The CEO Contract Must Increase Shareholder Value

Make it a policy to make CEO contract a fixed-term contract. The duration of the contracts depends on decision of organizations and their plans, the reputation of the person appointed to hold this responsible position, among other consideration. The terms and conditions will vary from organization to organization. (Foto by Torres)

It is said that the general rule is that these contracts must provide incentives and protections.

However, it is said that these contracts should contain a provision making compensation subject to increasing shareholder value.

It is believed that this will send a clear message to:

  • the Chief Executive Officer on your board's expectation
  • officers and employees of your organization
  • the investment community
  • Other stakeholders

Note, however, that the requirement to increase shareholders' value is presently under scrutiny.

A CEO Contract Should Not Provide Limitless Benefits

If your organization gives excessive incentives, it reveals that your organization may lack priority in its business dealings.

One of these is payment of performance bonus. What makes it controversial is the failure to connect its value to increase in shareholders value. However, some argue that increasing shareholders' value should no longer count as the main objective of business entities.

A survey has shown that many CEO contracts offer no or little protection for organizations.

The main purpose is to secure the time, and ability of the Chief Executive Officer to the organization. It may appear onerous but it reveals the qualities of the personalities involved, namely, members of the board and the chief executive officer.

Some CEO contracts have a weak link between pay and performance. Such contracts may fail to provide that if the organizational performance worsens the Chief Executive Officer's pay will diminish proportionately.

But the opposite is also true. If the incentives given are so little compared to the resulting positive financial performance it provides no motivation to CEOs to perform even better.

Review such a contract the next time before appointing a new Chief Executive Officer.

Key Performance Indicator (KPI) Measures CEO's Effectiveness

Photo by Wen Xin

Ensure that you include a provision in the CEO contract to measure the performance of CEO. This is the key performance indicator.

This sends a very clear message that performance to the expected standard is crucial to continued employment.

Selection Process
Pearl Meyer, a compensation consultant says of the CEO Selection Process:

    "The board too often narrows its selection to one candidate - then feels so relieved to have finally found someone they fall in love...instead, the board should require the recruiter to develop at least two well-qualified and interested candidates whom it would be glad to hire. Then there's an opportunity to negotiate a compensation package that is to the benefit of both the executive and the stockbrokers."

Can you identify the right candidate for the CEO job based on your current recruitment policy and process? What are the selection criteria and can these pinpoint the right person?

Standard Provisions of CEO Contracts
The common provisions include:

  • The organization will compensate the CEO for tax liability.
  • Surely executives who are paid a lot are able to pay their own taxes. There are arguments against giving this incentive.
  • CEOs whose services are terminated for cause are entitled to some compensation. This is reasonable.
  • CEO must make every effort to work and to cooperate with a substantial block holder. Control can change hand usually with shareholding of at least fifty one percent of stocks. This is in the shareholders' interests.

Jerald A. Jacobs, in his article "What to watch for with CEO contracts" (1996), he mentions 10 areas of particular concern (in the United States), namely:

  • Compensation in which "Federal legislation passed in 1993 limits the amount of income that can be recognized in accruing retirement benefits in federally qualified pension programs."
  • Personal use of employer-provided automobile may be considered taxable income.
  • Spouse travel is very likely taxable income.
  • Management over "engaging, advancing, compensating, assigning, and terminating all other employees so long as budget and legal restraints are observed."
  • Contract conflicts with the organization's by-laws. Resolve before executing contract.
  • Term can run into several years, automatically renewed yearly until either side ends the contract by giving written notice.
  • CEO contracts often provide for termination "with cause", with no severance benefits, in circumstances which is ambiguous such as "impropriety, dishonesty, and moral turpitude." Clearly state "causes" to avoid disputes.
  • Conflicts of interest where the CEO loses job to somebody else who has something to do with appointment or decisions on incentives.
  • Severance payment to be paid within two years of the end-date of the contract, as provided for under Federal income tax rules.
  • Many contracts provide post-employment consulting arrangements.

All of us can learn from this.

Avoid one-sided CEO contracts.

There had been cases where CEOs were paid a lot of money but performance was not tied to increasing shareholders' value. Alternatively, CEOs must ensure generation of increased profits.

Termination of Contract for Cause
If your organization wants to conclude an effective CEO contract, provide for both termination for cause and termination without cause.

Do not follow any contract that redefines "cause" very widely. This can result in "substantial additional payments" which your organization is obliged to pay to its detriment.

In any event, ensure that "cause" MUST include "failure to perform."

Some organizations define "cause" to include:

  • Felony and other crimes
  • Fraud
  • Embezzlement
  • Gross negligence
  • Moral turpitude
  • Willful refusal to follow board's direction
  • Bad faith (mala fide) as defined clearly in the contract
  • A court's judgment that the Chief Executive Officer has acted in bad faith
  • Poor performance falling short of the standard expected

There are few contracts that stipulate poor performance as a basis for termination.

But problems can arise from the listing of the "causes" as the reason or reasons for ending CEO contract. Are these the only "causes" or are causes that are fairly similar included? Is the list open-ended?

On the other hand, providing for a very precise definition of the "causes" in the contract also leads to problems.

Payment of Compensation for Termination
Some organizations pay some compensation for the termination of non-performing chief executive officer in order to ease him or her out.

Unfortunately, this is a win-lose situation in favor of the executive. The CEO contract in this case should have provided that non-performance will result in termination "with cause".

Buy-out Deal
The contract may provide that the Chief Executive Officer can leave under a buy-out deal. In this case, the executive may or may not have performed well.

Under these deals, your organization does not have to worry about litigation. But you may have to pay substantial compensation.

Enter a provision on a calculation formula as the amount payable under a buy-out arrangement.

One of the factors to take into consideration is the remaining length of the employment contract. Another factor is who is making the initial move. Provide for this in the contract. The contract may need to provide for arbitration in the event of non-agreement.

You may have negotiated that failure to perform to the expectation of the board will reduce the amount payable. The question is how to calculate this figure.

If you have a well-drafted CEO contract, there is no basis for paying an exorbitant amount. And surely, your organization does not want to continue paying benefits to the "ex-CEO" long after he or she had left. It is damaging to your organization's image.

Change of Control
Some contracts trigger the payment of compensation when there is change of control of an organization.

The employee's service is "deemed" terminated. But the new owners may want to re-engage the CEO depending on his performance record.

Change of control is normally understood as majority control. This means that at least fifty-one percent of shareholding is acquired by new substantial shareholder or shareholders.

Why CEO Contracts are Important
The Chief Executive Officer is the key person in an organization, providing the necessary leadership, vision, direction and focus on a sustained basis.

The Chief Executive Officer is answerable to the board. He or she must make all the major management decisions within the ambit of the employment contract.

It is noted that in some organizations, the CEO and the Chairman of the Board is the same person. Many of these family-owned companies. But a member of the family can act as the Chairman or President and some talented outsider as the CEO.

In all that he or she does, there is only one main objective of the CEO. To make the organization succeed and achieve higher revenue.

As a form of motivation, the contract must relate performance to compensation and continued employment as the CEO.

The contract MUST provide that organizational failure is fatal to the position of the Chief Executive Officer. This is an important form of protection for your organization.

Review of Existing CEO Contract
Review the existing contract. Find out how you can improve it.

Can you strengthen the performance-pay link? How do you improve the terms to achieve a win-win situation? Can you re-negotiate the contract based on the existing terms?

Even if you cannot negotiate the terms of the present agreement with the incumbent, you are at least prepared before a new Chief Executive Officer is appointed.

In this way, your board can conclude a good CEO contract the next time around.

One other thing that board of directors need to monitor the actions of new CEOs. There are surveys that indicate that they tend to drive short-term profitability in order to secure their positions. (Jeffrey S. Harrison and James O. Fiet)

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