Jim Citrin Leadership by Example

Pop quiz: If you were to select one course of action to improve executive compensation practices, would you choose:

A) Track and publish ratios of compensation between the CEO and the lowest-level and average employees.

B) Mandate broader disclosure in proxy statements of compensation awards beyond the top 5 corporate officers to the top 10 or 20 executives.

C) Institute a "just say no" style advertising campaign, targeting CEOs and board compensation committees to recognize that basic tenets of common sense and fairness should govern executive compensation.

D) Establish a more progressive tax scheme focusing on increasing taxes for the top 0.1 percent of earners.

E) Eliminate accelerated vesting of stock options, restricted stock, and other long-term rewards in the case that a CEO is terminated without cause.

My choice is E. Here's why.

CEO Compensation Basics

One of the most infuriating things to shareholders and the public is when a CEO is fired for poor performance (a.k.a. "without cause") and receives millions or tens of millions of dollars of compensation as a settlement. This practice goes fundamentally against the culture of meritocracy that lies at the root of the free market system.

The seeds of those large payments made to CEOs when they're terminated are often planted when a board enters into an employment agreement with a new CEO. A CEO appointment is a high-stakes, high-pressure situation. When a board determines that it's found a candidate to lead the company forward, whether through internal promotion or external recruitment, the next step is to negotiate an employment agreement.

The negotiation is governed by a balance of power. When an orderly succession happens with an internal promotion the company tends to have more power, and there's momentum for compensation to be set based on existing practices. However, if a proven and well-known prospective CEO is brought into a difficult company situation, the executive tends to have greater leverage. These executives will typically retain one of a small number of specialized CEO employment attorneys whose job it is to fight to secure all they can get for their clients, basing their demands on what's standard in the market.

Rewarded for Failure?

But just because something's been done a certain way for a long time doesn't mean it's right. Just this week, I got into a heated argument with a prominent employment attorney representing a CEO candidate in my firm. In negotiating the terms of a draft employment agreement, the attorney said, "On the equity, as is customary and standard, we expect accelerated vesting in the case of termination without cause or for good reason."

I replied, "Well, this offer is based on a pay-for-performance philosophy. Accelerated vesting isn't what's being put forth here." I recognize that accelerated vesting has been done in many CEO agreements in the past, but I don't believe that the CEO should benefit by accelerating the vesting of equity awards beyond an already fair severance if he's terminated for poor performance, which is usually the reason for termination without cause.

The attorney counter-argued that the executive was leaving a perfectly fine job to risk taking a role at a new company where the equity compensation is a primary motivation, and should therefore be protected. Maybe so, but 1) It's unfair to have all the downside protected while leaving all the upside of the equity, and 2) It's greedy at a time when there's a growing income disparity around the world to be richly rewarded for failing.

Sounds Good on Paper

We have yet to come to an agreement, but I believe it's not only unfair and inappropriate for a CEO to be awarded accelerated vesting in the case of termination without cause, it's not even in the executive's interest. To me, leadership by example means holding yourself to the same -- or higher -- standards than you expect of others.

Sure, the CEO might make a lot of money if his employment agreement mandates a big payout in spite of sub-par performance. However, the cost for accepting that is both the antipathy of the employees left behind to clean up the mess and a tarnished reputation. I've seen executives at the peak of their careers awarded a large payout that was contractually due them only to see their reputations damaged beyond repair. Not to mention the issue of self-respect: How could you look at yourself in the mirror after being richly awarded for failure, while others for whom you were responsible suffer?

So my strong advice to this current CEO candidate is to reject his attorney's counsel to push for acceleration of vesting of equity on termination without cause.

Preemptive Pay Discussion

While it's helpful for a board's compensation committee and the executive to remain steadfast on the core principle of pay for performance, an even better solution is to preempt the issue by moving it from the negotiation further upstream in the process. This is what was done recently by one of the more thoughtful boards I've worked with.

The company is a global, multibillion dollar market leader, and we led the search for their new CEO. We developed a slate of five external and two internal candidates. Toward the end of each candidate's interview, the lead director said, "We believe we have entered a new era of how the world thinks about CEO compensation. The board is interested in your personal philosophy about executive compensation."

This unleashed a wide-ranging discussion that illuminated the candidates' values, leadership philosophies, and degree of alignment with the board's views. Two of the candidates eliminated themselves from the process on this issue by arguing that a CEO needs to be compensated the same way as the top player on a sports team or the star of a big-budget movie, with downside protection if the team doesn't reach the playoffs or if the film doesn't open big. The other five candidates articulated a pay-for-performance philosophy.

A few weeks later, when the inevitable short strokes of the negotiation ensued with the selected candidate, we were able to shut down the possibility of even considering acceleration of equity in the case of termination without cause. The executive bought into this point, the deal successfully closed, and the CEO is off to a great start in his new role.

A Changing Landscape

Just to see how the experts I trust most think about this issue, I checked with the leading U.S. CEO employment attorney, who's successfully represented over 45 CEOs in their contracts, and a leading compensation consultant who has the leading market share of CEO employment compensation deals. Both (who asked to remain anonymous) confirmed that while acceleration had been standard, it's no longer best practice.

They also pointed out that there are important nuances to take into account. For example, if an equity grant is used to make up for an executive's earned equity position in the company he or she is leaving, it can be treated differently than new grants; the former is appropriate to vest in termination without cause, since it would've been earned had the executive stayed with their previous employer. Or, if a new CEO is close to retirement and had many years already earned in a pension plan in the previous company, accelerated vesting into the new plan -- or equity to match that amount -- is often appropriate.

In the case of private equity, where common practice is to award all the equity up front (versus annual or ongoing grants, which are more typical of public companies), a compromise -- especially for a "superstar" CEO -- is to get an extra year of vesting rather than full acceleration in the case of termination without cause. "We push to have no accelerated vesting in our plans today," the compensation consultant said. The attorney added, "The design of the plans is changing each year, but the trend is definitely to less and less acceleration, which I think is a good thing."