When ISS Will Recommend a No Vote on a Director for Compensation Related Matters

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Recently, Institutional Shareholder Services (“ISS”) issued its 2014 US Summary Guidelines (http://www.issgovernance.com/files/ISS2014USSummaryGuidelines.pdf). ISS expounded upon a few themes, one of which is especially worth considering as the calendar roles into the 2014 proxy season: when ISS will recommend a compensation related no vote on the election of a particular member of a company’s board of directors. 

ISS indicates it will recommend a vote “against or withhold from the members of the Compensation Committee and potentially the full board if:

  • There is no management say on pay (“MSOP”) on the ballot, and an against vote on an MSOP is warranted due to pay for performance misalignment, problematic pay practices, or the lack of adequate responsiveness on compensation issues raised previously, or a combination thereof;
  • The board fails to respond adequately to a previous MSOP proposal that received less than 70 percent support of votes cast;
  • The company has recently practiced or approved problematic pay practices, including option repricing or option backdating; or
  • The situation is egregious. “

When MSOP was mandated in 2010, ISS had suggested it would make a shift and build its director vote recommendations largely on the basis of MSOP outcomes.  That sounded fair and indeed a quick scan of the above quote does suggest a bias toward heeding the MSOP vote, but in reality ISS has maintained a great deal of discretion almost regardless of the MSOP vote.  The MSOP vote acts as a shield, and a limited one at that, only when the vote in favor of executive compensation is at least 70% of the votes cast. 

Aside from the egregious catch-all, there are three categories of concern, identified below.  Every year, ISS will recommend a vote based on all three of the factors below (assuming practices are not otherwise egregious). In years that the vote is taken, if executive compensation passes with at least 70 percent of the shareholders in favor, presumably ISS will not chase around a director if the only objection was (1) below, which is a misalignment of pay. However, for those companies which do not conduct an annual vote, in those years in which a vote is not taken, ISS will use misaligned pay as a reason to challenge a director’s election (that is a not so subtle suasion in favor of an annual vote).  Even if a vote is taken and executive compensation passes with more than 70% favorable vote, ISS will assess director suitability under (2) or (3) below.  If a vote is less than 70%, basically anything under the following is fair game.

1. Pay for Performance Misalignment.  Pay/shareholder misalignment is determined looking at the trend of CEO pay and comparing that to the company’s total shareholder return (”TSR”)[1].  Thus, it is only the CEO’s pay upon which this standard is judged.  For companies in the Russell 3000, ISS looks at “Peer Group Alignment” and “Absolute Alignment” to see if the CEO’s pay is directly linked to company results—if TSR goes up, CEO pay would be expected to go up and vice versa.

Peer Group Alignment is assessed by looking at the TSR of the company relative to a peer group which is determined by ISS to be 14-24 companies taking into account market cap, revenues, GICS industry classification and the GICS classification of the Company’s selected peer group.  The company’s annualized TSR is then compared to the TSR of the peer group over a three year period.  If the CEO pay is high relative to the peer group and the TSR is low, that could indicate a misalignment, depending on the magnitude of the deviation.  ISS also looks at the relative standing of the CEO’s pay to the median pay of the peer group.

Without regard to the peer group, ISS also assesses over a five year period the absolute movement of the company’s TRS and the CEO’s pay. If the annual trend for pay is substantially better than the TSR result, ISS will have a problem with the Company’s pay practices. 

If “misalignment” is indicated by a review of the above, ISS will then seek to identify what is going wrong, focusing on

  • the magnitude of performance based awards, as opposed to time vested awards,
  • the rigor with which performance targets are disclosed,
  • how the company benchmarks against its peers, company operating results (both in absolute terms and by reference to peer results),
  • special circumstances such as bi-annual grants or a new hire CEO, realizable pay (i.e., primarily valuing options only to the extent they are in the money, as opposed to Black Scholes—for S&P 1500 companies only), and of course,
  • all other factors.

Companies which are not in the Russell 3000 may not get quite the formalized scrutiny, but are subject to more absolute indicators of a misalignment of pay.

2.  Problematic Pay Practices.  Another trap for a director of a company that does not conduct an annual MSOP comes under the umbrella of problematic pay practices, which ISS breaks down into practices related to non-performance based compensation (primarily repricing, tax gross-ups, excessive change of control payments—more than 3X salary plus bonus—and single trigger change of control benefits), compensation practices that encourage excessive risk-taking and option back dating.

While those who followed the aftermath of the compensation-related blowback from the 2008 financial collapse might be surprised by the expansiveness of what this list considers to be risk taking, the things that ISS considers include:

  • Multi-year guaranteed bonuses,
  • Common performance metrics for both long-term and short-term plans,
  • Lucrative severance packages,
  • High pay opportunities relative to industry peers
  • Disproportionate supplemental pensions or
  • Mega annual equity grants that provide unlimited upside with no downside risk.

ISS indicates that these factors can be mitigated by clawbacks that can pull back compensation, most often in the case of financial restatement and ownership guidelines.  The focus is actually more on factors that drive short term wealth opportunities that may incentivize manipulation of results or practices that reward regardless of whether executives might be asleep at the switch. 

Option backdating was probably never the prevalent evil instrument that was portrayed in after the fact style by the SEC and institutional holders in the 2005 timeframe, but regardless the opportunity for mischief has been significantly curtailed since 2003 when Sarbanes Oxley required a 2 day reporting of transactions under Rule 16b-3 of the Securities Exchange Act of 1934, and then 2004 when Congress passed IRC Section 409A providing for severe penalties for almost all  backdating that results in an exercise price less than the grant date fair value)[2]. With a nod to the fact that many of the perceived abuses probably involved more a failure to understand the complex rules,[3] ISS says, with respect to the attention a company should receive in regard to backdating, the reason should be considered—was the action inadvertent or deliberate.  ISS also looks at the duration, size and corrective measures taken, such as cancelling grants and recouping gains. 

Despite the relative outdated nature of the backdating concern, ISS does offer a sound suggestion, that companies not only prohibit backdating (which again, would likely carry heavy potential tax penalties), but that they provide for fixed grant schedules or windows.  While this is always a complex issue that must be approached with due care for the unique circumstances of each company, for a variety of reasons this is at least a good starting point for a dialogue that includes the development of a comprehensive company guide for when and how grants will be made, and also by whom.

3. Lack of Adequate Responsiveness on Compensation Issues Raised Previously.   This item is not limited to MSOP issues.  It can apply whenever stockholders approve a compensation related shareholder proposal on executive pay.  It is kind of hard to imagine that the board would not act on such proposals made outside the MSOP, though there are circumstances that could put a director in a tough spot—for example if a vote created some conflict with another duty, perhaps to minority shareholders in certain circumstances, or was determined to be excessively expensive.

With respect to an MSOP, if the compensation is not approved by at least 70 percent of the votes cast, ISS will consider the reasons why “so many” shareholders may have voted no.  It is not exactly clear what ISS really intends a company to do—the vote is yes or no, and it may not be clear exactly what the objection might be.  Of course, ISS probably will have had some objections prior to the vote, and naturally that would be a place to start.  ISS indicates that the company should take into account:


  • Disclosure of engagement efforts with major institutional investors regarding the issues that contributed to the low level of support, including presumably proxy advisors such as ISS and Glass Lewis;
  • Specific actions taken to address the issues that contributed to the low level of support;
  • Other recent compensation actions taken by the company;
  • Whether the issues raised are recurring or isolated;
  • The company’s ownership structure; and
  •  Whether the support level was less than 50 percent, which would warrant the highest degree of responsiveness.

[1] ISS calculates TSR as follows:  “the three-year total shareholder return is the annualized rate of return reflecting price appreciation plus reinvestment of monthly dividends and the compounding effect of dividends paid on reinvested dividends over a three-year period.” http://www.issgovernance.com/policy/ExecutiveCompensationFAQ. A close approximation of ISS’ calculation can be found at https://www.radford.com/relativetsr/files/Whitepaper_TSR_HowTo_Guide.pdf.  For simplicity sake, many companies compute as follows: 

((Share price at end of 3 years MINUS share price at beginning of 3 years) PLUS dividends)

Share price at end of 3 years MINUS share price at beginning of 3 years

[2] Also, for the CEO and the next high three paid, IRC Section 162(m) prohibits stock options with an exercise price less than the fair market value on the date of grant.

[3] To put this in perspective, in one bankruptcy matter where the company previously had been required to restate its financial statements to account for a difference between the stock value at the time of actual grant and the often much lower exercise price, the company files contained a year 2000 vintage memo from the company’s “Big Six” (at that time) auditor who acknowledged—without challenge or adjustment to the company’s earnings—that the company would get to the end of a quarter, look back at all grants made throughout the quarter, and provide for an exercise price for all those grants based on the lowest fair market value that occurred during the quarter (under APB 25 which was in force at that time, such a practice should have required booking as an expense the amount to which the fair market value of the stock at grant exceeded the actual exercise price).  Obviously the auditors never consulted with their national research staff, but this is a dramatic example that even auditors at the best accounting firms often did not understand the bewildering accounting rules. 


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