On December 20, Institutional Shareholder Services (ISS) released its complete frequently asked questions (FAQ) document regarding U.S. compensation policies. Overall, the changes for 2019 are limited in scope:
Quantitative pay-for-performance screens will not change for 2019
- No changes will be made to the tests for 2019. Economic value added (EVA) metrics will not be used as part of the quantitative pay-for-performance model, but will be phased in to ISS research reports over the 2019 annual meeting season on an information only basis. Accounting performance (GAAP measures) will continue to be used in the financial performance assessment for the 2019 proxy season, though ISS will continue to explore the potential for EVA’s future use.
Use of total shareholder return (TSR) as an incentive metric
ISS added a specific FAQ to affirm that the board and the compensation committee are in the best position to determine incentive plan metrics and that ISS’ use of TSR in its quantitative screen is not meant to signal that it endorses or prefers TSR or any given incentive plan metric.
Front-loaded equity awards covering multiple years
- ISS states that it is unlikely to support grants that cover more than four years (grant year plus three years). ISS’ rationale is that in the case of unforeseen events or changes in performance/strategic focus, such awards limit board action as it relates to meaningfully adjusting future pay opportunities.
- Commitments not to grant additional equity awards during the period covered by the front-loaded award should be firm, and disclosure around performance criteria/vesting requirements should be detailed.
Problematic pay practice updates (most likely to result in an adverse say-on-pay vote recommendation)
ISS has added or expanded two items for 2019.
- “Good Reason” termination definitions presenting windfall risks, such as those triggered by performance failures (e.g., bankruptcy): Change-in-control severance should be limited under the “good reason” definition to constructive terminations, such as material changes to an executive’s compensation, function, title or location. Definitions triggered by performance failures like bankruptcy or delisting will be considered problematic and will likely result in adverse say-on-pay vote recommendations.
- Insufficient executive compensation disclosure by externally-managed issuers (EMIs) that limits or makes it impossible to assess pay programs and practices: ISS notes that most EMI provide only aggregate management fees paid, making it impossible to assess executive pay and practices. It prefers to see disclosure that clearly breaks allocation of fees towards executive compensation, breakdown of fixed versus incentive compensation and metrics used to measure performance.
ISS assessment of reduction in compensation disclosure when a company becomes a “smaller reporting company”
- Recent SEC changes to the definition of a “smaller reporting company” (SRC) have expanded the number of qualifying companies. Despite scaled back disclosure requirements, SRCs should provide a level of disclosure sufficient enough to allow investors to make an informed say-on-pay vote. ISS is unlikely to support a say-on-pay proposal that falls short on disclosure.
ISS views on changes to compensation programs made in light of the removal of 162(m) deductions
- Shifts to fixed or discretionary compensation away from performance-based remuneration will be viewed negatively by ISS. It is unclear if this alone will rise to the level of driving a negative say-on-pay vote recommendation.
ISS and policies around “excessive” levels of director compensation
- ISS will postpone issuing vote recommendations in 2019 based on findings of “excessive” nonemployee director compensation. As a result of ISS’ policy survey and roundtable feedback noting the need for additional transparency regarding the identification of pay outliers, potential negative vote recommendations will be delayed until 2020 (annual shareholder meetings on or after February 1, 2020).
- Beginning with meetings on or after February 1, 2020, ISS will identify compensation outliers comprising the top 2% to 3% of comparable directors (narrowed from previous methodology of 5%).
- Comparable directors will come from the same index (S&P 500; combined S&P 400 / S&P 600; remainder of Russell 3000; Russell 3000-extended) and two-digit GICS.
- Negative vote recommendations may be applied to outliers identified in both 2019 and 2020 (without sufficient mitigating rationale).
- Board-level leadership roles (non-exec chair and lead independent director) will be compared to like roles in an effort to recognize the typical compensation premium.
- Concern mitigation consideration will be given to groupings with narrow distributions of compensation, or when there is not a pronounced difference in pay magnitude between the top 2% to 3% of directors and the median director.
- ISS will also use the following items to evaluate whether proper mitigation rationale exists:
- New director grants that are clearly identified as one-time in nature
- Special payments related to corporate transactions or special circumstances (such as special committee service or requirements related to extraordinary need)
- Payments made in consideration of specialized expertise (such as scientific expertise biotech/pharma industries)
- Separate consulting agreements will be assessed on a case-by-case basis with particular focus on the company’s rationale. General performance/service rewards will generally not be viewed as compelling rationale by ISS
Michael Biggane and Brian Myers are executive compensation consultants based in Cincinnati and Arlington, Va., respectively. Jim Kroll is a director in Los Angeles who leads Willis Towers Watson’s governance advisory practice for executive compensation. Email firstname.lastname@example.org, email@example.com, firstname.lastname@example.org or email@example.com.