Wall Street Reform and Executive Compensation

Wall Street Reform and Executive CompensationA briefing on the Dodd-Frank Act

November 16, 2010 Boston NASPP

Overview of Dodd-Frank Act

3© 2010 Hay Group. All Rights Reserved

Overview

The Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law on July 21 by President Obama

This landmark piece of legislation addresses a range of issues, including:

Banking regulation

Consumer protection

Regulation of private placements and private investment funds

Executive compensation and governance reforms

This presentation outlines the key executive compensation and governance provisions included in the legislation, and the likely impact on executive compensation next year and beyond

Note that the Act directs the Securities and Exchange Commission (SEC) and the securities exchanges to interpret the law and make new rules, many of which are yet to come



Dodd-Frank is a law that enhances the power and influence of your company’s institutional shareholders on executive and director pay matters

Access to more and “better” information about pay programs (via disclosure rules)

Regular opportunity to tell directors how they feel about their pay decisions (via say on pay)

Institutional investment managers must disclose how they voted

Changes to broker voting, which will dilute the impact of the more typically management-friendly votes

Institutional shareholder advisory groups gain more power (ISS, Glass Lewis)

CEO pay ratio – a meaningless statistic designed to embarrass executives & directors

Shareholders will be forced to be more vocal on these issues, inside and outside of say on pay

The impact of regulatory reform – a new world order



Dodd-Frank Act: key executive pay and governance provisions

Area Provision Description

New authority for shareholders

Say on pay voteGives shareholders an advisory vote on exec pay – rules proposed, effective for meetings held after 1/21

Golden parachute voteGives shareholders an advisory vote on payments related to a change-in-control – rules proposed, may be effective for meetings held after 1/21

Proxy accessGives shareholders greater ability to nominate their own director candidates – delayed in court challenge

New disclosures

CEO pay ratio Requires disclosure of CEO pay to median employee pay

Pay for performanceRequires disclosure of relationship between pay and company financial performance

Chairman / CEO roles Requires disclosure of rationale on whether or not to split

Independence standards

Comp committeeRequires that committee members be “independent” and that they have the ability to retain their own counsel and consultants

ConsultantsRequires the committee to consider factors relating to the “independence” of their advisors



Area Provision Description

Provisions that apply to shareholders

Broker discretionary votingProhibits member brokers from voting customer shares without receiving their voting instructions – already in effect

Disclosure of investment manager voting

Requires annual public disclosure of how institutional investment managers vote on say on pay and golden parachutes – rules proposed October 2010

Managing the risk profile of compensation

ClawbacksRequires disclosure of company policy on clawbacks, including recoupment of excess pay in the event of restatement

Employee and director hedging policies

Requires disclosure of any policies in place relating to ability to hedge the change in value of the company stock

Dodd-Frank Act: key executive pay and governance provisions (cont’d)


Key Executive Pay and Governance Provisions


October –November 2010

Proposal regarding Shareholder votes on Executive Compensation and Golden Parachutes

Propose exchange listing standards on Compensation Committee Independence, Compensation Committee advisor independence and Compensation Committee consultant conflicts

January – March 2011

Adopt Rules Regarding Shareholder votes on Executive Compensation and Golden Parachutes

April – July 2011

Adopt exchange listing standards on Compensation Committee independence, Compensation Committee advisor independence and Compensation Committee consultant conflicts

Propose rules regarding disclosure of pay-for performance, pay ratios and hedging by employees and directors

After July 2011

Under development

SEC Issues Rulemaking Calendar



SEC issued proposal on Shareholder approval of Executive Compensation / Golden Parachute on October 18, 2010

Comment period on proposal through November 18, 2010

Effective Dates

For first Annual or Other Meeting of Shareholders occurring on or after January 21, 2011 for which proxy rules require executive compensation disclosure

Proxy statements filed before January 21, 2011 for meetings after such date must include Say on Pay / Say on Frequency

Effective regardless of status of SEC proposal

Disclosure around Golden Parachute arrangements in merger proxy NOT effective until final rules issued

Say-on-Pay / Say-on-Frequency / Say-on-Golden Parachute



Say-On-Pay

ISS’ Executive Compensation Evaluation policy applies to Say-On-Pay

Policy consists of three sections:

Pay for performance

Problematic pay practices

Board communication and responsiveness

Recommendations issued under the Executive Compensation Evaluation policy will apply to Say-On-Pay if on ballot

If egregious practices are identified, or if a Company previously received a negative recommendation on a Say-On-Pay resolution related to an issue that is still on-going, ISS may also recommend Withhold votes against Compensation Committee members

Say-on-Pay / Say-on-Frequency / Say-on-Golden Parachute (ISS Proposals)



Say-On-Frequency

ISS will adopt a new policy to vote in favor of companies providing for annual Say-On-Pay

Say-On-Golden Parachute

ISS will vote case-by-case on proposals to approve the Company's golden parachute compensation, consistent with ISS policies on problematic pay practices related to severance packages

Final “2011 Proxy voting Guidelines” to be issued in late November

Say-on-Pay / Say-on-Frequency / Say-on-Golden Parachute (ISS Proposals)



Non-binding Shareholder advisory vote on the compensation of the Company’s named executive officers

Vote covers all named executive officers’ compensation

Covers CD&A, compensation tables and other Item 402 disclosure

Does not cover directors’ compensation

Does not cover disclosure about compensation policies and practices as they relate to risk management and risk taking in general

Smaller reporting companies do not have to include CD&A

No preliminary proxy statement required

No discretionary broker voting

Future mandatory disclosure in CD&A on how Board has taken into account Say-on-Pay results

Smaller reporting companies do not have this requirement but may need to disclose in narrative disclosure

Say-on-Pay



SEC is NOT prescribing specific form of resolutions for Shareholder advisory vote

Sample 1 (CitiGroup)

Resolved, that the stockholders approve the compensation of executives, as disclosed pursuant to the compensation disclosure rules of the Securities and Exchange Commission, including the compensation discussion and analysis, the compensation tables and any related material disclosed in this proxy statement.

Sample 2 (Verizon)

Resolved, that the shareholders approve the overall executive pay-for-performance compensation policies and procedures employed by the Company, as described in the Compensation Discussion and Analysis and the tabular disclosure regarding named executive officer compensation, together with the accompanying narrative disclosure, in the proxy statement.

Sample 3 (Motorola) (not meant to comply with new rules)

Resolved, that the stockholders approve the overall executive compensation policies and procedures employed by the Company, as described in the Compensation Discussion and Analysis regarding named executive officer compensation (together with the accompanying narrative disclosure) in this Proxy Statement.

Sample 4 (Intel) (not meant to comply with new rules)

Do you approve of the Compensation Committee’s executive compensation philosophy, policies, and procedures as described in the ‘Compensation Discussion and Analysis’ section of this proxy statement

Say-on-Pay



Non-binding Shareholder advisory vote in proxy statements for annual meetings to determine whether the Say-on-Pay vote will occur every 1, 2 or 3 years

First vote to be held at first annual or other meeting requiring executive compensation disclosure following January 21, 2011 and then held not less often than every six years

Proxy card to allow for following choices: 1, 2, 3 years or abstain

Board may recommend a choice, but proxy statement must be clear that vote is a choice and not a vote for or against

Disclosure in Form 10-Q during period in which Say-on-Frequency occurs stating Board’s decision on frequency

Disclosure of Shareholder advisory vote on Form 8-K (Item 5.07) within four business days still in effect

If Board policy consistent with plurality vote on Say-on-Frequency, Company may exclude shareholder proposals on Say-On-Pay

Say-on-Frequency



Two Parts to Say-on-Golden Parachute

Separate Non-binding Shareholder advisory vote On “any agreements or understandings that such person [Company] has with any named executive officers of such issuer (or of the

acquiring issuer, if such issuer is not the acquiring issuer) concerning any type of compensation (whether present, deferred, or contingent) that is based on or otherwise relates to the acquisition, merger, consolidation, sale or other disposition of all or substantially all of the assets of the issuer” (Golden Parachute)

New disclosure obligations for Golden Parachute (In connection with seeking approval of merger) Disclosure of any agreements Company has with NEOs (or NEOs of Acquiring Company) concerning compensation that is based on

transaction

Proposed rules provide more detailed disclosure than existing requirements to describe “substantial interest” by executive officers and directors

Acquiring Company has similar disclosure obligations if it is seeking shareholder approval as well

Although not required under Dodd-Frank, SEC amended other forms to require Golden Parachute disclosure:

Going private transactions (Schedule 13E-3)

Third party tender offers (Schedule TO and 14D-9) Bidders required to disclose Target Company’s Golden Parachute compensation arrangements after reasonable inquiry

Registrations statements on S-4 containing disclosure on mergers and similar transactions

Proxy solicitations that do not contain merger proposals but require Item 14 disclosure of Schedule 14A

Say-on-Golden Parachute



No specific language or form of resolutions proposed by SEC

Smaller reporting companies must comply

Shareholder advisory vote NOT required for:

Golden Parachute compensation between Acquiring Company and NEOs, but disclosure still required

Golden Parachute compensation previously approved in an annual meeting S-O-P vote, but

Approval of existing change of control disclosure does not satisfy this requirement

New arrangements or revised terms would still be subject to separate vote

Annual meeting with no merger or similar vote (discretionary)




New Tabular Disclosure (Item 402(t) of Regulation S-K)

If in merger proxy, assume triggering event took place on latest practicable date, and price per share is closing price on latest practicable date

If in Annual meeting proxy, assume triggering event took place at year end and price per share is closing price at year end

Multiple Tables required if approving Revisions or Amendments to Golden Parachutes only



Golden Parachute Compensation

Name Cash Equity Pension Perquisites Tax /NQDC /Benefits Reimbursement Other Total

PEOPFOABC


Cash – Cash Severance payments (base salary, bonus, pro rata non equity incentive plan payments)

Equity – Dollar value of accelerated stock awards, in the money options for which vesting accelerated, payments in cancellation of stock and option awards

Pension – Pension and non qualified deferred compensation benefit enhancements

Perquisites -- Perquisites and other personal benefits and health and welfare (No de-minimus exceptions; no exception for non discriminatory health and welfare plans)

Tax Reimbursements - 280G tax Gross Ups

Other – Any other arrangements not called for above

Total – All elements listed above




New Tabular Footnote disclosure

Each separate form of compensation to be quantified

Individual perquisites and personal benefits to be identified and quantified

Separate footnote identifying

Amounts attribute to “single trigger” and “double trigger” arrangements

Time frames for “double trigger” events

Narrative Disclosure

Succinct narrative disclosure of any material facts necessary to understanding Golden Parachute Compensation

Specific circumstances that would trigger payments

Payments to be made in lump sum or over time

Who is to make payments

Material conditions to receipt of payments or benefits

Non compete, non solicitations, non disparagement

Duration of such agreements and provisions on waiver or breach




Company’s proxy materials to provide shareholders with information about, and ability to vote for, a shareholder or shareholder group’s nominee

Proxy Access included in Dodd Frank, although SEC had previously issued proposed rules in 2009

Effective Date was to be November 15, 2010

Legal Challenge: SEC has stayed Effective Date until resolution of Business Roundtable and Chamber of Commerce suit challenging new rule

Some states including Delaware have amended their state corporate law to allow companies to adopt proxy access procedures

Proxy Access



Ownership Requirements: significant, long-term stake required

Shareholder (or group) must own 3% of total voting power

Shareholder must have investment AND voting power over shares

Borrowed shares NOT included

Short shares NOT included;

Shares on loan MAY BE included if:

Shareholder has right to recall shares

Shareholder recalls shares if nominee included in proxy

Three year prior holding period, with intent to hold shares through date of election

Eligibility

Not available for shareholder seeking “change of control”

Not available for nominee or shareholder that has agreement with Company regarding the nomination

Nominee, if elected, must not violate federal or state law or rules of national securities exchange

Nominee must satisfy objective standards of independence

Subjective Board determination required by national exchanges does not apply

Proxy Access



Number and Priority of Nominees

Greater of:

1 or

25% of Board, rounded down

Shareholder (or Group) with largest holdings given priority (regardless of timing of notice filing (Schedule 14N)

Shareholder Nominee will count against limit even if Company allows nominee to be unopposed

New Schedule 14N to be filed by Shareholder

To be filed with SEC between 150 and 120 days before anniversary of mailing date of Company’s definitive proxy statement for previous year:

Up to 500 word statement of support

Certification that nomination is not intended to result in change of control

Information on share ownership, shareholder, and nominee

Proxy Access



Deadlines

Company to notify shareholder within 14 days after deadline for Schedule 14N if NOT including nominee

Shareholder has 14 days to correct any eligibility or procedures deficiencies

Company to notify SEC if excluding shareholder nominee at least 80 days before filing of definitive proxy statement

Shareholder to be notified no later than 30 days before Company files definitive proxy statement that shareholder nominee included

Other Points

Shareholder (or Group) may use Schedule 13G, unless they are conducting other activities that trigger Schedule 13D

Shareholder proposals on proxy access procedures permitted under proxy rules

Proxy Access



Independence of Compensation Committee and Advisors

Compensation committee members must meet new independence standards to be established by the national securities exchanges.

Committee must have authority to retain its own compensation consultants, legal counsel, and other advisors, but only after the committee has considered whether they are “independent” based on factors identified by the SEC.

Expansion of Executive Compensation Disclosure

The relationship between “executive compensation actually paid” and corporate financial performance;

The ratio between CEO total compensation and the median total compensation of all employees; and

Policies on employee and director equity hedging.

Clawbacks

Companies will be required to implement a “clawback” policy requiring current and former executive officers to return erroneously-paid incentive compensation (including equity) received during the three-year period preceding an accounting restatement due to material noncompliance with any accounting requirement.

Compensation Committee / Expansion of Comp Disclosure / Clawbacks


What to expect going forward



“Cleaner” pay practices across the board

Perquisites to continue their decline

Gross-ups on change-in-control payments

Single-trigger on equity will rapidly move to a double-trigger

Severance multiples

Less targeting of the 75th percentile – more targeting of the median

More conservative practices



Share usage and dilution are critical issues for your company’s institutional shareholders, and their advisory groups

This issue has never been more acute after a 2009 in which share consumption jumped in most companies

Harder to get shares in 2011

Linkage between vote on shares and “say on pay”

Used to get five years’ worth – now we’re lucky to get three

Eligibility to be restricted in some companies

Average salary levels for equity-eligible employees continue to increase

Greater use of cash-based LTI and phantom stock in others

David Ellis’ CNN Money, July 12 - Phantom stock may be the next big thing in employee pay

Liability accounting, tracking and administering cash-based performance plans = fun for stock plan administrators

How do you retain your “next level” when you lose the perfect retention vehicle?

Greater pressure on share pools



Two events driving this:

In some sectors, uncertainty is making absolute goal-setting difficult

Disclosure of relationship between financial performance and pay

The new disclosure requirement provides shareholders with all the information they need to conduct a relative pay-for-performance analysis fairly easily

No Board will want to explain why they underperformed their three largest competitors but also increased the CEO’s TDC

Could have substantial implications for HR, accounting teams and stock plan administrators

Greater use of relative TSR programs valuation complexity

Puts a premium on ability to track “performance condition” plans to handle quarterly true-ups

Puts a premium on the communications to employees about how the plan is tracking, as relative performance makes it much harder for the average employee to predict payouts

May require use of third party benchmarking resources, depending on the performance measure

Greater use of relative performance measurement



The “pay ratio” requirement is the silliest of all provisions within Dodd-Frank

A meaningless statistic without accounting for organizational structure, job size, etc.

Was a top focus of business lobby

Nonetheless, Boards will start looking at it too, and what gets watched, gets addressed

CEO TDC is driven primary by the LTI, which will prompt Boards to look for ways to lower the grant value of LTI while still giving the CEO significant upside opportunity

Hence, premium-priced or performance-vested options

Both plans will have lower valuations than plain vanilla stock options

Alternatively, some Boards will explore raising pay levels throughout the organization…

Which will not be a tenable solution long-term

However, this runs counter to the concern about dilution – the lower the value, the more you have to grant (theoretically)

Regardless, expect some companies with large ratios to dust these plans off

More companies will consider premium-priced or performance-vested option plans



Never underestimate the power of director embarrassment

Board consultants to stop doing any other work - period

Less use of traditional HR firms, more use of the boutiques

Has implications for other areas of HR where the same consultant is used for various services

Tracking of previously-exercised stock options may become more detailed

Clawback provision to apply to stock option gains, not just bonuses

Assessing how much to claw back will become quite an exercise

The other things to watch for


These provisions will cause most compensation committees to reexamine their programs in light of the new requirements and required disclosures as they determine what programs should look like in 2011

Some companies will naturally react to look for comfort in replicating what peers are doing – seeking out the “middle ground”. We are cautioning our clients that there is no safety in this “middle ground”, and that changing programs to look the same as that of peers may very well be an adverse outcome

The one area where we expect companies to find defensibility in their programs – regardless of the actual features of those programs – is in linkage to strategy

Companies need to explore every element of their pay program and redouble their efforts to ensure their program maintains a strong link to business strategy, and that this gets clearly communicated to shareholders

Not just disclosure, but active and targeted communication

Preparing for 2011



Does the mix of pay – or emphasis on fixed vs. variable pay, on annual vs. long-term performance – link to the time horizons of the company’s key challenges?

Does the use of long-term incentive vehicles – or emphasis on stock performance vs. strategic performance vs. ownership – map to the way in which the company intends to create value?

Does the make-up of top executives’ vested and unvested share holdings provide sufficient sensitivity to changes in the stock price to make a significant – but not excessive – difference in the value of those shares?

Are the performance measures chosen for the incentive plans linked to the strategic plan, and adequately controllable by executive behavior?

Are the performance levels selected for the incentive plans calibrated to the strategic plan, representative of true incremental value creation, and set at levels that are reachable?

If there are “other” components of the program – perquisites, severance or change-in-control provisions, and the like – can their link to strategy be identified and rationalized?

Taken together, the answers to these questions should provide a read on the degree to which the current program is linked to strategy, and provide a platform for shareholder communication

The questions to ask – and answer – before next year



Key discussion areas

Area What makes business sense?What do shareholders

want?Where’s the breaking

point?

Pay philosophyPay positioning that maps to competitive positioning

Pay positioning that maps to competitive positioning

Targeting P75 without P75 performance

Pay mixMapping pay mix to key time horizons for the business

>50% in LTI for CEOs >50% in STI

Performance measures

A balance that rewards something when returns are low but the team outperforms

High absolute returns AND relative outperformance

Big payouts when shareholders lose

STI / bonusesAllowing some discretion when warranted

Balancing financial and strategic measuresFormula-driven financial performance

Overriding the formula with big discretionary payouts

LTIPerformance-vesting when linked to the “right” measures and key milestones

Less dilution

Performance-vestingLack of a performance-vested vehicle

Perquisites Some of these, some of the time None of them Gross-ups

Change in control

Incentive for executives to be thinking in the best interest of shareholders

Double-triggers

2x payouts (from 3x)Single triggers – even on equity. And gross-ups

Managing risk in pay

Some balance – but not too much

Pay profile that maps to the risk profileBalance, but with a focus on shareholder value

One measurement that drives most of the pay



Questions?Speaker contact information

Michael AndresinoPosternak Blankstein & Lund [email protected]

David WiseHay GroupMetro New [email protected]

Documents

Wall Street Reform and Executive Compensation