THE IMPACT OF EXECUTIVE COMPENSATION PROVISIONS IN TITLE IX OF THE DODD-FRANK ACT AN ASSESSMENT OF SAY ON PAY, CLAWBACKS, PAY RATIO, PAY FOR PERFORMANCE AND INCENTIVE COMPENSATION Hearing on Enhanced Investor Protection after the Financial Crisis Senate Banking Committee July 12, 2011 Statement Submitted for the Record 1100 THIRTEENTH STREET | SUITE 850 WASHINGTON DC 20005 202.408.8181 | FAX 202.789.0064 | WWW.EXECCOMP.ORG Chairman Johnson, Ranking Member Shelby and Members of the Senate Banking Committee: The Center On Executive Compensation is pleased to submit testimony to the Senate Banking Committee providing its perspective on Title IX of the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank Act"). For the most part, this title of the Dodd-Frank Act is unprecedented in its vagueness and breadth, and we urge the Senate to take a practical view of the implications of this law and identify areas that would benefit from a review, revision or repeal. The Center On Executive Compensation is a research and advocacy organization that seeks to provide a principles-based approach to executive compensation policy from the perspective of the senior human resource officers of leading companies. The Center is a division of HR Policy Association and represents companies from a broad cross-section of industries. Because the senior human resource officers play a unique role in supporting the compensation committee chair, we believe that our Subscribers' views can be particularly helpful in understanding the complexities that would be required to implement the requirements set forth in Title IX of the Dodd-Frank Act. I. Say on Pay With over half of the first year of say on pay behind us, the Center has been closely tracking the recommendations and results of Fortune 500 companies. As of July 7, 2011, 384 Fortune 500 companies had reported results on their advisory votes on compensation. Of these companies, 378 received a majority of shareholder support (98.4 percent total shareholder approval). The mean shareholder approval percentage is 88.6 percent, and the median is slightly higher at 94.0 percent. The majority of companies (65.4 percent) received at least 90 percent approval from shareholders on their compensation programs. The overwhelming approval demonstrates that shareholders are supportive of executive compensation arrangements, especially for large companies. The results are not surprising. They are consistent with the experiences in the United Kingdom, which has had say on pay since 2002, and with say on pay votes required of TARP companies. Section 951 of the Dodd-Frank Act also mandated a periodic nonbinding shareholder vote on whether companies should hold a vote every one, two or three years. As of July 7, 2011, 394 Fortune 500 companies have submitted proxies to the Securities and Exchange Commission ("SEC" or "Commission") containing recommendations for say on pay frequency votes, with the majority (68.3 percent) recommending an annual say on pay vote. Of the 101 Fortune 500 companies that recommended a triennial frequency vote, only 29 have received a majority shareholder vote for a triennial frequency. The irony in the overwhelming support for an annual frequency for say on pay votes is that the timing of the vote and the deadlines for company compensation decisions are out of sync. The vote is on the company's prior year's compensation, but for most companies, that vote typically occurs after the current year's compensation arrangements have already been set and communicated. For this reason, a company that receives a negative vote or a significant vote against it will take two years before shareholders will have a say on pay vote on any changes made to pay arrangements based on the prior say 1 on pay vote. Accordingly, those changes will not be disclosed in the proxy for two years. This could have the effect of moving some companies and institutions to reconsider whether an annual say on pay vote makes the most sense. II. Pay Ratio Disclosure The pay ratio provision in Section 953(b) of the Dodd-Frank Act requires companies to disclose in their proxy statements the ratio of the median pay of all employees to the total pay of the chief executive officer. SEC officials from Chairman Mary Schapiro to the Director of the Division of Corporation Finance Meredith Cross, have indicated that due to the prescriptive nature of the provision, the SEC has very little interpretive authority with respect to this provision and thus would interpret it narrowly. For this reason, it is likely that companies would be required to calculate the pay of every employee globally, whether full- or part-time, in the same manner as compensation is calculated for the named executive officers. In comments to the SEC and the media, the author of this provision, Senator Menendez has insisted that this provision should not be modified, despite the considerable cost and burden imposed on the business community. It is a common misperception that companies have this information readily available at the touch of a button. Most global companies do not have centralized payroll systems; therefore, generating the pay ratio information would be a considerably complex undertaking for large, multinational companies since it would require a company to gather and calculate compensation information for each employee, part-time and fulltime, as required for senior executives under the SEC disclosure rules, determine the pay of each employee from highest to lowest, and then identify the employee whose pay is at the midpoint between the highest- and lowest-paid employee. No public company currently calculates each employee's total compensation as it calculates total pay for CEOs on the proxy statement; therefore, companies would be required to invest considerable resources to implement this mandate, which will not provide meaningful information to investors. Under the pay ratio requirement, the scope of the information gathering requirement presents significant hurdles for most large companies. Accuracy is a significant concern, since compensation data is often housed in dozens of computer systems around the globe and subject to the compensation and benefits rules of different countries worldwide. Furthermore, these illustrations say nothing with respect to the impact that exchange rate fluctuations will have on the calculations. Companies would be required to develop and coordinate a consistent calculation across all countries and then ensure that the results were accurate since Section 302 of Sarbanes-Oxley requires the CEO and the CFO to sign the proxy statement certifying its accuracy. The Center believes that pay ratio mandate is inconsistent with the purpose of the SEC disclosure rules. The SEC generally requires that companies disclose in the proxy statement all material information necessary to inform an investor of how and why a company compensates its named executive officers. Material information is that which would impact an investor's decision to invest in the company or its vote for directors. Therefore, the addition of nonmaterial information simply lengthens the disclosure and dilutes the impact of material information. Further, the inclusion of this ratio could mislead investors who seek to compare ratios between companies. 2 The ratio would not be comparable between companies as the pay of employees at all levels of an organization is subject to various forces in the market, such as competition, geography and job type. Companies employing more highly paid employees will likely have a smaller ratio due to the structure of their workforce as opposed to those employing a larger share of lower paid employees, such as retail clerks. However, the difference would not tell investors whether the company with the lower ratio is a better investment. Moreover, the ratio does not account for a company's global operational structure or business strategy, which would certainly have an impact. One company may rely on third parties for certain services like manufacturing or information processing whereas another company outsources it. Again, comparing the ratios between two such companies would provide little useful information. Since 2006, the SEC has made significant changes to its executive compensation disclosure rules relating to executive compensation in an effort to expand the material information that is available to investors. Because of these rules, the average compensation disclosure in a proxy statement of Center Subscribers is now 26 pages. That is over a quarter of the length of proxy statements for large companies, which now are routinely 100 pages long. The addition of nonmaterial information in the form of the ratio and any narrative disclosure to explain the ratio would only add to the length and make it more difficult for investors to digest the material information IV. No-Fault Clawback Policy Section 954 of the Dodd-Frank Act requires the SEC to promulgate rules directing the securities exchanges and securities associations to develop listing standards requiring companies to adopt and disclose a no-fault clawback policy. Specifically, the policy to be disclosed must provide, in the event of a material restatement, for the recoupment of incentive compensation that is "based on financial information required to be reported under the securities laws" from current and former executive officers of the company, if such compensation is in excess of that which would have been paid in view of the restatement. This mandate raises a number of issues, including: Which compensation is "based on financial information required to be reported under the securities laws;?" The mechanics of determining the amount to be recouped in the event of a material restatement; The role of board discretion in executing the recoupment policy, particularly where board discretion was applied in originally awarding the incentive compensation, where the cost of recoupment exceeds the amount to be clawed back, and in determining how to recoup the excess compensation over what would have been received; and The need to provide companies with sufficient lead time to implement a policy before the clawback mandate takes effect. 3 A. Clearly Delineate Compensation Subject to the No-Fault Clawback Policy The linchpin of the requirement in section 954 of the Dodd-Frank Act is that companies are required to disclose and enforce a policy that provides for recoupment of incentive compensation that is "based on financial information that is required to be reported under the securities laws." Thus, if incentive compensation is "based on" financial results that are reported under the securities laws, it is potentially subject to recoupment. Consistent with principles-based disclosure and recognizing the complexity of issues that are created by the language of the statute, the Center believes that the SEC will need to differentiate incentive compensation that is subject to the recoupment requirement from compensation that is not subject to it. This will enable Boards of Directors and Compensation Committees charged with enforcing it to better understand their obligations. Financial information that is required to be reported under the securities laws includes measures such as revenue, net income and earnings per share. It also may include nonGAAP measures such as earnings before interest, taxes, depreciation and amortization and return on net assets. Incentive information that is not required to be disclosed under the securities laws includes stock price, total shareholder return (which is based on the change in share price plus dividends over a period of time) and operational performance measures specific to the business such as market share and customer satisfaction. Such measures are not financial information that is filed with the SEC and therefore would not be subject to clawback under section 954. The Center believes that it is critical to understand how incentive plans are structured, so that the SEC may factor this information into its proposed regulations. Although compensation arrangements vary widely, depending upon the company, industry, competitive condition and global focus, below we present five hypotheticals, illustrating four common types of compensation arrangements: (1) Purely formulaic incentive plans, based on financial metrics that pay out in cash; (2) Formulaic incentive plans in which a pool is funded based on the achievement of objective financial measures, but the board has discretion whether to allocate the entire bonus pool toward incentives, where a recoupment would not be required; (3) Identical to (2), except the facts change so that recoupment is required; (4) Formulaic long-term incentive plans based upon financial performance with overlapping awards; and (5) Nonqualified stock option grants, that are not granted or vested based upon performance. Annual and Long-Term Cash Incentive Measures Based Upon Financial Metrics. The implementation of the recoupment policy is easiest when dealing with incentive plans that are purely formulaic, based exclusively on financial measures, and paid out in cash. In that situation, the clawback is the excess of what was actually received compared to the amount that would have been received under the formulaic plans had the financial statements been correct. 4 Example 1: Formulaic Incentive Plan With Incentives Based on Financial Metrics Annual bonus is based on achievement of targeted level of net income. The performance for 2009 equaled 105% of the targeted level of net income. The incentive formula increases payout by 3% for each 1% by which performance exceeds the target. The payout at 100% performance is 50% of salary. The payout based on the performance results would be 115% of the targeted payout. 115% of 50% of salary would produce an annual incentive payout of 57.5% of salary. Assume the performance results for 2009 had to be restated in 2011 and the impact was to reduce net income to 90% of the targeted level of performance. The incentive formula reduces payout by 3% for each 1% by which performance falls short of target. The incentive payout on the restated earnings would have been 70% of the targeted payout of 50% and would have produced an incentive payout of 35% of salary. The amount of annual incentive that would be clawed back would be the difference between what was paid (57.5% of salary) and that which would have been paid on the restated earnings (35%), which would equal 22.5% of salary. Assuming the executive had a salary of $500,000, the bonus amount to be clawed back would equal $112,500 (the difference between an incentive of $287,500 at 57.5% of salary and an incentive of $175,000 based on 35% of salary). Formulaic Incentive Plans Where Financial Measures Fund a Bonus Pool. Where the financial measure funds a pool which is distributed based upon financial and nonfinancial measures, the application of the clawback policy will differ based upon whether the Board and/or the Compensation Committee had discretion in determining how much of the pool to allocate for incentives and whether the Board and/or the Compensation Committee has discretion in determining the individual awards.1 Assuming the Board or Compensation Committee had discretion in determining the amount of the bonus pool to allocate to individual awards and the individual awards are determined based upon some measures that require the judgment of the board (rather than formulaic), a material restatement could require the Board to revisit its decisions. Examples 2 and 3 illustrate the pool concept and the role of Board discretion: If the Board does not have discretion (i.e., the bonus pool and the individual awards are formulaic), the clawback would be applied similar to Example 1 for the portion of the award based on the restated financial performance. 1 5 Example 2: Incentive Pool Approach With Restatement; Recoupment Not Required The annual incentive pool is generated based upon a percentage of net income, and at targeted level of net income for 2009 the pool would be sufficient to provide incentives equal to the sum of the incentive targets for the participating executives. The amount of incentive payout any individual would receive is based upon his or her individual performance against non-financial objectives in the areas of (1) talent development, (2) productivity and cost-savings, (3) operational performance measures and (4) modeling the desired company culture and promoting ethical behavior (weighted 25% each). In total the payouts to executives cannot exceed the incentive pool, but there is no requirement that the board allocate the entire pool to incentive payments. For 2009, the company hit 100% of the net earnings target, and the incentive pool was generated on that basis. The board allocated 95% of the pool for incentives. No executive received an incentive payment directly based upon the achievement of the net income target. Some executives received incentive payments above their targeted incentive; some received less than their targeted level of incentive and some received their targeted level of incentive. The amount received by an individual executive was based on the assessment of performance in the four areas listed above. Assume the performance results for 2009 had to be restated in 2011, and the impact was to reduce net income such that the incentive pool equaled 98% of the sum of the incentive targets for the participating executives. At this restated level of performance the bonus pool was sufficient to cover the actual amount of incentives paid (98% pool, 95% actually paid out). In this situation there does not appear to be a need to recoup any of the incentives paid unless the board determines it would have made different individual incentive decisions in view of the restated earnings. Example 3: Incentive Pool Approach; Recoupment Required Same as Example 2 but the restated earnings would have produced an incentive pool equal to 90% of the sum of the incentive targets for the participating executives. The Board has three options regarding how to recoup the 5% that exceeded the amount allocated to the incentive pool. o Ratably reduce all executive incentives by 5% (non-discretionary recoupment although the incentive paid to each individual was based on board discretion); 6 o Discretionary recoupment on an individual-by-individual basis (the same way the bonus amounts were awarded) such that the total amount recouped equaled the 5% overpayment (discretionary recoupment); o Recoupment is left to the discretion of the board, pursuant to the company's recoupment policy. Recognition for Board discretion in such situations is absolutely critical. Thus, the Board should have the ability to decide to use any of the three options, so long as its rationale is explained in the company's next proxy statement. Overlapping Long-Term Awards and the Impact of a Material Restatement on Target Setting. Long-term incentives are often three-year awards granted annually so that the awards are overlapping. In this situation a material restatement, and any required recoupment could affect up to four cycles of long-term incentive grants (the three outstanding performance cycles, plus the basis for setting the next award depending on whether the financial measures included in the restatement affect the long-term incentive program and also serve as the base year for setting performance targets for the next award). Example 4 illustrates the mechanics of this model: Example 4: Overlapping Long-Term Incentive Awards Assume that Performance Unit Awards are granted annually and have the following design: o Units are denominated as a dollar amount (e.g., $100,000 value for achieving targeted performance). o Performance in excess of the targeted level of performance increases the payout by 3% for each 1% by which targeted performance is exceeded. o Performance that falls short of target reduces the payout by 3% for each 1% shortfall in performance versus targeted level of performance. o The performance metric is cumulative earnings per share (EPS) over the three-year performance period. Since the awards are granted annually, and given that the performance period is three years, a participant will have 3 overlapping awards outstanding at any given time. Therefore, a given year will be included in three separate award cycles and, depending how performance targets are set, may serve as the base year upon which the performance targets for a 4th award cycle are set. Outlined below is an example of the outstanding awards under a performance unit program: 2007 2008 Award: 2008 2009 2010 2011 2012 2007 Award: 2007-------2008------2009 2008------2009-----2010 7 2009 Award: 2010 Award: 2009-----2010---2011 2010---2011-------2012 Assume that in mid-2010 the company materially restates downward the earnings for 2009, thereby reducing 2009 EPS. The impact of the restatement would be to reduce the performance for the 2007, 2008 and 2009 award cycles. The restatement would also lower the base year upon which the board set the EPS targets for the three-year award cycle beginning in 2010. The 2007 awards would have been paid out to the participants and therefore the company would have to initiate recoupment for the excess payment that was based on the pre-restated 2009 EPS. The 2008 and 2009 award periods would not yet have been completed and therefore the potential payout of the performance units would be automatically reduced. No recoupment would be required. The board should also revisit the targeted cumulative EPS goals for the performance cycle beginning in 2010 to determine if the goals would have been set at a lower level had the board been aware of the restated EPS for 2009 at the time the goals were set. Performance-Granted and Performance-Vested Equity Awards. Section 10D(b)(2) of the statute states that the clawback policy applies to "incentive-based compensation (including stock options awarded as compensation)." The Center believes this language should be read as requiring that the clawback policy applies to (1) incentive-based compensation as defined under the Commission's disclosure rules that is based upon information required to be reported under the securities laws; and (2) stock options that are awarded as compensation and that are incentive-based compensation as defined under the Commission's disclosure rules where the incentive is based on financial information required to be reported under the securities laws. This approach makes the clawback language in section (b)(2) consistent with the reporting language in (b)(1), which requires companies to disclose the policy of the company on recoupment of incentive-based compensation under the securities laws. Applying this interpretation, the Center believes that performance-granted and performance-vested equity awards can be incentive compensation subject to the recoupment mandate, if the above definitions are met. Unlike nonqualified time-vested stock options, restricted stock or restricted stock units, which are not considered incentive compensation under the Commission's rules, performance-granted or performance-vested stock options, for example, are incentives that are often granted based on financial performance or other performance measures. Time Vested Stock Options. Stock options generally take one of two forms: (1) performance-based stock options for which the granting or vesting of the award is based on the achievement of financial performance, as discussed above or, (2) time-vesting stock options for which the award is based on considerations other than financial 8 performance and the vesting of such awards is based on the passage of time and is not contingent on achieving financial performance objectives. Stock options that vest merely on the basis of time are not considered incentive compensation under the SEC's disclosure rules and therefore should not be subject to a mandatory clawback. Many companies determine the level of stock options granted to an individual based on the executive's level, tenure and expected performance level, which are not linked to financial performance. In this case the following example should apply: Example 5: Stock Option Awards Stock option awards are determined on an executive-by-executive basis. The actual award received is a function of salary grade, title, performance and potential. The determination of the performance of an individual executive for purposes of granting stock option awards is not tied directly to the financial results of the overall company. The option awards granted in 2006 have vested but the executives have not exercised the stock options. Assume the results for 2006 were restated in 2009 and the net income of the company was reduced by 1%. Correspondingly, the stock price dipped on the day of the restatement by 10% and has recovered over subsequent weeks but the recovery in stock price has trailed the overall movement of the market and the stock price appreciation of industry peers. In view of the fact that there has been no gain to the executives since the options have not been exercised, and in view of the fact that the size of the grant was not influenced by the net income of the company, no recoupment is warranted. An alternative stock option design would be a stock option that vests on the basis of achieving financial targets. In this case, the number of stock options that would not have vested based on the restated financial performance outlined above would be subjected to recoupment due to the material restatement. In sum, the Center believes that the better way to interpret the clawback language in section 954(b)(2) is to consider any incentive compensation that is awarded, granted or vested based on financial measures required to be reported under the securities laws as subject to recoupment. Conversely, vehicles such as time vested stock options, restricted stock and restricted stock units should not be considered incentive compensation, and if the granting of such awards was not based on the restated financial performance, it is therefore not subject to the clawback requirement. However, if the granting of individual stock option awards is based on the restated financial performance, the number of shares awarded would be subject to the clawback based on the excess of the award over that which would have been awarded based on the restated financial performance. 9 B. Boards Should Have Discretion in Executing the Recoupment Policy In implementing the clawback requirement, the role that Board or Compensation Committee discretion plays in setting executive compensation must be recognized, and any regulations should explicitly provide for Board and Compensation Committee discretion in the determination of the amount to be recouped and how that recoupment is to be executed. This interpretation recognizes that Board discretion often plays a role in how incentive compensation is awarded and allows the Board to make determinations to ensure that the recoupment is in the best interests of shareholders. The Level of Discretion Used by the Board/Committee in Determining Amount to Be Clawed Back Should Be the Same as That Used in Making Original Grant. Boards should be given the same level of discretion to determine the amount to be clawed back as was used in making the initial compensation decision. As illustrated in the examples above, this may involve discretion under section 162(m) incentive plans in which financial performance funds a pool to be used for the distribution of compensation to NEOs or other executive officers. Committee discretion may also be used in applying other financial criteria used to make individual awards. Board or Committee discretion is also increasingly an element of a company's risk mitigation system. Affording the Compensation Committee discretion allows it to reduce (or add) incentive payouts, when the committee takes the entirety of the circumstances into account. In addition, long-term incentive grants, whether granted on a value or a number of shares basis, are often made based on a formula, to which Committee discretion is applied in determining the actual grant. Discretion Not to Claw Back Where the Cost of Executing the Clawback Would Outweigh the Benefits to Shareholders. The Center believes that in addition to discretion as discussed above, Boards should have discretion in determining not to execute a clawback against a current or former executive officer where, for example, the amount to be clawed back is de minimis or the Board believes that protracted litigation would be required to recoup the compensation. In cases such as this, the Center believes the Board's ability to decide not to claw back and to disclose that decision in the proxy should be recognized. This is especially important with respect to executive officers in certain countries or other jurisdictions that are extremely protective of employees, where it may not be possible to recoup the entire amount. Boards should be afforded the deference to settle a clawback for less than the full amount. Discretion in Determining How to Recoup Compensation From a Current Or Former Executive Officer. The Center believes that since the statute is silent as to how clawbacks are to be executed, Board/Compensation Committee discretion should be explicitly recognized in executing recoupment by any method the Board deems to be appropriate (and discloses in the next proxy statement), including cancellation of unvested awards (equity and nonequity awards) and offsetting against amounts otherwise payable by the company to the executive (for example, deferred compensation) in place of having executives write a check, if the circumstances warrant. This flexibility helps to mitigate some of the procedural complexities involved in executing a clawback, including the need to file amended tax returns by both the company and the executives. 10 C. The Three-Year Recoupment Period Should Be Linked to the Restatement Filing Date The Center also believes that the trigger for recoupment (i.e., when a company is "required to prepare an accounting restatement") should be when the company actually files an accounting restatement due to the material noncompliance of the company with a financial reporting requirement under the securities laws. This creates a verifiable date certain from which to determine the three-year period over which the recoupment applies. It also avoids speculation over when a company determined it should have known it was required to prepare a restatement. The Center believes that restatements based on changes in Generally Accepted Accounting Principles should be excluded from the types of restatements that trigger a recoupment. These restatements are not based on oversights or deliberate errors by the company, but rather a change in the framework for reporting. Mandating a recoupment in such circumstances does not fulfill the policy objective sought by the clawback mandate: namely, if an executive did not earn incentive compensation based on financial results, he or she should be required to return it. D. Include Sufficient Lead Time to Implement the New Clawback Requirements The Center believes that the clawback policy will apply only to any new incentive compensation that is received after the effective date of the listing standards approved by the Commission. To apply the recoupment policy to compensation already granted would create excessive complexity in term of amendments required to outstanding compensation plans and executive contracts. In addition, the Center stresses that companies need sufficient time to put such policies into place prior to the effective date of the listing standards incorporating the disclosure and recoupment obligation taking effect because of the considerable number of issues, such as plan amendments and contract renegotiation that must be addressed. We believe that a reasonable time would be 12 months after the Commission approves the listing standards. III. Disclosure of Pay Versus Performance Section 953 of the Dodd-Frank Act adds a new section 14(i)(a) to the Exchange Act, entitled Disclosure of Pay Versus Performance, which requires that public companies disclose in its annual proxy statement "information that shows the relationship between executive compensation actually paid and the financial performance of the issuer." The Center believes there is a critical need for flexibility with respect to this disclosure in order to properly portray the unique aspects of individual company pay philosophies, programs and decisions. The statute requires companies to take "into account any change in the value of the shares of stock and dividends of the issuer and any distributions." We believe this disclosure should reinforce the purpose of the CD&A, namely to "put into context the compensation disclosure provided elsewhere."2 2 U.S. Securities and Exchange Commission, Executive Compensation and Related Person Disclosure, Release Nos. 33-8732A, 34-54302A, 71 Fed. Reg. 53,157, 53,164 (September 8, 2006). 11 With this in mind, the Center believes this disclosure should reflect the Board's and Compensation Committee's perspectives on compensation and financial performance in making its compensation decisions. Rather than focus on uniform disclosure, the requirement in new section 10(i) should be interpreted to focus on explaining the link of compensation "actually paid" to performance, allowing companies the flexibility to explain the committee's decisions in the context of its overall pay philosophies. Definition of Compensation "Actually Paid." We believe that the determination of "actually paid" will vary based on how the Compensation Committee and the Board structured the performance basis of incentive compensation granted to executives. This is consistent with the requirement that the CD&A "focus on the material principles underlying the registrant's executive compensation policies and decisions and the most important factors relevant to analysis of those policies and decisions."3 Because much of the CD&A focuses on the amounts in the Summary Compensation Table, the intended performance linkage between pay and performance may not be clear from the amounts in that Table, depending upon the philosophy of the company, especially with respect to long-term incentives. The linkage between pay and performance is fairly consistent as it relates to salary and annual incentive because the amounts realized are reported in the same year as the corresponding performance. However, the design of long-term incentive plans can vary considerably among companies depending on the basis upon which awards are granted, performance periods, performance objectives and incentive vehicles used. Long-term Incentives as Awards for Past Performance. For example, a Compensation Committee may grant long-term incentives as a reward for past performance. In this case, the grant date fair value estimate for long-term equity-based incentives in the Summary Compensation Table more appropriately reflects the decisions made by the Compensation Committee and the Board and thus the linkage between compensation "actually paid" and performance. Example 1: The Company has a tremendous year in terms of financial performance and the senior executive team is granted above guideline stock option awards to reflect the accomplishments of the prior year in the total planned annual compensation value. In this case, the Compensation Committee and the Board would discuss the relationship between the financial results and the date of grant value of the stock option awards, as reported in the Summary Compensation Table, when combined with other forms of incentive compensation reported in the Summary Compensation Table, as reflecting the relationship of pay and performance. If performance had been below expectations, a lower planned grant value could result. This pay for performance philosophy is in large part backward looking in that long-term incentive grants are the result of past performance. Alternative: Realized Compensation as "Actually Paid." By contrast, some companies are concerned that the long-term incentive estimates disclosed in the Summary Compensation Table do not completely reflect the pay for performance linkage underlying the committee's decisions. As a result, they may choose to put those amounts 3 Id. at 53,242. 12 into context by discussing how compensation actually realized -- the compensation actually received by the executive at the end of the performance period based on the degree of achievement of the underlying performance objectives -- is the proper reflection of pay for performance rather than grant date value of the award.4 This approach requires an explanation of how pay and performance were linked over the period the awards were outstanding and gives shareholders a sense for how such forwardlooking incentive programs operate in practice.5 Example 2: The Company is in a turnaround situation and the Compensation Committee believes that it is important to grant a market-competitive level of long-term awards to the executive team to motivate them to improve the performance of the company. In this case, the philosophy of the company is that the link between pay and performance is best reflected based upon the pay that will be actually realized by the degree to which performance goals are achieved and the long-term awards create gains to the executives. This pay for performance philosophy is forward looking in that future performance will determine the pay received from the performance-contingent awards. Some companies have begun disclosing the realized value of long-term incentive amounts in a table, similar to the following (which is separate from example 2): Form of Compensation Total Received ($) Annualized Amount Performance Results Over Performance Period That Produced the Compensation 2008-10 LTIP Payout $3,384,275 1,128,092 The total 2008-10 Long Term Incentive Plan award was $3,384,275. Performance criteria for this award were: (1) Total return to shareholders vs S&P Industrials Index companies, weighted 50%, for which the company ranked in the top 25 percent of companies, producing a near maximum payout for this component. (2) ROIC, weighted 25%, which exceeded the targeted level by 100%, resulting in maximum payout; and (3) Cash flow, weighted 25%, which exceeded the target by 15%, which resulted in a target payout. Overall the payout represented 150.25% of target. 4 This approach is also reflective of the way the Commission has distinguished estimates of compensation included in the Summary Compensation Table and compensation earned and paid out in the preamble to its 2006 disclosure release. See, e.g., U.S. Securities and Exchange Commission, Executive Compensation and Related Person Disclosure, Release Nos. 33-8732A, 34-54302A, 71 Fed. Reg. 53,157, 53,169 (September 8, 2006) ("This table, as amended, shows the named executive officers' compensation for each of the last three years, whether or not actually paid out.") referring to the Summary Compensation Table); Id. at 53,174("No further disclosure will be specifically required when payment is actually made to the named executive officer.") discussing the treatment of equity awards on the Summary Compensation Table. 5 This approach may also be useful in turbulent economic times where the accounting estimate of long-term incentive awards included in the Summary Compensation Table may vary considerably from the amounts actually realized. 13 As the two examples above demonstrate, it is important that there is flexibility for the Compensation Committee and the Board to present the pay for performance relationship in a manner that is consistent with the company's pay philosophy. Regardless of the approach used to describe the relationship between incentives and performance, the Center does not believe that the actuarial increase in defined benefit pension plans should be included in the calculation of compensation "actually paid" because the amounts are based on credited service, age, interest rates, and historical earnings, factors not generally related to financial performance, and given that pension estimates have not yet been received by the executive and thus should not be considered pay actually paid. The Center also believes that "other compensation," should be excluded as it is not related to financial performance. Definition of Financial Performance Should Be Company-Specific. We believe that the definition of "financial performance" should link the compensation "actually paid" to the financial metrics the Compensation Committee and the Board have incorporated into the company's incentive plans. Companies choose these financial measures because they link to short-term and longer term financial objectives intended to drive long-term shareholder value that will ultimately be reflected in stock price. We suggest that a company be required to clearly state the extent to which financial performance measures are used in determining the incentive compensation "actually paid" to named executive officers and how those amounts relate to financial performance. Example 3: For example, a company that links its long-term incentives to financial performance may state: "our company provides a long-term incentive program for senior executives that is paid out in shares of company stock at the end of the period, based on the achievement of certain financial results. A certain number of performance share units are granted at the beginning of the three-year performance period and adjusted based on performance at the end of the period. The financial performance on which the payout is based is: 60% Earnings per share; 20% Return on Invested capital; and 20% Cash flow." The company would then provide the pay (either on an estimated basis or realized pay basis) that is linked to the financial performance. Companies should be permitted to incorporate into this disclosure comparison of how other, nonfinancial measures compare with performance, consistent with the Commission's existing disclosure rules, so long as the link between financial performance and compensation actually paid is clear. This approach would allow companies to describe the link between pay and the performance on which it is based, whether financial, operational or strategic. Companies that base compensation decisions or measure performance based on financial and operational measures would report the compensation decisions or compare compensation received with the achievement of those objectives, while companies that base compensation actually paid on total shareholder return would measure performance on that basis. 14 Example 4: Company A determines a total long-term incentive value based on the committee's evaluation of the external market and allocates that total among two longterm incentive vehicles: 40% time-vested stock options, which vest after three years and provide value if the company's stock price exceeds the grant price; and 60% performance shares, which are based equally upon the achievement of earnings per share and total shareholder return measures. In this case, only the performance shares are related to financial performance. However, rather than requiring a separate disclosure in which the company shows the link between the portion of the long-term incentive that was based on financial performance and compensation, the company should be able to disclose how each element of the long-term incentive produced or is expected to produce compensation based on performance (depending on the committee's philosophy in granting compensation as discussed above), and to highlight the elements that are based on financial performance. Of course, as is the case under current SEC disclosure rules, companies would not be expected to disclose non-public performance metrics that would lead to competitive harm if disclosed to competitors. In sum, compensation is not a one-size-fits-all exercise, and companies use different approaches that fit their size, industry, strategy, competitive outlook and talent retention and development needs. A principles-based approach should be implemented with respect to disclosure of the relationship between pay and performance in order to promote clearer shareholder understanding of the decisions made by a Compensation Committee and/or the Board. V. Incentive Compensation at Covered Financial Institutions Section 956 of the Dodd-Frank Wall Street Reform and Consumer Protection Act requires the Agencies to promulgate regulations that prohibit incentive-based compensation that may encourage inappropriate risks by a financial institution by providing excessive compensation or that could lead to material financial loss. The Center is extremely concerned that the proposed rules are so prescriptive that they will effectively undermine the ability of covered financial institutions, especially those that are publicly held companies, to appropriately tailor compensation to performance for executives and other employees. The Center urged the Agencies to reconsider the prescriptive nature of these rules and to reshape these rules as guidelines to give the boards of directors of covered financial institutions the leeway and authority to govern a company effectively while accomplishing the statutory mandate of section 956. Allocating decision-making authority between the board, shareholders and the government as proposed will create disjointed programs that are likely to negatively affect company performance without adding measurably to the safety and soundness of the institutions. While the guidelines required by the Dodd-Frank Act were mainly in practice at most financial institutions, the regulations that have been jointly proposed by the Securities and Exchange Commission, Office of the Comptroller of the Currency, Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, Office 15 of Thrift Supervision, National Credit Union Administration and the Federal Housing Finance Agency (collectively, the "Agencies") have exceeded that statutory mandate and could negatively affect the financial services industry at a time promoting the economy and ensuring stability in this industry is a principal focus. The following summarize the Center's primary concerns with respect to the proposed regulations: Section 956 of the Dodd-Frank Act should be implemented in a Board-centric manner which draws on the informed judgment of the Board. Equipped with intimate knowledge of the company's business and talent strategy, the Board, is supported by the advice and council of independent expert advisors and is uniquely qualified to design and monitor incentive arrangements that are in the best long term interests of shareholders. Failing to maintain and reinforce the Board's unique role in managing compensation will create disjointed programs that are likely to negatively affect company performance without fulfilling the purpose of this rule - to improve the safety of financial institutions and mitigate unnecessary and excessive risk. This is especially the case with respect to executive compensation. Consistent with the duty to manage incentive arrangements in an informed and careful manner, Boards should continue to have responsibility for risk mitigation. Since the beginning of the economic downturn, companies took steps to minimize risk prior to government intervention. Accordingly, companies with strong corporate governance have involved the risk management function in discussions regarding compensation. The Center believes that the proposed regulations should recognize the initiatives Boards have undertaken to manage risk and adopt a flexible approach which allows Boards to adopt the most appropriate risk mitigation strategies for a company. Most companies seek to minimize risk in incentive compensation through multiple levels of review -- an appropriate and reasonable approach consistent with sound governance. These best practices should be recognized and accommodated in the rules. Requiring all companies to adopt a one-size-fits-all approach to risk mitigation is an overly broad reaction as most institutions already have in place a well-defined governance structure to assess risk in incentives. Additionally, companies should be free to allocate responsibility for risk management as appropriate for their business structure. The proposed regulations contemplate dictating a governance structure with respect to the compensation committee's responsibilities in reviewing, assessing and approving compensation for all individuals that have the ability to expose the institution to loss. Consistent with the oversight role of the Board, the responsibility for mitigation of risk in incentives below the executive level should be company management, and the Board should have responsibility to ensure processes are in place, and monitor such processes, to ensure risk mitigation is appropriate. The mandatory deferral provision in the proposed regulations exceeds the Agencies' statutory mandate and is contrary to a Board-centric approach to compensation. The Center is concerned that this requirement will lead to a "cookie-cutter" approach to executive compensation among large financial 16 institutions. Moreover, the requirement raises a number of questions with respect to how it will be interpreted and implemented, because it is drafted in such vague and ambiguous terms. The determination of what constitutes excessive compensation is best left to the judgment of the Board of directors. The Center believes that the Agencies should take a principles-based approach that would allow companies to develop compensation programs that are appropriately structured for the company and to discourage executives from taking excessive risk. Incorporating flexibility in these rules ensures that Boards can tailor the compensation programs - especially with respect to the competition for talent -- to reflect the unique company-specific facts and circumstances that surround each compensation decision. To the extent that the proposed regulations are duplicative of existing regulations, the Center requests that the Agencies consider removing the duplicative provisions. The annual report requirement is excessive, unclear and is redundant with many provisions that are already required to be filed under existing SEC disclosure rules and existing financial regulatory agency guidelines. As the proposed regulations are currently drafted, it is not always easy to determine which of the seven Agencies would be the appropriate regulating agency. This could lead to confusion in the future as each agency is permitted by the regulations to establish additional guidance. It is common for financial institutions to have two or more divisions that fall under a single corporate entity; therefore, it is possible that separate divisions could fall under the purview of different regulating Agencies with potentially inconsistent or contradictory requirements. The Center seeks clarification regarding the appropriate regulating agency rules. Conclusion The Center appreciates the opportunity to provide its views on this extremely important policy matter. We look forward to working with you and members of your staff to ensure that the Dodd-Frank Act will lead to the positive reform that was intended when it was enacted. 17