The proxy advisory firm ISS last week issued the 2012 Updates to its U.S. Corporate Governance Policy (PDF). The Updates outline this year’s changes to ISS’s policies in recommending investor votes at public companies’ shareholder meetings. Essentially, the policies say when ISS will act like the popular kids on Facebook and “like” a company’s postings – see this prior post. These recommendations are especially important in the upcoming proxy season, the second year of mandatory Say-on-Pay votes on public company compensation. ISS’s methodology and rationale also provide useful guidance for drafting compensation disclosures, as described below.
The 2012 Updates have been widely reported; for example, see these helpful summaries by the compensation consultants Frederic W. Cook & Co., Inc. (PDF) and Towers Watson. This post focuses on ISS’s pay-for-performance (p4p) methodology, which is critical in determining its Say-on-Pay vote recommendations. My next post will discuss another critical ISS policy – its evaluation of the board of director’s response in cases where the company experienced high levels of opposition in a previous Say-on-Pay vote.
P4P Methodology. Starting on page 9 of the Updates, ISS describes its new methodology for determining pay-for-performance alignment. This is described as a two-part test – first, ISS screens companies to identify the level of alignment between pay and performance over a sustained period; if a company shows unsatisfactory alignment, then ISS uses a second-stage qualitative analysis to arrive at a final recommendation.
For companies included in the Russell 3000 index, in the first phase ISS uses quantitative tests of alignment relative to a peer group and on an absolute basis. First, ISS compares the company’s TSR (total shareholder return) rank within a peer group, as measured over one-year and three-year periods, and the multiple of the CEO’s total pay relative to the peer group median. The peer group is generally comprised of 14 to 24 companies selected based on size and industry group. Second, the quantitative analysis also considers alignment on an absolute basis between the company’s trend in CEO pay over the past five fiscal years and the trend in the company’s TSR over the same period.
For companies not included in the Russell 3000 index, in the first phase ISS uses an undefined process to determine whether pay and performance are misaligned.
Where the first phase indicates unsatisfactory alignment, there is a second phase qualitative analysis that examines the following factors “to determine how various pay elements may work to encourage or to undermine long-term value creation and alignment with shareholder interests”:
- The ratio of performance- to time-based equity awards;
- The ratio of performance-based compensation to overall compensation;
- The completeness of disclosure and rigor of performance goals;
- The company's peer group benchmarking practices;
- Actual results of financial/operational metrics, such as growth in revenue, profit, cash flow, etc., both absolute and relative to peers;
- Special circumstances related to, for example, a new CEO in the prior fiscal year or anomalous equity grant practices (e.g., biennial awards); and
- Any other factors deemed relevant.
ISS based its Policy Updates in large part on the results of its 2011-2012 Policy Survey. In its “Rationale for Updates”, ISS reports:
“. . . 94 percent of institutional respondents to ISS' 2009-2010 Policy Survey indicated that pay-for-performance is a critical or important consideration in their vote determinations. This year, another overwhelming majority of institutional respondents to ISS' 2011-2012 Policy Survey indicated two factors as relevant to evaluating pay-for-performance alignment: pay relative to peers is considered very relevant by 62 percent and somewhat relevant by 32 percent; and 88 percent believe pay increases that are disproportionate to the company's performance trend are very relevant to this evaluation (plus 11 percent who consider it somewhat relevant). . . .”
“In cases where alignment appears to be weak, further in-depth analysis will determine causal or mitigating factors, such as the mix of performance- and non-performance-based pay, biennial grant practices, impact of a newly hired CEO, and rigor of performance programs. For example, 81 percent of investor respondents to ISS' 2010-2011 Policy Survey said that the way a company's short-term and long-term incentive metrics relate to the company's business strategy is among their most important considerations in evaluating executive pay. If long-term alignment of TSR performance and CEO pay opportunities is weak, investors expect current pay and pay opportunities to be strongly performance-based.”
Comment. The Updates feature some welcome changes, including ISS’s more individualized approach to peer group identification, a longer-term approach through use of a five-year metric and a heightened focus on specific qualitative factors in the second phase of analysis.
Public companies should take heed of the survey statistics cited above and the resulting quantitative and qualitative factors to be considered by ISS in connection with its recommendations. In evaluating their compensation programs and their compensation disclosures, public companies should be mindful of these factors, which can serve as a checklist of compensation features and processes that should be highlighted in next year’s CD&A disclosures.