Alert: ISS and Glass Lewis Release 2018 Policy Updates

ISS and Glass Lewis Release 2018 Policy Updates

December 19 2017

ISS and Glass Lewis recently published their policy guidelines for the 2018 proxy season.  ISS also released three new FAQ documents containing significant modifications to its compensation policies (including pay-for-performance and Equity Plan Scorecard methodologies) for 2018.  The updated guidelines will be effective for all companies with annual meetings on or after February 1, 2018.

Executive Summary
Compensation-related policy modifications announced by ISS include the following:

  • Assessment of Non-Employee Director Pay
    • ISS may recommend an Against vote for Directors who are responsible for setting “excessive” Director compensation for two or more consecutive years
      • This new guideline will not impact Director vote recommendations in 2018
    • Modifications to Pay-for-Performance Methodology
      • For S&P 500 companies, achieving a “Low” concern level on one of the current CEO pay-for-performance tests (Multiple of Median) was made more difficult
      • The calculation of Total Shareholder Return (TSR) was modified to reduce the impact of point-in-time stock price fluctuations
      • A new financial performance analysis was added as a secondary quantitative screen
        • Three-year average ROA, ROE, ROIC and EBITDA growth are the primary financial metrics that will be calculated
      • Equity Plan Scorecard Adjustments
        • For S&P 500 companies, the threshold score necessary to receive a positive vote recommendation was raised
        • Maximum score for Plan Features pillar was slightly reduced in concert with a corresponding increase in maximum score for the Grant Practices pillar
        • The Plan Features pillar modified various scoring factors including vesting upon Change in Control, CEO equity award vesting period, discretionary vesting and equity holding requirements

Compensation-related policy modifications announced by Glass Lewis were minimal and consisted of clarifying that the CEO pay ratio will not be a determinative factor in voting recommendations at this time and further explanation of the letter grades associated with their pay-for-performance model.

2018 ISS Compensation-Related Policy Updates

Assessment of Non-Employee Director Pay
ISS is introducing a policy that provides for adverse vote recommendations for board/ committee members who are responsible for approving/setting Director compensation when there is a recurring pattern (defined as two or more consecutive years of “excessive” Director pay) without disclosing a compelling rationale or other mitigating factors.

To determine excessive pay, ISS will compare individual non-employee director pay totals to the median of all non-employee directors at companies in the same index and industry.  Compensation for “extreme outliers,” defined as directors paid above the top 5% of all comparable directors, may be considered excessive.

The new policy update will not impact vote recommendations in 2018.  Going forward, negative recommendations would be triggered only after a pattern of excessive non-employee director pay is identified in consecutive years.

Modifications to 2018 Pay-for-Performance Methodology
The following adjustments to the pay-for-performance methodology are effective for annual meetings as of February 1, 2018:

  • Multiple of Median quantitative screen medium threshold reduced
    • For S&P 500 companies only, the threshold for a medium level of concern has been reduced from 2.33x to 2.0x
      • ISS notes that the threshold was reduced to reflect increasing investor scrutiny regarding the “escalating quantum” of CEO pay at large-cap companies
  • Calculation of Total Shareholder Return (TSR) modified to use monthly average stock price for the beginning and ending stock price of the performance period
    • To reduce the impact of point-in-time stock price fluctuations in the calculation of TSR, ISS will smooth both beginning-of-period and end-of-period stock prices for the purpose of calculating TSR by averaging the beginning and ending stock price for the month closest to the fiscal year end of a company
      • The impact of dividends and stock splits occurring during the averaging period will be factored into the calculation of TSR
      • ISS provided the following example of how TSR will be calculated
        • If a company’s fiscal year ends on November 29, 2017, then for the subject company and its peers, TSRs will be measured by averaging the daily closing prices of the end month, November 2017, and the beginning month, November 2014
      • If a company’s fiscal year end is on/after the 15th of the month, then that monthly average will be used; otherwise, the monthly average for the prior month will be used
    • Prior to this modification, ISS calculated TSR from point to point on the beginning day and end day of the measurement period
  • Addition of new Financial Performance Assessment (FPA) as a secondary quantitative pay-for-performance screen
    • Following the 2017 introduction of three-year relative financial performance calculations as a qualitative review, ISS has added the FPA test to the quantitative pay-for-performance screen as a secondary measure after the primary three screens (Multiple of Median, Relative Degree of Alignment, and Pay-TSR Alignment) have been calculated
    • As a result of the introduction of the FPA measure, ISS’ quantitative screen will now produce two concern results: (i) an “Initial Quantitative Concern” level and (ii) an “Overall Quantitative Concern” level
      • The “Initial Quantitative Concern” level is determined by the results of the three primary pay-for-performance measures
      • The “Overall Quantitative Concern” level reflects the final concern level for the quantitative screen, which may or may not have been impacted by the FPA results
        • The “Overall Quantitative Concern” will be the indicator for any pay-for-performance disconnect warranting an in-depth qualitative evaluation
    • The secondary FPA test may identify certain companies that received a “low” “Initial Quantitative Concern” level but had relatively weak fundamental financial performance; in those cases, the company’s final “Overall Quantitative Concern” may be increased to “medium” level
    • In addition, the FPA test will be used to identify certain companies that resulted in a “medium” level of initial concern, but had relatively strong fundamental financial performance, and may reduce the overall concern level to “low”
    • The weighted average performance rank is compared to the subject company’s CEO pay rank, in a similar fashion to the operation of the Relative Degree of Alignment test, creating a relative financial performance result.
      • This may range from -100 to +100, with -100 representing high pay for low performance
        • A negative result indicates that the CEO pay rank is greater than the weighted average financial performance rank, and a positive result means that the CEO pay rank is below the weighted average financial performance rank
    • The FPA result will not impact the “Overall Quantitative Concern” level for companies with a “high” concern level or a “low” concern level with all three tests below the “Eligible For FPA Adjustment” threshold (see below) on the initial quantitative tests
    • Financial metrics disclosed for FPA test
      • Three-year average ROA, ROE, ROIC and EBITDA growth are the primary financial metrics that will be calculated
        • The selection and weighting of these metrics will vary based on industry
      • While ISS disclosed the importance of each metric in each industry, the weights are not disclosed except in certain cases where two metrics will be equally weighted in a specific industry
        • For example, in the Insurance industry, ROIC and ROA will be weighted equally
          • Banks and Diversified Financials will only have three metrics (ROA, ROIC and ROE) measured
          • Operating Cash Flow growth replaces EBITDA growth in the Insurance, Semiconductor and Real Estate industries
      • Performance is measured using the 12 most recent trailing quarters (16 for growth metrics) as of ISS’ quarterly data download from Compustat
        • Note that performance used in this evaluation may be different than annual results shown elsewhere in the ISS research report
        • As an example, for companies with shareholder meeting dates ranging from March 1 until May 31, data will be downloaded on December 1


Equity Plan Scorecard Adjustments for 2018
The following adjustments to the Equity Plan Scorecard (EPSC) methodology are effective for annual meetings as of February 1, 2018:

  • Passing score for S&P 500 companies has been increased to 55 points
    • For all other companies, passing score remains 53 points
  • Maximum score for Plan Features pillar was slightly reduced in concert with a corresponding increase in maximum score for Grant Practices pillar
    • For S&P 500 and Russell 3000 companies, Plan Features maximum score is now 19 (20 in prior years) and Grant Practices maximum score is 36 (35 in prior years)
      • Plan Cost pillar maximum score of 45 points was not adjusted
    • For S&P 500 and Russell 3000 special cases (recent IPO, spin-off, or emergence from bankruptcy), maximum score for Plan Features was reduced by 2 points (from 35 to 33), while maximum Grant Practices score increased from 15 to 17
  • The Plan Features pillar modified various vesting and holding requirement factors so that companies can earn either full or no credit, partial points will no longer be awarded
    • Change in Control vesting factor
      • Full credit will only be earned in situations where the company’s equity plan contains both of the following provisions:
        • For performance-based awards, acceleration is limited to one of the following treatments:
          • Actual performance achieved
          • Pro-rata of target based on the elapsed proportion of the performance period
          • A combination of both actual and pro-rata
          • Performance awards are forfeited or terminated upon a change in control
        • For time-based awards, acceleration upon a change in control cannot be single-trigger or discretionary
    • Holding requirement factor reduced
      • The threshold for receiving full credit was reduced from a 36-month holding period to a 12-month holding period (or, as before, holding through the end of employment/retirement)
        • A holding period of less than 12 months will result in no credit
        • Note that companies with holding periods that apply only until ownership guidelines are met will not receive credit on this factor
    • CEO vesting requirement factor reduced
      • Full credit now received when equity awards granted to the CEO require at least 3 years of vesting from grant date until all shares vest
        • Includes time-based options, time-based restricted stock, and performance-based awards
        • Previous threshold to receive full credit was vesting of longer than four years
    • Broad discretion to accelerate vesting factor
      • Full credit will only be given in situations where board discretion is limited to cases of death and disability
        • Note that authority to accelerate awards in the case of a change in control will not receive credit under this factor

2018 Glass Lewis Compensation-Related Policy Updates

CEO Pay Ratio
While declaring that the CEO pay ratio has the potential to provide additional insight when assessing a company’s pay practices, Glass Lewis clarified that the ratio will not be a determinative factor in their voting recommendations at this time.  The firm will display the pay ratio as a data point in their research reports.

Pay-for-Performance Model Clarification
While noting that there is no change to their pay-for-performance model, Glass Lewis added clarification regarding the grading system.  Unlike a school letter grade, a “C” does not indicate a significant lapse; rather, a “C” in the Glass Lewis grade system identifies companies where the pay and performance percentile rankings relative to peers are generally aligned.  This suggests that the company neither overpays nor underpays its executives relative to its comparator group.

The grades “A” and “B” are also designated to companies which align pay with performance. However, these grades indicate lower compensation levels relative to the market and to company performance.  A “B” grade stems from slightly higher performance levels in comparison to market peers while executives earn relatively less than peers.  Receiving an “A” in their analysis shows that the company is paying significantly less than peers while outperforming the comparator group.

A grade of “D” or “F” in the analysis is due to high pay and low performance relative to the comparator group.  Glass Lewis identifies a pay and performance disconnect, with a “D” letter grade, while a “significant disconnect” receives a “F”.  A “F” grade indicates that executives receive significantly higher compensation than peers while underperforming the market.

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