Over the past several years, Institutional Shareholder Services’ (ISS’s) proxy voting guidelines have had an impact on corporate governance practices and the design of executive compensation programs at major publicly traded companies.
For example, several years ago, ISS determined that providing excise tax gross-ups to executives was a “problematic pay practice” and as a result, the prevalence of such provisions has declined substantially. In addition, given ISS’s preference that at least 50% of executives’ long-term incentive awards be performance-based, we have seen a significant increase in the prevalence of, and emphasis placed on, such awards (e.g., performance stock units).
One way that ISS shapes its proxy voting guidelines is through its annual policy survey (generally in September of each year), that seeks feedback from institutional investors, public companies, corporate directors and the consulting and legal communities on emerging trends in corporate governance, executive compensation and other matters. Both the structure of questions asked and responses to the annual policy survey provide insight into the areas of its proxy voting guidelines that ISS is considering updating—either changes to existing voting guidelines or the adoption of new guidelines to address emerging issues.
This article provides a high-level summary of three key corporate governance and executive compensation topics that ISS included in its 2018 Policy Survey (the “Survey”), to provide insight into the potential future policy areas that could be addressed. The questions (and results, where applicable) from the Survey regarding executive and director compensation matters are discussed below (Survey results are currently available only for the CEO pay ratio question).
CEO Pay Ratio
As most U.S. public companies will first disclose their CEO pay ratios in 2018, the Survey solicited information regarding how respondents will analyze pay ratio data. Fully 63% of investor respondents indicated they would both (i) compare the ratios across companies or industry sectors and (ii) assess year-on-year changes in the ratio at an individual company. The Survey also asked respondents to identify how shareholders should use the proxy disclosed pay ratio data. Investor respondents indicated that they would use the pay ratio data as:
■ One data point in determining votes on compensation-related resolutions.
■ Background material for engagement with a company.
■ One data point in determining votes on directors.
Importantly, it appears that investors will not place excessive weight on the new CEO pay ratio disclosure when evaluating a company’s compensation program for Named Executive Officers. At least for 2018, we believe that ISS will take into account the CEO pay ratio when performing its overall examination of a company’s executive pay programs. However, we do not believe that a company’s CEO pay ratio, standing alone, would result in an ISS recommendation AGAINST a company’s Say on Pay proposal.
Outcome-Based Compensation Measures
ISS currently utilizes a three-part quantitative analysis to evaluate the relationship between CEO pay and company performance (this quantitative analysis is limited to S&P 1500 companies). In this test, ISS utilizes the grant-date value of CEO compensation, which often doesn’t provide the best insight into the alignment of pay and performance as the realizable value of an executive’s compensation will vary based on future company results and stock price performance as the majority of executives’ compensation is performance-based and granted in the form of equity-based incentives.
ISS is considering changing its methodology for assessing the relationship between CEO pay and performance in the U.S. and Canada to take into account outcomes of performance-based pay programs using a realizable pay measure. The Survey asks whether a respondent supports the use of an outcomes-based measure, such as realizable pay, as part of ISS’s quantitative pay-for-performance evaluation. The Survey further asks respondents that favor the use of an outcomes-based measure to identify whether ISS should use realizable pay as part of its quantitative pay-for-performance evaluation in any of the following ways—i.e., realizable pay could:
■ Mitigate concerns regarding pay-TSR misalignment.
■ Mitigate concerns regarding excessive pay levels.
■ Exacerbate concerns regarding excessive leverage to performance (e.g., large payouts to modest performance).
Currently, ISS includes a realizable pay analysis in its qualitative assessment of CEO compensation, when a potential pay-for-performance misalignment is found under ISS’s three-part quantitative analysis. The feedback from the Survey may assist ISS in further developing a framework for assessing realizable pay outcomes in its qualitative evaluation. Whether ISS intends to incorporate the realizable pay assessment in its quantitative pay-for-performance evaluation is not clear.
Non-Employee Director Pay
Under its current policy, ISS reviews non-employee director pay to determine whether a company has a pattern of excessive director compensation that calls into question director independence. To assess non-employee director pay, ISS compares director pay levels to other companies within the same index and GICS industry group. If ISS finds a pattern of high director pay levels at a company relative to peers, ISS will include cautionary language in its proxy analysis.
The Survey seeks input on the comparisons ISS should consider in determining whether a company’s non-employee director pay program presents a governance concern due to the magnitude of pay. For example, ISS sought input on whether it should compare the subject company’s pay to all companies, peers in its GICS industry group, or other companies in its stock market index.
The Survey also asks respondents to identify whether any of the following compensation elements should be considered in determining whether a non-employee director compensation program presents a governance concern with respect to a problematic pay structure:
■ Stock option grants
■ Performance equity awards
■ Excessive perquisites
■ Non-retirement benefit programs
■ Retirement programs
The Survey also asks respondents to identify actions that would be appropriate in cases where ISS has identified a pattern (i.e., multiple years) of relatively high levels of director compensation at a company.
While we do not expect ISS to develop extensive voting guidelines on director compensation, ISS appears to be poised to develop a new proxy voting guideline for companies with non-employee director compensation programs that are outliers relative to market practice (either with respect to pay levels or pay practices).
These new voting policies, if adopted, could have an adverse impact on the vote recommendations for directors of these companies. However, director compensation levels are often very similar among comparable companies.
Tom Ramagnano (left) is a Partner and Ron Rosenthal (right) is a lead consultant at the executive compensation consulting firm Meridian Compensation Partners, LLC in Lake Forest, IL.