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.
I was recently asked to comment on a premium priced option granted to IBM’s CEO for an article in Bloomberg (“IBM Says CEO Pay Is $33 Million. Others Say It Is Far Higher“). There are a number of things that I find interesting about the grant.
The Option Grant
The option was granted to IBM’s CEO and is for a total of 1.5 million shares, granted in four tranches. Each tranche cliff vests in three years and has a different exercise price, ranging from $129.08 to $153.66 (premiums ranging from 5% to 25% of FMV).
The option was granted in January of last year, about a month before IBM’s stock price hit its five-year low. IBM’s stock price recovered to the point where all four tranches were in the money around mid-July and the option has mostly been in-the-money since then. IBM’s stock is now trading at around $160 (down from a three-month high of around $180). Either the options were very effective at motivating IBM’s CEO or IBM didn’t set the premiums high enough (or both).
The option doesn’t vest until January 2019 and we all know what can happen to any company’s stock price in that period of time, so there’s no guarantee that the option will still be in-the-money when it vests. The option has a term of ten-years, however, so if it isn’t in-the-money, there’s still plenty of time for the stock price to recover before it expires.
A History of Premium-Priced Options
This isn’t IBM’s first foray into premium priced options. From 2004 to 2006, IBM granted a series of stock options to its executives that were priced at a 10% premium to the grant date market value. In 2007 they dropped the practice and granted at-the-money options, then they ceased granting options altogether. This is the first option IBM has granted since 2007.
The Valuation Mystery
The reason I was asked to comment on the option is that the value IBM reported for the option (which is also the expense IBM will recognize for it) is significantly less than amount that ISS determined the option was worth. IBM reported that the option has a grant date fair value of $12 million but, according to the Bloomberg article, ISS puts the value at $29 million.
It’s not unusual for there to be variations in option value from one calculation to the next, even when all calculations are using the same model and the same assumptions. But a variation this large is surprising. Both IBM and ISS say they are using the Black-Scholes model, so the difference must be attributable to their assumptions. If I were to guess which assumption is causing the discrepancy, my guess would be expected term. The dividend yield and interest rate aren’t likely to have that much of an impact and it seems unlikely that there would be significant disagreement as to the volatility of IBM’s stock.
Why Price Options at a Premium?
The idea behind premium-priced options is to require execs to deliver some minimum amount of return to investors (e.g., 10%) before they can benefit from their stock options. It’s an idea that never really caught on: only 3% of respondents to the NASPP/Deloitte Consulting 2016 Domestic Stock Plan Design Survey grant them.
I’ve never been a fan of premium-priced options. I suspect that most employees, including execs, assign a very low perceived value to them (or assign no value to them at all), so I doubt they are the incentive they are supposed to be. And the reduction in fair value for the premium is less than the amount by which the options are out-of-the money at grant and far less than the reduction to perceived value, which makes them a costly and inefficient form of compensation.
ISS 2017 Equity Compensation Plan FAQ notes that where companies want ISS to include performance awards in their burn rate when the awards are earned, ISS now requires specific disclosures with respect to the performance awards.
A Quick Primer on ISS, Burn Rates, and Performance Awards
ISS includes performance awards in a company’s burn rate when the awards are earned, if the company includes this information in the disclosures related to its stock plan. If this information isn’t disclosed, ISS includes the performance awards in the burn rate calculation when they are granted.
The problem with including the performance awards when they are granted is that ISS doesn’t reduce the burn rate for subsequent forfeitures (due to either termination of employment or failure to meet the performance goals). Consequently, it is generally preferable to have performance awards included in the burn rate when they are earned. This will result in a more accurate (and possibly lower) burn rate, because only the shares that are actually earned and paid out will be included in the calculation.
What’s Changed?
In the past, ISS simply required companies to clearly and consistently disclose how many shares were granted and earned under performance awards, without defining what the disclosure should have looked like. In its 2017 Equity Compensation Plans FAQ, however, ISS has stipulated the following requirements for the disclosure:
Table format
Separate from the disclosure for time-based awards
Aggregate of all performance awards granted to all employees (providing the disclosure only for awards held by NEOs is insufficient)
Covering three years
Included every year going forward, even if the plan will not be acted on in a particular year
Included even if no performance awards were granted or earned in a particular year
ISS has also said that they generally won’t calculate the number of shares earned under performance awards, even if it would be possible for them to do this from information presented in narrative format.
The FAQs include a sample disclosure that looks remarkably like the old roll-forward tables companies used to include for all of their stock compensation under the original FAS 123.
Is This Legally Required?
The disclosure isn’t legally required or required under ASC 718. But if you want ISS to include your performance awards in your burn rate when they are earned, rather than when they are granted, the disclosure is necessary.
As most of my readers know, the FASB has amended ASC 718 to expand the exception to liability treatment that applies to shares withheld to cover taxes to include withholding up to the maximum individual tax rate. This has led many companies to consider changing their tax withholding practices for stock compensation.
Plan Amendment Likely Necessary
As noted in my blog entry “Getting Ready for the New Share Withholding” (May 5, 2016), companies that are interested in taking advantage of the expanded exception face an obstacle in that virtually all stock plans include a prohibition on using shares to cover taxes in excess of the minimally required statutory withholding. Where companies want to allow shares to be withheld for tax payments in excess of this amount, the plan must first be amended to allow this.
Shareholder Approval Not Necessary
In the aforementioned blog entry, I had noted that it wasn’t clear if shareholder approval would be required for the plan amendment, particularly if the shares withheld will be recycled back into the plan. I have good news on this question: both the NYSE and Nasdaq have amended their shareholder approval FAQs to clarify that this amendment does not require shareholder approval, even if the shares will be recycled.
Nasdaq (ID number 1269, it should be the last question on the second page. Or do a keyword search for the word “withholding” and the relevant FAQ should come right up.)
For a while, there was still a question as to whether the NYSE required shareholder approval when shares withheld from restricted stock awards would be recycled. In late December, John Roe of ISS arranged for the two of us to meet with John Carey, the Senior Director at NYSE Regulation, to get clarification on this. Just prior to our meeting, the NYSE updated their FAQs to clarify that shareholder approval is not required even in the case of share withholding for restricted stock awards, even when the shares will be recycled.
ISS Still Not a Fan of Share Recycling
It should come as no surprise that, where the withheld shares will be recycled, ISS isn’t a fan of amendments to allow shares to be withheld for excess tax payments. Now that it’s clear shareholder approval isn’t required for the amendment, this likely isn’t a significant concern for most companies, unless they are submitting their plan for shareholder approval for some other reason. It isn’t a deal-breaker, but it could enter into ISS’s qualitative assessment of the plan. This would particularly be an issue if ISS’s recommendation is tied to more than the plan’s EPSC score.
Not a Modification for Accounting Purposes
There also has been some question as to whether the amendment would be considered a modification for accounting purposes if applied to outstanding awards. Based on the FASB’s recent exposure draft to amend the definition of a modification under ASC 718 (see “ASC 718 Gets Even Simpler,” November 22, 2016), the FASB doesn’t seem to think modification accounting is necessary. The comment period on the exposure draft ended on January 6. There was little opposition to the FASB’s position: only 14 comment letters were received, one letter clearly opposed the change, 12 supported the change, and one was “not opposed” but not enthusiastic. Given that response, hopefully the FASB will finalize the proposed update quickly so that this question is settled.
In my blog entry this week titled “Other ISS Policy Amendments,” I said that ISS no longer permits the 5% carve-out with respect to minimum vesting requirements. This statement was not correct. ISS will still permit up to 5% of shares granted under a stock plan to vest quicker than required under the plan’s minimum vesting requirements. I apologize for my error and any confusion it created; I have corrected my original entry.
On November 29, I discussed ISS’s amendments related to dividends paid on awards (ISS Targets Dividends on Unvested Awards), but that’s not the only amendment to their 2017 Proxy Voting Guidelines that impacts stock compensation programs. For today’s blog entry, I discuss the other amendments.
Minimum Vesting Requirements
The plan must specify a minimum vesting period of one year for all awards to receive full points for this test under the Equity Plan Scorecard. In addition, no points will be earned if the plan allows individual award agreements to reduce or eliminate this vesting requirement (note, however, that ISS still permits an exception for up to 5% of shares awarded).
Anyone who listened to my podcast “Five Things Barbara Baksa Learned About the ISS Equity Plan Scorecard” knows that I’m not a fan of this test in the EPSC because I’m convinced it is just a compliance disaster waiting to happen. And now that the plan can’t allow any exceptions to it all, I like it even less.
Plan Amendments
Although ISS didn’t deem this change significant enough to include it in the Executive Summary, the policy with respect to how plan amendments are evaluated has also been updated. For most types of substantive amendments (i.e., amendments that aren’t purely administrative or that aren’t solely for purposes of Section 162(m)), the plan will be reevaluated under the EPSC and ISS will assess the amendments on a qualitative basis.
It isn’t clear to me why the EPSC isn’t enough by itself (since it would be enough for a new plan). Apparently ISS just doesn’t like some stuff that companies do with their equity plans and they want to be able to recommend that shareholders vote against amendments that would add those features to your plan, even if they would be allowed under the EPSC.
Where private companies are submitting a plan to shareholders for the first time, the plan will have to pass the EPSC even if no new shares are being requested (e.g., if the plan is submitted solely for Section 162(m) purposes) and ISS will make a qualitative assessment of any amendments.
The practice of paying dividends (or dividend equivalents, in the case of units) on unvested awards has been declining since we first started tracking it in 2007. No one likes the practice, other than companies and the employees who benefit from it. Investors certainly aren’t a fan, FASB imposes some onerous accounting requirements on it, and even the IRS has taken issue with the practice. Now, ISS’s 2017 Equity Plan Scorecard deducts points for this.
What’s the Big Deal?
The main criticism of paying dividends on unvested awards is philosophical: if dividends are paid out before an award vests, employees have arguably received compensation they aren’t entitled to. And, if the awards are subsequently forfeited, no one makes the employees pay back the dividends; they are allowed to keep the dividends on shares that they ultimately didn’t earn. Here are a few of the consequences of this practice:
Implicates the dreaded two-class method of reporting earnings-per-share, something few people, if any, even understand (I’ll admit it—I am not one of the few) (see “Applying the Two-Class EPS Method to Share-Based Payments,” by KPMG)
When the awards are forfeited, any dividends paid prior to vesting that aren’t also forfeited are treated as compensation expense (normally, dividends do not increase the expense associated with an award)
If paid on performance awards, the dividends cannot be considered performance-based compensation for purposes of Section 162(m) unless they are subject to vesting contingent on performance goals (see “IRS Clarifies Treatment of Dividends Under Section 162(m)“)
ISS Gets into the Game
One of ISS’s changes to its 2017 Corporate Governance Policy is to add paying dividends on unvested awards to the Plan Features pillar of its Equity Plan Scorecard. Plans will receive full points for this test only if they prohibit paying dividends prior to vesting for all awards offered under the plan. If the plan is silent or includes the prohibition for some awards but not others, the plan receives no points for this test.
It is permissible for dividends to accrue on awards prior to vesting, so long as the dividends are still subject to forfeiture in the event that the underlying award is forfeited.
The Data
This handy interactive infographic shows how payment of dividends on unvested awards has declined since 2007 (click on the years to see the data change):
Perhaps one day, paying dividends on unvested awards will go the way of reloads and pyramid exercises: mythic transactions rarely, if ever, seen in the wild.
– Barbara
* Data referenced in this blog, including the infographic, are from the Domestic Stock Plan Design Survey (years 2007, 2010, 2103, and 2016), co-sponsored by the NASPP and Deloitte Consulting LLP.
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 late March, ISS issued an updated Equity Compensation Plans FAQ. This development was largely eclipsed by the FASB’s issuance of ASU 2016-09, so I haven’t had a chance to get around to it until now. Here is a quick summary of the most significant updates:
Plan Amendments
FAQ 2 has been updated and a new FAQ 28 has been added to clarify that plan amendments may be evaluated under the Equity Plan Scorecard (EPSC), if the amendment could increase the potential cost of the plan. (By “cost,” ISS means dilution or shareholder value transfer; ISS is less concerned with the actual P&L expense.)
In other cases, i.e., amendments that don’t increase cost to shareholders, ISS evaluates the amendment based on whether it is favorable to shareholder interests, but without going through the whole EPSC.
Plans submitted for shareholder approval solely for Section 162(m) purposes fall into a separate category and ISS hasn’t changed or clarified anything with respect to these proposals.
Share Withholding
ISS suggests requesting new shares or extending the term of a plan as examples of the types of amendments that would trigger a new EPSC evaluation, but my guess is that this would also include amendments to allow share withholding for taxes up to the maximum tax rate when the shares withheld will be returned to the plan (my blog from last week explains why these amendments are necessary).
It’s possible that the timing of the release of these updated FAQs is not coincidental. It’s also possible I’m paranoid; hard to say. But then again, just because I’m paranoid, doesn’t mean ISS won’t apply the EPSC to your share withholding amendment. This issue is definitely a hot button for ISS. If your plan allows shares withheld for taxes to be returned to your plan, it’s a good idea to discuss this with whoever advises you on ISS concerns before you amend your plan.
Performance Awards
Previously, the FAQ provided that ISS would consider performance awards as being subject to accelerated vesting upon a CIC, unless the amount paid was tied to the performance achieved as of the CIC and was pro rated based on the amount of the performance period that was completed.
The new FAQ states that:
If a plan would permit accelerated vesting of performance awards upon a change in control (either automatically, at the board’s discretion, or only if they are not assumed), ISS will consider whether the amount of the performance award that would be payable/vested is (a) at target level, (b) above target level, (c) based on actual performance as of the CIC date and/or pro rated based on the time elapsed in the performance period as of the CIC date, or (d) based on board discretion.
I’m not sure this changes much, but it does seem to be a more nuanced position.
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.