A new RiskMetrics Group study – “Gilding Golden Parachutes: the Impact of Excise Tax Gross-Ups” – that I authored sheds light on a long obscured aspect of executive pay. The SEC’s new 2006 compensation disclosure rules lifted the veil on such benefits by requiring companies to estimate potential severance payments, including any tax gross-ups, in their annual proxy statements. These gross-ups are designed to eliminate the impact of a 20 percent penalty (excise) tax that is levied on change-in-control related severance payouts to executives that are deemed to be “excessive.”
Congress enacted the tax in 1984 in an attempt to put the brakes on what were then considered unjustifiably large payouts (though paltry by today’s standards) being made to top executives who lost their jobs after takeovers. But RiskMetrics’ study of S&P 500 companies found that, in fact, the regulation has likely spurred the growth of severance packages, as more and more companies have agreed to pay the penalty tax – and pass that expense onto shareholders. Key findings from the study include:
– A substantial two-thirds of the S&P 500 disclosed they would provide excise tax gross-ups to one or more top executives. That’s in spite of the fact that excise tax gross-ups are a costly benefit, since it generally takes at least $2.50 and as much as $4 to cover each $1 of excise tax that must be “grossed-up.”
– At 80 percent of these companies, the tax would have been triggered if the executives had received change-in-control severance at the end of the prior fiscal year–in other words, the company disclosed its estimates of the tax hit. The aggregate potential gross-up payments for all named executive officers at those companies averaged $13.9 million. And their total estimated severance, including tax gross-ups, averaged a staggering $78.4 million.
– The story was different for the one-third of companies not providing excise tax gross-ups–average total potential severance payouts to the “top five” executives at these firms was $43.9 million.
The huge gap ($34.5 million) between the average value of top executive severance packages at companies that do provide tax gross-ups, versus those that don’t, cannot be explained by the average value of the gross-ups alone ($13.9 million). This finding suggests that companies providing such gross-ups tend to pay higher change-in-control-related severance generally, likely not what Congress intended back in 1984.
Shareholders have been generally tolerant of these arrangements, but that might change now that more details are available on a regular basis. And, although the government may appreciate the revenue stream from the penalty tax, Congress may also take note of the unintended consequences of that attempt to control executive pay.
To get a window on what may happen if say-on-pay legislation is enacted in the US, look no further to the results from the recent annual shareholder meeting for Jackson-Hewitt Tax Services. As noted in the company’s Form 10-Q filed last week, 37.5% of the votes cast were voted against the company’s pay package (see Proposal III) – the highest level of opposition so far for an advisory vote in the U.S. market. This is only the fifth company in the US to allow say-on-pay on the ballot – once more companies allow it, I imagine the levels of opposition will grow given the environment out there today.
Congrats to Dave Lynn for getting quoted in this front-page article yesterday in the Washington Post. The article is entitled “Executive Pay Limits May Prove Toothless.” And more importantly, the article mentions our new treatise! I find it hard to believe, but someone told me they heard Alex Bennett review the treatise during his Sirius radio show yesterday…
As a possible harbinger of eventual extension of Section 162(m) to all Principal Financial Officers, it should be noted that the “Emergency Economic Stabilization Act” adds new subparagraph (5) to Section 162(m), which limits to $500,000 the deductibility of certain compensation paid to executives of those financial institutions participating in the Treasury’s TARP. Although this was an opportunity for Congress to amend Section 162(m) to bring the “Principal Financial Officer” (as defined by the SEC) into the definition of “covered employee,” the EESA only does this with respect to participants in TARP. Meantime, the “Principal Financial Officer” continues to be excluded from Section 162(m)’s scope (as first reported in the Sept-Oct 2006 issue of The Corporate Executive and formally accepted by the IRS in Notice 2007-49).
Careful readers will note that the EESA refers to the “chief financial officer” without defining the term, but Section 101(c)(5) of the EESA authorizes the Treasury Secretary to promulgate regulations defining terms in the EESA so the likely result will be 162(m) regulations defining ” chief financial officer” as the person who is the “Principal Financial Officer” for purposes of disclosure of executive compensation under the SEC’s rules.
The county of San Mateo, California, which lost $150 million in the recent bankruptcy of Lehman Brothers, has sued officers and directors of Lehman to recover some of their losses. The county is also suing Ernst & Young, Lehman’s auditors. The complaint – which is posted in our “Compensation Litigation” Portal – alleges that Lehman executives, in its public filings, during investor calls and at investor conferences, implied that the risks of its “Alt-A” mortgage business were adequately hedged. The executives’ public statements were not consistent with their more pessimistic internal memos, and of course, they look remarkably bone-headed now that the company has collapsed.
Since the county knew that Lehman was involved in a risky business, it essentially has to argue that Lehman’s disclosures didn’t scare them enough, which seems like a long shot.
Lehman executives recently had to appear before Congress to explain to skeptical lawmakers why Lehman’s failure wasn’t their fault. That’s part of the emotional appeal of this case, along with CEO Fuld’s huge compensation ($300 million) and vast personal fortune, which is mentioned several times in the complaint. The case bears watching to see if it survives summary judgment.
As noted in our recent paper, opponents of say-on-pay have cited a survey done for the Center on Executive Compensation of 20 of the largest investors that found only 25 percent of large institutional investors support say-on-pay.
Proponents of say-on-pay found the survey to be disingenuous. It was narrowly targeted to primarily poll institutional investors that have recognized conflicts of interests associated with the marketing their services to corporate executives. Few people were surprised to learn that large institutional investors with conflicts of interest were more reticent to support say-on-pay than shareholders generally.
We already know that 42–43% of shareholders support say-on-pay from voting results on resolutions over the last two years. From a CFA Institute survey, we also know that 76 percent of investment industry professionals support say-on-pay. What the largest and most conflicted few institutional investors might think about say-on-pay tells us more about how conflicts influence their judgment than it says about shareholder support for the concept. The fact is that nearly half of voting shareholders have consistently supported say-on-pay. Given market events of the past few months, we expect the level of support to grow.
– Jack Dolmat-Connell, CEO, DolmatConnell & Partners
We recently conducted a study on trends in executive compensation and long-term incentives (LTI) for 2008 in both the top 100 NYSE and Nasdaq firms. Despite fierce media, investor, and government claims to the contrary, the study conclusively finds that executive pay is related to firm performance. Both sets of firms have strong links between company performance and short-term and long-term incentive payouts, especially when long-term incentives are considered in a new light – that of realized and unrealized value.
The study looked at top 20 performing and bottom 20 performing companies in each index. It found that the elements of executive compensation that are the most correlated to performance (actual bonus paid, bonus payouts as a percentage of target, and the value of realized and unrealized equity), top performing CEOs far outpace their lower performing peers, both in absolute dollars and change from the prior year.
Actual total direct compensation at top performing companies for the CEO saw greater increases (up 16%) over the last year than bottom performing CEOs, who saw either little growth or slight reductions in total pay (between +3% and -3%).
More importantly, realized and unrealized equity compensation was vastly different between top and bottom performers, both in absolute amounts and year-over-year change. For example, unrealized equity compensation was at $63.4M in the NYSE top 20, up 77% from the prior year, and only $18.5M in the bottom 20, down 34.1% from the prior year. This is truly where pay for performance can be seen.
The study also revealed a direct relationship between real ownership (shares owned outright) and company performance in both indices. Top performing NYSE CEOs hold approximately eight times as much equity than their bottom performing counterparts, and top performing Nasdaq CEOs hold approximately ten times as much equity as bottom performing CEOs. Such high levels of ownership show a symbiotic relationship between ownership and performance, and give executives “skin in the game” to align their own personal wealth accumulation with the financial success of the company.
In going through Notice 2008-113 over the weekend, I found myself working out the effect of correction in the same year of a payment of deferred compensation made to a “specified employee” prior to the end of the 6-month delay as follows:
Under Section IV.B.2(b) (p.16) the employee is to repay the “amount that was erroneously paid….”
Under Section III.E (pg. 6) the “amount erroneously paid” is defined as the “gross amount paid…before…any withholding….”
Thus, it appears that if an employee in California receives approximately $65,000, net of federal and state income and employment tax withholding (at the minimum required rate and assuming any applicable wage base for employment taxes has already been exceeeded) of a $100,000 gross payment, the employee must pay back $100,000. While the employee will eventually receive $100,000 back from the employer, there is the obvious loss of use of the additional money during the time until repayment can occur, not to mention any transaction costs associated with raising the additional sum.
It also appears that while the employer can make an adjustment for employment taxes withheld under Sec. 6413 (pg. 17) the same is not to be true of withheld income taxes. Thus, part of the tradeoff for avoidance of the 409A taxes may be early payment of the income tax to be withheld.
A topic that we have been writing about much recently is hold-through-retirement provisions. Not only does this type of provision provide a fairly easy fix to the “excessive compensation” concerns raised by Treasury (and Corp Fin Director John White) – as we have blogged about before – it’s something that major investors also have recognized as a key safeguard against irresponsible pay.
Recently, the AFL-CIO, Connecticut Retirement Plans and Trust Funds and AFSCME have submitted shareholder proposals to a number of companies (eg. Citigroup), urging them to extend the minimum period that senior executives must hold onto shares obtained through equity awards. These investors plan to file about 12 proposals that seek to address the risk alignment between executives and shareholders with a hold-through-retirement provision.
As an example of these, here is the proposal submitted to Dow Chemical last week that urges the company’s compensation committee to adopt a policy requiring that senior executives retain a significant percentage of shares acquired through equity compensation programs until two years following the termination of their employment. The proposal also recommends that the committee not adopt a retention requirement lower than 75 percent of net after-tax shares.
In their supporting statement, the investors note that requiring executives to retain their company stock for extended periods prompts them to focus on the company’s long-term performance: “In the context of the current financial crisis, we believe it is imperative that companies reshape their compensation policies and practices to discourage excessive risk-taking and promote long-term, sustainable value creation.”
In addition, the Laborers’ International Union of North America, International Brotherhood of Teamsters and United Brotherhood of Carpenters and Joiners have submitted shareholder proposals to 25 of the financial companies that sought TARP funds (originally, they planned to target 50 companies but ran into deadline issues). These proposals also contain a request for hold-through-retirement by seeking a “strong retention requirement that mandates that senior executives hold for the full term of their employment at least 75% of the shares obtained through the exercise of options or the award of restricted shares.” For an example of this shareholder proposal, see page 22 of this exclusion request from SunTrust Banks.
With so many important action items impacting your proxy disclosures right now, you will want to read the Fall 2008 Issue of the Compensation Standards print newsletter that covers some key issues regarding proxy disclosures to consider now. As a bonus, the issue includes a feature entitled “The Box” that provides an important “heads-up” regarding insiders’ margin accounts and a related D&O questionnaire pointer.
Since members of CompensationStandards.com get a free subscription to the Compensation Standards print newsletter, we have posted the Fall issue online.
Don’t Forget to Renew: Since all memberships are on a calendar-year basis (ie. your membership expires at the end of December), you should renew for ’09 today to continue getting all the guidance on this blog, on this site and in the Compensation Standards print newsletter.
A Coming Wave of New-Age Repricings?
I know that a lot of companies are rethinking their executive compensation arrangements right now. We just sent the Nov-Dec ‘08 issue of The Corporate Executive to the printer. This issue contains the definitive guidance on repricings (and related compensation restructuring issues) and how to implement hold-through-retirement provisions that will help comply with Treasury’s “excessive risk” limitations.
Act Now: To receive a non-blurred version of this issue right away (and on a complimentary basis), enter a No-Risk Trial for ‘09 today.
Note that last week, the Council of Institutional Investors issued a statement warning companies not to reset the bar for CEO pay because of the market meltdown. We have posted this statement – and other memos regarding underwater options – in our “Stock Options” Practice Area. In addition, we have posted other memos about executive compensation restructuring in our “Rolling Back Compensation” Practice Area.
Congrats to the three heads of the Big Three automakers into making fools of themselves and further muddying the executive compensation debate. After failing to think on their feet and not adequately explain the justification for business use of corporate jets, the CEOs of General Motors, Ford and Chrysler tried to “make up” with America by driving to Washington this week to attend follow-up Congressional hearings.
Of course, the obvious lesson-learned is that public (and shareholder) perception matters. This lesson was not immediately apparent to GM’s CEO, who tried to convince the FAA into blocking public access to information about where its corporate jets flew after last week’s Congressional hearing fiasco made watching the jets’ whereabouts a daily journalistic endeavor. This is the same company that tried to curry favor with “the people” prior to last week’s hearing with a You Tube campaign. Apparently, that public relations campaign didn’t apply to the senior management team.
Anyways, this disturbing storyline raises all sorts of thought-provoking questions, including:
1. Given the road trip by the Big Three CEOs, is it safe for CEOs of other companies to now fly on corporate jets? Or will they also be tracked and hunted down by the media? This season’s perks disclosures are sure to obtain even more scrutiny than in the past.
2. Just how smart are these CEOs given that they say their companies are running out of cash this month – yet, they are willing to spend two days in the car driving back and forth to Washington?
3. Just how smart are these CEOs given that my last four cars have been Toyotas, including the two hybrids that we own now? It’s been painfully obvious to everyone that the Big Three’s business strategy has been way off-track. So how can their boards really argue that they have needed to pay these guys big bucks to “retain” them? (And of course, one has to seriously wonder about the judgment of those boards anyways for agreeing to pursue failed business strategies.)
4. Just how many of these reputation-obliterating episodes are we gonna have to witness with Bob Nardelli? You may recall that when he served as Home Depot’s CEO, he essentially refused to allow shareholders to ask questions at the company’s annual meeting (by not having the company’s directors and other senior officers attend the meeting). Shareholders were angry at that meeting because they wanted to ask the board about how they could give Bob such an outsized pay package.
It’s become quite clear to the general public that it’s not just a few rogue CEOs and boards that don’t “get it.” The public can see that many of our corporate “leaders” feel entitled to the pay packages lavished upon them, even though it’s hard to argue that they have earned it. And despite the little fact that they don’t own the companies…
Is Congress footnoted.org’s New Competition?
I thought it was worth noting this recent blog from Michelle Leder of footnoted.org:
Earlier this week, we saw various members of Congress outraged because the three top executives of GM (GM), Ford (F) and Chrysler took corporate jets to beg for $25 billion in money. What’s next, you might ask, will Congressmen (and women) actually start reading SEC filings?
Yikes! It’s already starting to happen! We nearly fell off our chairs when we saw this release from Rep. Steven LaTourette, who seems to have dived head-first into the amended Form S-4 that PNC Financial (PNC) filed yesterday in relation to its taxpayer assisted merger – Treasury is kicking in $7.7 billion – with National City (NCC). The newest thing in yesterday’s S-4 – updated from an earlier filing on Nov. 10 – was the disclosure of $49.49 million in severance payments for 14 executives at the bank. Here’s how the Congressman described it:
‘When you have 29,000 National City Bank employees in nine states worried about their jobs and retirement, how do 14 people get these perks when billions of taxpayer dollars are making this merger possible? What about the other 28,986 employees and the shareholders?’
Footnoted regulars may remember that National City has been something of a frequent flyer here, including this post from July which questioned the hefty parting gifts for outgoing CFO Jeffrey Kelly, who presumably will continue to collect his $54K a month through the end of 2010, even though his name is never mentioned in the filing. We also pointed out back in December 2006 – the stock was trading in the mid 30s then – the time-sharing agreement for use of the corporate jet. (Odd how it all comes full circle, huh?).
This filing also had some interesting tidbits on fees paid to different financial services companies including the $228 million that National City paid to Goldman Sachs (GS) over the past two years. But wait – there’s more. Just this morning, PNC filed a second amendment to the S-4, which spelled out details on the dilution of PNC stock and an additional $2.6 million for National City executives.
We can’t wait to read the Congressman’s take on that!