We have summarized the quantitative and qualitative pay-for-performance assessment and the peer group selection process including key findings and implications.

ISS’ Quantitative Assessment Of Pay-For-Performance Alignment

Historically, ISS reviewed a company’s one- and three-year total shareholder return (“TSR”). If TSR was below the median of the GICS industry group, ISS reviewed the CEO’s year-over-year change in pay level plus the five year trend in CEO pay relative to TSR performance over the same period. ISS’ current TSR screen only triggers a closer look for approximately 30% of companies.

For 2012, ISS developed a new pay-for-performance assessment that will focus on both relative and absolute company performance. The objective of ISS’ new methodology is to achieve three goals:

1. Measure the pay-for-performance alignment over multiple time horizons since executive compensation and company performance span a time horizon longer than one year.
2. Use multiple measures to assess this alignment because a single measure cannot decisively indicate that pay and performance is aligned.
3. Provide shareholders with information on the strength of the pay-for-performance relationship.

ISS’ new pay-for-performance alignment is based on two relative measures (relative degree of alignment and multiple of median) and one absolute measure (pay – TSR alignment). ISS back-tested each of these measures for a sample of 2,500 companies over a 5 year period (2006 – 2010). Based on ISS’ findings, they developed guidelines to identify outliers to denote companies that may have a misalignment between pay and performance.

Relative Degree of Alignment (“RDA”)

RDA measures a company’s CEO pay level and TSR performance relative to its ISS peer group for both a one- and three-year period. ISS analyzes pay1 levels disclosed for the CEO over the past three years and TSR based on the target company’s fiscal year end. ISS determines the company’s percentile rank for one- and three-year pay and performance. ISS calculates the RDA by subtracting the combined pay percentile ranks from the combined performance percentile ranks. The combined percentile ranks are weighted 40% for one-year and 60% for three-year (see below for an example of the calculation).

	Percentile Rank
	Performance	Pay	RDA
1- Year (40% weight)	42	52	-10
3-Year (60% weight)	26	64	-38
Total	32	59	-27

A company’s RDA can range from -100 to +100 with -100 reflecting high pay (100th percentile) and low performance (0th percentile). Based on ISS’ back testing, 50% of companies had an RDA range of -28 to +30. In other words, from ISS’ perspective, all things being equal, a zero RDA, would mean a company’s pay is tightly aligned with performance and a high positive number would indicate the company’s pay levels are conservative relative to the performance delivered.

Multiple of Median (“MOM”)

MOM measures the magnitude of a CEO’s pay for one-year relative to the median of the comparison group. Unlike RDA, the multiple of median for a company can be infinite. Based on ISS’ back-testing, 75% of companies have a multiple of median of 1.5x median or less and 90% of companies pay less than 2.1x median.

Pay-TSR Alignment (“PTA”)

PTA measures, directionally, how well pay increases for the CEO tracks with shareholder performance over a five-year period. ISS will use regression analysis to determine the trend in CEO pay and TSR over the five-year period. The final PTA will be the performance slope minus the pay slope. Based on ISS’ back-testing, PTA ranges from -106% to +129% with a median value of -3% (i.e., the trend rate for CEO pay at the median company was 3 percentage points higher than performance).

ISS Quantitative Assessment

ISS will analyze the findings from the RDA, MOM and PTA to determine if a company has a disconnect between pay and performance. A company that is a significant outlier (i.e., high concern) on any one measure or an outlier (i.e., medium concern) on multiple measures will receive a “high concern” level for a misalignment between pay and performance and ISS will conduct a qualitative assessment.

ISS developed parameters (see chart), based on its back-testing of each measure, to determine if a company elicits further review of its compensation practices. ISS will identify companies that are outliers (or significant outliers) for each measure.

Measure	Medium Concern		High Concern
Relative Degree of Alignment	-30	~ 25th Percentile	-50	~10th Percentile
Multiple of Median	2.33x	~ 92nd Percentile	3.33x	~ 97th Percentile
Pay-TSR Alignment	-30%	~10th Percentile	-45%	~5th Percentile

ISS compared results on its new quantitative assessment to the voting outcomes from say on pay resolutions. Companies with low concern on the pay-for-performance alignment received, on average, 92% support on the say on pay resolution while companies with a high level of concern received 81% support, on average.

CAP Perspective: ISS’ new quantitative analysis provides more rigor to identifying companies that may have a pay-for-performance issue. By placing more weight on pay and performance trends over a longer period of time, ISS is recognizing that one-year may not be a predictive indicator of the relationship between a CEO’s pay and company’s performance. However, by limiting the pay-for-performance assessment to TSR, ISS is not considering other financial factors that may ultimately determine compensation delivered/earned by executives. Additionally, by only analyzing the grant-date value of equity awards, ISS is not taking into account that outstanding equity awards may have little to no value despite the intended value at grant given many are performance contingent and tied to stock price.

Companies that would have received a high level of concern under ISS’ new pay-for-performance assessment still received approximately 80% of shareholder support on the say on pay resolution. However, shareholders may scrutinize a company’s executive compensation program in light of a high concern assessment by ISS. We believe the new tests provide a more robust perspective on pay-for-performance; however, they do not in and of themselves take into account company specific factors that may be driving pay decisions. This is why telling a compelling story for why the Company and Compensation Committee made specific decisions, especially when there may be a pay-for-performance disconnect, is critical. These items will only be picked up through the qualitative assessment and given the challenges institutional investors and their advisors face in reviewing an extraordinary number of proxies in such a short period of time, the more clear and concise the rationale, the better.

ISS’ Qualitative Assessment Of Pay-For-Performance Alignment

Companies that receive a high concern level based on the quantitative review from ISS will receive an in-depth qualitative assessment to determine how different elements of compensation are used to facilitate or impede shareholder value creation. ISS’ qualitative review may include an evaluation of:

• Performance-based compensation received by executives (focusing on recent decisions made by the Compensation Committee). This review will include the ratio of time-based vs. performance-based awards, cash awards paid vs. target opportunity level, the extent to which total compensation is comprised of performance-based awards, metric(s) used in performance-based awards and any adjustments made to non-GAAP metrics.
• Peer group used for benchmarking purposes as well as the company’s compensation philosophy. ISS will examine if a majority of peer companies are larger in size than the target company or if the target company has an above median pay philosophy.
• Financial / operational results of the company if the cash payout is the main reason for the pay-for-performance misalignment. ISS will review the performance goals related to the cash payout and may examine absolute and relative performance for GAAP measures (including return and growth measures) to determine if the quantitative findings are inconsistent with the company’s financial performance.
• Special circumstances (such as a new CEO or biennial equity grants) that may distort the quantitative analysis. Such circumstances will not automatically nullify the quantitative assessment but may be included as part of its review.

CAP Perspective: This qualitative assessment will compel companies to provide a clear rationale for their compensation decisions (including any recent compensation action) in the CD&A. This may also influence companies to include a concise executive summary of performance and pay at the beginning of the CD&A. We believe including the review of non-TSR metrics is an important step in understanding how decisions are made. Companies should consider how best to articulate their metrics so a reader of the CD&A can understand how decisions and outcomes occurred.

Peer Group Selection Process

Current Approach

ISS’ currently selects a peer group compromised of 8 – 12 companies in the same six-digit Global Industry Classification Standard (“GICS”) code based on .5x – 2x the company’s revenue size (or asset size for financial firms). If there are insufficient companies within the six-digit GICS, peer companies would be supplemented from the four-digit GICS or even the two-digit GICS, using the same size parameters. ISS currently uses market cap as another screen to find additional peers when companies have either very low or high revenue or asset size. For some very large companies, ISS may compile companies using a standard index (such as the Dow Jones 30 or the S&P 500 index).

Updated Peer Group Selection Process

ISS has revised its selection process for the upcoming 2012 proxy season. ISS will compare a company’s pay-for-performance alignment to a group of 14 – 24 companies. A peer group will be based on a company’s GICS code, revenue (or asset) size as well as market cap. ISS will create a peer group twice a year (based on quarterly data as of June 1 and December 1) for Russell 3000 companies based on the following:

• Revenue for the most recent trailing 4 quarters
• Total assets as of the most recent quarter
• 200 day average stock price x shares outstanding as of the most recent quarter (market cap)

To determine the peer group, ISS will identify companies in the two-digit GICS code with a revenue (or asset) size of .45x – 2.1x and a market cap of .2x – 5x. ISS has expanded the revenue/asset size from the standard .5x – 2x range to ensure that similar companies that are slightly beyond the standard range are included as potential peers. From this universe, ISS will select companies within the same six-digit GICS code while trying to maintain the target company’s revenue/asset size around median. ISS may select up to 24 companies from the six-digit GICS code for a peer group however a minimum of 14 companies will consider the peer group complete. If 14 companies are not selected, ISS will expand the list of potential peers to the four-digit GICS code and if the peer group list still does not contain 14 companies, the two-digit GICS code. On an exceptional basis, ISS may exclude company (for example, if a comparator is in bankruptcy).

ISS has also developed two supplemental methodologies if a peer group yields less than 14 companies under their new method.

1. ISS has identified approximately 25 very large non-financial companies in the Russell 3000 (revenue of $50B and a market cap greater than $30B) with very few to no peers. For ISS’ pay-for-performance evaluation, these companies will be compared to each other. ISS notes that industry-specific performance will be considered if a qualitative review is conducted.
2. If a 14 company peer group cannot be yielded under the standard methodology, ISS will include companies with revenues beyond the initial revenue range of .45x – 2.1x while maintaining the target company’s revenue around median and maintaining the market cap range.

CAP Perspective: ISS has provided more controls in selecting companies within a similar size range. Although ISS will review companies in a specific GICS code, there are some limitations to relying solely on the GICS code. Companies within the same GICS code may not be business competitors and, in some instances, a direct competitor may be within a different two-digit GICS code. ISS will not provide a qualitative review of selected peer companies and a peer group may, therefore, contain companies that do not compete with the target company. Additionally, companies with direct competitors that compete for talent and business but may be somewhat larger or smaller than the target company will most likely not be considered due to the size constraints. Therefore, while this new methodology may bring ISS peers more in line with peer groups used internally by companies, significant differences may continue to exist.

Conclusion

ISS’ new peer group selection process and pay-for-performance assessment are more transparent and more rigorous than the current approach. Although ISS has changed its peer group selection process, we expect that there may still be some disagreement on the business relevance of companies in ISS’ peer group especially when the selection parameters are expanded to include companies in the two- and four-digit GICS codes. The quantitative assessment is a more robust analysis of a company’s pay-for-performance alignment with more consideration for longer term performance than the current approach. Companies will want to assess their pay-for-performance from various perspectives including those similar to ISS to understand potential shareholder reaction.

Revisions to U.S. GRId 2.0

The revised U.S. GRId maintains its primary objective of assessing a company’s governance practices (based on Audit, Board, Shareholder Rights and Compensation) but has been refined to provide better insight into governance issues and improve the usefulness of the rating system. ISS made the following changes to the GRId:

• Revisions to the Compensation category. Updating the Compensation category of the GRId was a top priority for ISS. These revisions include:
  • New questions relating to ISS’ revised pay-for-performance assessment (see ISS’ New Quantitative and Qualitative Approach for Evaluating Pay for Performance Alignment CAPFlash here).
  • Expansion of potential responses for equity-based pay questions to better assess program features.
• Additional details on the size of severance pay and perquisites.
  • Reorganization of subcategories to better align with the framework of ISS’ principles for evaluating say on pay. New categories include: use of equity, equity risk mitigation, communication and disclosure, and termination / severance.

CAP Perspective: With ISS’ increasing its focus on compensation practices and reorganizing the subcategories to better align with their say on pay assessment, companies should have a clear and concise disclosure and rationale of their compensation program in the CD&A. Given the short amount of time and the number of companies ISS and other proxy advisory firms will be reviewing, it would be beneficial for a company to have an executive summary at the beginning of the CD&A or have charts to summarize the compensation program that includes rationale and highlight apects that they believe ISS and shareholders will view positively.

• Refinement and reorganization of subcategories. For the other categories, ISS has revised some of the subcategories to better group questions together. Specifically, ISS has reorganized the following categories:
  • Audit: ISS has targeted the role of the external auditor and will examine if there are any audit or accounting controversies.
  • Board: ISS has separated the prior “Board Practices” subcategory into “Board Practices” (to determine the behavior of the Board) and “Board Policy” (to understand governance policies) as well as added a subcategory on Related Party Transactions (“RPT”) to identify potential governance issues.
    • The Board Practices subcategory reviews if the CEO or directors serve on an excessive number of outside boards, the number of board meetings attended by directors and how many directors received a withhold/against vote of 50% or greater.
    • The Board Policies subcategory assesses if the company discloses board/governance guidelines, if directors can meet without management present and if directors can hire their own advisors without management approval.
    • The RPT subcategory evaluates what percentage of directors were involved in material RPT, if directors with material RPT sit on key board committees and if there are any RPTs involving the CEO.
• New and modified questions/answers under each category. ISS has added approximately 40 questions to the GRId with approximately 25 new questions under the Compensation category. See the Appendix (page 4) for a list of new GRId questions under each category. Topics covered by the new questions in the Compensation section include degree of alignment between CEO pay and company performance, excessive perquisites, change-in-control and severance benefits and features of the equity compensation plan. Additionally, ISS has expanded potential responses for its questions to capture the main features of a company’s programs and policies. Similar to their current approach, ISS will review publicly available data to obtain answers for each question.
• Enhancement and increased transparency in the rating system. Fundamentally, the rating system is consistent with the prior version of GRId; a company will receive an overall score and a concern level for each of the four categories. The basic changes to the rating system are related to how answers are scored and how the resulting scores are aggregated.
  • Each answer will receive a score. A negative score will denote a practice that raises concern and a positive score will denote a best practice that may lessen concerns elsewhere.
    • A score of -25 denotes medium concern level and a score of -50 denotes high concern level.
  • ISS has established a threshold and maximum for each subcategory in order to place more weight on certain subcategories. If, for example, in the Termination subsection of the Compensation category a company receives positive points for not having employment agreements, the total positive number a company can receive for this subcategory is +15 and will not eclipse other subcategories in Compensation2.
  • The final score for the overall category will reflect the sum of the subcategories. Each category will be subject to a threshold and maximum (same as the subcategory) and will range from -75 to +25. ISS will add 75 points to the final score to standardize the scale from 0 to 100 for each category. The chart below shows the resulting level of concern based on the total number of points.
  • ISS will disclose a company’s final score for each category in addition to the current “traffic light” system.

Total Points3	ISS Concern Level
<= 50 points	High
<= 75 points	Medium
>75 points	Low

³ The specific scoring and points are subject to change by ISS upon review and back-testing prior to the launch of GRId 2.0 in February 2012.

Conclusions

ISS will be increasing the transparency of its GRId and its focus on compensation for the upcoming proxy season. We will have to wait and see how the new rating system and questions will affect a company’s overall rating in each category but we would expect that companies that have a clear disclosure of their goverance practices and rationale for their policies would fair somewhat better than a company that does not.

Appendix – New GRId 2.0 Questions

Audit

• Has a securities regulator taken enforcement action against a director or officer of the company in the past two fiscal years?
• Is a director or officer of the company currently under investigation by a regulatory body?

Board

• What is the classification of the Chairman of the Board?
• Are the roles of Chairman and CEO separated?
• Has the company identifies a lead / senior independent director?
• What percentage of the board consists of family members?
• What percentage of the board are former or current employees of the company?
• Can directors hire own advisors without management approval?
• Are there related –party transactions involving the CEO?

Shareholder Rights

• Does the company have a poison pill (shareholder rights plan) in effect?
• What is the trigger threshold for the poison pill?
• Is the poison pill designed to preserve tax assets (NOL pill)?
• Was the poison pill approved by shareholders?
• When was the poison pill implemented or renewed?
• Does the company’s poison pill include a modified slow-hand or dead-hand provision?
• If the company has a majority voting standard, is there a plurality carve-out in the case of contested elections?
• Are there material restrictions as to timing or topics to be discussed, or ownership levels required to call a special meeting?

Compensation

• What is the degree of alignment between the company’s cumulative 3-year pay percentile rank, relative to peers, and its 3-year cumulative TSR rank, relative to peers?
• What is the degree of alignment between the company’s cumulative 1-year pay percentile rank, relative to peers, and its 1-year cumulative TSR rank, relative to peers?
• What is the size of the CEO’s 1-year cumulative pay, as a multiple of the median pay for company peers?
• What is the degree of alignment between the company’s TSR and change in CEO pay over the past five years?
• What is the ratio of the CEO’s total compensation to the next highest paid executive?
• Did the CEO receive tax gross-ups on perks other than relocation and other broad-based benefits?
• Did the company provide dividends on unvested performance shares in the last fiscal year?
• Has the company reimbursed NEOs for losses on sale of a home?
• Did the company pay tax gross-ups on a secular trust?
• What is the ratio of the CEO’s non-performance-based compensation (All Other Compensation) to Base Salary?
• Does the company’s active equity plans prohibit options / SAR cash buyouts?
• Do the company’s active equity plans prohibit share recycling for options / SARs?
• Do the company’s active equity plans prohibit option / SAR repricing?
• Do the company’s active equity plans have an evergreen provision?
• Do the company’s active equity plans have a liberal CIC definition?
• Do the company’s active equity plans provide for automatic vesting of equity awards in the case of change-in-control?
• What are the minimum vesting periods mandated in the plan documents for executives’ stock options or SARs in the equity plans adopted / amended in the last 3 years?
• What are the minimum vesting periods mandated in the plan documents adopted / amended in the last three years, for executives’ restricted stock?
• What proportion of the salary is subject to stock ownership requirements / guidelines for the CEO / Is the CEO subject to ownership guidelines?
• Did any executive or director pledge company shares?
• Does the company have a policy prohibiting hedging of company shares by employees?
• What is the level of disclosure on performance measures for the latest active or proposed long term incentive plan?
• What is the multiple of salary plus bonus in the severance agreements for the CEO (upon a change-in-control)?
• What is the multiple of salary plus bonus in the severance agreements for executives excluding the CEO (upon a change-in-control)?
• What is the basis for the change-in-control or severance payment for the CEO?
• What is the basis for the change-in-control or severance payments for executives excluding the CEO?
• What is the amount of the CEO’s estimated non-Change-In-Control severance amount as of the end of the last fiscal year, as a multiple of the executives’ average salary plus bonus over the past three years?

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.