In January 2013, Chadbourne hosted its annual presentation with Institutional Shareholder Services (“ISS”) to review the 2012 U.S. proxy season and provide a look ahead to 2013. The following is an edited excerpt of the transcript. The speakers are Marc Goldstein, Head of Engagement at ISS, and Bimal Patel, Head of ISS Global Policy Steering Committee. Also participating are Marc Alpert, Sey-Hyo Lee and Kevin Smith, Chadbourne corporate partners in New York.
Proxy Season Trends
ISS: It is not a surprise that executive compensation continues to be the top area of focus around the globe. Investor respondents again cited compensation as the perennial top governance topic similar to what we saw in the survey result last year. Issuer respondents also cited compensation as their top concern in North America and Europe.
C&P: What were some of the other top issues during the proxy season?
ISS: On a global basis, investors also focused on board competence, director qualifications and board independence. Across every region, board competence and independence were identified among the top three most important governance topics by investors. For issuers, board competence was the third most commonly cited topic across every region. Specifically, board independence and competence seems to resonate with both investors and issuers in the developing markets and Asia Pacific region where board issues may not be as evolved as in some of the more developed markets.
Majority Supported Shareholder Proposals
ISS: With respect to the U.S. market, one of the survey questions we have asked was on the issue of board responsiveness to majority supported shareholder proposals. The marketplace has been clearly evolving in this area both in terms of institutional investor expectations and in terms of the actual responsiveness by issuers.
According to our survey results, 86% of investor respondents expect that boards should implement a shareholder
proposal that receives support from majority of shares in the previous year. That is not too surprising to us. But what is surprising was that 47% of issuer respondents agreed with that view as well. Issuers have been increasingly responding to shareholder proposals that received only one year of majority of votes cast.
C&P: Did you also get any feedback from the issuers as to why they would not be implementing such majority supported shareholder proposals?
ISS: Yes, we certainly did. It was interesting because based on the survey results, 46% of issuers agreed with this approach. However we got a different message during the comment period. Some of the issuers or issuer-related organizations indicated that such a policy forces directors to abdicate their fiduciary duties and it could potentially reduce engagement with shareholders.
Overall, the issuers indicated that a case-by-case approach in looking at the board’s responsiveness and the actions they have taken is more appropriate or that a transition period should be provided for the policy to take effect.
C&P: What is the ISS position regarding boards failing to implement majority supported shareholder proposals or implementing alternative measures?
ISS: Generally speaking, we expect majority supported shareholder proposals to get implemented. There may be circumstances in which we will be flexible but it is going to be on a highly case-by-case and coverage-specific basis.
Under the current policy in the U.S. market, ISS recommends to vote against or withhold from the entire board except new nominees if the board failed to act on a shareholders proposal that received the support of a majority of shares outstanding in the last year, or a majority of shares cast in the last year and one of the two previous years.
This year we have transitioned to using a majority of shares cast in one year as a trigger to evaluate a company’s response to proposals appearing on ballots in 2013. Some of the other changes include flexibility to recommend against members as deemed appropriate and not necessarily the full board. We are also going to include more guidance on our case-by-case examination of the sufficiency of the company’s action in response to a majority-supported proposal.
However we are not retroactively applying this policy and we will not be taking action against directors this year on the basis for proposals in 2012. So the clock starts next year with respect to these proposals.
C&P: Would ISS recommend against the directors in instances where the board attempts but fails to implement the majority supported shareholder proposal? For example, a proposal to declassify the board would require the amendment of the charter through a supermajority approval. Even if the board listens to the shareholders and proposes to amend the charter to declassify at the next year’s meeting, the board would not be able to implement the proposal on its own without the supermajority approval by the shareholders.
ISS: We certainly don’t want to go against the board as long as the board is making an effort. However, if they try only once and it fails to receive the supermajority of the shareholders, we might not consider that to be sufficient effort. Again, this is going to be a case-by-case scenario but we certainly would expect the board to keep trying and not just give up after one attempt. We would expect the board to keep trying if not every year then at least every few years as the shareholder base will change over time. There has to be a robust solicitation effort from the board to try to solicit the shareholders.
Stock Pledges as Collateral for Marginal Loans
ISS: The practice of executives or directors pledging stock as collateral for margin loans has recently received more attention. Based on the results of this year’s policy survey, close to half of investors and 45% of issuers essentially have a zero tolerance policy on pledging. In fact, 80% of issuers and 87% of investors think that significant pledging is a concern; very few think it’s never a concern. Therefore we’ve decided to update our policy on pledging as well.
We view pledging as a risk oversight issue rather than a compensation issue. There is a very real risk to shareholders if pledged shares need to be sold in a hurry, as such sale would negatively impact the company’s stock price. Therefore we have amended our policies to include significant pledging as one of the material failures of governance, stewardship, risk oversight, or fiduciary responsibilities, which can result in recommendations against the directors.
C&P: What level of pledging would be considered “significant”?
ISS: There is no magic number because it’s going to differ from company to company. We’ll examine the number of shares outstanding, average daily turnover, percentage of shares pledged and, if there are multiple executives or directors who have shares pledged, we would look at that as well.
C&P: How should issuers with existing significant pledges respond to this policy update?
ISS: We would like to see boards adopt policies against future pledging and hopefully work on ways to unwind existing pledges responsibly over time. Obviously if companies are required to take such measures immediately, it would have the same impact as a margin call. Therefore we don’t expect companies to do that overnight. However we do expect to see some progress made over time in getting rid of pledges.
ISS: Peer groups have been another perennial hot topic. Our approach has historically been to use the Global Industry Classification Standard (“GICS”) group starting with eight digits and expanding to six, four, and if necessary, two digits. We recognize that this is imperfect but our investor clients use GICS to measure the performance of their portfolio companies to make investment decisions. Furthermore, everyone agrees that the size range of the company is important and that compensation correlates very heavily with the size of the company. Therefore you don’t want companies that are widely different in size being compared to each other.
That being said, issuers tend to ask or prefer that we use the peer groups that they choose, in part because their business activities often aren’t limited to one GICS group. Sometimes business characteristics change over time and GICS doesn’t get updated even though the business has changed. Also, some companies are conglomerates or at least have more than one line of business and so they have peers that straddle GICS groups.
For 2013 and beyond, we will start with the company’s eight-digit GICS group but also look at the subject company’s chosen peers and see if those companies are in industries that make sense. If the industry makes sense but perhaps the company that the subject company has chosen is the wrong size, we may pick a company in the same eight-digit GICS group as the company’s peer, but that’s closer in size to the subject company.
C&P: How do you get the information from the issuers? Is that something you would actively request from them?
ISS: Yes, to the extent that the peers stay the same from year to year, we start with what was in the last proxy. However we know that companies make changes year over year and we asked companies this past fall whether they made any changes in 2012 and asked them to send the changes to us so that we can get started on the process of using those for comparison purposes.
C&P: Issuers are going to be very interested in how ISS comes out in their peer group determinations and how they may differ from what the issuers are doing. Will ISS be disclosing its peer group designations to issuers and allow issuers to comment or have any say in the final determination?
ISS: At least for this year, we don’t have plans to disclose in advance as we are planning to make our final determination while we’re doing the analysis after the proxy is out. However, we’re expecting that the methodology will result in a lot more overlap between our peer group and the subject company’s peer group.
Realizable Total Compensation
ISS: Companies are providing a diverse set of realizable total compensation to show how executive pay has been affected by performance. While grant date pay in the summary compensation table showed the intent behind the pay decisions made by the compensation committee, it doesn’t necessarily reflect the final payouts of performance-based awards or changes in the value due to gains and losses in the company’s stock price. Therefore we changed the way we examine realizable pay based on the responses from the market.
As of 2013, we are going to be more systematic in calculating a realizable value for grants made during a performance measurement period of three years and then compare that value to the grant date value of the same pay and awards in order to provide a more explicit indication of the strength of the pay-for-performance linkage in a company’s compensation programs. Specifically, realizable pay includes all non-incentive compensation amounts paid over the measurement period. To that we add the value of equity or long-term cash incentive awards made during the period and either earned or, if their award remains ongoing, revalued at the target level as of the end of the measurement period.
This realizable pay component is being added for large-cap companies only for this year. We are focusing on the S&P 500 companies since these companies have the most complex compensation programs. In addition, these companies are increasingly using performance-conditioned awards that could be forfeited if the goals are not met. Finally since current disclosure rules don’t provide a standardized picture of realizable pay, we wanted to start with a subset of companies to ensure that we are using the most meaningful definition and getting it right.
Shareholder Proposals and Proxy Access
ISS: Proxy access was not entirely new but it was, for all intents and purposes, a new proposal in 2012 and therefore got a lot of attention at ISS. We saw several flavors of these proposals depending on the identity of the proponent, and there was a clear bifurcation. The proposal sponsored by the U.S. Proxy Exchange and some of the retail proponents tended to get fairly low levels of support. However, proposals submitted by institutional investors and some of the public funds and labor funds in the U.S. received much higher levels of support from investors in 2012.
C&P: Given the longstanding excitement regarding proxy access from the SEC and many shareholder activists, are you surprised by the generally underwhelming support by shareholders?
ISS: Well, not really. If you back out the retail investors’ proposals, which we did not support because we found the ownership thresholds to be too low, and focus on the proposals coming from institutions, the average rate of support was actually quite high considering this was effectively a first year proposal.
Ownership Thresholds for Proxy Access
ISS: Many of the proxy access proposals in 2012 were largely similarly to the defunct SEC Rule 14a-11, which would have permitted shareholders or shareholder groups who owned not less than 3% in voting power for at least three years to include their nominees in the company’s proxy materials for up to 25% of the board.
C&P: Is the SEC’s formulation by far the majority preference for your client base?
ISS: Yes. I don’t know about majority but certainly a number of our clients have indicated fairly strongly that they support this approach as they don’t want to see proxy access used as a substitute for a proxy contest to take over a company. Specifically, our survey indicates that investors indicated support for the 3% ownership threshold on a three-year holding period and the 25% cap on board seats. And those proposals got reasonably high support, that is, somewhere over 30%. In contrast, the retail proposals allowing 50 or 100 investors with $2,000 worth of shares to aggregate their holdings got no traction at all.
Say-on-Pay Votes and Compensation Committees
ISS: The overall support for say-on-pay was down very slightly in 2012 from 2011 but we’re talking about 90.8% on average versus 91.7%. The median level of support in the Russell 3000 was 96.2%. However, 58 companies or 2.5% of companies in the Russell 3000 that had votes this year, failed to get majority support. This is somewhat higher than 2011, where 40 companies or about 1.6% failed to get majority support. About 8% of the Russell 3000 had opposition greater than 30% to their say-on-pay proposal.
The negative votes were mainly due to the perceived disconnect between pay and performance. While shareholders don’t like issues like excise tax gross ups, those issues are largely going away, so the negative votes are being driven more by pay for performance than by anything else.
When say-on-pay first was introduced, we were hearing from a lot of investors that they would take a yellow card, red card approach. If they see a compensation problem, they’ll vote against the say-on-pay proposal in the first year. In the second year, they’ll consider going against the compensation committee if the underlying issue hasn’t been addressed. But what we saw in 2012 is that shareholders in fact were willing to vote against say-on-pay two years in a row but they haven’t been willing in large numbers to escalate to the red card of coming against the compensation committee.
In fact, the major factor in reducing negative votes on directors is say-on-pay. If shareholders have a compensation-related concern, they vote against say-on-pay instead of voting against the compensation committee. We also know that engagement, especially engagement with directors, has increased over prior years. That’s also largely driven by the say-on-pay votes as well. Therefore, compensation committee members are under less pressure than we had anticipated and we do not expect a lot of directors and compensation committee members to actually get voted out over pay concerns.
A Look Ahead to 2013
ISS: So turning to the 2013 preview, we have already identified a few big themes for the year including private ordering and proxy access. However the U.S. Proxy Exchange itself is no longer in existence and we think there are likely to be fewer access proposals from retail investors in 2013. Of course they are not going to disappear altogether but given the lack of success they had in 2012, we just don’t think that we’re going to see a massive push across the entire universe of companies for proxy access.
In terms of shareholder proposal topics, we don’t expect there will be a lot of new ones. The perennial favorites such as board declassification, elimination of super majority voting requirements, independent chair and so forth will not go away.
Some of the hot button governance issues in 2013 are largely the same as in 2012 and 2011. There are perennials, such as annual election of directors and independent chairs. We expect an increase in support among the shareholders for proposals on independent chairs but it hasn’t reached the levels yet of proposals for declassifying a board or implement ing majority voting for directors. So we’re going to see a lot of shareholder proposals on this topic but not quite at the level of those other two.
In terms of annual election of directors, our clients overwhelmingly support it. Investors want the ability to vote on directors every year but that doesn’t necessarily mean they’re willing to throw them all out. According to our own statistics, only 61 nominees out of over 17,000 in the Russell 3000 failed to get majority support. Therefore we expect to see pretty much the entire S&P 500 move to annual elections within a few years.
We’re also expecting to see more proposals for majority voting moving down to the next tier of companies after the S&P 500. We’re going to see continuing activity on special meetings and written consents where companies already have the right to call a special meeting but the threshold for doing so is high. We expect to see shareholder proposals calling for that to be lowered. We may see companies try to pre-empt that by lowering their own thresholds but not as much as shareholders want. And again, this is a continuation of a trend already seen in 2012.
Say-on-pay hasn’t completely done away with shareholder proposals on compensation-related topics and we expect to see a number of those in 2013. Shareholder proposals on recoupment or clawbacks tend to go beyond the requirements of Dodd-Frank and Sarbanes-Oxle, and seek recoupment even where there isn’t a formal restatement.
We will see proposals on holding periods for equity awards, retention ratios and bonus banking. In other words, make sure that the metrics for the pay are sustainably achieved before the bonus gets paid out.
We also expect to see at least one and probably more proposals specifically related to peer group benchmarking, especially targeted at companies that target their CEO compensation at the 75th percentile of their peer group.
Environment and sustainability issues such as labor and human rights issues throughout the supply chain are also expected to come up in 2013. Again, we’ve seen this in the past couple of years and that’s going to continue in 2013.
Finally, board diversity and especially gender diversity is going to be another focus. This issue will possibly be addressed through shareholder proposals or through dialogue and engagement. We don’t know how many shareholder proposals we’re going to see but we know that it’s an issue that is of concern to a lot of investors and that they are going to be talking to companies about it.