Although his reception was chilly, the president’s timing was excellent. That’s because, at this very moment, corporate directors everywhere are realizing precisely how much money they have handed over to executives in the past and how much they have promised to bestow in the future. People who have been privy to these boardroom awakenings say they have been rude.
The sturm und drang among directors is a result of new regulations requiring greater disclosure on executive pay. Previously unknown and big-ticket items — like the amount of exit pay executives will receive in a buyout and the accumulations in their pension plans — are coming to light. Proxy statements detailing these items are being prepared now. For the first time, directors are going to have to disclose — and justify — the size of these exit and pension packages when proxy season rolls around this spring.
Among the bigger shockers in these filings are the tallies showing how much money executives will cart away if they are terminated or agree to a merger. The numbers, which include the acceleration of performance pay that would otherwise have been doled out over time, are among the hugest and most troubling to shareholders. Think of Robert L. Nardelli’s $211 million from Home Depot and the $135 million paid to John A. Kanas, former chief executive of North Fork Bancorporation, upon its sale to the Capital One Financial Corporation last March.
Buried in these figures is one of the most contentious items in all of payland: the “tax gross-up.” That is the amount shareholders must pay to cover excise taxes arising when a top manager pulls the ripcord on his or her golden parachute.
“This number has never been disclosed to shareholders in the past, but new proxy requirements will force it into public view,” said Michael Kesner, principal at Deloitte Consulting in Chicago. “Boards are now just getting a sense of how big that number is. People are surprised.”
How can the same directors who supposedly O.K.’d the provisions be in the dark about their size? Mr. Kesner said board members might have been aware of the gross-up costs when the provisions were instituted 3, 5, even 10 years ago. But few directors have kept up with the growing bills that these provisions cover. Mr. Kesner said he has seen gross-up payments sometimes reach 8 percent of the total cost of a merger.
If directors are surprised by gross-ups, you can imagine how stockholders will react. And given how ubiquitous gross-ups are — surveys say 75 percent of chief executives have such arrangements with their companies — the shocks could be far and wide.
Still, some companies have already demonstrated enlightened leadership when it comes to gross-ups. Shareholders of the Sara Lee Corporation, the consumer goods company whose brands include Hanes, Jimmy Dean sausage and L’eggs hosiery, needn’t worry about undergoing cardiac arrest because of tax reimbursements promised to its executives. Last year, as described in the company’s proxy, it eliminated all gross-up provisions on its books. Now the company’s corporate officers will have to pay excise taxes that might arise from parachute payments.
A Sara Lee spokeswoman declined to discuss why the company changed its practice on reimbursements. But it is fair to guess that its board did not view such payments as a good use of shareholder money.
Excise taxes came into being in 1984 with federal legislation intended to rein in excessive parachute pay. A tax of 20 percent kicks in when an executive’s exit package exceeds 2.99 times his or her average annual pay over the last five years. Once the 2.99 multiple has been exceeded, the executive’s entire pay is taxed, not just the excess amount.
The gross-up provisions that came after the law are yet another example of the unintended consequences of trying to legislate executive pay. With their armies of accountants and lawyers, chief executives almost always find ways around any law created to tamp down their pay. Close the door, they’ll open a window.
This creativity on behalf of corporate executives winds up costing shareholders a lot of green. That’s because combining federal, state and excise taxes usually puts an executive in a 60 percent tax bracket, Mr. Kesner explained. A company would therefore have to spend $100,000 to cover $40,000 in taxes generated by a parachute payment.
“Gross-ups are very expensive to shareholders,” Mr. Kesner said. “The board has an obligation to look at them and see whether they are reasonable.”
Companies interested in reducing shareholders’ exposure to gross-ups can do so by modifying the reimbursement practices. For example, the provisions could be structured so that if the excise tax is about to be generated because the executive’s pay exceeds the threshold by a relatively modest amount, the company could cut that compensation to ensure that it remains below the 2.99 multiple. That way, excise taxes would not kick in.
Will more companies follow Sara Lee’s example and stop billing shareholders for excise taxes altogether? Don’t count on it. Because gross-ups are so prevalent, it will take unusually assertive directors to wean executives off of them. Like personal use of the corporate jet, gross-ups are one of those special treats that executives have come to believe they deserve, no matter what.
Training the spotlight on gross-ups may help stamp them out. As long as they were kept under wraps, directors didn’t have to justify them to angry shareholders.
This year, they must. And won’t it be fun to watch them try?