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Perspective Alert! ISS adds pay for performance to proxy voting guidelines


Written by: Mark Borges, Kelly Crean

 

Review key points of this Alert!

 

 About ISS

 

 How ISS evaluates compensation

 

     Plan cost

 

     Whether the cost is reasonable
 

     
Determining recommendations

     Repricing guidelines

     New “pay for performance” policy

 

     Director elections

   
     
Who must comply

 

 Substantive concerns

 Procedural concerns

 Potential implications for a withhold vote

 Conclusion

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.

 

About ISS

 

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.

 

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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.

 

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Plan cost

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.

 

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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.

 

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Determining recommendations

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:

  • the plan violates ISS’s option repricing guidelines; or
  • the company has violated ISS’s new pay-for-performance guidelines (discussed below).

 

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Repricing guidelines

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.

 

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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:

  1. the company’s one-year and three-year annualized TSR (as calculated on a fiscal year basis) were negative and
  2. the CEO’s total direct compensation (TDC) – which includes annualized base salary, cash bonus, other annual compensation, as well as the present value of stock options, the face amount of restricted stock awards, and the face value of actual long-term incentive plan payouts – was increased from the immediate past year and
  3. more than 50 percent of the increase in the CEO’s TDC is attributable to equity-based awards and
  4. the CEO is a participant in the plan under consideration.

 

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.

 

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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:

  1. the company’s one-year and three-year TSR were negative and
  2. the CEO’s TDC from the immediate past year was increased.

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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:

  • if a company has been publicly traded for less than three years or
  • if a CEO has been serving in that role for less than two fiscal years.

 

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.

 

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Substantive concerns

ISS’s methodology for identifying the disconnect between CEO compensation and corporate performance has limitations:

  • First, the methodology is based solely on a single measure, TSR, which may not work in all situations. Consider a company that has improved its operating and financial results – measures that are often used as the basis for awards under an incentive compensation program. It is likely to pay progressively larger bonuses, which may increase the CEO’s TDC year-over-year. But if its stock price remains flat or declines, that would constitute a “disconnect” under the new ISS policy.

  • In addition, companies with special compensation arrangements, such as a biennial grant cycle or multiple performance-year awards, will want to examine the TDC data used by ISS to ensure that it has been adjusted to reflect these arrangements properly. And in the case of TDC, companies should recognize that option values will be computed on a present value basis, which could lead to significantly different values than the ones used for disclosure or compensation analysis purposes.

  • A second limitation of the ISS methodology is its use of fiscal year-end TSR. Companies with different fiscal years in the same industry may find their results affect TSR differently. For example, while comparable retail companies may experience similar holiday sales results, the share price of a company with a January fiscal year end will likely reflect those results, while the stock of a company with a December fiscal year end will not. If results were poor, the TSR of the former company is likely to suffer, while the TSR of the latter company may not. Thus, a company’s fiscal year end, rather than its performance relative to its peers, may have a disproportionate affect on its TSR.

  • Further, ISS’s methodology does not account for when compensation decisions are made . TSR reflects year-end results, although companies typically set the compensation of the CEO and other executives at the beginning of the fiscal year. That is, in the first quarter of the fiscal year, the compensation committee generally determines the compensation for the year. TSR, on the other hand, is measured at the end of the year, when company performance, the general state of the economy, the condition of the securities markets, and other macro events can be reflected in share price. For example, if TSR for fiscal year 2003 is negative or flat but the CEO’s TDC for 2003 exceeds his or her TDC for 2002, a company will not meet the ISS’s new policy guidelines. This would effectively penalize a company (and its compensation committee) for not having the foresight to predict a down year when making its compensation decisions.
The use of the TSR measure will have a particularly harsh impact on companies in cyclical industries. Once caught in a downward trend, it often takes several business cycles before they can produce positive TSR. By using a fixed TSR measure, ISS may hinder the ability of these companies to fairly compensate their management teams.
  • Finally, even if TSR is a reliable benchmark, the use of absolute, rather than relative, TSR may be inappropriate. Indeed, if ISS had implemented its new policy in 2002, virtually every US company would have shown a negative one- and three-year TSR. In the case of executive compensation, a company's relative performance compared with a carefully constructed peer group would more accurately reflect what a management team, particularly the CEO, has actually contributed to corporate performance. A relative measure ensures that high-performing companies are not penalized when an industry as a whole is suffering. In a flat economy, particularly one that is unlikely to change for some time, the use of an absolute measure may inhibit the ability of a company to make appropriate compensation decisions.


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Procedural concerns

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.
 

Conclusion

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.

 

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