Towers Watson

November 18, 2011

ISS 2012 Policy Updates Focus on Pay for Performance and Responsiveness — Towers Watson’s Summary and Takeaways

By Brian Myers and Vicki Davidson

Institutional Shareholder Services (ISS) just released its 2012 U.S. corporate governance policy updates. The revised policies will apply to all U.S. companies with shareholder meeting dates on or after February 1, 2012. A link to the full policy document appears at the end of this summary.

The compensation-related updates are summarized below and arrive with few surprises since they track the draft policies released in October. (See “Time to Weigh In,” Executive Pay Matters, October 18, 2011.) The 2012 updates are largely focused on pay for performance and board responsiveness related to say on pay. Following is an overview of the 2012 updates, along with our key takeaways regarding their implications. 

Pay for Performance
ISS is revising its pay-for-performance methodology and will now focus on pay and performance alignment from two standpoints:

• Relative alignment to peers
• Absolute alignment between CEO pay and company total shareholder return (TSR).

ISS' updates should provide a more encompassing view of the pay-for-performance relationship by identifying strong vs. weak alignment. Also, the new methodology focuses on a longer time horizon, as opposed to a year-over-year review of CEO pay. With respect to Russell 3000 companies, the revised policy will consider the following:

Peer group (relative) alignment:

• Alignment of a company’s TSR rank vs. CEO total pay rank within a given peer group, as measured over one- and three-year periods (weighted 40%/60%)
• The multiple of the CEO’s total pay versus peer group median
• With regard to peer group selection, ISS will now use a unified peer group comprised of 14-24 companies
• Peers will be selected using market cap, revenue (or assets for financial firms) and GICS group
• ISS will seek to place the subject company close to the median in revenue (asset) size.

Absolute alignment

• Alignment between the trend in CEO pay and company TSR over the prior five fiscal years (i.e., trend in annual pay changes vs. annualized TSR).

“Weak” pay-for-performance alignment, while not yet defined by ISS, will be subject to a further qualitative review by ISS, including:

• Ratio of performance- to time-based equity awards
• Ratio of performance-based compensation to overall pay
• Disclosure and rigor of performance goals/metrics
• Company’s peer group benchmarking practices
• Actual results of financial/operational metrics.

Other say-on-pay policy updates include the following:

• “New” CEOs (i.e., those with CEO tenure less than two full fiscal years) generally will no longer be exempt from the pay-for-performance consideration.
• No changes or updates were made to the list of poor/problematic pay practices.
• Companies that are not in the Russell 3000 will be evaluated on the listed qualitative factors.

Towers Watson takeaways

• The broader examination of pay-for-performance alignment by ISS is welcome and should help shareholders more carefully consider unique company circumstances and pay decisions.
• As noted in our comment letter to ISS on the proposed 2012 policies, we believe the use of a uniform peer group to review both pay and performance makes sense.
  • This change in peer company selection is significant in that it marks a departure from current ISS practice of using a broader set of GICS industry peers to examine performance and a smaller number of industry peers when examining CEO pay.
  • At the same time, however, moving away from a more formulaic analysis might make it more difficult for companies to forecast potential ISS vote recommendations going forward, depending on the nature of further guidance from ISS.
• Companies should strongly consider performing their own analyses using both these new parameters and those they consider most relevant, presenting the results in the CD&A to demonstrate their pay-for-performance alignment.

Board Responsiveness

ISS is adopting policies surrounding board and compensation committee responsiveness to shareholders related to say-on-pay and say-on-frequency vote results.

Say-on-pay vote

ISS will review compensation committee members (and potentially the full board) and the board’s responsiveness if the previous say-on-pay proposal received support of less than 70% of votes cast. The vote recommendation will consider the board’s responses to the previous result, including:

• Disclosure of engagement efforts with institutional investors
• Specific actions (ideally new actions, rather than a reiteration of existing practices) taken to address the compensation issues of concern
• Discussion of whether the issues raised are recurring or isolated.

Say-on-frequency vote

ISS will recommend “against” or “withhold” from the entire board (except new nominees) if the board implements less frequent say-on-pay votes than favored by a majority of votes cast. When no majority was reached, implementation of a frequency receiving less than a plurality vote will result in a case-by-case analysis, reviewing:

• Rationale for the frequency chosen
• Ownership structure
• Compensation concerns
• Prior say-on-pay support levels.

Towers Watson takeaways

• Changes relating to say-on-pay vote outcomes and the actions taken by the compensation committee largely represent affirmation of existing ISS policies, although they also tend to validate the emerging consensus around an acceptable response to a failed say-on-pay vote.
  • More importantly, the new policies explicitly put boards on notice that when a company with a passing say-on-pay vote fails to achieve a given threshold of shareholder support (i.e., 70%), ISS will increase its scrutiny.
  • ISS indicated that say-on-pay proposals receiving less than 50% support warrant the highest degree of responsiveness.
• The updates track what several large shareholders believe should be expected of companies in this situation, including “comprehensive and meaningful” disclosure in the CD&A and elsewhere.
• They also reinforce that some actions are implied by the SEC proxy requirement to disclose “[w]hether and, if so, how the registrant has considered the results of the most recent shareholder advisory vote on executive compensation.”
• The articulation of these expectations by ISS is likely to accelerate company efforts to address shareholder comments received during the 2011 proxy season, a process that our consulting experience suggests is already under way at many companies.

Section 162(m) Proposals and Post-IPO Companies

Beginning in 2012, ISS will conduct a full review of equity plan proposals from recent IPO companies seeking shareholder approval of their equity plans for 162(m) purposes even in instances when the company is not requesting authorization for new shares. This will involve the full ISS quantitative analysis, including consideration of value transfer, burn rate (if applicable), plan provisions and pay for performance (if deemed appropriate by ISS).

ISS did not propose other more general changes to its equity plan review policies for 2012.

Towers Watson takeaway

• This change would prompt IPO companies to undertake a more detailed review of their equity plan provisions and share usage much sooner than anticipated, and would take away what ISS has seen as a “free pass” for such companies on these early 162(m) votes.

Other Observations

In the past, ISS has issued compensation FAQs that provide clarification on existing policies, including those being refined for the upcoming proxy season. ISS expects to release a technical document in December related to the new pay-for-performance methodology, which will be followed by more information about the new peer group methodology at a later time. The 2012 policy updates do not address any changes to GRId methodology or burn-rate thresholds, which we anticipate ISS will update in later communications.

In addition to the U.S. policy updates, the 2012 ISS policy updates will affect compensation matters in certain other countries, as follows:

• The pay-for-performance test proposed for Canadian companies was not adopted, although ISS has amended its policy related to employee stock purchase plans to increase the allowable employer matching contribution, among other changes.
• Equity plans at some French companies will be able to reserve a greater amount of capital and will also be subject to a burn-rate review and stricter performance criteria.
• The independence of compensation committee members at companies in Hong Kong will come under scrutiny, particularly if ISS does not consider a majority of the committee members to be independent.
• ISS policies related to option plans in Japan will be relaxed slightly while ISS reviews of director (i.e., mostly executives) pay will place greater emphasis on the disclosed rationale for any increase.
  Towers Watson takeaways
  • The diverse nature of ISS policy changes in these markets tracks some governance practices that are becoming common. Watch for a more detailed examination of ISS policy changes outside of North America in an upcoming post.

  Copies of the ISS 2012 U.S. policies, as well as updates to Canadian, European and International policies, can be found here.

  Brian Myers is an executive compensation consultant in Towers Watson’s Arlington, Virginia office and Vicki Davidson is an executive compensation consultant in the firm’s Los Angeles office. Email brian.myers@towerswatson.com, vicki.davidson@towerswatson.com or executive.pay.matters@towerswatson.com.