Considering pros and cons of signing executives up to work
Should an organization have employment contracts with its top executives? The focus on corporate governance in recent years is causing many companies, and compensation committees, to re-examine the rationale for, and terms and conditions of, executive contracts.
In determining if and when to use contracts for executives, it’s important to understand why employment contracts have been used or are under consideration. A good place to start is to review the basic approaches for executive contracts and then consider the pros and cons of these contracts.
There are four basic approaches:
No contract: Some employers do not use contracts at all. Instead they rely on general policies or more limited contracts to address specific issues such as severance, change in control, confidentiality and non-competition.
Contracts, but only for new hires: Other companies limit employment contracts to new-hire situations, especially where a sought-after executive is reluctant to join a new and unfamiliar organization without the protection of a contract.
Contracts for some: Many organizations extend employment contracts to some or all of the top executive team. Certain employers may have a contract with only their CEOs.
Contracts for all: A few companies use employment contracts to document their employment relationships with all executives above a certain level, such as vice-president.
Rationale for contracts
An executive contract sets out the key terms and conditions of the employment relationship. Contracts may address salary, bonus compensation, long-term incentives (often equity-based), benefits and perks.
There is little need for a contract if the objective is to simply codify these items. The most important reasons for an employment contract are to:
• specify and make clear what an executive will receive upon various events resulting in a termination of employment (such as death, disability, retirement, resignation, resignation for good reason, dismissal and dismissal for cause);
• address the impact of a change of control of the employer; and
• impose reasonable post-employment restrictions applicable to the executive (restrictive covenants addressing such matters as confidentiality and non-disclosure, non-competition, non-solicitation and non-disparagement).
Arguments against employment contracts
While both the employer and the executive can be well served by a contract, another view is that such contracts are unnecessary or overly favour executives. Some arguments against executive employment contracts include:
Pay for failure: An executive dismissed for poor performance is entitled to large severance based on the terms of an employment contract. Arguably, payments would have been more reasonable if no contract had been in place and the executive had to negotiate a severance package in connection with her termination. However, the executive may not have accepted the position without those same severance pay provisions.
Performance equals security: The protection provided by an employment contract is unnecessary for a top executive who is doing a good job and an executive should not have this protection if she is not performing well. In contrast, the increased turnover among CEOs and other senior executives in recent years — translating to a shorter job life expectancy — leads many executives to believe contractual protection is necessary.
Key provisions and usage
Severance and change-in-control protections are the most critical provisions in employment contracts for executives, while employers seek the benefits of restrictive covenants. Both parties gain certainty of the terms that will apply in identified circumstances, especially various termination events. A contract may enable an employer to determine what law will apply where there are contracts in multiple jurisdictions and, if desired, mandate arbitration of disputes regarding employment matters.
But the focus really should be on improving the contents rather than reducing their usage. Below is a helpful checklist when considering a new contract or evaluating a current contract.
Employment contract checklist
“Evergreen” renewal: “Evergreen” contracts typically provide for automatic extension or renewal unless advance notice is given. Procedures should be implemented to review these contracts before any such extension becomes effective. An employer’s advance notice not to extend the contract term or renew the contract should not trigger severance pay.
Critical definitions: The definitions of change in control, cause and good reason should be scrutinized. In reaction to some widely publicized severance payments to executives who were dismissed or resigned after poor corporate performance, the current trend is to expand cause definitions and to constrict good reason definitions.
Calculating pay: Where any payments are based on pay, a determination is needed on what amounts should be included. Companies typically use base salary or salary plus bonus. Also, an annual bonus can be variously defined so the method of its calculation should be specified.
Potential cost of retirement benefits or enhancements: Shareholder groups may object to giving new executives additional pension credits (often co-ordinated with supplemental executive retirement plan benefits). While that approach may be needed to recruit a mid-career executive to make up for benefits foregone at a former employer, the cost should be calculated and understood, and the rationale documented.
Overall cost analysis: The potential costs for all payments directly or indirectly affected by an executive’s contract should be determined on a worst-case, most-costly basis. These costs should be reviewed periodically to make sure the employer understands how changes in base salary, for instance, may affect these payments.
Vesting of incentives on a change of control: Accelerated vesting of share options would generally be appropriate where there is a non-cause dismissal of the executive following a change of control or where the executive would have no continuing equity interest in a merged entity. There are other issues pertaining to bonus and mid-term incentives.
Trigger event: Any change-in-control severance benefits should require a double trigger for payment rather than simply the single trigger change-of-control event.
Responsibility for drafting: The employer should have the contract drafted by its advisors, not by someone representing the executive’s interests. The drafting process should be within control of the board. Also, a general counsel should not be put in the position of negotiating contract terms with an executive to whom she may have to report.
Luis Navas, Christopher Chen and Wiclif Ma are compensation consultants with HayGroup in Toronto. For more information visit www.haygroup.com/ca.
In determining if and when to use contracts for executives, it’s important to understand why employment contracts have been used or are under consideration. A good place to start is to review the basic approaches for executive contracts and then consider the pros and cons of these contracts.
There are four basic approaches:
No contract: Some employers do not use contracts at all. Instead they rely on general policies or more limited contracts to address specific issues such as severance, change in control, confidentiality and non-competition.
Contracts, but only for new hires: Other companies limit employment contracts to new-hire situations, especially where a sought-after executive is reluctant to join a new and unfamiliar organization without the protection of a contract.
Contracts for some: Many organizations extend employment contracts to some or all of the top executive team. Certain employers may have a contract with only their CEOs.
Contracts for all: A few companies use employment contracts to document their employment relationships with all executives above a certain level, such as vice-president.
Rationale for contracts
An executive contract sets out the key terms and conditions of the employment relationship. Contracts may address salary, bonus compensation, long-term incentives (often equity-based), benefits and perks.
There is little need for a contract if the objective is to simply codify these items. The most important reasons for an employment contract are to:
• specify and make clear what an executive will receive upon various events resulting in a termination of employment (such as death, disability, retirement, resignation, resignation for good reason, dismissal and dismissal for cause);
• address the impact of a change of control of the employer; and
• impose reasonable post-employment restrictions applicable to the executive (restrictive covenants addressing such matters as confidentiality and non-disclosure, non-competition, non-solicitation and non-disparagement).
Arguments against employment contracts
While both the employer and the executive can be well served by a contract, another view is that such contracts are unnecessary or overly favour executives. Some arguments against executive employment contracts include:
Pay for failure: An executive dismissed for poor performance is entitled to large severance based on the terms of an employment contract. Arguably, payments would have been more reasonable if no contract had been in place and the executive had to negotiate a severance package in connection with her termination. However, the executive may not have accepted the position without those same severance pay provisions.
Performance equals security: The protection provided by an employment contract is unnecessary for a top executive who is doing a good job and an executive should not have this protection if she is not performing well. In contrast, the increased turnover among CEOs and other senior executives in recent years — translating to a shorter job life expectancy — leads many executives to believe contractual protection is necessary.
Key provisions and usage
Severance and change-in-control protections are the most critical provisions in employment contracts for executives, while employers seek the benefits of restrictive covenants. Both parties gain certainty of the terms that will apply in identified circumstances, especially various termination events. A contract may enable an employer to determine what law will apply where there are contracts in multiple jurisdictions and, if desired, mandate arbitration of disputes regarding employment matters.
But the focus really should be on improving the contents rather than reducing their usage. Below is a helpful checklist when considering a new contract or evaluating a current contract.
Employment contract checklist
“Evergreen” renewal: “Evergreen” contracts typically provide for automatic extension or renewal unless advance notice is given. Procedures should be implemented to review these contracts before any such extension becomes effective. An employer’s advance notice not to extend the contract term or renew the contract should not trigger severance pay.
Critical definitions: The definitions of change in control, cause and good reason should be scrutinized. In reaction to some widely publicized severance payments to executives who were dismissed or resigned after poor corporate performance, the current trend is to expand cause definitions and to constrict good reason definitions.
Calculating pay: Where any payments are based on pay, a determination is needed on what amounts should be included. Companies typically use base salary or salary plus bonus. Also, an annual bonus can be variously defined so the method of its calculation should be specified.
Potential cost of retirement benefits or enhancements: Shareholder groups may object to giving new executives additional pension credits (often co-ordinated with supplemental executive retirement plan benefits). While that approach may be needed to recruit a mid-career executive to make up for benefits foregone at a former employer, the cost should be calculated and understood, and the rationale documented.
Overall cost analysis: The potential costs for all payments directly or indirectly affected by an executive’s contract should be determined on a worst-case, most-costly basis. These costs should be reviewed periodically to make sure the employer understands how changes in base salary, for instance, may affect these payments.
Vesting of incentives on a change of control: Accelerated vesting of share options would generally be appropriate where there is a non-cause dismissal of the executive following a change of control or where the executive would have no continuing equity interest in a merged entity. There are other issues pertaining to bonus and mid-term incentives.
Trigger event: Any change-in-control severance benefits should require a double trigger for payment rather than simply the single trigger change-of-control event.
Responsibility for drafting: The employer should have the contract drafted by its advisors, not by someone representing the executive’s interests. The drafting process should be within control of the board. Also, a general counsel should not be put in the position of negotiating contract terms with an executive to whom she may have to report.
Luis Navas, Christopher Chen and Wiclif Ma are compensation consultants with HayGroup in Toronto. For more information visit www.haygroup.com/ca.
