EXECUTIVE REMUNERATION PERSPECTIVE

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1 EXECUTIVE REMUNERATION PERSPECTIVE US ISSUE 99 JANUARY 2013 TEN TIPS FOR A TROUBLE-FREE 2013 PROXY SEASON This Perspective was adapted from a more in-depth article from Mercer Select. Mercer Select is a membership service for Mercer clients and others interested in news, views and analysis on a broad spectrum of benefit, compensation and HR issues. Most of the content is available only to members and is designed to give those members the information they need to do their jobs more effectively. To learn more about Mercer Select or to become a member, please contact your Mercer consultant or visit IN THIS ISSUE, ANSWERS TO: What can companies do to prepare for the 2013 say-on-pay vote? How can companies better tell their compensation story? What is the best way to understand shareholders concerns? How have the proxy advisers influenced executive pay? As companies prepare for the 2013 proxy season, say on pay (SOP) continues to influence pay decisions, drive shareholder engagement efforts and encourage pay and governance disclosure enhancements. With no sign that shareholder activism in the executive pay arena is lessening, companies should understand shareholder and proxy adviser voting policies, tell their pay-for-performance story, explain their peer group selection process, reach out to shareholders and proxy advisers, and highlight best pay and governance practices in annual proxy statements. The following 10 tips should help companies experience a less stressful 2013 proxy season.

2 TIP 1 UNDERSTAND PROXY ADVISERS PAY-FOR-PERFORMANCE TESTS Pay-for-performance disconnects are the top reason for negative SOP vote recommendations from proxy advisers Institutional Shareholder Services (ISS) and Glass Lewis & Co. Companies have criticized the proxy advisers pay-for-performance analyses for flawed peer group comparisons and over-reliance on short-term total shareholder return (TSR). To deflect some of these concerns, the proxy advisers have updated their tests. ISS: ISS is changing its proxy voting policies, while retaining the basic structure of the pay-for-performance tests it used in 2012 to analyze SOP proposals. ISS subjects all companies to a quantitative screening, followed by a qualitative review of companies flagged in the initial screen. ISS uses three quantitative tests to compare (i) the company s TSR rank and its CEO s total pay rank within a peer group over one- and three-year periods, (ii) CEO pay as a multiple of the peer group median for the most recent year and (iii) the alignment of five-year trends in the CEO s annual pay relative to the company s TSR. CEO pay is lifted from the summary compensation table (SCT) with a slight difference in the valuation of stock options. The updates (effective for annual meetings held on or after Feb. 1, 2013) will consider a company s self-selected peer group in addition to the Global Industry Classification Standard (GICS) codes and size criteria that ISS currently uses. ISS will also report realizable pay values for S&P 500 companies in their individual company reports and will consider realizable pay as a qualitative factor for S&P 500 companies that fail the quantitative tests (see Tip 2). Glass Lewis: Glass Lewis adopted similar changes this year and is partnering with Equilar, a data provider, to conduct its pay-for-performance assessment. Performance is evaluated based on a weighted average of one-, two- and three-year results against six specified financial and share price performance factors. The model compares the company s performance factors and compensation data to that of a peer group of up to 30 companies, calculates a weighted average percentile ranking for each and identifies gaps between the two percentiles. Unlike ISS, Equilar uses algorithms (not GICS categories) to create peer groups based on publicly disclosed relationships among companies. 2 Mercer

3 TIP 2 TELL A COMPELLING PAY-FOR-PERFORMANCE STORY An effective Compensation Discussion and Analysis (CD&A) starts with an executive summary highlighting key points and selling the compensation program to shareholders. An effective summary typically addresses: How pay programs support business strategies Performance results that influenced executive pay decisions during the last fiscal year Pay and performance alignment through a narrative or graphic demonstration Significant corporate events and leadership changes Changes to pay plans made in response to shareholder concerns Best pay and governance practices Compensation risk mitigation features or techniques REALIZED AND REALIZABLE PAY Comparing performance with realized or realizable pay was probably the biggest disclosure development of 2012 a trend likely to pick up even more steam in The most significant difference between SCT reported pay and realized and realizable pay is the treatment of equity awards. In the SCT, equity awards are reported in the year of grant based on their accounting grant date fair value. There is no clear consensus among companies or the proxy advisers on what the terms realized and realizable pay mean, but definitions often include some variation of the following: Realized pay is the amount actually taken home by the executive in a given period, with stock awards measured using their value at vesting and stock options measured using the actual gain at exercise, regardless of when they were granted. Realizable pay typically measures the value of compensation granted to the executive during a specified period (for example, three years), regardless of whether it has been realized. Year-end stock price is used to value stock awards, the in-the-money or Black-Scholes value of options and performance awards in progress (with the number of shares based on target or probable performance outcome). Comparing performance with realized or realizable pay was probably the biggest disclosure development of 2012 a trend likely to pick up even more steam in Companies that simply create realized or realizable pay tables similar to the SCT must clearly distinguish them from the SCT to comply with US Securities and Exchange Commission (SEC) rules. A large retail store chain s 2012 proxy statement includes a realizable pay table that compares the company s relative composite performance percentile (based on TSR, EBITDA growth and revenue growth) to its CEO s relative three-year realizable pay percentile. Executive Remuneration Perspective 3

4 TIP 3 EXPLAIN THE PEER GROUP SELECTION PROCESS The practice of benchmarking executive pay levels to a group of peer companies has taken much of the blame for skyrocketing executive pay. Shareholders, proxy advisers and the SEC generally focus on two aspects of the benchmarking process: peer group selection and the targeted benchmark. Companies should thoroughly explain their process for selecting peers. Best practice disclosures discuss and quantify pertinent characteristics used to identify appropriate comparators, such as revenue, assets, market capitalization, number of employees and industry. For example, a multi-subsidiary health care organization includes in its 2012 proxy statement a peer group table that includes eight pertinent characteristics for each peer company. Much thought goes into where a company should target pay compared with its peers. Some companies believe pay must be targeted above the median to attract and retain executives. However, this strategy is hard to justify when performance is not above the median. Also, past SEC staff comment letters have required companies to disclose actual pay levels compared with the benchmarks. For example, a company should not only state that it targets total compensation at its peer group median, but should also disclose how actual pay levels compare with that target. If actual pay was at the 75th percentile, the company may want to explain the discrepancy. TIP 4 ENGAGE WITH SHAREHOLDERS AND PROXY ADVISERS Companies should meet with key shareholders and proxy advisers regularly to learn their concerns. Soliciting ongoing feedback through in-person meetings and telephone calls with large shareholders allows companies to receive timely input on potential concerns and address difficult issues before facing public scrutiny of pay programs. This is particularly important for companies facing a possible negative recommendation from ISS or Glass Lewis. Know your shareholders. Companies should determine which shareholders to contact to learn about their voting policies and practices, including whether they follow ISS or Glass Lewis recommendations. Smaller institutional investors are more likely to follow the proxy advisers, while larger institutions may have their own policies and may consider proxy firm reports as just one factor. Develop a process for engaging shareholders. The person who best represents the company in the engagement process will vary by company and shareholder and could include the compensation committee chair or members of the company s investor relations department. One pitfall to avoid is involving the CEO in defending pay programs. 4 Mercer

5 Seek regular feedback. Shareholder engagement should be an ongoing process that may include telephone calls between the company and its largest shareholders and proxy advisers, and occasional in-person meetings to discuss significant concerns. For easier access, proxy advisers and institutional investors recommend reaching out primarily in the summer, fall and winter and not waiting until the spring busy season. Use new proxy adviser feedback tools. Both ISS and Glass Lewis have established mechanisms to give feedback on adviser policies and analyses. ISS established a Feedback Review Board and Glass Lewis formed an issuer engagement portal. These tools should give companies greater opportunities to challenge controversial policies and recommendations. Rebut and negotiate to reverse negative vote recommendations. Some companies whose SOP proposals initially received against recommendations from ISS negotiated to address the proxy adviser s concerns and ultimately received a positive vote recommendation. Some companies filed supplemental proxy materials responding to specific problems raised by proxy advisers and shareholders and, in some cases, ISS reversed its negative recommendation. TIP 5 DISCLOSE RESPONSE TO PRIOR YEAR SOP VOTE Companies should explain how they responded to 2012 SOP results, including any changes made to pay programs. SEC rules require companies to describe in their proxy statements how the results of previous SOP votes factored into pay decisions. In addition, according to the proxy advisers policies, past SOP support levels of less than 70% (ISS) or 75% (Glass Lewis) warrant an explicit management response to address shareholder concerns. If the next proxy disclosure does not detail steps taken to remedy those concerns, ISS will recommend case-by-case voting against compensation committee members (or in rare cases, all directors) and the current SOP proposal. Glass Lewis likewise will recommend holding compensation committee members accountable if the next proxy disclosure indicates the board failed to take appropriate action to address shareholders concerns. Companies should explain how they responded to 2012 SOP results, including any changes made to pay programs. The importance of this tip is underscored for all companies. One company whose 2011 SOP proposal received 82% support includes a detailed description of its shareholder engagement process in its 2012 proxy, despite significant shareholder support. Executive Remuneration Perspective 5

6 TIP 6 ADDRESS ANY COMPENSATION ADVISER CONFLICTS OF INTEREST While companies need not affirmatively disclose that the compensation committee has determined there are no conflicts of interest they nevertheless may want to include such a statement to address shareholder concerns and ward off potential SEC staff comments. The only new disclosure requirement for 2013 addresses conflicts of interest raised by the work of a compensation consultant in determining or recommending the amount or form of executive or director compensation. If actual conflicts of interest did arise, the proxy statement must disclose the nature of the conflicts and how they were addressed. The compensation committee must consider the following six independence-related factors in identifying adviser conflicts: Other services provided to the company by the adviser s employer Fees paid by the company to the adviser s employer as a percentage of the employer s total revenues Conflict-of-interest prevention policies and procedures of the adviser s employer Any business or personal relationship between the adviser and a compensation committee member Any company stock owned by the adviser (but not by the adviser s employer) Any business or personal relationship between the adviser or the adviser s employer and an executive officer of the company While companies need not affirmatively disclose that the compensation committee has determined there are no conflicts of interest, as was the case when the SEC adopted risk disclosure rules, they nevertheless may want to include such a statement to address shareholder concerns and ward off potential SEC staff comments. The new disclosure requirement is closely tied to proposed stock exchange listing standards that will require compensation committees to consider the six independence-related factors listed above when selecting a compensation adviser. For purposes of the stock exchange rules, compensation advisers include independent legal counsel and other advisers as well as compensation consultants. 6 Mercer

7 TIP 7 CONSIDER EARLY ADOPTION OF DODD-FRANK PAY AND GOVERNANCE MANDATES The SEC has not made progress implementing the Dodd-Frank mandates covering clawback policies and pay-for-performance, internal pay equity and hedging policy disclosures. However, many companies have enhanced their disclosure regarding pay for performance and have adopted and disclosed anti-hedging and clawback policies. And some have addressed internal pay equity, although typically not in the manner contemplated by the law, which many companies view as excessively burdensome. Pay for performance. Proxy statements will have to discuss and may include a graph to illustrate the relationship between compensation actually paid to executives and corporate financial performance. As noted in Tip 2, many companies are already exploring different narrative and graphical approaches to disclosing the pay and performance link, including realized or realizable pay disclosures. The SEC has indicated it is considering a realizable pay approach to implementing this requirement. Hedging policies. Companies will have to disclose whether employees or directors can purchase financial instruments to hedge or offset any decrease in the market value of their holdings in company equity securities (for example, prepaid variable forward contracts, equity swaps, collars and exchange funds). Although this requirement is not yet in effect, companies are adopting and disclosing hedging policies in part in response to shareholder and proxy adviser prompting. This trend is likely to accelerate because ISS views significant pledging of company stock and any hedging by officers and directors as a failure of risk oversight that could trigger an against or withhold recommendation for some or all directors. Clawback policies. Exchange-listed companies will have to implement clawback policies to recover incentive-based compensation paid to current or former executives during the three-year period preceding the date on which the company must prepare an accounting restatement because of material noncompliance with financial reporting requirements. In response to shareholder and proxy adviser pressure, companies without clawbacks are abandoning their wait and see approach, knowing any policies they adopt may have to be amended when the SEC and stock exchanges act. For example, all the Dow Jones 30 companies have disclosed that they have adopted some sort of clawback policy. Internal pay equity. Dodd-Frank requires companies to disclose the ratio of the median annual total compensation of all employees other than the CEO to that of the CEO. Although companies may consider pay equity in making executive pay decisions, few have chosen to address internal pay equity in their CD&As. Of those that do, most address the ratio of CEO pay to that of other named executive officers. Efforts to repeal this mandate have not gained traction in Congress, and, according to SEC staff, the commission is currently working on this rulemaking initiative. Executive Remuneration Perspective 7

8 TIP 8 ELIMINATE PROBLEMATIC PAY PRACTICES Over the past few years, companies have been eliminating pay policies and practices that shareholders and proxy advisers consider problematic, such as tax gross-ups, perquisites, single-trigger change-in-control (CIC) provisions and excessive severance. In preparing for the 2012 SOP vote, several companies eliminated problematic pay practices in response to shareholder and proxy adviser concerns, and some saw significant increases in SOP support after failing in For example: One company eliminated excise tax gross-ups from future CIC agreements and perquisites not guaranteed under existing contracts and replaced single-trigger with double-trigger CIC provisions in its long-term incentive plan. Support for its SOP proposal increased from 39% in 2011 to 94% in Another terminated agreements with modified single-trigger CIC and tax gross-up provisions, and the company agreed that new executive employment agreements would have finite four-year terms. Support for its SOP proposal increased from 46% in 2011 to 97% in ISS identifies specific problematic pay practices that could lead to a negative SOP vote recommendation if they are deemed inappropriate or unjustified relative to executive pay best practices. In addition, ISS specifies unfavorable practices that, by themselves, may result in an automatic negative vote recommendation. Glass Lewis does not have a list of practices that lead to automatic no vote recommendations but considers several pay practices in its analysis. TIP 9 ENHANCE DISCLOSURE TO AVOID SHAREHOLDER LAWSUITS In 2011, shareholder SOP lawsuits were directed at companies whose pay programs failed to receive majority support. Typically, these shareholder derivative suits (on behalf of the company) asserted that executive pay was not consistent with company performance particularly where pay increased while performance decreased. Most of the lawsuits were dismissed on technical grounds. In response, plaintiffs lawyers are taking a different approach filing shareholder class-action lawsuits after a company files its proxy but before its SOP vote is taken to try to delay the vote. These complaints typically claim that proxy statements fail to provide adequate disclosure on executive pay, leaving shareholders with insufficient information to make a decision on the SOP proposal. Where applicable, they also allege the proxy fails to provide adequate disclosure on a proposal to amend or increase authorized shares under an equity incentive plan. 8 Mercer

9 Although the lawsuits may lack merit, some defendant companies are amending their disclosures and paying settlements or attorneys fees. The litigation can create bad publicity, even for companies whose disclosure is legally compliant. These lawsuits are likely to become more prevalent in TIP 10 RECOGNIZE THAT PAST SOP PERFORMANCE IS NOT AN INDICATION OF FUTURE RESULTS While overall SOP voting results for the 2012 proxy season were consistent with 2011, some companies experienced sharp swings negative and positive in shareholder support, and the number of failures rose. In both 2011 and 2012, most companies had a positive SOP outcome, with favorable shareholder votes for Russell 3000 companies averaging about 91%. But while failures are still rare less than 3% their frequency increased in 2012 with 59 companies reporting SOP failures as of Nov. 15, compared with 41 in all of Sharp swings are likely to continue in 2013, in part because the ISS pay-for-performance test relies heavily on one-year TSR. Thus, one year of weak performance could move a company from a top performer (compared with its peers) to below median. Since the only leverage most companies have at year end is to pay low or no annual incentives, some practitioners have suggested using a modifier or cap on pay to help maintain alignment and limit the impact of CEO pay increases on the ISS tests. To prepare for 2013, companies should determine how they are likely to fare under the revised ISS and Glass Lewis tests so they are ready to explain the results in the proxy statement and shareholder engagement process. Also, since this will be the first year a SOP vote is required for smaller reporting companies, the addition of many more companies could impair access to institutional investors and proxy advisers during the engagement process. Thus, all companies should allow extra time for engagement and open lines of communication early to avoid unfavorable results. Executive Remuneration Perspective 9

10 THE HIDDEN SIDE OF SOP With two years of reported SOP results, it is natural to look for trends and potential long-term ramifications. There is clearly greater accountability for pay and governance decisions and incremental changes in pay practices. But some changes may not have the intended effects and could ultimately have negative consequences for companies and shareholders. For example, some companies are: Eliminating problematic pay practices but replacing them with higher salary or larger bonuses Adopting clawback and hedging policies without understanding how they will be implemented Adding a relative TSR metric, even though it may not be appropriate for the company Additional resources To learn more, we encourage you to visit our library of Executive Remuneration articles and visit Mercer Leadership and Succession Planning Website. Concerns about excessive pay levels can be expected to continue. Leading this charge are the proxy advisers whose influence is unlikely to wane in the near future shareholder activists and the press. Thus, despite improvements in executive pay and governance practices, it is likely that executive pay will continue to make frontpage headlines, particularly in these still-troubled economic times. PERSPECTIVE AUTHORS AMY KNIERIEM amy.knieriem@mercer.com CAROL SILVERMAN carol.silverman@mercer.com SUSAN EICHEN susan.eichen@mercer.com EXECUTIVE REMUNERATION CONTACTS TIM NICE (Australia) tim.nice@mercer.com WILL FERGUSON (Global Leader) will.ferguson@mercer.com MARTIN IBAÑEZ-FROCHAM (Latin America) martin.ibanez-frocham@mercer.com HANS KOTHUIS (Asia Pacific) hans.kothuis@mercer.com GREGG PASSIN (New York) gregg.passin@mercer.com PIIA PILV (EMEA) piia.pilv@mercer.com SETH ROSEN, Editor (Los Angeles) seth.rosen@mercer.com MICHAEL THOMPSON (Canada) michael.a.thompson@mercer.com WEI ZHENG (Greater China) wei.zheng@mercer.com Executive Remuneration Perspective is published by: Mercer 1166 Avenue of the Americas New York, NY This article is for information only and does not constitute legal advice; consult with legal and tax advisers before applying to your situation. You are welcome to reprint short quotations or extracts from this material with credit given to Mercer LLC. Copyright 2013 Mercer LLC. All rights reserved A-HC