Executive Severance Arrangements: How and Why They Are Changing David M. Schmidt, James F. Reda and Kimberly A. Glass *

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1 Executive Severance Arrangements: How and Why They Are Changing David M. Schmidt, James F. Reda and Kimberly A. Glass * Severance practices continue to evolve, but not as dramatically as we have seen in previous years. 1 Corporate directors persist in implementing reformations of severance practices, but at this point these changes tend to involve minor tweaks rather than drastic revisions. These reformations take place in a variety of ways: the cash severance amounts are becoming smaller, less equity is being accelerated, and the excise tax gross-up 2 provision is being phased out. Why are these changes occurring? First and foremost, the role of severance has been rede ned to allow reasonable payments to an executive following termination, with or without a change-in-control (CIC) of ownership and without a windfall payday that will enable that executive to stop working. In addition, long-term incentives, still a major component of executive compensation, foster the belief that the wealth accumulated from these awards should cushion the blow if the executive's employment is terminated. The major forces that have allowed directors to a ect change include: E Severance practices are quanti ed by companies as a result of the 2006 U.S. Securities and Exchange Commission (SEC) proxy disclosure requirements, resulting in formerly enshrouded payment promises becoming more transparent. E Shareholders are voting on severance agreements in connection with their voting on the sale or purchase of a company. The deal can be approved even if the severance agreements are voted down. E Shareholders are pressuring companies to eliminate the parachute tax gross-up provision, as articulated by shareholder advisory groups such as Institutional Shareholder Services (ISS) and Glass Lewis. E Large shareholder pressure is coming from pension funds and private equity venture capital rms that oppose single equity triggers, whereby vesting restrictions end solely upon a change in control of ownership. This is particularly heightened as merger and acquisition activity is expected to expand in 2015 and These forces are leading to the following outcomes: E Continued steep descent of golden parachute excise tax gross-ups, which are becoming nearly obsolete. Old CIC agreements are being modi ed or renewed, resulting in these gross-up provisions being replaced by: 1) Capped severance amounts (typically 2.0 or 2.99 times salary and target bonus); 2) The best net payment provision 3 * JAMES F. REDA (Managing Director), DAVID M. SCHMIDT (Senior Consultant), and KIMBERLY A. GLASS (Principal) are with Arthur J. Gallagher & Co. Human Resources and Compensation Consulting Practice. 30

2 that caps the severance at the safe harbor limit to avoid the excise tax, or pays the full amount and lets the executive pay the excise tax, or 3) Simply dropping the excise tax gross-up altogether. In summary, directors have decided that executives should be responsible for paying their own taxes. E Cash severance multiples will continue to shrink, but at a slower rate than we saw between 2008 and E Fewer and fewer equity award arrangements will single trigger (e.g., fully accelerate upon a change in control of ownership regardless of employment termination). Now, most agreements require termination of employment along with the CIC. E Modi ed single-trigger cash and equity arrangements will continue to decline. These features allow executives to voluntarily terminate employment within a certain period following a CIC and still receive their severance. E Additional perquisites and bene ts such as pension or supplemental executive retirement plan enhancements, or lifetime medical Executive Severance Arrangements bene ts will be eliminated or frozen. One of the signi cant outcomes of the proxy statement compensation disclosures involves severance payments related to a CIC. The current disclosure guidelines launched in 2006 require that the role of each element of compensation be discussed and justi ed on a principle basis. These disclosures shine a spotlight on compensation practices that were, in many cases, inconsistent with perceived good governance and reasonableness. Prompted by these disclosures, investors, shareholders, proxy advisors and the media have driven important changes in the structure of severance and CIC plans and agreements, which are discussed throughout this article. With regard to severance, there are three broad issues for all companies to consider: E Multiple of salary (and bonus) for determining cash severance E Equity full acceleration, continued vesting, prorated acceleration, partial acceleration, committee discretion, forfeiture or additional time to exercise E Tax gross-ups and implications related to termination provisions 31 CASH SEVERANCE For the majority of executives eligible for executive severance bene ts, there have been noticeable changes. Over the past several years, we have witnessed a downward trend in salary and bonus severance multiples. This compression can be attributed primarily to the pressures exerted by proxy advisors such as ISS and Glass Lewis in regard to CIC severance multiples. Over the past ve to seven years, CEO severance multiples for a CIC-related termination have trended downward from 3x salary and bonus (or higher) to 2x salary and bonus. For example, our 2009 CIC study of 2008 compensation data indicated 44% of CEOs had a severance multiple of 3x or higher. Four years later, this number was down to 40% of CEOs, and down again to 36% in While 3x or higher is still the most prevalent multiple, there has been a corresponding increase in multiples of 2x. For the other NEOs (Named Executive O cers), the decrease in multiples is even more pronounced, with only 17% eligible for a multiple of 3x or higher in 2013, down from 29% in Continuing the trend to decrease the cash severance paid to CEOs and top executives, the prevalence of CEOs receiving no cash severance upon a

3 Journal of Compensation and Bene ts CIC and termination has risen from 16% in 2008 to 22% in In most cases (89%), these severance multiples are applied to the current salary and bonus of the executive. However, for multiples greater than three, the multiplier is usually only applied to base salary (see the table on page 8 for further details). In every case, cash payments are triggered only by both a CIC and termination without cause or for good reason ( double trigger ). Figure 1. Change-in-Control Severance Multiples: 2008, 2011 and 2013 Severance Multiple CEO NEOs CEO NEOs CEO NEOs >3 times ( x ) 1% 0% 2% 1% 2% 1% 3x 43% 29% 38% 23% 34% 16% 2.6 to 2.99x 13% 12% 7% 6% 8% 7% 2 to 2.5x 20% 32% 21% 31% 23% 33% 1 to 1.5x 4% 7% 5% 13% 6% 13% Service-based 0% 0% 1% 1% 1% 4% Range 2% 1% 2% 2% 1% 2% (incl <1x) 1% 3% 3% 2% 3% 3% No additional cash severance 16% 16% 21% 21% 22% 21% Note: Range is also service-based according to the number of weeks employed, but with a minimum and maximum multiple. CEO severance multiples in non-cic situations are often lower than those related to a CIC, especially when the CIC multiple is set at 3x. In 2013, only 14% of CEOs with a 3x CIC multiple also had a 3x multiple for non-cic terminations without cause. Indeed, CEOs will often have a non-cic severance multiple of 2x (38%) or default to a company-wide severance plan or executive severance plan that is based on years of service (36%). If a CEO has a CIC multiple of 2x, the non-cic multiple will usually also be 2x (83% of cases). As the table below shows, the change in non-cic multiples has been less than that for CICrelated multiples. Figure 2. Non-CIC (without Cause/Good Reason) Severance Multiples: 2008, 2011 and Severance Multiple CEO NEOs CEO CEO NEOs NEOs >3 times ( x ) 2.7% 1.7% 2.5% 0.5% 2.5% 0.5% 3x 8.0% 1.7% 6.0% 3.0% 4.5% 2.5% 2.6 to 2.99x 2.7% 0.9% 1.5% 1.0% 1.5% 0.0% 2 to 2.5x 34.5% 27.0% 31.0% 21.5% 30.5% 18.5% 1 to 1.5x 10.6% 26.2% 9.5% 24.5% 11.0% 25.5% Service-based 5.3% 6.1% 3.0% 3.5% 2.0% 2.0% Range 3.5% 4.3% 4.0% 5.0% 7.5% 12.0% (incl <1x) 4.4% 4.3% 4.0% 4.5% 4.5% 4.0% 32

4 Executive Severance Arrangements Severance Multiple CEO NEOs CEO NEOs CEO NEOs No additional cash severance 28.3% 27.8% 38.5% 36.5% 36.0% 35.0% CEO severance multiples for termination without cause or for good reason are also applied most often to salary plus bonus, but it is not as prevalent as a CIC-related termination. Eightynine percent (89%) of CIC multiples include salary plus bonus as compared with 64% for non- CIC termination. For other NEOs, 79% of CIC multiples include salary plus bonus as compared with 57% for non-cic terminations. The table below displays a particularly high prevalence of salary plus bonus for commonly used multiples like 2x and 3x. Figure 3. Percent Using Salary plus Bonus in Cash Multiple 2013 Severance Multiple CIC Non-CIC Termination Termination CEO All Multiples 89% 64% 3x 97% 78% 2x 86% 80% NEOs All Multiples 79% 57% 3x 97% 80% 2x 87% 63% When the CIC multiple includes bonus, we found a variety of approaches were used to de ne the bonus amount. The most commonly used bonus de nition is target bonus, which was disclosed for 56% of CEOs and 51% of other NEOs. This is slightly lower than our last study when the target bonus was included for 58% of CEOs and 55% for other NEOs. The next most common de nition in 2013 was the average paid in the last three years (12% for CEOs and 14% for other NEOs). As with a CIC-related termination, the most commonly used bonus de nition for a non-cic termination is target bonus which was disclosed for 63% of CEOs and 58% for other NEOs. Figure 4. De nition of Bonus Used in the Cash Multiple 2013 Bonus De nition Change-in-Control Termination Non-CIC Termination CEO NEOs CEO NEOs Target 56% 51% 63% 58% 3-year average paid 12% 14% 15% 17% 2-year average paid 2% 4% 3% 6% > target or average paid 6% 7% 1% 4% 3-year highest paid 3% 4% 1% 1% 21% 20% 17% 14% 33

5 Journal of Compensation and Bene ts In addition to receiving a speci ed multiple of salary and bonus, severance payments related to termination without cause, for good reason or in conjunction with a CIC, may also include payment of some portion of the current year bonus. As the table shows, a majority of companies do not pay any portion of the current year bonus, but for those that do, the most common methodology is to prorate the bonus for the time actually employed. Figure 5. De nition of Bonus Used to Calculate the Current Year Bonus Payout 2013 Bonus De nition Change-in-Control Termination Non-CIC Termination CEO NEOs CEO NEOs Full Target 2.5% 2.5% 0.5% 0.0% Full Actual 0.5% 0.0% 0.5% 1.5% Prorata Actual 12.0% 10.5% 21.5% 17.5% Prorata Target 18.5% 18.0% 7.5% 7.0% Prorata 8.0% 8.0% 3.0% 4.0% Prorata > Target or Actual 2.5% 2.0% 0.0% 0.0% Prorata > Target or Previous Paid 1.5% 1.0% 0.0% 0.5% 1.5% 3.5% 0.5% 0.5% No Current Year Bonus Speci ed 53.0% 54.5% 66.5% 69.0% EQUITY ACCELERATION When an executive termination occurs, it is likely that the executive holds a substantial amount of unvested equity. The value of unvested equity can often dwarf the value of cash severance paid to the executive. How this equity is treated varies by type of termination and by type of equity award. In the case of a CIC, a distinct shift has occurred from singletrigger accelerated vesting to double-trigger accelerated vesting. This means that the executive must be terminated without cause or for good reason within a certain timeframe of the CIC date, usually within two years, in order to receive accelerated vesting. For 2008, we found that 52% of CEOs had single-trigger acceleration of equity. As of 2011, only 28% disclosed a single-trigger policy while another 2% indicated a mix of single-trigger and double-trigger provisions. By 2013, single triggers had dropped to 18%. This dramatic change in equity triggers is primarily attributable to ISS supporting the use of doubletrigger conditions for severance payments. In most cases, vesting restrictions are canceled if a CICrelated executive termination takes place. With time-vested equity such as stock options or restricted stock, approximately 90% of companies accelerate the vesting to the CIC date. However, performance-vested equity often receives di erent treatment whereby the amount of equity that vests relates to time served (prorata), based either on target award levels or on actual performance as of the CIC data. In contrast to the cash multiples, the other NEOs are treated almost always the same as the CEO when it comes to acceleration of equity. The main reason is that the termination provisions are often contained in the equity award agreement or plan document, rather than appearing separately in individual employment or severance agreements. As seen in the tables below, there has been little change in the treatment of equity acceleration in relation to a CIC since

6 Executive Severance Arrangements Figure 6. Treatment of Time-Based Equity Upon Termination CIC CEO NEOs CEO NEOs Forfeiture 5% 4% 3% 3% Prorata Acceleration 1% 2% 2% 2% Continued Vesting 1% 1% 2% 2% Full Acceleration 91% 90% 92% 92% Discretion 2% 3% 1% 1% Figure 7. Treatment of Performance Awards upon Termination CIC CEO NEOs CEO NEOs Forfeiture 5% 5% 3% 4% Prorata Acceleration 26% 22% 27% 26% Full Amount 67% 70% 69% 69% Discretion 2% 3% 1% 1% Figure 8. Calculation of Payout for Performance Awards CIC (2013) Target CIC Date End of Perf Period >Target or Actual Combo of Actual and Target Full Amount CEO 60% 16% 5% 8% 6% 5% NEOs 60% 16% 5% 8% 6% 5% Prorata Amount CEO 28% 28% 12% 12% 9% 11% NEOs 30% 28% 7% 13% 10% 13% For time-vested equity like stock options or restricted stock, if the NEO was terminated without cause, 60% to 70% of companies required the forfeiture of awards in 2013; this is much higher than the forfeiture rate of Approximately 20% of companies allow full accelerated vesting of awards at termination. The remaining 10% to 20% of companies provide prorata vesting or allow vesting to continue as if the executive were still employed. Performance-vested awards are treated di erently whereby most companies provide accelerated vesting on a prorata basis rather than full vesting. Forfeiture of these awards upon termination without cause or for good reason occurs at slightly more than 50% of the companies (52% for CEOs to 58% for other NEOs). If the plan document or award 35 agreement allows payout of incentive compensation at target levels upon the executive's termination without cause, voluntary resignation for good reason, or retirement, the compensation does not meet the requirements of quali ed performance-based compensation regardless of whether the event occurs. The position of the Internal Revenue Service (IRS) is that these are not included in the list of permissible payment events in the Section

7 Journal of Compensation and Bene ts 162(m) regulations. Therefore to qualify these grants for 162(m), the payments must be subject to performance goals and be payable at the same time as it was otherwise payable. In our study we found that in cases of either prorata or full payments related to a quali ed termination, these payments were based on actual performance against preestablished goals through the termination date to the end of the performance period, which is typically three years in length. Service-based vesting is sometimes waived but performance vesting requirements continued with accelerated vesting and continued vesting to the end of the performance period. Figure 9 shows that for CEOs in 2013, the service requirement to receive the award is not waived in 64% of companies. Correspondingly, the award is vested in a variety of ways in 34% of companies (and the remaining 2% of companies use discretion or have equity treatment classi- ed as other ). At the same time, Figure 11 shows that 67% (full amount) and 83% (prorata amount) of CEO awards are vested at the end of the performance period. Unlike terminations related to a CIC, in non-cic situations more companies now require that awards be forfeited than they did in This relates not only to time-vested awards but also performance-vested awards. Figure 9. Treatment of Time-Based Equity upon Termination without Cause (Non-CIC) CEO NEOs CEO NEOs Forfeiture 47% 54% 64% 65% Prorata Acceleration 8% 7% 9% 10% Continued Vesting 14% 14% 7% 7% Continued Vesting Prorata NA NA 5% 5% Full Acceleration 29% 23% 13% 11% Discretion 2% 2% 1% 1% 0% 0% 1% 1% Figure 10. Treatment of Performance Awards upon Termination without Cause (Non-CIC) CEO NEOs CEO NEOs Forfeiture 42% 49% 52% 58% Prorata Acceleration/Continued Vesting 33% 33% 30% 27% Full Acceleration/Continued Vesting 22% 15% 16% 13% Discretion 3% 3% 2% 2% Figure 11. Calculation of Payout for Performance Awards Non-CIC (2013) Target Termination Date End of Perf Period >Target or Actual Combo of Actual and Target Full Amount CEO 22% 11% 67% 0% 0% 0% NEOs 23% 14% 63% 0% 0% 0% Prorata Amount 36

8 Executive Severance Arrangements Target Termination Date End of Perf Period >Target or Actual Combo of Actual and Target CEO 2% 10% 83% 2% 3% 0% NEOs 3% 8% 84% 2% 3% 0% ELIMINATION OF EXCISE TAX GROSS-UPS As a result of sustained pressure by ISS and other proxy advisors, excise tax gross-ups are disappearing. Just 17% of CEOs quali ed for some type of gross-up in As recently as 2011, 31% of CEOs were eligible for this type of bene t, and in 2008, 58% of CEOs were eligible. Figure 12. CEO Excise Tax Gross-Ups The standard full excise tax gross-up provision has evolved into less expensive provisions such as a full cutback or best net payment provision. In addition, many companies that currently have a grandfathered 280G excise tax provision have committed to a policy of no excise tax gross-up provisions in future employment agreements. The following graph shows the decline of gross-ups for CEOs. SAY ON GOLDEN PARACHUTES Shareholders vote on an advisory (non-binding) basis in regard to golden parachute compensation payments. These so-called Say on Golden Parachute (SOGP) proposals are a result of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) in Dodd-Frank generally requires a shareholder advisory vote on any agreements or understandings that the company has with any of its named executive o cers, which provides compensation based on a merger or other acquisition. There have been slightly over 400 SOGP votes since 2011 with only about 5% receiving less than a majority approval. For those companies that have had less than a majority vote in favor of the parachute provisions, the reasons appear to relate to features that ISS has published as problematic pay practices. These include: 37

9 Journal of Compensation and Bene ts E Single-trigger equity vesting E Single-trigger or modi ed single-trigger cash payments E Excise tax gross-ups While the e ects of a failed SOGP vote are minimal on the eventual merger, which generally receives a high level of support, it re ects poorly on the board of directors. So implementing polices that are market-based and that directors can support will go a long way to avoid future embarrassments. CONCLUSION Companies have a reasonable amount of exibility in designing severance provisions as there is a wide range of practices. As with the curtailment of excise tax gross-ups, severance practices will continue to be in uenced by investor concerns, IRS rule changes, proxy disclosure changes, the initiation of Say on Pay (including SOGP) and economic conditions. With the information provided in this report, it is possible to design severance provisions for an executive that satisfy executive needs, are competitive with other companies, and e cient and coste ective for the company. NOTES: 1 In order to determine the design of severance bene ts, Arthur J. Gallagher & Co.'s Human Resources & Compensation Consulting Practice has conducted three studies since This report features the most recent study of 2013 severance design as reported in 2014 proxy statements (for 200 of the top U.S. public companies based on market value), a similar top 200 study of 2011 design that was completed in 2012, and our 2009 change-in-control study of 2009 proxy lings disclosing 2008 data for 126 companies in the top 200. All tables and graphs herein contain data from these three studies. 2 Additional compensation paid to an employee to pay for income taxes and the 280G 20% excise tax on excess parachute payments. 3 In the Best Net Payment Provision, the company cuts back payments to the safe-harbor limit only if the individual would receive a greater aftertax bene t than if the excise tax were paid by the individual on the excess parachute payments. 38 Reprinted with permission from the copyright holder, Journal of Compensation and Benefits. Copyright /West. For more information about this publication please visit