long-term incentives (beyond that provided in equity incentive award agreement or plan document)
10. Getting little in exchange for severance provided (should consider no-compete, non-solicitation provisions, etc.)

Action Items

1. Conduct periodic/detailed review of existing severance policies vs. market best practices, including full board review on CEO severance protections, resulting in reasonable limits/protections
2. Limit one-off negotiations of exit packages, where severance policy serves as the floor value provided to executive
3. Ensure board has full understanding of potential costs and benefits provided (tally sheets). Compensation committee should review severance policies during a period where no terminations are in process.
4. Expert/independent advice where contracts are negotiated or severance policies are reviewed
5. Review appropriateness of non-compete/non-solicitation provisions

Change-in-Control Severance Protections

• Objectives
  • Sufficient protection such that executives will consider, even seek out, deals that are in the shareholders best interests, even if their employment might be in jeopardy (keep executives neutral to doing a deal)
  • Align the interests of professional managers and shareholders in the area of change-in-control transactions
• Competitive marketplace practices
  • 90% of major companies have some form of CIC protection, with about two-thirds providing cash severance protection
  • Double trigger contracts that only pay out following both a corporate CIC (multiple definitions) and either an involuntary or constructive termination, within two years of the CIC
  • Multiple tiers of covered executives (most often 2 or 3)
  • Differing multiplier of cash severance pay ranging from 1× to 3× "pay," defined as base salary plus target/actual bonus*
  • Accelerated vesting of equity incentives (per plan document/award agreements)
  • Pro rata payouts for both short- and long-term performance plans
  • Additional age/service credits equal to severance multiple*
  • Excise tax gross-up protections, at least for top tier*
  • Non-compete/non-solicitation provisions

Areas Where Some Have Gone Astray

1. Multiples in excess of 3× cash severance for the top tier*
2. Too many individuals in each tier (especially at the top), resulting in high overall cost as a percent of transaction value
3. Inclusion of long-term incentive grant values in severance multiples
4. Single trigger contracts and, to a lesser extent, modified single trigger (13^th month) contracts
5. Loosely defined "good reason" definitions that create "de facto" single triggers
6. Accelerated vesting of all equity incentives, either on deal announcement or even where grants are converted into NewCo, which eliminates existing retention aspects of program
7. Inefficient excise tax gross-up provisions*
8. Full reimbursement of legal fees without the need to win on one substantive issue
9. Lack of any restrictive covenant (non-compete, non-solicitation, etc.)

Action Items

1. Review designs that don’t use double trigger approach
2. Periodically review participation rates and severance levels vs. current marketplace practices
3. No accelerated vesting if awards are converted into NewCo (but be aware of existing contractual obligations)
4. No accelerated vesting if awards are converted into NewCo (but be aware of existing contractual obligations)
5. Tightened good reason provisions; don’t include vague changes such as titles or reporting relationships
6. Conduct detailed costing of existing CIC protections on a periodic basis (every 3 years) to appraise board of potential costs/exposure (tally sheets)
7. Consider modified gross-up provisions*
8. Ensure quid-pro-quo for benefit provided; e.g., inclusion of non-competition provisions
9. Expect new SEC proxy disclosure rules on CIC protections (covering all major design elements)

* Here is some commentary on some points made by Mike from members of the CompensationStandards.com Task Force:

While 3x and gross-up entitlements may have become so embedded in the compensation landscape that Boards rarely question them, do we have a responsibility to speak out about what needs to be changed? As the above outline points out, the original intent behind severance was to neutralize a CEO's concern about the merger and to provide a reasonable financial bridge to the next job. But, what about a CEO with equity worth $75 mil. at merger? Just what kind of financial bridge are we building with a 2X or 3X severance package on top of all that stock? Clearly, no severance is needed in that situation. And I doubt the takeover would be resisted if the price is right. So, maybe Boards should consider reducing or eliminating severance if stock and other benefits exceed certain defined levels.