Institutional Shareholder Services has proposed substantial changes to its voting policies for the 2015 proxy season that will give institutional investors greater flexibility in the way they evaluate companies’ equity plan proposals.
It also addresses a big complaint from companies that ISS takes a “cookie-cutter” approach to evaluating executive incentive-pay plans. The new policies provide for more nuances and consider more factors when assessing the merits of equity grants. Some companies, however, could find the new scrutiny casts their plans in an unflattering light.
Rather than assigning a “pass” or “fail” grade to a company’s plan under the current voting policy, ISS plans to implement a “scorecard” approach that gives weight to various factors beyond just plan cost. “Whether these changes are better for companies really depends,” says Deborah Lifshey, a managing director at independent compensation consultancy Pearl Meyer & Partners
In the past, for example, if a company’s plan cost was too high relative to its peers, that one factor could result in ISS recommending a vote against the equity plan. Under the new voting policy, however, even if a company is over the cost cap but has other favorable practices in place, the company could still receive a favorable ISS recommendation.
For other companies, the outcome may not be so rosy. Some companies that would have passed ISS’ test in previous years, could now be dinged for having plan features in place that ISS views as unfavorable.
Compensation experts stress that it’s important companies and their boards understand how proxy advisory firms evaluate equity plan proposals if they want to win say-on-pay votes during the coming proxy season. “ISS has tremendous influence, and it’s growing,” Lifshey says.
In some respects, ISS’ growing influence in the equity plan proposal process is “almost more grave a scenario” than its influence on say-on-pay, Lifshey says. Unlike an ISS “against” recommendation on say-on-pay, which may result in non-binding “against” votes on pay programs, “an ISS ‘against’ recommendation on an equity plan proposal may ultimately result in an adverse binding outcome if the plan is not approved by investors,” she says. “So that’s something to keep in mind.”
Currently, ISS applies a series of “pass/fail” tests to evaluate an equity plan. An equity plan will receive an “against” vote if:
The total cost of the company’s equity plans, including the proposed new plan, is “unreasonable”;
The company has a pay-for-performance “misalignment”;
The company’s three-year burn rate exceeds the applicable burn rate cap of its industry group; or
The plan includes certain problematic pay practices, such as the ability to re-price without shareholder approval and liberal change-in-control definitions.
In the past, ISS took a “pretty formulaic” approach to the way it evaluated equity plan proposals, Lifshey says. As a result, companies could fairly easily predict whether equity proposals would receive a favorable ISS recommendation, she says.
“Going forward, the new modular framework will make it easier for our clients to customize and fine-tune their own voting policies with respect to equity-based compensation.”
Patrick McGurn, Special Counsel, ISS
Under the revised methodology, however, ISS said it will now use a more nuanced “scorecard” approach that takes into consideration a range of positive and negative features, whereby a company’s total score would generally determine whether a “for” or “against” recommendation is warranted. ISS said it doesn’t intend for the scorecard methodology to change the number of negative recommendations issued.
Scorecard factors evaluated will fall under three main categories:
Plan cost (relative to industry peers);
Plan features; and
Grant practices
Separate scoring models will be employed for companies in the S&P 500, Russell 3000 (excluding S&P 500), and non-Russell 3000 index groups and for companies that have recently completed an initial public offering.
“The new tools will provide enhanced functionality and greater flexibility for both ISS’ research analysts and our institutional investor clients,” ISS Special Counsel Patrick McGurn says. “Going forward, the new modular framework will make it easier for our clients to customize and fine-tune their own voting policies with respect to equity-based compensation.”
Concerns Remain
Some compensation experts say that the new scorecard model is not transparent enough, making it difficult for companies to determine whether they’ll receive a favorable ISS recommendation. “We don’t have a thorough understanding as to how much each separate plan feature and grant practice will be weighted,” Lifshey says.
In a comment letter to ISS, Pearl Meyer & Partners is recommending that plan cost continue to be “the most heavily weighted factor, as it provides a company the opportunity to set their share request in the most predictable way,” the letter states. “At the end of the day investors care more about dilution than ISS-unfavorable plan features or grant practices.”
The letter further urges ISS “not to apply a one-size-fits-all mentality in reviewing plan features and grant practices. We are hopeful that ISS will clearly provide carve-outs in certain situations and not penalize companies for failure to comply with one-size-fits-all maxims.”
KEY CHANGES UNDER CONSIDERATION
Below is a list of key features in the ISS proposals.
(i) Scorecard factors evaluated will fall under three main categories:
Plan Cost: The total potential cost of the company’s equity plans relative to industry/market cap peers, measured by the company's estimated Shareholder Value Transfer (SVT) in relation to peers. SVT will be calculated for both (a) new shares requested plus shares remaining for future grants, plus outstanding unvested/unexercised grants, and (b) only on new shares requested plus shares remaining for future grants.
Plan Features:
Automatic single-triggered award vesting upon a CIC;
Discretionary vesting authority;
Liberal share recycling on various award types; and
Minimum vesting period for grants made under the plan.
Grant Practices:
The company’s three-year burn rate relative to its industry/market cap peers;
Vesting requirements in most recent CEO equity grants;
The estimated duration of the plan based on the sum of shares remaining available and the new shares requested, divided by the average annual shares granted in the prior three years;
The proportion of the CEO's most recent equity grants/awards subject to performance conditions;
Whether the company maintains a clawback policy; and
Whether the company has established post exercise/vesting shareholding requirements.
(ii) Scorecard factors and weightings will be keyed to company size and status: S&P 500, Russell 3000 (excludes S&P500), Non-Russell 3000, and Recent IPOs or Bankruptcy Emergent companies.
(iii) The dual cost measurement approach would eliminate ISS’ option overhang carve-out policy.
(iv) “Liberal share recycling” provisions will be evaluated as a plan feature rather than incorporated in SVT calculations.
(v) Burn rate benchmarks will be calibrated for respective index groups: (a) S&P500, (b) Russell 3000 (excluding S&P500), and (c) Non-Russell 3000; the relevant GICS industry classification will be used within each index group.
(vi) The company’s burn rate will be considered as part of the Scorecard evaluation, based on a range relative to its peers; this will eliminate any potential for commitments from companies to adhere to specific future burn rate caps (i.e., will eliminate “burn rate commitments”).
Source: ISS.
According to McGurn, the feedback ISS has solicited over the course of several seasons concerning the equity scorecard method has been more positive than not. “Many issuers had complained that the pass/fail nature of the old methodology gave them little credit for adopting progressive practices if they could not bring down plan cost,” he says.
Some compensation experts agree the changes are an overall positive development. “We would rather have them take a broader view of equity plans and pay programs than a narrower view,” says Michael Melbinger, lead partner and global head of the employee benefits and executive compensation practice group of law firm Winston & Strawn. The new scorecard model looks generally favorable, he says.
What’s Ahead
Later this month, ISS will launch QuickScore 3.0, the latest version of its governance risk scoring system and analytical tool, which was last updated in February. QuickScore 3.0 will include new weightings relating to shareholder rights, audit and risk oversight, and board structure.
With the release of QuickScore, Lifshey and Melbinger, along with other executive and compensation experts, recommend that companies review the list of features that ISS considers best practice, and decide from there which ones they may want to add to their equity plans, or what potentially negative practices they may want to eliminate.
To the extent the company can include any favorable practices that don’t unduly burden the compensation committee, “that’s something companies can start to think about,” Lifshey says. Putting in place some sort of discretionary clawback policy, even if not completely in compliance with what is expected to be in the Dodd-Frank clawback guidance, is one example of low-hanging fruit, she says.
Since say-on-pay resolutions have appeared on ballots, some compensation committees and their advisers have focused most, or all, of their outreach effort on getting broad feedback from their shareholders with respect to these advisory votes, McGurn says. “While pay-for-performance tends to drive investors’ votes on say-on-pay, they tend to provide equal or greater weight to costs when they cast ballots on equity plans,” he says. “When companies put equity plans up for votes, they need to engage with their shareholders on these cost and plan design features.”
“The proposed changes to our analytical framework with respect to equity-based compensation plans were many years in the making,” McGurn says. Thus, any additional changes made to ISS’ proposed policies are anticipated to be minimal
“While some of the details may change in light of feedback that we continue to receive, the prospects for change in 2015 are very close to 100 percent,” he says.
The final policies are expected to be published during the next week and will take effect for meetings of public companies on or after Feb. 1, 2015.
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