Executive and Director Compensation

">Stock Appreciation Rights (SARs)
Stock Appreciation Rights (SARs) are rights to receive the dollar appreciation of the underlying shares of common stock without actually having to acquire the shares. The rights may be attached to an option, thereby providing a specific exercise price and term.

Restricted Stock/Restricted Stock Units
Restricted stock and restricted stock units are shares of stock subject to a restriction period during which the shares cannot be sold. If employment is terminated prior to the lapse of restrictions, the restricted shares are subject to forfeiture. Typically, no payment is required and restrictions lapse after a three- to five-year period.

Performance Shares/Units
Performance shares and performance units are awards that are paid out, either in cash or shares, upon the achievement of pre-determined performance goals.  Performance cycles are typically three to five years.

Transferable Stock Options (TSOs)

Academic literature by Kevin Murphy and Brian Hall (“Option Value does not Equal Option Cost” and “The Trouble with Stock Options”) shows that employees place significant discounts on the value of their stock option grants. The misalignment results in an excess grant of stock options and transfer of shareholder equity at the expense of stockholders.

Transferable stock options (TSOs) may potentially bridge the gap. TSOs are stock options that the option holder can sell, generally at a discount to their Black-Scholes value, to a third party financial institution in exchange for cash or stock. Employees can readily see that value exists in their unvested stock options, even the underwater ones.

Transferable stock options have been marketed as potentially the next generation of equity awards.  The newness of such program may spark off an unprecedented trend in the marketplace and ISS believes that shareholders should have a voice in such programs.

Microsoft was the first company that conducted a one-time broad-based TSO program with the assistance of JP Morgan Chase in late 2003. The company offered to buy packages of options previously granted to employees. Those packages were then re-purchased by Morgan, after first removing forfeiture and other provisions unique to employee options. No companies have offered an ongoing TSO program.

There are two types of TSOs programs: one-time transfer and an ongoing transfer. For one-time transfer program, ISS will recommend withholding votes from compensation committee members if they fail to submit one-time transfer for shareholder approval. One-time transfer will be evaluated on a CASE-BY-CASE basis giving consideration, but not limited, to the following features:

• Executive officers and non-employee directors should be excluded for participating;
• Stock options must be purchased by a third-party financial institutions at a discount to their fair value using Black-Scholes Option Pricing Model or Binomial Option Valuation or other appropriate financial models;
• Two-year minimum holding period for sale proceeds (cash or stock) for all participants.

Additionally, management should provide a clear explanation of why options are being transferred.  For one-time transfer, particularly on underwater options, management should state whether the events leading up to the decline in stock price were beyond management's control. A review of the company's historic stock price volatility should indicate if the options are likely to be back “in-the-money” over the near term.

For an ongoing TSO program, TSOs will be one of the award types under a stock plan. The ongoing TSO program, structure and mechanics must be disclosed to shareholders. Since forfeiture rates will no longer have an impact on all award values starting in 2007, the detailed disclosure of the program structure is necessary in order to model the appropriate award value.  (Please note that this is not a policy change. ISS detailed the requirements of an on-going TSO program in the 2006 Policy Updates). Amendments to existing plans that allow for introduction of transferability of stock options should make clear that only options granted post-amendment shall be transferable.

In general, ISS believes that shareholders should have a voice in a TSO program.  TSO is an evolving program and only a handful of companies have adopted such program in the past.  In general, the authority to transfer stock options to a third-party financial institution without revealing the mechanics and structure of the program is insufficient for ISS to recommend a vote “for” the equity plan proposal.  The details and the structure of a TSO program must be disclosed in order for shareholders to understand the potential implication and for ISS to model the appropriate cost of the program.  The specific criteria to be considered in evaluating these proposals continue to evolve and may include, but not limited, to the following: eligibility, vesting, bid-price, term of options, transfer value to third-party financial institution, employees and the company, among others.

Reload Stock Options
Reload stock options allow an option holder who exercises a stock option with stock already owned to receive a new option for the number of shares delivered upon exercise. The exercise price of the new option is set at 100 percent of fair market value on the date of delivery, and the expiration date is equivalent to the term remaining on the original option. By reloading the option, the participant has continued upside potential through share price appreciation on the swapped shares.

Reloads can increase actual share ownership as the mechanism encourages participants to exercise early and hold a portion of the grant outright. On the other hand, since the company grants additional shares each time options are exercised, the company depletes its pool of option shares faster. Reload options are considered as a negative qualitative feature in the proxy analysis.

Quarterly Data Download Process
Much of the financial, accounting, and market data used in the SVT and allowable cap calculations are downloaded directly from Standard & Poor's Research Insight. In an effort to synchronize the data download process in a systematic manner, data for all companies is downloaded on March 1st, June 1st, September 1st, and December 1st of each year.  Depending on the company's annual or special meeting date, the appropriate quarterly data will be utilized.

Table 8-3. Quarterly Download Dates

Binomial Model

Interest in modeling techniques increased dramatically following the creation of the first registered securities exchange for the purpose of traded options: the Chicago Board Options Exchange in 1973. The Black-Scholes model became the basis of extensive empirical research that yielded alternative valuation techniques that are superior for handling the unique characteristics of non-publicly traded options.

The binomial valuation model takes into consideration the most significant differences between publicly traded call options and employee stock options: longer maturity, delayed vesting, the possibility of early exercise, forfeiture, non-transferability, dilution, and taxes. However, the Black-Scholes model, which does not accommodate these factors, is still widely used due to its simplicity.

Under a classic option swap, for example, an executive holding a 10-year option to purchase 1,000 shares at $10 finds that three years after receiving the award, his shares have finally vested but his company's stock has fallen to $6. While the executive still has the right to exercise this award any time over the next seven years, some argue that the award no longer provides the recipient with the intended incentive value. As a result, the company may cancel the old option and grant a new one with an exercise price of $6. The new "at-the-money" option may be fully vested and have a seven-year term remaining.

Other companies may use option re-grants in such a situation whereby the original option is canceled and replaced with an entirely new grant. The typical new grant would have a ten-year term, new vesting restrictions, and today's lower exercise price

Based on the listing rule changes for the Self-Regulatory Organizations, which went into effect in June 2003, any material amendment to the plan, such as re-pricing, is subject to shareholder approval unless it is expressly allowed in the plan. Under the New York Stock Exchange (NYSE) rules, a plan that does not contain a specific provision permitting the re-pricing of options will be considered as prohibiting re-pricing. Under NASDAQ's rules and interpretative letters dated Aug. 17, 2004 seem to indicate that companies whose plans are silent on the issue of re-pricing do have the authority to re-price underwater stock options without shareholder approval.

Therefore, if the equity plan (1) permits re-pricing, or (2) the plan is silent on re-pricing and the company has a history of re-pricing, ISS will recommend AGAINST the equity proposal. The American stock Exchange (AMEX) recommends that equity plans that are meant to permit re-pricing use explicit terminology to make this clear. For over-the-counter (OTC) companies, the general language of modifying and amending stock options is considered re-pricing unless the plan expressly prohibits re-pricing without shareholder approval.

ISS also considers buyouts of awards for cash or other payments as re-pricing. Although the exchanges are not explicit on buyout provisions, one may consider replacing stock options with cash as re-pricing. The difference here is that cash is not considered an equity instrument. According to the NYSE, “canceling an option at a time when its strike price exceeds the fair market value of the underlying stock, in exchange for another option, restricted stock, or other equity…” The statement addresses only equity instruments but not cash payments. Clearly, employees stand to benefit from an option exchange or buyout arrangement, whereas shareholders have no such alternatives.
 
The SEC's compensation disclosure rules require companies that re-price stock options for the top five named executives to provide shareholders with a ten-year history detailing option re-pricing activity. The disclosure requirement extends to any replacement grant that is related to any prior or potential cancellation. Companies are also required to disclose the reason for re-pricing underwater stock options in the compensation committee report of the proxy statement.

Re-pricing is a key factor in ISS' vote recommendation. After completing the quantitative analysis described above, each company's policy with respect to re-pricing is reviewed. With the June 2003 listing rule changes, a listed company having a history of re-pricing will no longer receive a negative vote recommendation since any future re-pricings are subject to shareholder approval for NYSE companies. However, if the company has the express ability to re-price underwater stock options under the proposed plan, ISS recommends a vote against the plan--even in cases where the plan is considered acceptable based on the quantitative analysis.

FIN 44: Repricing Redefined

Some companies put limits around re-pricing activity by prohibiting re-pricing for the top executives, restarting the vesting requirements, instituting an exchange program whereby two options must be given up for each new option granted, or restricting those shares that may be re-priced to a certain percentage of reserved shares. Such factors are disclosed in the analysis. These proposals are evaluated on a CASE-by-CASE basis, giving consideration to management's reason for seeking to re-price the options, the price history for the company's shares, and the number and terms for shares to be re-priced. See Management Proposals Seeking Approval to Re-price Options for more details.

Since 2005, ISS has considered the reasonableness of a company’s three-year average burn rate in evaluating most equity plan proposals. Annual burn rate levels are becoming important to institutional investors. Burn rate, also known as run rate, is another measure of dilution that shows how rapidly the company is depleting its shares reserved for equity compensation plans. It also captures the annual cost of granting equity to plan participants in terms of value, since stock options and full value awards are counted differently. The burn rate policy applies when the company has submitted an equity plan proposal for shareholder approval, with the exception of non-employee director plan proposals unless such directors receive a majority of shares granted each year. ISS recommends voting AGAINST equity plan proposals that have excessive three-year average burn rates. ISS defines excessive burn rate as the following:

• The company's three-year average burn rate (for the three most recently completed fiscal years) exceeds the mean plus one standard deviation of the company’s four-digit GICS group’s three-year average burn rate; and
• The company's three-year average burn rate exceeds a de minimis threshold of 2 percent.

For the purpose of calculating burn rate means and standard deviations for each four-digit GICS group, companies are first divided into two groups, depending on whether or not they are included in the Russell 3000 Index as of the index’s most recent annual re-constitution.

Table 8.5: 2008 Burn Rate Table

For companies that grant both full value awards and stock options, ISS will apply a premium on full value awards granted over the past three fiscal years. The guideline for applying the premium will be as follows:

For example, a company with annual volatility of more than 54.6% grants 10 million stock options and 2 million restricted stock awards during the fiscal year. Total equity granted is (10,000,000 + 1.5 * 2,000,000) = 13,000,000, which is then divided by weighted average common shares outstanding to compute burn rate for that fiscal year.

The annual stock price volatility is also one of the binomial model inputs used to determine award values. The specific equation is as follows:

Stock Volatility = Standard Deviation of 200 LN (Pt / Pt-1), where Pt is the closing stock price on day t and Pt-1 is the closing stock price on t-1. Calculate the natural log for the past 200-days stock price.

Annualized stock volatility = Stock Volatility x Square Root of 250.

Burn rate is calculated as the total number of equity awards (in the form of stock options/stock appreciation rights and full-value awards) granted during the fiscal year divided by the fiscal year weighted average common shares outstanding. Any equity awards that are counted against a plan’s share reserve will be considered in the numerator of the burn rate calculation, which includes awards made to employees, non-employee directors, advisors and consultants. Awards include stock options, stock appreciation rights, restricted stock, actual performance-based shares earned, deferred shares earned and any equity awards that deplete the share reserve.

For example, if a director converts $50,000 cash retainer into 1,000 deferred shares in 2006 and the shares are paid out in 2009, the 1,000 deferred shares would count towards the burn rate in 2006. Awards settled in cash will not be counted towards the burn rate. However, if a participant has the choice to receive an award in cash or stock, ISS shall assume stock as the worst-case scenario.

The gross number of equity awards is considered in the burn rate calculation and is not discounted by cancelled or forfeited shares. The reason is that the annual industry thresholds have been computed using gross figures. In order to perform the comparison against the industry thresholds consistently, the gross number of equity awards granted should be used.

More companies are disclosing the number of restricted stock or performance based shares granted each year. Although the disclosure of total full value awards such as restricted stock granted are not required by the SEC, ISS encourages companies to disclose this figure for better proxy disclosure and clarity.

Example of Three-Year Burn Rate Calculation (Full Value Multiplier = 2):

3-Year Average Burn Rate (2004 - 2006) = (3.20 percent + 4.91 percent + 3.20 percent)/3 = 5.65 percent

Application of Burn Rate Policy for Special Circumstances
For companies that have been acquired, ISS uses the burn rate data for the acquirer. For companies that have merged in a merger of equals, ISS would average the burn rate for both companies. IPO companies are not subject to the burn rate policy until the third year. However, the burn rate policy does apply to companies that have recently emerged from bankruptcy as they continue to be publicly-traded during the bankruptcy phase.

Burn Rate Commitment

A company that has failed the burn rate test may consider a public commitment in the form of an 8-K or DEFA 14A SEC filing. The company may commit to an annual burn rate equal to the mean plus one standard deviation of its GICS, or to the 2 percent de minimis, whichever is greater. The company would also be required to disclose in its future proxy statements the status of commitment during the applicable period.

During the first year of implementation of the burn rate policy in 2005, the burn rate commitment to the mean, especially in the cases of industries with low averages, seemed too restrictive. As a result some of the companies were unable to make the commitment. Also, by requiring the commitment to be stricter than the test, this becomes a punitive action, rather than being a constructive outcome. In 2006, ISS revised its policy to allow a burn rate commitment that is equal to the mean plus one standard deviation of a company's GICS group.

If a company fails to fulfill its burn rate commitment, ISS would consider withholding from the compensation committee.

Updated SEC Disclosure Requirements on Executive/Director Pay

In July 2006, the SEC unanimously approved new compensation disclosure rules. The rules applied to proxy statements filed on or after Dec. 15, 2006, for fiscal years ending on or after that date.

The amendments refined the previously required tabular disclosure, and combined it with improved narrative disclosure to elicit clearer and more complete reporting of the compensation of the chief executive officer, the chief financial officer, the three other highest-paid executive officers, as well as members of the board of directors.

Companies are required to prepare a Compensation Discussion and Analysis (CD&A) to address the objectives and implementation of their executive compensation programs. Those C&DA reports are “filed,” thus becoming a part of the disclosure subject to certification by a company’s CEO and CFO. Shareholders called on the SEC to keep compensation committee members accountable for their pay decisions. The staff addressed these concerns by requiring a condensed compensation committee report to accompany the CD&A section prepared by management.

The rules also require companies to detail retirement pensions and change-in-control provisions. The pension benefits table requires disclosure of the actuarial present value of each named executive officer’s accumulated benefits under each pension plan. In non-qualified deferred compensation tables, companies are required to disclose executive contributions, company contributions, withdrawals, all earnings for the year (not just the above-market portion), and the year-end balance.

In response to investor concerns, the SEC added requirements on option grants. Specifically, the rules require disclosure of whether grant dates are coordinated with the release of material non-public information. If the exercise price of an option grant is not the closing market price on the grant date, companies must provide a description of the methodology for determining the exercise price. Issuers will also have to address option grants to executives in their CD&A reports.

The rules improve transparency, promote board accountability, and strengthen shareholder oversight on executive pay.

The enhanced compensation disclosure data facilitates providing better research reports, particularly in areas of compensation-related policies like pay for performance, poor pay practices, and options backdating.

Pay-for-Performance Policy

Executive pay is often a topic of heated debate. Investors, economists, shareholders, and the media often portray executive compensation as “runaway” or “excessive,” continuing to spiral upwards even during poor financial performance. Shareholders are outraged when they witness poor performance and increases in executive pay. It is the lack of correlation between CEO pay and stock performance that lead to shareholder criticism.

The compensation committee also often does not do a good job in explaining the increase in pay in the compensation committee report. The report often provides a general description of a CEO’s performance and it lacks specific quantitative or qualitative assessments for shareholders to understand the increase in compensation.

In response to the rising CEO compensation and its disconnect with stock performance, ISS implemented a pay-for-performance policy in 2004. Specifically, if a company has negative one- and three-year fiscal total shareholder returns, and its CEO also had an increase in total direct compensation from the prior year, it would require closer scrutiny. If more than half of the increase in total direct compensation is attributable to the equity compensation, ISS may recommend a vote against the equity plan in which the CEO participates. The pay for performance policy requires a careful examination of the situation and does not result in an automatic withhold/against recommendation on compensation committee members and/or an “against” vote on the equity plan proposals.

The pay-for-performance policy first identifies companies with negative stock performance for the one- and three-year fiscal periods, coupled with an increase in total direct compensation for the CEO. The policy then compares the company's stock performance against its industry group. The comparison of a company's stock performance against its industry group or six-digit GICS group allows shareholders to gauge if there has been a widespread economic downturn for the sector. If a company had sustained negative stock performance and did not under-perform its industry group, this company is unlikely to trigger a withhold vote on the pay-for-performance policy.

The ISS analysis further examines the compensation committee report to understand the source of increase. Is the increase attributed to performance-based compensation like performance-based stock or time-based restricted stock? The compensation committee report should provide enlightening and meaningful disclosure with respect to the committee decisions on executive pay and the underlying rationale for increases in pay despite weak financial conditions. Boilerplate language in the report is strongly discouraged.

For purposes of the industry group comparison, the ISS analysis computes the total shareholder return for the one- and three-year time periods for all companies under the same six-digit GICS group. The industry group total shareholder return is weighted by market capitalization.

Total Direct Compensation is defined as the sum of annualized base salary, bonus, non-equity incentive plan compensation, stock awards (full grant date value), option awards (full grant date value as calculated by Equilar), change in pension value and nonqualified deferred compensation earnings and all other compensation as disclosed in the proxy statement. In cases where performance-based awards have been granted, the target value will be used in determining total direct compensation. With the exception of the estimated present value of stock options, all the information is readily disclosed by a company. The pay for performance assessment applies to Russell 3000 companies that have at least three fiscal years of stock price history and have had the same CEO in place for the past two fiscal years.

ISS will recommend WITHHOLD from or a vote AGAINST compensation committee members who were responsible for determining the CEO's most recent pay package. Newly appointed compensation committee members should not be held responsible for the disconnect between pay and performance, since they were not present at the decision-making process.

To cure the disconnect between CEO pay and a company's performance, the compensation committee members can demonstrate that they have improved committee performance based on additional public filings such as a DEFA 14A or 8K. The additional filing needs to present strong and compelling evidence of improved performance with new information that has not been disclosed in the original proxy statement. The reiteration of the compensation committee report will not be sufficient evidence of improved committee performance.

Evidence of improved compensation committee performance includes all of the following:

• The compensation committee has reviewed all components of the CEO's compensation, including the following:
• Base salary, bonus, long-term incentives;
• Accumulative realized and unrealized stock option and restricted stock gains;
• Dollar value of perquisites and other personal benefits to the CEO and the cost to the company;
• Earnings and accumulated payment obligations under the company's nonqualified deferred compensation program;
• Actual projected payment obligations under the company's supplemental executive retirement plan (SERP).
• A tally sheet setting forth all the above components was prepared and reviewed affixing dollar amounts under the various payout scenarios.
• A tally sheet with all the above components should be disclosed for the following termination scenarios:
• Payment if termination occurs within 12 months: $_____.
• Payment if “not for cause” termination occurs within 12 months: $_____.
• Payment if “change of control” termination occurs within 12 months: $_____.
• The compensation committee is committed to provide additional information on the named executives' annual cash bonus program and/or long-term incentive cash plan for the current fiscal year. The compensation committee will provide full disclosure of the qualitative and quantitative performance criteria and hurdle rates used to determine the payouts of the cash program. From this disclosure, shareholders will know the minimum level of performance required for any cash bonus to be delivered as well as the maximum cash bonus payable for superior performance.
  
  The repetition of the compensation committee report does not meet ISS' requirement of compelling and strong evidence of improved disclosure. The level of transparency and disclosure is at the highest level where shareholders can understand the mechanics of the annual cash bonus and/or long-term incentive cash plan based on the additional disclosure.
• The compensation committee is committed to grant a substantial portion of performance-based equity awards to the named executive officers. A substantial portion of performance-based awards would be at least 50 percent of the shares awarded to each of the named executive officers. Performance-based equity awards are earned or paid out based on the achievement of company performance targets.
  
  The company will disclose the details of the performance criteria (e.g., return on equity) and the hurdle rates (e.g., 15 percent) associated with the performance targets. From this disclosure, shareholders will know the minimum level of performance required for any equity grants to be made. The performance-based equity awards do not refer to non-qualified stock options1 or performance-accelerated grants2. Instead, performance-based equity awards are performance-contingent grants where the individual will not receive the equity grant by not meeting the target performance and vice versa.
• The level of transparency and disclosure is at the highest level where shareholders can understand the mechanics of the performance-based equity awards based on the additional disclosure.
• The compensation committee has the sole authority to hire and fire outside compensation consultants. The role of the outside compensation consultant is to assist the compensation committee to analyze executive pay packages or contracts and understand the company's financial measures.

1 Non-qualified stock options are not performance-based awards unless the grant or the vesting of the stock options is tied to the achievement of a pre-determined and disclosed performance measure. A rising stock market will generally increase share prices of all companies, despite of the company’s underlying performance. 2 Performance-accelerated grants are awards that vest earlier based on the achievement of a specified measure. However, these grants will ultimately vest over time even without the attainment of the goal(s).

Besides the additional disclosure, ISS requires the company to disclose complete information about the executive annual cash bonus or long-term cash bonus program. Executive bonus programs that comply with Section 162(m) of the Internal Revenue Code require shareholder approval.

Most executive bonus programs provide a long list of performance criteria that the compensation committee may use to determine payouts. However, at the end of the performance period, the compensation committee fails to provide details on the matrix used to determine the final payouts. As a result, shareholders do not know if any of the cash bonuses to the named executives are discretionary or formulaic.

ISS also requires the company to grant performance-based awards. Since the company has failed to link pay to performance, the requirement to shift from the typical long-term incentive awards to a substantial portion of performance-contingent grants is ideal. The link with the company performance is more transparent and direct with a performance-based equity award.

Based on the additional disclosure of improved performance of the compensation committee, ISS will generally recommend a vote FOR the compensation committee members up for annual election and vote FOR the employee-based stock plan if there is one on the ballot. However, ISS is not likely to recommend a vote FOR the compensation committee members and/or the employee-based stock plan if ISS believes the company has not provided compelling and sufficient evidence of transparent additional disclosure of executive compensation based on the above requirements.

Options Backdating

Options backdating has had serious implications for companies and shareholders, resulting in financial restatements, the de-listing of companies, and/or the termination of executives. As of November 2007, more than 220 U.S. companies had announced internal or regulatory investigations related to their stock option practices.

Since the passage of the Sarbanes-Oxley Act in 2002, companies have been required to report option grants within two business days. While this rule change has made it more difficult for companies to manipulate grant dates, a significant number of firms have missed these deadlines, raising concerns among some investors that option-timing is still occurring.

Before the 2007 proxy season, ISS introduced an options backdating policy. In cases where a company has practiced options backdating, ISS may recommend a WITHHOLD vote from (or a vote AGAINST) the compensation committee, depending on the severity of the practices, and the subsequent corrective actions on the part of the board. ISS will adopt a CASE-by-CASE approach to the options backdating issue. In recommending withhold/against votes on compensation committee members who oversaw questionable options grant practices or current compensation committee members who fail to respond to the issue proactively, ISS will consider several factors, including, but not limited to, the following:

• Reason and motive for the options backdating issue, such as inadvertent vs. deliberate grant date changes;
• Duration of options backdating;
• Size of restatement due to options backdating;
• Corrective actions taken by the board or compensation committee, such as canceling or re-pricing backdated options, the recouping of option gains on backdated grants; and
• Adoption of a grant policy that prohibits backdating, and creates a fixed grant schedule or window period for equity grants in the future.

A CASE-by-CASE analysis approach is preferred to differentiate companies that had sloppy administration versus those that committed fraud, as well as those companies that have since taken corrective action. Cases where companies have committed fraud are more disconcerting, and ISS will adopt formal policies to ensure that such practices will not re-occur in the future.

The compensation disclosure rules adopted by the SEC in 2006 require companies to address the timing of option grants in their CD&A reports. Companies have to disclose whether grant dates were coordinated with the release of material non-public information. If the exercise price of an option grant is not the closing market price on the grant date, companies must provide a description of the methodology used to determine the exercise price.

To reflect the enhanced and mandatory disclosure under the revised SEC rules, ISS’ research reports also detail a company’s option grant practices when the company has an equity plan proposal on its ballot.

Poor Pay Practices

Executive compensation disclosures have become more complete under the 2006 SEC disclosure rules. Companies are now required to disclose all forms of executive pay, including perks valued at $10,000 and above, deferred compensation and supplemental executive retirement plans (SERPs). The disclosure rules enable shareholders to understand each pay element. ISS believes that executive pay programs should be fair, competitive, reasonable, and appropriate, and that pay for performance should be a central tenet in executive compensation philosophy.

The ISS policy continues to: (i) identify best pay practices; (ii) provide examples of poor compensation practices; and (iii) may recommend a WITHHOLD/AGAINST vote on members of the compensation committee, the CEO, or even the entire board, where warranted.

On a CASE-BY-CASE basis, ISS may recommend a withhold/against vote on compensation committee members and/or the CEO where poor pay practices are identified. In addition, such a recommendation may be made if the entire board if the whole board was involved in and contributed to the poor compensation problems. Moreover, ISS may issue a withhold/against recommendation if issues that have previously received cautionary language persist and the item is not contractually bound. In these instances, the company has been warned of the poor pay practice and has had ample opportunity to review pay practices among their peers and/or general market and make appropriate adjustments. Last, poor disclosure practices have been added as a poor pay practice. Additional and/or clearer examples of poor pay practices are provided in many instances.

ISS has compiled a list of best executive pay practices, which should serve as a guide for corporate issuers.

• Employment contracts: Companies should enter into employment contracts under limited circumstances for a short time period (e.g., new executive hires for a three-year contract) for limited executives. The contracts should not have automatic renewal feature and should have a specified termination date.
• Severance agreements: Severance provisions should not be so appealing that it becomes an incentive for the executive to be terminated. Severance provisions should exclude excise tax gross-up. The severance formula should be reasonable and not overly generous to the executive (e.g., severance multiples of 1X, 2X, or 3X and use pro-rated target/average historical bonus and not maximum bonus). Failure to renew employment contract, termination under questionable events, or poor performance should not constitute as good reason for severance payments.
• Change-in-control payments: Change-in-control payments should only be made when there is a significant change in company ownership structure, and when there is a loss of employment or substantial change in job duties associated with the change in company ownership structure (“double-triggered”). Change-in-control provisions should exclude excise tax gross-up and eliminate the acceleration of vesting of equity awards upon a change in control unless provided under a double-trigger scenario.
• Supplemental executive retirement plans (SERPs): Sweeteners that can increase the SERP value significantly or even exponentially, such as additional years of service credited for pension calculation, inclusion of variable pay (e.g. bonuses and equity awards) into the formula. Pension formula should not reference to the extraordinary annual bonuses paid close to retirement years or maximum level of compensation earned.
• Deferred compensation: Above-market returns or guaranteed minimum returns should not be applied on deferred compensation.
• Disclosure practices: The Compensation Discussion & Analysis should be written in plain English, with as little “legalese” as possible and formatted using section headers, bulleted lists, tables, and charts where possible to ease reader comprehension. Ultimately, the document should provide detail and rationale regarding compensation, strategy, pay mix, goals/metrics, challenges, competition and pay for performance linkage, etc. in a narrative fashion.

ISS recognizes that companies adopt a variety of pay practices that may be acceptable in their respective industries or unique for a particular situation. While companies may not adopt all the above best practices, ISS believes that the following, while not exhaustive, are examples of poor compensation practices that may warrant withhold/against votes.

• Egregious employment contracts
• Contracts containing multi-year guarantees for salary increases, bonuses, and equity compensation
• Excessive perks
• Overly generous cost and/or reimbursement of taxes for personal use of corporate aircraft, personal security systems maintenance and/or installation, car allowances, and/or other excessive arrangements relative to base salary
• Abnormally large bonus payouts without justifiable performance linkage or proper disclosure
• Performance metrics that are changed, canceled or replaced during the performance period without adequate explanation of the action and the link to performance
• Egregious pension/SERP (supplemental executive retirement plan) payouts
• Inclusion of additional years of service not worked that result in significant payouts
• Inclusion of performance-based equity awards in the pension calculation
• New CEO with overly generous new hire package
• Excessive “make whole” provisions
• Any of the poor pay practices listed in this policy
• Excessive severance and/or change in control provisions
• Inclusion of excessive change in control or severance payments, especially those with a multiple in excess of 3X cash pay
• Severance paid for a “performance termination,” i.e., due to the executive’s failure to perform job functions at the appropriate level
• Change-in-control payouts without loss of job or substantial diminution of job duties (single-triggered)
• Perquisites for former executives such as car allowances, personal use of corporate aircraft, or other inappropriate arrangements
• Poor disclosure practices
• Unclear explanation of how the CEO is involved in the pay setting process
• Retrospective performance targets and methodology not discussed
• Methodology for benchmarking practices and/or peer group not disclosed and explained
• Internal Pay Disparity
• Excessive differential between CEO total pay and that of next highest-paid named executive officer (NEO)
• Options backdating (covered in a separate policy)
• Other excessive compensation payouts or poor pay practices at the company.

The SEC rules on executive and director compensation disclosure issued in 2006 have resulted in expanded compensation information for each of the named executive officers, and ISS continues to evolve its policy. The policy continues to take a balanced approach by providing investors and companies with guidance of what ISS considers to be the best and worst executive pay practices. In reference to our updated policy, ISS may issue WITHHOLD/AGAINST recommendations in cases where the company has been warned of the poor pay practice and the item(s) are not contractually bound. In these instances, the company has had ample opportunity to review pay practices among their stated competition and/or general market and make appropriate adjustments.

ISS continues to provide examples of the best and worst compensation practices. Information regarding clear disclosure has been added and focuses on the Compensation, Discussion and Analysis being more readable to the average investor. A variety of updates and changes have been added to the poor pay practices list. Base salary increases that are guaranteed as part of an employment contract have been added, given the absence of a pay-for-performance tie. Perquisites for former executives such as car allowances, personal use of corporate aircraft or other inappropriate arrangements have been added to the policy as well. While former executives may have ongoing consulting arrangements, they should not receive perquisites at shareholder expense that are not integral to performing any ongoing role. The category of "poor disclosure" has been added as a result of general ISS Research feedback; this topic received considerable attention in the recently released SEC Comment Letters focusing on executive compensation disclosure.

Many companies fail to provide a clear explanation of the CEO's involvement in the pay-setting process and the methodology for benchmarking practices and pay strategy. Additionally, retrospective performance targets and methodology for annual incentive plans should be disclosed and should not pose competitive harm. Disclosure of retrospective performance targets will allow shareholders to better assess bonus plan results and not just rely on vague references to performance outcomes.

Executive compensation will continue to take spotlight in the ensuing years, particularly when shareholders have access to more complete information. The updated policy will provide investors and companies additional context on what ISS considers to be the best and worst executive pay practices, incorporating data from the first year under the new disclosure rules. These updates will encourage companies to continue to review their existing compensation practices and strive for improvement.

Advisory Votes on Pay Programs

Shareholder ratification votes on pay programs are designed to ensure transparency and accountability in executive compensation and to encourage pay practices (and constructive dialogue) that investors can support. Shareholders in several markets, including the U.K., Australia, the Netherlands, and several Scandinavian countries, cast annual votes to express endorsement or disapproval of executive compensation, and support for similar votes have been growing in the U.S. Effective in 2008, ISS implemented two policy changes related to management-proposed advisory votes on companies’ overall pay programs:

1) The following five global principles will underlie market-specific policies in all markets where “say on pay” proposals arise, including the United States:

• Maintain appropriate pay-for-performance alignment, with emphasis on long-term shareholder value: This principle encompasses overall executive pay practices, which must be designed to attract, retain, and appropriately motivate the key employees who drive shareholder value creation over the long term. It will take into consideration, among other factors, the link between pay and performance; the mix between fixed and variable pay; performance goals; and equity-based plan costs;
• Avoid arrangements that risk “pay for failure”: This principle addresses the appropriateness of long or indefinite contracts, excessive severance packages, and guaranteed compensation;
• Maintain an independent and effective compensation committee: This principle promotes oversight of executive pay programs by directors with appropriate skills, knowledge, experience, and a sound process for compensation decision-making (e.g., including access to independent expertise and advice when needed);
• Provide shareholders with clear, comprehensive compensation disclosures: This principle underscores the importance of informative and timely disclosures that enable shareholders to evaluate executive pay practices fully and fairly;
• Avoid inappropriate pay to non-executive directors: This principle recognizes the interests of shareholders in ensuring that compensation to outside directors does not compromise their independence and ability to make appropriate judgments in overseeing managers’ pay and performance. At the market level, it may incorporate a variety of generally accepted best practices.

2) Adoption of guidelines for U.S. market say-on-pay proposals: ISS will evaluate management proposals seeking ratification of a U.S. company’s compensation program on a case-by-case basis. The above principles will help identify companies whose boards have failed to demonstrate good stewardship of investors’ interests regarding executive compensation practices, which may elicit AGAINST recommendations. The following factors are among those that may be considered, in the context of each company’s specific circumstances and the board’s disclosed rationale for its practices:

Relative Considerations:

• Assessment of performance metrics relative to business strategy, as discussed and explained in the Compensation Discussion & Analysis (CD&A);
• Evaluation of peer groups used to set target pay or award opportunities;
• Alignment of company performance and executive pay trends over time (e.g., performance down, pay down);
• Assessment of the disparity between total pay of the CEO and other named executive officers.

Design Considerations:

• Balance of fixed versus performance-driven pay;
• Assessment of excessive practices with respect to perks, severance packages, supplemental executive pension plans, and burn rates.

Communication Considerations:

• Evaluation of the information and board rationale provided in the CD&A about how compensation is determined (e.g., why certain elements and pay targets are used, and specific incentive plan goals, especially retrospective goals);
• Assessment of the board’s responsiveness to investor input and engagement on compensation issues (e.g., in responding to majority-supported shareholder proposals on executive pay topics).

The criteria for U.S. say-on-pay vote evaluations reflect investors’ demands for executive compensation programs that have a strong link to performance and minimize non-performance or potential “pay for failure” components. Voting recommendations typically will depend on the preponderance of evidence (i.e. an “against” recommendation may result when negative features outweigh the positive features presented in the company’s proxy statement).

Rationale

Institutional investors across the globe express consensus that pay programs should emphasize elements that lead to long-term shareholder value creation while minimizing non-performance-based pay and avoiding “pay for failure.” Examples of institutions that have issued public policy statements and/or guidelines aligned with this view include:

• The Canadian Coalition for Good Governance Guidelines for Principled Executive Compensation
• The U.K. Combined Code, Association of British Insurers, and Hermes
• TIAA-CREF Policy Statement on Corporate Governance
• International Corporate Governance Network
• Council of Institutional Investors
• National Association of Corporate Directors
• The U.S. Business Roundtable

ISS Governance Services clients have indicated a preference for advisory votes. The 2007 client survey found that a substantial proportion of investors believe that current disclosures are sufficient to allow informed votes with respect to potential say-on-pay resolutions at U.S. companies, and that all related disclosures should be considered in that evaluation.

The 2006 SEC disclosure rules on executive and director compensation confirmed the SEC’s view that increased transparency will enable market forces to exert influence on U.S. pay practices. Further, international regulatory bodies continue to adopt/recommend say-on-pay votes. Proposed U.S. legislation and/or shareholder pressure may result in widespread advisory votes on compensation at U.S. issuers within the next few years.

Supplemental Topics Impacting Equity-Based Compensation

Plan Amendments

Since June 2003, the Self-Regulatory Organizations (NYSE, NASDAQ and AMEX) require all listed companies to seek shareholder approval of all equity-compensation plans and material amendments to such plan, subject to limited exemptions. Common plan amendments include seeking additional shares under existing and approved equity plans, extending the term of the plan, expanding plan participants and many others.

Plan amendments that transfer additional shareholder value to employees, such as requesting new shares, extending the option term and expanding plan participants are subject to the five criteria described in earlier sections: (i) Total cost approach using the quantitative model (ii) Re-pricing provision (iii) Three-year burn rate (iv) CEO pay for performance (v) Poor compensation practices.

The following table serves as a guideline for evaluating amendments to equity plans:

Table 8-6. Guideline in Evaluating Plan Amendments

In cases where bundled plan amendments with no increase in shares are evaluated on a case-by-case basis, ISS takes into consideration to the following:

• Underlying motivation of the company--Do the proposed plan amendments benefit shareholders?
• Improvement in plan costs --Are the total costs of the proposed amended plan lower than the original plan?
• Improvement in plan features--Examples include a reduction in option term, issue stock options at 100 percent of fair market value or shift towards performance-based awards or performance-based vesting.

Bundled plan amendments involve proposing two ore more plan amendments in one proposal to shareholders. For example, if a company is reducing the plan term and changing the mix of the remaining shares in the plan reserve from stock options to a mix of restricted stock and stock options and presents this in one proposal, this would be considered a bundled plan amendment.

The binomial compensation model is used to validate the improvement in costs of a bundled proposal. The cost factor is not the primary factor in determining the vote recommendation. Instead, the three aforementioned factors: underlying motivation, improvements in costs and plan features drive our vote recommendation. The underlying rationale is that the equity plan has been approved by shareholders and is currently in place for a company. If the proposed amendments represent an improvement over the existing plan, ISS believes that shareholders are better off with the modified plan even though the cost may exceed the allowable cap. In evaluating bundled proposal, the three-year burn rate policy is not a consideration.

Employment Inducement Grant Exemption
The listing standards introduced in June 2003 do not require shareholder approval of employment inducement awards. These exempt grants may be made only with the approval of the company's independent compensation committee or the approval of a majority of the company's independent directors.

An employment inducement grant is an equity-based compensation award inducing a person or persons being hired by the listed company following a bona fide period of interruption of employment. Promptly following a grant of any inducement award reliance on this exemption, the listed company must disclose in a press release the material terms of the award, including the recipient(s) of the award and the number of shares granted.

ISS has concerns with the employment inducement grant exemption. ISS believes that some companies may abuse the inducement grant provision and use it to avoid shareholder approval. ISS believes that companies should grant employment inducement awards sparingly and use it for few specific identified individuals instead of a broad range of employees. Companies also should not reserve a pool of shares prior to identifying the specific recipients. ISS encourages the company to put the plan for shareholder vote for sound corporate governance practice or include these inducement shares under an approved plan.

Impact of Share Buybacks
Share buyback programs are sometimes established to run simultaneously with stock option plans. Company stocks typically react favorably to the announcement of a share buyback program, as share repurchases lower the supply of a company's stock and spread the company's earnings over a smaller number of shares.

A buyback announcement may also serve as a signal to the market that management believes its stock is undervalued. The impact on share price from an announced buyback program is captured in the model valuation. However, a share buyback does not offset shareholder value transfer (SVT) since shareholders' equity is used to repurchase the shares.

A share buyback does reduce voting power dilution (VPD) and may be subtracted out of the VPD calculation based on the company's disclosure on stock repurchase. For example, consider a plan with VPD of 7 percent. Assume further that a buyback program is instituted under which the number of shares issued under the plan is bought back through open market purchases. VPD for this plan is 0 percent instead of 7 percent, since the impact of VPD is entirely offset through the share buyback program.

VPD will be adjusted only in cases where the company explicitly states in its plan documents or plan proposals that awards made under the plan will be fully or partially offset by share buybacks in the open market within a year or two of the issuance of the awards. However, VPD will not be adjusted if the company has an ongoing buyback program that is not explicitly tied to the equity plan.

Impact of Dual Class Capital Structures
Companies with two or more classes of common stock require an adjustment to their voting power dilution (VPD) calculation to account for the disparate voting rights of the stock classes.  For example, consider a company with two classes of common stock: class A shares entitled to ten votes per share (20,000,000 shares outstanding) and class B shares entitled to one vote per share (50,000,000 shares outstanding). Assume further that the company seeks to authorize 3,000,000 class A shares for issue under a new plan and that there are no other existing plans. The numerator is (3,000,000 * 10), or 30,000,000, and the denominator is [(20,000,000 * 10) + (50,000,000 * 1) + (3,000,000 * 10)], or 280,000,000. VPD is calculated as 30,000,000/280,000,000, or 10.71 percent. Ignoring the fact that shares reserved under this plan carry superior voting rights would significantly understate VPD.

Multiple Equity Plan Proposals
Companies often seek shareholder approval of multiple equity plan proposals at their annual meetings.  Because shareholders vote on each proposal separately, ISS will generally recommend a vote in favor of the proposal(s) that, when combined, result in the greatest amount of shareholder value transfer (SVT) without exceeding the company’s allowable cap.

ISS measures the SVT of a company’s existing equity compensation programs along with the incremental SVT associated with each proposal.  Doing so ensures that the SVT associated with shares currently available for grant (B shares) and shares underlying outstanding awards (C shares) are not double counted.

For example, consider a company with three proposals reserving additional shares under three separate equity incentive plans.  Assume further that the SVT associated with shares currently available for grant and shares underlying outstanding awards is 7 percent, and that the company’s allowable cap is 14 percent.  ISS determines which proposal or combination of proposals is closest to the company’s allowable cap without exceeding it.

There are four distinct proposal combinations that must be evaluated:

1. Proposal 1 + Proposal 2 + Proposal 3:  Total SVT = 5% + 3% + 1% + 7% = 16%

2. Proposal 1 + Proposal 2:  Total SVT = 5% + 3% + 7% = 15%

3. Proposal 1 + Proposal 3:  Total SVT = 5% + 1% + 7% = 13%

4. Proposal 2 + Proposal 3:  Total SVT = 3% + 1% + 7% = 11%

In this case, approving all three proposals would result in SVT of 16 percent, which is above the company’s allowable cap of 14 percent.  Additionally, approving proposals 1 and 2 would result in SVT of 15 percent, which is also above the company’s allowable cap.  However, approving proposals 1 and 3 would result in SVT of 13 percent, which is less than the company’s allowable cap.  The combination of proposals 1 and 3 is preferable to the combination of proposals 2 and 3 because the first combination provides for 6,000,000 additional shares, whereas the second combination provides for only 4,000,000 shares. 

Accordingly, ISS would recommend a vote FOR proposals 1 and 3 because the combination is closest to the company’s allowable cap without exceeding it.

Evergreen Plans
Some stock-based incentive plans provide for an evergreen feature which automatically provides for an increase in the shares available for grant on an annual basis and can operate for no more than ten years under the June 2003 listing rule changes. The plan document needs to be explicit in the term of the evergreen program. The most common configuration provides that the pool of shares available for issue under the plan is increased by a specified percentage of shares outstanding each fiscal year. Such plans pose difficulties from a valuation standpoint, as assumptions must be made about shares outstanding over the stated term for the plan.

Another common version of the evergreen plan provides that the number of outstanding awards may not exceed a given percent of the company's common stock outstanding. An estimate of the shares reserved for issue under an evergreen plan is made by using the stated plan term. Shareholders do not favor evergreen equity plans. Because of the evergreen provisions, shareholders do not know the exact number of shares reserved under the plan.

Overhang, or granted-but-unexercised shares, is a measurement of the potential outflow of shareholder equity from option exercises and lapses of restricted stock units.

Some argue that by counting overhang, ISS unfairly penalizes companies whose employees hold their options and that ISS is encouraging option holders to exercise early. Critics assert that the overhang should not be counted when reviewing a new plan, or an amendment to an existing plan, because shareholders have already approved the issue of such shares.

That criticism is often intensified in cases where the company's stock has performed well and the options held by employees are deep in the money. (Counting such shares results in a higher cost since these options are more valuable). Critics argue that since the share price has appreciated, shareholders' have seen the value of their investments increase, so why should there be concern if employees also enjoy large payouts from their options?

For 2008, ISS adopted a new policy regarding overhang cost. Companies with sustained positive stock performance and high overhang cost attributable to in-the-money options outstanding in excess of six years may receive a carve-out of these options from the overhang as long as the dilution attributable to the new share request is reasonable and the company exhibits sound compensation practices. ISS will consider, on a case-by-case basis, a carve-out of a portion of cost attributable to overhang, considering the following criteria:

• Performance: Companies with sustained positive stock performance will merit greater scrutiny. Five-year total shareholder return (TSR), year-over-year performance, and peer performance could play a significant role in this determination.
• Overhang Disclosure: ISS will assess whether optionees have held in-the-money options for a prolonged period (thus reflecting their confidence in the prospects of the company). Note that this assessment would require additional disclosure regarding a company's overhang. Specifically, the following disclosure would be required:
• The number of in-the-money options outstanding in excess of six or more years with a corresponding weighted average exercise price and weighted average contractual remaining term;
• The number of all options outstanding less than six years and underwater options outstanding in excess of six years with a corresponding weighted average exercise price and weighted average contractual remaining term;
• The general vesting provisions of option grants; and
• The distribution of outstanding option grants with respect to the named executive officers;
• Dilution: ISS will calculate the expected duration of the new share request in addition to all shares currently available for grant under the equity compensation program, based on the company's three-year average burn rate (or a burn-rate commitment that the company makes for future years). The expected duration will be calculated by multiplying the company’s unadjusted (options and full-value awards accounted on a one-for-one basis) three-year average burn rate by the most recent fiscal year’s weighted average shares outstanding (as used in the company’s calculation of basic EPS) and divide the sum of the new share request and all available shares under the company’s equity compensation program by the product. For example, an expected duration in excess of five years could be considered problematic; and
• Compensation Practices: An evaluation of overall practices could include: (1) stock option repricing provisions, (2) high concentration ratios (of grants to top executives), or (3) additional practices outlined in the ISS current poor pay practices policy.

Companies with sustained positive stock performance may exhibit high SVT costs attributable to overhang if optionees hold their options for prolonged periods. Such a combination likely reflects employees' confidence in their company's future prospects. However, ISS may recommend a vote against a new share request due to excessive cost that is driven primarily by overhang. Although positive stock performance will typically result in a higher allowable cap for a company (and an increase in market capitalization), the high cost of overhang may still represent a significant component of SVT. In addition, although most full-value awards (such as time-based restricted shares) fully vest after no more than three or five years, most stock options are granted with 10-year terms, and thus may impact overhang for a longer period than full-value awards if not exercised within five years after they are granted. The six-year threshold was determined based on general option vesting and exercise trends. Options are generally granted with vesting periods of less than five years and are typically exercised within six years of the date of grant. The proposed case-by-case approach would be invoked in situations in which a company successfully retains its employees and the employees hold the options for prolonged periods of sustained positive stock performance. Such cases may represent successful retention of employees, who have a positive outlook on the future performance of the company.

Difficulties arise for companies that are growing rapidly, but currently pay no dividends. Companies can make a persuasive case that dividends could be instituted and increased markedly in future years. Assuming for valuation purposes that this company's dividend yield was in line with industry averages, it would result in a lower estimated option value.

This is easily seen in the extreme, where a firm sacrifices the necessary investments in future growth, research, and development to pay large dividends. Such forecasts, while possibly accurate, are subject to considerable uncertainty and manipulation. For companies that have not paid dividends in the past, ISS assumes that no dividends will be paid in the future.