Proxy table changes 021513

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Timing is Everything – Recommendations for Fixing the Timing Disconnect in the
Summary Compensation Table

February 2013
Proxy disclosure rules have undergone sweeping, metamorphic changes over the last decade. New
comprehensive compensation tables, Dodd-Frank, “Say on Pay,” the CD&A (Compensation Discussion &
Analysis section), and evolving shareholder advisory firm assessment methodologies and influence,
among other things, have all been enacted over the years to help enhance the transparency of company
pay decisions.

With all these changes, the equity values disclosed in the Summary Compensation Table (SCT) remain
regrettably disconnected from the time period for which the decisions on the vehicles and amounts
were made. This timing disconnect can lead to inaccurate conclusions about pay and performance by
analysts, shareholder advisory firms, the media, etc., who rely on the SCT to inform their analysis, since
the performance against which the SCT pay is compared may reflect different time periods. These
inaccurate conclusions can then also have significant implications for say-on-pay votes and Board of
Director elections, along with reactionary changes to executive pay programs by companies, which may
not be warranted, necessary or in the company’s best interest.

Pay-For-Performance Timing Disconnect
Issue – The current rules for the SCT can result in inaccurate conclusions about pay for performance
alignment since the pay required to be disclosed may reflect multiple performance periods.

One of the main tools companies use for making decisions about executive pay levels and pay plan
design changes is the pay-for-performance analysis for the CEO, whereby company pay (both target and
actual) and financial performance are compared to a selected group of peer companies (the “Peer
Group”)1. Peer Group proxy and financial data is usually extracted directly through required SEC filings,
or through a database service that can aggregate the data with appropriate oversight and quality
assurance protocol. Because of the current proxy disclosure rules, the data displayed in the SCT will
overlap multiple years and decision making cycles, which can lead to inaccurate conclusions about the
pay for performance relationship.

1
For information on how to select appropriate and defensible Peer Groups, please visit the Resource Section of
our website at www.dolmatconnell.com

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The SCT requires that companies report the following:

Non-Equity
Stock Option All Other
Year Base Salary Bonus Incentive Plan Total
Awards Awards Compensation
Compensation
2012 $507,423 -- $900,000 $900,000 $450,000 $10,000 $2,767,423

Based on the table above, the company is showing all pay received, earned or awarded in 2012.
However, some of the decisions that led to that disclosed pay were based on 2011 and 2012
performance. For example,

1) Base Salary – One reason base salary is not displayed as rounded a number as one might expect,
is that the amount reflects the actual base salary received in 2012, which includes a pro-rated
portion of pay at an old salary rate (prior to any increase) and the new rate. For calendar fiscal
year companies, pay adjustments are often effective March or April 1 (although some
companies have rate increases retroactive to Jan 1), so the disclosed rate often reflects 2-3
months of the old rate and 9-10 months of the new rate. Decisions on base salary are often
based on prior year performance and reflect additional responsibilities as companies grow, so
for this pay element, the pay-for-performance relationship and disclosure are aligned, although
as you’ll see below, our recommendation is to also show the new annualized rate.

2) Non-Equity Incentive Compensation – This pay element is most often the annual bonus from a
formal plan that an executive received based on individual or company performance, or both. In
our example, the amount would be paid in 2013, for 2012 performance and disclosed in the
2012 year. This relationship is exactly what we want to see for this pay element. We want to
know, based on 2012 performance, how much of the target bonus did the executive actually
receive. Accordingly, pay, performance and disclosure are all aligned for this pay element. As
you’ll also see below, we are also recommending that the target amount be included in the SCT.

3) Equity Awards (Stock and Option Awards) – These columns create the main issue of
misalignment under the rules. Unlike the bonus, the equity awards disclosed here will reflect the
awards made in 2012 for 2011 performance, not the 2013 awards for 2012 performance. This
remains the most glaring disconnect in the entire proxy disclosure, and therefore, pay,
performance and disclosure for this pay element are significantly misaligned.

4) Pay-for-Performance Timing Misalignment – As described above, the SCT currently illustrates
the pay-for-performance relationship accurately and along the appropriate time frames for only
two out of the three critical and most material pay elements. Because equity usually comprises
the largest pay element for most executives, the effect of this is timing misalignment becomes

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magnified and ultimately can lead to inaccurate conclusions about the pay-for-performance
relationship.

Since the SCT does not tally the entire actual pay for the year, trying to ascertain it often requires
searching for the proverbial needle in a haystack, through pages and pages of text to try to piece it all
together. Target pay, when disclosed, also often needs to be pieced together through multiple tables
and pages of text as well. Other public sources exist to consult in trying to piece together the most
current compensation provided, such as 8-Ks and Form 4s, which generally require companies to report
material changes to compensation plans and recent equity grants, respectively, much closer in proximity
to when the decisions are made. Those filings, however, are more time consuming and costly to
research, and more importantly are usually bare bones and devoid of the underlying rationale that the
typical CD&A section typically provides. Consequently, relying on this information may not provide the
most accurate or complete depiction of the total actual or target compensation for a particular
executive. So, we are generally left with the SCT, and due to the mis-alignment of the pay decision and
disclosure timing, it can lead to inaccurate conclusions.

Recommendation

1. Change the Rules – If there is an interest in retaining the current rules, as they generally line up
with the financial statements for the particular year, our suggestion is to simply mandate the
inclusion of another table of current year pay decisions and future target pay. For example:

Non-Equity All Other
Base Stock Option
Year Bonus Incentive Plan Compensation Total
Salary Awards Awards
Compensation (Estimated)
2013 Target $510,000 -- $1,000,000 $1,000,000 $510,000 $10,000 $3,030,000
2012 Actual $507, 423 -- $900,000 $900,000 $450,000 $10,000 $2,260,000
2012 Target $505,000 -- $1,000,000 $1,000,000 $505,000 $10,000 $3,020,000

Or the table can be broken up into target and actual pay, categorizing the information according
to the type of pay:

Target Compensation

Base Stock Option
2013 Target $510,000 -- $1,000,000 $1,000,000 $510,000 $10,000 $3,030,000
2012 Target $505,000 -- $1,000,000 $1,000,000 $505,000 $10,000 $3,020,000

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Actual Compensation

Base Stock Option
2012 Actual $507, 423 -- $900,000 $900,000 $450,000 $10,000 $2,260,000

These tables show the 2012 target opportunity (set based on 2011 factors), the actual amounts
paid in 2012 based on performance and other factors for 2012, and future 2013 target
opportunity. The underlying rationale for each of these line items can be described in the
accompanying CD&A. Based on the figures displayed, without further explanation, a reader
would be able to ascertain rather quickly that the company or the executive must have
underperformed in 2012 since equity awards and bonus payouts are below target and no
changes were made to future target pay opportunity. Base salary changed only slightly, likely to
reflect changes to the organization scope (e.g., higher revenue base) and market trend, and
therefore, by extension, the executive’s responsibility.

2. Provide Supplementary Tables – Many companies are already voluntarily providing
supplementary tables like the one above or variations thereof to help more accurately tell their
story. Unfortunately, the current rules do not (yet) mandate a standardized format, making
consistent comparisons across companies challenging, and in some cases, flawed given the
disconnect in timing of the performance and the pay decision. We generally recommend that in
addition to complying with the disclosure rules, companies provide supplemental information
about decisions for the current year, better aligned with the prior performance in 2012. By
doing so, the company can demonstrate the decisions that led to 2012 pay decisions and those
that led to 2013 pay decisions. Additional work should be minimal as similar tables have already
likely been prepared for the internal discussions and decision making. By providing that
additional disclosure, companies will be able to better communicate their story of how pay
decisions were made, including what role performance played in the decisions.

Rationale

Increases Response Time to Shareholder Feedback

This main issue with the current rules is that shareholders may be voting on pay decisions that occurred
over twelve months ago, when decisions for the current year usually have already been made. If the
goal is for shareholders to have a “say” on pay, why have them wait almost two years before any
changes would take place. For example, if shareholders vote down the say-on-pay vote in the 2013
proxy for 2012 decisions, the company has likely already made 2013 pay decisions based on 2012
performance, so they would not likely change practices until 2014, nearly two pay cycles after the
negative vote. If however, they were casting their vote that also included the recent decisions for 2013,

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changes could be implemented in 2013 for 2014 awards and improvements shown in time for the 2014
vote.

We have seen some commentators suggest companies adjust their grant date timing to later in the year
to accommodate shareholder advisory pay-for-performance assessment models, which rely heavily on
the SCT. Suggesting that companies adjust their performance management cycle, before they would
have all the requisite performance information, so that it looks more favorably by a system that is
inherently flawed because of the disclosure rules may address the symptom, but does not address the
cause.

Re-Aligns Disclosure of the Pay Decision with the Performance

Moreover, by showing the 2012 actual pay and 2013 target pay changes, the shareholders would have
the most current pay information, which they can use to compare against the most current performance
information in order to assess the quality of the decision-making. For calendar year companies, they
would have total shareholder return and full year performance information through 12/31 to make peer
comparisons. Boards and Companies will also be able to more accurately describe their reasoning for
making the decisions they made both from the prior year (which likely occurred in the beginning part of
the year) and the current year. The example below highlights this disconnect:

Assume the Company awarded a $500K equity award in 2013, $1M equity award in 2012, and
$800K award in 2011. For the 2013 proxy, the Company would disclose the $1M award in 2012,
which would suggest a 25% year-over-year increase from 2011 to 2012 ($800K to $1M). Let’s
also assume that the Company’s total shareholder return for 2012 was -15% and in the bottom
quartile of the Peer Group. Due to the disclosure disconnect, this company would look like they
increased pay during a year in which the company had significantly underperformed. When in
reality, the opposite is true, since they reflected the poor performance in the significantly
smaller 2013 equity award, and therefore, had strong pay-for-performance alignment.

Conclusion
Rule changes take time. In the meantime, companies should consider the use of supplemental tables,
where appropriate, to ensure that they accurately, completely, and transparently tell their story, so that
those reading it will have a better chance of understanding how, when, and why pay decisions were
made. Our hope is that companies are not forced to abandon their current approach to their robust and
comprehensive talent and performance management process and make equity grants at the wrong
time, just so that the timing syncs up with external methodologies for measurement based on flawed
rules.

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For More Information
This article is intended for informational purposes only and is not meant to be relied upon as specific
advice. For more information about this article, please contact Justin Fossbender at 781-496-3406 or at
Justin_Fossbender@ajg.com. Justin is a Principal consultant out of the firm’s Boston office.

About Connell & Partners
At Connell & Partners, we help clients develop strategic compensation plans that are aligned with
shareholder interests and deliver competitive advantage to attract, motivate and retain a high caliber
workforce. We specialize in executive compensation consulting that is dedicated to providing
independent, insightful, and innovative advice in all areas of executive compensation and Board of
Directors remuneration.

Connell & Partners is an independently run division of Gallagher Benefit Services, which is a division of
Arthur J. Gallagher (NYSE:AJG), a $2.4B insurance brokerage and risk management services firm.

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