On November 17, 2011, Institutional Shareholder Services ("ISS"), a leading proxy advisory firm, released its U.S. and international corporate governance policy updates for the 2012 proxy season.
For details, please see the U.S. Corporate Governance Policy 2012 Updates ("2012 Policy Updates"), available at http://www.issgovernance.com/policy/2012/policy_information
The 2012 Policy Updates apply to shareholder meetings held on or after February 1, 2012.
This client alert reviews the most significant U.S. policy updates and additional detail on the policies provided by Patrick McGurn, Special Counsel at ISS, at the November 18, 2011 meeting of the American Bar Association's Business Law Section's Subcommittee on Shareholder and Investor Relations. The client alert concludes with commentary and recommendations in light of the ISS policy updates.
Pay-for-Performance Evaluation. Under ISS's current pay-for-performance test, ISS first runs a quantitative analysis to determine whether a company's one- and three-year total shareholder returns ("TSR") fall below the median of the company's four-digit GICS industry group and whether the compensation of a CEO who has served for at least two years has increased or not declined. Next, for those companies exhibiting a below-median TSR under the foregoing tests, ISS conducts a qualitative review to analyze the various pay elements and whether they create or reinforce alignment with shareholders. In conducting this review, ISS takes into account factors such as the extent and clarity of disclosure around performance-based incentives and the alignment between the CEO's pay and the company's TSR performance over the last five years (with the most recent year-over-year change being a key consideration). If ISS finds a "pay for performance" disconnect under this review, it recommends "Against" the company's say-on-pay proposal or, if there is not a say-on-pay proposal, "Against" the directors who have served on the company's compensation committee.
For 2012, ISS is revising its quantitative screening test and, for those companies that are identified through this screening test, refining its review of qualitative components. The quantitative analysis will now include analysis of two measures: (1) relative performance; and (2) absolute performance, as discussed below.
- Relative performance is company performance measured against an ISS-created "peer group" of 14-24 companies that ISS deems similar to the company in market capitalization, revenue or assets and GICS industry group. The relative performance component will measure both the degree of peer group alignment, specifically between the company's TSR rank and the CEO's total pay rank within the peer group, measured over one- and three-year periods (with one-year rank weighted at 40% and three-year rank weighted at 60%), and the multiple of the CEO's total pay relative to the peer group median.
- The absolute performance component will measure the trend in CEO pay against the company's annualized TSR during the past five fiscal years.
If the quantitative analysis demonstrates "significant unsatisfactory" long-term pay-for-performance alignment, ISS will next undertake a qualitative review to determine its voting recommendation. The qualitative analysis will consider:
- the ratio of performance-based to time-based equity awards;
- the ratio of performance-based compensation to overall compensation;
- the "completeness" of disclosure and "rigor" of performance goals;
- the company's peer group benchmarking practices;
- absolute and relative financial and operational performance, such as growth in revenue, profit and cash flow;
- any special circumstances, such as the appointment of a new CEO in the last fiscal year or "anomalous" equity grant practices (e.g., granting awards every two years); and
- any other factors ISS deems relevant.
In light of the longer-term emphasis of the new policy, ISS generally will no longer exempt from the pay-for-performance test those companies with a CEO who has served for less than two consecutive fiscal years. Rather, compensation committees will be held accountable for any "overpayment" that occurs in connection with CEO turnover.
Mr. McGurn and other ISS personnel have commented that the revised quantitative screening test is designed to reduce the number of "false positives" among companies that are subjected to a qualitative evaluation. However, the revised list of qualitative factors appears to be more in the nature of a refinement and clearer articulation of the qualitative factors that ISS considers under its current policy. Mr. McGurn noted that during 2011, approximately 800 companies were identified through the below-median TSR test under ISS's current policy, while ISS then recommended an "Against" vote due to a "pay-for-performance disconnect" at approximately 23% of those companies. ISS personnel have indicated that, in retrospectively testing the revised quantitative screening methodology against 2011 data, the companies that fail the new test are more closely correlated with those where ISS made negative recommendations. This suggests that the number of companies that are identified through the quantitative screening test is likely to decline, but those that are identified may be more likely to garner an "Against" voting recommendation on their say-on-pay proposal or compensation committee members.
ISS plans to issue additional technical guidance on its peer group methodology and its pay-for-performance methodology in December 2011.
Board Response to Say-on-Pay Votes. The 2012 Policy Updates include a new policy that, where a company's last say-on-pay proposal received support of less than 70% of votes cast, ISS will recommend votes on a case-by-case basis with respect to the re-election of compensation committee members (or, in exceptional cases, all directors) and the company's say-on-pay proposal, taking into account:
- the company's response to investor concerns, including disclosure of engagement efforts with major institutional investors regarding the issues that led to low investor support;
- specific actions taken to address these issues;
- other compensation actions taken by the company;
- whether the issues that led to lower investor support were recurring or isolated in nature; and
- the company's ownership structure (e.g., whether the vote would have been lower but for a large insider ownership block).
The policy also states that say-on-pay support below 50% will warrant the "highest" degree of responsiveness and, according to Mr. McGurn, closer ISS scrutiny. Corresponding to the new SEC requirement that a company's Compensation Discussion and Analysis address whether and how the company considered its most recent say-on-pay vote in determining the company's executive compensation decisions and policies, the ISS policy states that companies with low votes on their most recent say-on-pay proposals should disclose their outreach efforts to institutional investors and identify any specific actions taken to address investors' concerns.
Board Response to Say-on-Frequency Votes. ISS also adopted a new policy to address board responsiveness to shareholder preferences on say-on-pay frequency. ISS will recommend votes "Against" the re-election of all directors if the board decides to conduct future say-on-pay votes on a less frequent basis than that supported by a majority of votes cast in the most recent say-on-frequency vote. If no frequency received a majority of votes cast and the board decides to conduct future say-on-pay votes less frequently than the frequency that received a plurality of the votes cast, ISS will recommend votes on directors on a case-by-case basis, taking into account:
- the board's rationale for choosing a frequency different than the one that received the most votes cast;
- the company's ownership structure and vote results;
- ISS's analysis of whether there are any compensation concerns or a history of problematic compensation practices; and
- the voting results of the previous year's say-on-pay proposal.
ISS will not recommend votes "Against" directors for deciding to conduct future say-on-pay votes on a more frequent basis than the frequency that received a majority or plurality of votes cast.
Section 162(m) Incentive Plan Proposals.
recommends that shareholders vote "For" cash and/or equity-based incentive plans when a company is seeking shareholder approval
to enable compliance with Section 162(m) of the Internal Revenue Code and not also seeking approval (with respect to equity-based plans) to increase the shares reserved for issuance under the plan.
However, under the 2012 Policy Updates, if the proposal relates to an equity plan that is being voted on by shareholders for the first time following a company's initial public offering, ISS will evaluate the plan under the same criteria that it would a proposal to adopt a new plan, taking into account factors such as ISS's shareholder value transfer analysis and burn rate policies.
Proxy Access. ISS currently determines voting recommendations on proxy access shareholder proposals on a case-by-case basis, taking into account the proposed ownership threshold and the proponent's rationale for targeting the proposal to the company with respect to board and director conduct. As a result of the 2012 Policy Updates, ISS will continue to apply a case-by-case approach, but it will now extend the policy to company proxy access proposals and consider both company-specific factors as well as the proposal's specifics, including the:
- proposed ownership thresholds (i.e., percentage and holding duration);
- maximum percentage of directors that shareholders may nominate each year; and
- method of determining which nominations appear in the proxy if multiple shareholders submit nominations.
While ISS no longer specifically references the proponent's rationale for targeting the company, it remains a factor that ISS may consider in evaluating such proposals. Mr. McGurn indicated that ISS expects to see three versions of proxy access shareholder proposals this coming proxy season: (1) a proposal largely modeled on the SEC's vacated proxy access rules, with a 3%/3 year ownership standard and various other limitations on the availability of proxy access; (2) a proposal advocated by U.S. Proxy Exchange, an individual investor advocacy organization, which has a 1%/2 year and 100 proponent "crowd access" ownership standard with no limit on the aggregate number of access nominees; and (3) a binding proposal with a 1%/1 year ownership threshold and some of the limitations from the SEC's vacated proxy access rule.
Board Accountability. The 2012 Policy Updates memorialize ISS's policy (which it has applied in the past) to recommend "Against" or "Withhold" votes on individual directors, board committee members, or the entire board due to "material failures" of risk oversight. ISS noted that this policy is not intended "to penalize boards for taking prudent business risks or for exhibiting reasonable risk appetite." Instead, this policy is intended to emphasize oversight of the company's risk management practices as a component of the board's fiduciary duties.
Shareholder Rights and Defenses
Exclusive Venue Company Proposals. Exclusive venue proposals are requests to amend a company's governing documents to limit shareholder suits to a specific jurisdiction, typically Delaware. ISS currently recommends votes "Against" these proposals unless the company has adopted certain governance practices, including permitting 10% of outstanding shares to call a special meeting. Under the 2012 Policy Updates, ISS will consider exclusive venue proposals on a case-by-case basis, taking into account both the company's litigation history and governance practices, except that ISS will no longer consider the company's special meeting provision given that it is "less relevant" to exclusive venue proposals as opposed to other proposals. Thus, ISS will evaluate whether the company:
- has been "materially harmed by shareholder litigation outside its jurisdiction of incorporation, based on disclosure in the company's proxy statement;" and
- has an annually elected board, has majority voting in uncontested director elections, and does not have a non-shareholder approved poison pill.
Dual-Class Structure. ISS currently recommends votes "Against" proposals to create a new class of common stock with superior voting rights and "For" proposals to create a new class of nonvoting or "subvoting" common stock under certain circumstances. The 2012 Policy Updates eliminate the focus on voting rights and consolidate the current approach into one policy on the formation of a dual-class capital structure. Thus, ISS generally will recommend votes "Against" proposals to create a new class of common stock, unless:
- the company discloses a compelling rationale for the dual-class capital structure, such as its auditor concluding that there is substantial doubt about the company's ability to continue as a going concern, or the new class of shares will be transitory;
- the new class is intended for financing purposes with nominal or no dilution to current shareholders in both the short term and long term; and
- the new class is not designed to preserve or increase the voting power of an insider or significant shareholder.
Political Spending. Under the 2012 Policy Updates, ISS generally will recommend votes "For" proposals seeking disclosure of corporate political contributions and trade association spending, instead of assessing these proposals on a case-by-case basis. In addition, ISS now will explicitly consider a company's disclosure of its oversight mechanisms. Thus, under this new policy, ISS will consider:
- "the company's current disclosure of policies and oversight mechanisms related to its direct political contributions and payments to trade associations or other groups that may be used for political purposes, including information on the types of organizations supported and the business rationale for supporting these organizations;" and
- any recent significant controversies, fines, or litigation related to the company's political contributions or political activities.
Lobbying Activities. The 2012 Policy Updates amend ISS's lobbying activities policy to clarify that it applies not only to shareholder proposals seeking information on a company's lobbying initiatives but also to those seeking information on its lobbying activities generally, including grassroots lobbying. ISS will continue to evaluate such proposals on a case-by-case basis, considering:
- the company's current disclosure of relevant policies and oversight mechanisms;
- any recent significant controversies, fines, or litigation related to the company's public policy activities; and
- the impact that the policy issues may have on the company's business operations.
Hydraulic Fracturing. The 2012 Policy Updates set forth a new policy on shareholder proposals requesting additional disclosure concerning a company's hydraulic fracturing (or "fracking") operations, including a company's measures to address the potential effects of those operations on the community and environment. ISS generally will recommend a vote "For" such proposals, considering:
- the company's current level of disclosure;
- the company's level of such disclosure in comparison to its industry peers;
- potential regulatory developments; and
- controversies, fines, or litigation related to the company's fracking operations.
Workplace Safety. The 2012 Policy Updates set forth the ISS policy developed in response to shareholder proposals during the 2011 proxy season requesting workplace safety reports, including reports on accident risk reduction efforts. ISS will consider these proposals on a case-by-case basis, taking into account:
- the current level of company disclosure of its workplace health and safety performance data, management policies, initiatives, and oversight procedures;
- the nature of the company's business, as it affects exposure to health and safety risks;
- recent significant controversies, fines, or violations related to health and safety in the workplace; and
- the company's relative workplace health and safety performance in comparison to its industry peers.
Recycling. ISS currently assesses shareholder proposals to adopt a comprehensive recycling strategy on a case-by-case basis. In light of 2011 proposals requesting reports on corporate recycling strategies, ISS updated its policy to include proposals seeking such reporting and to consider a company's current level of disclosure. ISS now will determine its voting recommendation on a case-by-case basis on proposals both to report on an existing recycling program and to adopt a new program, taking into account the:
- nature of the company's business;
- current level of disclosure of the company's existing related programs;
- timetable prescribed by the proposal and the costs and methods of program implementation;
- ability of the company to address the issues raised in the proposal; and
- comparison of the company's recycling programs with similar programs of its industry peers.
Water Issues. The 2012 Policy Updates include a new policy concerning proposals requesting a company to report on, or to adopt a new policy on, water-related risks and concerns. ISS will consider these proposals on a case-by-case basis, taking into account:
- the company's current disclosure of relevant policies, initiatives, oversight procedures, and usage metrics;
- the degree of alignment between the company's existing policies and practices and relevant internationally recognized standards and national or local regulations;
- the potential financial effect or risk to the company associated with water-related issues; and
- recent significant controversies, fines, or litigation related to water use by the company and the company's suppliers.
Considerations and Recommendations
While the extent of ISS's influence over voting results is debated, even institutional shareholders that do not follow ISS voting recommendations often look to ISS's analyses to identify areas of potential concern. Thus, companies can benefit from the degree of transparency that ISS provides by assessing their practices and disclosures against the criteria and factors described in ISS's voting policies. In many cases, the extent to which a company recognizes an issue and proactively addresses the concern in its disclosures and discussions with its shareholders can make a significant difference in the content of ISS's analysis and, at times, its voting recommendation. For example, when commenting on ISS's voting recommendations on shareholder proposals relating to hydraulic fracturing, Mr. McGurn commented that there were significant variations in the quality of company disclosures.
With respect to ISS's revised pay-for-performance analysis, companies should consider providing specific disclosures to address the elements of ISS's quantitative and qualitative analyses, and consider how their compensation practices may be viewed under those standards. For example, it is unclear how companies with recently appointed CEOs will fare under the policies when (as is common) the compensation committee has slowly elevated compensation levels up to a median peer group level (which peer group will likely differ from the ISS peer group) over the first three years of the CEO's tenure. As companies, shareholders and ISS gain experience with the new voting guidelines, companies may again determine to file additional soliciting materials to respond to and elaborate upon issues raised in an ISS analysis as many did last proxy season.
As has been frequently noted, engagement with shareholders will continue to be important. As demonstrated by the ISS voting policy on board responses to say-on-pay votes, that engagement should not be reserved for the period after a company's proxy materials are filed. Rather, the input from shareholder engagement will need to be considered in the board's deliberative process and in the proxy drafting process.