Should CEOs have Guaranteed Severance Agreements?

According to a recent study by MarksonHRC, employment agreements, with payments for separation without cause, remain common for CEOs.  However, Say-on-Pay, an increasing regulatory focus on ‘risky’ pay practices and periodic public severance-pay  embarrassments (Ovitz, Prince, Nardelli, Corzine et al.) have led some Boards to reexamine the rationale for guaranteed executive severance.

Most US employees are employed at will and can be terminated for any non-discriminatory reason.  In the event of termination, companies develop a severance package based on the prevailing facts and circumstances.   Often, employees only become aware of these benefits once they are actually terminated.   For the broad employee population, severance benefits range from “don’t let the door hit you on the way out” to two weeks of base pay for every year of service. 

 At the top of the organization, severance is often handled differently.  The majority of CEOs have guaranteed severance agreements ranging from six months of base salary to three times base and bonus plus accelerated vesting of equity grants.  Our review of publicly filed proxies indicates that among large companies – defined as those with more than $1.0 billion in annual revenue - 68% of CEOs with more than five years of service have guaranteed severance in the event of termination without cause.  Among smaller companies – defined as those with annual revenue less than $450 million – the findings are similar: 60% of CEOs with tenure of more than five years have guaranteed severance for termination without cause. 
The most common rationale for guaranteed severance is that it is needed to lure a new CEO and compensate him for the unknown risk that lies ahead.  We believe this is justifiable for the first few years of a CEO’s term, especially since the Company’s performance in the beginning may still reflect strategies put in place by the prior CEO.  However, after a CEO has been in tenure for more than five years, we would argue that the risks are known and the strategy is his own.  Another argument is that a guaranteed severance agreement is needed to retain a CEO.  However, the CEO can move to another job at any time; therefore, the severance agreement is only a one-way guarantee binding the shareholders.
We should point out that there is an important and altogether different category of severance benefits that has a reasonable business justification.   Generous severance made after a change-in-control event can help to reduce any incentive for a CEO to resist a transaction that might result in a job loss but that would otherwise benefit shareholders.

There are many examples of companies that faced public embarrassment and shareholder outrage at the size of severance payments that they were required to make to CEOs who departed due to poor performance.  Robert Nardelli at Home Depot and Stanley O’Neal at Merrill Lynch were terminated without cause and therefore entitled to their previously negotiated severance agreements.  However, it was clear that their terminations were a result of poor results, and their enormous severance - about $210million for Nardelli and $160 for O’Neal - were poorly received by all stakeholders and harmed the credibility of the Board.

While the majority of both large and small companies have guaranteed severance agreements with their CEOs, we note that a significant number do NOT offer guaranteed severance:  32% of large- and 40% of small companies fall into this category.  Many of these companies explicitly state that they do not offer any kind of employment agreement, including severance packages, because they want employment to be at-will.  Lowe’s goes as far to state the following:  “The Company’s historical practices of not having employment agreements with its officers demonstrate the Board’s commitment to protecting shareholder value by attracting and retaining skilled executives without providing excessive severance packages.”