ISS Compensation Peer Group Comparisons Raise Hackles

As companies wade into the second year of shareholder advisory votes on executive compensation, their approaches to say-on-pay range from brash defiance to penitent compliance.

The wide array of strategies may be due to a new evaluation method at proxy advisory firm Institutional Shareholder Services that makes it harder to hew to the norm and is creating confusion for some companies.

As of this year, ISS is comparing the relationship between a company's executive compensation and  shareholder return over the short and long term, as well as how the company stacks up to its peers during those timeframes. Corporate America's point of contention is that ISS peer groups typically don't match the ones companies have been using for their own benchmarking. This occurs largely because ISS groups companies by revenue levels and market capitalization, as well as by industry.

Some argue that the peer groups ISS is using are making apples-to-oranges comparisons. Steven Hall, managing director at compensation consultancy Steven Hall & Partners, says one of his clients in the gaming industry is being compared with a restaurant chain. The methodology “does not work well in many instances,” adds George Paulin, chairman and CEO of compensation firm Frederic W. Cook.  

Paulin says comparisons are difficult across high-growth companies that have significant market cap values in relation to their revenues, or in low-margin distribution companies that are the opposite. “Further, based on early indications, ISS is not closely following its own peer-selection criteria as laid out in its guidelines, which is frustrating,” he says.

That type of frustration was what led Disney Co. to lash out at ISS in a recent filing with the Securities and Exchange Commission, after the proxy advisory firm recommended shareholders vote against a compensation package valued at $33.4 million last year for CEO Robert Iger. In the letter, Disney said it believes ISS “has substituted its opinion for the studied analysis and judgment reached by the board” regarding its efforts to retain Iger for another four years.

Among the bullet points Disney offered in its defense: Iger's compensation is “entirely in line” with that of CEOs at the four other media companies with which it compares itself (CBS, News Corp., Time Warner, and Viacom), its stock price has performed better than those peers during Iger's tenure, and much of the value in the $33.4 million figure cannot be realized for years to come.

“ISS's position is out of touch with the reality that no company could attract and retain top management if its compensation packages are not competitive with those offered by the companies with whom it competes for talent,” the filing from Disney reads.

According to preliminary counts, Disney shareholders approved its package at the annual meeting last week, but barely, with 43 percent of investors, including California pension giant CalSTRs, voting against it.

In defense of ISS, Carol Bowie, the firm's head of compensation research, says that matching lines of business “is not a specific requirement for us, because at that level, general leadership and management skills tend to be as important as or even more important than specific business knowledge.”

“Our purpose is very different than a company's purpose in benchmarking,” Bowie adds. “They are looking at companies they believe they compete with for talent; we are looking at it from the shareholders' perspective.”

Mismatched peer grouping is only one of the factors stoking companies to speak their minds against the proxy advisory firms. Compensation experts say the new ISS methodology also inflates actual executive pay by considering grant-date valuations for equity, rather than realized value, and by using alternative inputs for option-value calculations that typically make them higher.

“Part of the problem is that the way ISS is putting things together, you don't know until you've filed your proxy how you'll come out.”

—Steven Hall,

Managing Director,

Steven Hall & Partners

Actuarially boosted pension values are also a problem, Hall says. “Actuaries are deciding they have to adjust the pension values to accommodate lower interest rates, and that has caused some companies to be reflecting CEO pay values that are as much as $1 million higher—does that make sense?”

Such complaints were at the center of Actuant Corp.'s December response to negative recommendations from ISS and Glass Lewis & Co., the other major proxy advisory firm. Actuant did not dispute ISS' peer group analysis, but strongly opposed the valuations assigned to equity awards and the notion that executives weren't suffering as a result of poor stock price performance.

Among Actuant's arguments in a shareholder letter: Top executives did not receive salary increases for 2009, 2010, or 2011; the realized value of past equity awards is 71 percent below granted value due to a weak stock price; proxy advisory firms overstate the Black-Scholes value of granted stock options; and they also underestimate the time lag between financial performance and stock performance.

While Actuant stock is indeed up about 25 percent, the company was not able to persuade investors to see things its way and became the first company to fail a say-on-pay vote in the 2012 season.

Say-on-Pay Failures

How many companies will ultimately fail this season is a matter of some debate. Many experts believe the level will be about the same as last year—around 2 percent. And Bowie of ISS says she expects a similar number of negative recommendations, about 12 to 13 percent for the S&P 500, even though “we don't have any quotas,” she explained.

WALT DISNEY FIRES BACK

Below is an excerpt from Disney's letter about the ISS recommendation:

In recommending against the company's position on say on pay, ISS has again substituted its opinion for the studied analysis and judgment of the Board as to the compensation that was appropriate to secure Mr. Iger's services for the company through mid-2016.

Given the Board's focus on driving long-term shareholder value, the Board rightfully considered Mr. Iger's performance over the course of his tenure when viewed in relation to the industry peers against which both he and his compensation package are most fairly measured. On that measure Mr. Iger's compensation is fully warranted.

oThe Committee looks at performance and compensation in relation to the single most appropriate set of peers available: the five major publicly held entertainment companies whose management issues and challenges most closely resemble those of The Walt Disney Company (News Corporation, Time Warner, Comcast, CBS and Viacom).

oMr. Iger is among the most successful and well-regarded chief executive officers in the media industry. Disney has delivered exceptional total shareholder return during Mr. Iger's tenure relative to any reasonable comparison group.

A $100 investment made in Disney when Iger became CEO on October 1, 2005 would have been worth $171 on December 30, 2011. This compares to:

Only $117 for an investment in the S&P 500 index.

No more than $136 for an investment in any of the four media company peers that were publicly traded on October 1, 2005 (CBS – $136; News Corporation – $121; Time Warner – $110; and Comcast – $130. Viacom wasn't publicly traded on October 1, 2005).

oMr. Iger's compensation is entirely in line with the compensation paid chief executive officers of the five other media peers. With the exception of 2008, Mr. Iger's compensation during his tenure as chief executive officer has been near to or lower than the median reported compensation of the chief executive officers of these companies, despite the fact that the Company is a larger and more complicated company than any of these peers.

oNotwithstanding these comparators, the Compensation Committee (a) provided Mr. Iger no upfront grants to induce him to extend his tenure (even though CEOs of other media companies have recently been given significant up – front grants); and

(b) structured Mr. Iger's compensation package such that 90% of its potential value is in the form of performance-based bonus, performance-based restricted stock units and options and thus is dependent on Mr. Iger's ability to continue to deliver returns to shareholders.

The opinion that ISS has substituted for the studied analysis and conclusions reached by the Board is flawed in a number of important ways:

oISS arbitrarily ignores the Company's performance over the tenure of Mr. Iger's leadership of the company, which the Board considers a critically important factor in assessing Mr. Iger's capability to drive long-term shareholder value.

oISS has off-handedly and improperly dismissed the board's well considered judgment that the five media companies with whom the company competes for talent are the most relevant points of comparison to assess performance and to structure a compensation package to retain a CEO.

ISS's position is out of touch with the reality that no company could attract and retain top management if its compensation packages are not competitive with those offered by the companies with whom it competes for talent.

oISS has arbitrarily chosen to understate the performance-based nature of Mr. Iger's compensation by declaring that options are not performance based even though they are of value only if and to the extent that the share price when exercised exceeds the price on the date of grant.

For the foregoing reasons, we believe ISS's recommendations are unwarranted and urge you to vote for each of the directors and for approval of the advisory vote on executive compensation.

Source: SEC.

Paulin, however, is more hopeful, expecting fewer companies to fail this year. His optimism is spurred by “big companies doing a much better job of using their investor relations resources to engage directly with shareholders,” and correcting any misperceptions they believe the proxy advisory firms may have, he says. In addition, “many of the big investment funds seem much more knowledgeable this year, and more open to go against the proxy advisors' vote-against recommendations on say on pay.” 

What can companies do to ensure smooth sailing? Bowie says that ISS runs the new quantitative screen on the pay practices of all public companies and then compares results against the distribution for the Russell 3000 index. “Real outliers relative to that distribution” are what trigger a more in-depth, qualitative analysis that can lead to a negative recommendation, she says, noting that the thresholds defining the norm are publicly available in an ISS white paper. Staying out of the crosshairs, then, means having the right policies in place, rather than the right numbers.

“Companies tend to focus on the quantitative, often on the advice of advisers, but in fact, [negative] recommendations are only made after qualitative review,” Bowie says. Practices that would keep the alarm bells ringing include benchmarking pay levels above the median, using significantly larger companies for peer group comparisons, and relying heavily on time-based awards (including standard stock options).

Some of the best examples of how to get it right may come from companies that failed or got a bare majority of votes last year. When only 61 percent of shareholders at Johnson & Johnson voted to approve the executive compensation package last year, “we were disappointed,” the pharmaceutical giant notes in this year's proxy, “and initiated a review to gain further feedback from key stakeholders.” That effort included telephone and live interviews with major investors, internal discussions with employees, discussions with proxy advisory services, and a review of media coverage on the issue.

As a result of its efforts, the company says it made the biggest changes to its executive compensation program in 60 years. A key facet of the change: dropping cash-based long-term incentives and introducing “performance share units,” a system in which pay-outs hinge on achieving certain sales, earnings per share, and total shareholder return goals over three years.

Ironically, last year many pay packages were approved that showed an increasing use of time-based awards, and bonus target ranges stretched large enough to encompass almost all levels of performance, according to a recent analysis by compensation consultancy James F. Reda.

“Because of the uncertainty in the economy, companies either scrapped performance-based goals because they didn't know how to set them, or shortened the time period to reset the goals every year,” says David Schmidt, senior consultant at Reda. This year he expects higher bonus targets, but not a dramatic shift to performance-based equity. “I don't think we'll see big changes in the composition of equity,” he says, particularly among the vast majority of companies that had strong support last year from shareholders on executive comp packages.