It used to be that ISS would make only a few changes per year to its voting policies that affected stock compensation. Some years the changes didn’t even warrant a blog entry. But now ISS has the Equity Plan Scorecard and a scorecard requires constant tweaking. As a result, we now have a lengthy list of changes to review every year. Today’s blog entry is a summary of the ones I think are most significant.
It’s Harder for S&P 500 Companies to Earn a Passing Score
Big news for S&P 500 companies: your stock plans now have to earn an extra two points (a total of 55 pts) to receive a favorable recommendation. Everyone else’s plans still pass with only 53 pts.
The Burn Rate Test Gets a Little Easier for Acquirers
More big news: all companies can now request that ISS exclude restricted shares granted in consideration for an acquisition from their burn rate. Companies that want to request this must include a tabular disclosure reporting the number of restricted shares granted in this context for their most recent three fiscal years.
Partial Credit Eliminated for Some Factors
No more partial credit for CIC provisions, holding requirements, and CEO vesting requirements, and in some cases, the requirements to receive full credit have been relaxed.
To earn full credit for CIC provisions, the provisions must meet both of the following conditions (unless the company doesn’t grant time-based awards, in which case only the condition related to performance awards matters):
Performance awards can allow the following: (i) pay out based on actual performance, (ii) pro rata pay out of the target level (or a combination of i and ii), or (iii) forfeiture of awards.
Time based awards cannot provide for automatic single-trigger or discretionary acceleration of vesting.
To receive full points for the holding period requirement, shares must be required to be held for 12 months (down from 36 months in past years) or until the end of employment. No points for requiring shares to be held until ownership guidelines are satisfied.
To receive full points for the CEO vesting requirements, awards granted to the CEO in the past three years cannot vest in under three years (down from four years in the past). Still no points if no performance awards have been granted to the CEO in the past three years, but grants of time-based awards are no longer required to earn full credit.
One area of ISS’s voting policy that you can count on changing every year are the burn rate benchmarks. ISS updates these benchmarks based on historical data. In theory, if granting practices haven’t changed, the burn rate benchmarks won’t change either. But, inevitably, practices change (in response to changes in the economic environment, the marketplace, and compensation practices, not too mention pressure to adhere to ISS’s burn rate benchmarks) and the burn rate benchmarks change as well.
Surprise, Surprise (Not!)—Burn Rate Benchmarks Lower in 2016
It seems like a self-fulfilling prophecy to me that if ISS sets a cap that burn rates can’t exceed and companies are forced to manage their grants to come in under that cap, burn rates are going to keep decreasing. This year, by my calculations, burn rate benchmarks dropped for 40% of industries in the S&P 500, 59% of industries in the Russell 3000, and 68% of industries in the Non-Russell 3000. ISS indicates that the median change across all industries/indices is a decline of .07%.
It’s a “Benchmark” Not a “Cap”
ISS calls the standard a “benchmark” not “cap.” When they made this change last year, I thought maybe this was because they thought the word “benchmark” sounded friendlier. This isn’t the case at all, however. It’s a “benchmark” because the cap is actually lower than the benchmark. To get full credit for the burn rate test in ISS’s Equity Plan Scorecard (EPSC), a company’s burn rate has to be less than 50% of the benchmark. In other words, the cap is 50% of the benchmark.
Burn Rate Scores Can Go Negative
Laura Wanlass of Aon Hewitt tells me that, just like the score for the SVT test (see “Update on the ISS Scorecard,” July 21, 2015), the burn rate score can also be negative.
Burn Rate Is Important
Burn rate is not quite as important as a plan’s SVT score, but it’s still significant—a negative score could be impossible to come back from in the EPSC. Laura tells me that it is the largest percentage of points in the Grant Practices pillar, which is worth less than Plan Cost (i.e., the SVT test) but more than the Plan Features pillar.
Before the EPSC, burn rates didn’t matter as much. If a company didn’t pass the burn rate test, they simply made a three-year commitment to stay under ISS’s cap in the future—no harm, no foul. But those three-year commitments are just a distant fond memory under the EPSC.
The Burn Rate Test Is Getting Harder
While the standard to earn full points for burn rate remains 50% of the benchmark, overall, the benchmarks have been lowered for most industries/indices. In addition, Laura tells me that ISS is recalibrating the test so that burn rates above 50% of the benchmark will earn fewer points and will go negative sooner than last year.
Last Friday, ISS issued an updated FAQ for its Equity Plan Scorecard. For most companies, the overall scorecard structure remains unchanged: a max of 100 points and 53 points is a passing grade. For companies disclosing three years of equity data, the points available under each pillar also remain the same, but the scores for each test within the pillars may have been adjusted (ISS doesn’t disclose the number of points each test is worth).
Here’s what ISS is changing for 2016 (effective for shareholder meetings on or after February 1, 2016):
New Company Category
The IPO/Bankruptcy category has been renamed “Special Cases” and includes any companies that have less than three years of disclosed equity grant data. This is still largely newly public companies and companies emerging from bankruptcy, but it could include other companies. For example, if a public company implemented a new stock compensation program in 2016 and had not previously granted any equity awards, they would presumably be in this category (because they wouldn’t have any equity grant data to disclose for prior years).
In addition, the Special Cases category is now divided into S&P 500/Russell 3000 companies and non-Russell 3000 companies. The S&P 500/Russell 3000 companies can earn 15 points for the Grant Practices pillar; to provide these points, their max score for the Plan Cost pillar is reduced by ten points to 50 and their max score for the Plan Features pillar is reduced by five points to 35. Scoring for the non-Russell 3000 companies in this category is the same it was for IPO/Bankruptcy companies last year: 60 points for plan cost, 40 points for plan features, and no points for grant practices.
CIC Provisions
The “CIC Single Trigger” category under Plan Features is renamed “CIC Equity Vesting” and is a little more complicated (last year it was pass/fail).
For time-based awards:
Full points for 1) no acceleration, or 2) acceleration only if awards aren’t assumed/substituted
No points for automatic acceleration of vesting
Half points for anything else (does this mean half points for a double trigger?)
For performance-based awards:
Full points for 1) forfeiture/termination, or 2) payout based on target as of CIC, or 3) pro-rata payout
No points for payout above target (ISS doesn’t say if this applies if performance as of the CIC is above target)
Half points for anything else
Post-Vest Holding Periods
The period of time required to earn full points for post-vest holding periods increased from 12 months to 36 months (or termination of employment). 12 months (or until ownership guidelines are met) is still worth half credit.
Now that the proxy season is winding down and I’ve had the chance to attend a couple of presentations on the new ISS Equity Plan Scorecard, I thought it would be a good time to provide an update on how the scorecard has worked out so far.
Most Plans Passed
Very few plans failed to obtain a favorable rating under the new EPSC. But I’m not sure this should come as a surprise. Of course, most plans passed; that’s why companies pay for the ISS Compass model and hire consultants certified in the use of this model—to ensure that they don’t undertake the expense of submitting a plan to a shareholder vote and not get the votes they need to pass. If a favorable ISS recommendation is key to ensuring the plan is approved, companies are going to do what it takes to get a favorable recommendation. But, how much did companies have to reduce their share requests (and how many of the scorecard factors did companies have to incorporate into their plans) to get favorable recommendations?
It’s Only Going to Get Harder
One thing that’s been clear from the beginning is that ISS is likely to tweak both the pass threshold and the points allotted to each test in the EPSC from year-to-year (this is how they operate scorecards they have created for other purposes). Ken Lockett of AST, Laura Wanlass of AON Hewitt, Scott McCloskey of Lincoln Financial, and Melinda Hanzel of D.F. King presented on the EPSC at the Philadephia/DC/VA/MD joint half-day meeting in June. Given that so few companies failed this year, they noted that they expect the EPSC to be harder to pass next year.
Negative Points Are Possible
Laura noted that on some of the tests, including the SVT, a company can score so poorly that the plan is awarded negative points. The Corporate Executive noted, in its January-February 2015 issue, that with the SVT worth 45% of the score for most companies, it is virtually impossible to achieve a favorable recommendation without earning at least some points for this test. Now it turns out that the plan could score so poorly on the SVT that it is actually impossible to make up enough points the elsewhere in the scorecard to pass.
Where companies need to make up points under the scorecard, there are several provisions they can remove from (e.g., liberal share recycling, discretion to accelerate vesting) or add to (e.g., post-vesting holding periods, minimum vesting requirement) their plan to earn additional points.
I’ve heard from several practitioners that post-vest holding periods are worth more than expected under the scorecard. This is a nice break, since post-vest holding requirements aren’t necessarily a takeaway for execs when the company already has stock ownership guidelines in place (and what public company doesn’t have these already). To learn more about post-vesting holding periods, check out our podcast with Terry Adamson or our March webcast.
Peter Kimball of ISS Corporate Services presented on the scorecard at the Phoenix NASPP chapter meeting in May and noted that many companies were reluctant to remove discretion to accelerate vesting or to stipulate a minimum vesting period under the plan. I can understand this—there are perfectly legitimate reasons to accelerate vesting. And minimum vesting periods are a disaster waiting to happen. I’ve already encountered one company that had a minimum vesting requirement, and then granted RSUs that vested in under that time frame and did not discover the error until after the RSUs had vested and been paid out. I’m not sure how you fix that mistake; the lawyers I asked about it did not want to touch that question with a ten-foot pole (or without an attorney-client relationship to protect everyone involved).
Learn More at the NASPP Conference
The session “Demystifying the ISS Equity Plan Scorecard” at the 23rd Annual NASPP Conference will provide a full analysis of how companies fared under the scorecard this year and includes a case study from one company that has already navigated it. The Conference will be held in San Diego from October 27 to 30; register by August 7 to save!
ISS has released 104 additional FAQs on their corporate governance policy. That’s 44 pages of FAQs but they still haven’t answered the question we all want to know, which is how many points each of the tests in the Equity plan Scorecard are worth. In fact, a lot of the FAQs provide information that I thought was already general knowledge or is so a granular as to be applicable to only a small number of companies (I think ISS must be using the term “frequently” very loosely).
For what it’s worth, here are a few highlights from the FAQs on equity plans.
Excluding Certain Grants from Burn Calculations
ISS will exclude assumed or substitute grants issued as a result of an acquisition as well as grants issued pursuant to a shareholder-approved repricing from the burn rate calculation if these grants are disclosed separately in the plan activity table in the company’s Form 10-K. This explains why I see companies do this.
Disclosing Performance Based Awards
ISS generally counts performance based awards in the burn rate calculation in the year they are earned, provided that the company has included disclosures sufficient for this purpose. Separately report the number of performance awards granted and the number of performance awards earned when disclosing plan activity. Be careful about this: if ISS can’t figure out your disclosures, they could end up counting performance awards twice.
Updating Disclosures After Year-End
If circumstances for your company have changed so significantly since the end of the year that you want ISS to base the SVT and (presumably) other tests on new numbers, ISS will do this if you update “ALL” of the disclosures required for their analysis in your proxy statement (or in another public filing that the proxy statement references). See the FAQs for list of disclosures that must be updated; it sounds like ISS is going to be a stickler about this (the use of all caps for the word “ALL” was their idea).
Fungible Share Reserves and SVT
ISS calculates the cost of plans with fungible share reserves by running the SVT test twice; once assuming all shares are issued as stock options/SARS and a second time assuming all shares are issued as full value awards. The plan has to pass both tests. It isn’t clear from the FAQ what happens if the plan passes both tests but scores better on one than the other (the SVT score is scaled; plans can earn partial credit for scores within a certain range). Maybe the plan is assigned the lowest score.
Fungible Share Reserves and Plan Duration
The plan duration is calculated by adding the shares requested to the share available in the plan and dividing by the company’s burn rate multiplied by the company’s weighted shares outstanding. For purposes of calculating the burn rate in this formula, for plans with a fungible share reserve, the FAQs state that ISS will apply the share multiplier in the plan to full value awards. Normally, ISS has its own multiplier that it uses for burn rate calculations that is based on the volatility of the company’s stock, so this is a little surprising to me. I can only assume that it hurts companies in some way (not that I’m cynical); perhaps plan multipliers are typically lower than ISS’s multiplier, resulting in a lower burn rate, which would result in a longer plan duration.
Burn Rate Commitments
If you have made a burn rate commitment in the past three years, you aren’t off the hook. Even though these commitments are defunct under the scorecard, ISS expects companies to adhere to any commitments they’ve already made. If you don’t, they may take it out on your compensation committee members.
Fixing a Liberal Change-in-Control Definition
A liberal change-in-control definition is a deal-breaker; ISS will recommend against the plan regardless of how perfect the plan’s scorecard is. A liberal change-in-control definition is one that provides for single-trigger acceleration of vesting upon a trigger that could occur even if the deal doesn’t close (e.g., shareholder approval of the deal) or other triggers that are suspect (e.g., acquisition of a low percentage of the company’s common stock).
But there’s good news—this is fixable. You can modify the CIC provision in your plan (the FAQs provide suggested language). ISS is good with this, even if the modification only applies to new awards.
Other Matters
Most of the FAQs (75 of the 104 questions) relate to Say-on-Pay votes and other corporate governance considerations, rather than directly addressing equity plan matters. These are beyond the scope of things I care about, so I didn’t read them. It’s possible they are more scintillating than the FAQs on equity plan matters.
Last week, I discussed ISS’s new Equity Plan Scorecard. If you were hoping that the scorecard gave you a free pass on your burn rate, I have some disappointing news. The scorecard doesn’t eliminate the burn rate caps—the caps are a component of a plan’s overall scorecard rating.
The Word “Cap” Is So Limiting
One interesting change I noticed is that ISS is no longer calling them “caps”; now they are “benchmarks.” I’m not sure if this is to make them seem less restrictive or to make companies feel worse about exceeding them because the caps aren’t an arbitrary limit but a benchmark established by their peers.
According to ISS’s FAQ on the Scorecard, a plan gets max points when the company’s burn rate is 50% or less of the benchmark for its industry. The FAQs say that the burn rate score is “scaled,” so I assume this means that partial credit is available if the company’s burn rate is more than 50% of the benchmark but still below it. (If burn rates follow the pattern established in other areas, companies will get half credit if they are in this range. But don’t quote me on that; I didn’t find anything in the FAQs about this–I’m totally guessing). I’m also guessing that if you are over the benchmark, no points for you.
Good News for (Most) Russell 3000 Companies; Not So Good News for S&P 500 Companies
The most significant change is that ISS has broken out S&P 500 companies from other Russell 3000 companies for purposes of determining the burn rate benchmarks. For S&P 500 companies, this results in significantly lower burn rate benchmarks. In a number of industries (energy, commercial & professional services, health care equipment & services, pharmaceuticals & biotechnology, diversified financials, software & services, and telecommunication services), the benchmark dropped more than two points below the cap that S&P 500 companies in these industries were subject to last year.
For most of the Russell 3000 companies that aren’t in the S&P 500, ISS increased the burn rate benchmark slightly. For non-Russell 3000 companies, burn rate benchmarks dropped for the most part (only seven out of 22 industries didn’t see a drop), so I’m guessing that the benchmarks for the Russell 3000 would be lower if the S&P 500 companies hadn’t been removed.
How Does This Play Into the Scorecard?
Burn rate is just one part of one pillar in the scorecard, the grant practices pillar, which is worth 35 points for S&P 500/Russell 3000 companies (25 points for non-Russell 3000 companies). All three types of companies can also earn points in this pillar for the duration of their plan (shorter duration=more points). S&P 500/Russell 3000 companies also earn points in this pillar for specified grant practices. Thus, even if a company completely blows their burn rate benchmark, the plan can still earn partial credit in the grant practices pillar.
In a worst-case scenario, where a plan receives no points at all for grant practices, there’s still hope in the form of the plan cost and plan features pillars. For S&P 500/Russell 3000 companies, plan cost is worth 45 points and the plan features pillar is worth 20 points. That’s a potential 65 points, well over the 53 required to receive a favorable recommendation.
As I noted on October 21 (“ISS Changes Stock Plan Methodology“), ISS is changing how they evaluate stock plan proposals. Just before Christmas, ISS released additional information about their new Equity Plan Scorecard, including an FAQ. For today’s blog entry, I take a look at how the scorecard works.
What the Heck?
Historically, ISS has used a series of tests (Shareholder Value Transfer, burn rates, various plan features) to evaluate stock plan proposals. Many of these tests were deal-breakers. For example, fail the SVT test and ISS would recommend against the plan, regardless of how low your burn rate had been in the past or that fact that all the awards granted to your CEO vest based on performance.
Under the new Equity Plan Scorecard (known as “EPSC,” because what you need in your life right now is another acronym to remember), stock plans earn points in three areas (which ISS refers to as “pillars”): plan cost, grant practices, and plan features. Each pillar is worth a different amount of points, which vary based on how ISS categorizes your company. For example, S&P 500 and Russell 3000 companies can earn 45 points for the plan cost, 35 points for grant practices and 20 points for plan features. Plans need to score 53 points to receive a favorable recommendation. [I’m not sure how ISS came up with 53. Why not 42—the answer to life, the universe, and everything?] So an S&P 500 company could completely fail in the plan cost area and still squeak by with a passing score if the plan got close to 100% in both the grant practices and plan features area.
Plan Cost
Plan cost is our old friend, the SVT analysis but with a new twist. The SVT analysis is performed once with the shares requested, shares currently available under all plans, and awards outstanding, then performed a second time excluding the awards outstanding. Previously, ISS would carve out options that had been outstanding for longer than six years in certain circumstances. With the new SVT calculation that excludes outstanding options, this carve out is no longer necessary (at least, in ISS’s opinion–you might feel differently). The points awarded for the SVT analysis are scaled based on how the company scores against ISS’s benchmarks. Points are awarded for both analyses (with and without options outstanding), but the FAQ doesn’t say how many points you can get for each.
Grant Practices
The grant practices pillar includes our old friend, the burn rate analysis. But gone are the halcyon days when burn rates didn’t really matter because companies that failed the test could just make a burn rate commitment for the future. Now if companies fail the burn rate test, they have to hope they make the points up somewhere else. Burn rate scores are scaled, so partial credit is possible depending on how companies compare to the ISS’s benchmarks. This pillar also gives points for plan duration, which is how long the new share reserve is expected to last (full points for five years or less, no points for more than six years). S&P 500 and Russell 3000 companies can earn further points in this pillar for certain practices, such as clawback provisions, requiring shares to be held after exercise/vest, and making at least one-third of grants to the CEO subject to performance-based vesting).
Plan Features
This seems like the easiest pillar to accrue points in. Either a company/plan has the features specified, in which case the plan receives the full points, or it doesn’t, in which case, no points for you. There are also only four tests:
Not having single-trigger vesting upon a CIC
Not having liberal share counting
Not granting the administrator broad discretionary authority to accelerate vesting
Specifying a minimum vesting period of at least one year
That’s pretty simple. If willing to do all four of those things, S&P 500/Russell 3000 companies have an easy 20 points, non-Russell 3000 companies have an easy 30 points (more than halfway to the requisite 53 points), and IPO/bankruptcy companies have an easy 40 points (75% of the 53 points needed).
Alas, this does mean that companies no longer get a free pass on returning shares withheld for taxes on awards back to the plan. Previously, this practice simply caused the arrangement to be treated as a full value award in the SVT analysis. Since awards were already treated as full value awards in the SVT analysis, it didn’t matter what you did with the shares withheld for taxes. Now you need to be willing to forego full points in the plan features pillar if you want to return those shares to the plan.
Dealbreakers
Lastly, there are a few practices that result in a negative recommendation regardless of how many points the plan accrues under the various pillars. These include a liberal CIC definition, allowing repricing without shareholder approval, and a couple of catch-alls that boil down to essentially anything else that ISS doesn’t like.