In the sunlight of required disclosure, excise tax grossups are looking grosser than ever.
A new study of grossups—where companies cover the 20 percent excise tax levied on severance payments that exceed certain limits imposed by the federal tax code—reveals that the payments can often cost millions, and often dwarf the underlying benefit the executive is receiving. The findings are sure to galvanize governance activists still more, as they prepare for fierce assaults on executive pay packages in the coming proxy season.
The report, conducted by proxy advisory firm RiskMetrics, examines excise tax grossup provisions on potential change-in-control termination payments among S&P 500 companies, based on an analysis of the most recent proxy statements of companies in the index as of July 1, 2008. Companies are disclosing the value of grossup payments thanks to new rules from the Securities and Exchange Commission forcing more disclosure of executive pay generally. Until now, everyone knew about excise tax grossups, but few understood how much they actually cost.
Two-thirds of those companies promise excise tax grossups to senior executives in connection with a change in control. Of that number, 81 percent had named executive officers with severance agreements that would trigger the tax grossup as of the time of disclosure. Most of the companies that pay excise tax grossups (82.4 percent) would provide them to all their named executive officers.
Strategies to make excise tax grossups more tolerable to shareholders have also emerged, although consultants say they aren’t yet widespread.
For the companies that reported grossup payments, RiskMetrics reports that the average grossup totaled $13.9 million, roughly 18 percent of total potential change-in-control payments. In extreme cases, the report notes, grossup payments may exceed $100 million and constitute up to 45 percent of total payouts.
Excise tax grossups comprise such a large portion of potential change-in-control payments because in addition to the excise tax, they often also cover the additional income tax resulting from the gross-up payments.
RiskMetrics also found a sharp difference in total possible change-in-control payments between those companies that do offer excise tax grossups and those that don’t. The average possible payout for companies with grossups was $72.5 million, compared to only $43.9 million for companies that don’t pay grossups.
Bowie
“A key finding is that companies providing excise tax grossups are paying higher severance packages in the first place,” says Carol Bowie, who leads RiskMetrics’ Governance Institute. “That connection is unmistakable and it’s definitely raised some questions as to the total impact of the practice.”
Indeed, on average, the total potential payments for companies that provide excise tax grossups are a whopping 65 percent higher than the total potential payments for companies that don’t, according to the report.
TOP 15 GROSS-UPS
The 15 largest potential excise tax gross-up payments, based on disclosures in 2008 proxy statements.
Ticker
Company Name
Sector
Potential Gross-Up Payment
NBR
Nabors Industries
Energy
$160,317,723
STT
State Street
Financials
$78,990,000
BK
Bank of NY Mellon
Financials
$65,644,102
TXT
Textron
Industrials
$64,755,777
HON
Honeywell
Industrials
$49,987,044
WYE
Wyeth
Healthcare
$49,000,000
BJS
BJ Services
Energy
$48,486,770
XTO
XTO Energy
Energy
$46,619,137
FCX
Freeport-McMoran
Materials
$43,627,320
SGP
Schering-Plough
Healthcare
$43,299,512
MCK
McKesson
Healthcare
$42,221,304
SRE
Sempra Energy
Utilities
$41,128,712
HES
Hess
Energy
$40,775,086
CVS
CVS Caremark
Staples
$37,617,644
CI
Cigna
Healthcare
$35,719,000
Source
RiskMetrics (November 2008).
Among the companies studied, the 15 largest potential excise tax grossup payments all topped $35 million. A prime example is Nabors Industries, the oil services giant: It says it would be obligated to pay a combined $160 million in grossup payments to its two senior executives upon a change in control. Nabors’ total potential change-in-control payments would amount to $613 million, or 7.24 percent of the company’s average market cap in 2007.
Fired Up on Grossups
Although loathed by investors, excise tax grossups are fairly common. Research at The Corporate Library shows that 56 percent of Russell 1000 companies and roughly 32 percent of Russell 2000 companies provide excise tax grossups to their CEOs upon a change in control.
Hodgson
“That’s a direct cost to shareholders with no real benefit,” says Paul Hodgson, senior research associate at The Corporate Library.
Companies often claim that excise tax grossups equalize the unfair excise tax treatment against long-serving executives, those who don’t exercise options, and those who defer compensation. Since the test for excessive severance payments is based on W-2 compensation, which includes the value realized from option exercises but excludes deferred compensation, an executive who has realized large taxable gains from exercising options and hasn’t deferred compensation in the five years prior to a change-in-control would have a higher base amount than an executive who didn’t exercise options or defer compensation; that second person would be less likely to trigger the excise tax.
Seelig
But Steve Seelig, executive compensation counsel at recruiting firm Watson Wyatt, says that when his firm tested that theory, “It didn’t hold water.”
Watson Wyatt modeled the compensation of 10 CEOs in large companies in various industries that provide excise tax grossups. It divided CEOs into “bad soldiers” who exercised options as quickly as possible, and “good soldiers” who held options until they were monetized in a change-in-control event. (Watson Wyatt plans to publish that data in January.)
The result? “In 9 out of 10 cases, we found that the ‘good soldier’ did better … even without the excise tax grossup,” Seelig says. “For some companies, the math might not work the same way, but I suspect many companies would be surprised to see the [excise tax] grossup might not be necessary.”
He suggests companies “do the math and figure out whether they’re paying additional money in excise tax grossups that isn’t needed.”
Still, consultants say getting rid of excise tax grossups isn’t an easy task. Unlike other types of grossups (such as those on perks) the provisions are “baked into employment contracts so they’re difficult to unwind,” says Deb Bilak, a principal at Mercer Consulting.
That being said, the RiskMetrics report cites a number of companies that have revised their employment and severance agreements to curtail excise tax grossups, including AT&T, Ciena, Colgate-Palmolive, EMC, Fortune Brands, MetLife, Snap-On, and UnitedHealth Group.
Borges
“Shareholders have never liked them, but until recently they didn’t have hard data to back up the claims that these provisions are too expensive,” says Mark Borges, a principal at Compensia. “Now that companies are disclosing how much they would pay, it’s a real eye opener for shareholders and compensation committees.”
TOP 10 CIC PAYMENTS
The ten largest potential change-in-control payments as percentage of market capitalization.
Company
Total Potential CIC
% of Market Cap
Nabors Ind.
$613,382,159
7.24%
PerkinElmer
$120,738,090
3.84%
Tesoro Petroleum Co.
$263,311,090
3.74%
Dillard
$73,902,220
3.23%
Meredith Corp.
$83,582,046
2.99%
Wendy’s
$34,771,815
2.51%
AK Steel Holding
$96,203,177
2.39%
Aber. & Fitch
$151,379,857
2.20%
Hercules
$50,091,682
2.19%
BJ Services
$166,525,742
2.13%
Source
RiskMetrics (November 2008).
Due to the increased scrutiny of compensation generally, Bilak says companies are “more thoughtful” when they enter into new employment agreements. For instance, she sees more companies considering double triggers for severance payments that, in addition to a change in control, require that the executive be dismissed to receive payment.
Securing Support
Strategies to make excise tax grossups more tolerable to shareholders have also emerged, although consultants say they aren’t yet widespread. Most common is the “modified grossup,” which scales back the severance payment to avoid triggering the excise tax. The trouble with that approach, Borges says, is that while companies can quantify an executive’s cash severance, they can’t predict what the value of any equity that would vest upon a change-in-control five years in the future would be—so nobody can be sure whether the severance payment would trigger the grossup.
A less popular option is to eliminate the acceleration of equity awards upon a change in control to mitigate the risk of triggering the excise tax. Another possibility is to establish limited grossup provisions that phase out over time, although Bilak says she hasn’t seen any companies do that yet.
As a result of existing shareholder pressure combined with renewed demands to scale back compensation programs in light of the current economic crisis, Borges says he expects to see fewer excise tax grossups in the coming year.
And not surprisingly, the provisions will again be a sore point with investors for the 2009 proxy season. RiskMetrics has added excise tax grossups to its list of poor practices that could result in negative recommendation on compensation committee members. Additionally, Bowie says at least three shareholder proposals targeting gross ups have already been filed. More are bound to come.
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