This excerpt taken from the CVS DEF 14A filed Apr 4, 2007.
The members of the CVS executive management team generally have long service with the Company and have provided the vision and leadership that have built the Company into the successful enterprise that it is today. The Committee feels that the interests of stockholders will be best served if the interests of our senior management are aligned with them, and providing change in control benefits should eliminate, or at least reduce, the reluctance of senior management to pursue potential change in control transactions that may be in the best interests of stockholders, while simultaneously preserving their neutrality in the negotiation and execution of a transaction favorable to shareholders. In addition, the security of competitive change in control arrangements serves to eliminate distraction caused by uncertainty about personal financial circumstances during a period in which CVS requires focused and thoughtful leadership to ensure a successful outcome.
CVS employment agreements with the executive officers provide certain specified severance benefits to them in the event of their termination under certain circumstances following a change in control. A change in control is defined to include a variety of events, including significant changes in the stock ownership of CVS, changes in CVS board of directors, certain mergers and consolidations of CVS, and the sale or disposition of all or substantially all the consolidated assets of CVS.
The severance benefits available to all of CVS executive officers after a change in control are structured as double trigger arrangements. That is, a change in control by itself does not result in a right to severance benefits. Such benefits are only provided if, within two years after a change in control, the executives employment is terminated by CVS without cause, or by the executive due to a constructive termination without cause. The Committee believes that it is in the best interests of the Company and its stockholders to offer such severance benefits to its executive officers. CVS competes for executive talent in a highly competitive market in which companies routinely offer similar benefits to senior employees. The severance benefits include cash severance payments, benefit continuation, pro-rata payment of outstanding LTIP awards, and a SERP enhancement and an excise tax gross-up payment, if applicable.
The Committee views the cash severance payment and the continuation of health and welfare benefits as appropriate for the executive officers, including the CEO, who may not be in a position to readily obtain comparable employment within a reasonable period after an involuntary termination subsequent to a change in control. It likewise views the vesting of outstanding LTIP awards as appropriate, since it is generally not possible to accurately measure performance according to the originally established targets during the balance of the LTIP performance cycle after a change in control.
The potential tax gross up payment, while substantial, is only applicable in the event of a change of control of the Company and subsequent termination of the executives employment and, in the Committees view, is an appropriate method for the Company to protect the executive officers from the punitive effects of a 20% excise tax levied by the federal income tax laws on certain income paid to executive officers in such circumstances. CVS offers this protection only to certain executive officers, and views it as part of the
overall change in control benefit strategy designed to remove personal financial considerations from the executives responsibility to guide the Company to the outcome most beneficial to shareholders in the event of such a transaction.
The 1997 ICP provides for the immediate acceleration of vesting on all outstanding unvested stock options and the immediate lapse of restrictions on all restricted stock or stock units upon a change in control, as defined by the 1997 ICP. To the extent that the executive officers have unvested equity awards at the time of a change in control of CVS, those awards, together with those of all other CVS employees, will be subject to the immediate acceleration and lapse of any restrictions imposed by the plan. In the Committees view, the accelerated vesting of all outstanding equity awards upon a change of control of the Company is a customary and reasonable component of an equity incentive program. The Committee believes that the equity awards granted to the executive officers and to other CVS employees have been reasonable in amount, and a substantial part of the value that would be received by them in the event of a change in control of the Company would result from the increase in the price of the Companys common stock over the years. The Committee believes that this is an appropriate result since the share price increase has likewise benefited the Companys long-term stockholders, and our executive team plays a major role in our stocks performance.
With the assistance of its compensation consultant, the Committee reviews the severance benefits annually to evaluate both their effectiveness and competitiveness. The review in fiscal 2006 found the current level of benefits to be within competitive norms for design.
The amount of the estimated payments and benefits payable to Messrs. Ryan, Rickard, Merlo, Bodine and Sgarro assuming various termination scenarios as of the last day of fiscal 2006, including a change of control of the Company and a subsequent qualifying termination of employment, is shown in the discussion of Payments Under Termination Scenarios beginning on page 47.
IRC Section 162(m) generally disallows a tax deduction to public companies for compensation over $1 million paid to a companys chief executive officer and the four other most highly compensated executive officers at year end. Qualifying performance-based compensation will not be subject to the deduction limit if certain requirements are met.
The Committees policy is to generally preserve corporate tax deductions by qualifying compensation paid to named executive officers that is over $1 million as performance-based compensation. To this end, the Board adopted and stockholders approved the 1997 ICP, which permits annual incentive awards and stock options (and certain other awards) to qualify as performance-based compensation not subject to the limitation on deductibility. However, maintaining tax deductibility is but one consideration among many and is not the most important consideration in the design of the compensation program for senior executives. The Committee considers the anticipated tax treatment both to the Company and the executive in its review and approval of compensation grants and awards. The deductibility of some types of compensation payments will be contingent upon the timing of an executives vesting or exercise of previously granted rights, and is also subject to amendment or modification based on changes to applicable tax law. The Committee may, from time to time, conclude that certain compensation arrangements are in the best interest of CVS and its stockholders and consistent with its stated compensation philosophy and strategy despite the fact that such arrangements might not, in whole or in part, qualify for tax deductibility. As a general practice the only elements of the multi-faceted CVS executive compensation program that currently do not comply with the deduction rules of Section 162(m) are any base salaries above $1,000,000 (which applies only to Mr. Ryan as of April 2006) and certain time-vested restricted stock unit awards. However, most of these units have been voluntarily deferred to termination of service, which will preserve their deductibility. The majority of the variable pay opportunities offered to the CVS executive team, including the annual incentive award, outstanding and future cycles of the LTIP and the annual stock option award, are performance-based and fully deductible.
Effective January 1, 2006, CVS was required to recognize compensation expense of all stock-based awards pursuant to the principles set forth in FAS 123(R). Consequently, the Company began recording a compensation expense in its financial statements for stock options and other equity awards granted during fiscal 2006 and thereafter. Despite the accounting change, the Committee believes that stock options and other forms of equity compensation are an essential component of the Companys equity strategy, and it intends to continue to offer options and restricted stock units as a major portion of its long-term incentives.