Already facing pressure from investors to shrink the hefty payouts executives often collect when their companies are sold, Corporate America may reconsider some aspects of the golden parachute now that businesses must disclose more details about them.
Historically, companies have had to disclose the existence of change-in-control and termination arrangements with their executives, but they haven’t had to put a dollar value on them. Under the new Securities and Exchange Commission rules for greater disclosure of executive compensation, companies now must quantify the often lucrative pay packages, which may lead some to re-examine the arrangements.
Deborah Lifshey, of compensation consulting firm Pearl Meyer & Partners, says, “There will be a lot of clean up of either poor—or crafty—drafting that has entitled some executives to windfalls on the way out the door.”
Lifshey
For example, she says, many companies are likely to reconsider “double dips,” where an executive is entitled to one severance payment or acceleration of stock option vesting upon a change of control and a second payment if he or she is later terminated. Other items likely to be reconsidered are single-trigger equity acceleration, the continued costs of perquisites and health insurance on a post-employment basis, and tax gross-ups for individuals other than the chief executive officer, Lifshey says.
The final SEC rules require companies to quantify and disclose a dollar estimate of payments and benefits that are potentially payable under various termination scenarios, and to explain the assumptions the company uses. The value of severance and change-in-control agreements is calculated with the assumption that the triggering event occurred on the last business day of the prior fiscal year, and that the price per share was the closing market price that day. That direction from the SEC has assuaged many fears about the original rule, says Paula Todd, managing principal at Towers Perrin, “but the math can be pretty complex.”
Once companies quantify their post-employment obligations, Lifshey says, they’ll be able to better assess which pieces of the package cost the most, whether those pieces make sense, and which ones might be candidates for elimination, both for good corporate governance and good public relations.
Lane
Many observers, including Brian Lane of the law firm Gibson Dunn & Crutcher, don’t expect to see outrageous disclosure in most cases, “but there are always some outlier companies who may have gotten carried away,” he says.
Lifshey says executives may be asked to give up certain portions of their termination payments in exchange for more salary, “with the theory that a bird in hand is better than two in the bush.” But such an arrangement would involve extensive analysis and assumptions, which “will take a good amount of time and expertise,” she notes.
Mounting Pressure On Some Points
Change-in-control and termination payments were under scrutiny at many corporations prior to the new rules. Scott Spector, chair of the executive compensation group at law firm Fenwick & West, cites the eye-popping golden parachutes handed out to David Ovitz at Disney and Dick Grasso at the New York Stock Exchange as two high-profile examples that other companies want to avoid. Both men received nine-figure sums; Ovitz got his after less than two years on the job, and Grasso’s received so much criticism that New York Attorney General Elliot Spitzer sued, saying it violated the charter of the then not-for-profit NYSE.
“Many companies have already re-examined their change-in-control payments because of the Grasso and Disney cases,” Spector says.
Kelly
One common standard has been to pay executives triple their salary and bonus at the time of their termination. Now, however, more companies want to lower that multiple, compensation experts say—particularly those companies that face shareholder resolutions asking them to cap executive severance. For example, says Tom Kelly, compensation office practice leader at recruiting firm Watson Wyatt Worldwide, companies such as Hewlett-Packard and Chevron reduced their severance multiples.
RULE
An excerpt from the post-employment termination provisions of the SEC’s final rule on executive compensation follow.
Other Potential Post-Employment Payments
We are adopting the significant revisions that we proposed to our requirements to describe termination or change in control provisions. The Commission has long recognized that “termination provisions are distinct from other plans in both intent and
scope and, moreover, are of particular interest to shareholders.”312 Prior to today’s amendments, disclosure did not in many cases capture material information regarding these plans and potential payments under them. We therefore proposed and are adopting
disclosure of specific aspects of written or unwritten arrangements that provide for payments at, following, or in connection with the resignation, severance, retirement or other termination (including constructive termination) of a named executive officer, a
change in his or her responsibilities,313 or a change in control of the company.
Our amendments call for narrative disclosure of the following information regarding termination and change in control provisions:
the specific circumstances that would trigger payment(s) or the provision of other
benefits (references to benefits include perquisites and health care benefits);
the estimated payments and benefits that would be provided in each covered circumstance, and whether they would or could be lump sum or annual, disclosing the duration and by whom they would be provided;
how the appropriate payment and benefit levels are determined under the various
circumstances that would trigger payments or provision of benefits;
any material conditions or obligations applicable to the receipt of payments or
benefits, including but not limited to non-compete, non-solicitation, non-
disparagement or confidentiality covenants; and
any other material factors regarding each such contract, agreement, plan or
arrangement.
The item contemplates disclosure of the duration of non-compete and similar agreements,
and provisions regarding waiver of breach of these agreements, and disclosure of tax
gross-up payments.
A company will be required to provide quantitative disclosure under these
requirements even where uncertainties exist as to amounts payable under these plans and
arrangements. We clarify that in the event uncertainties exist as to the provision of
payments and benefits or the amounts involved, the company is required to make a
reasonable estimate (or a reasonable estimated range of amounts), and disclose material
assumptions underlying such estimates or estimated ranges in its disclosure. In such
event, the disclosure will be considered forward-looking information as appropriate that
falls within the safe harbors for disclosure of such information.
We have modified the requirement somewhat in response to comments that
compliance with the proposal would involve multiple complex calculations and
projections based on circumstantial and variable assumptions. We adopt commenters’
suggestions that the quantitative disclosure required be calculated applying the
assumptions that:
the triggering event took place on the last business day of the company’s last
completed fiscal year; and
the price per share of the company’s securities is the closing market price as of
that date.
We have also revised the rule to provide that if a triggering event has occurred for
a named executive officer who was not serving as a named executive officer at the end of
the last completed fiscal year, disclosure under this provision is required for that named
executive officer only with respect to the actual triggering event that occurred. These
modifications will both facilitate company compliance and provide investors with
disclosure that is more meaningful. We further clarify that health care benefits are included in this requirement, and quantifiable based on the assumptions used for financial
reporting purposes under generally accepted accounting principles.
We further clarify in response to comments that to the extent that the form and
amount of any payment or benefit that would be provided in connection with any
triggering event is fully disclosed in the Pension Benefits Table or the Nonqualified
Deferred Compensation Table and the narrative disclosure related to those tables,
reference may be made to that disclosure. However, to the extent that the form or
amount of any such payment or benefit would be increased, or its vesting or other
provisions accelerated upon any triggering event, such increase or acceleration must be
specifically disclosed in this section. In addition, we have added an instruction that
companies need not disclose payments or benefits under this requirement to the extent
such payments or benefits do not discriminate in scope, terms or operation, in favor of a
company’s executive officers and are available generally to all salaried employees.
Source
Final Rule On Executive Compensation And Related Person Disclosure (Securities and Exchange Commission, Aug. 29, 2006)
And while it isn’t automatic, Todd notes that lowering the multiple decreases the likelihood that executives would be subject to the 280-G excise tax. The tax is a 20 percent bite that hits executives if their total parachute is greater than 2.99 times their average base compensation, calculated as the five-year average of the executive’s W-2 pay for the years prior to the change in control.
By lowering the parachute multiple, companies can eliminate the need for a tax gross-up to cover that extra bit for Uncle Sam. Commonly used, gross-ups often give rise to the biggest dollars upon a change in control. In “extreme cases,” Todd says she’s seen gross-ups that have caused the cost of a parachute to double.
Experts say companies may make some changes in the way they pay gross-ups, but few expect most companies to eliminate them, despite their inflammatory nature. Rather, a more likely solution would be conditional gross-ups (also called “valley” tests), which would cap the severance payout if it falls within a certain percentage range of the total, to avoid the excise tax and the resulting gross-up. Those that already have such provisions may widen the percentage range they use, while other companies may cap the size of their gross-ups.
Deciding On New Paths
Spector
As with many provisions of the new compensation disclosure rules, companies are still so busy trying to comply that they haven’t yet evaluated the changes they might make. Companies may make minor changes before the beginning of their next fiscal year to conform the definitions under their various agreements “so the disclosure is more manageable,” Spector says.
There’s another reason companies will wait until after next proxy season to re-evaluate their provisions, too, Kelly says: “They want to wait to see how they compare to their peers. After next spring, the pressure will increase and these disclosures will definitely get more attention.”
Some companies also are waiting for the final deferred-compensation regulations under Section 409A of the Internal Revenue Code, Lifshey says. Businesses are particularly confused about whether “good reason” termination payments treat severance payments as deferred compensation under the proposed rules, she says.
Other Changes
Todd
While the more robust disclosure may prompt boardroom discussions, experts say, in some cases, it ultimately may not change much. “Companies don’t put these provisions in without giving them careful consideration,” says Todd. “Although the dollars may be high, some companies may feel their programs are appropriate.”
Reforms also may be slow because many change-in-control agreements are pursuant to individual employment contracts or other contractual arrangements and can’t be changed unilaterally. Boards may want to revise lucrative packages, Todd says, “but there are limits to what they can change and how quickly.”
For that reason, Kelly believes that companies may move away from individual agreements in favor of umbrella policies that are easier to amend. And “walk away” clauses, which enable executives for a limited period after a change in control to quit for any reason and take their full severance, are likely to be reconsidered. Other companies may put in place change in control agreements that apply for only two or three years after hire, rather than “evergreen” agreements, he says.
Whatever the future may hold, disclosures and any subsequent changes will vary widely by company. “Every company has to look at the moving parts in their own arrangements and see what’s giving rise to the big numbers,” Todd says.
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