ISS Issues 2013 Policy Updates
Institutional Shareholder Services, the prominent corporate governance advisory services firm, has updated its U.S. corporate governance benchmark policy guidelines for 2013. In the aftermath of the criticism it received with respect to its new “pay for performance” methodology for evaluating the link between corporate performance and executive pay (which is a key consideration in how ISS formulates its voting recommendation on a company’s Say-on-Pay proposal), this update largely focuses on a pair of refinements to this methodology. The update also reflects a handful of other changes being made to the corporate governance policies that ISS will use to determine its voting recommendations for its proxy advisory clients during the upcoming 2013 proxy season.
The ISS’ Benchmark U.S. Corporate Governance Policies can be accessed here »
The updated policies are effective for shareholder meetings held on or after February 1, 2013.
As in past years, these policy updates may present significant challenges for companies with late fall fiscal year-ends (and, consequently, annual meetings of shareholders scheduled for early 2013) since there will be little practical experience with the changes until well into the proxy season. Further, since ISS doesn’t issue its frequently-asked questions and answers or other guidance on its policies until mid-December, these companies will be hard pressed to ascertain the potential impact of the policies on their executive compensation programs and the attendant ISS analysis of these programs before the deadline for filing their proxy materials.
Three Things Technology and Life Sciences Companies Should Know About the ISS Policy Updates
- Evaluating Say-on-Pay Proposals. In response to significant criticism of the pay-for-performance methodology that it introduced in 2012, ISS will (a) evaluate the industries reflected in a company’s own compensation peer group as a possible input in analyzing the degree of alignment between a CEO’s total compensation ranking and the company’s total shareholder return ranking and (b), in the case of “large cap” companies, add a comparison of the CEO’s “realizable pay” to his or her “granted” pay to its qualitative evaluation of factors that may work to encourage or undermine long-term value creation and alignment with shareholder interests
- Pledging of Company Stock. Responding to long-standing shareholder concerns, ISS will treat the presence of significant pledging of company stock as a “problematic” pay practice that may lead to an “against” or “withhold vote” recommendation relating to the election of the board of directors. In addition, the presence of any stock hedging arrangements will lead to an “against” vote recommendation
- Say-on-Golden Parachute Votes. ISS has revised its policy for evaluating a Say-on-Golden-Parachute advisory vote proposal to include a review of legacy change in control arrangements
Significance of Policies
As a long-time advisor to the institutional investor community, ISS is the bellwether for the key shareholder issues to be addressed each proxy season. ISS regularly publishes annual updates to its standards on good corporate governance and executive compensation policies and practices. These standards, which are contained in a series of policy statements, including a comprehensive “Executive Compensation Evaluation” policy statement, are used by ISS to formulate the voting recommendations that it provides to its clients for the election of directors, the shareholder advisory vote on executive compensation required by the Dodd-Frank Wall Street Reform and Consumer Protection Act, and other proposals submitted for shareholder action at annual meetings of shareholders, as well as to analyze companies’ corporate governance and executive compensation policies and practices.
While most technology and life sciences companies focus on the policy updates that affect their corporate governance structure and executive compensation programs, the updates actually encompass a broader range of social and environmental matters (such as political spending and workplace safety issues).
This article summarizes the policy updates for 2013 that affect executive and equity compensation matters.
Evaluating a Say-on-Pay Proposal
ISS’ new methodology for analyzing an executive compensation program in the context of a Say-on-Pay proposal generated the most attention – and controversy – of all its policy guidelines during the 2012 proxy season. Using separate quantitative and qualitative analyses, the methodology begins with a quantitative assessment of the company’s CEO’s compensation (starting with the compensation reported in the Summary Compensation Table, or “SCT,” but using ISS’, own approach for valuing stock options) and financial performance (based on its total shareholder return) relative to an ISS-constructed peer group.
ISS came under severe criticism from many quarters for two key aspects of this methodology. First, it was criticized for the peer group selection process, which largely ignored the company’s own compensation peer group. As many companies pointed out, frequently the ISS peer group failed to recognize that a company operated across multiple business lines, resulting in the omission of direct competitors and/or the inclusion of wholly unrelated companies. Secondly, it was criticized for using an accounting-based “fair value” approach to determine the long-term incentive (including equity) portion of a CEO’s annual pay. In 2012, investors began to express an interest in understanding, in the case of equity awards and other forms of long-term incentive compensation, their actual (and potential) outcomes when evaluating pay and performance.
For the 2013 proxy season, ISS has revised its methodology to address each of these criticisms as follows:
Peer Company Construction
ISS will now use information from a company’s self-constructed compensation peer group to identify and prioritize industry sectors based on the Global Industry Standard Classification (“GICS”) system (a national industry taxonomy developed by MSCI and Standard & Poor’s) beyond the company’s primary GICS classification. In other words, ISS will generate its peer group after considering both a company’s specific GICS group as well as any other GICS groups represented in the company’s self-constructed peer group, while maintaining the approximate proportions of these industries in its peer group, where possible. ISS will focus initially at the 8-digit GICS level rather than more specific levels.
In addition, when selecting peer companies, ISS will prioritize peers that maintain the company near the median of its peer group (in terms of revenue), are in the company’s compensation peer group, and that have themselves selected the company as a peer. (For many technology and life sciences companies, this emphasis on revenue may result in an ISS-generated peer group that contains companies with significantly smaller market capitalizations than the subject company.) As was the case this year, ISS will continue to maintain its focus on identifying companies that are reasonably similar in terms of industry profile, size, and market capitalization when generating its peer group.
View “Frequently-Asked Questions” published by ISS on December 4th on its peer group selection methodology here ».
Consideration of Realizable Pay
ISS is adding realizable pay as a measure to be considered in evaluating certain companies. Specifically, where a company is deemed to have a pay-for-performance “disconnect” (based on ISS’ quantitative analysis) it will compare a CEO’s realizable pay to grant date pay (the ISS-modified SCT pay) as part of the qualitative analysis.
For this purpose, “realizable pay” will consist of the sum of the relevant cash and equity-based grants and awards made to a company’s CEO during the performance period being measured, based on the actual award values for equity awards that are earned, or the target award values for ongoing awards, calculated using the stock price at the end of the performance period. Notably, ISS will revalue stock options and stock appreciation rights using the full remaining award term (rather than its expected term) and updated assumptions, as of the end of the performance period, in a Black-Scholes option pricing model.
Realizable pay will only be considered when evaluating so-called “large cap” companies (which are defined as companies in the S&P 500). In addition, this review of realizable pay will be part of ISS’ qualitative analysis of an executive compensation program and, consequently, may serve to mitigate (or exacerbate) any concerns about a company’s pay-for-performance alignment.
Observations. Although the changes that ISS is making purport to address the key criticisms of its pay-for-performance methodology, it is not yet clear how these revisions will ultimately affect the outcome of its quantitative and qualitative analyses. It appears that, to the extent that one or more of the companies in the company’s self-constructed compensation peer group are outside its own GICS group, that fact will have some effect in possibly expanding the range of potential peers that ISS will consider. Unfortunately, the time that will be required to update these peer groups using the most current financial data means that companies with annual meeting early in 2013 will be hard pressed to assess and respond to their standing under the revised methodology.
Further, as before, it appears that size (revenue and market capitalization) considerations will play a deciding factor in the selection process. While this, by itself, is not objectionable, it remains unclear whether other considerations (such as competitive status and location) – which often influence the composition of a company’s compensation peer group – will carry any weight in the process. ISS has indicated that the “overlap” between a company’s self-identified peers and the peer companies that it will use should increase. Of course, only time will tell if this, in fact, is the case. Consequently, companies will go into the 2013 proxy season still unsure of which companies they will be compared against for purposes of ISS’ pay-for-performance methodology.
As for the inclusion of realizable pay in the qualitative analysis, ISS’ decision to re-calculate the “fair value” of stock options using the full remaining option term, rather than simply use an option’s “intrinsic value,” simply perpetuates the principal problem with how it computes a CEO’s total compensation in the first place. Since companies universally do not consider the value of equity awards as reported in the SCT (regardless of how their “fair value” is determined) to be reflective of how a company’s performance affected an executive’s pay, this decision does nothing to alter that shortcoming in ISS’ current analysis. Instead, it simply changes some of the assumptions that go into the computation; but, curiously enough, not the most important assumption – the option’s term – since ISS has indicated that it will still use the full remaining contractual term (instead of the expected term) in valuing an option. This could lead to some unusual – and potentially distortive – results. For example, an “underwater’ stock option valued by ISS using its remaining contractual term may have a “fair value” that is greater than the “fair value” originally assigned to the option by the company on its grant date using an expected term assumption.
Once again, it is only one of several factors that will be assessed as part of the qualitative analysis and, thus, it is unclear as to how much weight this factor will carry. Further, it will only be used when evaluating large cap companies. Finally, realizable pay is being compared to “granted” pay rather than to the company’s actual performance. Currently, this is not how this data has been used, so it remains to be seen what impact it will have on the ISS analysis. At a minimum, this change is likely to significantly increase the number of presentations in the Compensation Discussion and Analysis comparing performance to realizable pay where a company has a good story to tell.
While we don’t have all of the information as to how these changes will operate, we are starting to obtain clarification on some important issues as ISS has begun to publish its “Frequently Asked Questions” providing additional guidance on how the updated policies will be applied. Among the question that we expect to be answered are the following:
- How will ISS make use of the expanded range of possible peer group companies while, at the same time, maintaining the approximate proportions of the industries (as selected by the subject company) in its final peer group?
- Whether, as part of its realizable pay comparison, ISS will take into consideration a company’s actual performance to date for ongoing performance periods?
Pledging of Company Shares
ISS is adding the pledging of company stock to its list of “problematic” pay practices. However, rather than treating such a practice as automatically prohibited and impacting its Say-on-Pay proposal evaluation, ISS will assess a company’s pledging activity (if any) on a case-by-case basis and, where deemed significant, treat stock as a failure of risk oversight and, thus, an area where directors should be held accountable.
In formulating its vote recommendations for the election of directors at companies where executive officers or directors have pledged company stock, the following factors will be considered:
- The presence in the company’s proxy statement of an “anti-pledging” policy that prohibits future pledging activity;
- The magnitude of the aggregate pledged shares in terms of total common shares outstanding or market value or trading volume;
- The disclosure of progress (or lack thereof) in reducing the magnitude of the aggregate pledged shares over time;
- The disclosure in the company’s proxy statement that stock ownership and holding requirements do not include pledged company stock; and
- Any other relevant factors.
Separately, ISS will treat the hedging of any company stock (whether acquired in a compensatory or open- market transaction) as a “problematic” pay practice without regard to the amount involved. Thus, the disclosure of a hedging arrangement will result in an “against” or “withhold vote” recommendation on the election of directors.
Observations. The addition of share hedging in any amount as a significant “problematic” pay practice, coupled with the SEC’s forthcoming rules as required by the Dodd-Frank Act regarding the disclosure of companies’ share hedging policies, should lead companies that don’t currently have an anti-hedging policy in place to consider adopting one. In addition, companies that have allowed their executive officers to pledge shares of company stock will need to determine how to disclose such arrangements, as well as how to unwind these arrangements over time and/or prohibit new pledging transactions prospectively.
In addition to the more well-known Say-on-Pay vote and its related shareholder advisory vote on the frequency of future Say-on-Pay votes, the Securities Exchange Act of 1934 requires a third shareholder advisory vote involving the approval of any compensation payable to named executive officers in connection with a merger, acquisition, or other corporate transaction. During the 2011 and 2012 proxy seasons, ISS evaluated proposals to approve this so-called “golden parachute” compensation, using its policies on “problematic” pay practices related to severance packages.
Going forward, ISS will consider existing change-in-control arrangements maintained with named executive officers, rather than focusing primarily on new or extended arrangements, in formulating its vote recommendation. “Problematic” pay practices or features that may trigger an “against” vote recommendation include one or more of the following, depending on the number, magnitude, and/or timing of issue(s):
- “Single-trigger” or modified “single-trigger” cash severance arrangements;
- “Single-trigger” acceleration of unvested equity awards;
Excessive cash severance payments (that is, payments in excess of three times base salary and bonus);
- The actual trigger and payment of an excise tax “gross-up” (as opposed to a provision to provide excise tax gross-ups);
- Excessive “golden parachute” payments (on an absolute basis or as a percentage of transaction equity value); or
- Recent amendments that incorporate any problematic features (such as those above) or recent actions (such as extraordinary equity awards) that may make packages so attractive as to influence merger agreements that may not be in the best interests of shareholders; or
The company’s assertion that a proposed transaction is conditioned on shareholder approval of the Say-on-Golden-Parachute vote.
Where approval of the change-in-control arrangements has been incorporated into a company’s Say-on-Pay Vote (which is permitted by the Dodd-Frank Act to enable companies to potentially sidestep the separate vote at the time of the transaction), ISS will evaluate the Say-on-Pay proposal using the same guidelines, which may give greater weight to that component of the overall evaluation of the company’s executive compensation program.
Observations. Even though ISS is increasing its scrutiny of change-in-control arrangements generally, as well as in the context of a Say-on-Golden-Parachute vote, it is unlikely that this update will have a dramatic effect on corporate transactions and current design and disclosure practices. Of the approximately 100 companies that have conducted Say-on-Golden-Parachute votes and reported the results of these votes, only a handful of votes failed to receive at least majority support (70% of the companies received 80% or greater support of their Say-on-Golden-Parachute proposal) and not one of the votes had an adverse impact on the approval of the related transaction. Thus, even though (as ISS reports) the Say-on-Golden-Parachute vote has received, on average, 10%-15% less support than the related transaction, it is unclear that companies or investors have placed much weight on the impact of the vote.
Other Policy Updates
In addition to the foregoing changes involving ISS’ executive compensation policies, it has also made changes to its corporate governance policies, including the following:
- For annual meetings of shareholders in 2014 and thereafter, ISS will recommend an “against” or “withhold vote” from individual directors, committee members, or the entire board of directors as appropriate if the board failed to act on a shareholder proposal that received the support of a majority of the shares cast in the previous year
- Generally, ISS will recommend an “against” or “withhold vote” for directors who attend less than 75% of the aggregate of their board and committee meetings for the period for which they served, unless an acceptable reason for these absences is disclosed in the company’s proxy statement or another SEC filing
- Generally, ISS will recommend an “against” or “withhold vote” for an individual director who sits on more than six public company boards; or is the CEO of a public company who sits on the boards of more than two public companies besides his or her own company
ISS will be publishing a series of “Frequently Asked Questions” during December that will provide additional guidance related to some of its new policies. It is expected that this guidance will address several of the most common questions that are likely to arise in connection with the application of its pay-for-performance methodology.
Compensia has significant experience in helping companies understand and address ISS’ corporate governance and executive compensation policies. If you have any questions on the topics covered in this Thoughtful Pay Alert or would like assistance is assessing how the policies are likely to affect your executive compensation program, please feel free to contact us.