RiskMetrics' 2010 recommendation guidelines on executive compensation

By Cydney Posner

There were only a few updates to RiskMetrics' specific recommendation guidelines on executive compensation for 2010.  And even RiskMetrics now posts FAQs.

To clarify the factors that support its recommendations, RM has adopted a reorganized Executive Compensation Evaluation policy that integrates its policies on pay for performance, pay practices, and board responsiveness and communication on compensation issues. This policy also incorporates additional guidelines adopted in 2007 for management say-on-pay ("MSOP") proposals.

Within this reorganized evaluation framework, there are updates to the policy guidelines that RM characterizes as "notable":

• The pay-for-performance evaluation will additionally consider the alignment of the CEO's total direct compensation (TDC) and total shareholder return (TSR) over a period of at least five years. The new consideration will be an evaluation of long-term pay alignment through a five-year historical trend of CEO TDC and company TSR
• In light of the current focus on excessive risk-taking concerns, RM's evaluation of problematic pay practices will include consideration of whether incentive practices may motivate inappropriate risk-taking by executives. This evaluation will also assess the extent to which techniques such as clawback policies or stock ownership/holding requirements may mitigate this risk

If there is an MSOP proposal, it will be "the primary communication avenue to initially address problematic pay practices, with additional or alternative negative recommendations on Compensation Committee members (or the board) in especially egregious situations. If these concerns are not sufficiently addressed in the following year, the policy would recommend votes against Compensation Committee members." (What this pronouncement seems to be suggesting is that if you have an MSOP proposal, RM will apply its compensation-related analysis primarily to its recommendations on that proposal, not on directors, recommending against directors only in the extreme case.  Only if the problems continue into the subsequent year will RM then consider withhold recommendations for the comp committee (except for extreme cases, as noted above).  However, if there is no MSOP proposal and RM is dissatisfied with the comp practices, it will consider withhold recommendations for the comp committee from the get-go.)

In an MSOP evaluation, pay for performance, performance metrics and pay practices are viewed as the most important elements, with the result that a company that triggers a negative outcome on one or more of these critical factors may elicit an against recommendation regardless of other factors. 

Although all pay practices are evaluated on a case-by-case basis, certain pay practices are considered most problematic and could result in a withhold/against recommendation regardless of other factors:

• Egregious employment contracts, such as contracts containing multi-year guarantees for salary increases, non-performance based bonuses and equity compensation
• New CEOs with overly generous new-hire package, such as excessive "make-whole" provisions without sufficient rationale or any other problematic pay practices
• Abnormally large bonus payouts without justifiable performance links or proper disclosure, including 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 payouts, such as inclusion in new arrangements of additional years of service not worked that result in significant benefits and inclusion of performance-based equity awards in the pension calculation
• Excessive perquisites, such as perquisites for former and/or retired executives or extraordinary relocation benefits (including home buyouts)
• Excessive severance and/or change-in-control provisions, such as payments exceeding three times base salary and bonus, single trigger payments, new or materially amended employment or severance agreements that include modified single triggers that provide payments even if the executive leaves voluntarily for any reason or provide for excise tax gross-up or even modified gross-ups
• Reimbursements of income taxes on certain executive perquisites or other payments (e.g., personal use of corporate aircraft, executive life insurance, bonus, etc)
• Dividends or dividend equivalents paid on unvested performance shares or units
• Executives using company stock in hedging activities, such as "cashless" collars, forward sales, equity swaps or other similar arrangements
• Repricing or replacing of underwater options or SARs without prior shareholder approval (including cash buyouts).

The following practices are also viewed as adverse, but slightly less egregious:

• Excessive severance and/or change-in-control provisions, including payments in connection with performance failure or liberal change-in-control definitions that could result in payments without an actual change in control
• Overly generous perquisites, including personal use of corporate aircraft, personal security systems maintenance and/or installation, car allowances and executive life insurance
• Excessive internal pay disparity between CEO total pay and that of next highest-paid NEO
• Voluntary surrender of underwater options by executive officers, which could be viewed as indirect repricings if those cancelled options are returned to the plan and can be regranted to executives at a lower exercise price or the executives subsequently receive unscheduled grants in the future

RM will continue to examine more closely the Russell 3000 companies that have one- and three-year TSRs in the bottom half of their industry groups to determine if there is any pay-for-performance disconnect, taking into account, for each company, whether the CEO's pay has increased or decreased, the magnitude of the change, the reason for the change in pay with respect to the pay mix, and the long-term (at least five years) alignment of the CEO's total direct compensation with the company's TSRs, with particular focus on the most recent three years. Problems here may result in votes withheld from comp committee members or against equity plans; however, if the offending company makes a renewed commitment to pay-for-performance, RM may recommend a vote in favor. For example, if the primary source of pay increase results from time-vested equity awards, the company could commit to making at least 50% of equity awards to NEOs performance-based.  Transparent and detailed disclosure in a public filing, such as a proxy or 8-K, would be required.

RM believes that option repricing programs should be undertaken only as a last resort because they create "a gulf between the interests of shareholders and management, since shareholders cannot reprice their stock."  In addition to standard shareholder friendly features, such as value-for-value exchanges, exclusion of NEOs and directors and resetting vesting schedules, RM advocates that only deep underwater options be eligible for the program, especially if the company's stock is volatile: using a "52-week high as the threshold exercise price may be reasonable in a depressed economy, but it may not be rational in a market rebound." Generally, the threshold exercise price for participation should be the higher of the 52-week high or 50%, also taking into account the timing of the request, whether the company has experienced a sustained stock price decline that is beyond management's control, and the current stock price (i.e., a 50% premium where the stock price is $1 may be a low threshold if the company's stock price is particularly volatile). To avoid any assumption that equity grants are awarded primarily to management, a company should discuss the various levels of employees (management versus non-management) who will be eligible participants in the program.

If a company fails to meet the three-year average burn rate policy, it may commit to a prospective gross three-year average burn rate, excluding reload options granted prior to 2005, equal to the higher of two percent of the company's common shares outstanding or the mean of its industry peer group. A company's burn rate may exceed the peer group average in the first year, provided the prospective three-year average burn rate remains below the commitment level. The commitment must be disclosed in a public filing. Making a commitment does not guarantee a vote change if RM otherwise has concerns with the company's equity plan design.

RM has an option overhang carve-out policy applicable to new share requests (that are not unreasonably dilutive) by companies with sound compensation practices and sustained positive stock performance.  Under the carve-out, the company's high overhang cost must be attributable to options that have been outstanding in excess of six years and continuously in the money after vesting. Details must be provided to RM to analyze (e.g., see Myriad Genetics' DEFA 14A filed October 28, 2009); however, as it will be difficult for the company to pre-determine the portion of the options to be carved out, supplementary proxy filings may be required. High overhang cost means that the sum of outstanding options and stock awards and remaining shares available under existing equity plans exceeds or approaches the company's specific allowable cap, with outstanding options and stock awards in the range of 75% to 100% of the total overhang. A concentration ratio (i.e., the distribution of awards to NEOs as compared with other employees and directors) in the past fiscal year that exceeds 50% may be of concern in this context.

In its pay-for-performance analysis, RM may take into account option grants made subsequent to the immediately preceding "performance" year if complete disclosure is made in the proxy statement, including the number of shares subject to each of these grants, the exercise price or grant price and option term. Some companies provide an alternate summary comp table that takes into account the recent equity awards. Be forewarned, RM will not search Form 4 filings to make these adjustments but will rely on the specific proxy disclosures.