Quantitative Test Continues to Be Based on Relative TSR But 2017 Reports Also Will Show Relative Financial Performance Based on Six New Metrics; Peer Group Submission Window Opens November 28

SUMMARY

Institutional Shareholder Services, the proxy advisory firm, has announced updates to its pay-forperformance methodology for U.S. companies. Effective February 1, 2017, ISS proxy research reports will display a measure of the company's financial performance relative to peers based on a new weighted combination of six financial metrics--return on equity, return on assets, return on invested capital, revenue growth, EBITDA growth and cash flow (from operations) growth--each over a three-year period. The relative financial performance measure will not affect ISS's quantitative analysis of relative pay-forperformance for 2017, which will continue to assess CEO pay against relative three-year total shareholder return (TSR), but may be considered in ISS's qualitative assessment. ISS announced that neither measure will apply unless companies have at least two years of CEO pay and trading or financial data.

ISS also announced that the online peer group submission window for issuers will be open from November 28 through December 9, 2016 through its Governance Analytics platform. In light of the expanded use of peer group metrics under the updated policy, companies should take necessary steps to ensure that ISS's peer group construction incorporates the most updated list of peers used by the company in setting compensation.

DISCUSSION OF UPDATES

ISS's pay-for-performance evaluation is a significant driver of its say-on-pay recommendations. As described in further detail in ISS's Pay for Performance report, this evaluation begins with a quantitative assessment that has three components:

  • Alignment of CEO pay and three-year TSR relative to peer group;
  • CEO pay relative to peer group median; and
  • Absolute alignment of CEO pay and five-year TSR.

If the quantitative assessment reflects an apparent pay-for-performance disconnect, ISS conducts an in-depth qualitative multi-factor assessment of how compensation components align executive interests with the company's long-term performance and stockholder interests. The outcome of the quantitative evaluation, any qualitative evaluation and a discussion of the various components and factors are set out in ISS's proxy research reports along with various other financial metrics.

Beginning February 1, 2017, ISS proxy research reports will include a standardized table comparing CEO pay and three-year financial performance relative to the ISS peer group. The analysis of financial performance, historically limited to TSR, will be expanded to include relative financial performance based on a new weighted combination of six financial metrics, each on a three-year basis:

  • Return on equity;
  • Return on assets;
  • Return on invested capital;
  • Revenue growth;
  • EBITDA growth; and
  • Cash flow (from operations) growth.

The weightings of these metrics will be determined by the company's Global Industry Classification Standard (GICS) industry group. ISS will use this weighted measure to generate a numeric indicator of the alignment between three-year financial performance and three-year CEO pay for the company and its peers. Most of these metrics are already included in ISS reports, both on an absolute basis and on a relative basis against specific peers, but the new presentation will combine them into one weighted performance measure that will be compared across the peer group.

This change will not impact the quantitative assessment discussed above--the first of the three quantitative components will continue to be based on relative TSR alone. ISS did, however, announce that this component of the quantitative test, and the new relative financial performance measure, will not apply to companies that do not have at least two full years of CEO pay and TSR or financial data.

IMPLICATIONS

ISS's updates to its pay-for-performance evaluation methodology reinforce the importance of communicating to investors how executive compensation aligns with company performance. Companies should consider whether the company's performance under any of the new metrics will require further explanation to enable investors to understand pay-for-performance alignment and may wish to consider whether it is appropriate to broaden the financial metrics used to discuss financial performance in their compensation committee materials and proxy statement disclosure.

In addition, these changes in presentation and evaluation further highlight the importance of the peer group chosen by ISS. ISS constructs a company's peer group based on market cap, revenue (or assets for financial firms), GICS industry group and a company's self-selected peers. Companies should utilize the ISS peer group submission process to ensure that ISS is using the most updated list of companyselected peers (that is, those that will be used in making 2016 compensation decisions). ISS's online peer group submission window for issuers will be open from November 28 through December 9, 2016, through its Governance Analytics platform.