Why is Everyone Grumbling? An Introduction to Understanding ISS Guidelines and Other Investor Concerns about Equity Plan Design and Governance

Transcription

1 Why is Everyone Grumbling? An Introduction to Understanding ISS Guidelines and Other Investor Concerns about Equity Plan Design and Governance SPEAKERS Jon Burg, Radford, an Aon Hewitt Company Jon Doyle, International Law Partners Reid Pearson, Alliance Advisors

2 Agenda Background 2011 Equity Plan Proposal Experience Myths Dispelled Equity Governance Know Your Shareholders ISS Policy Overview Dilution, Shareholder Value Transfer, and Share Pool Management Burn Rate and ISS Policy Pay for Performance Other Considerations Planning for Your Share Request Appendix Shareholder Value Transfer and Burn Rate Examples 2

3 Background SEC approved changes to the NYSE and NASDAQ listing requirements to require shareholder approval of most equity plans in June 2003 Obtaining shareholder approval for equity plan proposals is critical to companies compensation strategies There have been 3,048 equity plan proposals from 2008 to date submitted by Russell 3000 Companies for which results have been reported1 Only 44 failed to obtain majority support (1.4%) BUT, these statistics may be misleading Despite the low failure rate, understanding equity plan governance and the impact it will have for your company is as important today as determining how to allocate it Shareholders generally fall into three categories: Insiders, Institutions, and Retail Institutional Advisors, such as Glass Lewis and Institutional Shareholder Services (ISS), have become very influential in the process 1 Data obtained from ISS Voting Analytics database 3

4 Statistics for Equity Plan Proposals YTD Total Total Proposals ,374 Total Known Vote Results ,048 Pass ,004 Fail ISS Against Data from ISS Voting Analytics Data for Russell 3,000 4

5 2011 Equity Plan Proposal Experience Over twenty companies issued supplemental proxy filings, at least ten made changes in response to ISS report athenahealth (amends share counting) Questcor (revised repricing language) First Industrial Realty Trust (revised repricing language) Anika Therapeutics (reduced share request) Hersha Hospitality Trust (reduced share request) Sykes Enterprises Inc. (reduced share request) Kenexa Corp (reduced share request) Reinsurance Group of America (revised repricing language) Westar Energy (reduced share request) OraSure Technologies (reduced share request) Equity proposals have failed Integrated Silicon Solution Vantage Drilling Company Valassis Communications Aspen Insurance Holdings Limited Horsehead Holding Company General Maritime Corporation IRIS International ZAGG Incorporated (ISS recommended FOR) 5

6 Myths Dispelled ISS makes mistakes and refuses to fix them ISS policies can be ignored since over 90% of proposals pass despite negative vote recommendations Receiving an ISS FOR recommendation ensures shareholder approval The Shareholder Value Transfer model is a complete black box Paying for the ISS model is a waste because you never know what ISS will recommend Liberal share counting has to be eliminated Retail vote is not worth pursuing 6

7 Equity Governance 7

8 Know Your Shareholders Analyze Your Shareholder Base Management and Directors: Friendly Votes Retail Holders Only about 20 to 30% of retail holders will vote without being prompted Typically follow management s recommendation Institutional Shareholders Determine how the institution makes proxy voting decisions Do they follow the recommendations of ISS or Glass Lewis? Do they have their own internal guidelines (Fidelity, Vanguard, State Street for example)? Determine the influence that ISS is going to have How strictly does the institution follow ISS? Determine who makes the vote decision at the institution Equity side, compliance team, or hybrid 8

9 Know Your Shareholders Sample Shareholder Base Rank Ins(tu(on % O/S Proxy Influence 1 Dimensional Fund Advisors 12.00% ISS 2 Columbia Management Investment 11.00% Glass Lewis 3 State Street Global Advisors 7.00% Internal Guidelines 4 Fidelity Research & Management 5.00% Internal Guidelines 5 InsItuIon E 5.00% ISS 6 InsItuIon F 3.50% Internal Guidelines Proxy Influence of Company 50.00% 40.00% 30.00% 20.00% 10.00% 0.00% ISS Glass Lewis Internal D&O Retail 9

10 Know Your Shareholders How Will They Analyze Your Plan For the institutional shareholders that have their own internal guidelines, you must determine what vote drivers they use. Some institutional shareholders will have a defined set of policies, others will use a set of general screens for maximum flexibility. Voting Power Dilution Burn rate Fully-Diluted Dilution Basic or Simple Dilution Gross or Net Minimum Vesting Restrictions Evergreen Provisions Draft your equity plan proposal so it complies with the largest number of shareholders guidelines possible to give the best chance of the plan securing shareholder approval...seems obvious enough. Figure out the shareholders whose votes you ll need in order for the proposal to pass. Vote projections are a helpful tool to determine likely FOR and AGAINST votes. 10

11 Know Your Shareholders Sample Vote Projection Scenario 1: ISS and GL Recommend AGAINST, Fidelity Votes AGAINST SHAREHOLDER SEGMENT Shares % % O/S % Votes % Cast % Cast Held* of O/S Voting Cast For Against Fidelity Management & Research Co. 4,366, % 7.26% 8.69% 8.69% Wellington Management Co. LLP 4,319, % 5.07% 6.07% 6.07% Waddell & Reed Investment Management Co. 3,760, % 6.25% 7.48% 7.48% TCW Asset Management Co., Inc. 3,486, % 5.80% 6.94% 6.94% Wells Capital Management, Inc. 3,438, % 5.72% 6.84% 6.84% AllianceBernstein LP 2,234, % 3.72% 4.45% 4.45% BlackRock Fund Advisors 2,231, % 3.71% 4.44% 4.44% Vanguard Group, Inc. 2,082, % 3.46% 4.14% 4.14% Capital Research Global Investors 1,432, % 2.38% 2.85% 2.85% Kalmar Investments, Inc. 1,351, % 2.25% 2.69% 2.69% Columbus Circle Investors 1,257, % 2.09% 2.50% 2.50% OppenheimerFunds, Inc. 1,195, % 1.99% 2.38% 2.38% Neuberger Berman LLC 1,064, % 1.77% 2.12% 2.12% TimesSquare Capital Management LLC 1,043, % 1.74% 2.08% 2.08% State Street Global Advisors 1,034, % 1.72% 2.06% 2.06% Argyll Research LLC 977, % 1.63% 1.94% 1.94% Arbor Capital Management LLC (Minnesota) 836, % 1.39% 1.66% 1.66% Next Century Growth Investors LLC 812, % 1.35% 1.62% 1.62% Norges Bank Investment Management 806, % 1.34% 1.61% 1.61% RS Investment Management Co. LLC 766, % 1.28% 1.53% 1.53% Dreyfus Investment Advisors, Inc. 690, % 1.15% 1.37% 1.37% The Boston Company Asset Management LLC 665, % 1.11% 1.32% 1.32% Lord Abbett & Co. LLC 656, % 1.09% 1.31% 1.31% Northern Trust Investments 639, % 1.06% 1.27% 1.27% Turner Investment Partners, Inc. 597, % 0.99% 1.19% 1.19% Top 25 Positions Total 41,747, % 67.34% 80.56% 30.11% 50.45% Other Institutions 6,971, % 11.60% 13.87% 5.55% 8.32% Officers & Directors 2,377, % 4.65% 5.57% 5.57% 0.00% TOTAL: 51,096, % 83.58% % 41.23% 58.77% 11

12 Know Your Shareholders Develop an Outreach Strategy Institutional Investors Continue to monitor changes in shareholder base Determine who makes the vote decision Equity side or the compliance side Determine the best relationship you have to use in approaching each institution Call upon your proxy solicitor to find out if they know of any developments concerning your key shareholders that could impact the vote Retail Vote First step is to determine if enough shares are held in retail positions to warrant an extra effort to get out the retail vote Only about 20% of retail positions are likely to vote depending on type of mailing used Vote with management about 80-85% of the time There are strategies a company can use to increase the retail vote Reminder mailings and calling campaigns 12

13 ISS Policy Overview ISS policy and methodology for new equity plans and additional share requests include a number of quantitative and qualitative tests The relevant criteria for determining the number of shares ISS may support is the Shareholder Value Transfer (SVT) test, which is a measure of the value of a company s equity compensation programs expressed as a percentage of the Company s market capitalization SVT is compared to an allowable cap that is based on equity utilization among a broad comparator group of comparably sized companies A request that yields SVT within the ISS allowable cap will Pass ISS test and will be supported provided several other quantitative and qualitative screens applied by ISS are also satisfied: Shareholder Value Transfer Three-Year Average Gross Burn Rate CEO Pay for Performance Evaluation Option Repricing, Liberal CIC Definition and Other Problematic Pay Practices ISS generally applies an all or nothing approach failure to pass any one of the tests will result in: Recommendation that shareholders vote against an equity plan/share request Note that the tests listed above apply both to stand-alone share requests and plan amendments failure of one or more of the tests will generally cause ISS to recommend against the proposal 13

14 ISS Policy Overview Drivers of Negative Recommendations 37% of the approximately 1,300 equity plans in the U.S. analyzed by ISS received negative vote recommendations in 2010 Total greater than 100% because there may be more than one driver of an AGAINST recommendation for a proposal Source: ISS Presentation Equity Compensation Proposal Trends, January

15 Dilution, Shareholder Value Transfer, and Share Pool Management Many Institutions that do not follow ISS, use dilution and / or burn rate as a primary vote driver Dilution is often expressed as overhang and is the primary or critical metric used by some institutions (e.g., Vanguard, State Street, T. Rowe Price, TIAA-CREF) Overhang can be calculated many ways, but most common are: Issued Overhang = Outstanding Awards / Common Stock Total Overhang = (Available Awards + Outstanding Awards) / Common Stock Fully Diluted Overhang = (A + B + C) / (A + B + C + D), where A = New Share Request B = Shares available under all existing equity plans C = Total awards (unexercised options and unvested/unsettled full value awards) granted and outstanding D = Total common shares outstanding on record date (occasionally includes convertible debt/equity) As a rule of thumb, dilution over 10% will increase chance of failing slightly and over 15% significantly Some additional allowances are given for early stage companies and high growth industries For 2011, Fidelity eliminated its overhang analysis and now only reviews burn rate ISS now applies a more sophisticated approach to Overhang called Shareholder Value Transfer 15

16 Dilution, Shareholder Value Transfer, and Share Pool Management Shareholder Value Transfer (SVT) cost determined by binomial option pricing model and is expressed as a percentage of total market value Essentially a sophisticated overhang calculation Plan cost is deemed reasonable if it does not exceed a company-specific allowable cap Allowable cap is set based on 25 GICS industry groups, segmented by market capitalization Vote recommendation is AGAINST if SVT cost exceeds allowable cap Value of new shares is measured along with value of shares available from existing plans and value of issued overhang Options and SARs are valued using binomial model Full-value awards are valued based on 200-day avg. share price Liberal Share Counting provisions for Options and SARS will receive a more expensive valuation (equal to full-value awards) and eliminate advantage of fungible share reserve structure: Stock-settled SARs where only the shares issued count against the share reserve Provisions that allow administrator to use proceeds of option exercises to repurchase shares on the open market and add these shares to the plan s available pool of shares Provisions that allow shares tendered to pay the exercise price of options or withheld for taxes to be added back to the pool of available shares See ISS Proxy Voting Manual for full details on methodology 16

17 Dilution, Shareholder Value Transfer, and Share Pool Management Fungible Share Provision Share-counting provision in a stock plan that calls for counting full-value shares at a higher rate than stock options and SARs For example, it may say: Each stock option counts as 1.0 share against the pool Each restricted stock unit counts as 2.0 shares against the pool Provides for maximum flexibility Evergreen Provision Automatically replenishes share pool each annum (e.g., 5% of common stock) Results in an automatic AGAINST vote from Fidelity and generally impossible to satisfy the ISS SVT test because ISS deems maximum number of shares that can be added to plan over life of the evergreen as already available for grant Inducement Exemption Non-shareholder plan that can be used for new hires Provides short-term solution when share pool is limited Net-Settlement and Tax Withholding Shares not issued as a result of net-settlement or withholding for tax may be allowed to return to the pool ISS view varies: results in higher SVT% for options / SARs; no impact for tax withholding on Restricted Stock; 17

18 Burn Rate Also known as Run Rate In the context of Equity Comp, it is a measure of how many shares are being transferred to employees via Equity Awards i.e., it measures the potential dilutive effect of annual equity grants Two schools of thoughts: Share Burn Rate = # of shares granted as equity awards as a % of common shares outstanding (CSO) Economic Burn Rate = Value of equity granted as a % of market value of outstanding shares Why do we care? Shareholders don t want to over dilute the value of their shares and when your company gives out equity awards that represent a larger % of CSO than your peers 18

19 Burn Rate ISS will analyze the burn rate for companies proposing stock option plans and potentially recommend AGAINST votes at companies with excessive burn rates Policy reviews the average burn rate over the past three fiscal years Burn rate includes both stock options and full-value awards Full-value awards are counted as more than one share towards the burn rate depending on the volatility of the company Burn rate is defined as the number of awards granted in a year divided by the weighted average common shares outstanding for that fiscal year Burn rates are benchmarked by GICS industry group and segmented between companies in the Russell 3000 and companies outside the Russell 3000 Policy applies if company s three-year average burn is over 2% AND exceeds one standard deviation of the industry mean Companies can make a prospective burn-rate commitment to avoid an AGAINST recommendation 19

20 Burn Rate Implication Companies shift equity utilization toward RSUs Arbitrage between ISS multiple and Company internal ratio for RSUs to Options Eligibility and Participation rates for broad-based equity programs have decreased Examples of Burn Rate Commitment: Virage Logic & Tasty Baking are 2010 examples of companies that made the commitment and were supported by ISS Chesapeake Energy Corp stated their intent to limit the average annual burn rate over the next three years to the ISS allowable cap for the industry Borders Group committed to a three-year average burn rate after discussions with ISS 20

21 Pay for Performance This policy screens for companies that have total shareholder returns over the past 1- and 3-fiscal years that are below the median level of shareholder returns for the company s industry peers (determined using 4-digit GICS groupings). 1-year 3-year 5-year Company TSR (%) 26.5% -13.2% -3.4% Sector TSR (%) 48.6% -3.4% 1.9% Russell 3000 Index TSR (%) 25.5% -7.4% -1.2% If both returns are below the industry median an analysis of the CEO s Total Direct Compensation (TDC) is performed. Total Direct Compensation = Salary + Bonus + Non-Equity Incentive Plan Compensation + Change in Pension & NQDC Earnings + All Other Compensation Source: Summary Compensation Table and Grants of Plan Based Awards Table from Proxy, option fair value adjusted per Equilar methodology If TDC has not significantly decreased in the past year, a review of the alignment between shareholder returns and CEO TDC over the past five years will be performed 21

22 Pay for Performance Disconnect? VS. 22

23 Other Problematic Pay Practices Plan must prohibit repricing underwater options without stockholder approval, including cancellations of underwater options in exchange for cash Definition of change in control must specify that the triggering event is the actual consummation of a change in control transaction Problematic Pay Practices Policy provides a list of problematic practices that could trigger adverse vote recommendations However, poor pay practices rarely impacts ISS recommendations on equity plans only in cases where practices in question relate to the equity compensation plan or CEO equity grants Focus of problematic pay practices policy will largely be on Say on Pay proposals and withhold recommendations for members of the compensation committee Examples of poor practices related to equity plans History of repricing without shareholder approval or proposed plan does not explicitly prohibit it Change in control provisions that include single triggers, modified single triggers, and/or tax gross-ups within the equity plan Payment of dividends or dividend equivalents on unearned performance awards Employment agreements for executives containing multi-year guarantees for equity grant levels in situations where the executives subject to such agreements receive a significant percentage of the company s total equity grants 23

24 Planning for Your Share Request Success or failure is largely dependent on the composition of your shareholders What percentage is owned by insiders, institutions, and retail? How much influence does ISS have? What are the voting guidelines of my shareholders that do not follow ISS? If you are not a small cap or in an industry with higher dilution, and your dilution is Above 10%, you should be cognizant of the increased possibility of failure Above 15%, you should actively engage your top shareholders in a discussion on acceptable dilution How many shares are reasonable? Will depend on individual investor, historical practices, and how long it will last? Returning to shareholders every two to three years is becoming the norm When should I begin developing my strategy? It should be a continuous process between requesting additional shares, monitoring usage, and preparing for the next one 24

25 Contact Information Jon W. Burg, FSA Vice President 199 Fremont Street, Floor 17 San Francisco, CA Bus: (415) Mobile: (415) E- mail: Jon F. Doyle Partner 22 BaOery Street, Suite 1000 San Francisco, CA Bus: (415) E- mail: Reid Pearson ExecuIve Vice President 5524 Wedgewood Ct. Lilburn, GA Bus: (404) Mobile: (770) E- mail: 25

26 Appendix 26

27 ISS Policy Shareholder Value Transfer Example Company ABC issues options and stock awards Outstanding and Available Equity Awards 10M options outstanding with a $6.00 weighted average strike price and 5.00 year remaining term 5M restricted stock awards outstanding 4M available shares for grant SVT Calculation Inputs Common shares outstanding 100M 200-day average stock price is $5.00 Market capitalization is $0.5B (100M x $5) 200-day annualized volatility is 50.00% SVT Allowable Cap is 14% Based on equivalent GIC and adjusted for market capitalization 27

28 ISS Policy Shareholder Value Transfer Example (continued) SVT Calculation: Category Shares Average Award Value SVT Cost SVT % Simple Overhang Issued Options 10,000,000 $2.00 $20,000, % 10.00% Issued Stock 5,000,000 $5.00 $25,000, % 5.00% Available Awards 4,000,000 $5.00 $20,000, % 4.00% Share Request 1,000,000 $5.00 $5,000, % 1.00% 20,000,000 $70,000, % 20.00% ISS assigns the highest possible award value to new and available shares - All are assumed to be issued as restricted stock ($5.00 Fair Value) The company can ask for 1M new shares and still meet ISS standards since the Allowable Cap is 14% 28

29 ISS Policy SVT Mitigation Strategy I What if you Company ABC limited the number of awards that could be issued as restricted stock (i.e., plan sub-limit)? Provision added to plan limiting restricted stock to 50% Average Award Value = 50% x $ % x $3.00 = $4.00 Options with 10-year contractual term have a $3.00 fair value Category Shares Average Award Value SVT Cost SVT % Simple Overhang Issued Options 10,000,000 $2.00 $20,000, % 10.00% Issued Stock 5,000,000 $5.00 $25,000, % 5.00% Available Awards 4,000,000 $4.00 $16,000, % 4.00% Share Request 2,250,000 $4.00 $9,000, % 2.25% 21,250,000 $70,000, % 21.25% Company ABC can now ask for 2.25M additional shares 29

30 ISS Policy SVT Mitigation Strategy II What if Company ABC adopted a fungible share ratio in which every restricted stock counts against the plan as 1.67 options? All new and available shares assumed to be issued as an option for SVT Average Award Value = $3.00 Category Shares Average Award Value SVT Cost SVT % Simple Overhang Issued Options 10,000,000 $2.00 $20,000, % 10.00% Issued Stock 5,000,000 $5.00 $25,000, % 5.00% Available Awards 4,000,000 $3.00 $12,000, % 4.00% Share Request 4,333,333 $3.00 $13,000, % 4.33% 23,333,333 $70,000, % 23.33% Company ABC can now ask for 4.33M additional shares 30

31 ISS Policy SVT Mitigation Strategy III What if Company ABC adopted a fungible share ratio and limited the maximum option term to 7 years All new and available shares assumed to be issued as an option for SVT Average Award Value = $2.50 Category Shares Average Award Value SVT Cost SVT % Simple Overhang Issued Options 10,000,000 $2.00 $20,000, % 10.00% Issued Stock 5,000,000 $5.00 $25,000, % 5.00% Available Awards 4,000,000 $2.50 $10,000, % 4.00% Share Request 6,000,000 $2.50 $15,000, % 6.00% 23,333,333 $70,000, % 25.00% Company ABC can now ask for 6.00M additional shares 31

32 ISS Policy Developing Burn Rate Limits Burn rate thresholds are up significantly for many industry groups ISS calculates allowable burn rate thresholds every fall/winter for the following proxy season using a consistent methodology. For the latest update: Three years of grant activity was analyzed for each company in December using grant data for fiscal years ending through Oct. 30, 2010 Volatility was calculated for each company as of Dec (measured over the prior 200-trading days) Current volatility multiplier for each company was applied to all 3 years of full-value grant activity Industry means and standard deviations were calculated Factors for increased burn rate thresholds for 2011 shareholder meetings Lower volatility in Dec assumptions as compared to 2009 assumptions led to higher volatility multipliers for full-value awards on average Higher levels of unadjusted equity grants in latest 3-year measurement period (unadjusted equity grants means calculating the burn rate without applying a multiplier to full value awards) for many industry groups In 2011 policy update, ISS provided that going forward burn rate limits will not fluctuate year-overyear by more than 2% Source: ISS Presentation Equity Compensation Proposal Trends, January Companies above the relative threshold may still obtain ISS support for an equity plan proposal by adopting a burn rate commitment for the next 3 fiscal years

33 ISS Policy Burn Rate Example Year Options Granted Stock Granted Stock Multiplier Total Granted Common Stock Burn Rate ,000,000 2,000, x 5,000, ,000, % ,000,000 1,000, x 5,500, ,000, % ,000, , x 6,200, ,000, % Three-Year Average Burn Rate 5.33% Company ABC will satisfy ISS Burn Rate Policy if the 2011 Limit is greater than 5.33% Otherwise, they would need to make a public burn rate commitment Company ABC Three-Year Burn Rate Time-based restricted stock counted in the year granted; performance-based are counted when earned Stock multiplier based on the company s 200-day historical annual volatility: Annual Volatility Multiplier Great than 54.6% 1.5x 36.1% to 54.6% 2.0x 24.9% to 36.1% 2.5x 16.5% to 24.9% 3.0x 7.9% to 16.5% 3.5x Less than 7.9% 4.0x 33