Focus on Equity Pay Plans This Proxy Season

Executive pay hasn’t been controversial at recent annual meetings. Say-on-pay votes have settled into a routine, with a failure rate at roughly 2 percent. A record-setting stock market, powered by strong company earnings, should mean smooth sailing and minimal shareholder scrutiny this proxy season.

Emphasis on “should.”

Compensation consultants are warning companies not to be complacent this proxy season. Topping the list of concerns is the greater scrutiny placed on equity plans. Proxy advisory firm Institutional Shareholder Services is leading that charge with a new approach for evaluating them. It goes into effect at annual meetings that take place on or after Feb. 1.

Under its previous approach, ISS evaluated equity pay plans with a straightforward review that assessed whether the plans were in the best interest of shareholders. The new policy uses a scorecard approach that considers a broader range of factors, positive and negative, when making a “for” or “against” recommendation.

Basic categories (plan cost, plan features, and company grant practices) will be evaluated, with a final score that awards or subtracts points for matters grouped under those headings, including reviews of the portion of CEO equity that is performance-based, vesting provisions of recent CEO grants, the cost of new and available shares, minimum vesting provisions, and discretionary vesting authority.

The scorecard is structured so that a positive factor can offset the presence of a negative one, explains Steven Hall, managing director of Steven Hall & Partners, an executive compensation consultant. Favorable features (minimum vesting standards, no liberal share recycling, double trigger vesting of equity awards in connection with a change in control) can counteract ISS concerns regarding excessive equity plan costs or burn rate.

On the other hand, he says, “if ISS identifies provisions that are problematic, it might recommend voting against an equity plan proposal, irrespective of whether the cost of the equity plan meets the policy requirements.”

“Some of the things ISS looked at under their say-on-pay analysis are shifted over to have a role in their equity plan reviews. We are all very anxious to see what it will be like to operate under this new methodology.”
Jim Kroll, Senior Executive Compensation Consultant, Towers Watson

While most in the compensation world are happy to see the inflexible pass/fail model come to an end and welcome the expanded approach taken by ISS, concerns do exist about how the new reviews will play out.

“Companies have to be flexible and nimble because there are so many more moving parts to the methodology,” says Jim Kroll, a senior executive compensation consultant with Towers Watson. “Some of the things ISS looked at under their say-on-pay analysis are shifted over to have a role in their equity plan reviews. We are all very anxious to see what it will be like to operate under this new methodology.”

The renewed focus on equity plans could have an even greater affect on companies than say-on-pay. The latter is a non-binding advisory vote by shareholders; the former is binding.

The new approach may be “a positive development,” says Kimberley Anderson, a partner with the law firm Dorsey & Whitney, but she is concerned by a lack of detail about how the scoring will work in practice. “ISS didn’t give us some of the crucial metrics,” she says. “How are things weighted in each of the factors? Companies will need to go through a proxy season or two to see how ISS applies its more nuanced approach.”

“Certain things used to be deadly if you did them and you would get a ‘no’ from ISS,” Hall says. “Now, we don’t know anymore. They have a wide base of issues and a scoring system but they aren’t telling us how they are doing the scoring or weighting.”

Another concern is how the scorecard treats multiple plans on the same proxy. All plans will be combined into an aggregate score, with the worst features of each plan heavily weighted in the calculation. “They are looking at these plans in the worst possible light to figure out what your aggregate score is,” Anderson says. “If you don’t have a passing score, but each of your individual plans pass, only one of them gets a pass.”

KEEPING SCORE OF EQUITY PLANS

The following is a selection from an “FAQ” issued by Institutional Shareholder Services regarding its new Equity Plan Scorecard. The new policy is effective for annual meetings on or after Feb. 1, 2015.
What is the basis for ISS' new scorecard approach for evaluating equity compensation proposals?
The new policy will allow more nuanced consideration of equity incentive programs, which are critical for motivating and aligning the interests of key employees with shareholders, but which also fuel the lion’s share of executive pay and may be costly without providing superior benefits to shareholders. While most plan proposals pass, they tend to get broader and deeper opposition than, for example, say-on-pay proposals. The voting patterns indicate that most investors aren't fully satisfied with many plans.
How does the new ISS' Equity Plan Scorecard work?
The EPSC considers a range of positive and negative factors, rather than a series of "pass/fail" tests, to evaluate equity incentive plan proposals. The new policy (in effect for shareholder meetings as of Feb. 1, 2015) also will continue to result in negative recommendations for plan proposals that feature certain egregious characteristics (such as authority to re-price stock options without shareholder approval). In general, however, a company's total EPSC score—considering the proposed plan and certain grant practices relative to applicable factors —will determine whether a "For" or "Against" recommendation is warranted.
Which types of equity compensation proposals will be evaluated under the EPSC policy?
Proposals related to the following types of equity-based incentive program proposals will be evaluated under the EPSC policy:

Approve Stock Option Plan

Amend Stock Option Plan

Approve Restricted Stock Plan

Amend Restricted Stock Plan

Approve Omnibus Stock Plan

Amend Omnibus Stock Plan

Approve Stock Appreciation Rights Plan (Stock-settled)

Amend Stock Appreciation Rights Plan (Stock-settled)
Other types of equity-based compensation proposals will continue to be evaluated as provided under ISS' policy for Equity-Based and Other Incentive Plans.
Source: Institutional Shareholder Services.

Glass Lewis, the other prominent proxy advisory firm, plans a less controversial change. It will more closely review one-time awards that fall outside standard incentive plans as part of its say-on-pay analysis. Companies will be asked to offer a “cogent and convincing explanation” of why existing awards were insufficient, connecting the out-of-the-ordinary incentive to future performance.

Recommendations will consider any effect the one-time compensation may have on current pay plans or future strategy and pay practices. “They are looking more closely at not just what the awards are, but also the rationale and any companion changes to their compensation program,” Kroll says.

Storm Clouds Appear?

Beyond proxy advisers, companies will want to consider other developments that could affect this, and future, proxy seasons.

Lurking in the shadows, for example, are a variety of Dodd-Frank Act compensation disclosure rules the Securities and Exchange Commission has yet to adopt. Most controversial among them is a requirement to disclose the ratio of CEO pay compared to that of the median employee. Despite speculation that a final rule would be published by now, it remains missing in action.

A source familiar with the SEC’s deliberations says that rule may not be released this summer, until after the current proxy season, and become effective in 2017. Even if that proves true, companies may want to start preparing for the rule’s arrival at this year’s annual meetings.

“Obviously there would be nothing in the proxy that you would be required to disclose,” Anderson says. “But maybe we need to be thinking about starting to address concerns and explain things to give shareholders a hint about what is going to be coming. It may be less a matter of what you think your ratio is going to look like, than a discussion of your workforce. Will where the employee base is located skew results? Are employees who are low paid by U.S standards actually well-compensated in their own countries?”

Companies that have failed (or may fail) say-on-pay votes may have shareholder proxy access proposals to worry about as well. New York City Comptroller Scott Stringer, on behalf of the $160 billion New York City pension funds, recently announced an initiative to win shareholders the right to nominate directors, and proxy access proposals were submitted for 75 companies. Among the criteria for those selections, and any future ones: “excessive CEO pay.”

Shareholder Outreach

This year’s increased focus on pay-for-performance and equity plans should be a signal for companies to improve their compensation disclosures and shareholder outreach.

“It is a good time to shore things up and to take a fresh look at the compensation discussion and analysis section of your proxy statement,” says Adam Miller, a partner with the law firm Vorys. “Companies get into a pattern, particularly if they have relatively strong results on say-on-pay, to just regurgitate the same analysis year after year. But the SEC expects you to take a fresh look every year. What justified a compensation decision in one year doesn’t necessarily justify it the next year. It is easy to get into a pattern on updating the numbers without really changing the analysis.”

“Review what your shareholder outreach efforts look like,” he adds. “Are you addressing their concerns? If you are just giving them lip service, you are going to struggle with say-on-pay and the proxy advisory firms are going to be more aggressive with their recommendations.”