What you need to know:
ISS recently issued its policy updates, with changes relating to voting on director nominees and executive pay evaluation. These updates are applicable to US public companies that have a meeting on or after February 1, 2013.
What you need to do:
Companies should review their existing company practices in light of these updates—particularly practices regarding hedging and pledging of company stock and construction of the company peer group.
Institutional Shareholder Services recently released its 2013 updates to voting guidelines for US public companies, which are applicable to shareholder meetings on or after February 1, 2013. The primary changes relate to voting on director nominees and executive pay evaluation. With respect to voting on director nominees, ISS adopted a policy regarding hedging and pledging of company stock and revised its existing policy on responsiveness to shareholder proposals. With respect to executive compensation, ISS refined the construction of the peer group relevant to say-on-pay evaluation and, for large cap companies, incorporated a “realizable pay” analysis into its compensation analysis. ISS has indicated that, in December 2012, it will release Frequently Asked Questions that will provide further guidance on these and other policy updates.
Policy Updates Relating to Director Nominees
Hedging and Pledging of Company Stock. The ISS updates provide that “any amount of hedging” or a “significant pledging of company stock” would constitute a failure of risk oversight at the company warranting a negative vote recommendation. The ISS update provides that in determining the vote recommendation of directors of companies who currently have executives or directors with pledged company stock, ISS will consider:
- Presence in the company’s proxy of an antipledging policy that prohibits future pledging activity;
- Magnitude of aggregate pledged shares in terms of total shares outstanding or market value or trading volume;
- Disclosure of progress in reducing the magnitude of pledged shares over time;
- Disclosure that shares subject to stock ownership and holding requirements do not include pledged company stock; and
- Other relevant factors.
Companies should act to ensure that no directors or executives currently hedge their shares (e.g., covered calls or collars) and evaluate their existing corporate governance policies to ensure that they contain an antipledging policy (e.g., prohibit the use of company stock as collateral for third-party loans) and that stock ownership and holding requirements do not include pledged stock.
Response to Majority Supported Shareholder Proposals. ISS has strengthened its existing policy to provide that, commencing in 2014, it will vote against or withhold from individual directors, committee members or the entire board if the board failed to act on a shareholder proposal that received the support of a majority of the shares cast in the previous year. ISS also clarifies that responding to a shareholder proposal will generally mean full implementation of the proposal or, if the proposal requires shareholder approval, a management proposal on the next annual ballot to implement the proposal. Responses that involve less than full implementation will be considered on a case-by-case basis, taking into account:
- The subject matter of the proposal;
- The level of support and opposition provided to the resolution in past meetings;
- Disclosed outreach efforts by the board to shareholders in the wake of the vote;
- Actions taken by the board in response to its engagement with shareholders;
- The continuation of the underlying issue as a voting item on the ballot; and
- Other factors as appropriate.
As a result of this policy, companies will face increasing pressure to act on precatory proposals that are supported by shareholders and will need to focus on efforts to keep proposals from coming to a vote in the first instance, such as ensuring ongoing engagement with active shareholder groups.
Policy Updates Related to Executive Compensation Evaluation
Peer Group Selection in Say on Pay. ISS currently uses three quantitative tests to identify companies with a misalignment of pay and performance. Companies that pass these tests receive a “for” recommendation from ISS for management’s say on pay proposal unless ISS identifies “problematic pay practices” (e.g., tax-gross-ups, single-trigger change-in-control severance payments). Companies that fail the quantitative tests are subject to a further qualitative analysis. For two of the quantitative tests (the relationship between a company’s total shareholder return rank and its CEO’s total pay within a peer group of companies and the CEO’s pay as a multiple of a peer group median) ISS creates peer groups on the basis of revenue, market capitalization and Standard & Poor’s Global Industry Classification Standard.
In response to criticism that ISS-constructed peer groups often lacked correspondence to company-constructed peer groups, ISS will now take into account the company-constructed peer group. ISS indicates that the methodology will initially focus at an eight-digit GICS resolution to identify peers that are more closely related in terms of industry, and that when selecting peers, the methodology prioritizes peers that maintain the company near the median of the peer group, are in the company’s peer group and have chosen the company as a peer. Peer groups will no longer have members based upon a two-digit GICS. Companies should proactively analyze which companies are likely to fall within the ISS-constructed peer group and the implications, both positive and negative, for ISS’ pay-for-performance analysis.
Realizable Pay Analysis in Say on Pay. ISS will now use “realizable pay” in its qualitative evaluation of compensation for large cap companies should a company fail the quantitative tests. ISS defines realizable pay to be the sum of relevant cash and equity-based grants and awards made during the performance period being measured, based on equity award values for actual earned awards, or target values for ongoing awards, calculated using the stock price at the end of the performance measurement period. ISS indicates that stock options or stock appreciation rights will be re-valued using the remaining term and updated assumptions, as of the end of the performance measurement period, using a Black-Scholes option pricing method. This change is in response to the continuing trend towards supplemental disclosure or filings by companies to disclose actual compensation paid to executives and directors, as opposed to theoretical compensation using grant date fair value measures. This change emphasizes the value for all companies, and not just large cap companies, of considering supplemental disclosure of actual compensation that helps investors understand a better picture of what was actually paid to executives and directors.
- Say on Golden Parachutes. ISS will no longer ignore change-in-control arrangements adopted prior to the last annual shareholder meeting for potential problematic pay practices and instead will now focus on all compensation arrangements in its review.
- Overboarding. ISS will no longer count as one directorship a publicly traded subsidiary owned 20% or more by the parent company. However, subsidiaries with only publicly traded debt will continue to not count separately.
- Attendance. ISS has adopted a stronger approach to directors who do not attend 75% of the board and committee meetings, including a withhold or against vote on any director whose attendance is questionable due to unclear and insufficient disclosure.
Current Action Items for Companies
In response to the ISS updates, companies will want to:
- Evaluate existing practices regarding hedging and pledging of company stock by directors and executives;
- Analyze which companies are likely to fall within their ISS-constructed peer group and the implications, both positive and negative, for the ISS’ pay-for-performance analysis; and
- Consider supplemental disclosure of actual compensation that helps investors understand what was actually paid to executives and directors.