Key 1: Committee Composition

Composition of the board Compensation Committee is the first step toward achieving an effective Committee. Below are some tips to keep in mind when determining which Board members should be on the Compensation Committee:

• Compensation Committees are typically composed
  of 3 – 5 board members with different, yet complementary backgrounds and skills
• The Committee should have representation from an active senior executive, an academic, an industry expert, etc., as appropriate. If the Compensation Committee is composed of members with different backgrounds it will allow for more comprehensive and fully vetted discussions
• The Chair of the Committee should be a strong facilitator who pushes forth open discussion and is willing to hear opposing viewpoints, while being an effective communicator and consensus builder
• The Chair works to bring meetings to resolution and to conduct efficient meetings

Key 2: Planning

A second important factor for having an effective Compensation Committee is proper planning. Providing Committee members with a road map of what is going to happen at each meeting and throughout the year allows for a more thoughtful approach to topics. Some planning tips include:

• Annually review the Compensation Committee charter to ensure that the Committee complies with their responsibilities and to see if any changes are required based on regulatory and legislative changes, or evolving practices
• Review the annual calendar at the beginning of each fiscal/calendar year and highlight any key priorities for the year (e.g., long-term incentive plan re-design)
• Provide Committee member education on key and emerging topics on an ongoing basis so they can make informed decisions. Recent emerging topics include the risk assessment process, SEC disclosure rules, shareholder red flags, and the voting policies of the two main proxy advisory firms – Institutional Shareholder Services (“ISS”) and Glass Lewis
• Obtain views of shareholders on an ongoing basis; listen closely to shareholders to get ahead of any potential issues on an annual basis
• Educate new members to provide them with a background on the company’s historical pay practices and performance

Key 3: Establish Processes

Finally, another important factor for having an effective Compensation Committee is having proper and systematic processes for each Committee meeting. Effective Committee processes include:

• Set meeting dates with plenty of lead time to allow for well attended meetings by Committee members, management and external advisors
• Preview each meeting agenda with Committee Chair; establish time limits for topics
• Preview meeting materials well in advance of meetings to address all issues that may potentially arise
• Allow major decision points to be covered at two meetings to give the Committee time to preview and fully vet prior to final approval
• Ensure open and ongoing communication with management to have context for decision making
• Involve the Audit Committee and company Finance during the goal setting process for absolute performance plan goals in the annual incentive and long-term incentive plans
• Involve Legal in CD&A and proxy disclosure, potential filings related to any pay decisions and other technical issues
• Annually test effectiveness of pay plans relative to actual company and stock price performance as well as pre-established goals
• Monitor evolving regulatory, legislative and corporate governance practices by including the topic as an annual or biannual agenda item
• Conduct an executive session at each Committee meeting to ensure any concerns are addressed
• Schedule calls after each Committee meeting with Committee Chair, management and external advisors to debrief and confirm next steps
• Annually assess the performance of the Compensation Committee and its external advisors during the self-assessment process

In our experience, Compensation Committees that incorporate these three keys have more efficient meetings and are more effective in bringing tough decisions to resolution. While not all approaches will be the same, using a framework with similar characteristics often leads to more engaged Committee members and more organized meetings. In today’s environment, with Say on Pay and increased shareholder concerns, it is increasingly important to have a best-in-class Compensation Committee.

If a separate Chair role is desired, the position may be occupied by either an executive or a non-executive. An Executive Chair is frequently a founder or a recently retired CEO who continues on as Chair for a transition period. In a few cases, particularly where a high level of Board independence is necessary, an outsider is hired into the role. In contrast, a non-executive Chair is often a sitting member of the Board whose role is expanded.

At companies where the roles of Chair and CEO are combined, the Lead Director position has become common. In CAP’s annual survey of director compensation at the 100 largest U.S. public companies, the percentage of companies with a Lead Director increased from 38% to 47% in three years, from 2009 to 2011. The percentage of companies reporting a separate non-executive Chair has stayed more stable over the period, at approximately 20%. (In public companies where there is not an independent non-executive Chair or Lead Director, there will be an independent Presiding Director, at times a rotating position.)

When determining the appropriate Board leadership structure, directors must consider which structure will be optimal for their company and its culture. If a Lead Director or a separate Chair is elected, it is essential that the separate roles are clearly defined. This will allow the Board to work more effectively with the CEO and other members of the management team, as well as to best determine the appropriate compensation for the role.

Typical Responsibilities of Various Board Leadership Roles

Typical responsibilities are summarized below. As the typical responsibilities and related time commitment can vary substantially, so does the typical compensation for each role.

Role	Responsibilities
Executive Chair	Provides counsel to the CEO on organization structure, financial structure and related topics Plays integral part in strengthening relationships with external stakeholders, including shareholders and regulatory bodies Develops and executes the company strategy with the CEO
Non-Executive Chair	Takes primary responsibility for shaping Board agendas, with input from the CEO Facilitates discussions between independent directors on key issues outside of Board meetings Has a critical role in succession planning May represent the organization to external stakeholders and employees (at the board’s discretion) Does not typically have a direct role in the company’s operations
Lead Director	Chairs executive sessions of the Board Works with the Chairman & CEO to set agendas for Board meetings Serves as liaison between the Board and the CEO Facilitates discussions between independent directors on key issues outside of Board meetings Does not typically represent the company to external stakeholders Does not typically have a role in the company’s operations

Executive Chairman

The role of Executive Chair is often viewed as a transitional role. The role’s influence on the business can vary dramatically from company to company. As such, compensation practices vary widely across companies and will reflect each company’s specific circumstances, including:

• Balance of responsibilities between the CEO and the Executive Chair
• Time commitment/involvement (e.g., 1 vs. 3 days per week)
• Expected tenure of the Executive Chair
• Tenure and experience of the CEO
• Equity ownership – equity grants are less likely if the Executive Chair already has a large ownership stake or if the position is viewed as short-term in nature
• Founder vs. non-founder status

For an Executive Chair, compensation levels often reflect the individual’s prior pay package as CEO, as well as the compensation program and pay levels of the current CEO.

• Typical pay elements include base salary, annual bonus opportunity and long-term incentive awards
• Base salary levels may reflect the salary earned in the individual’s prior position. If the time commitment is reduced, a salary reduction may also apply
• Long-term incentive opportunities of an Executive Chair are normally lower than what the CEO receives
• Long-term incentive vehicles granted may vary from the company’s core executive compensation program, due in part to the expectation of a shorter tenure and less ability/time to impact long-term results

CAP consultants reviewed compensation data among 57 general industry companies with an Executive Chair, comparing Executive Chair pay to that of the CEO. We found that, at median, Executive Chair compensation (including salary, bonus and long-term incentives) was approximately 70% of the CEO’s compensation.

2012 Executive Chair Data	Exec Chair Salary as % of CEO Base Salary			Exec Chair TCC as % of CEO TCC			Exec Chair TDC as % of CEO TDC
	25th	Median	75th	25th	Median	75th	25th	Median	75th
57 General Industry Cos. (Median Revenues of $2.4B)	70%	90%	100%	65%	85%	105%	35%	70%	100%

For reference, below is a breakout of the pay package for three recent, high profile Executive Chairs.

Recent Executive Chairman Compensation Packages at Large Organizations
Company	Hewlett-Packard	Kraft Foods Inc.	Sara Lee
Revenue	$127.2B	$54.3B	$8.7B
Executive Chairman	Raymond J. Lane	John T. Cahill	Jan Bennink
Date Hired as Executive Chairman	September 2011	January 2012	January 2011
Previous Role	Non-Executive Chair	Outside / New Hire	Non-Employee Director
Base Salary	None	$0.75M	$1.00M
Target Bonus	None	$0.75M (100% of base)	$1.75M (175% of base)
Long-Term Incentives	$8.44M (1)	$4.50M	$5.25M
Target Total Direct Compensation (TDC)	$8.44M	$6.00M	$8.00M
TDC as a % of CEO	46%	97%	129%
LTI Award Vehicle LTI Grant Frequency (annual, one-time)	20% Time-Based Stock Options 80% Performance-Based Stock Options One-Time(2)	75% RSUs 25% Stock Options Not disclosed	50% RSUs 50% Stock Options Not disclosed
Vesting	Time-Based: 3 Year Ratable Vesting Performance-Based: Requires 120-140% price appreciation	3 Year Cliff Vesting (RS) 3 Year Ratable Vesting (SO)	2 Year Cliff Vesting
LTI Award Vehicles Different from Executive LTI Program	Yes	Yes	Yes

1. Excludes fees as non-executive Chair, including $2.19M RSU award
2. 1M stock options were awarded (200,000 options with 3-year ratable vesting; 400,000 options vest upon stock price appreciation of 120% from grant price; 400,000 options vest upon stock price appreciation of 140% from grant price).

Non-Executive Chairman / Lead Director Compensation

Compensation packages for non-executive Chairs and Lead Directors typically consist of the core compensation program for non-employee directors along with an additional stipend (or premium) that reflects the responsibilities and time commitment of the role. This approach appropriately recognizes the differential between a leadership position and other directors, with the magnitude of the premium reflecting the additional responsibilities.

CAP’s market data indicates that all companies with a non-executive Chair provide a premium for the role, and 69% of companies provide a pay premium for the Lead Director role.

Non-executive Chair pay is typically delivered in one of two ways:

• An additional retainer paid in cash or stock, in addition to the regular outside director pay program
• A separate fixed dollar amount provided in cash, stock or a combination, in lieu of the regular outside director pay program

As indicated below, the premium provided to a Lead Director is often much smaller than the premium provided to a non-executive Chair. Our data indicates that a non-executive Chair receives a median premium of +65% compared to a regular outside director’s package. For a Lead Director, the median premium is +10%.

	Non-Executive Chairman and Lead Director Premium Compensation General Industry Companies with Median Revenues of $2.3B
Leadership Position	No of Cos.	Prevalence of Cos. Providing Additional Compensation	Multiple of Non-Employee Director Compensation (Median) Primary Reference	Additional Premium – Median	Additional Premium – Range
Non-Executive Chairman	42	100%	1.65x	$100,000	$20k – $577K
Lead Director	114	69%	1.10x	$20,000	$5K – $140K

Conclusions

The structure and amount of compensation paid to Executive Chairs differ from non-executive Chairs and Lead Directors, a direct reflection of the roles, duties and time commitment required for each position.

Executive Chairs participate in the company’s executive compensation programs. Base salary, annual incentive and long-term incentives are commonly offered, yet pay programs are situation-specific and frequently transitional in nature. The Executive Chair’s expected tenure and perceived ability to influence longer term results are considerations that impact the amount and form of incentive compensation used.

As companies increasingly focus on improving Board independence, it will be important to evaluate whether or not separate Chair and CEO roles are appropriate. Companies should assess which organization structure makes sense given its unique circumstances. Companies anticipating a transition period due to executive turnover, the need to improve governance or a corporate transaction should re-assess the appropriate structure necessary to best navigate through turbulent times.

For the 114 company sample, median revenue was $30B, median market capitalization was $29B and median Total Shareholder Return (TSR) was 3% for 2011.

What We Found

Companies have modified their stock ownership guidelines and stock retention (or holding) requirements to enhance their governance practices. Median value of CEO stock ownership guideline has increased to 6x base salary, also more in line with Institutional Shareholder Services’ (ISS) definition of “robust” stock ownership. Overall, the use of stock retention requirements increased to approximately 1/3 of companies, while the use of stock retention requirements alone is flat year over year.

Prevalence Of Stock Ownership Guidelines And Stock Retention Requirements

The prevalence of stock ownership guidelines (approximately 90%) among companies in our database remained relatively flat in 2011 compared to findings in 2010. Companies with both stock ownership guidelines and stock retention requirements increased to 36% (from 22%), demonstrating increased efforts towards good corporate governance. However the prevalence of companies with stock retention requirements only stayed relatively flat year over year at 4%.

Of the 46 companies with stock retention requirements, nearly half (52%) of the companies report retention requirements that are linked to stock ownership guidelines (e.g., companies must hold shares until the stock ownership guideline level is achieved). Companies with stand-alone stock retention requirements that are not linked to stock ownership guidelines decreased slightly to 48% in 2011 (vs. 57% in 2010).

Stock Ownership Requirement

Similar to 2010, most companies (approximately 80%) express stock ownership guidelines as a multiple of salary and 15% express guidelines as a fixed number of shares. Fixed share guidelines are more prevalent in the Financial Services (57%), Technology (31%) and Retail (27%) industries.

CEO Stock Ownership Requirement Prevalence	2011 (n = 104)		2010 (n = 99)
	# of Cos	% of Cos	# of Cos	% of Cos
Multiple of Salary	84	81%	80	81%
Fixed Shares	15	14%	15	15%
Lesser Of Approach	3	3%	2	2%
Other	2	2%	2	2%

 

Stock ownership guidelines for CEOs increased from 2010, with the median CEO requirement increasing from a 5x multiple of salary to 6x salary in 2011 (See chart below for details). The median fixed share guideline also increased to 175,000 shares from 150,000 shares in 2010. This median requirement suggests that companies may be increasing their guidelines to respond to shareholders and provide more favorable optics. For several industries, however, (i.e., Automotive, Financial Services, Healthcare and Retail) the median CEO stock ownership guidelines of 5x salary was the same year over year.

The median stock ownership requirement value for the CEO increased modestly to $7.0M in 2011.

CEO Stock Ownership Requirement	2011 (n=104)			2010 (n=99)
	25th %ile	50th %ile	75th %ile	25th %ile	50th %ile	75th %ile
Multiple of Salary	5x	6x	6x	5x	5x	6x
Fixed Shares	120,000	175,000	300,000	100,000	150,000	300,000
Total Value	$5.7M	$7.0M	$9.7M	$5.4M	$6.7M	$8.6M

 

Most companies require executives to achieve the guideline requirement within 5 years. 20% of companies in our database disclose a penalty for not achieving the required ownership. Common penalties for non-compliance include restrictions on selling shares, requiring annual bonus or performance cash awards to be paid in shares and reducing future total compensation.

74 of 104 companies disclose the type of shares that count toward the guideline. While approximately 40% of companies count unvested restricted stock toward the requirement, less than 10% of companies count unearned performance shares or unvested stock options. These findings are similar to our findings in 2010.

Shares Counting Toward Guideline Requirement	2011 (n = 104)		2010 (n = 99)
	# of Cos	% of Cos	# of Cos	% of Cos
Shares directly owned	72	69%	55	56%
Shares in 401(k) plan	49	47%	33	33%
Unvested RS	43	41%	33	33%
Shares indirectly owned	36	35%	29	29%
Deferred Compensation	33	32%	25	25%
Vested but unexercised options	11	11%	6	6%
Unearned performance shares	7	7%	5	5%
Unvested options	5	5%	1	1%
Not disclosed	30	29%	29	29%

 

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

Stock Retention Requirement

Companies with stock retention requirements most often require executives to hold net shares from option exercises or restricted stock share/unit vesting. Fewer companies, less than 50%, subject net shares from performance-based equity awards to stock retention requirements.

Note: Percentages add up to greater than 100% due to some companies requiring that multiple forms of equity be held.

Most companies require executives to hold net shares after exercise or vesting for a period of 1 year (41%) or through retirement (25%). Few companies require executives to hold shares post-retirement (13%), although the prevalence has increased from 2010.

Period Subject to Hold	2011 (n = 32)		2010 (n = 24)
	# of Cos	% of Cos	# of Cos	% of Cos
1 year post exercise/vest	13	41%	11	46%
2 years post exercise/vest	1	3%	1	4%
Retirement	8	25%	8	33%
Post-retirement	4	13%	1	4%
Other	4	13%	4	17%
Not disclosed	3	9%	1	4%

 

Note: Reflects companies with stock retention requirement only. Percentages add up to greater than 100% due to one company requiring different holding periods for CEO and other NEOs.

Disclosed Stock Ownership Guideline Changes

Approximately 20% of companies disclose changes to their stock ownership guideline requirements for 2011 or for 2012. A majority of these companies (55%) increased the ownership requirement for at least one NEO. Other notable changes include the addition of retention requirements (32%) and requiring a more stringent definition of shares that count toward the stock ownership guideline (9%).

Changes to Stock Ownership Guidelines	2011 (n = 22)		2010 (n = 25)
	# of Cos	% of Cos	# of Cos	% of Cos
Increased guideline requirement	12	55%	12	48%
Added holding requirement	7	32%	6	24%
Modified shares counting toward guideline	2	9%	n/a	n/a
Modified penalty for non-compliance	1	5%	5	20%
Newly adopted	1	5%	1	4%
Adopted mandatory holding of shares through retirement	1	5%	1	4%
Extended Participation	1	5%	n/a	n/a
Decreased guideline requirement	1	5%	n/a	n/a

 

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

Summary

In 2011, companies made modest changes to their stock ownership guideline requirements; most often in an effort to make them more robust. Additionally, companies continue to implement stock retention requirements, albeit at a relatively slow pace, to enhance their governance practices. We expect companies to continue to adopt and implement stock retention (holding) requirements and to increase their stock ownership guidelines. Both of these policies address issues that are important to shareholders and proxy advisory groups, and further align senior executives with shareholders.

In January, 2013, Institutional Shareholder Services (ISS) made two announcements of note related to executive compensation

1. Realizable Pay: Updated the Evaluating Pay for Performance document to provide a detailed description of its methodology for calculating realizable pay
2. QuickScore: Rolled out QuickScore as a replacement for its GRId score

Realizable Pay

For S&P 500 CEOs at companies with an annual meeting after February 1, 2013, the standard ISS research report will show three-year total realizable pay in addition to the three-year total grant date pay that is used in its quantitative analysis. If a company’s quantitative test results in a medium or high level of concern, ISS will discuss realizable pay levels vs. grant date pay as a part of the qualitative review. If realizable pay is significantly lower than grant date pay, it could be a potential indicator that the actual pay-for-performance relationship is more aligned than the quantitative analysis indicates. Conversely, if realizable pay is greater than grant date pay in a company whose quantitative analysis results in a medium or high level of concern, it may aggravate concerns about the pay for performance alignment. Although there are still some limitations to realizable pay analysis (discussed further below), we believe that, on an overall basis, this brings ISS’ analysis one step closer to assessing the true pay-for-performance relationship.

ISS methodology for total realized pay is to include all of the following (typically for the three-year period):
Compensation Element	ISS Approach	CAP Perspective
Base Salary	As reported for all three years	We support this approach
Bonus / Short-term Non-Equity Incentives	As reported for all three years	We support this approach as it reflects what was actually earned
Long-term Cash	The earned value of the award (if earned during the same measurement period) or its target value in the case of on-going award cycles (i.e., not completed before the end of the measurement period)	ISS’ approach of using target for incomplete performance periods could overstate or understate, perhaps significantly, the amount that is ultimately delivered to the CEO as all this performance-based compensation is still 100% at risk. An alternative approach would be to use what actual payouts of these plans were during the three-year period, recognizing that the payouts may relate to performance before the three-year period under review This is further exacerbated where companies have these types of plans as the largest component of compensation
Share-based Awards	The value (based on stock price as of the end of the measurement period) of awards made during the period (less any shares/units forfeited due to failure to meet performance criteria based on complete and clear disclosure); or, if performance awards remain on-going, the target level of such awards
Stock Options	The net value realized with respect to such granted options which were also exercised during the period; for options granted but not exercised during the measurement period, ISS will re-calculate the option value, using the Black-Scholes option pricing model, as of the end of the measurement period	The use of the Black-Scholes value of stock options could be problematic, as underwater options have no intrinsic value and really do not have a “realizable” value unless the stock price appreciates. However, for what ISS is attempting to do with the realizable pay analysis (i.e., test the validity of the quantitative test and/or “demonstrate the company’s adherence to a pay-for performance philosophy”) we believe that using the Black-Scholes option pricing model is a plausible method for measuring potential pay
Change in Pension Value and Nonqualified Deferred Compensation Earnings	As reported for all years	Including the change in pension value introduces unnecessary “noise” to the calculation that has less to do with compensation design or performance than with interest rate fluctuations or the oddities of actuarial calculations We believe ISS should view the change in pension value on a qualitative basis to see if a company has poor practices related to pension (e.g., significantly higher formula for executives, grants of additional years of service, etc.)

CAP Perspective Almost any definition of realizable pay will be subject to criticism and scrutiny. Our main concern with the realizable pay approach proposed by ISS is that it is not directly connected to a review of the firm’s performance over the time period. Comparing realizable pay to grant date pay may be an indicator of the pay for performance relationship, but it is our position that it would be better viewed next to multiple years of performance relative to peers. We suspect that over time ISS will refine how realized pay is defined and could directly incorporate it into the pay-for-performance quantitative test.

ISS notes that it is their intent to collect the required information in a standardized way that is easily obtained from a company’s tabular disclosure. Companies can help improve the accuracy of ISS’ analysis by clearly revealing, in a supplemental table, any performance based awards that have been forfeited prior to the completion of ISS’ assessment period (i.e., most recent three years).

ISS QuickScore

On January 25th, ISS rolled out QuickScore as a replacement of its GRId score. It will apply a scoring system based on the decile ranking of a company relative to others in the respective country.

• Coverage: 3,000 largest U.S. public companies
• Methodology: The scoring will be applied over the same four quadrants used for the GRId score, with several subcategories in each quadrant

Categories for the Quickscore
Board Structure	Compensation/Remuneration	Shareholder Rights	Audit Practices
Board Composition Composition of Committees Board Practices Board Policies Related Party Transactions	Pay for Performance Non-Performance Based Pay Use of Equity Equity Risk Mitigation Non-Executive Pay Communications and Disclosure Termination Controversies	One Share One Vote Takeover Defenses Voting Issues Voting Formalities Other Shareholder Rights Issues	External Auditor Audit and Accounting Controversies Other Audit Issues

• Screening Process:Assesses companies based on multiple qualitative factors to see if they exceed, meet, or fall short of market practices
  • Quantitatively assessed correlation between 16 performance and risk factors
• Factor Criteria: Provides red flag summary of practices that raised concern and green stars for practices that mitigate concern
• Data Verification: Companies have the ability to verify their data between January 28th and February 15th. When the product launches, companies will once again be able to verify their data

CAP Perspective: The structure and criteria of the QuickScore appear very similar to what was used under the GRId score. The main change appears to be the relative scoring approach, which should provide a better indicator of governance risk compared to other companies

Conclusion

While ISS’ evaluation criteria are always challenging for companies to address, the changes made to the ISS pay-for-performance evaluation and the transition from GRId to QuickScore represent directional improvement. We expect that the calculation of realizable pay and its role in the pay for performance evaluation will continue to evolve over time. Similar to GRId, it is not clear what role QuickScore will play in shareholder voting decisions. We expect that it will be a starting point for deeper analysis in cases where the score indicates governance concern.

We are pleased to present the 3nd annual report on non-employee director (NED) compensation produced by Compensation Advisory Partners LLC (CAP). The report provides a review of current director pay practices among the largest public U.S. corporations (trend setting organizations) and Observations regarding trends and outlook.

• Evaluation of Executive Pay (Management Say on Pay)
1. Incorporate a company’s selected peers as an input to its peer group selection methodology, while maintaining an approach that includes company size and market capitalization constraints
2. Potentially incorporate a comparison of realized pay to grant date pay as part of the qualitative evaluation of pay-for-performance alignment
• Voting on Golden Parachutes in an Acquisition, Merger, Consolidation, or Proposed Sale
1. Include existing change in control arrangements maintained with named executive officers rather than focusing only on new or extended agreements
2. Place further scrutiny on multiple legacy problematic features in change in control agreements
• Pledging
1. Identify significant pledging as a failure of risk oversight with a negative vote recommendation directed against the board of directors

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

Current Peer Group Selection Process for Pay-for-Performance Evaluation

For 2012, ISS selected the subject company’s peer group using market cap and revenue (or assets for financial firms) and the subject company’s GICS industry group. The peer group is generally comprised of 14-24 companies that are closest to the subject company, and where the subject company is close to median of the peer group in revenue/asset size.

Updated Peer Group Selection Process for Pay-for-Performance Evaluation

For 2013, ISS revised the peer group selection process to include companies in GICS industry groups represented in the subject company’s self-selected peer group. The size parameters used in the selection process continue to include market cap and revenue, though assets will be used for certain financial firms. ISS will consider the subject company’s GICS industry group as well as the GICS industry group(s) of companies within the subject company’s self-selected peer group. The peer group continues to generally include 14-24 companies and is designed to emphasize peers that are closest to the subject company in terms of revenue/asset size and industry, are in the subject company’s peer group and have chosen the subject company as a peer. Selected peer companies will also remain within the company’s market cap bucket.

ISS will also use slightly relaxed size constraints, especially at very small and very large companies. For certain financial firms, revenues will be used instead of assets for screening.

ISS Intent and Impact

The new approach incorporates the subject company’s GICS industry group as well as additional GICS industry group(s) represented in the company’s self-selected pay benchmarking peer group. This change was intended to identify and prioritize GICS industry groups beyond the subject company’s GICS industry. Backtesting of the new vs. old methodology indicates that this change will result in a greater degree of overlap between the ISS peer group and the subject company’s self-selected peer group. This revision will not impact the size comparison of the subject company relative to the selected peer group since size revenue/asset and market cap size constraints will be maintained.

CAP Perspective: ISS’ peer group revisions address the criticism that the current “one size fits all” approach to the peer group selection process does not accurately take into account a company’s business model and company-specific considerations. Without taking into consideration the company’s self-selected (and Board approved) peer group, ISS’ current process has limitations and lacks credibility.

The revised approach provides greater alignment between ISS’ peer group and the company’s self-selected peer group. We expect companies and Compensation Committee to find the revised peer groups to be more credible due to the stronger emphasis on the relevance of the company’s business model. In addition, the revised peer groups are more likely to take into account the companies used for compensation benchmarking purposes.

Current Pay-for-Performance Evaluation

The approach for 2012 included quantitative and qualitative components. The quantitative analysis reviews three factors for companies in the Russell 3000 index:

Relative Peer Group Alignment –

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

Absolute Alignment – this factor measures long-term alignment between pay and company performance, as:

3. 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

If ISS determines that these analyses demonstrate 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

Updated Pay-for-Performance Evaluation

The pay-for-performance evaluation for 2013 continues to include a quantitative and qualitative component. The three quantitative tests remain unchanged from 2012 although the tests will be performed using the revised peer group described above.

ISS will continue to conduct a qualitative review for companies that demonstrate a weak alignment between pay and performance. The considerations incorporated in the qualitative review for 2013 remain the same as 2012 with the addition of a comparison of realizable pay to grant pay for large cap companies.

Realizable pay will consist of relevant cash and equity-based grants and awards made during a specified period being measured. Equity award values are based on actual earned awards, or target values for ongoing awards, calculated using a stock price at the end of the performance measurement period. Stock options or stock appreciation rights (SARs) will be re-evaluated using the remaining term and updated assumptions, using a Black-Scholes option pricing model.

ISS Intent and Impact

ISS’ revision to potentially incorporate a comparison of realizable pay to grant date pay as part of the qualitative evaluation, when necessary, for large cap companies provides an additional perspective for assessing the pay-for-performance alignment between CEO compensation and company performance. This new factor may either increase or reduce the pay-for-performance concerns identified through the quantitative component of the pay for performance review. Large cap companies will likely be defined as the S&P 500 or a similar group.

CAP Perspective: ISS’ inclusion of realizable pay provides a critical perspective on CEO compensation. If the CEO’s compensation creates a pay-for-performance misalignment, it is important to understand the total value the CEO may be able to realize over a specific performance period or at a given time. We believe this assessment will provide additional context for CEO compensation decisions.

ISS’ final 2013 policy summary is silent on whether the realizable pay will be compared to the ISS peer group or company’s financial performance. An ISS representative indicated that realizable pay will be compared to grant date pay, but not to peer companies. In isolation from financial performance or a relative peer analysis, assessing the CEO’s realizable pay vs. actual compensation has its limitations and does not provide sufficient context for the company’sspecific situation.

One problem with ISS’ definition of realizable pay is that outstanding stock options will be valued using a Black-Scholes model rather than intrinsic value. As a result, a portion of the so-called realizable pay may never be realized, if options are underwater.

Voting on Golden Parachutes in an Acquisition, Merger, Consolidation, or Proposed Sale

Current Recommendation

ISS will vote on a case-by-case basis on proposals to approve the company’s golden parachute compensation, consistent with policies on problematic pay practices related to severance packages. Features that may lead to a vote against include:

• Recently adopted or materially amended agreements that include excise tax gross-up provisions (since prior annual meeting);
• Recently adopted or materially amended agreements that include modified single triggers (since prior annual meeting);
• Single trigger payments that will happen immediately upon a change in control, including cash payment and such items as the acceleration of performance-based equity despite the failure to achieve performance measures;
• Single-trigger vesting of equity based on a definition of change in control that requires only shareholder approval of the transaction (rather than consummation);
• Potentially excessive severance payments;
• Recent amendments or other changes that may make packages so attractive as to influence merger agreements that may not be in the best interests of shareholders;
• In the case of a substantial gross-up from pre-existing/grandfathered contract: the element that triggered the gross-up (i.e., option mega-grants at low point in stock price, unusual or outsized payments in cash or equity made or negotiated prior to the merger); or
• The company’s assertion that a proposed transaction is conditioned on shareholder approval of the golden parachute advisory vote. ISS would view this as problematic from a corporate governance perspective.

New Recommendation

For 2013, ISS revised the features that may lead to a vote against the company’s golden parachute compensation to include consideration of existing change in control arrangements maintained with named executive officers, rather than focusing only on new or extended arrangement.

ISS will scrutinize multiple legacy problematic features in change in control agreements and may recommend against the proposal if agreements include one or more of the following, depending on the number, magnitude, and/or timing of issue(s):

• Single- or modified-single-trigger cash severance;
• Single-trigger acceleration of unvested equity awards;
• Excessive cash severance (>3x base salary and bonus);
• Excise tax gross-ups triggered and payable (as opposed to a provision to provide excise tax gross-ups);
• Excessive golden parachute payments (on an absolute basis or as a percentage of transaction equity value); or
• Recent amendments that incorporate any problematic features (such as those above) or recent actions (such as extraordinary equity grants) that may make packages so attractive as to influence merger agreements that may not be in the best interests of shareholders; or
• The company’s assertion that a proposed transaction is conditioned on shareholder approval of the golden parachute advisory vote.

Recently adopted or materially amended agreements that include problematic practices will tend to carry more weight on the overall analysis. However, ISS will closely scrutinize the presence of multiple legacy problematic features.

ISS Intent and Impact

ISS’ revised voting recommendations puts additional pressure on boards of directors and companies to revisit existing contractual obligations. Clearly companies are not able to simply walk away from their obligations, but there may be me greater appetite to renegotiate this arrangement.

The biggest change to the list of problematic practices is the addition of single-trigger acceleration of unvested equity awards. This practice is widespread, even though a number of companies have moved to double trigger vesting.

We look forward to understanding how ISS will define an “excessive” golden parachute going forward.

CAP Perspective: ISS’ revised policies place increasing pressure on companies to make changes to existing contracts with problematic features. ISS’ stringent point of view on single-trigger acceleration of unvested equity awards will likely have an impact on contracts with this provision over time. The pressure to eliminate certain problematic provisions will be stronger for companies that are moving towards a corporate transaction.

Pledging

ISS’ proposed draft policy on the practice of pledging company stock as a problematic pay practice under ISS’ say-on-pay evaluation was viewed negatively by issuers. ISS indicated that discussions with investors led it to conclude that significant pledging is problematic and represents a failure of risk oversight. ISS concluded that the potential negative vote recommendation should be directed towards the election of directors rather than to a company’s say-on-pay proposal.

For 2013, ISS will view pledging on a case-by-case basis to determine whether the pledging rises to a level of serious concern for shareholders. ISS is viewing significant pledging as a failure of risk oversight whereby directors should be held accountable (rather than communicating concern through a say-on-pay recommendation). To determine the vote recommendation for directors, at companies with pledging policies, the following should be considered:

• Presence in the company’s proxy statement of an antipledging policy that prohibits future pledging activity;
• Magnitude of aggregate pledged shares in terms of total common shares outstanding or market value or trading volume;
• Disclosure of progress or lack thereof in reducing the magnitude of aggregate pledged shares over time;
• Disclosure in the proxy statement that stock ownership and holding requirements do not include pledged company stock; and
• Any other relevant factors.

ISS also indicated that any hedging will result in a negative voting recommendation on the election of directors. Hedging includes a variety of strategies used to reduce or eliminate the impact of stock price declines, including puts, covered calls, collars or other derivative transactions.

ISS Intent and Impact

ISS 2013 policy on pledging places pressure on companies to monitor and unwind situations where pledging rises to a level of serious concern for shareholders. ISS is silent on the definition of “significant” pledging, however, ISS indicates that significant pledging may have an impact on the vote recommendations for the election of directors.

CAP Perspective: Pledging provides flexibility by allowing executives access to lower cost financing without having to sell company stock to fund other purposes. It is important to provide balance between this greater flexibility and monitoring of excessive leverage. Excessive leverage is never a good thing and to the extent that executives do pledge shares certain safeguards should be in place.

Pledging causes concern for investors if the stock price could be impacted by an executive’s sale of the shares. In addition, issues may arise if a margin call forces a sale, particularly during a period where the trading window is closed. These concerns could be prevented by requiring the executive to attest that other liquid assets, unrelated to company stock, are readily available to satisfy any potential margin call. Stock ownership guidelines help to mitigate the compensation risk associated with pledging since it ensures that the executive remains invested in the company stock, even while pledging a portion of shares owned.

CAP is a leading independent consulting firm specializing in executive and director compensation and related corporate governance matters. Our consultants have served as independent adviser to Boards and senior management at many leading companies in the areas of compensation strategy and program design, and share ISS’ interest in promoting sound corporate governance principles.

Management Say-on-Pay Proposals (U.S.)

ISS will vote against advisory votes on executive compensation if there is a perceived misalignment between CEO pay and company performance under the methodology ISS uses for pay-for-performance analysis for companies or the company maintains significant problematic pay practices. ISS is considering the following policy changes for 2013:

1. Use a company’s selected peers as an input to its peer group selection methodology, while maintaining an approach that includes company size and market capitalization constraints
2. Potentially incorporate a comparison of realized pay to grant date pay as part of the qualitative evaluation of pay-for-performance alignment
3. Add pledging of shares as a factor that may lead to negative recommendations under the existing problematic pay practices evaluation

ISS Request for Comment – Peer Group Selection

Are there additional or alternative ways that ISS should use the company’s self-selected peer group to inform its peer group construction?

CAP Perspective: We believe it is a positive step for ISS to expand its formulaic peer selection methodology to better take into account each company’s self-selected, Board approved peer group. By using an 8-digit GICS resolution and incorporating the GICS groups represented in the subject company’s peer group, ISS peer groups will increase the degree of overlap between the ISS peer groups and the subject companies self-selected peer group(s).

We encourage ISS to further acknowledge the importance of pay comparisons that use a subject company’s disclosed peer group. We believe that it is important to use a consistent peer group for both pay benchmarking and for performance comparisons. In contrast, ISS noted that “these peer groups are designed not for pay benchmarking…, but rather to compare pay and company performance.” Further, we believe that understanding of a company’s self-selected peer group is material to understanding each company’s compensation decisions. Given this, we suggest ISS include results of its formulaic pay-for-performance tests (RDA / MOM / PTA) for its peer group side-by-side with each company’s disclosed peer group.

Since company size is highly correlated with levels of executive pay, what is a reasonable size range (revenue/assets) for peer group construction?

CAP Perspective: We agree that ISS’ current screening criteria for revenue/assets (0.45 – 2.1x subject company) is reasonable, but we believe that the current approach continues to be too formulaic. ISS should allow for a limited number of peer companies (e.g., up to 20%) to range up to 3x of subject company revenue/assets, if these companies are in the company disclosed peer group.

Are there additional factors that investors should consider in peer group construction for pay-for-performance evaluation?

CAP Perspective: We believe that more weight should be placed on the subject company’s business model, even if this is done in a qualitative fashion. One of our clients manufactures consumer durable products and the ISS selected peer group is dominated by home-builders. Another client sells luxury branded products and is compared to sellers of undifferentiated low price-point merchandise. The result is a loss of credibility for ISS, since many peer companies are a poor fit in terms of business model.

ISS Request for Comment – Realizable Pay

How would you define realizable pay?

CAP Perspective: ISS currently uses the compensation reported in the annual proxy statement (modifying option grant date values to reflect the full option term, rather than the expected life of the options) for its quantitative pay-for-performance tests. For realizable pay, we suggest the following definition:

1. 3-year average cash or cash equivalents, including Salary, any discretionary Bonus, Non-Equity Incentive Compensation (including annual and long-term cash incentive payments), Change in Non-Qualified Deferred Compensation and Pension, and All Other Compensation; each as disclosed in the Summary Compensation Table; plus
2. 3-year average intrinsic value of Stock Options granted during the 3 year period, valued based on the ending stock price; plus
3. 3-year average value of restricted shares, RSUs and performance share units granted during the 3 year period, each valued based on the ending stock price. If disclosure clearly indicates the number of performance shares actually earned, this value would be used. Otherwise the target number would be incorporated in the calculation.

The resulting value could be compared to “grant date” pay and also relative to other companies. We recognize that this is not a perfect solution, but we believe it reasonably responds to the issue of measuring realizable pay without adding undue complexity to the calculations. For example, the 3-year period corresponds to the disclosure contained in one proxy statement. We acknowledge that 3 years is a relatively short period to assess a stock option with a 10-year term, but believe it to be acceptable since the comparisons are done relative to peer companies measured during the same 3-year period and this value most directly relates to shareholder experience during the performance period being reviewed.

We are pleased that ISS has recognized the trend to focus on realizable pay rather than “grant date” pay when Committees assess a pay-for-performance relationship. However, we are disappointed that ISS only plans to use realizable pay as part of its qualitative assessment, if triggered by below par quantitative results. We urge ISS to make broader changes to its approach, by incorporating realizable pay in the Pay-TSR Alignment (PTA) test. We believe realizable pay should be used in the PTA test since realizable pay is more closely aligned with absolute shareholder returns than a construct where pay reflects the grant date value of stock options and equity awards.

Should stock options be considered based on intrinsic value or Black-Scholes value, and what is the rationale for your choice?

CAP Perspective: When analyzing realizable pay, we urge ISS to consider the intrinsic value of stock options. This directly ties compensation value with performance (in this case TSR / shareholder wealth creation). In contrast, a Black-Scholes value would include valuation related to the time value of money over the remaining term of the option. Moreover, we believe all inputs to the realizable pay analysis should be accessible from compensation amounts disclosed in annual proxy statements. This would not be the case with a Black-Scholes valuation which would require additional calculations and agreement on assumptions for volatility and expected life, among other factors.

What should be an appropriate measurement period for realizable pay? One year, or three years, or five years or others?

CAP Perspective: We believe the appropriate measurement period for realizable pay is three years. This period strikes the right balance between accuracy and efficiency, since it can be calculated with the information provided in a single proxy statement.

ISS Request for Comment – Other

Please feel free to add any additional information or comments on the proposed policy change.

CAP Perspective: We have additional comments that relate to ISS Say on Pay vote recommendations. Outlined below, we describe additional changes that we urge ISS to consider related to: a company’s response to its Say on Pay shareholder support level; how ISS measures TSR for the quantitative CEO pay-for-performance assessment; ISS’ policies around the rigor of performance goals; and how ISS treats multi-year long-term incentive grants.

Board Response to Say-on-Pay Vote

We believe that when a high percentage of shareholders, for example, 90% or more, support a pay program, little or no year-over-year change should be expected. Therefore, we urge ISS to add to its qualitative assessment of the pay-for-performance relationship a review of prior shareholder support for the Say on Pay resolution. Given 90+% shareholder support and no substantial program changes year-over-year, ISS should recommend shareholders support a Say on Pay resolution in the subsequent year.

Alternatively, when a company receives less than 70% shareholder support for Say on Pay and pay program change is expected by ISS, we urge ISS to recognize the typical compensation program decision making calendar. For example, when Compensation Committees make final executive compensation program design decisions for the upcoming year, usually in the first quarter, they will not yet have results of the Say on Pay vote. In these instances, we urge ISS to focus on changes to compensation program design that will occur the following year as disclosed in the text of the CD&A, rather than Summary Compensation Table disclosure that reflects actions taken prior to knowledge of Say on Pay support level.

TSR Measurement

In line with the methodology used for SVT calculations, we urge ISS to use an average stock price at the beginning and end points of the TSR calculations used in its pay-for-performance test. Use of a 20 trading day average stock price would limit the impact of very short-term price fluctuations on the results.

Performance Goals – Evaluation of “Rigor”

ISS reviews the rigor of performance goals in its qualitative pay-for-performance assessment. It would be helpful to better understand the parameters for this assessment.

Multi-year Long-term Grants

When recruiting new CEOs, companies often grant long-term incentives that are intended to make up for compensation forfeited from a previous employer (often called “make-whole” grants). In these instances, we encourage ISS to exclude these grants from the pay-for-performance testing since the grants fill a very specific need and would not be granted in the absence of forfeited compensation.

In other situations, companies make multi-year grants (sometimes called “special” or “retention” grants). These awards are not granted annually. Instead a larger grant is made up-front, followed by a period where grants are smaller or not made at all. In these cases, the amounts disclosed in the Summary Compensation Table and Grants of Plan Based Awards Table reflect the full-value, but companies view these awards as applying to multiple years. We urge ISS to annualize such grants in their analysis, and believe it would be a more accurate representation of long-term compensation. The value of the award could be readily annualized over its vesting period. ISS could also limit the number of years over which an award could be annualized (e.g., over no more than three years).

ISS Request for Comment – Pledging of Company Stock

ISS is considering adding pledging of company stock to the list of problematic pay practices that may result in an adverse vote recommendation. ISS noted that pledging of company stock as collateral for a loan may have a detrimental impact on shareholders if the officer is forced to sell company stock, for example to meet a margin call. Alternatively, when done prudently, hedging can provide flexibility by allowing executives access to lower cost financing without having to sell company stock to fund other purposes. The key here is balance. Excessive leverage is never a good thing and to the extent that executives do pledge shares certain safeguards should be in place.

What would you consider a “significant” level of pledging of company stock that causes concern for investors?

CAP Perspective: We would consider a significant level of pledging of company stock that causes concern for investors to be an amount where the stock price could be impacted by the sale of the shares. We believe pledging of shares with a value that exceeds 5 percent of the company’s market value should be considered significant.

In addition to the potential impact on stock price, investors could be concerned if a margin call forces a sale, particularly during a period where the trading window is closed. This could be prevented by requiring the executive to attest that other liquid assets, unrelated to company stock, are readily available to satisfy any potential margin call. Finally, stock ownership guidelines and policies prohibiting hedging should be in place to ensure that the executive remains invested in the company stock, even while pledging a portion of shares owned.

If pledging raises concerns significant enough to warrant voting action, should this action be directed at the (i) management say-on-pay proposal (if available), (ii) the board, or (iii) members of one of the board committees (e.g., Audit, Governance, Compensation – please specify)?

CAP Perspective: If pledging of shares is significant enough to warrant remedial action and ISS plans for this to influence its vote recommendations, we urge ISS to direct their concern regarding pledging to the Say on Pay vote. Pledging would be addressed by company policy akin to related issues, such as stock ownership guidelines, which are best reflected in the Say on Pay advisory vote.

Would you consider a company’s remedial actions on pledging (such as a commitment not to pledge in the future, commitment to unwind their positions within a reasonable period) sufficient to address concerns?

CAP Perspective: Yes, we urge ISS to consider a company’s remedial actions on pledging sufficient to address concerns. These positions may require time to unwind. Given the timing of the updated policy release, we hope that ISS considers the complexity of companies trying to align themselves with ISS policies.

Are there additional factors that investors should consider for the case-by-case analysis?

CAP Perspective: Yes, we believe there are additional factors investors should consider for the case-by-case analysis. One factor is a disclosed trading policy that prohibits hedging, that is short-selling and derivative positions, which potentially immunize an executive against exposure to company stock. A second factor is a policy on stock ownership guidelines. The third factor is limits on the amount pledged expressed in terms of the total shares relative to the company’s capitalization and to the executive’s total position.

Say on Golden Parachute Proposals (U. S.)

ISS is proposing to update the policy on Golden Parachute proposal to:

1. Include existing change-in-control arrangements maintained with named executive officers rather than focusing only on new or amended arrangements.
2. Place further scrutiny on multiple legacy problematic features in change in control arrangements.
   When the Golden Parachute vote is incorporated into the advisory Say on Pay vote, ISS will evaluate the Say on Pay proposal in accordance with these guidelines, which may give higher weight to that component of the overall evaluation.

ISS Request for Comment – Golden Parachutes

In your organization’s view, when evaluating payments arising from problematic pay practices in the context of a say on golden parachute proposal, would you differentiate between new and existing arrangements when determining whether to support the proposal? If yes, please specify.

CAP Perspective: Yes, we encourage ISS to differentiate between new and existing arrangements when determining whether to support a say on golden parachute proposal. Often times, existing arrangements are contractual and therefore not quick or simple to modify.

CAP also encourages ISS to differentiate between the problematic features it identified. Certain features strike us as more problematic than other features. For example, assume that two companies put forward proposals where each had a single problematic feature. Assume that Company A had excise tax gross-ups, while Company B had single trigger acceleration of unvested stock options. We submit that the excise tax gross-ups could result in a material cost to shareholders. In contrast, single trigger equity vesting accelerates the executive’s ability to participate in the transaction along with shareholders. A company that has single trigger equity vesting may not be taking a leading edge position on compensation governance issues, but is also not supporting practices that are necessarily unfriendly to shareholders.

Would the number of problematic features be a consideration when evaluating a say on golden parachute proposal? If yes, please specify.

CAP Perspective: We believe ISS should focus on the potential value of arrangements it views as problematic, rather than a formula driven by a pre-determined number of program features. For these arrangements to justify ISS to consider an Against vote recommendation, ISS should come to the conclusion that potential payments are “excessive.” (See below for discussion of ‘excessive’)

Are there any other factors that should be considered in evaluating say on golden parachute proposals? If yes, please specify.

CAP Perspective: Given the timing of the updated policy release, we hope that ISS considers the complexity of companies trying to align themselves with ISS policies. In addition, an ISS defined problematic practice includes: “excessive golden parachute payments (on an absolute basis or as a percentage of transaction equity value).” We urge ISS to clarify their definition of excessive – both in absolute terms and as a percentage of transaction equity value – as it is difficult for companies to comply with a policy without specifics.

CAP is submitting commentary on its own behalf and not on behalf of any specific clients.