Taking Potshots at Golden Parachutes

Turbulence again is getting heavier for golden parachutes and other forms of compensation designed to reward corporate executives who successfully sell their companies for the benefit of shareholders. Denounced as giveaways in their earliest days, parachutes and their cousins have evolved into relatively routine payments that encourage target managements to consider acquisition bids objectively. But more recently, they have come under increasing flak in the highly charged post-Enron world governed by Sarbanes-Oxley rules. Indeed, the intersection of executive compensation and m&a has become a new flashpoint in the struggle between corporate governance reformers, boards, and senior managements at companies in play. The battle partly results from the tighter scrutiny on corporate governance but also has been fueled by an astonishing number of incidents in which executive payments have been denounced as excessive, touched off lawsuits, and sparked questions about whether the huge amounts actually have become deal stimulants. The latest controversy could lead to severe cutbacks in both payout sums and conditions, either by government regulation or shareholder pressures on boards and managements. Whether you are a deal adviser, a member of a management team contemplating your future after your company changes hands, or a shareholder of a target or acquirer, you would be well advised to take note of changes in the landscape in the stormy region where deals intersect with pay. The Grasso Effect While former New York Stock Exchange Chairman Dick Grasso’s struggle to retain his multimillion compensation package, pegged at as much as $240 million, doesn’t grow out of an m&a situation, it has clearly focused attention on the question of when executives’ compensation packages are out of bounds. Executive benefits consultant Brent Longnecker, of Longnecker & Associates in Houston, says the Grasso case is an example of flaws in the executive compensation process that can also haunt boards in m&a situations. “No one ever added up all the pieces of his settlement. In the trial, the key will be how the process worked,” Longnecker says. He adds that when significant parts of Grasso’s pay package were approved, most board members weren’t present. The lesson dealmakers can take away from the Grasso case, he notes, is that somebody has to examine the entire package to determine whether it has any significance to the transaction. Payouts Create Turmoil Grasso isn’t the only lighting-rod case drawing attention from corporate governance crusaders, regulators, and shareholders. Many of the other current cases that have exploded into the news grow directly out of deal situations. In July, Deutsche Bank AG’s chief executive Josef Ackermann was acquitted on criminal charges stemming from bonuses paid to former Mannesmann AG executives and board members during the hostile takeover of Mannesmann by Vodafone Group PLC in 2000. Ackermann and five co-defendants were charged with aiding or abetting breaches of trust by approving $70 million in bonuses and pension settlements for then-Mannesmann CEO Klaus Esser and other Mannesmann executives and directors. Ackermann and the other defendants were directors or executives at the company when the payments were approved. Deal opponents say the fees amounted to bribes to win support for the takeover from Mannesmann officials, including Esser who was initially opposed to the bid, which at $180 billion is Europe’s largest hostile takeover ever. Despite the acquittal, Judge Brigitte Koppenhofer’s comments in the ruling raised questions about the propriety of the payments to Mannesmann executives. In another European case, the SEC used a clause in Sarbanes-Oxley to cancel golden parachutes paid to executives suspected of wrongdoing. The agency used this new power to block a $25 million severance payment to former Vivendi Universal SA chairman Jean-Marie Messier. Messier ended up paying a $1 million fine without admitting or denying wrongdoing and accepted a bar from being a director of a public company for 10 years. Meanwhile, the merger of Bank One Corp. and J.P. Morgan Chase & Co. kicked up executive compensation dust in the form of a class action suit, which charges that J.P. Morgan CEO William Harrison paid what amounted to a $7 billion fee to keep the top job at the combined company. The suit alleges that Bank One CEO Jamie Dimon offered to sell his company for no premium if he was given the top job immediately. Instead, J.P. Morgan agreed to pay a 14% premium, worth $7 billion, to allow Harrison to run things for two years after the merger, the complaint alleges. Another deal being challenged, in part on executive compensation issues, is Anthem Inc.’s proposed $16.4 billion acquisition of WellPoint Health Networks Inc. Although 97% of the companies’ shareholders approved the acquisition in June, the deal still needs state regulators’ approval. Opponents of the deal cite an estimated $600 million in cash bonuses and stock options that would be paid to nearly 300 executives at WellPoint as a reason to stop the deal, or at least change its terms. The California Public Employee’s Retirement System (CalPERS) and other public pension funds that hold about $350 million in both companies’ stock were planning to vote against the deal to protest the bonuses. “This is beyond the realm of excessive,” says Sean Harrigan, President of CalPERS’ board of administration. “We oppose this merger because the only ones it will help are the elite corps of senior managers who have structured it in a way that benefits those without any tie to future performance of the future entity.” Anthem executives say the company must pay the bonuses because they were approved years earlier. California insurance regulators have held up the deal principally on competition issues, but CalPERS still could fight out the compensation question if the transaction ultimately wins clearance from the state or the courts. Parachute Pros and Cons Against this backdrop of deals being contested over executive pay issues, it behooves dealmakers to make sure that their deal closing celebrations aren’t doused with cold water in the form of class action suits, bad publicity, and regulatory roadblocks. Listen, then, to some of the general concerns of corporate governance experts as well as specific recommendations by consultants who structure executive benefit packages. Setting the stage for the conflict-of-interest issues now bobbing to the surface, according to Alexandra Reed Lajoux, Senior Research Analyst at the National Association of Corporate Directors, is the dramatic increase in executive pay over the last 15 years. Not only have pay packages become fatter, she says, but her research shows a high correlation between the total revenue of a company and the pay of its chief executive. These findings suggest that the best-compensated executives are predisposed to position their companies as acquirers to keep the top line growing. But it was concern about the behavior of managements on the sell side that led to the creation of golden parachutes. They were designed to allow executives to objectively analyze the benefits of a deal despite the likelihood that the merger or other change might leave them jobless. Although their original intent was to reduce the anti-deal bias of managers who stand to lose their positions, golden parachutes have grown in directions that now may encourage management to believe they have more to lose by not selling the company than by staying in place. “These extraordinary payments raise questions about whether they are an encouragement for you to do a transaction for the wrong reasons,” says Charles Elson, Director of the Center for Corporate Governance at the University of Delaware. Agreeing with Elson, Peter Clapman, Senior Vice President of pension fund TIAA-CREF, adds, “The ultimate values in these packages have gotten so big, in some cases they probably stimulate deals that might not have gone through otherwise. Clapman’s group has found steadily increasing support for shareholder proposals to limit golden parachutes. “Shareholders are tired of paying the cost of these packages and, the tax costs as well,” he notes. To Nell Minnow, a Director of the Corporate Library, a corporate governance consulting group, the goal of setting up executive packages, including golden parachutes and change-in-control clauses, is to align the interests of management with those of shareholders. Despite the increased concerns about displaying enlightened corporate governance in the wake of the Enron Corp. scandal and the Sarbanes-Oxley response, boards still are not focusing on compensation issues enough, she states. “Shareholders don’t get to vote on these arrangements so we are focusing on the responsibility of board members in this area,” Minnow says. She adds that the manner in which board members handle compensation issues will be a key data point in the next generation of director ratings to be issued by her organization. Elson echoes Minnow’s point about the responsibility of boards in this area. “It comes back to the responsibility of the board. Parachute payments might be beneficial, but when the money becomes so huge, its understandable that people question why a company’s leaders have to be paid extra to do their jobs.” Tailored Parachutes As a result of these high-profile cases and the related concerns voiced by boards, regulators, and shareholder advocates, specialists in executive compensation have identified some trends that m&a mavens should be on top of to prevent post-closing hassles. Longnecker believes that boards should consider not only the size of golden parachute payments but also timing issues, in order to align executives’ interests with shareholders’. Among the options available to compensation committees and other planners are single-trigger structures, which start payment of compensation and benefit obligations automatically upon an event such as a change in control or an executive’s voluntary termination after a change in control. Another choice is the double trigger, which requires two events to trigger payments, for example, a change in control and a termination of employment. A third option is a modified single trigger, which allows the executive to voluntarily separate from the company for any reason during a specified time period. Longnecker says some of these basic options can be augmented by structures specifically tailored to a given situation. “You can have a good program in place, but after a tender offer starts, the board or an executive can choose to enhance the provisions by, in effect, putting a vitamin B-12 shot into the change-in-control provisions.” Carol Bowie, Director of the corporate governance service at the Investor Responsibility Research Center (IRRC) says that as golden parachutes become more complex, they attain a life of their own and must be closely monitored. “There is nobody more creative than a compensation consultant,” she says. Size Matters…So Does Timing Overall, the goal is to eliminate self-interest from executive suite deliberations about a transaction, says Daniel Ryterband, a Managing Director at benefits consulting firm Frederic W. Cook & Co. He says directors and other interested parties have to cost out the whole package of employee benefits in a change-in-control situation. “You don’t want the board approving these things without realizing the final price tag,” he says. According to Frank Dzubeck, President of Communications Network Architects, a Washington, D.C.-based consulting firm, the size of the compensation is a major issue. “You have to get an independent assessment of how much is too much.” He adds that what constitutes independent is a tricky issue, but says that at the least, a company shouldn’t use the same recruitment firm that found an executive to evaluate the appropriate size of his or her benefits package and its change-in-control provisions. In a change-in-control situation, the longer the executive is in his or her job, the amount of money allocated by the clause should go down, he adds. He reasons that if a company changes hands shortly after an executive comes on board, he or she should get more than if the company is acquired a few years later. If the board sells the company some time after his or her initial employment, the executive will have had time to positively impact its results, and that performance will be rewarded in other parts of his or her compensation package, such as bonuses and stock options that have appreciated. Another issue is the timing of a company’s change-in-control provisions. This surfaced in the Mannesmann-Vodafone trial because some executives switched from opposing the transaction to supporting it after Vodafone sweetened their personal stake if the deal were to go through. Longnecker says one of the most basic things companies should do in this regard is to have the structure of the golden parachutes and other change-in-control items in place before a deal appears. “You have to have all your ducks lined up, otherwise you risk looking like you are reacting to the tender offer and then creating your change-in-control setup. If you do it after the fact, a lot of questions will be asked. It looks bad if everybody is scrambling after the fact to create these provisions.” The change in control has to be evaluated in the context of the rest of the executive’s employment contract, he adds. “If you don’t have a non-compete (agreement), and if you don’t have a non-solicitation (arrangement), then the change-in-control payments need not be as high.” If the executive knows he can’t work for a year, he’s entitled to more pay on departure, says Longnecker. He also advocates that only one benefits consultant be assigned to negotiate with the executive team, the board, and the investment banking team that is advising on the deal. “You need to have somebody that all three constituencies can listen to.” Underlining the importance of getting the golden parachute and change-in-control parts of a deal right is Longnecker’s observation that the severance provisions usually amount to 1% to 4% of the deal price. And while the ideal executive compensation package aligns the interests of senior management, the board, and shareholders, Longnecker says that when he sees this delicate balance get out of whack, it is usually “more aggressive for the executives than it should be.” Payouts Gone Awry An example of what many believed to be an outsized package was Michael Orvitz’s $140 million severance package from Walt Disney Co. in the 1990s. Some shareholders alleged that Michael Eisner, the CEO of Disney and a onetime close friend of Orvitz, hired the former high-profile talent agent before discussing the merits with Disney’s board or compensation committee and over the objections of three directors. Ultimately, the Delaware courts didn’t uphold the dissidents’ challenge. But the Orvitz payment, which contributed to the controversy that erupted over Eisner’s stewardship this year, is an example of a worst-case scenario. “If you pay out that kind of money, nobody’s going to believe anything you say to justify it,” Longnecker says. It’s important to think about what constitutes a change in control, he adds. If a small deal, say a 10% ownership interest, triggers the clause, a company may be liable for a payment in a situation where there was no overall intent to change status. It is also vital to consider who needs a change-in-control provision and who doesn’t. “You don’t want to give anybody something for which the shareholders don’t get anything back.” Pointing to Anthem and WellPoint’s proposed deal, some in California are questioning whether all 300 WellPoint executives who have golden parachutes are entitled to them. Another example of executive compensation that produced unintended effects was seen in the 1998 merger of Martin Marietta Corp. and Lockheed Corp. The deal was friendly, but parachutes were generated. Martin Marietta CEO Norman Augustine received $8 million in payments as a result of the change and then became the head of the merged company. Another golden parachute story gone wrong grew out of the proposed merger of MCI Corp. and Sprint Corp., which was shot down by government regulators. The agreement triggered nearly $100 million in payments, which were not rescinded by the government’s rejection of the deal. Ryterband of Frederic W. Cook asserts that companies shouldn’t approve a package that is so expensive that it acts as a transfer of value to management from the shareholders. Items that must be included are salary, bonus, prorated incentive payments, stock options, golden parachute payments, use of the company plane, and a common executive perk, the “gross-up,” he notes. A gross-up is a payment to help the executive pay the taxes on his package. In the Grasso case, the former NYSE chairman is reported to have been paid $880,000 in gross-up fees to help him pay his taxes in the mid-1990s alone. If items in benefits packages are not looked at together, the packages can amount to a poison pill whose weight alone can affect the viability of a transaction, experts say. Looking Ahead In the U.S., Minnow, Elson, and others say that primary responsibility lies with the board. Is better education for compensation committee members one answer? It may be, but there are also signs of a pushback against reform. The SEC in October proposed that shareholders be allowed to place their own board candidates on company ballots. This mechanism could be used to pressure directors on pay, but momentum to institute the reform is waning. In the Vodafone-Mannesmann case, the judge’s criticism is likely to affect the way top executives and board members get bonuses in future deals. Ackermann’s lawyers said in a statement after the trial that the German corporate governance commission and other regulatory bodies should issue new guidelines. Dealmakers may differ on potential solutions to Grasso-like packages, but they will find their change-in-control clauses and parachute terms increasingly open to challenge. “Too many of these packages seem to fall apart. You always have to think you can end up in court so make sure you put in the appropriate safeguards,” Longnecker says. n Copyright 2004 Thomson Media Inc. All Rights Reserved. http://www.thomsonmedia.com http://www.majournal.com