(Hay Group Article) - Executive Edition (November 2010)

regulatory

Getting ready for say on payby Greg Kopp

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank), signed into law on July 21, 2010, contains signifi cant execu-tive compensation and corporate governance provisions generally applicable to publicly traded companies. Since many Dodd-Frank provisions are dependent upon rulemaking by the Securities and Exchange Commission (SEC), the SEC devel-oped an implementation schedule for proposed (and some fi nal) rules extending through July 2011, with no time period as yet targeted for issu-ing many fi nal rules. Under this timetable, only the ‘say on pay’ related provisions are expected to be eff ective for the upcoming proxy season.

What is say on pay?The term ‘say on pay’ was coined to refer to a vote by a company’s shareholders on the compen-sation of its executives. Any such vote may be mandatory (as has been required since February 2009 for companies that received US Treasury in-vestment under the Troubled Asset Relief Program [TARP]) or discretionary (as undertaken in recent years by a few US companies). Whether or not a

vote is required, it typically is only advisory – a means for shareholders to express their general satisfaction or dissatisfaction with a company’s executive pay program.

Dodd-Frank made say on pay mandatory for US public companies; it requires a non-binding advisory vote of shareholders to approve the com-pensation (as disclosed in the company’s annual proxy statement, including the compensation discussion and analysis (CD&A), compensation tables, and narrative disclosures) of its named executive offi cers. Under Dodd-Frank a say on pay vote must be held at least once every three years, starting with the fi rst annual shareholders’ meeting occurring on or after January 21, 2011. A separate vote of shareholders – captioned a ‘say on frequency’ – also will be required at the same time (and then again at least once every six years) on whether the mandated say on pay vote subse-quently will be held annually, every two years, or every three years.

As an off shoot of say on pay, Dodd-Frank requires certain disclosures and a non-binding shareholder vote regarding executive compensation arrange-ments in connection with proposed change-in-control transactions (‘say on parachute’ votes).

Your resource on executive compensation

2010 No. 4 November 2010

TheExecutive Edition

Copyright © 2010, Hay Group.All rights reserved in all formats.

This publication is designed to

provide accurate and authoritative

information with regard to the

subject matter covered. If legal, tax,

or accounting advice is required,

the services of a person in such

area of expertise should be sought.

> Inside this issue

regulatory

1 Getting ready for say on pay

data

5 Prevalence of clawbacks in the Hay Group 450

7 Severance pay policies: a study of practices and prevalence

hot topics

11 Excise tax gross-up considerations in the new world order

2 The Executive Edition No. 4 November 2010

In any proxy statement for a shareholders’ meeting at which approval is sought regarding an acquisition, merger, con-solidation, or proposed sale of all (or substantially all) of the company’s assets, disclosure is required regarding:

any agreements or understandings with a named executive offi cer concerning any type of compensation that is based on or otherwise relates to the transaction; and

the aggregate of all such compensation that may be paid to or on behalf of such named executive offi cer, including the conditions upon which such compensation may be paid.

A say on parachute vote will not be required until the SEC rules regarding such vote are eff ective; this is expected to be on or relatively shortly after the January 21, 2011 date for say on pay votes.

Proposed SEC rulesOn October 18, 2010, the SEC issued proposed rules regarding say on pay, say on frequency, and say on parachutes; fi nal rules are expected early in the fi rst quarter of 2011. Regardless of when fi nal rules are issued, say on pay and say on frequency votes nevertheless will be required for annual shareholder meetings on and after January 21, 2011. Notable aspects of the proposed rules include:

No specifi c language or form of resolution would be re-quired regarding any of these votes.

A company would be required to disclose in the proxy that it is providing a separate shareholder vote on executive compensation (i.e., the compensation of its named execu-tive offi cers) and to briefl y explain the general eff ect of the vote, such as whether the vote is non-binding.

A company would be required to discuss in its next CD&A (following the say on pay vote) whether (and if so, how) the compensation committee has considered the results of the advisory votes and how the results have impacted compen-sation policies and decisions.

With regard to the frequency vote, shareholders must be given four choices – whether the shareholder vote will oc-cur every one, two, or three years, or to abstain from voting on the matter.

The results of a say on pay vote must be disclosed on a Form 8-K within four business days following the meeting date.

Director compensation is not covered by a say on pay vote.

While Dodd-Frank provides that a say on parachute vote is not required if the compensation has already been subject to a vote by shareholders, the proposed rules fl esh out the scope and conditions regarding this narrow exception.

A company subject to TARP’s requirements (which include a similar say on pay mandate) is exempt from say on pay and say on frequency votes until after its repayment of all TARP funds.

The say on pay, say on frequency, and say on parachute votes all are advisory only and may be disregarded. However, a negative say on pay vote will put pressure on compensation committees to review and justify programs and policies that impact the compensation of named executive offi cers. In the event of a negative vote, compensation committee members may feel compelled to conform to a standard advocated by shareholder representatives and activist groups in an eff ort to avoid receiving withhold or against votes when they next stand for election.

Preparing for say on payAlthough many of the provisions of Dodd-Frank have been discussed and anticipated for several years, our experience – based on conversations with clients and other professionals – is that few companies are truly prepared for the say on pay votes.

One of the challenges of say on pay is that it calls for a singular vote on the overall total remuneration program and related amounts and payouts (…the shareholder vote must relate to all executive compensation disclosure set forth pursuant to Item 402 of Regulation S-K). It is possible that a benefi t, perquisite, or contract provision that receives particular attention from proxy advisors or the press, or does not otherwise fi t the ‘norm,’ by itself could trigger a negative vote by shareholders. In the event of a negative vote, or even a relatively close favorable vote, it may not be easy to determine what was objectionable to shareholders and resulted in the negative vote. In addition, a compensation committee should not infer from a positive

vote that shareholders support all aspects of the company’s executive compensation program.

Reviewing pay programs in advance of say on payShareholder groups, proxy advisors, and the press, among others, in recent years have expressed growing opposition to various aspects of executive pay. Complaints generally have centered around the view that pay is excessive in some manner – whether in the aggregate or in one or more specifi c features. Some common areas of focus include:

limiting or eliminating various guarantees or commitments (e.g., guaranteed bonuses, severance benefi ts, change in

control (CIC) benefi ts, perquisites, post-retirement benefi ts, tax gross-ups)

pay levels, design practices, and equity usage to be reason-able and consistent with market norms

improved alignment with performance – with an emphasis on alignment with long-term shareholder performance.

The implementation of say on pay should further heighten the attention on any problematic component of executive pay. In the current skeptical environment, a compensation com-mittee and its advisors should evaluate each element of the company’s pay program and compare it against a ‘hot buttons’ checklist; a sample is included:

Remuneration element Description of practices Rationale Hot button issue (Yes/No)

Contractual elements

Existence of employment contracts

Severance

CIC benefi ts

Single/double trigger events

Perquisites

Employment benefi ts

Post-termination benefi ts

Pay design

Peer group

Target pay positioning

Base salary

Annual incentive

Structure (e.g., % of salary)

Metrics

Number of metrics

Leverage curve

Long-term incentive

Types of programs

Vesting type (time, performance)

Metrics

Number of metrics

Leverage curve

Deferrals

Clawbacks for all programs

Equity usage

Share allocation

Burn rate

4 The Executive Edition No. 4 November 2010

The preceding checklist, adjusted for a company’s specifi cs and other relevant considerations, can be used to evaluate individual pay practices and to assess the overall executive compensation program. In examining executive pay, the focus should extend beyond the traditional compensation elements of base salary, annual incentives, and long-term incentives. A company and the compensation committee must understand what practices may be especially sensitive in a shareholder vote.

A comprehensive examination of the individual elements of executive pay can be critical in understanding a company’s overall executive compensation program. While a CD&A disclosure may describe a company’s pay for performance objectives, an analysis (including a consideration of the value of all other compensation elements) may show that the program is neither especially variable nor focused on pay-for-performance. Use of tally sheets should be helpful in analyzing the details of the overall executive pay program.

Needed teamIn preparing for the say on pay process and accompanying communications, it can be helpful to form a working team that includes those members of the board and management who (1) are knowledgeable about the programs or (2) may meet with shareholders and interact with proxy solicitors. In developing this team, a company generally would start with members of the compensation committee and then consider including a member of the governance committee (depend-ing on the individual’s role in board-shareholder communi-cations), the chief fi nancial offi cer, the general counsel, the head of human resources, and a senior executive in investor relations. Outside legal and compensation advisors also would be consulted.

Communicating with shareholdersIf not already underway, a company immediately should begin communications with its institutional shareholders to gain their insights on the strengths and weaknesses of the execu-tive pay program. Interaction with shareholders can enable a company representative to discuss the rationale supporting the remuneration program and to understand shareholder concerns. Critical issues can be discussed and, where concerns are elicited, suggested modifi cations can be considered. Be-fore launching a communications program, it generally would

be helpful to develop a formal strategy with investor relations and outside advisors.

Legal niceties of course must be observed in these meetings and communications with shareholders. Company representa-tives should be informed on what types of information and disclosure can be provided. During the process of obtaining input from various shareholders on such matters as proposed equity compensation plans, a company must take care not to run afoul of Regulation FD by sharing material, non-public information.

Enhanced disclosures and communicationsCommunication eff orts should include appropriate disclosure within the CD&A, especially the reasons for a material compensation program or feature. Ideally this should be supported by rigorous analysis, including the alignment with the business and human capital strategies and business metrics. Companies should consider creating tables, charts and graphs to supplement and clarify the disclosures. Any discussion should address both the company’s use of best practices and any modifi cations made to controversial programs. Where any material, ‘hot button’ feature or program is continued, the reason(s) should be explained. As with all of these disclosures, plain English is recommended to enhance understanding and to eliminate any perception of ‘obfuscation as a core strategy.’

Voting frequencyAs previously noted, companies will be required to provide a separate shareholder advisory vote regarding how frequently a say on pay vote will occur. The SEC expects that a company will provide its recommendation as to the vote’s frequency. Early indications suggest that many companies are encouraging shareholders to approve a say on pay vote once every three years – ostensibly to provide an adequate amount of time to evaluate and modify pay programs. However, the proxy should make clear that shareholders are not voting on whether or not to approve the company’s recommendation, but rather among the frequency choices. Not surprisingly, proxy advisory fi rms seem to favor a more frequent vote; ISS announced it will recommend an annual vote.

Going forwardWhile we welcome eff orts to rationalize pay and to enhance communications with shareholders, there is some concern that management and board members may feel pressured by say on pay to homogenize their pay programs. Compensation committee members may attempt to attract a substantial ma-jority of ‘yes’ votes by conforming to the myriad compensation policy and design guidelines developed by proxy advisors, shareholder representatives, institutional managers, and other organizations. In the face of a tide favoring compensation programs that are in compliance with various guidelines and policies, some compensation committees may look to ‘cookie cutter’ compensation programs in an eff ort to avoid criticism. One sign to watch for might be an increase in communications stating that a particular pay component or compensation program ‘is consistent with our peer group.’

At the core, management and compensation committees want pay programs that create human capital advantages in attracting and retaining talented executives and aligning pay and incentives with the business strategy. As such, companies will continue to strive for appropriate – and at times unique – pay programs that are refl ective of the capabilities of their businesses and executives to drive performance. To the extent that companies ‘color outside of the lines,’ they need an execu-tive pay strategy that can be clearly conveyed to their stake-holders in an eff ort to obtain a positive say on pay vote.

Encouragingly, in discussions with clients the conversation of-ten turns to the opportunities that come with the challenges of say on pay. Compensation committees need to realize that now is the time to improve the design of compensation pro-grams, to enhance alignment with the business performance, and to improve communications with stakeholders.

Greg Kopp is a consultant in Hay Group’s executive compensation practice. You can reach him at +1.201.557.8435 or at [email protected].

data

Prevalence of Clawbacks in the Hay Group 450by Steve Sabow

Hay Group reviewed the proxy statements of the Hay Group 450* to (1) determine the prevalence of clawbacks or com-pensation recovery policies, (2) see when the clawbacks were adopted, (3) identify which incentive compensation vehicles are currently covered by clawbacks, and (4) provide industry prevalence summary data.

Clawback backgroundClawbacks or compensation recovery policies are not new phenomena; they have been in place at some companies for over a decade. However, due in part to the clawback remedy in the Sarbanes-Oxley Act of 2002 (SOX), repayment provisions have since been gaining in popularity annually. SOX sanctions the recovery of any bonus or other incentive-based or equity-based compensation received by a public company CEO and CFO during the 12-month period following the public release

* The Hay Group 450 is comprised of all public US companies with 2009 fi scal year revenue in excess of $4 billion that fi led a fi nal proxy statement between October 1, 2009 and September 30, 2010. There are 456 companies in this year’s sample.

6 The Executive Edition No. 4 November 2010

of a fi nancial statement which is subsequently restated due to material noncompliance of the company, as a result of ‘mis-conduct,’ with any fi nancial reporting requirement under se-curities law. SOX also calls for, under the circumstances above, the recapture of any profi ts realized from the sale of securities of the company during that 12-month period.

In recent years, companies have been using clawbacks to prevent fraud and enforce non-competition and non-solici-tation covenants. Additionally clawbacks are used to rectify situations where performance-based pay has been awarded in excess of what was actually due because performance was overstated or miscalculated. Many companies have provided enhanced disclosure regarding their clawback policies in their annual proxy statements, in part to assure their shareholders that they have appropriate policies in place to help prevent or mitigate the type of practices that devastated the fi nancial community in 2008.

Adding to the drive to adopt clawbacks was the enactment of the American Recovery and Reinvestment Act of 2009 (ARRA), which set another standard for compensation recovery policies for fi nancial and other institutions subject to ARRA’s mandates. ARRA set the stage for this year’s expansion of man-dated clawbacks to all public companies.

On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). Going beyond what has been required under previous legislation, Dodd-Frank requires public companies to develop, implement and disclose a clawback policy meeting certain standards, under rules to be established by the Securities and Exchange Commission (SEC). Under Dodd-Frank, a clawback policy must provide for the recovery from both current and former executive offi cers of the company of any incentive-based compensation in the event of a required accounting restatement of certain fi nancial information. The basic require-ment calls for the recoupment of any excess incentive-based compensation (including stock option gains) paid in the previous three-year recovery period. Public companies which do not have a clawback policy will now have to develop one, and those that already had a policy will need to compare their policies to the Dodd-Frank standard to identify variances and make the needed modifi cations to at least the Dodd-Frank minimums.

Clawback prevalenceOur Hay Group 450 review indicates that 55 percent of the companies disclosed (in the text of their 2010 proxy state-ments) a clawback provision for at least some executives. Con-trast that fi nding with recent Equilar data indicating that claw-back policies have grown among the Fortune 100 companies from 17.6 percent in 2006 to 82.1 percent in 2010. In view of the Dodd-Frank mandate, our review of next year’s 2011 proxy statements should show that the prevalence of clawbacks will have risen to near 100 percent of the Hay Group 450.

Clawback adoptionHay Group research has indicated that 40 percent of the clawbacks disclosed were adopted or amended in either 2009 or 2010.

Chart 1: Clawback adoption among the Hay Group 450

Incentive compensation recoveryThe early clawbacks were written to recover gains from the ex-ercise of stock options or stock appreciation rights. In a short period of time, clawbacks were expanded to recover other long-term incentives and soon thereafter, annual incentives. But our interpretation of the language used in the proxy state-ments of the Hay Group 450 indicates that 92.4 percent of the companies now want to recover annual incentives, followed by performance equity (69.3 percent) and stock options (68.5 percent).

9.6%

39.8%

50.6%

Not specified

Adopted in 2009/2010

Adopted pre-2009

Chart 2: Recovery of incentive compensation vehicles

among the Hay Group 450

Industry penetrationTaking the lead, 71.9 percent of technology companies and 69.2 percent of basic materials companies have disclosed clawbacks in their proxy statements. Given the recent experi-ence of many fi nancial companies, one would have thought that those organizations would be in the lead; yet only 56.4 percent of fi nancial companies disclosed clawbacks. However, 75 percent of commercial banks reported clawbacks. At the bottom, only 47.3 percent of consumer service companies and 50 percent of utilities disclosed clawbacks.

Chart 3: Clawbacks industry prevalence among the Hay

Group 450

Future clawbacksAs previously noted, thanks to Dodd-Frank, next year’s proxy statements should have more information than ever on claw-backs. Hay Group will extract that information and update the summary details soon after the sample is complete.

Steve Sabow is a consultant in Hay Group’s executive compensation practice. You can reach him at +1.201.557.8409 or at [email protected].

Severance pay policies: a study of practices and prevalenceby Brian Tobin and Megan Butler

Hay Group conducted a 2010 survey of severance policies in the normal course of employers’ business activities. Our main objective was to obtain current data on the prevalence of vari-ous practices aff ecting severance among employers of all sizes and across a broad group of industries.

Since we last examined severance policies four years ago, the struggling national and global economies, declining share prices and expanded proxy disclosures have resulted in an intense public focus on executive severance payments. This environment is causing corporate boards to scrutinize potential severance scenarios and inquire regarding the range of possible payouts. Boards also want to structure severance pay in a market-competitive manner that serves shareholders’ interests.

Our study yielded responses from 322 organizations regard-ing the prevalence of severance policies, benefi t calculations, termination triggers, covenants, clawbacks, welfare benefi ts, and other related concerns. As in our prior surveys, we limited our examination to severance programs in non-change-in control-situations.

Prevalence of severance policiesApproximately 90 percent of the organizations participating in the 2010 survey have a formal or informal broad-based severance policy for all employees; 65 percent of this group formally defi ne the policy.

92.4%

69.3%

68.5%

63.3%

33.1%

0.0% 20.0% 40.0% 60.0% 80.0% 100.0%

Annual incentives

Performance equity

Stock options

Restricted stock/RSUs

Performance cash

8 The Executive Edition No. 4 November 2010

The use of employment contracts to memorialize severance policies and related pay is fairly common across the survey group. Among survey participants, 55 percent reported using employment contracts with at least some executives. The prevalence of employment contracts is largely a function of an executive’s position, as shown below:

The median contract term is three years for CEOs, two years for executive/senior vice presidents and vice presidents.

Severance benefi t calculationIn calculating severance benefi ts, the most common approach (39 percent) among survey participants is using a multiple of pay. Next in frequency (21 percent of participants) is determin-ing severance benefi ts as a specifi ed dollar amount, based on service to date.

Among the survey participants that use a multiple of pay, a two-year multiple for the CEO role is the most prevalent (56 percent). For executive/senior vice presidents and vice presi-dents, survey participants report most commonly using a one-year multiple of pay for severance benefi ts. For non-executive employee levels, a six-month multiple is most common.

Defi nition of ‘pay’In the 2010 survey group, the most common defi nition of ‘pay’

for severance purposes is base salary (80 percent). Another 11 percent of the respondents defi ne ‘pay’ as base salary and bonus; only two percent of companies defi ne ‘pay’ as base salary plus bonus plus long-term incentives, a practice which has been widely criticized. The remaining companies use other defi nitions.

In determining bonus payouts for severance benefi t purposes, those survey participants includ-ing bonus in the defi nition of ‘pay’ most commonly use the target bonus opportunity (35 percent). Another fairly common approach is a pro-rated bonus calculation (26 percent). Only two percent of survey partici-pants reported using maximum bonus, highest bonus during contract period or a stated period, or higher of target bonus or average bonus over a stated period.

91%

71%

59%

44%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

CEO EVP SVP VP

Multiple of pay(e.g., 18 months of severance is a multiple of 1.5)Employee level

0.5 0.75 1 1.5 2 2.5 3 >3

CEO 0% 0% 20% 16% 56% 0% 8% 0%

EVP 9% 0% 41% 27% 18% 0% 5% 0%

SVP 5% 5% 43% 24% 19% 0% 5% 0%

VP 26% 6% 56% 6% 6% 0% 0% 0%

Director 50% 25% 0% 0% 25% 0% 0% 0%

Exempt 75% 0% 0% 0% 25% 0% 0% 0%

Non-Exempt 67% 0% 0% 0% 33% 0% 0% 0%

80%

11%

2%7%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

Base salary

only

Base salary &

bonus

Base salary,

bonus & LTI

Other

As for the calculation of a ‘short-year’ bonus for the year in which the termination occurs, 56 percent of survey partici-pants reported using a pro-rated bonus award (i.e., based upon length of time actually employed during the bonus year). Survey participants indicated notable use of ‘other’ methods (18 percent) and target bonus (15 percent). Less than two percent of survey participants reported using maximum bonus, highest bonus during contract period or a stated period, or higher of target bonus or average bonus over a stated period.

Termination triggersWell-designed executive severance policies carefully defi ne the triggering events that entitle an executive to payment. Events that typically authorize payment are an involuntary ter-mination by the company other than ‘for cause’ and a volun-tary ‘good reason’ resignation by an executive. However, cause and good reason can vary substantially in scope; ‘executive-friendly’ defi nitions have broad good reason and narrow cause defi nitions. Often a considerable portion of the negotiations regarding the terms and conditions of an executive contract relate to the breadth and scope of these defi nitions.

19%

26%

7%

10%

35%

0% 10% 20% 30% 40%

Other

Pro-rated award, based on

target / actual results

Average bonus award over

contract period or a stated

period

Most recent bonus award

Target bonus

18%

56%

2%

7%

15%

0% 10% 20% 30% 40% 50% 60%

Other

Pro-rated award, based on target /

actual results

Average bonus award over

contract period or a stated period

Most recent bonus award

Target bonus

Good reason

Defi nition of ‘good reason’Prevalence among survey participants

Reduction in duties or title 66%

Relocation of offi ce beyond mutually agreed area (e.g., 50 mile radius 53%

Reduction in compensation 38%

Breach of employment contract by company 33%

Failure to nominate executive for board of directors 4%

For cause

Defi nition of ‘for cause’Prevalence among survey participants

Misconduct aff ecting the scope of employment (e.g., fraud) 82%

Non-performance (willful failure or refusal to perform duties) 76%

Gross negligence 71%

Conduct that has a material adverse eff ect on employer 71%

Conviction of or plea to a felony 66%

Alcohol or drug abuse adversely aff ecting duties 57%

Breach of contract 54%

Misconduct outside the scope of employment (e.g., moral turpitude) 45%

Failure to cooperate in an investigation of the employer by regulatory authorities 34%

Failure to provide certifi cation required by Sarbanes-Oxley Act 22%

10 The Executive Edition No. 4 November 2010

PayoutsThe largest number (43 percent) of survey participants pay severance benefi ts on a salary continuation basis. Lump-sum payments were the next most prevalent method of payment (41 percent).

CovenantsAmong survey participants, severance agreements are the most common location for restrictive covenants (62 percent). We found that 41 percent of survey participants also include restrictive covenants in individual employment contracts.

Covenant(s) utilized in: Prevalence

Severance agreements 62%

Employment contracts 41%

Change in control 23%

LTI award agreements 13%

LTI plan documents 11%

It is common for employers to include restrictive covenants in their severance policies. Typical covenants include:

Non-competition: no competition with current employer for a specifi ed period of time following termination

Non-solicitation: no solicitation of employer’s customers/clients and/or employees for a certain period of time

Confidentiality / non-disclosure: no disclosure of confi dential company information

Non-disparagement: no criticizing an employing organization in public

Confi dentiality/non-disclosure, non-competition and non-solicitation of employees, in declining order, were the most prevalent covenants across the 2010 survey participants.

Among survey participants utilizing restrictive covenants, the most common term length was ‘through contract term’ followed by ‘one to two years.’

ClawbacksThirty-fi ve percent of all 2010 survey participants use ‘claw-backs’ to enforce their covenants. (A clawback provision, in its most basic form, requires an executive to return previously paid compensation if he or she violates an existing covenant.) The most prevalent compensation element subject to claw-backs is cash payments (60 percent). Once the Securities and Exchange Commission has fi nalized rules regarding clawback policies and disclosure required by the Dodd-Frank Wall Street Reform and Consumer Protection Act, clawbacks should be-come virtually universal at public companies.

Compensation covered by clawbacks Prevalence

Cash payments 60%

Long-term incentive grants 24%

Non-qualifi ed deferred compensation 10%

Cash value of benefi ts 3%

Other 3%

Welfare benefi tsAmong the survey participants, health insurance is the most likely welfare benefi t to be continued post-termination. Life insurance and long-term disability are continued on a less frequent basis per the survey responses. For those companies that continue to provide benefi ts post-termination, the most prevalent continuation practices were through contract term and six months to one year.

6%

10%

41%

43%

0% 10% 20% 30% 40% 50%

Other

Choice of lump-sum or salary

continuation (in compliance with

Internal Revenue Code section 409A)

Lump-sum payment

Salary continuation

70%

74%

75%

79%

94%

0% 20% 40% 60% 80% 100%

Non-disparagement

Non-solicitation (customers /

clients)

Non-solicitation (employees)

Non-competition

Confidentiality / Non-disclosure

OutplacementApproximately 80 percent of the survey participants include outplacement services in their severance policies. Of these respondents, the majority defi nes the outplacement benefi t via a set period of time. Common responses for other benefi ts include per contract, negotiated amount, and percent of base pay.

Outplacement benefi t Prevalence

Set time period 49%

Fixed $ amount 28%

Other 23%

The CEO role receives the highest fi xed dollar amount and set time period benefi t. As the employee level goes down in the organization, so does the fi xed dollar amount and set time period benefi t for outplacement services.

MitigationIn some cases, organizations will require a former employee to return or cease receiving certain compensation and/or benefi ts upon taking another position with a new employer. Consistent with our 2006 and 2004 survey results (22 percent and 21 percent respectively), 18 percent of the survey par-ticipants indicated that mitigation is part of their severance policy. 94 percent of survey participants condition severance payments upon waiver of all claims against the employer by the employee.

RecapSeverance policies and contracts directly impact an organi-zation’s ability to attract and retain top talent and are often viewed as a way to maintain the good will of employees. We have found that the recent economic times have driven a renewed focus on severance and that companies are revisiting the long-term eff ect of these arrangements on the organiza-tion. In the changing executive compensation landscape and with increased legislative pressure, companies cannot aff ord to neglect these potential liabilities. As a result, new practices and trends have been developing in this area and Hay Group will continue to collect trend information regarding severance policies and practices.

Brian Tobin and Megan Butler are consultants in Hay Group’s executive compensation practice. You can reach Brian at +1.312.228.1847 or at [email protected]. You can reach Megan at +1.312.228.1827 or at [email protected].

hot topics

Excise tax gross-up considerations in the new world orderby Irv Becker and Matthew Kleger

‘Excessive’ amounts payable on a change-in-control may be subject to a loss of tax deduction to the company and an excise tax on the employee under the golden parachute provi-sions of the Internal Revenue Code (IRC) – sections 280G and 4999, respectively. Over the years many corporations deter-mined that a ‘gross-up’ for the impact of the parachute excise tax was the preferred approach for working around the excise tax.

Recently, excise tax gross-ups have attracted negative atten-tion and have been criticized as poor pay practices. With the enactment of legislation mandating say on pay and say on golden parachutes, combined with the increased infl uence of shareholder advisory groups such as Institutional Shareholder Services (ISS), compensation committees should carefully con-sider issues resulting from the use of excise tax gross-ups.

The inequity of the parachute excise tax and the argument for tax gross-upsIn determining the amount (if any) of parachute payments subject to the 20 percent excise tax on excess parachute pay-ments, the income tax regulations start with a disqualifi ed individual’s ‘base amount.’ The base amount is the average – for the fi ve years immediately before the year of the change-in-control – of an employee’s box 1 income from Form W-2. If the aggregate present value of all payments made to an executive that were contingent upon the change-in-control at least equals three times the base amount, then all payments made in excess of one times the base amount are subject to the 20 percent excise tax. The following example illustrates how the excise tax can be unfair.

12 The Executive Edition No. 4 November 2010

Example: Executives A and B both earn $1,000,000 in base salary and receive a $2,000,000 bonus for each of the fi ve preceding years. In addition, both A and B could exercise stock options worth $500,000 per year. Executive A exercises all of his stock options every year during the fi ve-year period, while Executive B does not exercise any of her stock option awards. Also, A does not defer any of his base salary or bonus while B defers 25 percent of both base salary and bonus on an annual basis. In the year of a change-in-control, both A and B receive a $10,000,000 golden parachute package.

While this example may be extreme, it highlights the potential inequity of the excise tax.

Executive A took all of the cash he could from the company and did not align his interests with those of the sharehold-ers. As a reward for ‘cashing out’ every year, A pays $0 in excise tax.

On the other hand, Executive B does everything that a com-pany and shareholder would like – defers cash and does not exercise stock options thereby cementing her long-term interests with those of the company. By doing the right thing from a corporate governance perspective, as well as taking less cash annually, B gets hit with an excise tax bill of $1,555,000. (Of course, many executives postpone exer-cising stock options simply in hopes of maximizing their ultimate returns.)

This example illustrates why excise tax gross-ups became prevalent in senior executive employment agreements. These excise tax gross-ups ‘leveled the playing fi eld’ for similarly-sit-uated executives who may have acted diff erently with respect to stock option exercises and deferrals of compensation.

The mounting criticism and push-back against excise tax gross-upsIn recent years many shareholder advocacy groups and vari-ous business media have become increasingly critical of excise

tax gross-ups. Their argument is that gross-ups constitute poor (or most recently, problematic) pay practices that shareholders should oppose by voting against programs that contain them or by casting withhold or against votes regarding compensa-tion committee members (and, in certain instances, other directors) who approve arrangements with these gross-ups. In addition, the presence of this type of perquisite will negatively infl uence a company’s scoring on various governance ratings (including the ISS GRId scoring).

The general public seems to agree; in an age of high unem-ployment and stagnant wages, an executive who leaves with millions of dollars in severance benefi ts – and millions more in tax gross-ups – may be depicted as a poster child for excessive compensation. Because excise tax gross-ups are considered additional parachute payments subject to the excise tax (as well as regular federal and state income taxes), it typically costs a company 2.5 to 3 times the initial excise tax to gross-up the payment to make the executive whole on an after-tax basis.

As a result of enhanced Securities and Exchange Commission (SEC) disclosure rules, companies have been required for over three years to estimate termination payments under diff erent scenarios as of the last day of the reporting year. Even though these scenarios are calculated and disclosed in a company’s proxy statement, the average investor does not understand how the calculations are derived, but does know that these payments and related gross-ups are very expensive. This negative attention – and particularly the threat of withhold or against vote recommendations – has led many companies to review their attitudes towards golden parachute payments and the associated excise tax gross-ups. Many boards have made or are considering eliminating excise tax gross-ups altogether, often by restricting golden parachute payments so that they are ‘cut-back’ to ensure the IRC section 4999 excise tax is not triggered.

Box 1 W-2

average

2.99* x base

amount

Parachute payments

($10,000,000) greater

than 2.99* x base

amount?

Subject to 20

percent excise

tax

Amount subject

to 20 percent

excise tax

20 percent

excise tax

A $3,500,000 $10,465,000 No No $0 $0

B $2,250,000 $6,727,500 Yes Yes $7,775.000 $1,555,000

*2.99 used as short-hand approximation of calculating just below three times the base amount

Compensation committee considerations for 2011This coming year – 2011 – will raise the stakes for compensa-tion committees regarding the use of excise tax gross-ups. Not only must compensation committees deal with the public scrutiny and proxy advisor oversight from organizations such as ISS, but the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) will require that a public com-pany – eff ective for shareholder meetings on or after January 21, 2011 – provide shareholders with an advisory, non-binding vote on the pay (as described in its annual proxy statement) of its named executive offi cers. In addition, once the imple-menting rules of the SEC are eff ective (expected to be on or close to the January 21, 2011 date), a separate advisory, non-binding vote of shareholders will be required by Dodd-Frank on golden parachute compensation for a company’s named executive offi cers in connection with an acquisition, merger, consolidation or certain other business transactions.

Under rules proposed by the SEC concerning the say on parachute provisions of Dodd-Frank, new disclosures would be required in both tabular and narrative forms regarding golden parachute arrangements between named executive offi cers and the target or acquiring company. The proposed tabular disclosure must be quantitative and requires very detailed footnotes around the type and form of each separate component of compensation paid as a result of a change-in-control. The proposed narrative disclosure must describe the circumstances resulting in payment, along with any material conditions and obligations applicable to golden parachute payments. While the say on parachute vote is only required in connection with the proxy seeking approval of the trans-action triggering the golden parachute payments, the new disclosures and shareholder voting opportunity should result

in closer scrutiny of the change-in-control benefi ts off ered by many companies.

Also, any new or amended employment agreements entered into in 2011 will trigger a review from ISS. As previously noted, ISS considers any form of an excise tax gross-up a problematic pay practice that alone may trigger a negative vote recom-mendation against compensation committee members. Accordingly, compensation committee members need to un-derstand that if any new or materially amended employment agreement contains a parachute excise tax gross-up, they likely will be forced to defend their position to shareholders to rebut a negative recommendation from ISS.

For executives who do not receive protection through excise tax gross-ups, there likely will be an increased use of planning techniques to avoid or limit the potential application of any parachute excise tax. Some approaches may not align with shareholder interests such as a reduction of compensation deferrals, earlier stock option exercises (followed immediately by sales of shares so acquired), and holding only the minimum amount of company stock to satisfy any stock ownership guidelines. In addition, compensation committees will be exploring with their advisors various ways of mitigating any potential excise tax though compensation design practices, including consulting and non-compete agreements which can shift compensation from contingent upon a change-in-control to reasonable compensation for future services.

Irv Becker is the US executive compensation practice leader for Hay Group. He can be reached at +1.215.861.2495 or [email protected].

Matthew Kleger is a consultant in Hay Group’s executive compensation practice. He can be reached at +1. 215.861.2341 or [email protected].

14 The Executive Edition No. 4 November 2010

Contacts

Irv Becker – U.S. National

Practice Leader, Executive

Compensation

New York215.861.2495 [email protected]

James Otto

[email protected]

Brian Tobin

[email protected]

Robert Dill

[email protected]

Garry Teesdale

Los [email protected]

David Wise

New [email protected]

Jeff Bacher

Philadelphia215.861.2399Jeff [email protected]

Fred Whittlesey

San [email protected]

Hay Group is a global management consulting fi rm that works with leaders to transform strategy into reality. We develop talent, organize people to be more eff ective and motivate them to perform at their best. Our focus is on making change happen and helping people and organizations realize their potential.

We have over 2600 employees working in 86 offi ces in 48 countries. Our clients are from the private, public and not-for-profi t sectors, across every major industry. For more information please contact your local offi ce through www.haygroup.com

General Inquiries

Bill Gerek – Editor,

U.S. Regulatory Expertise

Leader

[email protected]@haygroup.com