Golden Parachutes and Executive Severance Agreements

Vote FOR shareholder proposals to require golden parachutes or executive severance agreements to be submitted for shareholder ratification, unless the proposal requires shareholder approval prior to entering into employment contracts.

Vote on a CASE-BY-CASE basis on proposals to ratify or cancel golden or tin parachutes. An acceptable parachute should include the following:

• The parachute should be less attractive than an ongoing employment opportunity with the firm

• The triggering mechanism should be beyond the control of management

• The amount should not exceed three times base salary plus guaranteed benefits

Golden parachutes, which were popularized after the corporate takeover rage of the 1980's, are designed to protect the employees of a corporation in the event of a change in control. Increasingly, companies that have golden parachute agreements for executives are extending the coverage to all employees via tin parachutes. The extension is primarily due to the increasing demand among corporate employees for more equal treatment with regard to compensation and job security. In fact, states such as Massachusetts, Pennsylvania, and Rhode Island have tin parachute statutes, though federal courts largely invalidated them in the 1990s (Massachusetts and Rhode Island) under the preemption of the Employment Retirement Income Security Act (ERISA).

The mechanisms that trigger the payout under the two types of parachutes are also very similar. Most have a double trigger requiring both a change in control and termination of employment. Typically, the change-in-control agreement will specify the exact payments to be made under the golden/tin parachutes. While the calculation for payout can be complex, it is usually based on some multiple of an employee's annual or monthly compensation.

It should be noted that an effective parachute arrangement is one which is considerably less attractive than an ongoing employment opportunity with the firm. Also, the parachute should be triggered by a mechanism or procedure that is beyond the control of management.

According to a 2001 survey of Fortune 1000 companies by Executive Compensation Advisory Services, 81 percent of companies had golden parachute plans, compared to 35 percent in 1987, and 52 percent of the golden parachutes had gross-up provisions to cover taxes on the parachute benefits. Less common tin parachutes were in place at seven percent of firms surveyed. [1]

Empirical studies have shown that these arrangements encourage target managements to more fully consider takeover bids and cause the acquirer to more carefully consider the full cost of acquisition. Further, studies indicate that parachutes tend to result in higher takeover bids, which lead to greater returns for shareholders of target companies.

The Internal Revenue Service considers any amount that equals or exceeds three times an employee's average annual compensation during the five years prior to the triggering of the protection to be excessive. [2] ISS favors golden parachutes that are between two and three times base salary, plus guaranteed retirement and other benefits (i.e., health or life insurance). Although a company must disclose the terms of its golden parachute agreements in its proxy statement, disclosure of the terms of tin parachutes is not required.

Executive severance

While traditional parachutes were designed to protect executives financially if they were forced out by a takeover, companies in recent years have extended the 2.99x parachute threshold to ordinary severance for any type of termination other than for cause. (“For cause” or “for good reason” is usually narrowly defined in employment agreements to preclude dismissal for anything but a felony conviction.) This has led to exit packages that are so generous that they fail to hold executives accountable for poor performance. In some cases, executives may walk away with more money than they made while they were working. Noteworthy examples include Mattel Inc. CEO Jill Barad’s $50 million departure payment after the company suffered mounting losses under her tenure; John Reed’s $30 million in severance and $5 million per year for life after being forced out as co-chairman of Citigroup Inc.; and ousted Conseco Inc. founder Stephen Hilbert’s $72 million separation arrangement. Hilbert’s replacement as CEO, Gary Wendt, received a $45 million signing bonus, then collected a $17 million pension (but no severance) when he left after the company declared bankruptcy.

Even breaches of ethics and compliance codes do not preclude rich goodbye deals. A Conference Board poll of 50 employers found that 62 percent still give out financial packages to executives who depart because of major violations in ethics rules.[3]

According to The Corporate Library, 55.5 percent of 367 companies examined pay salary, bonus, and equity awards for at least three years after a CEO departs. [4] Other companies use rolling contracts, which are common in the United Kingdom, that must be paid off if the executive is dismissed. [5] Between 2001 and 2003, the average cash severance at S&P 500 companies was $16.5 million. That excludes stock awards as well as extra perks which can range from free appliances (Maytag Corp.) to corporate jets, box seats at baseball games, and lavish Manhattan apartments (General Electric Co.'s Jack Welch). Even the more common accoutrements--health benefits, lucrative pensions, accelerated option vesting, secretaries, office space, country club memberships, financial planning assistance, loan forgiveness, and tax gross-ups—can increase the value of the average severance package by 50 percent. [6]

Notwithstanding the cost, big pay-for-failure packages can expose a company and its board to potential liability claims. In May 2003, the Delaware Court of Chancery refused dismissal of a shareholder suit against the directors of The Walt Disney Co., which charges them with breaching their fiduciary duty for approving a generous employment and “non-fault termination” agreement for former president Michael Ovitz. Ovitz departed Disney in 1996 with a cash and stock option severance package worth $140 million (about ten percent of Disney's net income that year) after serving only 14 months. The plaintiffs want the money returned to Disney. The court ruled that if the shareholders' allegations were true, it could imply that the Disney directors “consciously and intentionally disregarded their responsibilities” in overseeing Ovitz's tenure and that their “conduct fell outside the protection of the business judgment rule.” The final court decision will be significant because the directors could be held personally liable for failing to do their duty. (The business judgment doctrine protects board members from personal liability if their decisions were made in good faith, with due care, and under proper authority.) [7]

Givebacks and shareholder backlash

Corporate scandals and shareholder pressure are prompting a number of companies to address severance issues. The Boeing Co., for example refused severance to two top executives who were dismissed in November 2003 for cause for violating the company’s ethics standards. Similarly, Freddie Mac faces a cease-and-desist order from the Office of Federal Housing Enterprise Oversight to retroactively classify the departures of two executives as terminations for cause and effectively forfeit their severance benefits. (Chairman and CEO Leland Brendsel and CFO Vaughn Clarke resigned/retired in June 2003 amid an accounting scandal, but were promised $24.4 million and $750,000 million in compensation, respectively, pursuant to their employment contracts.) And Tyco International Ltd. sued defrocked CFO Mark Swartz, who stands accused of looting $600 million from the company, to disgorge the $44 million in cash severance, deferred compensation, and supplemental pension he received from the company. Tyco has since agreed to limit future executive severance pay to 2x salary and bonus (2.99x for change-in-control parachutes).

Other issuers have similarly been reigning in walkaway packages following a slew of shareholder initiatives. During 2002 and 2003, shareholders submitted 20 and 18 proposals, respectively, asking companies to let them vote on future executive severance packages—typically those over 2.99x salary and bonus (though a few specified a 2x threshold). With heightened support levels--13 received majority votes in 2003—nearly a dozen firms, including Sprint Corp., Norfolk Southern Corp., Union Pacific Corp., Bank of America Corp., Verizon Communications, and Alcoa Inc., have adopted policies to obtain shareholder approval for future severance arrangements.

Investors are also holding compensation committee members responsible for windfall severance. In 2003, members of Electronic Data Systems Corp.'s (EDS) compensation panel garnered 27 percent withhold votes for approving a $37 million exit package to outgoing Chairman and CEO Richard Brown after a series of setbacks and losses on large contracts.

Shareholders should not be forced to pay for inflated severance packages given to executives that have performed badly. Shareholders should therefore support proposals requiring that golden parachutes or executive severance agreements be submitted for shareholder ratification, unless the proposal requires shareholder approval prior to entering into employment contracts.

Table 1: What color is your parachute?
Parachutes can take on many colors depending on the size and scope of the payout.

Golden parachutes are those that exceed the IRS threshold for excessive severance payments. The payout consists of a minimum of 2.99x annual salary and bonus and three years' of continued principal benefits. Generally, companies only extend golden parachutes to the top five executives. Traditional parachutes pay out if the executive is terminated following a change in control.

Silver parachutes typically pay out 1.5x to 2.5x annual salary, bonus and benefits. These are awarded to executives below the top level.

Tin parachutes are severance plans covering all employees in the event of a change in control. The payment is usually based on years of service and/or age and may be capped (such as 1.5x annual compensation).

Platinum parachutes are oversized severance packages awarded to senior executives that are not necessarily tied to a change in control.

Golden bungees are a combination jump. The executive collects a golden parachute then bounces back with a new employment or consulting agreement. These provisions arise from a walk-away right which allows the executive to resign during a window period after a change in control. To keep the executive, the acquirer may have to pay some of the severance and extend a new employment or consulting agreement.

Golden handcuffs are attractive financial benefits that the employee will lose if he leaves the company.

Golden hellos are cash bonuses (signing bonuses) paid to a new executive up front as an incentive to join the company.

Golden handshakes/golden goodbyes are early retirement incentives (large payments to an executive if terminated before his contract expires)