Contact: Mercer Feedback
Written by: Mark Borges, Kelly Crean
Institutional Shareholder Services (ISS), the leading US proxy advisory firm, has announced significant changes to its proxy voting guidelines for executive and equity compensation matters that will have an impact on its voting recommendations for the upcoming proxy season.
These changes, sparked by ongoing concern about the relationship between CEO compensation and corporate performance, will affect recommendations relating to the reelection of directors who serve on a company’s compensation committee and the adoption or amendment of an equity compensation plan.
This Alert! reviews ISS’s approach for making recommendations and discusses its equity compensation guidelines, including the new pay-for-performance requirements and their implications for compensation committees. In our view, ISS’s new requirements may pose serious challenges for companies, and it is not yet clear whether they will in fact help make executive compensation more commensurate with performance.
ISS has significant influence on corporate governance and equity compensation matters. It provides proxy and corporate governance services to approximately 1,000 institutional and corporate clients in the US and Europe. It also analyzes proxy statements and issues voting recommendations on proposals submitted for shareholder action at over 10,000 US and 10,000 non-US companies’ annual meetings each year.
ISS updates its criteria annually for making voting recommendations to reflect its current position on both US and global corporate governance issues. Generally, these criteria address matters such as board composition and independence, the categorization of directors (independent or affiliated), shareholder proposals, and executive and equity compensation. While clients do not always follow its voting recommendations, ISS’s criteria do influence which corporate governance issues will be scrutinized and debated each proxy season.
How ISS evaluates equity compensation
Generally, ISS evaluates an equity compensation plan being submitted for shareholder action on the basis of the plan’s cost and reasonableness. In addition, as discussed in more detail below, starting in 2004, ISS will recommend a vote against a proposed equity compensation plan if the link between CEO compensation and corporate performance is inadequate according to its new evaluation method.
In evaluating an equity compensation plan, ISS measures two costs – the “Shareholder Value Transfer” (SVT) and the “Voting Power Dilution” (VPD).
SVT is calculated using a proprietary binomial option pricing model that assesses the amount of shareholder equity that will be transferred from the company to plan participants as awards are granted. Although ISS has disclosed some information about how it calculates SVT, the precise details of its model are kept confidential. Plan proposals are evaluated together with all existing plans to provide an overall picture of a company’s equity compensation program.
VPD assesses the relative reduction in voting power that occurs as stock is issued under a compensation plan and the corresponding reduction in the ownership interest of existing shareholders.
These two costs are then combined, assigning a 95 percent weight to SVT and a 5 percent weight to VPD.
Whether the cost is reasonable
Once the cost of a proposed equity compensation plan has been calculated, its reasonableness is determined by comparing it to established caps. Each cap is industry-specific, market capitalization-based, and tied to an average amount paid by companies performing in the top quartile of their peer group. To formulate allowable caps, ISS uses a limited number of industry classifications (based on a company’s SIC code), identifies top quartile performers, and establishes SVT norms. ISS states that the percentage of companies receiving an unfavorable vote recommendation as a result of this analysis is targeted at no more than 30 percent of the companies in each industry.
ISS determines its voting recommendations primarily on the basis of this quantitative analysis. If the cost of a proposed equity compensation plan exceeds the allowable cap for a company, ISS will recommend a vote against the plan. If the cost of a proposed plan is less than the allowable cap, ISS will generally recommend a vote for the plan unless:
If a proposed equity compensation plan permits the repricing of “underwater” stock options (options that have an exercise price lower than the market price of the underlying stock) without shareholder approval, ISS will recommend a vote against the plan even if the cost of the plan is considered acceptable under its quantitative analysis. In addition, if a company has a history of repricing stock options without shareholder approval – and the applicable corporate governance listing standards or the plan itself does not prohibit the future repricing of underwater stock options without shareholder approval – ISS will recommend a vote against the plan.
New “pay for performance” policy
In early January ISS announced that, in addition to the general voting criteria described above, starting with the 2004 proxy season, it will apply new criteria to evaluate pay for performance in an equity compensation plan proposal.
The new pay-for-performance policy will affect companies that ISS believes have a “disconnect” between CEO compensation and corporate performance. As discussed below, ISS has established a series of criteria designed to identify when a company’s CEO pay decisions do not correlate to its total shareholder return (TSR), a measure of share price appreciation and dividends paid. ISS will recommend a vote against an equity compensation plan proposal (even if the cost of the plan is considered acceptable under its quantitative analysis) if these four criteria are met:
ISS will determine TSR and TDC using data obtained from Equilar, Inc., an analytics firm that conducts executive compensation research. Equilar calculates TSR using fiscal year-end (rather than calendar year-end) data. TSR calculations are done on an absolute, not a relative, basis; three-year TSR is derived from annualized TSR levels over the three-year period. Equilar gets TDC data from corporate proxy statements.
Director elections, including compensation committee members
ISS has indicated that, in addition to equity compensation plan proposals, its new pay-for-performance policy will also apply to director elections taking place on or after February 1, 2004. ISS will recommend that its clients withhold votes from members of a company’s compensation committee who are up for reelection to the company’s board of directors if:
Who must comply
Starting with annual meetings on or after February 1, 2004, the new pay-for-performance policy will apply to all companies included in the Russell 3000 Index. (The Russell 3000 Index measures the performance of the 3,000 largest US companies based on total market capitalization. It represents approximately 98 percent of the investable US equities market.) However, ISS has indicated that the policy will not apply:
Nonetheless, in the case of this latter exception, a company may still be subject to ISS scrutiny if its one- and three-year annualized TSR were negative and the compensation of a newly appointed CEO represents an increase over that of his or her predecessor.
ISS’s methodology for identifying the disconnect between CEO compensation and corporate performance has limitations:
ISS’s decision to implement its new policy on the eve of this year’s proxy season also presents procedural difficulties. For example, a company with a negative one- and three-year TSR that intends to submit an equity compensation plan for shareholder action at its annual meeting now faces the likelihood of a negative vote recommendation. Moreover, ISS does not appear to be willing to negotiate with companies seeking to head off a negative vote recommendation unless there is a clear, quantifiable, or exceptional reason for the negative rating (such as, if Equilar valued a multi-year equity award over a single year, a company provided a biennial option grant, or the CEO’s salary or bonus was artificially frozen or eliminated in a prior year).
Consequently, companies will need to carefully consider the alternatives – tabling a plan proposal, excluding the CEO from the plan, or redoubling their efforts to ensure a favorable vote. While institutional shareholders such as CalPERS and TIAA-CREF have recently changed their voting policies on equity compensation matters, they provided companies with sufficient lead time to integrate the changes into their equity compensation planning.
Potential implications for a withhold vote
Recommending a “withhold” vote for compensation committee members has potential implications beyond the immediate director vote. The SEC is currently considering new rules that will let significant, long-term shareholders include director nominees in a company’s proxy materials if there is evidence that shareholders previously may not have had access to an effective proxy process. Under the proposed rules, shareholder access is triggered where, among other things, at least one director nominee of the company receives “withhold” votes from more than 35 percent of the votes cast.
Even though these rules are not expected to be adopted until later this year, the SEC has indicated that events during the 2004 proxy season may permit shareholder access in 2005 and beyond. Consequently, a company with a negative one- and three-year TSR that has increased the compensation of its CEO will face a “withhold” recommendation for any compensation committee member up for reelection. Not only will the company have little opportunity to consider alternatives, but even if the director is reelected, a significant “withhold” vote may activate the shareholder access rules and their attendant consequences.
ISS’s new policy invites unintended consequences that may be misaligned with long-term shareholder interests. However legitimate its concerns about pay for performance, its approach to address these concerns is too rigid, and its policy announcement is too sudden. Companies with imminent shareholder meetings that are affected by the policy now face difficult decisions as they attempt to respond to potential negative vote recommendations. Moreover, the new policy may unduly tie the hands of the compensation committee and lead to compensation packages that are focused on stock price rather than true operational performance – which, ironically, has been a primary criticism of executive pay.
In the post-Sarbanes-Oxley environment, other recently enacted corporate governance reforms should be given an opportunity to work before such drastic policies are implemented.