Severance and the Failure of Succession Planning

10/28/11


Guest post by Charlie Tharp, CEO, Center On Executive Compensation

The recent media attention on Hewlett-Packard, along with other companies that have made large severance payments to departing executives has raised criticism of severance packages to the level last seen during the financial meltdown. Yet, with the CEO turnover rate at 13% a six-year high, and the economy uncertain, many new CEO agreements contain provisions ensuring that in the event of termination the executive will be afforded a generous exit package. How is this justifiable in the current environment and what role should severance play?

While the size and structure of executive severance packages may be appropriately criticized in certain cases, focusing solely on the severance arrangement runs the risk of missing the key lesson that one should take away from the HP leadership change. A board's failure to have internal successor candidates for the key leadership roles puts a company in the untenable position of having to tap the spot market for executive talent to fill senior leadership openings when they arise. Not only must the company pay a premium to attract external talent to fill these openings but the company often must also offer generous severance protection to entice a high caliber candidate to leave his or her current position and join the company. For example, in view of the history of CEO turnover at HP, it was predictable that any serious candidate for the CEO role would negotiate a meaningful safety net to provide financial protection in the event of termination.

Vilifying executive severance is often a misdirected criticism since, if properly constructed, severance arrangements provide a valuable tool to help protect the interests of the company while providing a necessary element of the pay package for attracting talent. We acknowledge that there may be rare and unique, and hopefully infrequent, situations that necessitate recruiting an external candidate for the CEO role, and in such cases the severance arrangement for the new recruit may similarly require unique provisions or guarantees. However, by providing severance in the event of termination the board can protect the company by demanding and enforcing non-compete, non-solicitation and non-disparagement restrictions against the departing executive. Severance arrangements also help to entice a successful executive to join a company that is in a turnaround situation or for which there are significant challenges that would make the probability of success less than certain. In these situations severance may be an efficient and effective alternative to providing an upfront sign-on payment. Unlike sign-on bonuses which are paid at the start, severance is a contingent payment.

The Center On Executive Compensation believes that there are ways to tailor severance arrangements to best serve the interests of the company while minimizing criticisms. One such approach would be to coordinate the increase in the value or vesting of equity awards with a declining level of protection under the severance offered to attract the external candidate. While the overall level of executive severance protection provided to senior management has trended downward over recent years according to a recent surveyby Frederic W. Cook & Co., it is still a prevailing practice to include severance protection in the structure of executive compensation arrangements, and especially prevalent for new hires. However, the risk of having to provide an overly rich level of severance protection may be increased when a company is required hire externally for a senior leadership role.

While there are many examples of companies with well-developed and successful CEO succession models - Procter & Gamble, General Electric, Northrop Grumman, McDonald's and others - there are far too many boards that feel they have not taken the necessary steps to ensure there are internal candidates to fill CEO succession needs. A 2010 surveyby Heidrick & Struggles and the Stanford University Rock Center for Corporate Governance found that less than half of the survey respondents were grooming successors for the CEO role.  Unfortunately such lack of preparation comes at a time when CEO turnover is running at a 13% annualized rate, a six year high. The increased rate of CEO turnover places a premium on the board's role in ensuring the company has a disciplined, rigorous and ongoing leadership development and succession planning process.

One of the key learnings from recent media attention regarding severance arrangements is that companies and their boards should redouble their focus on leadership development and succession to help reduce the likelihood they will be negotiating in the spot market for executive talent to fill leadership gaps. This is a key area in which CHROs can add tremendous value by helping their boards adopt a model for succession planning and encouraging the board to tailor severance arrangements to achieve talent attraction needs in coordination with other elements of the executive compensation package. CHROs can also add value by keeping the board abreast of the latest trends and best practices. Failure to properly plan for and manage succession—even at unexpected times -- increases the risk that the company will be forced into compensation arrangements that impose reputational costs to the board and the company.