Advisory Panel Observations of the Options Policies Forum

Advisory Panel Observations of the Options Policies Forum

March 30, 2007

Note: This report was prepared by the Forum’s chairman with the concurrence of its Advisory Panel, the members of which may append individual comments.

Based on observations of the Forum program’s meetings, workshops and other communications, the following three principles are proposed for consideration by marketplace decision-makers as a foundation for addressing issues relating to stock options policies and other equity-based forms of management compensation:

Common interest: Corporations are organized for the essential purpose of governing the common interests of investors and managers in the competitive success of a business enterprise. Although this purpose can be undermined by short-term financial, professional or political interests, most investors and managers will ultimately benefit from the fair sharing of economic risks and rewards associated with their enterprise.
Shareholder rights: Grants of management equity participation, whether in the form of stock options or any other interest that dilutes shareholder interests in their capital investment, can be authorized only with the fully informed consent of shareholders.
“Guidance” relating to performance: The compensation risks and rewards a company’s management has accepted are a highly credible indication of the shareholder value objectives they expect to achieve. Investors must therefore be able to understand the relevant conditions of management compensation, and particularly its relation to performance goals, as a basis for informed capital allocation and voting decisions.

These principles were defined in the context of increasingly evident support for marketplace processes that encourage actual investor and corporate decision-makers to resolve issues based on their shared objectives. This was demonstrated most clearly in the broad consensus among both investor and corporate Forum participants who saw advisory voting on compensation as a constructive communication process that should be adapted on a company-specific basis, rather than as an adversarial “say on pay” enforcement tool requiring legislated imposition.[1]

Members of the Forum’s Advisory Panel may be appending their individual comments to this report, and those statements will be distributed as they become available. The Forum will also be addressing further attention to the report’s proposed principles in its continuing activities, including the project for developing “validation processes” with membership organizations representative of relevant marketplace decision-making constituencies.[2]

Forum participants are of course invited to offer their views relating to these principles, and to the associated Forum projects.

GL – 3/30/07

Forum chairman:

Gary Lutin

Lutin & Company, 575 Madison Avenue, New York, New York 10022

Telephone: 212-605-0335

Email: gl@shareholderforum.com

Members of the Advisory Panel:

Amalgamated Bank/Longview Funds: Julie Gozan, Cornish F. Hitchcock

Association of BellTel Retirees: C. William Jones

Blue Harbour Group: David Silverman

Delaware Investments/Lincoln National: Kenneth Broad

Federal Reserve Bank of Richmond: Thomas J. Mackell, Jr.

Forbes: Vahan Janjigian

Hermes Equity Ownership Services: Bess Joffe, Paul Munn

Palmer Brennan; also NYSSA: Peter F. Brennan

Pfizer: Margaret M. Foran

Putnam Mutual Funds: John A. Hill

Reda & Associates: James F. Reda

Reinhart Boerner Van Deuren; also International Roundtable on Executive Remuneration: Keith L. Johnson

[1] See item #2 in the Forum Report of its December 6, 2006 Open Meeting, and the first two bullet-point sections in the Forum Report of its March 7, 2007 Open Meeting summarizing participant views captioned “Broad appreciation of advisory voting benefits” and “Disagreement about purpose and means of adapting advisory voting.” These observations were validated in a subsequent survey of security analyst members of the CFA Institute, reporting in a preliminary March 30, 2007 release that 76% of the 2,239 initial respondents supported advisory voting but that 68% opposed its legislative imposition.

[2] See item #1 in the concluding section of the Forum Report of its March 7, 2007 Open Meeting. See also the previous footnote’s example of the CFA Institute survey reporting responses by representative investor constituency decision-makers.

Options Policies Forum Advisory Panel Observations

Supplemental Comments Submitted by Keith Johnson

April 2007

Common Interest

Stock options can provide an effective means of aligning the interests of company management and shareowners. However, poorly designed option plans can also create incentives to manipulate financial performance and produce short-term gains at the expense of long-term company health. The Advisory Panel’s observations on “common interest” merit delineation of several related principles:

Options are inherently a long-term compensation vehicle and will be most likely to produce the desired alignment of interests when compensation committees are able to integrate option plan incentives with the company long-term business plan.
Stock option plans can be counterproductive when they are not performance-based. Consideration should be given to vesting requirements that use both company operational goals and stock performance criteria. Minimum equity ownership requirements and holding periods for vested awards should also be employed in order to maximize alignment of management with long-term shareowner interests.
Greater customization of option plans to company-specific circumstances and business goals may make comparisons across companies, even in the same industry, less meaningful. Implementation of a pay for performance philosophy requires use of compensation consultants with skills that go beyond knowledge of compensation surveys.

Shareholder Rights

The concept of shareholder rights imposes responsibilities to shareholders on directors. However, it also implies that shareholders have an obligation to exercise their rights responsibly. Both boards and shareholders will have to allocate appropriate resources to evaluating and understanding option plan and other executive compensation issues.

The new SEC executive compensation disclosure requirements have turned the annual proxy into a vehicle that companies could use to effectively communicate how their option plans are designed to produce pay for performance. It is up to boards to wrest control of the Compensation Discussion and Analysis portion of the proxy away from the company's lawyers and use it as a shareholder communication tool. However, board action alone will be insufficient if shareowners do not also develop the skills, or acquire the resources needed, to understand and evaluate the incentives built into each company’s compensation plan.

Performance Guidance

Companies send signals to the marketplace both by what they do or do not say about the design of their stock option and other executive compensation plan components and by how they say it. Boards would be well advised to retain and cultivate non-conflicted sources of advice on compensation plan design issues, as well as on how the marketplace perceives the incentive structures built into their company's compensation plan.

Communication is a two-way street. Compensation committees and shareowners that cannot both convey their views effectively and listen to feedback openly are likely to find themselves at a disadvantage as the marketplace develops a better understanding of executive compensation incentive scheme ramifications.

Hermes Equity Ownership Services – Comments on Advisory Panel Observations of the Options Policies Forum

27 June 2007

As fellow members of the advisory panel, we have reviewed the Forum Report published on 30 March 2007 and agree in substance with its observations.

In general, we would prefer market participants to be the drivers of best practice rather than rely on regulators. Inasmuch as Forum participants sought to do this, we were pleased to take a lead role.

As is stated in the Observations, equity-based compensation for managers is intended to align the interests of management and shareholders and also to properly incentivize management in their achievement of corporate goals. Given these objectives, it is particularly disturbing that a number of companies were implicated in backdating scandals since backdating effectively negates these objectives by removing both the alignment of interests and the element of risk.

However, we continue to believe that equity-based compensation, when granted within the confines of reasonable structures and approved by shareholders, can be used to the benefit of all market participants.

Performance Criteria and Disclosure

As such, we advocate the use of equity-based compensation that is linked to objective performance criteria (ie. not simply tied to stock price appreciation) in order to effectively tie this variable compensation to the successful achievement of corporate goals. Moreover, in order to be able to assess whether these compensation plans are actually linked to performance, shareholders should be provided with full disclosure of types of awards, performance measures employed and targets for payout levels. We note that this is not intended to be an exhaustive list, but that the disclosure surrounding compensation should clearly express the company’s philosophy regarding executive compensation and should also reflect the discussions that the board had in arriving at the final decisions.

Advisory Vote on Compensation

As a final check on this system, we strongly recommend that companies voluntarily ask shareholders to vote annually on executive compensation on an advisory basis. In this way, shareholders will be able to express their views and companies will be motivated to continually engage with shareholders on compensation matters.

Hermes has experience of voting on compensation committee reports in various markets around the world, and has seen the significant benefits which such votes can bring for the relationships between companies and their shareholders. Since the UK introduced this rule in 2002, it has successfully provided shareholders with a basis for dialogue with remuneration committees and boards of companies where there are concerns regarding compensation. While the concept was first introduced in the UK, there is a growing international consensus in its favour. Such votes are now compulsory in the UK, the Netherlands and Australia. They are also being considered elsewhere; for example, we are aware of South Africa’s Companies Bill which currently includes a requirement to put the remuneration report up for shareholder approval.

Such votes need not generate controversy and dissonance between companies and their shareholders. In fact, the contrary has been the experience so far. Of the hundreds of times such resolutions have now been considered by shareholders around the world, they have been defeated in only a handful of cases. The significant impact of the right to approve the remuneration report is that there has been a dramatic increase in the level and quality of discussion between remuneration committees and investors.

Our view is that the US market would benefit from such an improvement in dialogue between companies and investors. The contact between US companies and their investors is currently typified by a confrontational atmosphere whereby contact is more likely to be through legal formality than by healthy dialogue in pursuit of a mutual understanding of objectives. Such dialogue is one way in which to build more concrete accountability of board directors to the shareholders on whose behalf they work. We believe that more accountability would be a basis for less prescriptive regulation of companies; certainly the European experience is that there has been much less demand for detailed regulatory rules because there are better mechanisms for ensuring that directors are accountable to, and actively pursuing the interests of, shareholders.