A View to 2012: ISS Releases Draft 2012 Policies for Comment

A View to 2012: ISS Releases Draft 2012 Policies for Comment

October 25 2011

Last week, ISS released its Draft 2012 Policies for comment by institutional investors, companies and other members of the governance community.  The annual event is viewed as a harbinger of the final guidelines ISS will use to evaluate thousands of proxies next spring.  ISS expects to release final guidelines for 2012 during the week of November 14th.  We have summarized key executive compensation policy changes under consideration below.  The entire release can be found here.

Evaluation of Executive Pay (Management Say-on-Pay, “MSOP”) – In response to feedback that the pay-for-performance alignment should be viewed in a long-term context rather than just the most recent year, ISS is modifying its approach to the evaluation of executive compensation, and specifically the pay-for-performance alignment.  While the new approach provides a more transparent and structured framework for analysis, it remains focused on CEO pay only, and continues to rely upon TSR as the predominant indicator of company performance.

As proposed, ISS will identify companies that have demonstrated strong, satisfactory, or weak alignment between TSR and CEO pay over an extended period utilizing an approach that includes a quantitative analysis, followed by a qualitative analysis to determine causal or mitigating factors.  ISS has back-tested this new methodology and does not expect a significant change in the percentage of negative recommendations.

The proposed approach first evaluates the pay for performance alignment on a quantitative basis:

  • Relative alignment (weighted 50%)
    • The degree of alignment between the company’s TSR rank and the CEO’s total pay rank within a peer group over one– and three-year periods (weighted 40/60 so as to put more emphasis on the longer term)
      • Peer group to be comprised of 14 to 24 companies similar to the company in market cap, revenue (or assets), and industry (as determined by GICS)
    • The multiple of the CEO’s total pay relative to the peer group median.  In a striking departure from past practice, in which strong performers were largely given a pass on the level of compensation paid to reward that performance, ISS makes the point that this test may identify cases where a high performing company may be overpaying
  • Absolute alignment (weighted 50%)
    • Alignment between the trend in CEO pay and company TSR over the prior five fiscal years

Companies demonstrating strong or satisfactory performance will generally receive a positive recommendation.

Companies demonstrating weak alignment will be subject to a qualitative review which will consider the following:
–  The ratio of performance- to time-based awards
–  The overall ratio of performance-based compensation
–  The robustness of disclosure and rigor of performance goals
–  The company’s peer group benchmarking practices
–  Actual results of financial/operational metrics, such as growth in revenue, profit, cash flow, etc. both absolute and relative to peers
–  Special circumstances related to, for example, a new CEO in the prior FY or equity grant practices (e.g. biannual awards)
–  Any other factors deemed relevant

ISS requested comments on:
–  The appropriateness of the factors used in the pay-for-performance evaluation approach
–  Whether the approach gives adequate consideration to long-term alignment
–  Whether the proposed approach will identify companies with strong pay-for-performance alignment
–  Additional factors, if any, that should be considered and displayed to improve the ability of investors to evaluate long-term pay-performance alignment

Board Response to Management Say-on-Pay Vote – For companies where the most recent say-on-pay vote received significant opposition, ISS is considering a policy change that will recommend CASE-BY-CASE on Compensation Committee members (and in instances where the whole Board is deemed responsible, all Directors) and the current MSOP based on whether or not the company has taken sufficient actions to address compensation concerns underlying such votes.

While the term “significant opposition” remains undefined, ISS has indicated that companies where the MSOP received the support of less than 50 percent of all votes cast will be subject to a higher level of scrutiny.  They are also requesting comments on what level of opposition should trigger an explicit Board response.

ISS believes an appropriate response from the company must include comprehensive and meaningful disclosure of its outreach efforts to major institutional investors as well as concrete actions that it has taken or will take to address the compensation issue(s) that resulted in significant opposition votes.  ISS further specifies that these specific actions should ideally be new rather than a reiteration of existing practices.

Factors that ISS will take into account when making its recommendations include:
–  The level of opposition
–  The company’s ownership structure
–  Disclosure of engagement efforts with major institutional investors regarding the compensation issue(s)
–  The company’s response
–  Specific actions taken to address the issue(s) that appear to have caused the significant level of against votes
–  Other recent compensation actions taken by the company
–  ISS’ current analysis of the company’s executive compensation and whether any prior issues of concern are recurring or one-time

The recurrence of previously identified compensation issues, or new issues, depending upon severity, may also result in AGAINST vote recommendations for the MSOP and Compensation Committee members.

ISS requested comments on:
–  Does a support level of less than 70 percent warrant an explicit response from a company to address concerns – i.e., including actions or an action plan?  If not, what opposition level warrants such a response
–  Whether or not boards should be expected to provide an explicit response by the following year or accountability should be based on poor results on multiple MSOP votes
–  Any additional factors investors should consider with respect to evaluating the response

Other compensation-related items addressed in the release include:

  • Board Response to Management Say-on-Pay Frequency Vote – In cases where companies implement an MSOP frequency vote that is less frequent than the option preferred by shareholders, ISS proposes to:
    • Vote WITHHOLD/AGAINST all incumbent director nominees
    • Vote CASE-BY-CASE if the Board implements an MSOP on a less frequent basis than the frequency which received a plurality, but not majority.
  • Equity Plans Related to Section 162(m) – Previously, ISS generally recommended that investors support equity plan proposals that were up for vote solely to secure 162(m) approval, regardless of whether or not the plan included provisions viewed as not shareholder friendly (evergreen provisions, liberal change-in-control definitions, etc.).  The contemplated modification would require a CASE-BY-CASE evaluation to include a full equity plan analysis, including consideration of shareholder value transfer, burn rate analysis, repricing and liberal change in control provisions.

Our View: These proposed modifications suggest that ISS is adopting an increasingly complex approach to evaluating compensation.  While we believe that this may help to address past concerns that ISS recommendations sometimes missed the forest for the trees, it also further underscores the need for companies to use the CD&A to tell their pay for performance story and back it up with clear and robust disclosure regarding the programs and policies in place.  Additionally, we believe that companies should consider explicitly addressing the results of last year’s say-on-pay vote and describing actions taken following the review of the vote results.

Action Items: We encourage companies to provide feedback to ISS on the draft policies by the October 31st deadline.  We are currently in the process of composing a comment letter.  If you wish to discuss further, please don’t hesitate to contact us.

PDF:  A View to 2012: ISS Releases Draft 2012 Policies for Comment