Several CEOs departed in 2006 who received generous exit packages despite their poor performance, costing companies and their investors millions of dollars. Pfizer’s Henry McKinnell and Home Depot’s Robert Nardelli received exit packages of more than $200 million each, despite poor stock performance during their tenures.[1] 

These large exit packages are due primarily to executive employment agreements. Employment agreements are legally binding contracts that spell out the terms under which executives are hired. The problem is that they may guarantee a specified level of compensation regardless of performance, as in the case of Robert Nardelli.[2]

Source: “Has the Exit Sign Ever Looked So Good,” The New York Times, 4/8/2007.

Employment agreements also spell out what executives will receive under different termination scenarios. Such employment agreements often include what has become known as a “golden handshake” in which the company promises payment upon retirement or termination. Executives also may receive “golden parachute” payments if the company undergoes a change in ownership or if the executive is terminated because of a change in control. 

Supporters of such severance agreements argue that they provide managers with the incentive to maximize shareholder wealth without worrying about losing their job as a result of a change in control. However, the amounts guaranteed by golden parachutes and golden handshakes may add up to millions of dollars. When these packages become excessive, they may motivate executives to engage in a merger, even though it may not be in the interests of shareholders. Golden parachutes also may result in lower firm valuation, according to Harvard professor Lucian Bebchuk.[3] 

Typically, exit packages involve a cash severance of two or three times salary plus bonus. These agreements also often call for accelerated vesting of stock awards, option awards and pension benefits, quickly boosting the size of the total payment. Sometimes the termination terms for stock awards, option awards and pension benefits are not included in the employment agreement, but in the individual plans for each of those benefits. 

Moreover, if the golden parachute payment received upon a change of control exceeds 2.99 times the executive’s average annual salary and bonus for the five preceding years, then the amount exceeding the average annual salary and bonus cannot be deducted by the company, meaning that it must pay taxes on it.[4] 

The executive also must pay a 20 percent excise tax for golden parachutes on everything over his or her average base salary and bonus for the preceding five years, though many companies offer to “gross up” or pay that tax as well,[5] costing shareholders even more. 

Because executive employment agreements are legally binding, companies must pay the executives according to the terms specified under them. In the case of KB Home, former CEO Bruce Karatz could collect as much as $175 million, despite his involvement in backdating stock options at the company. That’s because the company accepted his retirement, and he was not fired for cause.[6] 

Karatz’s compensation is frozen until an agreement is reached between him and KB Home on how much he actually will receive.[7] Investors have urged the company not to pay Karatz. However, because of the legally binding employment agreement, KB Home has a weakened case if it decides not to pay him. It is all the more important for shareholders to be cognizant of the terms of exit packages when they are drawn up, not when the executive receives the payment.

In previous years, it was difficult to ascertain the value of executive severance packages, until an executive actually left a company. The new U.S. Securities and Exchange Commission (SEC) executive compensation disclosure rules now require companies to disclose the terms of written or unwritten arrangements that provide payments in case of the resignation, retirement or termination of the “named executive officers” or the five highest-paid executives of a company. The SEC rules also require companies to detail the specific circumstances that would trigger payment and the estimated payment amounts for each situation.

Though the new SEC disclosure rule will show whether an executive has an excessive severance package, it does not provide investors with a way to limit them. Congress is considering legislation that will require public companies to hold a non-binding vote on executive pay plans, including an advisory vote if a company awards a new golden parachute package during a merger, acquisition or proposed sale. 

This advisory vote will give shareholders a way to voice their support or opposition to a company’s golden parachute. Knowing they will be subject to some collective shareholder action will encourage boards of directors to address shareholder concerns before approving a questionable golden parachute.