RiskMetrics Group (RMG), on November 19, 2009, issued Updates to its Corporate Governance Policy applicable to shareholder meetings held on or after February 1, 2010. The Updates applicable to U.S. companies are available at http://www.tinyurl.com/RMGUSUpdates. Depending on a company’s shareholder base, a RiskMetrics voting recommendation may significantly affect the outcome of votes at an annual meeting. In 2010 director elections, a negative RMG voting recommendation, combined with no broker discretionary voting in the absence of customer instructions (new in 2010) and the increasing number of companies with some form of majority voting in director elections, carries an increased risk that one or more directors are not elected or are required to submit their resignations. The trend is clear. RiskMetrics reported that in the 2009 proxy season 91 directors from 49 U.S. companies did not receive a majority of votes favoring their election. In 2008, 32 directors from 17 companies did not receive a majority vote.
This article summarizes the more important RiskMetrics Updates for typical U.S. public companies. Corporate secretaries, counsel and directors (especially those serving on the compensation or nominating and governance committees) should focus on the potential impact of the 2010 Updates and evaluate areas of possible vulnerability well in advance of the 2010 proxy season.
Key Changes for the 2010 Proxy Season
Shareholder Rights Plans (Poison Pills)
RiskMetrics has amended its policy with respect to voting on directors at companies where directors have adopted a poison pill that has not been approved by shareholders. They now review and recommend on a case-by-case basis where directors have adopted a pill with a term of 12 months or less without shareholder approval.
RMG will recommend a negative vote for all continuing directors where they have, without shareholder approval: 1) adopted a pill with a term longer than 12 months; 2) renewed a pill; 3) made any “material adverse change” to an existing pill; or 4) maintained an existing pill that has not been approved by shareholders. If a company has a classified board RMG, will review their pill every year; otherwise, they will review every three years for companies where the board is elected annually.
These revised policies will be applied to companies adopting or renewing poison pills after November 19, 2009, the date RMG’s new policies were announced. RMG continues to have a separate voting policy where rights plans are adopted for the stated purpose of preserving net operating losses (NOLs). The shareholder rights plan analysis in the NOL context remains on a case-by-case basis and considers the rights plan trigger, the value of the NOL, the term of the rights plan and any other shareholder-friendly aspects in the rights plan. RMG will also consider the company’s overall governance structure and its history of responsiveness to shareholders.
Executive Compensation and Equity Plans
RMG has combined its guidelines for management “say-on-pay” review with its guidelines used to analyze equity plan proposals and board elections. The focus now is on identifying “problematic pay policies.” If RMG concludes that a company has problematic pay policies, it may recommend a vote against a management say-on-pay resolution, against an equity plan proposal, and/or against or to withhold votes from either compensation committee members or all directors. Problematic pay practices include those that could incentivize excess risk taking by management, such as high pay opportunities in relation to industry peers, large annual equity grants with unlimited upside and no downside risk, large supplemental pensions, lucrative severance packages and guaranteed bonuses. Factors that potentially mitigate the impact of risky incentives are noted by RMG and include “rigorous” claw-back provisions and “robust” stock ownership guidelines. RMG notes that past problematic pay practices that they deem most significant include “egregious” employment contracts, “abnormally large” bonus payouts, particularly without justifiable performance linkage, “excessive” perquisites, “egregious” pension terms, “excessive” severance or change in control provisions, tax reimbursements, paying dividends on unearned performance awards, repricing or replacing underwater stock options or stock appreciation rights, executives using company stock in hedging activities (for example, forward sales or equity swaps), and “overly generous” new CEO compensation packages.
RMG will also determine whether to recommend a negative vote for the reelection of compensation committee members (or in certain cases the full board) by assessing pay-for-performance, which now will include an assessment of CEO pay in relation to a company’s total shareholder return over five years. In discussing its new focus on potential incentives for excessive risk-taking, RMG, in addition to the problematic pay practices mentioned above, highlighted the danger of using a single performance measurement for either short- or long-term plans.
RMG, upon releasing its Policy Updates, also released a set of frequently asked questions relating to its evaluation of U.S. companies’ compensation practices at http:// www.tinyurl.com/RMGCompFAQ. In these FAQ responses, RMG has provided additional guidance regarding option exchange programs and stated that in addition to favoring shareholder-friendly provisions, such as excluding named executive officers and directors, that option exchanges should only be used when options are significantly under water and that, as a general rule, the threshold exercise price for the new options should be the higher of 50% above the current stock price or the 52-week high.
RMG has amended its evaluation of director independence by broadening the definitions of transactional relationships and professional services that may impair independence. For New York Stock Exchange listed companies, RMG will apply the NYSE’s test of the “greater of $1 million or two percent of the recipient’s gross revenues” in evaluating transactional relationships. This test will also apply to Amex listed companies. For all other companies, the NASDAQ test of the “greater of $200,000 or five percent of the recipient’s gross revenues” will be applied to assess the materiality of transactional relationships. RMG also clarified the definition of “professional services” to focus on services that are “advisory in nature.”
The definition of “egregious actions” has been broadened. RMG will recommend negative votes for individual directors, specific committees, or for the entire board under its existing standards for egregious actions; or for the failure, under appropriate circumstances, to replace management. RMG will also consider, in extraordinary circumstances, “material failures of governance, stewardship or fiduciary responsibilities at the company.” Relating to directors’ service on other boards, they will consider actions that “raise substantial doubt about his or her ability to effectively oversee management and serve the best interests of shareholders.”
Expected Effects of the Policy Updates
As mentioned above, because of the increase in companies adopting majority voting for the election of directors and/or director resignation policies, combined with the elimination of brokers’ ability to vote in director elections without instructions from customers, negative vote recommendations by RMG are likely to have a greater impact in 2010. Looking back at the 2009 proxy season, in spite of the large number of “against” and “withhold” votes, few directors were not seated, primarily because most companies where a director received a majority negative vote had a plurality standard in place for director elections and no director resignation policy.
Historically, RMG has provided S&P 500 companies with notice when it intends to issue a recommendation to vote “against” or “withhold” from a director. Usually those companies are given a tight 48-hour period to respond and discuss with RMG their intentions. Smaller companies have generally not received any advance notice. Considering the historically tight time frame, preparation well ahead of any RMG determination is essential. Companies should familiarize themselves with the criteria used by RMG in recommending a vote “against” or “withhold” in director elections.