RiskMetrics Group ISS Governance Services (ISS) recently released updates (2009 Updates) to its corporate governance policies that guide its voting recommendations to institutional shareholders on matters submitted by companies for shareholder approval at annual shareholder meetings. The 2009 Updates will be used by ISS in connection with annual meetings held on or after February 1, 2009.
The 2009 Updates reflect the unprecedented volatility in the equity markets, the ongoing credit crisis, and increased scrutiny by investors as well as the U.S. federal government on executive compensation and oversight of corporate risk. Significantly, the 2009 Updates:
- Expand the list of “poor pay practices”
- Revise the peer-group methodology against which corporate performance is measured
- Borrow from the Emergency Economic Stabilization Act of 2008 to bolster its policy with respect to “clawback” shareholder proposals
- Harmonize various corporate performance tests that factor into several existing ISS voting policies
- Modify the performance test that ISS will apply to director withhold vote recommendations to factor in “problematic” governance provisions (e.g., classified boards or poison pills) with corporate underperformance
- Raise the stakes with respect to independent board chairman proposals by adding new items, including egregious compensation practices, to the list of items that will constitute problematic governance provisions that might require ISS to vote for shareholder proposals demanding an independent board chairman
Given the increased focus on corporate governance and executive compensation that will surely follow one of the worst years in the stock market’s history—and the additional attention expected to be paid to these issues by the Obama administration and Congress—all companies should closely consider the impact of these 2009 Updates on their 2009 annual stockholder meetings. This is particularly true if director withhold votes have been high in the past or sensitive items (such as the approval of new or modified equity compensation plans) are expected to be on the meeting agenda.
With the changes in leadership at the U.S. Securities and Exchange Commission (SEC), it also is anticipated that in 2009 the SEC is likely to approve the New York Stock Exchange’s long-pending proposal to amend its broker voting rule (Rule 452) to deny brokers the right to use their own discretion to vote uninstructed shares in connection with the annual election of directors. However, even if approved, it is not clear that such a change would be effective for meetings to be held this spring. As brokers have traditionally voted their uninstructed shares for management’s slate of directors, amendment to Rule 452 would increase the percentage impact of withhold votes in the future.
A summary of some of the most significant 2009 Updates is set forth below, with recommendations on actions that companies should consider taking in response. A full description of the 2009 Updates on ISS’s website is available at http://www.riskmetrics.com/policy/2009/policy_information.
The 2009 Updates advise that, in the current environment, shareholders should have no patience for “pay for failure” executive compensation programs. Companies should consider the following as proxy season shifts into high gear:
Check All Change-in-Control Severance Arrangements
The 2009 Updates add to the list of poor pay practices that will influence ISS’s voting recommendations with respect to the reelection of compensation committee members (and, potentially, other board members), the approval of new or modified equity compensation plans, and shareholder proposals relating to independent board chairmen. These additional practices include:
- New employment or change-in-control arrangements that include tax gross-ups on golden parachute excise payments triggered by severance and other amounts paid in connection with a change in control
- Modified “single-trigger” change-in-control provisions that allow an executive to voluntarily leave the company during a window period following a change in control and still receive a change-in-control severance payout
- “Liberal” change-in-control definitions such as treating stockholder approval of a transaction to be equivalent to an actual change in control for purposes of equity award vesting and severance benefits
A plan will not be considered to be a new change-in-control arrangement to the extent that it is amended solely to comply with Section 409A.
Check Your Perks Packages
The 2009 Updates also define poor pay practices to include any tax gross-up associated with the payment or provision of perquisites to executives, regardless of the amount being provided to the executive. ISS has also clarified that excessive perquisites will include personal use of a company aircraft by an executive greater than $110,000 during a single year or an auto allowance for an executive that exceeds $100,000 during a single year. All aspects of perquisites are expected to receive enhanced scrutiny in the current market environment, as investors consider them to be an indication of how closely board members are reviewing executive compensation practices. Consider using tables and simplifying perquisites disclosure when practicable.
Consider Executive Compensation Clawback Provisions
Section 304 of the Sarbanes-Oxley Act of 2002 requires CEOs and CFOs of public companies to disgorge certain bonuses and gains on stock sales in connection with a financial restatement resulting from both misconduct and material noncompliance with the financial reporting requirements of the federal securities laws. Since the adoption of SOX, the courts have held that Section 304 is only enforceable by the SEC (and not by private plaintiffs), and the SEC has successfully invoked Section 304 in an enforcement proceeding on only one occasion (in a December 2007 settled enforcement proceeding against the CEO of UnitedHealth Group). Aside from enforcement difficulties, SOX 304 also has been viewed to have limited usefulness due the limited scope of covered individuals and the requirement of having an accounting restatement and misconduct.
Institutional shareholders have pressured companies to voluntarily adopt executive compensation recoupment policies due to these limitations. In the past, ISS would not support a clawback shareholder proposal if the company could show that it had adopted a corresponding policy. Over the past few years, several public companies have adopted clawback policies and housed them in non-binding corporate governance guidelines or policies and have generally tracked the terms of SOX 304.
Participating financial institutions in the Troubled Asset Repurchase Program (TARP) must agree to amend employment contracts, plans and arrangements to include binding clawback provisions. The clawback provisions under the TARP program apply to all senior executive officers and cover any bonus and incentive compensation payments that were later found to be based on materially inaccurate earnings, gains or other criteria (and is somewhat broader than the coverage under SOX 304, which focuses only on “financial results” and requires a formal accounting restatement to trigger recoupment).
ISS has announced that it will likely support any shareholder proposal relating to clawbacks if the proposal tracks the TARP conditions, which ISS has determined to represent the new “best practice” in the area of clawback provisions. In light of emerging best practices under TARP, ISS will similarly consider shareholder proposals requesting that companies amend equity compensation arrangements to impose mandatory holding periods so that executives bear the risks of their decisions in a manner similar to long-term investors.
Check The Composition of and Methodology Behind Your “Peer Group”
Many companies benchmark their compensation to a stated level of compensation paid by a peer group. If a company uses a benchmark to determine executive compensation levels, SEC disclosure rules require detailed disclosure of the peer group and the methodology used to compose the peer group. In its 2009 Updates, ISS announced that it has revised its own methodology for constructing the peer groups it uses in evaluating relative performance for Russell 3000 companies. Under its revised methodology, ISS states:
- Company size will be a key determinant, with size parameters ranging from 0.5 to 2.0 times the company’s size as measured by income or, in the case of financial services companies, assets.
- Peer groups will have a minimum of eight companies rather than 12.
- In the case of extremely large companies, ISS will use a wider industry sector or market index to create a peer group of reasonably similar companies.
In addition to modifying its peer grouping formula, ISS has harmonized the performance measure that it will use in comparing relative corporate performance. Previously, ISS used multiple performance tests for different policies. In the 2009 Updates, ISS has announced that, going forward, “poor performance” for Russell 3000 companies will be defined as below-median Total Shareholder Return (TSR) relative to industry peers (under the ISS’s peer grouping), or to the Russell 3000 index as a whole, over one- and three-year performance periods.
ISS has also stated that it intends to publish in its reports for each company a side-by-side comparison of CEO compensation relative to the company’s peer group versus CEO compensation relative to ISS’s peer group. If a company discloses that its own CEO’s compensation is set to reflect the “median” level of compensation among the CEOs in the company’s peer group, be prepared to answer shareholder questions about why the ISS report shows otherwise.
Consider Closely Any Proposals Relating to Your Equity Compensation Plan
On one positive note, the ISS announced that the recent volatility in the stock market has prompted a modification to its basic formula used to calculate a company’s equity compensation plan share “burn rate.” ISS will generally recommend voting against a new or modified equity plan if the company’s most recent three-year average burn rate exceeds one standard deviation in excess of the industry mean and is over 2 percent of the common shares outstanding. (It has been possible in certain situations to avoid a negative vote recommendation by committing to a future three-year burn rate not to exceed these limits as measured at the time of making such a commitment.)
ISS calculates the annual “burn rate” as the number of shares subject to options granted plus (if applicable) the number of full-value shares awarded times the applicable multiplier, with the resulting sum divided by the weighted average common shares outstanding. ISS applies a premium on “full-value awards,” or awards other than stock options and stock appreciation rights, by counting each share subject to a full-value award as greater than one share in the “burn rate” calculation. The multiplier for full-value awards is based on the company’s volatility. Historically, the stock price volatility measure was based upon changes in the stock price over the prior 200 trading days. Given the recent unprecedented disruption to the stock markets, stock price volatility will be measured against changes in the stock price over the prior 400 trading days for the quarterly downloads until September 1, 2009. ISS intends to again revert back to the 200-day period for measuring stock price volatility as of December 1, 2009.
ISS announced the following updates to its voting policies relating to the board and its members. Companies are advised to take the following actions in response to these new policies:
Consider Whether Directors Up for Reelection Next Spring Are at Risk for Withhold Votes
In evaluating management proposals to re-elect an incumbent director at the annual shareholder meeting, ISS evaluates the company’s performance relative to its peers when determining whether to recommend a for or withhold vote for each nominee. ISS has adopted a single performance test based upon Total Shareholder Return over a one-year and three-year period. If a Russell 3000 company underperforms (falls below the median of) its industry group, ISS may recommend a withhold vote for all incumbent director nominees if it also finds evidence of poor board oversight and lack of shareholder accountability. Evidence of poor board oversight and lack of shareholder accountability include the existence of non-shareholder approved anti-takeover protections (e.g., poison pills), classified boards, supermajority voting requirements, majority voting standards with no carve-out for contested elections, the inability of shareholders to call special meetings, the inability of shareholders to act by written consent, and dual-class structures.
Consider an Independent Board Chairman
In previous years, ISS has recommended in favor of any shareholder proposal requiring that the board chairman position be filled with an independent director unless the company maintained a counterbalancing governance structure with an independent lead director, established corporate governance guidelines, did not exhibit poor TSR performance relative to its peers and industry group, and had no problematic governance issues. In its 2009 Updates, ISS clarified that problematic governance issues will include:
- Egregious compensation practices
- Multiple related-party transactions or other issues putting director independence at risk
- Corporate and/or management scandals
- Excessive problematic corporate governance provisions
- Flagrant actions by management or the board with potential or realized negative impacts on shareholders
It is unclear whether or which poor pay practices will constitute “egregious compensation practices.” A company with a combined chairman/CEO position should evaluate its exposure to an independent chairman shareholder proposal under this new policy.
Keep Track of the Reasons for Director Non-Attendance at Board Meetings
The SEC’s proxy disclosure rules require companies to disclose if any individual director failed to attend at least 75 percent of board and committee meetings over the course of the year. ISS has traditionally had a policy to recommend that shareholders withhold their vote for any director who fell below the 75 percent attendance mark unless such director had a “valid excuse.” Valid excuses include illness, service to the nation, work on behalf of the company and, under the 2009 Updates, attending a funeral. ISS will require companies to explain the circumstances for any director who fails to meet the 75 percent attendance threshold. While including such explanations in proxy disclosures is always encouraged, if the circumstances involve personal, sensitive information companies are not expected to include such disclosures in their public filings.