1. Employment Agreements and Executive Severance

The employment of many senior executives is governed by an employment agreement. Employment agreements normally define the terms and conditions governing an executive’s employment, including:

• Term of employment and contract renewal provisions
• Position, title, and reporting relationship
• Minimum compensation opportunities, including base salary, target bonus opportunity, and eligibility for long-term incentives
• Vacation, executive benefits, and perquisites
• Severance protection in the event of termination

When an executive is hired, the terms of an employment agreement may require extensive negotiation. This often results in locking the company into commitments that are difficult to unwind. If the company unilaterally eliminates certain benefits or otherwise changes the terms of employment, the executive may be eligible to receive severance from the company by triggering the agreement’s “good reason” termination provision (i.e., the executive can claim that the company effectively terminated his or her employment by materially changing employment terms).

Another issue with individual employment agreements is that they can result in disparate treatment among the executive group based on the timing of when they join the company, as well as the individual executive’s aggressiveness in negotiating the terms of employment. Provisions that may be acceptable to the company for one executive may become problematic if provided to many executives. However, once one executive establishes the precedent for a particular provision, other executives will likely negotiate for similar treatment. This is especially true because employment agreements with executive officers are required to be filed with the SEC, making the terms public knowledge.

For these reasons, we suggest that companies avoid entering into employment agreements with executives whenever possible. Instead, a preferred approach is to use an executive severance policy to cover all similarly situated executives under comparable terms. The most critical protection that an employment agreement provides is protection in the event that the employee is terminated or constructively terminated through a material reduction in responsibilities or compensation. Severance policies provide this protection to senior executives but give the company flexibility to change the program without obtaining the consent of participants. A severance policy also reduces the likelihood of executives negotiating for concessions at termination. Shareholder advisory groups and other external observers tend to be highly critical when companies make special payments to terminated executives.

Another approach is to have a standardized employment agreement that provides a consistent, basic level of protection for all executives at a particular level within the company. This can allow the company to avoid negotiating unique provisions. In addition, if the employment agreement is structured so that it expires after a fixed term or contains a notice period that allows the company to revisit the terms, the company retains a degree of flexibility.

Executive severance benefits are typically provided in two scenarios: (i) termination by the company or by the executive for good reason, or (ii) actual or constructive termination in connection with a change in control (CIC). Severance is generally not provided if the executive resigns without good reason, retires, dies, becomes disabled, or is terminated for cause.

Executive severance benefits that apply in the cases of termination by the company or by the executive for good reason frequently include the following components:

• Cash severance paid in regular payroll installments, which is typically equal to the employee’s base salary, but can be increased to include target bonus or a multiple of salary in the case of the CEO
• Actual bonus prorated for service during the year of termination
• 12 years of benefit continuation, normally limited to health and life insurance coverage for a period that frequently matches the cash severance period

Companies frequently include various covenants that limit the executive’s ability to compete or solicit employees and customers after termination. Common covenants include confidentiality provisions, non-compete and non-solicitation provisions, non-disparagement clauses, and agreements by executives to participate in investigations for fraud or other malfeasance after employment ends. Finally, companies require the executive to sign a personal release before severance is made available to reduce the likelihood of litigation.

Executive severance benefits that apply in connection with a CIC are often more generous for senior executives, on the theory that shareholders may be receiving a premium in the transaction and that the executive is losing their job through no fault of their own. Typical components include:

• Cash severance paid in a lump sum, which is usually 3x base salary plus target bonus for CEOs and 2x–3x base salary plus target bonus for other named executives
• Actual bonus prorated for service during the year of termination
• Accelerated vesting of equity and other long-term incentives
• 2–3 years of benefit continuation, or the cash equivalent for a period that frequently matches the cash severance period

CIC benefit payments are known as “golden parachutes.” Under Section 280G of the IRC, parachute payments include all payments made within one year of a CIC that are contingent on or accelerated by the CIC. If the total parachute payment is more than 2.99x an executive’s base salary (five-year average W-2 income), the payment is an excess parachute payment according to the IRS. Any excess parachute payment is subject to a 20% non-deductible excise tax, in addition to regular income and payroll taxes. Payments triggered by the CIC can include not only cash severance, but also the value of the benefit, from accelerated vesting of equity or long-term performance plan to benefit continuation. The IRS uses a complicated methodology to calculate the value of such parachute payments.

In order to insulate executives from the cost of the excise tax penalty, an additional payment was often promised to the executive to pay for the excise tax and incremental excise and income taxes on the payment. These “excise tax gross-ups” can be very expensive for companies. For example, if an executive is subject to a 40% income tax and a 20% excise tax, then the payment required to fully gross-up an executive will be 2.5x the value of the 20% excise tax.

Shareholder advisory groups have strong views about severance payments, often viewing them as non-performance-based pay or “pay for failure.” Largely because of input from the shareholder advisory firms, companies have been reducing CIC severance and eliminating practices that are viewed as unfriendly to shareholders. Practices that are being phased out include the following:

• Cash severance triggered solely by the occurrence of the CIC without a termination of employment (i.e., a “single-trigger” benefit)
• Cash severance pay multiples that include any form of long-term incentive compensation in the definition of pay (e.g., 3x (base salary plus target bonus plus cash long-term incentive target))
• Excise tax gross-ups
• Additional service credit for retirement benefits

In the past, it was common to provide an excise tax gross-up as part of the CIC severance benefits for senior executives (see discussion above for more detail). Excise tax gross-ups are unpopular with shareholder advisory groups. For example, ISS has made it part of its “Say on Pay” voting policy that they will recommend against the pay plan of any company that puts an excise tax gross-up in a new or materially modified contract. While some companies still have grandfathered contracts or severance arrangements with excise tax gross-ups, very few companies incorporate them into new arrangements.

In place of the excise tax gross-up, many companies have adopted an approach where they give the executive a choice — that is, the executive can opt to take the entire parachute payment and pay any excise taxes due without help from the company, or they can cap the payment just below the level that triggers the excise tax gross-up if that maximizes the payment’s after-tax value. This approach optimizes the after-tax payout to the executive and reduces the risk that the company loses its tax deduction on severance pay.

Another approach, which is seen less frequently, is for the company to employ a hard cap and limit the parachute payment to avoid the excise tax. This approach guarantees that any severance payments will be tax deductible to the company but is much less generous to the executive.

Key Questions for Committee Members to Ask:

• Are any of our executive officers covered by employment contracts? If so, is there a standard form, or do the contracts vary by executive?
• In the absence of employment contracts, is an executive severance policy in place? What benefits are provided?
• Is it possible for the company to unwind the employment contracts over time without triggering a severance payment for “good reason” termination under the agreements?
• Do any of our employment contracts or severance arrangements provide for excise tax gross-ups?
• Do any of our employment contracts provide for cash severance payments of more than 2.99x pay?
• Are we doing anything more for the departing executive than what we are contractually obligated to do? If so, do we have a strong rationale for why it is in the interests of shareholders?