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This Client Alert discusses the significant changes described in the 2008 U.S.
Corporate Governance Policy updates issued in
December by ISS Governance Services, a unit of RiskMetrics Group (ISS).
These changes will be
of major interest to Boards, given ISS’s highly
influential role in the proxy voting process through its analysis
of companies’ proxy
statements and corporate governance structure.
Certain companies whose equity use or compensation arrangements formerly
would have been viewed
negatively may obtain some relief through specific
changes adopted in the 2008 policy updates.
These updated guidelines, which include compensation-related
corporate governance issues, are effective for shareholder meetings
on or after February 1, 2008.
I. Say on Pay: Advisory Votes on Executive
Compensation Management Proposals
ISS views “say on pay” as a growing trend and expects
to see over 100 such shareholder proposals in 2008. ISS’s policy
is to support shareholder proposals that seek non-binding shareholder
ratification of the compensation paid to the Named Executive Officers
and the accompanying narrative disclosure provided to explain the
Summary Compensation Table in each company’s proxy statement. The
first management-sponsored proposal seeking an advisory vote on executive
compensation is expected to be on AFLAC’s 2008 proxy ballot, anticipated
to be mailed in mid-March.
ISS’s 2008 update includes a new framework of five general
global principles to be used on a case-by-case basis to determine
their position on management-sponsored “say on pay” proposals:
- Maintain appropriate pay-for-performance
alignment, with emphasis on long-term shareholder value – This includes the
link between pay and performance;
the mix of fixed and variable pay; performance
goals; and equity-based plan costs
- Avoid “pay for failure” risks – This includes
the use and appropriateness of long or indefinite employment contracts,
excessive severance packages
and guaranteed compensation
- Maintain an independent and effective compensation
committee – Directors should have appropriate skills, knowledge,
experience,
and a sound process for compensation decision-making,
including access to independent advice
- Provide clear and comprehensive compensation disclosures – Disclosures should
be informative,timely, and enable full and fair evaluations of
executive pay practices
- Avoid inappropriate pay to non-executive directors – Board compensation should
not compromise members’ independence or ability to make appropriate
decisions regarding executive pay and performance
For U.S. companies, ISS has additional criteria it may utilize in determining
its position on a management-sponsored “say on pay” proposal:
- Relative considerations – Includes assessment
of performance metrics; evaluation of compensation peer groups;
alignment of company performance and
executive compensation trends; and internal
pay equity between the CEO and other executives
- Design considerations – Includes balance between
fixed and performance-based pay; perquisite practices; severance
pay packages;
SERPS; and excessive burn rates
- Communication considerations – Includes the quality
of the Compensation Discussion and Analysis
(CD&A), particularly the disclosure of performance targets, as well as the board’s
response to majority- supported shareholder
proposals related to executive pay
PM&P Observation: U.S. companies opting to include “say on pay” management-sponsored
proposals on their annual meeting agendas won’t get an automatic pass
from ISS simply for being on the governance forefront
PM&P Observation: ISS has commented that
U.S. investors are very focused on issues related to pay-for-performance
practices and will be looking to compensation committees to exercise
good stewardship
II. Updated Poor Pay and Exemplary Pay Practices
ISS may issue a withhold vote recommendation for compensation
committee members, the CEO, or the full board if it deems a company
to have “poor pay practices,” as well as recommend a vote against
a related equity compensation plan. ISS lists examples of what it
considers to be poor pay practices for 2008, with italicized items
indicating a policy update or clarification from last year:
- Egregious employment contracts – includes contracts
containing multi-year guarantees for salary
increases, bonuses and equity grants
- Excessive perquisites that dominate
compensation – includes overly generous cost or reimbursement
of taxes for personal use of corporate aircraft,
personal security systems, car allowances,
or other excessive arrangements. Base salary
will be used as the relative measure to determine
if certain perquisites are excessive
- Abnormally
large bonus payouts without justifiable link
to performance or proper disclosure – includes change, cancellation or replacement
of performance metrics during
the performance period
without adequate explanation of the action
and the link to performance
- Egregious pension/SERP
payouts – includes additional years of service
credit that result in significant payouts and/or
inclusion of performance-based equity awards in the pension
calculation
- Excessive severance and/or change
in control provisions – includes: (i) cash
payouts in excess of 3X base plus bonus; (ii)
severance paid for failure to perform; (iii) single
trigger change in control (CIC) payouts;
and (iv) perquisites for former executives
such as car allowances, personal
use of corporate aircraft or other
inappropriate arrangements
- Poor disclosure
practices – includes: (i) unclear explanation
of how the CEO is involved in the pay setting
process (ii) retrospective performance targets
and (iii) lack of disclosure and
explanation of the methodology used
for benchmarking practices
and/or peer group selection
- Internal
pay disparity – excessive differential between
total pay for
CEO and next highest
paid named executive officer
- Stock
option backdating
- Overly generous new hire
package for CEO – includes excessive “make
whole” provisions and/or any of the above poor
pay practices
At the same
time, ISS also provided an updated list
of what it will view as exemplary pay practices:
- Employment contracts –
Should have: (i) short terms (ii) no automatic
renewal features and (iii) a specified termination date
- Severance
agreements – Should: (i) exclude tax
gross-ups (ii) use reasonable formulas (e.g.,
up to 3x multiples, pro-rated target/average
(rather than maximum) historical bonus) and
(iii) not permit payments for failure to renew,
or for termination under questionable events
or due to poor performance
- Change in control payments –
Should: (i) accelerate and/or be payable only
upon a double–trigger event (i.e., when there
is a CIC coupled with loss of employment) and
(ii) exclude excise tax gross-ups
- SERPs – Should
exclude additional years of service credit
and variable pay from formula
Deferred compensation – Should not have above-market
returns or guaranteed minimum
- Disclosure practices –
CD&A
should be written in “plain English,” using tables
and charts to help the average investor understand
program details and rationales, and
include performance
target information
PM&P Observation: The list of “poor
pay practices” is not exhaustive. ISS will be looking
for what it deems to be other excessive compensation
payouts or poor pay practices at each company.
Conversely, failing to adhere to the exemplary
pay practices listed will not in itself result in
a withhold vote recommendation
III. Binomial Model: Stock Option Overhang Cost and New Exception
ISS utilizes a binomial option pricing model to determine the “cost” of equity
awards to shareholders, referred to as Shareholder Value Transfer
(SVT). Total SVT is based on the sum of: the number of new shares
proposed for a plan; all shares currently available for future grants
under all equity compensation plans; and the number of shares granted
but not yet exercised. The total SVT cost of a company’s equity compensation
program is then measured against an “allowable” cost, which reflects
the company’s performance, market capitalization and industry.
Typically, options have a ten-year term and are
exercised within five to six years. Some companies with good performance
have high SVT that is largely attributable to employees who hold options
that are well in-the-money for a prolonged period of time. Such high
SVT can pose a problem for companies seeking to replenish an equity
compensation plan or adopt a new plan if the high overhang pushes
the SVT cost over the allowable cap.
ISS will consider, on a case-by-case basis, a
carve-out of a portion of the cost of the unexercised in-the-money
options when a high level of overhang is attributable to in-the-money
options outstanding in excess of six years. This carve-out may be
applied where the following favorable characteristics are present:
- Positive company performance –
Sustained positive stock performance, based on one- and five-year
absolute TSR performance, as well as relative
TSR
performance compared to peer companies
- Sufficient overhang disclosure – The company
must clearly disclose how much overhang is
related to in-the-money options outstanding
for more than six years as opposed
to more recently
issued options, vesting provisions, and distribution
of grants among NEOs
- Reasonable dilution
attributable to equity compensation – Based
on the estimated duration of the new shares
requested (i.e., how many
years the share replenishment is likely
to last, based on the company’s past grant
patterns), ISS will determine if the company
is requesting
too many shares at one time
- Good overall compensation practices – ISS will
look at the company’s overall compensation
practices, the distribution of equity grants to senior
executives, and the existence of poor pay practices
PM&P
Observation: This change clearly favors
companies with long-term positive performance
that previously were
penalized on the SVT
test only because their executives
had
chosen to hold on to their options
longer than expected. Unfortunately,
it remains unclear how consistently and
frequently ISS will grant this
carve-out
as it examines programs on a case-by-base
basis
IV. Burn Rate Updates
ISS recommends against equity-based compensation plans if the company’s average
three-year burn rate exceeds its industry group’s mean by more than
one standard deviation and is more than 2% of common shares outstanding,
even if the total plan cost is within the allowable SVT cap.
Prior to 2008, the burn rate converted full-value
share awards to option equivalents, based on three categories of multipliers
that corresponded to stock price volatility. The burn rate was calculated
by dividing the number of shares granted by the total common shares
outstanding as of fiscal year-end for each of the three years, then
averaging these three quotients.
To add more precision to the calculation, ISS
has made two changes to the burn rate calculation
and methodology:
- The denominator will be the weighted average common
shares outstanding for the three years
(rather than common shares outstanding as
of fiscal year-end) and
- Six (rather than three) categories of volatility
will be used, as follows:
Annual Stock Price Volatility & Multipliers
54.6% and higher - 1 full-value award will count
as 1.5 option shares
36.1% or higher and less than
54.6% - 1 full-value award will count as 2.0 option
shares
24.9% or higher and less than 36.1% - 1 full-value
award will count as 2.5 option shares
16.5% or higher and less than
24.9% - 1 full-value award
will count as 3.0 option shares
7.9%
or higher and less than 16.5% - 1 full-value award
will count as 3.5 option shares
Less than 7.9% 1 full-value award will
count as 4.0
option shares
PM&P
Observation: The updated methodology
will be more precise for companies that have
swings in shares outstanding
during the year due to buybacks
or stock issuances. Having more
levels of volatility in the formula will likewise
smooth over distribution
for full-value shares based
on actual volatility
V. Conclusion
The changes being implemented by ISS for the 2008 proxy
season, while complex, may prove beneficial to some companies with
highly specific equity use or compensation considerations that formerly
were more likely to be judged negatively. These include the new provision
for a cost carve-out for unexercised long-term in-the-money stock
options that cause relatively high SVT, as well as the more precise
manner in which ISS will calculate burn rates going forward.
Provided By:
Pearl Meyer & Partners
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