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CEO Employment Agreements in a "Say on Pay" World

CEO Employment Agreements in a "Say on Pay" World

Michael S. Katzke and Henry I. Morgenbesser

Posted February 8, 2014

Although much has been written and discussed in the past few years about the impact of "Say on Pay" and Dodd-Frank on CEO compensation practices (including the narrowing or elimination of employment agreement provisions such as excise tax and other tax gross-ups and automatic "evergreen" renewal terms which have not been viewed as shareholder friendly), there has been less discussion as to whether employment agreements remain a viable option in a Say on Pay world.  In spite of the complicated relationship between a CEO hire and the company, some companies, as a policy matter, do not put the terms of such relationship in writing.  Complexities that are often spelled out in a written agreement include duties and responsibilities of the CEO, compensation (including formulaic increases during the term), the duration of the term of employment, termination provisions, severance payments under certain termination scenarios, and post-employment restrictive covenants.  As discussed below, in our view, written employment agreements continue to be viable and recommended, particularly in the case of CEOs hired from outside the company.

The use of written employment agreements may in part depend on whether the CEO is an external hire as opposed to an executive being promoted from within the company.  In a recent Wall Street Journal article, it was noted that an increasing percentage of S&P companies hiring a new CEO did so from outside the Company (28%), a marked increase from less than 10% in the 1970s. Similarly, a Booz & Company study found that 29% of new CEOs hired in 2012 were outsiders, as compared to only 20% during the period between 2009 and 2011. The increase in outside hires in recent years has resulted, in part, in the continued usage of employment agreements (or detailed explicit employment offers) in spite of noise that employment agreement usage may be declining. Some of the key factors cited for the prevalence of employment agreements for CEOs appointed from outside the firm have been documented in an academic study, Explicit vs. Implicit Contracts: Evidence from CEO Employment Agreements (Gillan, Hartzell & Parrino, 2008).  The authors found that outside CEOs were more likely to demand and receive employment agreements (i.e., when compared to their insider CEO counterparts) for reasons such as (i) greater uncertainty about their relationship with their new company, (ii) weaker relationships with the board of directors and (iii) less knowledge about the company itself.  Abnormal compensation and high levels of incentive compensation (generally found in compensation arrangements for outside hires, particularly when make-whole equity grants and mid-career SERPs are provided) were also found to lead to the use of detailed written employment agreements.

A review of outside CEO hires in 2012 and 2013 demonstrates that written agreements for such CEOs have been prevalent, even among some companies which historically may not have favored written arrangements.  Avon, Best Buy, Symantec, Green Mountain, Yahoo, The New York Times, Boston Properties, WellPoint, Big Lots Stores, RadioShack and Vaalco Energy all provided outside CEOs with employment agreements or detailed letters.  Most of these agreements contain provisions on new equity grants and/or make up equity grants for awards forfeited at a prior employer.  In contrast, while internal CEO hires at times do receive new employment agreements, well-known companies such as Citigroup, Legg Mason and McDonalds did not provide employment agreements to their recently promoted internal CEO candidates.  

We are of the view that a detailed agreement serves a valid purpose in many (if not most) instances in the case of a new CEO relationship (whether the candidate is internal or external), particularly when the executive is stepping into an uncertain situation and is giving up valuable consideration from prior employment. From the board's perspective, we also believe that, in today's environment, it is useful to set forth, in writing, the key parameters of the CEO relationship and the respective obligations of both parties upon employment termination, including clawbacks, severance, post-employment cooperation by the former CEO, restrictive covenants, releases, nondisparagement provisions and dispute resolution procedures. The evidence of a commitment may also be useful in attracting and at times retaining exceptional talent who may demand a codified arrangement. Lastly, proxy advisors such as ISS and Glass Lewis are not likely to voice objections to appropriately crafted arrangements which do not provide for egregious compensation or perquisites or off-market provisions that have been the subject of recent attack.

Michael S. Katzke
Henry I. Morgenbesser