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Tallying the costs of soft landings for CEOs

A CEO is hired and negotiates a nice pay package. But later, the same CEO leaves and receives another, perhaps even sweeter, deal regardless of performance. Such turnover at the top can pile up, costing a company much more money than many investors realize.

By Luke Timmerman
Seattle Times business reporter

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Loudeye didn't plan to pay any single person one-fifth of its annual revenues. But when it went through a crisis and revolved through three CEOs in a couple of months, it paid that much to compensate them all — on the way in and on the way out.

The turbulent — and expensive — situation is more common than many investors realize, particularly in the Northwest, where many small companies are struggling to establish themselves in competitive, volatile industries. One out of five public companies in Washington, Oregon and Idaho changed CEOs in the past two years. The turnover cost one-third of them more than $1 million, according to a Seattle Times analysis of regulatory filings.

Each of those companies faced such a big bill because:

• The average tenure of CEOs has shrunk to about five years.

• Executives have responded by bargaining for employment contracts with golden parachutes, which are severance packages making sure shareholders take care of them when they depart, regardless of performance.

The phenomenon has become widespread and lucrative. The Corporate Library, a watchdog group, reported in a survey of 367 large companies last year that more than half of them would pay their CEOs total compensation for three years or more if the CEO were terminated. Fewer than 2 percent of companies would pay less than a year's worth, according to the report.

Graef Crystal, a San Diego-based executive compensation expert, said CEOs have successfully negotiated a way to protect themselves against the risks of shortened tenure.

"Before (in the 1970s and '80s), being a CEO was like a civil-service job, but now you actually can get fired," Crystal said. "So CEOs are responding by saying that 'if I'm going to take more risk, then I want more reward for succeeding.' And they also essentially say, 'I want $50 million or so if I fail. I want to be insured against failure, and I want it built into my contract.' "

In Loudeye's case, CEO John Baker IV received $288,000 in salary and bonus in 2002, according to regulatory filings. He resigned in early February 2003, when the company's stock traded around 35 cents a share. His departure triggered a common contract clause that sped up the vesting of 1.5 million stock options, which translated into a $1.3 million gain for him.

When Baker left, Loudeye hired a crisis-management firm, Regent Pacific Management. The firm put Philip Gioia in charge and billed Loudeye $878,000 over the next several weeks. The firm is arguing in court that it is owed another 4 million stock options for its work.

By March, Loudeye decided to promote its sales boss to the top job. It paid Jeff Cavins $331,835 in salary and bonus, and also gave him 1.5 million stock options — the same sort of incentive that proved so costly with his predecessor.

Loudeye would not say what it has done to prevent another costly CEO turnover situation. It released this statement: "Like many growing companies in an emerging market, Loudeye has been through management changes. Since the appointment of Jeff Cavins as CEO in March 2003, Loudeye has raised more than $30 million, seen its market capitalization grow by more than 1,200 percent and its share price increase more than 775 percent."

In other words, they think he's worth it.

Fred Whittlesey, an executive compensation consultant with Aon Compensation Consulting in Seattle, said the reason companies get stuck with big severances is that it's overlooked in job negotiations. Companies, he said, usually believe the newly hired CEO will lead them to greatness, making the severance issue a minor detail.

"It's one of those rare areas in business where you have a 20-page contract and nobody asks what could this cost the company in the best-case scenario, or the worst case," Whittlesey said. "It's like getting married. Nobody wants to talk about how bad things can go, you don't want a prenuptial, it spoils the mood."

Whittlesey also points out that severances have evolved away from the original intention. Severances were created to provide a safety net to workers who lost their jobs through no fault of their own in cyclical industries, to enable them to keep paying their mortgage for a few months while they found a new job.

Since CEOs are in demand, he said, they don't need nearly as much severance as they get. It's common for even failed CEOs to find a new job within six months, he said.

"Boards should be able to say to a CEO, 'You can get a job tomorrow, you're independently wealthy, there's no business reason whatsoever to pay you a severance,' " Whittlesey said.

Not every CEO departs as a failure with a big check. Some retire, some are bumped upstairs, and a few leave riding high after a turnaround.

Many of the 35 Northwest companies who changed their CEO kept the predecessor on the payroll as a consultant.

At Dendreon, a Seattle biotech company, veteran chief executive Christopher Henney handed over the controls to Mitchell Gold, and moved upstairs to board chairman. In a little more than a year, Gold bought another company, raised more than $180 million for drug development, and saw Dendreon's stock price more than double.

While that was happening, Henney dialed back his workload and his pay. He made $575,000 in salary and bonus in 2002, the last year he was in charge, and took home $375,000 in salary last year as chairman. Because Henney stayed around to give advice, the company ended up paying its new chief and old chief a combined $1.4 million last year. This month, Henney, 63, a co-founder of Immunex and Icos, said he's retiring. A fuller picture of his severance package will likely be disclosed within a year.

Actual retirements of CEOs — as opposed to instances when companies use the term to let an ousted executive save face — are one of the more murky areas of pay, said Whittlesey, the compensation consultant.

At Alaska Air Group, John Kelly handed over control to William Ayer in May 2003. Kelly earned about $410,000 in salary and bonus for about half a year's work. The company disclosed in regulatory filings that Kelly also received about $141,000 in other pay, which included a $97,000 cash parting gift, $31,000 worth of art work, and $1,900 of frequent-flier miles. The company also contributed $100,000 to a charity of Kelly's choosing. This occurred with the company was struggling with a steep drop-off in passengers following the Sept. 11, 2001, terrorist attacks and it had asked its unions to accept wage concessions.

The company's regulatory filing for 2003 also includes an unusual section on Alaska's executive retirement plan. Based on Kelly's 26.7 years of service and his final average base salary of $515,000, he's eligible to receive $417,000 a year in pension benefits.

Not many companies disclose details about executive pensions, especially for departing executives. Whittlesey said most attempts to analyze total executive pay underestimate it, because pension information is hard to find. Supplemental executive pensions are often enormous, he said, and not required to be disclosed every year to the Securities and Exchange Commission along with standard executive-pay packages.

Whittlesey said there is a movement at the SEC to require more disclosure about pensions, which are a stealth component of pay packages.

CEO pay expert Crystal said he would like to see a law that CEO severance packages come out of the board of directors' personal money. "The gravy train would come to a screeching stop," Crystal said. "And then (directors) wouldn't be able to say, 'Who cares, it's not my money.' "

Luke Timmerman: 206-515-5644 or ltimmerman@seattletimes.com

Copyright © 2004 The Seattle Times Company

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