Pay Ratio and Pay for Performance for

Stock Administrators: A Beginner’s Guide

Mark Borges

Art Meyers

Josh Schaeffer

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DODD-FRANK RULEMAKING Summary

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Dodd-Frank Requirements-Executive Compensation

Dodd-Frank Wall Street Reform and Consumer Protection Act signed into law July 21, 2010.

Significant executive compensation rules include:

Say-on-Pay vote – Final rule Jan 2011

Pay-Ratio disclosure – Final rule Issued Aug 2015

Incentive Comp. for Financial Inst.–Re-Proposed rule Apr 2016

Hedging Disclosure – Proposed rule Feb 2015

Pay vs. Performance disclosure – Proposed rule Apr 2015

Clawbacks – Proposed rule Jul 2015

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PAY-RATIO Understanding the Rule

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Pay Ratio – The Big Picture

Executive Compensation disclosures must include the ratio of

the annual total compensation of the CEO to that of the

company’s median employee

Required for the first fiscal year beginning on or after January 1,

2017

(Generally, these numbers will first appear on proxy statements

filed in 2018)

Exclusions: Emerging growth companies, smaller reporting

companies, private issuers, multijurisdictional disclosure system

filers, and registered investment companies

Ratio disclosure is considered “filed, not furnished”

The Rule in Short: 𝐂𝐄𝐎 𝐏𝐚𝐲

𝐌𝐞𝐝𝐢𝐚𝐧 𝐄𝐦𝐩𝐥𝐨𝐲𝐞𝐞 𝐏𝐚𝐲

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Pay Ratio – Calculation Overview

• Median Employee

– Median selected from all employees (excluding CEO)

– Can be selected at any date in the last three months of the fiscal year

– Determined at least once every three years

– Use any reasonable compensation measure

• Data exclusions

– If foreign law does not allow use of data and certain other conditions are met

– De minimis: Exclude up to 5% of workforce in foreign jurisdictions (must exclude all employees in country and all exclusions must add to less than 5%)

• Other factors:

– Part-time and seasonal employees: no adjustments

– Employees hired in year can be adjusted to full year

– Geographic cost of living adjustments permissible but challenging

– Independent contractors treatment as employees unclear

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“I wrote this provision so that investors and the general public know whether companies’ pay practices are fair to their average employees, especially compared to their highly compensated CEOs…Such information is highly material to investors who have the right to know about companies’ policies and practices on compensation before they invest.”

- Senator Bob Menendez

“The pay ratio rule will harm investors. . . . [A]ny investor that uses pay ratio disclosures to compare companies will be at best distracted from material information and at worst misled about the investment itself.”

- Former SEC Commissioner Michael Piwowar

Pay Ratio: For and Against

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PAY-RATIO Practical Implications

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Due to company specific factors, numbers may be difficult to compare

– Part time vs. full time

– Internal employees vs. outsourcing

– Use of foreign employees

Year over year differences for a company will provide a snapshot of a company using same methodology over time

– Variation is based on percentages, smaller dollar changes for median employee will have larger impact

– Variation for median may be limited for many firms

Comparing the Numbers

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This will be a new disclosure for companies

Employees will learn whether they are above or below median

May cause internal conflicts

Employees may not consider total compensation based on summary comp table, causing additional friction

Employee Concerns

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Decision Point: Brief Disclosure Vs. Supplementary Analytics

Start by considering the principal risks

you need to manage.

What story should we tell? Should we be

giving additional slices of insight?

What’s my pay

ratio for full-

time

employees

only?

What’s my pay

ratio per

business

segment?

What’s my pay

ratio for

domestic

employees

only?

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PAY-RATIO Identifying the Median Employee

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Once the Median is Identified… Selecting the Median

Employee Significant methodological

flexibility

Calculating the Pay Ratio

Very little flexibility in how the ratio itself is computed (plug CEO and median employee into the SCT framework)

Employee # Base Salary

1 (CFO) $900,000

2 (CIO) $750,000

3 $700,000

4 $650,000

…

749 $51,000

750 (Joey) $50,000

751 $48,000

…

1,499 $15,500

1,500 $15,000

Salary Bonus Stock

Awards

Non-

Equity

Incentive

Plan Comp

Change

in

Pension

& NQDC

Earnings

All Other

Comp

Total

CEO $3,000,000 $0 $9,000,000 $7,000,000 $800,000 $200,000 $20,000,000

Median $50,000 $1,500 $0 $0 $0 $0 $51,500

Pay Ratio = $20,000,000

= 388.34 $51,500

1 2

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But the median easily could have been someone else…

Should certain

populations be

excluded?

Why was base salary

used instead of some

other measure of

compensation?

1. Base salary

2. Base salary + actual bonus

3. Base salary + target bonus

4. + Fair value of stock awards

5. + Pension value changes

6. Application of cost of living

adjustments

1. International employee exclusion

(5% threshold)

2. Exclusions due to data privacy

Why not just use

“statistical sampling” to

identify the median

employee?

What should the data

cutoff day be? Or

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More up-front effort may be useful for understanding and explaining differences over time.

More detailed inputs

Selecting a new median employee each year

Full population in place of sampling

Consistency vs. Convenience

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Sampling: Not An Easy Answer Sampling: not as good as it

sounds

…The way we wish it

worked… To cut out data acrobatics

across international

departments and data sources

…The way it must work…

Must be performed

considering every business

group and international entity

Full population: look for silver

lining

Apply numerical simplifications

for international jurisdictions

where all employees are clearly

above or below the median

Full population yields simpler

backup and auditability (useful

given filed, not furnished status)

Full population streamlines

production of supplementary

disclosure analytics

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Sampling: Lack of Consistency

0

100

200

300

400

500

600

700

800

900

1,000

50 100 500 1000

CEO Pay

Ratio

Sample Size

5th percentile

Minimum Value

Maximum Value

95th percentile

75th

50th

25th

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PAY VS. PERFORMANCE Understanding the Rule

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– Tabular plus narrative/graphical disclosure in the company’s proxy statement

Proposed Pay vs Performance Rule: In a Nutshell

Executive compensation actually paid Financial performance

• Company’s cumulative total shareholder return

(TSR) over a five-year period

• Market-cap weighted average TSR of the

companies in the peer group identified by the

company in its stock performance graph or in its

CD&A

• TSR Expressed in Dollars

Year

SCT Table

Total for

CEO

Compensation

Actually Paid to

CEO

Avg SCT Total for

non-CEO Named

Executive Officers

Avg Compensation Actually

Paid to non-CEO Named

Executive Officers

Total

Shareholder

Return

Peer

Group

TSR

=

2019

2018

2017

2016

2015

1/1/2015-12/31/2019

1/1/2015-12/31/2018

1/1/2015-12/31/2017

1/1/2015-12/31/2016

1/1/2015-12/31/2015

SCT total compensation

Change in pension value

Grant date fair value of equity awards

Equity award fair value as of vesting date

Applicable pension value earned for the year

Considerable ambiguity

• We know: 5-year lookback

• Don’t know: declining lookback periods

as of current FY vs. fixed 5-year

lookbacks as of preceding FY end dates

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Footnote disclosure describing adjustments used in calculation

Narrative or graphs must show:

– Relationship between executive compensation actually paid and the Company’s TSR, and

– Relationships between the Company’s TSR and that for the peer group.

Does not apply to foreign private issuers, registered investment companies, or emerging growth companies

Smaller reporting companies are subject to lesser disclosures

Phase-in over 5 years of data

Disclosure Requirements

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PAY VS. PERFORMANCE Impact of Rule

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Voluntary pay-for-performance disclosure may be inconsistent with new disclosure.

– Many disclosures use alternate metrics such as earnings.

Can be anywhere in the proxy

– Somewhat related to Summary Compensation Table

– May be included in CD&A section

Additional disclosure is permitted

XBRL tagged

Proxy Impact:

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Implication: Match award terms with disclosure requirements

Disconnect

In 2018, TSR is negative, but PSU award paid out.

Why??

Reason: The award vested in 2018, based on performance as of

the end of 2017 (positive TSR)

Because disclosure is based on relative TSR, companies may increase the use of this metric

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PAY VS. PERFORMANCE Understanding the Calculation

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By using equity award value at vesting, the reported amount captures value creation or loss while the Summary Compensation Table reflects fair value at grant date

How Does it Work?

Stock Price Increases:

• Value of restricted stock at vest > grant price

• Increased value of options

Stock Price Declines:

• Value of restricted stock at vest < grant price

• Lower value of options

• Key Concern: Need fair value of options which may require a different valuation model than at vest

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Measuring the value of options as of the vest date isn’t as easy as for full value awards because options do not settle on the vest date

– The actual option value must be estimated; intrinsic value could be materially different

– A frequent comment on the proposed rule asks for intrinsic values instead

Okay, option values aren’t so hard. I’ll just get out my Black-Scholes calculator…

– But what expected term should we use?

Option Valuation at Vest

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Companies may be unable to use Black-Scholes given the fact that options are in or out of the money

Solution: a lattice model should be used when valuing an option that is partway through its life – Lattice models simultaneously avoid Black-Scholes’

technical limitations and sidestep the need to select an expected term by modeling behavior in light of future stock price movements

May require different techniques for the pay vs. performance calculation from the financial statements

For companies with frequent (monthly) vesting, will need to develop assumptions as of each vesting date

Understanding The Problem: Option Value at Vest

Period 1 Period 2 Period 3 Period 4

$

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CLAWBACKS Understanding the Rule

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In 2015, XYZ Corp. beat earnings targets of $2.00 per share by $0.03, causing $20 million in performance awards to vest

In 2016, the CFO of XYZ Corp.’s retail division was arrested for fraud for channel stuffing and falsifying sales numbers. Restated financials resulted in earnings of $1.96 per share

XYZ Corp. now has to decide what to do with compensation provided to those unrelated to the fraud

“This is money that the executive would not have received if the accounting was done properly.”

-Senate Committee on Banking, Housing and Urban Affairs, April 30, 2010

Clawbacks: The Big Picture in a Really Short Story

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Executive Officer defined based on Section 16 definition of Officer

Any compensation earned, granted, or vested based wholly or in part

on satisfying a financial reporting measure performance goal

Triggered if a restatement is required due to the material

noncompliance of issuer with any financial reporting requirements

No-fault and non-discretionary in nature

Potential retroactive application

Complex Tax Considerations

Clawback: Key Points

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FINANCIAL INSTITUTION PAY REQUIREMENTS

Understanding the Rule

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Basic Requirements: Institutions with total consolidated assets ≥ $1 bn

• Excessive compensation prohibited

• Compensation cannot encourage inappropriate risk-taking

• Board of Directors Oversight

• Cannot hedge for employees

Enhanced Requirements: Institutions with total consolidated assets ≥ $50 bn

• Incentive compensation subject to downward adjustment and forfeiture

• Mandatory deferrals of incentive compensation

• Clawbacks (7 years from vest)

• Maximum incentive-based compensation opportunity (leverage)

Bank Pay Rules: Key Points

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HEDGING DISCLOSURE Understanding the Rule

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Disclosure only rule

Disclose whether employees are permitted to hedge:

– Purchase financial instruments that are designed or have the effect of

hedging or offsetting any decrease in stock price

– Transactions include but are not limited to prepaid variable forward contracts,

equity swaps, collars, and exchange funds

Hedging and pledging are treated differently

Major proxy advisory firms generally discourage executive

hedging

Hedging Disclosure: Key Points