Executive compensation remains under the microscope of politicians, shareholders and shareholder advisory firms. A major point of contention revolves around benefits provided to executives in connection with a change in control. Surprisingly, these benefits increased during the last few years, driven primarily by the recovery in the stock market.
Change in control benefits can include severance payments, acceleration of equity awards (such as stock options or restricted stock), fringe benefits and/or any gross-up payments for excise taxes imposed as a result of Internal Revenue Code Section 280G. The Securities and Exchange Commission requires that public companies disclose the value of these benefits in the company’s annual proxy filing, and shareholders can now voice their frustration with the company’s pay practices through the say-on-pay vote.
To help companies monitor whether their change in control benefits are in line with those of their peers and to shed light on current pay practices, Alvarez & Marsal Taxand, LLC’s Compensation and Benefits Practice conducted a study of change in control arrangements among the top 200 U.S. publicly traded companies. The study was conducted in , and . We have now updated the results based on the 2011 proxy season filings.
This article summarizes our methodology and key findings for 2011. Find the comprehensive report with the full survey results, including industry-specific analysis here.
Methodology for Change in Control Analysis
We conducted a comprehensive analysis of executive change in control arrangements of the top 200 U.S. publicly traded companies. To compare practices in different industries, we reviewed the 20 largest companies in 10 different industries. The companies were selected based on market capitalization.
The analysis focused on change in control protections provided to the chief executive officer (CEO) and other named executive officers (NEOs). The analysis was based on information in each company’s SEC filings and disclosures. In particular, we reviewed the CEOs’ and other NEOs’ employment agreements, as well as the companies’ policies, equity plans, annual bonus plans, retirement plans, deferred compensation plans and proxy disclosures. Below is a summary of some key findings of the analysis, including a summary of the value of change in control benefits provided to CEOs.
- The average value of change in control benefits provided to CEOs increased to $30,263,141 in 2011 from $22,987,661 in 2009.
- 49 percent of CEOs are entitled to receive “gross-up” payments — meaning the company pays the executive the amount of any excise tax imposed, thereby making the executive “whole” on an after-tax basis. This is a reduction of almost 20 percent from the 2009 study, when this benefit was provided to 61 percent of CEOs.
- In 2011, 53 percent of companies had at least one equity plan that used a double trigger (change of control and termination of employment), compared with 28 percent in 2009.
- There are significant differences in change in control protection between industries. To examine differences in change in control protection by industry, you can access a full copy of the survey results here.
Benefit Values for CEOs
One of the main goals behind the SEC executive compensation disclosure rules is transparency. To aid in this effort, one requirement is for companies to quantify any parachute payments the CEO and other NEOs would receive upon a hypothetical change in control at year-end. From information provided in the “Potential Payments upon Termination or Change in Control” section, as well as other sections of the executive compensation disclosure, we calculated the average value for certain typical parachute payments.
On average, CEOs were entitled to change in control benefits of $30,263,141 in 2011. Nearly 60 percent of the value came from accelerated vesting of equity awards, the value of which is largely driven by fluctuations in the stock market. The pie chart below illustrates the average value for each type of benefit received by the CEOs at the top 200 U.S. publicly traded companies.
Change in control benefits for CEOs increased 32 percent over 2009, but are still lower than the 2007 values (when the stock market was at its peak). The bar chart below displays the average total benefit values provided to CEOs in 2007, 2009 and 2011.
Excise Tax Protection
Under the “Golden Parachute” provisions of Code Section 280G, a payment to an executive exceeding the “safe harbor” limit results in a 20 percent excise tax on the executive and a disallowance of the tax deduction to the corporation. Companies may address this excise tax issue in one of the following ways:
- Gross-up: The company pays the executive the full amount of any excise tax imposed. The gross-up payment thereby makes the executive “whole” on an after-tax basis. The gross-up includes applicable federal, state and local taxes resulting from the payment of the excise tax.
- Modified gross-up: The company will gross-up the executive if the payments exceed the safe harbor limit by a certain amount (e.g., $50,000) or percentage (e.g., 10 percent). Otherwise, payments are cut back to the safe harbor limit to avoid any excise tax.
- Cutback: The company cuts back parachute payments to the safe harbor limit to avoid any excise tax.
- Valley provision: The company cuts back parachute payments to the safe harbor limit if it is more financially advantageous to the executive. Otherwise, the company does not adjust the payments and the executive is responsible for paying the excise tax.
- None: Some companies do not address the excise tax; therefore, executives are solely responsible for the excise tax.
This pie chart illustrates the prevalence of excise tax protection provisions for CEOs in 2011.
Shareholder advisory firms continue to drive changes in excise tax protection. Providing excise tax gross-up protection in new or amended agreements is viewed as a “poor pay practice” that could lead shareholder advisory firms to recommend voting against the company’s say-on-pay resolution and/or the re-election of members of the compensation committee. Because of this, many companies have chosen to eliminate the use of excise tax gross-ups from executive agreements. Additionally, 51 percent of the companies that currently provide excise tax gross-up protection have disclosed their intention to eliminate this benefit in the future. Companies that have removed, or intend to remove, gross-up protection are generally moving to using a valley provision or to providing no excise tax protection to the executive.
The decline in the prevalence of excise tax gross-up protection for CEOs from 2007 through 2011 is illustrated in the chart below.
Change in Control Triggers
Upon a change in control, many companies provide for accelerated vesting of equity. For equity plans, the two most common practices to vest equity are the single trigger (only a change in control must occur) and double trigger (change in control and termination of employment must occur). We continue to see a shift towards double trigger vesting, with 53 percent of companies in 2011 that have an equity plan providing for double trigger vesting, up from 28 percent in 2009. Notwithstanding the current shift to double trigger vesting, the most prevalent method of vesting equity upon a change in control is still single trigger vesting. Our study indicates that 85 percent of companies have at least one equity plan that provides for single trigger vesting.
Alvarez & Marsal Taxand Says:
The executive compensation landscape continues to shift. While the value of benefits that CEOs are entitled to upon a change in control is on the rise, the increase is largely tied to the rebound in the stock market. Sustained pressure from shareholders, shareholder advisory firms and regulators is beginning to have a significant impact on the type of benefits provided to executives.
Benchmarking existing plans against other companies’ plans will help to validate existing benefits or expose opportunities to adjust change in control arrangements. Boards of directors and compensation committees do not want to be perceived as providing excessive change in control benefits relative to their peers, or offering benefits that conflict with maximizing shareholder value. With the increased scrutiny, companies need to be prepared to stand behind their change in control benefits.
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The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.