Every year, ISS conducts a survey in advance of updating its corporate governance policy. The survey is open not only to ISS clients and institutional investors but also to entities that are often the subject of ISS recommendations, including both companies and corporate directors, as well as other market participants, such as those that advise companies. There are a couple of questions in this year’s survey that caught my eye.
Frequency of Say-on-Pay Votes
Although most companies currently hold Say-on-Pay votes every year, the SEC’s final regulations allow these votes to be held every one, two, or three years, at the election of shareholders. The “Say-on-Pay frequency vote” must be held at least once every six years. In 2017, for the first time since Say-on-Pay went into effect, most companies will once again give shareholders an opportunity to vote on how often their Say-on-Pay vote should be held.
In anticipation of this, ISS has included a couple of questions on the frequency of Say-on-Pay votes in this year’s survey. Currently, ISS’s policy recommends an annual Say-on-Pay vote. The survey contemplates a different recommendation, possibly one that is dependent on company circumstances, such as company size, performance, problematic pay practices, and/or past Say-on-Pay vote results.
P4P Analysis
As part of its evaluation of CEO pay, ISS performs a “Pay-for-Performance Evaluation.” This consists of a quantitative analysis in which the company’s TSR performance is compared to the CEO’s pay and both metrics are ranked against the company’s peers. If the company performs poorly in the quantitative analysis, the next step is a qualitative analysis, in which ISS looks at the company’s specific pay practices.
The survey focuses on the quantitative analysis, asking if this analysis should be based on other metrics, in addition to TSR, and, if yes, what other metrics should be included.
In the past decade, we’ve seen a significant increase in the use of TSR targets in performance awards. In the NASPP/Deloitte Consulting 2013 Domestic Stock Plan Design Survey, use of TSR had increased to 43% of respondents, up 48% from the 2010 survey. I expect usage will be even higher in this year’s survey—possibly nearing or exceeding 50% of respondents. No other metric comes close, in terms of prevalence.
But, TSR is not without its critics. For example, see the article we just posted by Brett Herand of Pearl Meyer, “Re-Evaluating Total Shareholder Return as an Incentive.” It is interesting to see that the TSR backlash has reached enough of crescendo that ISS is considering changing its policy.
Survey Closes August 30
If you want to participate in ISS’s survey, you don’t have much time. The survey closes on August 30.
In a prior installment of this blog, I explored the renewed interest in mandatory holding periods for equity compensation post vest. In today’s blog, we’ll look at some of the scenarios where this makes the most sense.
We’ve looked at some general reasons why companies may find it attractive to implement a requirement for a participant to hold shares after they are vested. Among the top considerations are ease of facilitating clawbacks, good corporate governance, points on the ISS Equity Plan Scorecard, and the possibility of a reduced fair value accounting expense. I now want to dive into the nuances of where these holding periods seem to make the most sense.
Does One Size Fit All?
While there are many compelling reasons to implement a post vest holding period, a closer look suggests that this may not be a one size fits all approach. This means that not all employees and not all forms of equity compensation are considered “equal” in determining if and how to apply mandatory holding periods. Let’s cover the “who” first, and then the “what.”
Who Should be Subject to Post-Vest Holding Periods?
In contemplating the intent behind the post-vest holding periods (ease of clawbacks, good governance, ISS scorecard points, etc.) it becomes clear that the ideal target for mandatory holding is the executive population. Not only are they the subject of most of the logic behind the holding periods, but this is also a population that tends to have significant amounts of equity compensation. Beyond that level within the organization, there are likely to be varied opinions about who else should be subject to mandated holding periods. There may be a case to include other levels of management, such as middle or senior managers who receive equity compensation. Should post-vest holding periods be broad based? Probably not. Employees who have no equity have nothing to “hold” and those with limited equity (such as only via participation in the ESPP and/or a limited amount of stock options) don’t appear to fit the profile that supports the “why” behind implementing holding periods. Additionally, employees within the non managerial ranks of the organization have tend to have no influence over governance practices, are not subject to clawbacks, and don’t typically represent a significant piece of the accounting expense pie.
What Types of Equity Compensation Make the Most Sense?
We’ll explore three major categories of equity compensation: restricted and performance awards, employee stock purchase plans (ESPPs) and stock options. According to the sources I’ve heard from on this topic, stock options are the least likely candidate for a post-vest holding period. Any mandatory holding period would be tied to the shares post exercise and since the vast majority of stock options are exercised in a same-day-sale transaction, there are most often no shares to tie to a holding period.
With stock options generally off the table, we are left with ESPP shares and restricted stock and performance awards. In my opinion, ESPPs fall into the “maybe” category. Certainly a company could implement a post purchase holding period. However, a key question is whether the population most engaged in ESPP is the same population that would be targeted by post-vest holding periods. We’ll explore the “who” should be affected shortly, but that is a key question in determining whether ESPP shares should be subject to such a mandated holding. Even if executives participate in the ESPP, they are most often likely to have other forms of equity compensation that would be more significant targets for holding periods. Additionally, employees contribute their own funds to the ESPP, and this may be an additional concern in evaluating whether a holding period makes sense (not so much at the executive level where it’s usually deemed good to have skin in the game, but at the mid or lower levels of the company).
The last category is restricted stock and performance awards/units. This appears to be the most likely area of focus for post-vest holding periods. In considering subjecting these types of award to mandatory holding post-vest, companies will need to consider the timing of taxation for awards and units. Restricted stock awards (absent an 83(b) election) are taxed upon vest, and the existence of a mandatory holding period can complicate matters if the participant is not permitted to sell shares to cover the taxes. Restricted stock units are subject to income tax when the award is distributed, making it more attractive to attach these types of awards to post-vest holding. Since income tax isn’t due until the shares are released to the employee, companies could delay settlement until after the post-vest holding period, eliminating the question of how to pay taxes if shares can’t be sold. FICA/FUTA taxes will still be due at vest for both awards and units, but there are ways to collect those taxes over time (such as using the IRS’s Rule of Administrative Convenience) or via payroll deduction from other cash compensation.
Scratching the Surface
This blog can only be so long, and I’ve only scratched the surface on the considerations for post-vest holding periods. One significant evaluation that I left out is the potential for a discount on the fair value for equity compensation subject to mandated hold after vest. This week I was fortunate enough to catch the DC/MD/VA Chapter meeting which (by pure coincidence) was on this exact topic. Terry Adamson of Aon Hewitt and Gustavo Dalanhese of E*TRADE did a great job of bringing companies up to speed on all of these considerations, including a deeper dive into the fair value savings. One thing I learned is that (several factors considered, including stock volatility) the discount can be significant. This is not a minor perk, but could be a strong driver in a company’s evaluation of whether or not to implement a post-vest holding period. We’re out of time today, but the good news is that next week’s NASPP webcast (March 11th) will explore this in much more detail. Be sure to tune in. And, for a quick run down, check out our Hold After Vest podcast episode (it’s much shorter than the webcast, so not as much detail, but definitely a great primer on this topic).
ISS has published its burn rate tables for the 2014 proxy season and the news isn’t good. For most industries, the ISS burn rate caps have decreased for 2014. For today’s entry, I have a few fun facts about the new burn rate tables.
For Russell 3000 companies:
Burn rate caps decreased for 14 of the 22 industries in the Russell 3000 that ISS publishes caps for.
Caps increased for seven of the 22 industries (automobiles & components, banks, consumer services, insurance, retailing, semiconductor equipment, and transportation) and the cap stayed the same for the utilities industry.
The largest decrease was for the media industry, which dropped from 5.6% last year to 4.43% for this year (1.17 points). ISS did not decrease the caps for any other industries by more than 1 point.
The largest increase was for the automobiles & components industry, which increased from 3.28% last year to 3.81% this year (.53 points).
For non-Russell 3000 companies:
Burn rate caps decreased for 15 of the 22 non-Russell 3000 industries.
Just as for the Russell 3000 companies, ISS increased the caps for seven industries, but not the same seven. For non-Russell 3000 companies, the industries where the caps were increased are banks, capital goods, commercial & professional services, consumer durables & apparel, insurance, retailing, and technology hardware & equipment.
ISS did not leave the cap the same for any non-Russell 3000 companies.
The largest decrease was 2 points, which is the maximum change (either increase or decrease) ISS allows from one year to the next (yes, ISS puts a cap on the change in the cap).
There were two industries for which burn rates dropped by 2 pts: energy and diversified financials. For energy, the maximum burn rate dropped from 9.46% to 7.46%, but would have dropped to 6.26% without ISS’s cap on changes in maximum burn rates. For diversified financials, the maximum burn rate dropped from 9.56% to 7.56%, but would have dropped to 7.17% without the cap.
For just under half of the industries where the maximum burn rate decreased, the decrease was greater than 1 point. In addition to energy and diversified financials, these industries included automobiles & components, pharmaceuticals & biotechnology, telecommunication services, transportation, and utilities.
The largest increase was in capital goods, which went from 6.69 in 2013 to 8.16 in 2014 (1.47 points).
It’s Like We’ve Got a Good Set of Tarot Cards
For anyone that listened to the NASPP’s November webcast highlighting the results of our 2013 Domestic Stock Plan Design Survey (co-sponsored by Deloitte Consulting), this isn’t a surprise. The survey results foreshadowed this trend. Only 24% of respondents to the survey reported a three-year average burn rate of 2.5% or more (down from 31% in 2010) and, in the past year, almost one-fifth (19%) of respondents took action to reduce their burn rate. The ISS caps are extrapolated directly from actual burn rates (for each industry, the cap is generally the industry’s three-year average burn rate plus one standard deviation); ISS policy in this area simply reflects what is happening in practice.
But there’s one sound That no one knows What do the investors say?
Actually, What Do the Investors Say?
As we are heading into next year’s proxy season (and now that you have that horrible song in your head), I thought it might be a good time to look at what the investor hot buttons are likely to be with respect to executive and stock compensation. I listened to the recording of the session “Say-on-Pay Shareholder Engagement: The Investors Speak” at the 10th Annual Executive Compensation Conference and found a few recurring themes. The panelists were Aeisha Mastagni of CalSTRS, Karla Bos of ING, and Donna Anderson of T.Rowe Price; the panel was moderated by Pat McGurn of ISS.
The investor panelists take a rather dim view of retention grants. They also don’t like programs that grant the same value of stock to execs every year (so that when the stock price drops, execs get more shares).
They weren’t keen on TSR or EPS as performance metrics. They felt EPS is too easily manipulated and too short-term and they would rather see goals that drive TSR, not TSR goals themselves. Which is interesting because TSR and EPS are the two most popular performance metrics in our 2013 Domestic Stock Plan Design survey (co-sponsored by Deloitte).
They didn’t have a lot of use for supplemental proxy filings but opinions were mixed as to the value of realizable pay disclosures.
For next year’s proxy season, the main areas of focus that they generally agreed on were performance awards and metrics, CIC provisions, and employment contracts (e.g., retention bonuses). If you don’t have a good story to tell on those topics, you might want to get cracking.
They all thought the CEO pay-ratio disclosure was of dubious value.
They all also insisted that they were very open-minded about stock and executive compensation and that they don’t blindly follow ISS (it’s just that they happen to agree with ISS on most issues).
Another key takeaway for me was that all of the investors explained that they focus on “the outliers” when reviewing proxy statements. They have lots of proxies to review and can’t do an in-depth analysis of each one. But if something about your executive pay grabs their attention because it is outside the norm, they will look closer at your company. So make like a junior high student and try to blend in.
Lululemon, an athletic apparel company, recently received some attention from the media because one of their shareholders (a pension fund) is suing them over an increase to their bonus program that their compensation committee approved just before the company announced a $60 million recall. Emily Cervino of Fidelity forwarded an article (“C-Suite Addiction to Stock Options No Bonus for Shareholders“) on the development to me because she knows of my penchant for both stylish workout gear and stock compensation. It’s rare that I get to combine the two interests.
Arrrggh!
The author of the article uses the Lululemon story as a jumping off point to lambast stock options, eventually making the statement that “While stock options are a no-lose proposition for those who get them, they are a no-win situation for existing shareholders.” Which is ridiculous.
For one thing, as far as I can tell, the suit against Lululemon has nothing to do with stock options. The investors are suing over an increase to the executives’ bonus program, not stock options (the reporter’s tenuous connection is that sometimes incentive compensation takes the form of stock options). Moreover, stock options most certainly aren’t a “no lose” deal for employees, any more than they are a “no-win” proposition for shareholders.
In fact, grants of stock options, rather than cash bonuses, might have been a more palatable solution for shareholders in this case. Unlike bonus plans, stock option payouts are non-discretionary. Either the stock price appreciates or it doesn’t. The compensation committee can’t decide to just pay out more under the options (setting aside the possibility of repricing). And if the company announces a major recall just after options are granted, presumably the company’s stock price will decline and the options will be worthless. If the options aren’t worthless, the stock price didn’t decline and investors haven’t lost money as a result of the recall.
Even if we allow the possibility of repricing, most public companies can’t do that without shareholder approval. Bonus plans, however, can typically be changed with just compensation committee approval (unless the plan is intended to qualify as performance based compensation under Section 162(m)).
What Do Responsible Stock Options Look Like?
The conclusion of the article asks readers to comment on how stock options can be structured to reward workers and protect investors, which got me thinking about what responsible options look like for executives. Here are some of the components that I think make for an option program that aligns with shareholder interests:
No mega grants. Small options granted frequently; never more than a single year’s worth of shares in one grant.
Appropriately sized options for everyone, execs included. When granting to execs, the size of grants should be determined based on option fair value, consideration of several possible payout scenarios, and consideration of the amount of wealth the executive has already accumulated through the company’s compensation programs. I know this thought makes me a communist, but really, how much money does one person need?
No flipping for executives. Require executives to fund exercises through netting, sell-to-cover, cash, or other payment methods that don’t require a sale and implement a holding period on the shares issued to the executive. I’m fine with allowing the rank-and-file to flip, however.
Reasonable caps on the option gain for everyone, execs and rank-and-file. You should really be doing this for full value awards as well. It’s a smart way to reduce plan expense with minimal to no impact on perceived value.
Appropriate clawback policies on shares/gain for execs.
No single-trigger vesting acceleration on a change-in-control (for everyone, both execs and the rank-and-file).
No repricing of options held by executives. Only shareholder approved, value-for-value repricing for the rank-and-file, preferably in lieu of that year’s annual grants, with renewed/extended vesting, and cancelled shares that aren’t regranted are retired (rather than returned to the plan).
On January 16, the SEC approved the new NYSE and NASDAQ listing standards relating to compensation committee independence. As noted in the NASPP’s alert on the original proposals (“Exchanges Issue New Standards for Compensation Committee Independence“), the new standards include three primary requirements:
The compensation committee must be comprised of independent directors, based on a number of “bright line” tests (many of which were already applicable to independent directors under each exchange’s prior listing standards) as well as additional factors that the SEC suggested should be considered in determining a director’s independence. Also, NASDAQ will now require a separate compensation committee (the NYSE already required this).
The compensation committee must have authority and funding to retain compensation advisors and must be directly responsible for appointment, compensation, and oversight of any advisors to the committee.
The committee must evaluate the independence of any advisors (compensation consultants, legal advisors, etc.).
The final rules make only a few minor changes to the original proposals, including clarifying that the compensation committee will not be required to conduct the required independence assessment as to a compensation adviser that acts in a role limited to:
consulting on a broad-based plan that does not discriminate in favor of executive officers or directors of the company, and that is available generally to all salaried employees; or
providing information (such as survey data) that is not customized for a particular company or that is customized based on parameters that are not developed by the adviser, and about which the adviser does not provide advice.
Public companies now need to assess whether the compensation consultants and other advisors engaged by their compensation committee raise any conflicts of interest and disclose any identified conflicts in their proxy statement (for annual meetings after January 1, 2013 at which directors will be elected). Although not required, where no conflict of interest is found, we expect that many companies will include a disclosure to indicate this.
In his Proxy Disclosure Blog on CompensationStandards.com, Mark Borges of Compensia highlights a recent disclosure on this topic in Viacom’s proxy statement, which might be useful to review as you draft your own disclosure (if this isn’t your gig, perhaps you can score some points by forwarding it on to the person that will be drafting this disclosure).
ISS has issued a draft of proposed updates to its corporate governance policies for the 2013 proxy season.
Speak Your Mind–But Be Quick About It
If you have an opinion on the draft that you’d like to express to ISS, you need to get your comments in by October 31. I know you’re thinking that maybe I could have mentioned this a little sooner, but actually, I couldn’t have. The draft was just released last week, after my blog was published. If you follow the NASPP on Twitter or Facebook, however, you at least knew about the draft by last Thursday, when we posted an NASPP alert on it.
You Probably Don’t Have a Lot to Say Anyway
The quick turnaround time for comments probably isn’t a problem because my guess is you aren’t going to have much to say about the proposed changes. ISS is proposing only three changes on their policies relating to executive compensation and only one of those changes relates directly to stock compensation. Here are the proposed changes:
New methodology for determining peer groups
Qualitative analysis will consider how “realizable pay” compares to grant date pay
Allowing executives to pledge company stock will be considered a problematic pay practice
Peer Groups
ISS’s determination of peer groups is critical to their analysis of whether CEO pay aligns with company performance. ISS puts together a peer group of around 14 to 24 companies (I have no idea why 14 to 24 and not, say, 15 to 25–that’s just what ISS says): if your CEO’s pay outpaces the peer group by more than the company’s performance, ISS perceives a possible pay-for-performance disconnect. As noted in my blog “Giving ISS an Earful” (August 14, 2012), the peer group methodology was already an anticipated target for change in this year’s policy.
Up to two years ago, ISS based peer groups solely on GICS codes. Last year, ISS updated it’s policy to base peer groups on revenue and market capitalization, in addition to GICS codes. This year, ISS is further refining peer identification to take into account the GICS codes of the company’s self-selected peers.
Realizable Pay vs. Grant Date Pay
If you follow Mark Borges’ Proxy Disclosure Blog on CompensationStandards.com, you know that a number of companies have been comparing the grant date pay disclosed in the Summary Compensation Table to “realizable pay.” Grant date pay, is, of course, the fair value of awards at grant. Realizable pay is a calculation of how much the executives could realize from their awards as of a specified point in time (usually the end of the year). As I’m sure my reader’s can imagine, the values are usually very diffferent.
Where ISS perceives a pay-for-performance disconnect, it will perform a more in-depth qualitative analysis of the CEO’s pay. In this year’s policy, ISS is proposing to include “realizable pay compared to grant pay” in that analysis.
ISS doesn’t provide any further information, such as what might be considered a favorable comparison or even how “realizable pay” will be determined. In taking a quick gander at the realizable pay disclosures Mark has highlighted recently in his blog, it seems that there is significant variation in practice as to how companies calculate this figure. Some look at pay realizable only from options and awards granted during the current year, others look at all outstanding options and awards, and others look at options and awards granted within a specified range (e.g., five years). I’m not sure whether ISS will perform its own realizable pay calculation (and whether it would have sufficient information to do so) or just accept the number disclosed by the company (assuming a company chooses to make this voluntary disclosure).
More Information
For more information on ISS’s proposed policy updates, including their discussion of the policy around pledging and proposed changes to their policy for Say-on-Parachute-Payment votes, see the NASPP alert “ISS Draft of 2013 Policy Updates.”
While normally ISS’ annual release of policy updates is a relatively exciting, blog-worthy event, this year’s release feels anti-climatic (at least with respect to their compensation policy–maybe there’s some really hot updates to their policies on, say, hydraulic fracturing and recycling–I wouldn’t know) because they previewed the changes several weeks ago (see my Nov 15 blog, “ISS Previews Policy Changes“).
As far as I can tell, the final policy doesn’t really differ much from the proposed policy. In fact, given the short comment period on the proposal and the quickness with which the final policy was released, I have to wonder if they received many, if any, comments and if they did much with the comments. Unlike the IRS, FASB, and the SEC, ISS doesn’t publish/summarize the comments they received or address how those comments were taken into consideration.
Policy Changes for Stock Compensation
As summarized in my previous blog, really the only policy change that directly impacts stock compensation is that when newly public companies first submit a stock plan for shareholder approval for Section 162(m) purposes, ISS will now conduct a full review of the plan. In the past, they basically rubber-stamped these proposals.
This might be big news for LinkedIn, Yelp, Groupon, Zynga, and other recent and anticipated IPOs (and their compensation consultants), but for most of my readers, who have been public for a while now, this isn’t that groundbreaking.
Pay-for-Performance
The changes with regards to how ISS evaluates pay for performance also seem to have been adopted largely as proposed. ISS will now determine peer groups based on market capitalization, revenue, and GICS codes, rather than just relying on GICS codes. This could make it difficult for companies to determine who is in their ISS peer group on their own, thus making it hard for companies to predict how they’ll compare against their peers.
ISS will compare a company’s TSR and CEO pay rankings in the peer group and the CEO’s total pay relative the peer group median. Where merited, ISS will also perform a qualitative analysis. This will include a number of factors, the most interesting of which to me is that ISS will look at the ratio of performance to time-based equity awards (I assume this is limited to awards issued to the CEO, but this isn’t completely clear to me from ISS’ summary of the updates). As my readers know, there were several companies this year that modified time-based awards held by their CEO’s to vest based on performance conditions (see my May 3 blog, “Eleven and Counting“). I have to believe these two developments are connected and we can expect ISS to push for more performance-based vesting–at least for CEOs–in the future.
Burn Rates
The updated burn rate tables are not included in the summary of the changes–last year ISS didn’t release these until mid-December so I guess that’s when we’ll get them this year. Is it just me, or does it seem like ISS is releasing these tables later and later?
NASPP “To Do” List We have so much going on here at the NASPP that it can be hard to keep track of it all, so I keep an ongoing “to do” list for you here in my blog.
On October 18, ISS issued a preview of some of the policy changes it is considering for the 2012 proxy season. In today’s blog, I take a look at proposed policy changes relating to how ISS evaluates CEO pay and stock plans submitted for shareholder approval for Section 162(m) purposes.
ISS, CEO Pay, and Company Performance
ISS currently evaluates CEO pay and company performance by comparing the company’s TSR to that of its GICS industry group to identify underperformance, then applying a qualitative analysis of various other factors that relate the CEO’s pay to TSR.
Under the newly proposed policy, ISS will apply a relative measure that compares the company’s TSR to that of its peers, which will be determined based on market capitalization, revenue, and GICS industry group. ISS will compare the company’s TSR ranking within the group to that of its CEO pay ranking. ISS will also consider the multiple of the CEO’s pay to the peer-group median.
In addition to the relative measure, ISS will apply an absolute measure that tracks changes in the company’s TSR against changes in its CEO’s pay.
The results of ISS’s pay-for-performance evaluation can impact recommendations ISS issues for the company’s Say-on-Pay proposal and stock plan proposals (if a significant portion of the CEO’s misaligned pay is in the form of equity), as well as individual director nominations.
ISS and Section 162(m)
In the past, when stock plans have been submitted for shareholder approval solely for the purpose of qualifying for exemption under Section 162(m), ISS has generally recommended that shareholders approve the plans. Under the newly proposed policy, however, ISS states that they will complete a full analysis of future plans submitted to shareholder vote for this purposes.This will include consideration of the total shareholder value transfer, burn rate analysis (if applicable), and specific plan features (such as repricing and change-in-control provisions).
This may particularly be a concern for newly public companies that wish to qualify performance unit awards for exemption under Section 162(m). Under recently proposed rules, the IRS clarified that the Section 162(m) exemption for post-IPO grants of stock options, SARs, and restricted stock made during a transition period does not apply to RSUs. Thus, newly public companies that wish to grant exempt performance unit awards will need to submit their plans for shareholder approval, triggering a full analysis of the plan by ISS.
Comments and More Information
ISS accepted comments on the policy through the end of October. (We posted an NASPP alert on the policy changes shortly after ISS issued the proposal. If you follow the NASPP on Twitter or Facebook, then you knew about our alert in time to submit comments to ISS.)
NASPP “To Do” List We have so much going on here at the NASPP that it can be hard to keep track of it all, so I keep an ongoing “to do” list for you here in my blog.