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Tightening the Parachute Strings

Human Resource Executive Online, March 11, 2008

The IRS recently acted to tighten the rules affecting executive severance of more than $1 million, requiring companies to review their agreements. And more changes may be in the winds as well, as Congress continues to look into executive comp.

By Stephen Barlas

Companies have some new tax considerations that will force them to rethink many of the performance-based severance packages they have developed for top executives in the past.

It's possible the Internal Revenue Service was responding to prevailing political winds when it tightened its rules dealing with when executive compensation of more than $1 million can be deducted from corporate taxes.

The IRS > action on Feb. 21 may deflate some lucrative exit packages -- known as golden parachutes -- and may be the harbinger of upcoming congressional moves to eliminate the pay deduction entirely.

Steve Seelig, executive compensation counsel at Washington-based Watson Wyatt, says it is not clear whether the < IRS > was primarily motivated by what it learned in recent corporate audits or by the current political climate.

For example, had the new < IRS > ruling been in effect prior to Stan O'Neal's forced resignation from Merrill Lynch in October -- just a week after the investment bank reported its largest-ever quarterly loss of $2.24 billion -- Merrill would have qualified for a much smaller tax deduction.

O'Neal appeared before the House Oversight and Government Reform Committee on March 7, as part of chairman Rep. Henry Waxman's continuing investigation into the "compensation of executives who preside over billion-dollar losses."

Waxman, D-Calif., noted in his opening statement that the hearing was not about "illegality or even ethical breaches. It's a hearing to ... help us understand whether this situation is good for the companies, the shareholders and for America."

O'Neal -- who left Merrill Lynch with a $161 million retirement package -- was joined at the Waxman hearing by other CEOs who had been extremely well compensated by their floundering companies: Angelo R. Mozilo of Countrywide Financial Corporation -- who received more than $120 million in compensation and sales of stock as the company lost $1.6 billion in 2007 and its stock lost 80 percent of its value -- and Charles Prince of Citigroup -- who was awarded a $10 million bonus, $28 million in unvested stock options and $1.5 million in perks when he left the company.

It is congressional dissatisfaction with those kinds of pay packages that has led to talk about further curtailing exceptions to the $1 million pay cap.

A spokesman for Sen. Max Baucus, D-Mont., chairman of the Senate Finance Committee, says Baucus "is reviewing proposals that would affect deferred compensation, as he has been since last January. He remains committed to working with his colleagues, including Sen. [Chuck] Grassley, on this issue."

Grassley, from Iowa, is the top Republican on the committee.

With regard to the new < IRS > policy, Seelig says companies now need to examine severance and retirement packages to make sure they don't simply pay out at target levels.

This raises a couple of possibilities of how companies will seek to amend existing agreements. For example, a plan that pays out at target for a termination one year into a three-year performance might make the executive wait until the actual results come in at the three-year mark before paying out.

Or the company could substitute a severance agreement that entitles an executive to a specific dollar amount if he or she leaves prior to the end of the performance period.

Section 162(m) of the < IRS > Code explains when companies can take more than a $1 million deduction for the pay of any of its top five executives, excepting the chief financial officer. That $1 million cap does not apply to qualified performance-based compensation.

Based on rulings the < IRS > issued in 1999 and 2006, companies could pay, and top executives could receive, a pro-rated share of a performance-based award even if they left the company before the performance period ended, and before it was clear those performance goals had been met, as long as the executive left the company as a result of being terminated without "cause" or if he or she voluntarily terminated his or her employment for "good reason."

In its revenue ruling issued on Feb. 21, the < IRS explained that an employee could leave for "good reason" or be terminated without "cause" simply because that employee missed interim performance targets. Therefore, he or she was not eligible for performance-based pay, nor could the company deduct that pay of more than $1 million.

Seelig says that although 162 (m) explicitly deals with the five highest-paid corporate employees (not including the CFO), companies typically look at pay packages for lower-ranking employees outside the top five.

That is because, if a company, for example, sets a three-year performance period for its top 10 executives, it won't be clear at the start of the period which of those 10 will be in the "top five" three years later.

Infrastructure, cost blunt E85 adoption

Automotive Engineering, March 2008

Alexander Karsner, an assistant secretary at the Department of Energy, was obviously ticked at what he perceives as the slow introduction of E85-fueled vehicles when he appeared before the Senate Energy Committee on February 7. Sen. Jeff Bingaman (D-N.M.) had called the hearing because of growing fears that the renewable fuels mandate included in last year’s energy bill is unworkable.

Both Bingaman and Sen. Pete Domenici (R-N.M.), the ranking Republican, indicated that the committee may write a “technical corrections” bill which would revise the renewable fuel provision in the Energy Independence and Security Act (EISA) of 2007, which President Bush signed on December 19. That provision mandated the use of 9 billion gallons of renewable fuel in U.S. autos by 2008 and 36 billion by 2022. That is quite an increase from the 2005 energy bill, which set a goal of 5.4 billion gallons in 2008. The EISA provision did not establish any numerical goals for the production of flexible fuel vehicles, which ostensibly will be needed to use the corn- and cellulose-based ethanol fuel that will be produced in large amounts. But there is certainly de facto political pressure on Detroit to step up its FFV production, and fast, a fact reflected in Karsner’s testimony.

But reaching 9 billion gallons in 2008 depends on a heck of a lot more than the appearance of new FFV models from Detroit. Numerous witnesses at the Bingaman hearings—none of them from the auto industry—testified that the near term ethanol production/use goals were probably unrealistic and that for the goals to be reached many things will have to fall into place, including a fueling infrastructure and certification by EPA of fuels somewhere between E10 and E85 for use in conventional engines, actions which have nothing to do with the production rate of E85 vehicles.

Karsner noted the infrastructure problems, the shortage of fueling stations and the difficulty of getting ethanol to the East Coast. But he seemed to come down particularly hard on the auto industry on a day after GM North America President Troy Clarke told the Chicago Auto Show that GM will have 11 ethanol-capable vehicles on the market this year, and 15 in 2009.

Karsner wasn’t impressed, apparently. Speaking to Bingaman and Domenici, he read from his prepared testimony and said, “Both the Secretary (Samuel Bodman) and I have been calling on automakers to make flex-fuel and hybrid vehicles ubiquitous across the fleet, for every make and model, for every manufacturer who services the U.S. market.” He then picked up his head from the paper he was reading and emphasized, departing from his prepared testimony, “They need to be made available not in the hundreds, not in the thousands, but in the millions,” implying that U.S. automakers are dragging their feet.

Going back to his prepared testimony, he read, “We do not see any technical reasons that at least the option of flex-fuel vehicles could not be offered to all consumers at a relatively low price.” And again, add-libbing, he added, “And in short order.”

Asked after the hearings whether Karsner is annoyed with U.S. auto manufacturers, Julie Ruggiero, an Energy Department spokeswoman, said that isn’t the case. But she said Karsner believes, “We need to move beyond prototypes and concept cars and we need to do it with a sense of urgency.”

However, there is a real question about whether consumers would buy, in the short term, more flex fuel vehicles than Detroit is producing. Charles Drevna, president of the National Petrochemical & Refiners Association, noted that FFVs get about 20-30 percent fewer miles per gallon when fueled with E85. And if that were not bad enough—especially given the new CAFE mandates the industry faces—he pointed out that a gallon of E85 can cost upwards of $.80 a gallon more than a gallon of E10.

If mileage and price don’t discourage consumers, lack of fuel pumps certainly will. There are only 1,348 fueling stations in the U.S. offering E85.There is another 1,350 terminals where ethanol can potentially be blended.

Maybe a solution to those problems would justify more aggressive production of FFVs. So would the Environmental Protection Agency’s (EPA) certification of blends between E10-E85 in conventional auto engines. The DOE and the American Coalition for Ethanol co-sponsored an Optimal Ethanol Blend Level Investigation last year, and released the results in December 2007. “The investigation revealed unprecedented data that E20 and E30 blends can provide better fuel economy than regular gasoline in non-flex fuel vehicles with fewer harmful tailpipe emissions,” said Brian Jennings, executive vice president of the ACE.