ISS Publishes Guidance on Pay-for- Performance Assessments and Updates to Governance Ratings System

Transcription

1 ISS Publishes Guidance on Pay-for- Performance Assessments and Updates to Governance Ratings System Provides Additional Detail on Measuring Relative and Absolute Alignment Between CEO Pay and Total Shareholder Return; Update to GRId Ratings System Adds Numerous New Elements to Governance Scoring in Compensation and Other Areas SUMMARY Institutional Shareholder Services, the influential proxy advisory firm, issued two publications this week that U.S. public companies should be aware of in connection with year-end compensation and governance planning, proxy statement drafting and investor relations. First, ISS has published a technical document containing additional detail as to how it will assess pay-for-performance alignment for purposes of recommending votes on 2012 say-on-pay advisory votes. Second, ISS has issued a comprehensive update to its Governance Risk Indicator, or GRId, ratings system, adding dozens of new questions designed to probe a company s governance practices in a more detailed way. Companies should review these documents and consider any impact they may have on the expected level of support for the company s 2012 say-on-pay proposal or on the company s GRId ratings for PAY-FOR-PERFORMANCE ASSESSMENT In November 2011, ISS adopted a new methodology for evaluating a company s executive pay practices in order to determine whether to recommend a vote in favor of the company s advisory say-on-pay proposal. The technical document published this week provides detail on how this new methodology will New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney

2 be implemented. 1 ISS s new approach begins with a quantitative analysis of both relative and absolute alignment of pay-for-performance, and then, when appropriate, applies a qualitative analysis to companies where the quantitative assessment reflects an apparent pay-for-performance disconnect. The new technical document provides sufficient detail to allow companies to roughly assess how they will score on the absolute component. It will be difficult, however, for companies to assess their performance under the relative components, because that will depend on the 2011 compensation decisions by their peers and, perhaps more importantly, how ISS constructs their peer group for these purposes, as discussed further below. Components of Quantitative Analysis The three components of the new ISS quantitative assessment are as follows: Relative Alignment of CEO Pay and Total Shareholder Return (One-Year and Three-Year). The metric that is given the greatest weight in the quantitative assessment is the relative alignment of CEO pay and total shareholder return, or TSR, 2 to those of a peer group. The relative alignment metric looks at the difference between (a) the percentile rank within the ISS-selected peer group of a company s TSR and (b) the percentile rank within that peer group of a company s CEO pay. The company s score is based on this difference calculated on a one-year basis and a three-year basis (weighed 40% and 60%, respectively). The scoring system effectively gives greater weight to this metric by triggering high concern at a relatively low level specifically, if the weighted pay percentile exceeds the weighted TSR percentile by 30 percentage points or more, which they estimate will occur at approximately 25% of companies. Relative CEO Pay to Peer Group Median (One-Year). The second relative component of the payfor-performance assessment is prior-year CEO pay as a multiple of the peer group median. ISS s scoring system may trigger a high concern if this multiple is 2.33x or higher, which they estimate will be the case only for approximately 8% of companies. Absolute Alignment of CEO Pay and Total Shareholder Return (Five-Year). The third component measures alignment between the trend in the CEO s pay and the company s shareholder returns over a five-year period. This will not depend on year-by-year sensitivity of CEO pay to changes in TSR, but instead compares the straight-line slopes of five-year trend lines (based on a linear regression) for each of CEO pay and TSR. The document indicates that a high concern may be triggered if the CEO pay trend slope exceeds the TSR trend slope by 30 percentage points or more, which they estimate will occur at approximately 10% of companies. Peer Group Construction A company s rank with respect to the relative measures described above will depend on how it compares to companies in its peer group a group of 14 to 24 companies selected by ISS based on size, industry 1 2 The technical document regarding pay-for-performance is available on the ISS website at See our memorandum, dated November 17, 2011, entitled ISS Finalizes 2012 Proxy Voting Updates for a further discussion of ISS s pay-for-performance and other updates to its policy governing voting recommendations for the 2012 proxy season. TSR measures how much an investment in the stock would have changed over the relevant period, assuming the reinvestment of dividends. -2-

3 and market capitalization. ISS s previous approach to evaluating pay-for-performance focused on companies whose TSR was in the bottom quartile of their industry, based on the company s four-digit GICS category. 3 The new peer group system, which is explained in an appendix to the ISS technical document, will include only 14 to 24 companies that have a size (based on assets for financial companies and revenues for other companies) and market capitalization within a specified range of those of the company. The categorization will start with those in the company s GICS industry (based on the six-digit GICS code) but, as needed, can expand to companies in the company s general sector (based on the two-digit GICS code) if needed to reach the requisite number of peers. The approximately 25 largest non-financial companies (so-called super-mega non-financial companies) will be compared with each other, since ISS indicates that they likely have few, if any, industry peers of comparable size. The new system could lead to companies being placed in peer groups with companies that operate in different segments of their industry. This could have a significant effect on the relative TSR comparison (in particular, the three-year TSR, which would cover the period from the beginning of 2009 through the end of 2011), since equity market movements broadly over the past several years have impacted different industries very differently. It is unclear when ISS will notify companies of their peer group composition. Determination of Total CEO Pay All of the quantitative metrics look at the level of CEO pay. The technical document confirms that CEO pay for a particular year for these purposes is the total compensation reported in that year s Summary Compensation Table in the proxy statement under SEC rules. This introduces potential comparative difficulties, because different forms of compensation are reflected differently in the table even though they may pertain to services in the same period. For example, if awards for services in a particular year are made shortly after year-end, these will be included in the Summary Compensation Table as compensation for the subsequent year, if made in equity, because that is when the grant occurred, but will be included in the current year if made in cash and already earned. In addition, difference in equity granting practices may skew results for example, in the case of special one-time grants. Furthermore, this measurement will not take into account any post-grant change in value of an equity award due to an increase or decrease in the stock price. Qualitative Analysis If the relative and absolute quantitative analysis demonstrates significant misalignment between CEO pay and TSR, then ISS will use a further qualitative review to determine a final vote recommendation. The qualitative review would take into account a range of factors, including the ratio of performancebased equity awards to time-based equity awards, the ratio of performance-based compensation to total 3 Global Industry Classification Standard, or GICS, is an industry taxonomy developed by Standard & Poor s and MSCI that categorizes companies based on two-digit sector codes, four-digit industry group codes within those sectors, six-digit industry codes and eight-digit sub-industry codes. -3-

4 compensation, performance goals used, peer group benchmarking practices, financial performance and any special circumstances. UPDATES TO GRID GOVERNANCE RATINGS SYSTEM This week, ISS also published a comprehensive update to its methodology for determining and presenting corporate governance ratings for public companies worldwide under its GRId system. 4 The GRId system, which was introduced in 2010 as a successor to ISS s Corporate Governance Quotient, provides corporate governance scores for public companies in each of four areas: Audit, Board, Shareholder Rights and Compensation. 5 The GRId ratings are absolute measures of the company s practices measured against what ISS perceives to be prevailing best practices, not measured against industry peers. The ratings are based on a series of several dozen questions, which vary by country. One overall change will be the manner of presentation of the ratings companies will now receive a numeric score between zero and 100 in each of the four areas, rather than an indication of high concern, medium concern or low concern. Under the new ratings system, a score of greater than 75 will equate to low concern and a score of 50 or less will equate to high concern. The ISS technical document describing the changes presents all the questions on which the ratings will be based, highlighting those that are new, along with a discussion of the rationale and scoring approach. The new questions address a number of new topics, and probe more deeply into existing topics, including the following for U.S. companies: in the Audit category, whether a director or officer is under investigation by a regulatory body or the subject of an enforcement action, or has been in the past two fiscal years; in the Board category, more detailed questions on the independence of the board chairman, the separation of CEO and chairman, and the role of lead independent director, as well as whether there are related party transactions involving the CEO, what percentage of directors are family members or former employees, and whether, based on the company s disclosure, the board can hire its own advisors without management approval; in the Shareholder Rights category, more detailed questions on the terms (such as the triggering threshold) and manner of adoption of poison pills, as well as the right of shareholders to call a special meeting without material restrictions, including ownership thresholds and timing and agenda restrictions; 6 and The technical document describing the GRId update is available on the ISS website at See our memorandum, dated March 11, 2010, entitled RiskMetrics Releases New Corporate Governance Metric for Public Companies for 2010 Proxy Season for a further discussion of the GRId system. The scoring approach indicates that an absence of a special meeting right, or an ownership threshold greater than 15%, may raise a moderate degree of concern. -4-

5 in the Compensation category, questions that integrate the new pay-for-performance approach outlined above, as well as those that address the ratio of CEO pay to that of the next highest paid executive, the ratio of the CEO s other compensation (e.g., perquisites) to total compensation, the payment of specific perquisites (including tax gross-ups and reimbursement of loss on sale of a home), the change-in-control and option repricing terms of the company s equity plans, CEO severance arrangements, and pledges of stock by executives, among other things. The updated GRId methodology will apply to U.S. companies beginning February 2012, prior to the 2012 proxy season, and will be rolled out to the other GRId markets (Canada, U.K., France, Netherlands, Germany and Sweden) in the third quarter of In accordance with their standard process, ISS will give companies a limited amount of time to review the draft ratings reports prior to publication. * * * Copyright Sullivan & Cromwell LLP

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7 New York Marc R. Trevino Frederick Wertheim Washington, D.C. Janet T. Geldzahler Eric J. Kadel, Jr Robert S. Risoleo Los Angeles Patrick S. Brown Eric M. Krautheimer Alison S. Ressler Palo Alto Sarah P. Payne John L. Savva SC1: