The Advisors' Blog

– Rosanna Landis Weaver and Joann Chya, ISS’s Compensation Research Team

The reverberations of the recent financial crisis continued to ripple through U.S. corporate boardrooms this year, and executive compensation was often the epicenter of challenges and changes. Directors, only too aware of the criticisms they faced on compensation, appeared eager to announce reforms, no matter how small.
Facing increasing pressure from investors and others, some companies took steps to curtail or eliminate certain elements of non-performance-related pay. ISS is aware of at least 228 companies that have revised or eliminated problematic components of their compensation packages within the past year, for example.

The most common changes, by far, continue to be related to change-in-control practices, and more specifically to excise tax gross-ups. Excise taxes are only due upon a change of control, and then only when an executive’s payout exceeds a defined threshold. The original intention of Congress, when it defined an “excess” parachute was to limit the size of such packages by creating tax disadvantages for both the company and the individual in such cases. One unintended consequence of that legislation, though, was a move by many companies to insulate the executive from his or her potential adverse tax consequences. That trend has been changing.

At this time last year, ISS was aware of 60 companies that had made such a change. That total figure is now well over 200. Companies eliminating excise tax gross-ups, in either current or future agreements, cite evolving best practices, feedback from shareholders, the advice of consultants, and a report from the Conference Board as well as the changing policy of proxy advisory organizations. Or, as KBR stated in its proxy statement: “In light of current financial crisis, excise tax gross-ups may no longer be an appropriate component of executive compensation packages.”

Initially, many companies adopted a policy that related only to future agreements, essentially grandfathering in existing employees, and that is still a widely used approach. Interestingly, several companies that took action in 2009 to create such policies subsequently amended existing contracts or plans so that current executives would also be covered by the policy. Lender Processing Service, for example, made a commitment in May 2009 not to enter into future arrangements with the provision, then in December 2009 entered into amended agreements with officers that, among other things, eliminated tax gross-ups. Similarly, Fidelity National Financial adopted a policy in May 2009 and then amended existing contracts in February. In addition, as time passes, it appears that the greater proportion of companies making the change include current executives–rather than “grandfathering” them–either by revising their change in control plan or policies (Western Union and Scana) or by having executives agree to amendments (Analogic Devices, Assurant, BMC Software, Charming Shoppes, Church & Dwight, Global Industries Limited, Kemet, Kindred Healthcare, and Verizon Communications.) In a limited number of cases, some executives voluntarily waived their rights to a gross-up while others did not (e.g., at Dana Holdings and Brink’s Co.).

It may be that the change is most likely to occur at companies when a current contract or plan expires (e.g., AGL Resources, Group 1 Automotive, and Virgin Media.) However, companies with contracts that include auto-renew features may have more difficulty making such changes. For example, American Medical System noted that its current employment agreements “cannot be amended in any way to adversely affect executives without executive’s consent, the committee determined not to request the consent of the executives” who had agreements but adopted instead a future-focused policy.

In the majority of cases, the companies eliminating gross-up provisions replaced them with an approach often known as “best result,” under which the executive may choose between receiving the full payment and paying any resulting 20 percent excise taxes, or having the payment reduced to an amount below what would be defined as an excess parachute payment, to avoid triggering the excise tax liabilities. In some cases, the executive makes this election, but in others, the company calculates whether reduction would or would not result in the best interests of the executive “receiving greater benefits on an after tax basis.” Since the company loses a substantial tax deduction if the excise tax is triggered, a better practice is to limit the amount paid so that it falls below the threshold. For example, Kennedy-Wilson Holdings’ employment agreements provide that “in the event that CIC benefits would trigger the excise tax under Section 4999 of the [Internal Revenue] Code, benefits are to be cut back to $1 below the tax threshold.” Other companies that have adopted similar policies include Consolidated Communications Holdings and Hawaiian Electric Industries.

Many companies addressing the gross-up feature took the opportunity to make other changes as well. ISS is aware of 27 companies that moved from single-trigger to double-trigger agreements, five that eliminated modified single triggers, and six that reduced at least some severance packages.

Other Reforms

After the reforms related to change-in-control payments, the most common area of change involved executive perquisites. Several companies eliminated all or some perks. eHealth eliminated housing allowances, airfare, and auto lease perquisites, as well as gross-ups on those perks. This week, Sysco reduced its executive relocation benefits and no longer will provide reimbursement for a loss on a house sale. Interestingly, the most commonly eliminated perk was reimbursement for financial counseling, which is not one that shareholders typically object to.

Far more common was the removal of tax gross-ups on perks: 88 companies stopped paying tax gross-ups related to all or some of the perks they offer. While excise tax gross-ups can be worth millions of dollars, gross-ups on perks tend to be for amounts under $100,000. Since the actual amount of such gross-ups is usually not a significant component of what can be a multi-million dollar pay package, directors and executives alike appear to be aware that the cost in bad publicity exceeds the benefits.
A number of companies adopted multiple changes simultaneously. ISS has tracked 53 companies that adopted two pay reforms, and 15 that adopted three or more significant changes. However, it should be noted that some of the companies that adopted multiple reforms also replaced perks with other benefits: AO Smith and PolyOne offered benefit allowances, and Eastman Chemical explicitly increased salary, for example.