Timely Topics in Executive Compensation

Timely Topics in Executive Equity
Compensation

Say on Pay, Assessment of Compensation Risk &
Modifications to Proxy Disclosure

William Parsons
Principal – CompWiser Consulting

Michael Stevens
Partner – Alston & Bird, LLP

Say on Pay

What is it?
How does it work?
What effect might it have on your Equity
Compensation Programs?

Say on Pay

What is “Say on Pay”?
• On July 16th 2009, the Treasury delivered draft "say-on-pay" legislation to
Congress that would require all publicly traded companies to give
shareholders a non-binding vote on executive compensation packages.
• “Say on Pay” also included in the “Corporate and Financial Institution
Compensation Fairness Act,” which recently passed the House.
• The vote is a “yes or no” vote approving the overall executive compensation
as disclosed in the proxy statement.
• Would apply both to annual compensation and, in the event of a merger or
sale of the company, on “golden parachute” payments.

© 2009 CompWiser. All Rights Reserved. 3

Say on Pay

What is “Say on Pay”?
The disclosures that would be subject to the say-on-pay vote include the
following:
• Compensation Discussion & Analysis (CD&A)
• Summary Compensation Table
• Grants of Plan-Based Awards
• Pension Benefits and Non-Qualified Deferred Compensation
• Summaries of golden parachute and potential payments upon termination


Say on Pay

What does Say on Pay not do?
• Say on Pay is a non-binding vote. Therefore, organizations are not required
to change or modify executive compensation programs even in the case of a
“no” vote.
• A “no” vote would not necessarily identify specific issues of concern regarding
executive compensation.
• Under the Treasury Bill, Say on Pay applies only to the executives whose
compensation is required to be publicly disclosed in the annual proxy filing of
public companies.


Say on Pay

What does Say on Pay hope to accomplish?
• Say on Pay is promoted as a way to rein in uncontrolled executive
compensation levels.
• Say on Pay proponents believe that such legislation will improve director
accountability to shareholders by provided a means for shareholders to
express opinions on executive compensation.
• Say on Pay is intended to allow boards and shareholder to work together to
design compensation that gives executives strong incentives to maximize
shareholder value.
• All of these issues are currently under contentious debate.


Say on Pay

Is Say on Pay truly landing on U.S. shores?
• In 2002, the UK adopted regulations mandating an annual non-binding vote
on pay, since this time similar policies have been instituted in Australia,
Sweden, Norway, and the Netherlands.
• In 2007, AFLAC became the first US company to adopt say-on-pay.
• The American Recovery and Reinvestment Act required all financial
institutions participating in the Troubled Asset Relief Program (TARP) to
include an advisory vote in their proxy statements if filed after February 16th
2009. This covered over 300 companies.
• In addition to the TARP participants, over 10 public companies including
Aflac, Intel and Verizon Communications held advisory votes on executive
pay during the 2009 Proxy season
• The release of the Treasury’s draft legislation on July 16th is likely to result in
say-on-pay becoming mandatory for the 2010 proxy season.


Say on Pay

Is Say on Pay an effective tool?
• Although it is non-binding it does provide a means for shareholders to
communicate their level confidence in the executive compensation program
and trust in the Board of Directors.
• A Harvard Business school study published in March 2009 reported
numerous examples of UK companies modifying certain compensation
practices as a result of consultation arising from say-on-pay.
• A review published by Compensia in June 2009 reported that the introduction
of an advisory vote seems to have had the following impact:
• it has strengthened the links between pay and performance
• It has resulted in a reduction of the size of severance packages.
• So far, it has not led to a decrease in overall CEO compensation


Say on Pay

How does Say on Pay impact equity compensation programs?
• Equity Compensation is a complicated and complex form of compensation.
• Current disclosure requirements for equity compensation may muddy the
waters with respect to a shareholder comprehension of value.
• The Compensation Discussion & Analysis becomes even more critical with
respect to communicating aspects of equity compensation programs.
• Communication in plain English is key.
• Design of equity compensation in terms of both size of award levels and
vesting provisions may be impacted.
• The design of equity compensation may need to be simplified in order to ease
the communication burden to shareholders.
• Formally defined ownership guidelines and holding provisions on equity
programs may become more commonplace.


Assessment of Compensation Risk

How may a risk assessment impact the design and
implementation of your equity programs?


Focus on “Risky” Compensation FPO
Started with the Financial Institutions
• Four Major TARP/CPP Requirements
• Prohibition of incentives tied to
“unnecessary and excessive risk”
• “Clawbacks” to recover bonuses and
incentive payments based on materially
inaccurate performance criteria
• Prohibition of “golden parachutes”
• $500,000 limit on deductibility of
compensation


Additional Limitations on Executive
Compensation shortly followed the
original rules:
• During the TARP assistance period,
TARP recipients are prohibited from
paying or accruing any bonus,
retention award, or incentive Restricted
Stock
compensation. 33%

• Equity Awards were permitted within
the following constraints: Annual Cash
• Must consist only of restricted stock and Incentives Base Pay
be no greater than 1/3 of Total 0% 67%
Compensation.
• Minimum two-year vesting, with certain Total Compensation Under the
exceptions Additional Limitations
• Transferability linked to repayment during
TARP Assistance Period.



In addition to the regulated restructuring of executive pay for TARP/CPP
participants, requirements were put in place with regards to the assessment of
risk in compensation.
• Within 90 days of participation a Senior Risk Officer (SRO) must be identified and
tasked with the responsibility of overseeing the risk assessment process in coordination
with the Compensation Committee and other departments.
• Risk assessments of all employee compensation plans required every six months (not
limited to executive arrangements).
• Compensation Committee should report findings of risk assessment to the CEO and full
Board.
• Incentive plans encouraging “unnecessary and excessive risk-taking” should be
corrected.
• Compensation Committee must certify in the annual Proxy filing that process was
completed.
• Within 90 days of each fiscal year-end of TARP participation, the CEO and CFO must
certify that the Compensation Committee met with the SRO to discuss risk in executive
incentive pay arrangements.



How does the focus on risk in executive compensation among financial
institutions participating in TARP impact your organization?
• Newly proposed proxy disclosure rules include a requirement that all publicly
owned organizations address risk in compensation programs.
• Required disclosure should discuss relationship between a company’s
overall compensation policies and risk.
• The discussion extends beyond the executive officers to include all broad-
based compensation policies and overall compensation practices for all
employees that could affect risk, to the extent these may have a material
effect on the company.



So how does a risk assessment impact equity compensation
programs?
• Equity compensation is impacted in a number of ways based upon a
consideration of risk.
• Does the equity compensation program provide an adequate balance
between annual short-term cash incentives and three to five year (or longer)
equity-based incentives?
• If equity compensation programs entail performance vesting, do the
performance metrics take into consideration the impact on long-term viability
of the organization? Are there claw-back provisions on these programs?
• Are the equity vehicles used in equity compensation programs providing a
balance between upside and downside potential to ameliorate risk?
• Do equity programs have vesting periods of sufficient length to address long-
term performance?
• Do equity programs have provisions such as ownership requirements or
holding provisions to reduce risky behavior?



So what changes might we expect to see in equity compensation programs in
consideration of a focus on risk?
• An increase in the use of restricted stock or restricted stock units.
Stock options provide little upside or downside after a plummet in stock price. Restricted
stock always would provide both an upside and downside to discourage risky behavior.
• Holding provisions placed on equity awards.
Holding provisions make become more common as companies seek to prevent the quick
purchase and sale of vested stock options.
• Longer or overlapping vesting periods or performance periods.
Equity awards may require vesting over longer periods of time to encourage a longer-term
perspective from grant recipients. Overlapping periods may prevent an attempt to increase
short-term performance at the risk of performance in future years.
• Ownership Requirements
To keep executives (and directors) with skin in the game, formalized ownership
requirements will likely become more common.
• Careful Evaluation of Performance Metrics on Performance vesting awards
Both timelines and award levels tied to performance will be carefully considered in light of
risk. Maximum award levels may be reduced to prevent risk-taking.



How do the proposed modifications impact your proxy
disclosure and compensation benchmarking for the
coming year?


On July 10, 2009 the SEC issued proposed amendments to its
compensation and corporate governance rules. Key changes are as
follows:
• Revisions to reporting of options and other equity awards.
• A discussion of compensation risk and associated analysis in the CD&A.
• A discussion Board leadership structure (separation of Chairman and CEO
positions) and the role of the Board in risk management.
• Enhanced director and director nominee disclosure.
• Reporting of shareholder voting results on Form 8-K.



Proposed changes to the reporting of equity awards
• In 2006 a major revision to reporting requirements was implemented. The
value of equity awards in the Summary Compensation Table was reported in
terms of the annual FAS 123(R) expensed value of equity awarded to the
Executive Officer.
• The proposed changes would require disclosure of the aggregate grant date
fair value of awards in accordance with FAS 123(R).
• The changes impact the values reported in the Summary Compensation
Table as well as in the Director Compensation Table.
• Amounts for prior years may be required to be recalculated to provide a
uniform methodology for all years included in the table.
• The SEC received comments proposing alternative approaches. There has
been particular concern regarding reporting performance-vested awards, for
which the grant date value may have little relationship to the amounts actually
earned.



How would these changes impact executive compensation disclosure?
• New hire grants, promotional grants, and “mega grants” could impact which
executives will be identified as named executive officers.
• Organizations with equity grants on a multiple-year schedule, as opposed to
an annual schedule, could experience notable year-to-year variance in
compensation.
• Compensation benchmarking and assessment of the competitiveness of pay
could be remarkably different than prior years depending upon methodologies
used to asses equity values.
• Under the current economy of relatively low stock prices, the values reported
for equity compensation would likely be notably lower than previous values
disclosed.


The figure below shows the impact of changes in the reporting for a single year of equity
compensation from the annual expensed value to the full grant date fair value. Data is
calculated from the 2009 proxy filing of a bay-area technology company.
200%
155% CEO
150% 128%
96%
100% 70%
42% 51% CFO
50%
10%
0%
Former
-50% CEO

-100%
-100% -79%
-150%
Change in Option Value Change in Stock Value Change in Total Comp Value


The figure below shows the impact of changes in the reporting requirements on the three
year average equity values. Data calculated from the 2009 filing of a bay-area technology
company.
200%
166% CEO
150% 137%
115%
100% CFO

50%
20%
Former
0%
CEO

-50%
-48% -58%
-100%
Stock Options Restricted Stock/ Restricted Stock Units



• Variance in equity compensation values from prior years may be relatively
unpredictable and tied to the unique characteristics of the award terms.
• Vesting schedules may vary by individual grant and will notably affect
reported values.
• The interval on the timing of awards will significantly alter reported values.
• Actively vesting historical awards will no longer be incorporated in the equity
compensation values reported.
• Benchmarking and assessment of competitive pay standing must carefully
take into considerations the effect of these reporting changes.



New risk analysis required in CD&A.
• Discussion of whether and how compensation practices for employees
generally (not just NEOs) may have a material effect on the company from a
risk perspective.
• Specific emphasis on identifying compensation practices that differ between
business units.
• Specific emphasis on variances in risk and reward structure (where paid out
before risk to company is abated).
• Analysis should be meaningful, comparing design philosophy, mix of long-
and short-term awards, identification of company-specific risks, and
disclosure of risk mitigation strategies (clawbacks, holdbacks, discretionary
reductions, stock retention requirements, and such)



New disclosure of compensation consultant independence.
• If a consultant or its affiliate provides any role in determining or
recommending the amount or form of compensation and provides other
services (i.e., benefits consulting or actuarial services), must disclose all
services and fees paid.
• Disclose whether decision to engage consultant for additional services was
made or reviewed by management or the board or compensation committee.
• Additional disclosure not required if consultant’s role is limited to working on
broad-based non-discriminatory plan available generally to all salaried
employees.



New disclosure relating to board governance and director qualifications.
• Must indicate whether company combines or separates Chairman and CEO
roles and why.
• If Chairman and CEO roles are combined, must disclose lead independent
director and describe his or her specific roles.
• Must described board’s role in risk management process, including the
specific roles of any committees.
• Must describe specific experience, qualifications or skills that qualify a
director to serve as a board and committee member.
• Must disclose any other public company directorships at any time during past
5 years.
• Time period for disclosure of certain legal proceedings extended to ten years.



New disclosure of voting results.
• New item 5.07 of Form 8-K would require the disclosure of the results of
shareholders votes within four business days (rather than the next 10-Q or
10-K, as currently required).


Any Questions?

William Parsons
Principal – CompWiser Consulting
wparsons@compwiser.com
(415) 894-5556

Michael Stevens
Partner – Alston & Bird, LLP
mike.stevens@alston.com
(404) 881-7970

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