This leads to a number of questions, such as:

1. How is the benchmark group of companies defined?
2. What metric is used most often to measure relative performance?
3. What level of performance should equate to maximum, target and/or minimum payouts?
4. What other considerations should be taken into account when designing these programs?

This CAPFlash tracks companies’ response to these questions through our proprietary research database. Each year, Compensation Advisory Partners (“CAP”) reviews proxy disclosures for a cross-industry sample of Fortune 250 companies. In 2011, our study included 111 companies, with 26 companies, or 24% of our sample, incorporating relative performance measurement into their long-term incentive program as a primary performance measure. An additional 7 companies, or 6% of our sample, incorporate relative performance measurement into their long-term incentive program through the use of a modifier.

How is the Benchmark Group of Companies Defined?

For relative performance measurement in long-term incentive (“LTI”) plans, the benchmark group of companies that performance is most often compared to is the executive compensation peer group. We found that 45% of companies measure pay and performance against a consistent group of companies. As shown below, just over half of companies take a different approach. For example, 42% of companies measure performance against an index that differs from the group of companies used to benchmark compensation levels.

	No. of	% of Cos.
Comparator Groups Used to Measure Relative Performance	Cos.	n=33
Compensation Peer Group	15	45%
General Industry Index (e.g., S&P 500)	9	27%
Industry Specific Group (Non-Compensation)	6	18%
Industry Specific Index	5	15%
Subset of Compensation Peer Group	1	3%

Note: Percentages add up to greater than 100% due to companies using multiple comparator groups.

Some companies use more than one comparator group. For example: AT&T measures performance relative to the Dow Jones Industrial Average constituents as well as a group of 11 domestic and global telecommunications companies. Intel measures relative Total Shareholder Return (“TSR”) against its executive compensation peer group as well as against the S&P 100; and Northrop Grumman measures relative TSR against a group of leading U.S. and European aerospace and defense companies and the S&P Industrials Index.

Companies tend to use industry peer groups or indices when economic factors have a unique impact on the industry. Companies that use a broader market group, such as a general industry index like the S&P 500, believe that companies compete broadly for investor dollars. They may also operate in industries with a small number of players, making it difficult to identify peers in the same industry.

What Metric is Used Most Often to Measure Long-Term Relative Performance?

As shown below, relative performance plans most often measure company TSR. While EPS is the second most common metric used, it is only used by 15% of companies studied and is typically given less weight than TSR in a relative long-term performance plan.

Relative Financial Metrics Used in Long-Term Incentive Plans

	Relative Metric
	TSR	EPS	Other
Overall Prevalence	73%	15%	23%
Most Prevalent Weighting Given To Relative Metric	100%	50%	100%

Note: Excludes companies with TSR used as a modifier (n=7). Percentages do not add up to 100% due to certain companies using multiple relative metrics.

Some companies use more than one measure of relative performance. PNC Financial Services (EPS & ROCE) is one example and MetLife (TSR & EPS) is another. Approximately half of the companies studied (52%) combine relative metrics with absolute financial metrics in long-term performance plans. The most prevalent metric used to measure absolute financial performance, alongside a relative performance metric, is EPS.

What Level of Performance Should Equate to Maximum, Target or Minimum Payouts?

The chart below shows that the relative performance benchmarks used for maximum, target and/or minimum payouts of relative long-term performance plans vary by company. The most common approach is to set threshold, target and maximum payouts at the 25th, 50th and 75th percentiles compared to peers, as highlighted below:

Relative Long-Term Incentive Plan Performance Percentiles

Threshold	Prevalence	Target	Prevalence	Max	Prevalence
(relative position)		(relative position)		(relative position)
10th %ile	6%	40th %ile	5%	75th %ile	33%
20th %ile1	29%	45th %ile	5%	80th %ile	22%
25th %ile	29%	50th %ile	68%	85th %ile	11%
30th %ile	6%	55th %ile	12%	90th %ile	6%
35th %ile	24%	60th %ile	5%	95th %ile	6%
40th %ile	6%	65th %ile	5%	100th %ile	22%

Note: In cases where a rank approach is uses, percentile was interpolated.

Companies use two approaches to define relative market positioning: either “percentile” or “rank.” As shown below, the percentile approach is most common. Examples of companies that use a ranking system include Motorola Solutions, Pfizer and Target. Examples of companies that use a percentile system include Lockheed Martin, Chubb and Express Scripts.

Relative Long-Term Incentive Plan Payout Measurement

	Payout Based On
	Percentile	Rank
Number of Companies	17	10
Prevalence	63%	37%

Note: Excludes companies (n=6) that do not specifically disclose basis for relative long-term performance plan payout.

Leverage is another feature of long-term performance plans. Plans must define what percentage of the target opportunity threshold or maximum performance will yield. The chart below describes the leverage in relative performance plans among the companies in our study. It is most common for threshold performance to result in a payout of 50% of target, and for maximum performance to result in a payout of 200% of target.

Relative Long-Term Incentive Plan Payouts

Threshold	Prevalence	Max	Prevalence
(as % of target)		(as % of target)
15%	9%	120%	4%
20%	5%	125%	4%
25%	22%	150%	8%
30%	9%	200%	80%
35%	14%	250%	4%
40%	5%
50%	31%
60%	5%

Note: Percents have been rounded to nearest 5%.

What Other Considerations Should Be Taken into Account When Designing These Programs?

Accounting Implications

When determining what long-term incentive design to implement, it is important to consider accounting implications. If the award is denominated and paid in cash, then it requires mark-to-market accounting where the charge is generally “trued up” to the value of the final payout. A share-based award that utilizes a financial metric has a somewhat similar treatment, where the accounting charge is trued up for the number of shares earned, but the equity value is fixed at grant. Differently, for a share-based award that uses a market-based metric (such as TSR) the accounting charge is fixed on the grant date and the expense does not change to reflect the final payout. While some view this design feature as a positive as it avoids “volatile” period-to-period accounting, others are uncomfortable with the fact that the charge cannot be reversed if performance is below threshold and a payout does not occur.

A properly designed modifier approach (where the primary award determinant is an internal financial metric) is an alternative for companies not wanting to have a “fixed charge” while still utilizing a market-based relative metric. In this case, if internal financial goals are not met, there is no expense as the impact of the market condition was considered and locked in as part of the grant-date fair value per share. The final total expense equals the grant-date fair value per share times the number of shares earned under the EPS goal. Thus, total expense is trued up for the outcome of the performance condition – but not for the outcome of the market condition, which was incorporated in the grant date value per share.

Important: Before selecting a specific go-forward design for your unique circumstance, we recommend that you confirm accounting treatment for all designs under considerations with outside advisors.

Discretion

Relative performance plans help reduce the need for discretionary adjustments to performance goals, which is often viewed as a positive feature of these plans. However, attraction / retention issues can occur when relative performance plans do not pay out. Annual grants with overlapping performance cycles are a common way of maintaining motivational impact, even when performance is down in one or two years. While not seen frequently, we have observed some companies attempt to solve for these issues by using alternative approaches. Some approaches include:

• Providing an added opportunity to earn an award if a financial metric (such as EPS) exceeds a pre-determined level of absolute performance;
• Adjusting earned awards down by a small amount if absolute results do not reflect improvement;
• Limiting payout based on relative TSR to no higher than target if a company has negative TSR while it is outperforming its benchmark group; or
• Guaranteeing a minimum payout (threshold).

In most cases, annual grants are the approach that makes the most sense, since it clearly aligns with shareholder interests.

TSR Modifier

Of the 33 companies studied with relative performance plans, 7 companies or 21%, incorporate relative financial performance into their LTI program using a TSR modifier. These companies’ LTI plans are measured against absolute metrics and then a TSR modifier is used to adjust the payout up or down. Companies with plans that incorporate a TSR modifier measure relative TSR performance against a variety of benchmarks.

	No. of	% of Cos.
Comparator Groups Used to Measure Relative Performance	Cos.	n=7
Compensation Peer Group	3	43%
General Industry Index	3	43%
Industry Specific Index	1	14%

A TSR modifier typically applies in all cases. However, some companies intend for a TSR modifier to only operate in “fringe” situations where absolute performance results differ substantially from relative performance. For example, a modifier could function so that if relative three-year TSR is in the bottom quartile, the performance share payout will be reduced by 25%. Conversely, if relative three-year TSR is in the top quartile, the performance share payout will be increased by 25%.

Views of Proxy Advisory Firms are Important

Glass Lewis recently wrote that: “[the] sole use of absolute metrics under long-term incentive plans is inappropriate as they may reflect economic factors or industry-wide trends beyond the control of executives on individual performance.” This statement seems to indicate that they believe incorporating a relative measure into a long-term incentive plan can provide balance. Likely under a similar premise, ISS reviews both relative and absolute performance as part of its pay-for-performance analysis (specifically focused on TSR). Therefore, support of proxy advisory firms is another reason to consider relative performance measurement.

Conclusion

When designing long-term incentives, we recommend that companies start by defining their objectives (business, employee and shareholder), and then assess their ability to set long-term goals. When companies determine that a relative performance metric could help management drive performance, these plans should be considered. In the current Say on Pay environment, a properly calibrated relative long-term performance plan is one way to say: “we only pay above target for outperformance.”

New SEC Compensation-Related Rulemaking Schedule

As background, for Dodd-Frank to be implemented the SEC needs to develop rules governing several aspects of the legislation impacting executive compensation. The list below provides a summary of the current planned timing of when rules will be issued.

January – June 2012 (Planned)

• §952: Adopt exchange listing standards regarding compensation committee independence and factors affecting compensation adviser independence; adopt disclosure rules regarding compensation consultant conflicts
• §953, §955: Propose rules regarding disclosure of pay-for-performance, pay ratios, and hedging by employees and directors
• §954: Propose rules regarding recovery of executive compensation (clawback policies)

July – December 2012 (Planned)

• §952: Report to Congress on study and review of the use of compensation consultants and the effects of such use
• §953, §955: Adopt rules regarding disclosure of pay-for-performance, pay ratios, and hedging by employees and directors
• §954: Adopt rules regarding recovery of executive compensation (clawback policies)

Conclusion

The delay in the SEC’s rulemaking schedule pushes implementation of the pay-for-performance and pay ratio disclosure aspects of Dodd-Frank to the 2013 proxy season. However, 2012 will likely still be a busy year for both management and compensation committees in implementing new aspects of Dodd-Frank as final rules become available. The implementation of Say on Pay votes in 2011 (Dodd-Frank §951) has already been a catalyst for change, and we expect many of the new rules to lead to meaningful changes to executive compensation programs in 2012-13, including those related to governance and disclosure.

• Evaluation of Executive Pay (Management Say on Pay)
• Board Response to the Management Say on Pay (MSOP) vote and the MSOP Frequency vote
• Developing a voting policy for recent IPO companies 162(m) approvals

Below CAP summarizes the key policy changes and we also provide perspective on the key implications for companies to consider.

Evaluation of Executive Pay

Current Pay-for-Performance Analysis Approach

Companies with one- and three-year total shareholder returns (TSR) below the median of their 4-digit GICS industry group are reviewed by ISS for potential pay-for-performance disconnects. For these companies, ISS conducts a qualitative assessment to determine if pay and performance are misaligned. The factors reviewed include year-over-year change in CEO pay and trends in CEO pay and company TSR over 5 years.

Updated Pay-for-Performance Evaluation

The approach for 2012 continues to have quantitative and qualitative components. The quantitative analysis reviews three factors in two categories (for companies in the Russell 3000 index):

1. Peer Group Alignment – Two factors are analyzed to determine the pay-for-performance alignment relative to a peer group that is generally comprised of 14-24 companies selected using market cap, revenue (or assets for financial firms), and GICS industry group. The selection process is designed to identify peers that are closest to the subject company, and where the subject company is close to median of the peer group in revenue/asset size. ISS will disclose its peer group methodology and rationale in various communications leading up to the 2012 proxy season.
   1. The degree of alignment between the company’s TSR rank and the CEO’s total pay rank within the peer group, as measured over one-year and three-year periods (weighted 40/60, to put more emphasis on the longer term)
   2. The multiple of the CEO’s total pay relative to the peer group median
2. Absolute Alignment – this factor measures long-term alignment between pay and company performance, as:
   • Alignment between the trend in the CEO’s pay and the company’s TSR over the prior five fiscal years – i.e., the difference between the trend in annual pay changes and the trend in annualized TSR changes during the prior 5-year period

There is no explicit description of the relative importance of the peer group alignment and absolute alignment in ISS’ evaluation. If ISS’ analysis finds that the above analysis demonstrates a weak alignment between pay and performance, ISS will conduct a qualitative review before issuing a final vote recommendation.

Considerations for the qualitative review include:

• The ratio of performance- to time-based equity awards
• The ratio of performance-based compensation to overall compensation
• The completeness of disclosure and rigor of performance goals
• The company’s peer group benchmarking practices
• Actual results of financial/operational metrics, such as growth in revenue, profit, cash flow, etc., both absolute and relative to peers
• Special circumstances related to, for example, a new CEO in the prior FY or anomalous equity grant practices (e.g., biannual awards)
• Any other factors deemed relevant

It should be noted that except in extenuating circumstances, ISS indicates that there is no longer a “new” CEO exclusion from the pay-for-performance evaluation.

In the spirit of transparency, ISS will provide additional guidance on the 2012 Pay-for Performance methodology in a technical document that is scheduled for release in December.

ISS Intent and Impact

The new approach continues to use multiple factors with a stronger emphasis on long-term alignment, while maintaining in-depth qualitative analysis. ISS does not anticipate that the change in methodology will result in a significant change in the number or percentage of negative recommendations issued. Backtesting by ISS of the new methodology indicates a strong correlation between the results and shareholder say-on-pay votes in 2011.

CAP Perspective: ISS’ changes appear to address criticism that their current approach is a one size fits all approach and does not take into consideration company specific circumstances. This is evidenced in several areas:

• the modification of peer group to take into account factors in addition to industry such as similarity and size
• inclusion of absolute alignment gives weight to a company’s own pay and TSR trends
• more robust list of qualitative factors that consider operational results in addition to TSR as well as company specific practices

We expect companies and Compensation Committees to continue their focus on aligning their compensation programs with performance as we head into the second full year of Say on Pay. The elimination of the exclusion for “new” CEOs may create a challenge for any companies that have had to pay significantly to recruit a CEO and will likely be viewed as controversial as the new CEO will have had limited ability to impact performance.

Board Response to the MSOP and MSOP Frequency Votes

Following the first year of Say-on-Pay, ISS has conducted research with investors indicating a high degree of interest in having boards and Compensation Committees provide an explicit response to MSOP proposals that receive less than a majority support or weak majority support.

ISS’ policy update states that they will recommend case-by-case on Compensation Committee members (or in rare cases where the full board is deemed responsible, all directors) and the current MSOP proposal if the company’s prior year say-on-pay proposal received less than 70% of votes cast, taking into account:

• The company’s response, including:
  • Disclosure of engagement efforts with major institutional investors regarding the compensation issue(s)
  • Specific actions taken to address the issue(s) that appear to have caused the significant level of against votes
  • Other recent compensation actions taken by the company
• Whether the issues raised are recurring or isolated
• The company’s ownership structure
• Whether the support was less than 50 percent, which would warrant the highest degree of responsiveness

In terms of the MSOP Frequency, ISS’ policy is more straightforward. ISS will recommend a withhold/against vote on all incumbent director nominees if the company implements an advisory vote on executive compensation on a less frequent basis than what the majority of voters supported. ISS will address votes on a case-by-case basis on all incumbent director nominees if the company implements an advisory vote on executive compensation on a less frequent basis than the frequency preferred by a plurality (but not a majority) of voters. Factors entering into ISS’ decision will include the board’s rationale for choosing the frequency, the company’s ownership structure and vote results, ISS analysis of the company’s executive compensation plans and the previous year’s level of support for the MSOP.

CAP Perspective: ISS has developed these two new policies to develop an enforcement mechanism to ensure that boards are responsive to shareholder votes on these non-binding measures. By potentially recommending a withhold/against vote on a director if the company is not adequately responsive to shareholders on MSOP or MSOP frequency, ISS is trying to ensure that these votes have “teeth” and directors are held accountable. Where companies received a less than 70% approval vote on the MSOP, “substantive and meaningful” disclosure of key steps taken to address potential shareholder concerns about the compensation program will be essential to getting ISS support in the following year.

Equity Plans Related to 162(m)

Under a proposed ruling related to IRC Section 162(m), recent IPO companies will now have to obtain shareholder approval before awarding certain performance-based restricted stock units (“RSUs”) to named executive officers in order to qualify them as performance-based compensation. While ISS has generally recommended that investors support equity plans solely for 162(m) purposes, they felt a new policy was warranted to address these IPO companies.

ISS will generally vote for proposals to approve or amend executive incentive bonus plans if the proposal:

• Is only to include administrative features
• Places a cap on the grants any one participant may receive to comply with the provisions of Section 162(m)
• Adds performance goals to existing compensation plans to comply with the provisions of Section 162(m) unless they are clearly inappropriate
• Covers cash or cash and stock bonus plans that are submitted to shareholders for the purpose of exempting compensation from taxes under the provisions of Section 162(m) if no increase in shares is requested

ISS will generally vote against proposals if:

• The compensation committee does not fully consist of independent outside directors, per ISS’ director classification
• The plan contains excessive problematic provisions

ISS will vote on a case-by-case basis on proposals if:

• In addition to seeking 162(m) tax treatment, the amendment may result in the transfer of additional value to employees (e.g., by asking for additional shares, extending option term, etc.); it will be subject a Shareholder Value Transfer analysis vs. the allowable cap
• A company is presenting the plan to shareholders for the first time after the company’s initial public offering (IPO). A full equity analysis will be conducted, including a review of total shareholder value transfer, repricing, burn rate analysis and liberal change in control. Other factors such as pay-for-performance or problematic pay practices as related to MSOP may also be included in ISS’ recommendation

CAP Perspective: This provision is unlikely to have major impact, but is something that companies moving toward an IPO should incorporate into their planning. To increase the likelihood of ISS support, pre-IPO companies should ensure that their equity plans overall have shareholder friendly provisions and that the share reserve is not excessive.

Conclusion

We expect the pay-for-performance policy to be the area of greatest focus as companies enter the 2012 proxy season and try to understand how ISS will be evaluating their compensation programs. While ISS’ new approach appears to be an attempt to recognize issues with their current pay-for-performance test, there will likely continue to be a difference between how ISS views a company’s performance and the company’s own internal view of performance. ISS’ move towards increased transparency may assist companies in replicating their pay for-performance analysis. This may provide a better understanding of how ISS is likely to view their compensation programs. Companies with concerns about the shareholder vote on MSOP and ISS’ potential recommendations may find it worthwhile to model out the ISS analysis on their own, though the exercise will likely require significant resources and expense.

In addition, the new pay-for-performance disclosure under Dodd-Frank may vary from ISS’ proposed approach and create additional confusion around what is the appropriate way to assess pay-for-performance. In any case, ISS and other shareholders will be looking for a clear demonstration that positive action is taken where there is a major shareholder concern about the executive compensation program.

• Evaluation of Executive Pay (Management Say on Pay)
• Board Response to the Management Say on Pay (MSOP) vote and the MSOP Frequency vote
• Developing a voting policy for recent IPO companies 162(m) approvals

Below CAP summarizes the key policy changes contemplated by ISS, along with areas where they are seeking comment. We also provide perspective on the key implications for companies to consider.

Evaluation of Executive Pay

Current Pay-for-Performance Analysis Approach

Companies with one- and three-year total shareholder returns (TSR) below the median of their 4-digit GICS industry group are reviewed by ISS for potential pay-for-performance disconnects. For these companies, ISS conducts a qualitative assessment to determine if pay and performance are misaligned. The factors reviewed include year-over-year change in CEO pay and trends in CEO pay and company TSR over 5 years.

Proposed Pay-for-Performance Analysis Approach

The proposed approach for 2012 continues to have quantitative and qualitative components. The quantitative analysis would review three factors in two categories:

1. Relative Alignment – Two factors are analyzed to determine the pay-for-performance alignment within a group of companies similar to the company in market cap, revenue (or assets), and industry. The peer group is generally comprised of 14-24 companies that are selected on the basis of size and GICS industry group, via a process designed to select peers that are closest to the subject company in terms of revenue/assets (for financial firms) and industry and also within a market cap range that is reflective of the company’s life cycle maturity phase
   1. The degree of alignment between the company’s TSR rank and the CEO’s total pay rank within the peer group, as measured over one-year and three-year periods (weighted 40/60, to put more emphasis on the longer term)
   2. The multiple of the CEO’s total pay relative to the peer group median, which may identify cases where a high performing company may be overpaying
2. Absolute Alignment – this factor measures long-term alignment between pay and company performance, as:
   • Alignment between the trend in the CEO’s pay and the company’s TSRs over the prior five fiscal years – i.e., the difference between the slope of annual pay changes and the slope of annualized TSR changes during the prior 5-year period

For the quantitative assessment, the relative and absolute test may be weighted 50/50. ISS will generally provide a positive recommendation (absent other pay related issues) to companies demonstrating strong or satisfactory alignment. If the alignment is weak, ISS will conduct a qualitative review before issuing a final vote recommendation.

Considerations for the qualitative review include:

• The ratio of performance- to time-based equity awards
• The overall ratio of performance-based compensation
• The robustness of disclosure and rigor of performance goals
• The company’s peer group benchmarking practices
• Actual results of financial/operational metrics, such as growth in revenue, profit, cash flow, etc., both absolute and relative to peers
• Special circumstances related to, for example, a new CEO in the prior FY or equity grant practices (e.g., biannual awards)
• Any other factors deemed relevant

ISS Intent and Impact

The proposed approach continues to use multiple factors with a stronger emphasis on long-term alignment, while maintaining in-depth qualitative analysis. ISS does not anticipate that the change in methodology will result in a significant change in the number or percentage of negative recommendations issued. Backtesting by ISS of the new methodology indicates a strong correlation between the results and shareholder say-on-pay votes in 2011. ISS is requesting comments on the factors they are using, whether the new approach appropriately emphasizes the long-term and if there are other factors they should be considering.

CAP Perspective: ISS’s proposed changes appear to address criticism that their current approach is a one size fits all approach and does not take into consideration company specific circumstances. This is evidenced in several areas:

• the modification of peer group to take into account factors in addition to industry such as size and life cycle
• inclusion of absolute alignment gives weight to a company’s own pay and TSR trends
• more robust list of qualitative factors that consider operational results in addition to TSR as well as company specific practices

We expect companies and Compensation Committees to continue their focus on aligning their compensation programs with performance as we head into the second full year of Say on Pay.

 

Board Response to the MSOP and MSOP Frequency Votes

Following the first year of Say-on-Pay, ISS has conducted research with investors indicating a high degree of interest in having boards and Compensation Committees provide an explicit response to MSOP proposals that receive less than a majority support or weak majority support.

ISS’ proposed policy update states that they will recommend case-by-case on Compensation Committee members (or in rare cases where the full board is deemed responsible, all directors) and the current MSOP proposal if the company’s prior year say-on-pay proposal received significant opposition from votes cast, taking into account multiple factors, including:

• The level of opposition
• The company’s ownership structure
• Disclosure of engagement efforts with major institutional investors regarding the compensation issue(s)
• The company’s response
• Specific actions taken to address the issue(s) that appear to have caused the significant level of against votes
• Other recent compensation actions taken by the company
• ISS’ current analysis of the company’s executive compensation and whether any prior issues of concern are recurring or one-time

ISS will place more scrutiny on companies where an MSOP proposal received less than 50 percent support from all votes cast or where there are previously identified compensation issues or newly identified compensation concerns. Depending on the severity of the concerns, it may result in an against vote recommendation on Management Say on Pay and the Compensation Committee members. ISS is seeking comment on this policy to determine what the threshold (e.g., <70% support) should be for requiring an action plan from companies on how they will address shareholder concerns with their compensation plans and whether ISS should require more than one year of a low vote before expecting a response to shareholder concerns from boards.

In terms of the MSOP Frequency, ISS’ proposed policy is more straightforward. ISS will recommend a withhold/against vote on all incumbent director nominees if the company implements an advisory vote on executive compensation on a less frequent basis than what the majority of voters supported. ISS will address votes on a case-by-case basis on all incumbent director nominees if the company implements an advisory vote on executive compensation on a less frequent basis than what the majority of voters supported. Factors entering into ISS’ decision will include the board’s rationale for choosing the frequency, the company’s ownership structure, ISS analysis of the company’s executive compensation plans, the previous year’s level of support for the MSOP and the difference between the frequency adopted and the frequency supported by shareholders. ISS is asking for comments on whether there should be any additional factors considered in cases where a company adopts a say-on-pay frequency different from that preferred by the majority of shareholders and in plurality cases whether the factors identified are helpful and if there are other factors that would be of more use in assessing the decision to deviate from the frequency preference of the plurality of shareholders.

CAP Perspective: ISS has developed these two new policies to develop an enforcement mechanism to ensure that boards are responsive to shareholder votes on these non-binding measures. By potentially recommending a withhold/against vote on a director if the company is not adequately responsive to shareholders on MSOP or MSOP frequency, ISS is trying to ensure that these votes have “teeth” and directors are held accountable.

Equity Plans Related to 162(m)

Under a proposed ruling related to IRC Section 162(m), recent IPO companies will now have to obtain shareholder approval before awarding certain performance-based restricted stock units (“RSUs”) to named executive officers in order to qualify them as performance-based compensation. While ISS has generally recommended that investors support equity plans solely for 162(m) purposes, they felt a new policy was warranted to establish a new policy to address these IPO companies.

ISS will vote on a case-by-case basis on these plans and will subject them to a full equity plan analysis, including a review of total shareholder value transfer, repricing, burn rate analysis and liberal change in control. If the plans are not asking for additional shares, ISS still anticipates supporting the vast majority of plans.

CAP Perspective: This provision is unlikely to have major impact, but is something that companies moving toward an IPO should incorporate into their planning. To increase the likelihood of ISS support, pre-IPO companies should ensure that their equity plans overall have shareholder friendly provisions and that the share reserve is not excessive.

Conclusion

We expect the pay-for-performance policy to be the area of greatest focus as companies enter the 2012 proxy season and try to understand how ISS will be evaluating their compensation programs. While ISS’ proposed approach appears to be an attempt to recognize issues with their current pay-for-performance test, there will still likely continue to be a disconnect between how ISS views a company’s performance and the company’s own internal view of performance. In addition, the new pay-for-performance disclosure under Dodd-Frank may vary from ISS’ proposed approach and create additional confusion around what is the appropriate way to assess pay-for-performance. In any case, ISS and other shareholders will be looking for a clear demonstration that positive action is taken where there is a major shareholder concern about the executive compensation program.

Stronger Governance Practices

What We Found

In response to increased pressure from shareholders and proxy advisory firms, as well as recent Say on Pay legislation, companies continue to monitor their executive compensation programs. In the past, companies would re-evaluate their programs every 2-3 years. Given today’s intense scrutiny of executive compensation, we are seeing companies and compensation committees re-evaluate their programs annually. New governance standards include completing the annual risk assessment and implementing updated clawback policies. In addition, companies have removed excise tax-gross ups from change in control benefits and perquisites, continue to emphasize stock ownership guidelines and stock retention requirements, and have reduced supplemental retirement benefits.

Compensation Risk Disclosure

Clear and explicit disclosure of the compensation risk assessment process is becoming standard practice, especially after the recent economic downturn and passage of SEC rules on enhanced compensation disclosure. Of the 111 companies in our study, 105, or 95%, make some type of affirmative disclosure on risk assessment in the most recent proxy. Similar to 2009, none of the companies disclosed that their incentive programs create material adverse risks.

Most companies make their risk-related disclosure in the CD&A of the proxy statement, with the corporate governance section of the proxy statement ranking as the second most common place for this disclosure. The table below summarizes where risk disclosures were made:

Section of the Proxy Statement with Compensation Risk Disclosure	2010		2009
		% of Cos.		% of Cos.
	No. of Cos.	n=105	No. of Cos.	n=75
CD&A	49	47%	39	52%
Corporate Governance Section (Section 407)	25	24%	19	25%
CD&A and Corporate Governance Section (Section 407)	14	13%	7	9%
Separate Stand Alone Section	11	10%	8	11%
CD&A and Compensation Committee Report	4	4%	2	3%
Compensation Committee Report	2	2%	n/a	n/a

Responsibility for completing the risk assessment process varies by company. Of the companies disclosing a risk assessment, 35 companies (33%) had management and the compensation committee working together to conduct the assessment, while 17 companies (16%) reported that the compensation committee worked alone to conduct the assessment. One change we noted is that this year 95% of companies disclosed who conducted the risk assessment versus only 65% last year. The table below provides further detail on which groups were involved in the compensation risk review:

Approach to Compensation Risk Reviews	2010		2009
		% of Cos.		% of Cos.
	No. of Cos.	n=105	No. of Cos.	n=75
Management & Compensation Committee	35	33%	10	13%
Compensation Committee	17	16%	7	9%
Compensation Committee & Consultant	15	14%	9	12%
Management	13	12%	7	9%
Management, Compensation Committee & Consultant	12	11%	15	20%
Management & Consultant	8	8%	1	1%
Not Disclosed	5	5%	26	35%

Clawbacks

Despite the SEC’s delay in proposing policies to recoup executive compensation under Dodd-Frank, companies have been proactively adopting clawback policies. Even though clawbacks are mandated by the SEC for all public company CEOs and CFOs under SOX and for the top 25 executives in TARP participants, companies have implemented their own clawbacks to obtain broader protection.

A significant majority of our research companies – 89 of 111 (80%) – maintain some form of clawback provision. For 2010, 17 of the 89 companies adopted a new clawback policy and 10 modified existing policies by expanding the type of compensation that can be recouped, the executives covered or the events that trigger a clawback. The majority of companies are awaiting final SEC regulations, however, before making comprehensive changes to update existing policies.

Similar to our findings in 2009, a financial restatement is required to trigger a clawback in nearly all cases (74 companies or 83% of those with a clawback). Further, 66 companies (74% of those with a clawback) disclosed that misconduct is a triggering event and 45 companies (51%) disclosed fraud as a trigger.

Based on our review of CD&A disclosures, companies with a clawback include the ability to clawback or recoup the following types of compensation: earned, exercised, outstanding, vested or unvested.

Compensation Subject to Clawback		% of Cos.
	No. of Cos.	n=89
Prior annual incentive	81	91%
Prior LTI	79	89%
Future annual incentive	20	22%
Future LTI	14	16%

Note: Percentages add up to greater than 100% due to multiple responses.

Of the type of compensation that is subject to a clawback, clawbacks of both cash and equity are equally prevalent.

While the majority of companies do not explicitly state who their clawback policy applies to, it is clear that coverage extends to the NEOs at 83 companies (93%).

A minority of companies (18 companies or 20%) indicate the time period which compensation can be recovered after a restatement. Of the 18 companies that disclosed a time frame, the most common is 1 year from the date of restatement and the range is 1-3 years.

It is apparent from reviewing CD&A disclosure that most companies are waiting for the SEC to rule before modifying their current policies. Companies will need to develop and implement a policy to provide for recovery of compensation that aligns final rules issued by the SEC. The proposed rules apply to both current and former executives and cover all incentive compensation within 3 years of a financial restatement (with or without intentional misconduct). It is unlikely that companies will make final modifications to their policies that apply to the 2012 proxy season, since the SEC is not expected to issue final rules until the first half of 2012.

Stock Ownership Requirement Changes

Companies continue to monitor their stock ownership requirements in order to align executives with shareholders. This year 25 companies (23%) initiated a change with respect to stock ownership or stock holding requirements. The most prevalent change was an increase in stock ownership guideline levels, with 12 of the 25 companies (48%) disclosing an increase. This is likely attributed to a recovery in the economy as well as stock prices, and increasing pressure from regulators and proxy advisory firms. Other common changes were 24% of companies added a new stock holding requirement and 20% modified or added a penalty for non-compliance. Further detail on changes made to executive stock ownership guidelines are below:

Changes made to Executive Stock Ownership Guidelines	2010		2009
		% of Cos.		% of Cos.
	No. of Cos.	n=25	No. of Cos.	n=17
Increased	12	48%	3	18%
Added holding requirement	6	24%	n/a	n/a
Modified penalty for non-compliance	5	20%	n/a	n/a
Changed to multiple of salary	2	8%	n/a	n/a
Increased holding requirement	2	8%	n/a	n/a
Decreased holding requirement	2	8%	n/a	n/a
Newly adopted	1	4%	10	59%
Decreased	1	4%	1	6%
Adopted mandatory holding of shares through retirement	1	4%	n/a	n/a

Note: Percentages add up to greater than 100% due to multiple changes by several companies.

Stock Ownership Requirements Detail

For companies disclosing shares counted toward ownership requirements, it is interesting to note that one-third of companies count unvested restricted stock towards meeting the guidelines, since companies expect executives to vest in these shares. However, only 6% count vested/unexercised options and 5% count unearned performance shares since these shares are viewed as being subject to greater risk. See below for further detail:

Shares Counting For Guideline Requirements		% of Cos.
	No. of Cos.	n=99
Shares directly owned	55	56%
Unvested RS	33	33%
Shares in 401(k) plan	33	33%
Shares indirectly owned	29	30%
Shares purchased on open market	29	29%
Not disclosed	29	29%
Deferred Compensation	25	25%
Vested but unexercised options	6	6%
Unearned performance shares	5	5%
Unvested options	1	1%

Note: Percentages add up to greater than 100% due to multiple types of equity counted by various companies.

Among CEOs, most companies (82%) express their guidelines as a multiple of base salary and 17% of companies express their guidelines in fixed share amounts. The fixed share approach is more prevalent among financial services and technology companies.

The median guideline for all company CEOs in our study sample is a 5x multiple of base salary or a fixed share guideline of 150,000 shares. The median value of these guidelines is $6,700,000.

CEO Stock Ownership Guidelines (n=99)	Prevalence	25th Percentile Level	Median Level	75th Percentile Level
Multiple of Base	82%	5.0x	5.0x	6.0x
Fixed Share	17%	100,000	150,000	300,000
Fixed Value	1%	$5,000,000	$5,000,000	$5,000,000
Total Value	–	$5,389,894	$6,700,000	$8,600,000

15% of companies disclose some type of penalty for non-compliance with stock ownership guidelines. The most common penalties disclosed include mandatory payment of a portion of the annual bonus in stock and requiring executives to hold shares after an option exercise or the vesting of stock awards.

Stock Holding Requirements Detail

Having stock holding or stock retention requirements in addition to stock ownership guidelines is a growing trend. In our sample of 111 companies, 30 companies (27%) disclose some type of stock holding requirement. Over half of the 30 companies have a stand-alone stock holding requirement. This type of requirement is most prevalent among financial services companies in place at 75% of financial services companies.

Most of these companies (46%) require executives to hold equity after vesting or exercise for 1 year. Holding shares until retirement (33%) is the second most prevalent holding period, although it is relatively rare. 70% of companies disclose that the equity to be held is the net after-tax shares retained by the executive after option exercise/equity vesting. See below for further detail:

Definition of LTI subject to Hold		% of Cos.
	No. of Cos.	n=30
RS/RSUs	25	83%
Options	22	73%
Performance Shares	12	40%
Net after tax shares	21	70%

Note: Percentages add up to

1. Going forward, a Say on Pay vote will be an annual event at most companies
2. A simple majority should not be considered a passing grade
3. Companies with stronger performance generally received higher levels of shareholder support
4. Say on Pay voting has already been a catalyst for change

As background, on January 25, 2011, the SEC issued final rules implementing Section 951 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), which generally provides shareholders of US public companies with the right to cast three types of advisory votes related to executive compensation:

1. A vote to approve the compensation of the Named Executive Officers (NEOs), effective for shareholder meetings occurring on or after January 21, 2011;
2. A vote on the frequency with which shareholders should be entitled to cast Say on Pay votes (every one, two or three years), effective for shareholder meetings occurring on or after January 21, 2011; and
3. A vote on golden parachute arrangements for NEOs related to a sale, consolidation or merger, effective April 25, 2011.

Say on Pay Frequency Vote Results (2011 Proxy Season)

An annual vote frequency has emerged as the clear shareholder preference. Among 93% of S&P 500 companies reporting vote results, a majority of shareholders supported annual Say on Pay vote frequency. This differs from vote recommendations, where only 68% of the companies had recommended an annual vote.

Company Recommendation (n=455)

Vote Frequency	# of Companies	% of Companies
Annual	310	68%
Bienniel	13	3%
Triennial	111	24%
No Recommendation	21	5%

Vote Results: Received Majority Shareholder Support (n=438)

Vote Frequency	# of Companies	% of Companies
Annual	409	93%
Bienniel	1	0%
Triennial	21	5%
None (only plurality)1	7	2%

The strong support for annual votes is not a surprise. 39 institutional investors, representing more than $830 billion in assets, issued a public call for companies and investors to support annual advisory votes on executive compensation in 2011 proxy statements. Similarly, a number of major mutual funds have also indicated support for annual Say on Pay votes, and ISS’ policy recommends that shareholders support annual votes (Glass Lewis has indicated a similar preference).2

CAP Comment: Following the frequency vote, the SEC rules mandate disclosure of how often the company will hold future Say on Pay votes, generally through an 8-K. Issuers must also provide proxy-based disclosure of the current frequency of Say on Pay votes and when the next scheduled Say on Pay vote will occur.

CAP Comment: When companies conduct their Say on Pay vote in line with the frequency preferred by a majority of shareholders, they may exclude shareholder frequency proposals from the proxy for six years.

Say on Pay Vote Results (2011 Proxy Season)

Say on Pay resolutions received majority shareholder support at all but eight S&P 500 companies, with average support of 89% (most companies received greater than 80% support for their NEO pay program).3

%inFavor	#of Companies	%of Companies	Average1-Yr TSR @12/31/10	A “threshold” for acceptable passage rates seems to have emerged; to-date, results indicate this threshold is around 80% shareholder support.
90%-100%	274	62%	25.2%
80%-90%	73	17%	24.3%
70%-80%	43	10%	16.5%
50%-70%	40	9%	7.4%
0%-50%	8	2%	9.6%

As shown above, companies with stronger TSR on a 1-year basis generally received a higher level of support from shareholders on their executive pay programs.

CAP Comment: While a company does not “fail” its Say on Pay vote unless a majority of shareholders vote against the compensation program, many companies have received 90+% shareholder support and an “acceptable” shareholder support threshold has emerged around 80%. Below this level of support, we have found that there often is a notable level of shareholder discontent that should be carefully reviewed.

CAP Comment: While these votes are non-binding, we expect that most companies will carefully evaluate their vote results, taking some action if there is low shareholder support (not just in the limited cases where a majority of shareholders did not support the company’s executive compensation program).

CAP Comment: The final SEC rules require additional disclosure in the CD&A regarding whether, and if so how, companies have considered the results of the most recent Say on Pay vote.

CAP Comment: As a result of the Dodd-Frank legislation, the SEC will eventually adopt rules requiring proxy-based disclosure of the pay-for-performance relationship at each U.S. public company (rules currently schedule to be adopted during 2012).

The eight companies where a majority of shareholders did not support the executive compensation program, and the Say on Pay vote results for these companies, are:

Company	1-Yr TSR	% Votes in Favor
Hewlett-Packard	-17.7%	48.2%
Freeport-McMoran Copper & Gold	52.6%	45.5%
Jacobs Engineering	21.9%	44.8%
Masco Corp.	-6.1%	44.6%
Nabors Industries	7.2%	42.5%
Janus Capital Group	-3.2%	40.1%
Constellation Energy Group	-10.3%	38.0%
Stanley Black and Decker	32.7%	38.0%

Impact of Proxy Advisor Recommendations

On average, shareholder support for Say on Pay votes was considerably lower when ISS recommended an “Against” vote to shareholders.4,5

ISSVote Recommendation Average Shareholder Support For(n=377) 92% Against(n=61) 64%

Companies Receiving “Against” Vote Recommendation % in Favor # of Companies % of Companies 90% – 100% 2 3% 80% – 90% 4 7% < 80% 55 90%

CAP Comment: Where ISS recommended an “Against” vote for Say on Pay, 90% of companies received less than the 80% percent shareholder support threshold discussed above.

As shown below, companies that received an “Against” vote recommendation from ISS generally had lower TSR.

 

ISS Vote Recommendation	# Companies that Passed	# Companies that Failed	Total	Average 1-Yr TSR @ 12/31/10
For	377	0	377	24.3%
Against	53	8	61	10.3%
Total	430	8	438	22.5%

 

CAP Comment: Of the 438 companies reporting vote results, to-date, ISS recommended an “Against” vote for Say on Pay at 61 S&P 500 companies (14%). Only 8 of the 61 companies (13%) did not receive majority support for their Named Executive Officer compensation program.

Responding to Proxy Advisor Recommendations

Some notable companies took additional steps related to executive compensation during this proxy season, filing supplementary soliciting materials and/or making last minute modifications to their CEO pay program. Select examples include: General Electric, Disney, ExxonMobil, Johnson & Johnson, Hewlett-Packard, Lockheed Martin, and Northern Trust. While these filings were generally in reaction to negative vote recommendations from shareholder advisory services such as ISS, ExxonMobil went a step further by filing supplementary materials (essentially an executive pay brochure) on the same day as the proxy. ExxonMobil still received a negative vote recommendation from ISS, and later filed additional soliciting material rebutting ISS’ vote recommendation.

Conclusion

During the 2011 proxy season, a clear shareholder preference for annual Say on Pay votes emerged. In terms of the actual Say on Pay vote, an 80% threshold emerged as an “acceptable” level of shareholder support, a significantly higher hurdle than simple a pass / fail test.

Say on Pay has already been a catalyst for change. Companies are more willing to address controversial pay practices than they were a year earlier. Disclosure of executive compensation in proxy statements has evolved, and the influence of proxy/shareholder advisory services (such as ISS) has increased.

Looking forward, companies will need to carefully evaluate their Say on Pay vote result from the 2011 proxy season, and determine how to best incorporate any findings into planning for 2012.