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Your resource on executive compensation

The Executive Edition


2010 No. 4 November 2010

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regulatory
1 Getting ready for say on pay

regulatory
Getting ready for say on pay
by Greg Kopp
The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank), signed into law on July 21, 2010, contains significant executive 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 developed an implementation schedule for proposed (and some final) rules extending through July 2011, with no time period as yet targeted for issuing many final rules. Under this timetable, only the say on pay related provisions are expected to be effective for the upcoming proxy season.

vote is required, it typically is only advisory a means for shareholders to express their general satisfaction or dissatisfaction with a companys 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 compensation (as disclosed in the companys annual proxy statement, including the compensation discussion and analysis (CD&A), compensation tables, and narrative disclosures) of its named executive officers. Under Dodd-Frank a say on pay vote must be held at least once every three years, starting with the first 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 subsequently will be held annually, every two years, or every three years.

data
5 Prevalence of clawbacks in the Hay Group 450 Severance pay policies: a study of practices and prevalence

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

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.

What is say on pay?


The term say on pay was coined to refer to a vote by a companys shareholders on the compensation of its executives. Any such vote may be mandatory (as has been required since February 2009 for companies that received US Treasury investment under the Troubled Asset Relief Program [TARP]) or discretionary (as undertaken in recent years by a few US companies). Whether or not a

As an offshoot of say on pay, Dodd-Frank requires certain disclosures and a non-binding shareholder vote regarding executive compensation arrangements in connection with proposed change-incontrol transactions (say on parachute votes).

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In any proxy statement for a shareholders meeting at which approval is sought regarding an acquisition, merger, consolidation, or proposed sale of all (or substantially all) of the companys assets, disclosure is required regarding:

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 flesh out the scope and conditions regarding this narrow exception. A company subject to TARPs 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.

any agreements or understandings with a named executive officer 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 officer, 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 effective; this is expected to be on or relatively shortly after the January 21, 2011 date for say on pay votes.

Proposed SEC rules


On October 18, 2010, the SEC issued proposed rules regarding say on pay, say on frequency, and say on parachutes; final rules are expected early in the first quarter of 2011. Regardless of when final 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:

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 officers. 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 effort to avoid receiving withhold or against votes when they next stand for election.

No specific language or form of resolution would be required 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 executive officers) and to briefly explain the general effect 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 compensation policies and decisions. With regard to the frequency vote, shareholders must be given four choices whether the shareholder vote will occur every one, two, or three years, or to abstain from voting on the matter.

Preparing for say on pay


Although 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 benefit, perquisite, or contract provision that receives particular attention from proxy advisors or the press, or does not otherwise fit 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 companys executive compensation program.

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

Reviewing pay programs in advance of say on pay


Shareholder 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 specific features. Some common areas of focus include:

pay levels, design practices, and equity usage to be reasonable and consistent with market norms improved alignment with performance with an emphasis on alignment with long-term shareholder performance.

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

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 committee and its advisors should evaluate each element of the companys pay program and compare it against a hot buttons checklist; a sample is included:

Remuneration element
Contractual elements Existence of employment contracts Severance CIC benefits Single/double trigger events Perquisites Employment benefits Post-termination benefits 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

Description of practices

Rationale

Hot button issue (Yes/No)

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The preceding checklist, adjusted for a companys specifics 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 companys overall executive compensation program. While a CD&A disclosure may describe a companys 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-forperformance. Use of tally sheets should be helpful in analyzing the details of the overall executive pay program.

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 representatives 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 communications


Communication efforts 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 companys use of best practices and any modifications 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.

Needed team
In 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 (depending on the individuals role in board-shareholder communications), the chief financial officer, the general counsel, the head of human resources, and a senior executive in investor relations. Outside legal and compensation advisors also would be consulted.

Voting frequency
As 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 votes 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 companys recommendation, but rather among the frequency choices. Not surprisingly, proxy advisory firms seem to favor a more frequent vote; ISS announced it will recommend an annual vote.

Communicating with shareholders


If not already underway, a company immediately should begin communications with its institutional shareholders to gain their insights on the strengths and weaknesses of the executive 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 modifications can be considered. Before launching a communications program, it generally would

Going forward
While we welcome efforts 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 majority 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 effort 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 reflective of the capabilities of their businesses and executives to drive performance. To the extent that companies color outside of the lines, they need an executive pay strategy that can be clearly conveyed to their stakeholders in an effort to obtain a positive say on pay vote. Encouragingly, in discussions with clients the conversation often 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 programs, to enhance alignment with the business performance, and to improve communications with stakeholders.
Greg Kopp is a consultant in Hay Groups executive compensation practice. You can reach him at +1.201.557.8435 or at greg.kopp@haygroup.com.

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Prevalence of Clawbacks in the Hay Group 450
by Steve Sabow
Hay Group reviewed the proxy statements of the Hay Group 450* to (1) determine the prevalence of clawbacks or compensation 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 background
Clawbacks 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 equitybased 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 fiscal year revenue in excess of $4 billion that filed a final proxy statement between October 1, 2009 and September 30, 2010. There are 456 companies in this years sample.

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of a financial statement which is subsequently restated due to material noncompliance of the company, as a result of misconduct, with any financial reporting requirement under securities law. SOX also calls for, under the circumstances above, the recapture of any profits 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-solicitation 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 financial 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 financial and other institutions subject to ARRAs mandates. ARRA set the stage for this years expansion of mandated clawbacks to all public companies. On July 21, 2010, President Obama signed into law the DoddFrank Wall Street Reform and Consumer Protection Act (DoddFrank). 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 officers of the company of any incentivebased compensation in the event of a required accounting restatement of certain financial information. The basic requirement 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 modifications to at least the Dodd-Frank minimums.

Clawback prevalence
Our Hay Group 450 review indicates that 55 percent of the companies disclosed (in the text of their 2010 proxy statements) a clawback provision for at least some executives. Contrast that finding with recent Equilar data indicating that clawback 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 years 2011 proxy statements should show that the prevalence of clawbacks will have risen to near 100 percent of the Hay Group 450.

Clawback adoption
Hay 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

9.6%

39.8%

Not specified Adopted in 2009/2010 Adopted pre-2009

50.6%

Incentive compensation recovery


The early clawbacks were written to recover gains from the exercise 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 statements 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).

Chart 2: Recovery of incentive compensation vehicles among the Hay Group 450
Performance cash Restricted stock/RSUs Stock options Performance equity Annual incentives 33.1% 63.3% 68.5% 69.3% 92.4%

Future clawbacks
As previously noted, thanks to Dodd-Frank, next years proxy statements should have more information than ever on clawbacks. Hay Group will extract that information and update the summary details soon after the sample is complete.
Steve Sabow is a consultant in Hay Groups executive compensation practice. You can reach him at +1.201.557.8409 or at steve.sabow@haygroup.com.

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

Industry penetration
Taking 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 experience of many financial companies, one would have thought that those organizations would be in the lead; yet only 56.4 percent of financial 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

Severance pay policies: a study of practices and prevalence


by 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 various practices affecting 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 regarding the prevalence of severance policies, benefit calculations, termination triggers, covenants, clawbacks, welfare benefits, 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 policies


Approximately 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 define the policy.

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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 executives position, as shown below:
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% CEO EVP SVP VP 71% 59% 44% 91%

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 presidents, survey participants report most commonly using a oneyear multiple of pay for severance benefits. For non-executive employee levels, a six-month multiple is most common.

Definition of pay
In the 2010 survey group, the most common definition of pay
90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Base salary Base salary & Base salary, only bonus bonus & LTI Other 11% 2% 7% 80%

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

Severance benefit calculation


In calculating severance benefits, the most common approach (39 percent) among survey participants is using a multiple of pay. Next in frequency (21 percent of participants) is determining severance benefits as a specified dollar amount, based on service to date.

for severance purposes is base salary (80 percent). Another 11 percent of the respondents define pay as base salary and bonus; only two percent of companies define pay as base salary plus bonus plus long-term incentives, a practice which has been widely criticized. The remaining companies use other definitions. In determining bonus payouts for severance benefit purposes, those survey participants including bonus in the definition 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 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.

Employee level
0.5

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


0.75 1 1.5 2 2.5 3 >3

CEO EVP SVP VP Director Exempt Non-Exempt

0% 9% 5% 26% 50% 75% 67%

0% 0% 5% 6% 25% 0% 0%

20% 41% 43% 56% 0% 0% 0%

16% 27% 24% 6% 0% 0% 0%

56% 18% 19% 6% 25% 25% 33%

0% 0% 0% 0% 0% 0% 0%

8% 5% 5% 0% 0% 0% 0%

0% 0% 0% 0% 0% 0% 0%

Target bonus

35%

Target bonus Most recent bonus award 7% 2%

15%

Most recent bonus award Average bonus award over contract period or a stated period Pro-rated award, based on target / actual results Other

10%

7%

Average bonus award over contract period or a stated period Pro-rated award, based on target / actual results Other

56% 18% 0% 10% 20% 30% 40% 50% 60%

26%

19% 0% 10% 20% 30% 40%

Termination triggers
Well-designed executive severance policies carefully define the triggering events that entitle an executive to payment. Events that typically authorize payment are an involuntary termination by the company other than for cause and a voluntary good reason resignation by an executive. However, cause and good reason can vary substantially in scope; executivefriendly definitions have broad good reason and narrow cause definitions. Often a considerable portion of the negotiations regarding the terms and conditions of an executive contract relate to the breadth and scope of these definitions.

As for the calculation of a short-year bonus for the year in which the termination occurs, 56 percent of survey participants 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.

Good reason
Definition of good reason Reduction in duties or title Relocation of office beyond mutually agreed area (e.g., 50 mile radius Reduction in compensation Breach of employment contract by company Failure to nominate executive for board of directors Prevalence among survey participants 66% 53% 38% 33% 4%

For cause
Definition of for cause Misconduct affecting the scope of employment (e.g., fraud) Non-performance (willful failure or refusal to perform duties) Gross negligence Conduct that has a material adverse effect on employer Conviction of or plea to a felony Alcohol or drug abuse adversely affecting duties Breach of contract Misconduct outside the scope of employment (e.g., moral turpitude) Failure to cooperate in an investigation of the employer by regulatory authorities Failure to provide certification required by Sarbanes-Oxley Act Prevalence among survey participants 82% 76% 71% 71% 66% 57% 54% 45% 34% 22%

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Payouts
Confidentiality / Non-disclosure 94% 79% 75% 74% 70% 0% 20% 40% 60% 80% 100%

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

Non-competition Non-solicitation (employees) Non-solicitation (customers / clients)

Salary continuation

43%

Non-disparagement

Lump-sum payment Choice of lump-sum or salary continuation (in compliance with Internal Revenue Code section 409A) Other

41%

10%

6% 0% 10% 20% 30% 40% 50%

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

Clawbacks
Thirty-five percent of all 2010 survey participants use clawbacks 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 clawbacks is cash payments (60 percent). Once the Securities and Exchange Commission has finalized rules regarding clawback policies and disclosure required by the Dodd-Frank Wall Street Reform and Consumer Protection Act, clawbacks should become virtually universal at public companies.
Compensation covered by clawbacks Cash payments Long-term incentive grants Non-qualified deferred compensation Cash value of benefits Other Prevalence 60% 24% 10% 3% 3%

Covenants
Among 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: Severance agreements Employment contracts Change in control LTI award agreements LTI plan documents Prevalence 62% 41% 23% 13% 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 specified period of time following termination Non-solicitation: no solicitation of employers customers/ clients and/or employees for a certain period of time Confidentiality / non-disclosure: no disclosure of confidential company information Non-disparagement: no criticizing an employing organization in public

Welfare benefits
Among the survey participants, health insurance is the most likely welfare benefit 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 benefits post-termination, the most prevalent continuation practices were through contract term and six months to one year.

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

Outplacement
Approximately 80 percent of the survey participants include outplacement services in their severance policies. Of these respondents, the majority defines the outplacement benefit via a set period of time. Common responses for other benefits include per contract, negotiated amount, and percent of base pay.
Outplacement benefit Set time period Fixed $ amount Other Prevalence 49% 28% 23%

hot topics
Excise tax gross-up considerations in the new world order
by 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 provisions of the Internal Revenue Code (IRC) sections 280G and 4999, respectively. Over the years many corporations determined 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 attention 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 influence of shareholder advisory groups such as Institutional Shareholder Services (ISS), compensation committees should carefully consider issues resulting from the use of excise tax gross-ups.

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

Mitigation
In some cases, organizations will require a former employee to return or cease receiving certain compensation and/or benefits 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 participants 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.

Recap
Severance policies and contracts directly impact an organizations 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 effect of these arrangements on the organization. In the changing executive compensation landscape and with increased legislative pressure, companies cannot afford 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 Groups executive compensation practice. You can reach Brian at +1.312.228.1847 or at brian.tobin@haygroup.com. You can reach Megan at +1.312.228.1827 or at megan.butler@haygroup.com.

The inequity of the parachute excise tax and the argument for tax gross-ups
In determining the amount (if any) of parachute payments subject to the 20 percent excise tax on excess parachute payments, the income tax regulations start with a disqualified individuals base amount. The base amount is the average for the five years immediately before the year of the changein-control of an employees 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.

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Example: Executives A and B both earn $1,000,000 in base salary and receive a $2,000,000 bonus for each of the five 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 five-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.
Box 1 W-2 average 2.99* x base amount

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 compensation 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 influence a companys scoring on various governance ratings (including the ISS GRId scoring).

Parachute payments ($10,000,000) greater than 2.99* x base amount? No Yes

Subject to 20 percent excise tax No Yes

Amount subject to 20 percent excise tax $0 $7,775.000

20 percent excise tax

A B

$3,500,000 $2,250,000

$10,465,000 $6,727,500

$0 $1,555,000

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

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 shareholders. As a reward for cashing out every year, A pays $0 in excise tax. On the other hand, Executive B does everything that a company 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 exercising stock options simply in hopes of maximizing their ultimate returns.)

The general public seems to agree; in an age of high unemployment and stagnant wages, an executive who leaves with millions of dollars in severance benefits 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 grossup 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 different scenarios as of the last day of the reporting year. Even though these scenarios are calculated and disclosed in a companys 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.

This example illustrates why excise tax gross-ups became prevalent in senior executive employment agreements. These excise tax gross-ups leveled the playing field for similarly-situated executives who may have acted differently with respect to stock option exercises and deferrals of compensation.

The mounting criticism and push-back against excise tax gross-ups


In recent years many shareholder advocacy groups and various business media have become increasingly critical of excise

Compensation committee considerations for 2011


This coming year 2011 will raise the stakes for compensation 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 company effective 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 officers. In addition, once the implementing rules of the SEC are effective (expected to be on or close to the January 21, 2011 date), a separate advisory, nonbinding vote of shareholders will be required by Dodd-Frank on golden parachute compensation for a companys named executive officers 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 officers 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-incontrol. 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 transaction triggering the golden parachute payments, the new disclosures and shareholder voting opportunity should result

in closer scrutiny of the change-in-control benefits offered 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 recommendation against compensation committee members. Accordingly, compensation committee members need to understand 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 irv.becker@haygroup.com. Matthew Kleger is a consultant in Hay Groups executive compensation practice. He can be reached at +1. 215.861.2341 or matthew.kleger@haygroup.com.

14 The Executive Edition

No. 4

November 2010

Hay Group is a global management consulting firm that works with leaders to transform strategy into reality. We develop talent, organize people to be more effective 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 offices in 48 countries. Our clients are from the private, public and not-for-profit sectors, across every major industry. For more information please contact your local office through www.haygroup.com

Contacts
Irv Becker U.S. National Practice Leader, Executive Compensation New York 215.861.2495 Irv.Becker@haygroup.com

James Otto Atlanta 404.575.8740 James.Otto@haygroup.com Brian Tobin Chicago 312.228.1847 Brian.Tobin@haygroup.com Robert Dill Dallas 469.232.3824 Robert.Dill@haygroup.com Garry Teesdale Los Angeles 949.251.5429 Garry.Teesdale@haygroup.com

David Wise New England 201.557.8406 David.Wise@haygroup.com Jeff Bacher Philadelphia 215.861.2399 Jeff.Bacher@haygroup.com Fred Whittlesey San Francisco 415.644.3739 Fred.Whittlesey@haygroup.com

General Inquiries
Bill Gerek Editor, U.S. Regulatory Expertise Leader Chicago 312.228.1814 Bill.Gerek@haygroup.com execedition@haygroup.com