Developments in Securities Regulation, Corporate Governance, Capital Markets, M&A and Other Topics of Interest. MORE

The Department of the Treasury has issued a proposed rule to implement Section 155 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which directs the Department to establish by regulation an assessment schedule for bank holding companies with total consolidated assets of $50 billion or greater and nonbank financial companies supervised by the Board of Governors of the Federal Reserve to collect assessments equal to the total expenses of the Office of Financial Research, or OFR. Included in the OFR’s expenses are expenses of the Financial Stability Oversight Council, or FSOC, as provided under Section 118 of the Dodd-Frank Act, and certain expenses of the Federal Deposit Insurance Corporation, as provided under Section 210 of the Dodd-Frank Act. The proposed rule outlines the key elements of Treasury’s assessment program, which will collect semiannual assessment fees from these companies beginning on July 20, 2012.

Check dodd-frank.com frequently for updates on the Dodd-Frank Act and other important securities law matters.

The SEC has updated its Dodd-Frank rulemaking schedule.  Highlights of those rules slated for action in the January to June timeframe of 2012 are as follows:

  • §952: Adopt exchange listing standards regarding compensation committee independence and factors affecting compensation adviser independence; adopt disclosure rules regarding compensation consultant conflicts
  • §§953 and 955: Propose rules regarding disclosure of pay-for-performance, pay ratios, and hedging by employees and directors
  • §954: Propose rules regarding recovery of executive compensation
  • §1502: Adopt rules regarding disclosure related to “conflict minerals”
  • §1504: Adopt rules regarding disclosure by resource extraction issuers
  • §926: Adopt rules disqualifying the offer or sale of securities in certain exempt offerings by certain felons and others similarly situated
  • §418: Adopt rules to adjust the threshold for “qualified client”
  • §919B: Implement recommendations contained in study on ways to improve access of investors to registration information regarding investment advisers and broker-dealers
  •   §951: Adopt rules regarding disclosure by institutional investment managers of votes on executive compensation
  •   §1088: Issue rules and guidelines (jointly with the CFTC) to require investment companies and broker-dealers to adopt policies and procedures to prevent identity theft.

For those of you following the hotly contested rules related to the registration of municipal advisors under Section 975 of the Dodd-Frank Act, those rules are scheduled to be adopted between July and December of 2012, a significant delay.

Check dodd-frank.com frequently for updates on the Dodd-Frank Act and other important securities law matters.

The Dodd-Frank Wall Street Reform and Consumer Protection Act requires the Financial Stability Oversight Council, or FSOC to submit a report to Congress regarding the implementation of prompt corrective action , or PCA, by the Federal banking agencies.  More specifically, section 202(g)(4) of the Dodd-Frank Act requires FSOC to issue a report on actions taken in response to the GAO study required by section 202(g)(1) of the Dodd-Frank Act. FSOC has issued a report that discusses the existing PCA framework and the findings and recommendations of the GAO study.  It also highlights some lessons learned from the financial crisis and outlines actions taken that could affect PCA, as well as additional steps to modify the PCA framework that could be considered.

Check dodd-frank.com frequently for updates on the Dodd-Frank Act and other important securities law matters.

 

Cincinnati Bell has agreed to settle one of the say-on-pay law suits which is pending against it in the Hamilton County Court of Common Pleas.  The lawsuit arises out of the shareholder’s “say on pay” vote taken at Cincinnati Bell’s May 2011 annual meeting. The Dodd-Frank Wall Street Reform and Consumer Protection Act signed into law in July, 2010, requires that all public companies solicit an advisory shareholder vote on executive compensation.  We previously reported on a related case here and here which survived a motion to dismiss.

According to Phillip R. Cox, Chairman of Cincinnati Bell’s Board of Directors, “The proposed settlement includes features which will clarify the Company’s executive compensation policies and which will more clearly communicate these policies to our shareholders. Importantly, the changes represented by this agreement should better assist our shareholders’ understanding of how these policies are applied to covered employees.”

One of Plaintiffs’ Counsel, Ed Korsinsky, adds that: “The longer-term and perhaps most important aspect of the settlement is that it provides a binding agreement that executive compensation decisions remain consistent with the Company’s pay for performance philosophy and that the Board of Directors will continue to clearly articulate the Company’s philosophy to its shareholders.” As part of this settlement, Cincinnati Bell will, among other things, reaffirm its pay for performance practice and provide for an annual discussion of its philosophy related to executive compensation.

Many may conclude the failed say-on-pay law suit which is settled for disclosure relief will become a shake down for an attorney fee award, much like numerous cases filed to block an acquisition.  It will be interesting to see what kind of fee award the court grants for this type of “success.”  That may drive how many of these litigations are filed in the future.

But the case settled is a different one than the case which survived a motion to dismiss.  The effect of the settlement on that case, pending in the United States District Court for the Southern District of the Western Ohio Division, is unclear.  However, that case has taken some unusual twists and turns.

After the court denied the defendants’ motion to dismiss, the defendants learned that diversity jurisdiction did not exist.  Plaintiffs failed to identify itself as a citizen of Georgia and one of Cincinnati Bell’s defendant directors was a citizen of Georgia.  Plaintiffs attempted to correct the subject matter jurisdiction by amending the complaint to drop the director which resides in Georgia and voluntary dismissal of the director.  The court granted defendants motion to strike the amended complaint and voluntary dismissal as procedurally improper.  Apparently the plaintiffs can still a motion to amend the complaint following the proper procedures.

But there is another twist to the case that can only make the defense bar smile.  The court sua sponte issued an order to the plaintiffs attorney to show cause why the attorneys should not be sanctioned under Rule 11 for failure to conduct a reasonable inquiry into the factual contentions as to the alleged diversity.  The court ultimately concluded it was an honest mistake but found the attorneys “incomplete answer to the Court’s direct question of him at oral hearing represented misbehavior of an officer of the Court in his official transactions.”  As a result, the court revoked the attorneys pro hac vice admission in the case.

Check dodd-frank.com frequently for updates on the Dodd-Frank Act and other important securities law matters.

The SEC has adopted new rules outlining how mining companies must disclose the mine safety information required by the Dodd-Frank Wall Street Reform and Consumer Protection Act.  Under Section 1503 of the Dodd-Frank Act, mining companies are required to include information about mine safety and health in the quarterly and annual reports they file with the SEC. The Dodd-Frank Act disclosure requirements are based on the safety and health requirements that apply to mines under the Federal Mine Safety and Health Act of 1977, which is administered by the Mine Safety and Health Administration (MSHA).

In General

The new SEC rules, which take effect 30 days after publication in the Federal Register, specifically require those companies to provide mine-by-mine totals for the following:

  • Significant and substantial violations of mandatory health or safety standards under section 104 of the Mine Act for which the operator received a citation from MSHA
  • Orders under section 104(b) of the Mine Act
  • Citations and orders for unwarrantable failure of the mine operator to comply with section 104(d) of the Mine Act
  • Flagrant violations under section 110(b)(2) of the Mine Act
  • Imminent danger orders issued under section 107(a) of the Mine Act
  • The dollar value of proposed assessments from MSHA
  • Notices from MSHA of a pattern of violations or potential to have a pattern of violations under section 104(e) of the Mine Act
  • Pending legal actions before the Federal Mine Safety and Health Review Commission
  • Mining-related fatalities

The accompanying instructions specify that a mining company must report the total penalties assessed in the reporting period, even if the company is contesting an assessment. For legal actions, mining companies are instructed to report the number instituted and resolved during the reporting period, report the number pending on the last day of the reporting period, and categorize the actions based on the type of proceeding.

In addition, the Dodd-Frank Act added a requirement for U.S. companies to file a Form 8-K when they receive notice from MSHA of an imminent danger order under section 107(a) of the Mine Act; notice of a pattern of violations under section 104(e) of the Mine Act, or notice of the potential to have a pattern of such violations. The new SEC rules specify that the Form 8-K must be filed within four business days and include the type of notice received, the date it was received, and the name and location of the mine involved. The new rules specify that a late filing of the Form 8-K will not affect a company’s eligibility to use Form S-3 short-form registration.

Changes to Form 10-K and 10-Q

The SEC is amending Form 10-Q to add new Item 4 to Part II and Form 10-K to add new Item 4 to Part I, which would require the information required by new Items 104 and 601(b)(95) of Regulation S-K; Form 20-F to add new Item 16H; and Form 40-F to add new Paragraph (16) of General Instruction B. As discussed in more detail below, the disclosure is required to be provided in each periodic report.

As proposed, the amendments will require issuers that have matters to report in accordance with Section 1503(a) to include brief disclosure in Part II of Form 10-Q, Part I of Form 10-K and Forms 20-F and 40-F noting that they have mine safety violations or other regulatory matters to report in accordance with Section 1503(a), and that the required information is included in an exhibit to the filing. The exhibit would include the detailed disclosure about specific violations and regulatory matters required by Section 1503(a) as implemented in the SEC’s new rules. Many issuers have already implemented this approach in their periodic reports that contain the disclosure required under Section 1503(a). Consistent with the proposal, the final rule does not require disclosure in the body of the periodic report of certain information, such as all fatal accidents or receipt of notice that a mine has a pattern of violations.

The SEC does not believe it is necessary to require this additional disclosure in order to implement Section 1503; and, as noted in the proposing release, that in the event that mine safety matters raise concerns that should be addressed in other parts of a periodic report, such as risk factors, the business description, legal proceedings or management’s discussion and analysis, inclusion of this new disclosure would not obviate the need to discuss mine safety matters in accordance with other rules as appropriate.

The amended rules, as proposed, do not specify any particular presentation requirements for the new disclosure, but the SEC continues to encourage issuers to use tabular presentations whenever possible if to do so would facilitate investor understanding. Many issuers are currently providing the disclosure required by Section 1503(a) in tabular format in their periodic reports.  The SEC has provided an example of a possible tabular presentation that may encourage uniformity and comparability of disclosures.  However,  issuers are free to present the required information in any presentation they believe is appropriate for the disclosure.

Filed, Not Furnished

The final rules require the disclosure in each periodic report filed with the SEC, and such disclosure will be considered “filed,” not “furnished.”  Therefore, as is the case with other disclosure filed as part of a periodic report, Section 18 of the Exchange Act will apply and the disclosure is encompassed by the Exchange Act Rule 13a-14 and 15d-14 certifications. In addition, if the issuer files a Securities Act registration statement (such as Form S-3) that incorporates by reference its periodic reports, the disclosure included in Exchange Act reports in accordance with the new rules will be incorporated by reference.

Time Periods

The final rule requires each Form 10-Q to include the required disclosure for the quarter covered by the report. For each of Forms 20-F and 40-F, the disclosure is required for the issuer’s fiscal year. Similarly, in a change from the proposal, the final rule requires each Form 10-K to include disclosure of the information for the fiscal year only, not also for the fourth quarter.

Check dodd-frank.com frequently for updates on the Dodd-Frank Act and other important securities law matters.

The SEC has adopted final rules to amend the definition of “accredited investor” under the Securities Act rules.  Section 413(a) of the Dodd-Frank Act required the definition of “accredited investor” in the Securities Act rules to exclude the value of a person’s primary residence for purposes of determining whether the person qualifies as an “accredited investor” on the basis of having a net worth in excess of $1 million. This change to the net worth standard was effective upon enactment by operation of the Dodd-Frank Act, but Section 413(a) also required the SEC  to revise its current Securities Act rules to conform to the new standard.

New Definition

As amended, the new individual net worth standard in the accredited investor definition is any natural person whose individual net worth, or joint net worth with that person’s spouse, exceeds $1,000,000.

Except as provided below, for purposes of calculating net worth:

  • The person’s primary residence shall not be included as an asset;
  • Indebtedness that is secured by the person’s primary residence, up to the estimated fair market value of the primary residence at the time of the sale of securities, shall not be included as a liability (except that if the amount of such indebtedness outstanding at the time of the sale of securities exceeds the amount outstanding 60 days before such time, other than as a result of the acquisition of the primary residence, the amount of such excess shall be included as a liability); and
  • Indebtedness that is secured by the person’s primary residence in excess of the estimated fair market value of the primary residence at the time of the sale of securities shall be included as a liability.

The foregoing does not apply to any calculation of a person’s net worth made in connection with a purchase of securities in accordance with a right to purchase such securities, provided that:

  • such right was held by the person on July 20, 2010;
  • the person qualified as an accredited investor on the basis of net worth at the time the person acquired such right; and
  • the person held securities of the same issuer, other than such right, on July 20, 2010.

Mortgage Debt

Under the final rules, as in the proposed rules, individuals’ net worth will be calculated excluding any positive equity they may have in their primary residence.  Under the final rules, any excess of indebtedness secured by the primary residence over the estimated fair market value of the residence is considered a liability for purposes of determining accredited investor status on the basis of net worth, whether or not the lender can seek repayment from other assets in default.

Under the final rule, any increase in the amount of debt secured by a primary residence in the 60 days before the time of sale of securities to an individual generally will be included as a liability, even if the estimated value of the primary residence exceeds the aggregate amount of debt secured by such primary residence.  Net worth will be calculated only once, at the time of sale of securities (the same time as under current rules). The individual’s primary residence will be excluded from assets and any indebtedness secured by the primary residence, up to the estimated value of the primary residence at of that time, will be excluded from liabilities, except if there is incremental debt secured by the primary residence incurred in the 60 days before the sale of securities. If any such incremental debt is incurred, net worth will be reduced by the amount of the incremental debt. In other words, the only additional calculation required by the 60-day look-back provision is to identify any increase in mortgage debt over the 60-day period preceding the purchase of securities.

The SEC believes approach will make it more difficult for individuals to manipulate their net worth as calculated under our rules by borrowing against their primary residence shortly before seeking to qualify as an accredited investor, to take advantage of any positive equity in the primary residence. It should, therefore, significantly reduce the incentive for individuals to try to “game” the accredited investor net worth standard or for salespeople to attempt to induce individuals to take on incremental debt secured against their homes to facilitate a near-term investment in an offering.

Limited Grandfathering

In cases where securities would be purchased based on an investment decision made before enactment of the Dodd-Frank Act (for example, a capital call that is not subject to conditions under the investor’s control, under an agreement entered into before enactment of the Dodd-Frank Act), accredited investor status would have been determined at the time of the investment decision. A subsequent change in the investor’s accredited status would not be relevant, so special accommodation would not be needed.

The final rules contain a provision under which the former accredited investor net worth test will apply to purchases of securities in accordance with a right to purchase such securities.  The grandfathering provision applies to the exercise of statutory rights, such as pre-emptive rights arising under state law; rights arising under an entity’s constituent documents; and contractual rights, such as rights to so long as:

  • the right was held by a person on July 20, 2010, the day before the enactment of the Dodd-Frank Act;
  •  the person qualified as an accredited investor on the basis of net worth at the time the right was acquired; and
  • the person held securities of the same issuer, other than the right, on July 20, 2010.

For example, if an investor who qualified as accredited based on net worth at the time of her original investment owned common stock of an issuer on July 20, 2010, and on that date had pre-emptive rights to acquire additional common stock of that issuer, then when the issuer makes an offering of common stock that triggers the pre-emptive rights, the investor’s net worth will be calculated as it was before enactment of the Dodd-Frank Act. Likewise, if the same investor owned Series A preferred stock of an issuer on July 20, 2010 and on that date had a right of first offer to purchase any equity securities offered by the issuer in a future sale, and the issuer proposed to sell Series B preferred stock at a future date, then the investor’s net worth will be calculated as it was before enactment of the Dodd-Frank Act for purposes of exercising the right of first offer to purchase Series B preferred stock from the issuer. The provision is limited to persons who qualified as accredited investors on the basis of net worth at the time the relevant rights were originally acquired, and who held securities of the issuer other than the rights on July 20, 2010.

Check dodd-frank.com frequently for updates on the Dodd-Frank Act and other important securities law matters.

The CFTC has approved its final rule on real-time reporting of swaps. This rule is intended to provide swap transaction and pricing data to the public on a real-time basis so as to enhance price discovery.

What Swaps Must Be Reported

The new rule defines “publicly reportable swap transactions” as (1) any swap that is an arm’s-length transaction between two parties that results in a corresponding change in the market risk position between the two parties; or (2) any termination, assignment, novation, exchange, transfer, amendment, conveyance, or extinguishing of rights or obligations of a swap that changes the pricing of a swap. The rule covers such swaps in all five asset classes (i.e., interest rate, credit, equity, foreign exchange, and other commodity), whether cleared or uncleared, and regardless of the method of execution (e.g., executed bilaterally, or on a registered swap execution facility or designated contract market). However, certain swaps in the “other commodity” asset class are not subject to the rule’s requirements.

The rule specifies data fields that are to be reported for each swap for the purpose of categorizing the swap and capturing its price and volume data.

Who Must Report

For those publicly reportable swap transactions executed on or pursuant to the rules of a registered swap execution facility or designated contract market, the parties satisfy their reporting obligation by executing the transaction on or pursuant to the rules of the execution facility. A registered swap execution facility or designated contract market must report the swap transaction and pricing data to the appropriate registered swap data repository for public dissemination.

For those publicly reportable swap transactions that are not executed on or pursuant to the rules of a registered swap execution facility or designated contract market, unless otherwise agreed to by the parties prior to execution, the parties to the transaction would report to the appropriate registered swap data repository for public dissemination as follows:
• If only one party is a swap dealer or major swap participant, then the swap dealer or major swap participant should report to the registered swap data repository;
• If one party is a swap dealer and the other party is a major swap participant, then the swap dealer should report to the registered swap data repository; and
• In all other situations, the parties shall designate which party should report to the registered swap data repository.

When and To Whom Swaps Must Be Reported

Swaps must be reported “as soon as technologically practicable” after execution. Swaps will be reportable to a registered swap data repository. The compliance dates for the real-time public reporting requirements are as follows:
• Compliance date 1, the date on which exchanges, swap dealers (SDs), and major swap participants (MSPs) must commence compliance with respect to interest rate and credit swaps, is the later of (a) July 16, 2012, or (b) 60 days after publication of Commission definitions of “swap,” “swap dealer,” and “major swap participant.”
• Compliance date 2, the date on which such entities and counterparties must commence compliance with respect to equity swaps, foreign exchange transactions, and other commodity swaps, is 90 calendar days after compliance date 1.
• Compliance date 3, the date on which non-SD/MSP counterparties must begin compliance with respect to swaps in all asset classes, is 90 calendar days after compliance date 2.

The CFTC has approved its final rule on swap data recordkeeping and reporting, summarized below.

RECORDKEEPING

All persons transacting in swaps (as well as exchanges and clearing organizations) must keep records throughout the existence of a swap and for five years following termination of the swap. Swap Dealers (SDs) and Major Swap Participants (MSPs) must keep such records readily accessible throughout the life of a swap and for two years following its termination and keep them retrievable within three business days for the remainder of the retention period. Non-SD/MSP counterparties must keep records retrievable within five business days.

REPORTING

What Must Be Reported

The final reporting rule calls for electronic reporting to a Swap Data Repository of swap data from two important stages of existence of each swap: (1) the creation of the swap and (2) the continuation of the swap over its existence until final termination or expiration. Required swap creation data includes all primary economic terms (PET) data and all confirmation data for a swap. Required swap continuation data means all changes to primary economic terms and all valuation data. The final rulemaking calls for the use of three unique identifiers in connection with swap data reporting, including a Unique Swap Identifier (USI), a Legal Entity Identifier (LEI), and a Unique Product Identifier (UPI).

Who Must Report

The Commission has assigned the reporting obligation to the entity with the easiest, fastest, and cheapest access to the data. Swap creation data is reportable by an exchange or a clearing organization, if such entities are used. Otherwise, such data is reportable by one of the counterparties—a SD or MSP if present. Continuation data for cleared swaps is reported by the clearing organization, though SD and MSP reporting counterparties must also report valuation data. For uncleared swaps, all continuation data is reported by one of the counterparties—again, a SD or MSP, if present in the transaction.

Thus, non-SD/MSP counterparties must report data only for the small minority of swaps in which both counterparties are non-SD/MSP counterparties. Even within this small minority of swaps, the non-SD/MSP reporting counterparty will have no reporting obligations for on-facility, cleared swaps, or for off-facility swaps accepted for clearing within the deadline for PET data reporting by the non-SD/MSP reporting counterparty. If an off-facility swap is accepted for clearing after the PET data reporting deadline, the non-SD/MSP counterparty is excused from reporting confirmation data, which will instead be reported by the DCO. For on-facility, uncleared swaps, the non-SD/MSP reporting counterparty’s reporting obligations are limited to reporting continuation data during the existence of the swap. Where one of two non-SD/MSP counterparties is a financial entity as defined in the Dodd-Frank Act, the final rule makes the financial entity the reporting counterparty.

Compliance Dates

Compliance date 1, the date on which exchanges, clearing organizations, SDs and MSPs must commence compliance with respect to credit swaps and interest rate swaps, is the later of (a) July 16, 2012, or (b) 60 days after publication of Commission definitions of “swap,” “swap dealer,” and “major swap participant.” Compliance date 2, the date on which such entities and counterparties must commence compliance with respect to equity swaps, foreign exchange transactions, and other commodity swaps, is 90 calendar days after compliance date 1. Compliance date 3, the date on which non-SD/MSP counterparties must begin compliance with respect to swaps in all asset classes, is 90 calendar days after compliance date 2.

The Federal Reserve Board has proposed steps to strengthen regulation and supervision of large bank holding companies and systemically important nonbank financial firms. The proposal, which includes a wide range of measures addressing issues such as capital, liquidity, credit exposure, stress testing, risk management, and early remediation requirements, is mandated by the Dodd-Frank Act.

The proposal generally applies to all U.S. bank holding companies with consolidated assets of $50 billion or more and any nonbank financial firms that may be designated by the Financial Stability Oversight Council as systemically important companies. The Board will issue a proposal regarding foreign banking organizations shortly. In general, savings and loan holding companies (SLHCs) would not be subject to the requirements in this proposal, except certain stress test requirements. The Board plans to issue a separate proposal later to address the applicability of the enhanced standards to SLHCs.

The Board is proposing a number of measures, including:

  • Risk-based capital and leverage requirements. These requirements would be implemented in two phases. In the first phase, the institutions would be subject to the Board’s capital plan rule, which was issued in November 2011. That rule requires firms to develop annual capital plans, conduct stress tests, and maintain adequate capital, including a tier one common risk-based capital ratio greater than 5 percent, under both expected and stressed conditions. In the second phase, the Board would issue a proposal to implement a risk-based capital surcharge based on the framework and methodology developed by the Basel Committee on Banking Supervision.
  • Liquidity requirements. These measures would also be implemented in multiple phases. First, institutions would be subject to qualitative liquidity risk-management standards generally based on the interagency liquidity risk-management guidance issued in March 2010. These standards would require companies to conduct internal liquidity stress tests and set internal quantitative limits to manage liquidity risk. In the second phase, the Board would issue one or more proposals to implement quantitative liquidity requirements based on the Basel III liquidity rules.
  • Special Corporate Governance Provisions.  The proposed rule would require that each covered company and each over $10 billion bank holding company establish a risk committee of the board of directors to document and oversee, on an enterprise-wide basis, the risk management practices of the company’s worldwide operations.  The Board proposes that a covered company and over $10 billion bank holding company’s risk committee must be chaired by an independent director.  In addition to the independent director requirements, the proposed rule would require at least one member of a company’s risk committee to have risk management expertise that is commensurate with the company’s capital structure, risk profile, complexity, activities, size, and other appropriate risk-related factors.  The proposed rule would require a company’s risk committee to have a formal, written charter that is approved by the company’s board of directors. In addition, the proposed rule would require that a risk committee meet regularly and as needed, and that the company fully document and maintain records of such proceedings, including risk management decisions.
  • Requirements for a Chief Risk Officer.  The proposed rule directs each covered company to appoint a CRO to implement and maintain appropriate enterprise-wide risk management practices for the company.  Under the proposed rule, a CRO would be required to have risk management expertise that is commensurate with the covered company’s capital structure, risk profile, complexity, activities, size, and other appropriate risk related factors.

Check dodd-frank.com frequently for updates on the Dodd-Frank Act and other important securities law matters.

ISS previously issued its 2012 policy update.  ISS has now delivered the promised additional guidance on the 2012 Pay-for-Performance (P4P) methodology in a technical document.

By way of back ground, ISS ‘ revised analysis will consider the following factors:

  • Peer group alignment.
    • The degree of alignment between the company ‘s Total Shareholder Return, or TSR, rank and the CEO ‘s total pay rank within a peer group, as measured over one-year and three-year periods (weighted 40 percent/60 percent) (“relative degree of alignment”);
    • The multiple of the CEO’s total pay relative to the peer group median (“multiple of median”).
  • Absolute alignment. The absolute alignment between the trend in CEO pay and company TSR over the prior five fiscal years – i.e., the difference between the trend in annual pay changes and the trend in annualized TSR during the period (“pay-TSR alignment”).

In cases where alignment appears to be weak, further in-depth analysis will determine causal or mitigating factors, such as the mix of performance- and non-performance-based pay, grant practices, the impact of a newly hired CEO, and the rigor of performance programs.

The new guidance has some utility in further understanding the ISS methodology but to many the ISS methodology will still be a black box.  Some highlights from the ISS guidance are set forth below.

What Does ISS Measure?

 ISS stresses it measures total compensation as set forth in the summary compensation table.  ISS feels this is a better measure than “realized” compensation for a number of reasons.  One reason is that is how companies benchmark their pay practices.  ISS focuses on the CEO’s pay because that package sets the “compensation pace” at most companies; also the compensation committee and board are most directly involved in and accountable for the decisions that generate the CEO’s pay.  ISS utilizes a standard set of assumptions to value equity-based grants, but the guidance does not suggest what those standard assumptions might be.

As for performance, ISS uses the TSR benchmark.  While there might be many ways to do this, ISS believes this is what shareholders want and it is objective and transparent.

Peer Group Alignment

Two measures are used, the “relative degree of alignment” and the “multiple of median.”

Relative Degree of Alignment (RDA)

The relative degree of alignment measure addresses the question: Is the pay opportunity delivered to the CEO commensurate with the performance achieved by shareholders, relative to a comparable group of companies? The measure compares the percentile ranks of a company’s CEO pay and TSR performance, relative to a comparison group of 14-24 companies.

Peer groups are generally constructed with reference to the company’s industry (based on GICS classification), revenue (or assets with respect to financial companies), and market value.  The comparison companies selected by ISS are not intended to serve the function that a “peer group” does for a board of directors when it benchmarks executive pay. Boards use peer groups to help determine an appropriate pay package for attracting and retaining executive talent.  The ISS comparison groups are intended, rather, to help evaluate the alignment of executive pay and company performance that results from a board of directors’ pay decisions over time.  Further details on the construction of peer groups are set forth in the appendix to the guidance.

To determine relative degree of alignment, the subject company’s percentile ranks for pay and performance are calculated for one- and three-year periods.  Because of the sensitivity of TSR to overall market performance, annualized TSR performance for all companies (subject company and comparison companies) will be measured for the same period: that is, the one- and three-year periods ending on the last day of the month closest to the fiscal-year end of the subject company. To illustrate: if a company’s fiscal year ends on November 29, 2011, then all TSRs will be measured over the periods December 1, 2010-November 30, 2011 (for one-year) and December 1, 2008-November 30, 2011 (for three-year).

Combined percentile ranks for pay and for performance are calculated, based on a 40% weighting for the one-year and a 60% weighting for the three-year ranks. The relative degree of alignment is equal to the difference between the ranks: the combined performance rank minus the combined pay rank.  If three years of data are not available for the subject company, the combined measure will reflect only the one-year rankings.

Values for the relative degree of alignment measure range between -100 and +100, with -100 representing the high pay for low performance (i.e., 100th percentile pay combined with 0th percentile performance), zero representing a high degree of alignment (the pay rank is equal to the performance rank), and positive values representing high performance for low pay.

Multiple of Median (MOM)

This multiple of median measure addresses the question: Is the overall level of CEO pay significantly higher than amounts typical for its comparison group? Is the company significantly more than comparable companies, even for strong performance?

Calculating this measure is straightforward: the company’s one-year CEO pay is divided by the median pay for the comparison group.  Values can therefore range from zero (if the subject company paid its CEO nothing) to infinity. In ISS’ back-testing analysis, the highest observed value was just over 25 times peer median.

Pay-TSR Alignment (PTA)

ISS’ new measure of long-term absolute alignment is intended address the question: have shareholders’ and executives’ experiences followed the same long-term trend? It is important to note that PTA is not designed to measure the sensitivity of CEO pay to performance – whether pay and performance go up and down together on a year-over-year basis. It is a long-term measure of directional alignment.

If you have managed to follow the calculations so far, this is where it gets really mind numbing:  At a high level, the measure is calculated as the difference between the slopes of weighted linear regressions for pay and for shareholder returns over a five-year period. This difference indicates the degree to which CEO pay has changed more or less rapidly than shareholder returns over that period.

The trend lines calculated by these regressions are analogous to a 5-year “trend rate” for pay and performance, weighted to reflect recent history. The final pay-TSR alignment measure is simply equal to the difference: performance slope minus the pay slope. Potential values for PTA are theoretically unbounded, but in practice they range from just over -100% to just over 100%,

Qualitative Evaluation

If misalignment in pay-for-performance quantitative measures is detected, ISS will perform an in-depth qualitative assessment to determine either the likely cause or mitigating factors.  The ISS guidance indicates a number of factors that ISS may consider.

For example, if a company exhibits long-term disconnect between pay and performance, ISS closely examines its disclosed benchmarking approach to determine whether that may be a contributing factor. For example, a preponderance of self-selected peers that are larger than the subject company may drive up compensation without regard to performance. Above-median targeting may have the same effect.

Special circumstances are also considered.  The qualitative analysis may also consider exceptional situations, such as recruitment of a new CEO in the prior fiscal year or unusual equity grant practices (e.g., bi- or triennial awards) that may distort a quantitative analysis.  Recruiting a new CEO is not a free pass however.  While shareholders may welcome a new CEO in light of lagging performance, they may nevertheless be concerned about a board that has been forced to pay dearly for outside talent but fails to appropriately link the new CEO’s pay to performance improvement.

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