In today’s post Dodd-Frank executive compensation market, most companies are familiar with, and many have implemented, “shareholder-friendly policies” such as clawbacks, hedging/pledging, and stock ownership guidelines. Further, companies have grown increasingly savvy on the executive compensation policies of shareholder advisory firms such as Institutional Shareholder Services (ISS) and Glass-Lewis—specifically as they relate to Say on Pay resolutions (SoP). Most executive compensation professionals—ourselves included—do not deny the influence on voting results when a company receives the dreaded Against recommendation from one or more of the proxy advisory firms. Our research shows that when ISS and Glass-Lewis recommend Against an SoP resolution, there is an approximate 20-30% and 5-15% reduction in the voting results, respectively.

Is this causation or simply correlation? Perhaps that question cannot be answered so easily, but it is possible to study how large institutional shareholders vote on SoP in order to try and understand what factors influence their voting. Companies are already aware of who their largest shareholders are, but an understanding of their voting policies and practices can provide insights on potential shareholder reaction to executive compensation program design, program modifications, and company performance.

To gain a deeper understanding of how large institutional shareholders tend to vote on SoP, CAP compiled a list of the top 25 institutional shareholders (in terms of assets under management) that were invested in at least 250 of the companies in the S&P 500 (“Institutional Shareholders”). CAP collected voting data from Proxy Insight, a leading provider of global shareholder voting analytics.

Among these Institutional Shareholders, 92% (23 out of 25) have their own “in-house” voting policies. What that means, is that even if ISS or Glass-Lewis makes a recommendation, the Institutional Shareholder will make the final determination on its voting decision. Based on 2016 voting results, Institutional Shareholders voted Against SoP 6.6% of the time, at median, for S&P 500 companies. When we expanded the scope of our review to all U.S. public companies, we found that Institutional Shareholders voted Against SoP 8.2% of the time, at median.

Source: Proxy Insight

Why do Against votes occur more frequently among all U.S. public companies compared to S&P 500 companies? This outcome could reflect that S&P 500 companies, in the aggregate, are larger and tend to have the resources to develop and maintain more balanced compensation programs. For example, a long-term incentive (LTI) program that is composed of a portfolio of time- and performance-based awards is viewed positively by institutional shareholders and is more common among S&P 500 companies versus all U.S. Companies. S&P 500 companies also have the capacity to lead more extensive shareholder outreach campaigns, which allows them to explain the rationale for their programs.

Although most Institutional Shareholders vote For SoP in most cases, there are some that will vote Against SoP 10% of the time or more. When voting on S&P 500 Companies, 5 out of 25 of the Institutional Shareholders vote Against 10% of the time or more. When voting on all US companies, 11 out of 25 vote Against 10% of the time or more.

Institutional Shareholder

Percent of Time Voting Against SoP

Institutional Shareholders Voting Against S&P 500 Companies 10% of the Time or Greater

Robeco/RobecoSAM

30%

BNY Mellon

27%

Dimensional Fund Advisors, Inc.

18%

California Public Employees’ Retirement System (CalPERS)

16%

Schroders

10%

Institutional Shareholders Voting Against U.S. Companies 10% of the Time or Greater

BNY Mellon

44%

Robeco/RobecoSAM

28%

Dimensional Fund Advisors, Inc.

23%

California Public Employees’ Retirement System (CalPERS)

20%

Canada Pension Plan Investment Board (CPPIB)

13%

Schroders

13%

AllianceBernstein LP

12%

T. Rowe Price Associates, Inc.

10%

AXA Investment Managers

10%

Principal Global Investors LLC

10%

RBC Global Asset Management, Inc.

10%

Source: Proxy Insight

CAP suggests that companies should track the voting tendencies of their major institutional shareholders, particularly if they vote Against more frequently. Companies may want to look at historical voting on SoP and should review their institutional shareholders’ proxy voting guidelines—particularly as it relates to compensation. For example, BNY Mellon voted Against SoP at 27% of S&P 500 companies and Against SoP at 44% of all U.S. companies. A review of BNY Mellon’s proxy voting guidelines states that they “consider proposals on a case-by-case basis in situations where:”

  • There are tax gross-ups or make-whole provisions in CIC/severance agreements
  • The company has poor relative stock performance, especially when compensation is deemed excessive compared to peers
  • The company fails to address compensation issues identified in prior meetings
  • There appears to be an imbalance between performance-based and time-based long-term incentive awards

Therefore, if one of your company’s major shareholders is an institutional investor that supports SoP less frequently, it is important to understand their voting guidelines, especially if your executive compensation program has practices or includes features that are viewed negatively (i.e. tax gross ups, 100% time-based LTI program, etc.).

Although most Institutional Shareholders have in-house voting policies, they do still subscribe to proxy advisory research from ISS and Glass-Lewis. Among Institutional Shareholders, 88% (22 out of 25) subscribe to ISS and 48% (12 out of 25) subscribe to Glass-Lewis. While there is only one out of these 25 Institutional Shareholders that generally automatically-votes with ISS (Principal Global Investors LLC), CAP determined that there is a correlation between an ISS or Glass-Lewis Against recommendation and voting results. When subscribing to ISS or Glass-Lewis, we found that Institutional Shareholders’ voting aligns with an Against recommendation, at median, 62% of the time for ISS subscribers and 31% of the time for Glass-Lewis subscribers. The data exhibits a greater correlation (approximately double) of vote alignment with an Against recommendation from ISS than Glass-Lewis. This may occur because Glass-Lewis recommends Against about twice as often as ISS does (16% of companies receive an Against recommendation from Glass-Lewis vs. 8% from ISS).

Source: Proxy Insight

As mentioned above, it is not easy to confirm whether the alignment of an Against recommendation from ISS or Glass-Lewis and voting outcomes is the result of causation or simple correlation—perhaps it is a bit of both. However, when companies are trying to understand the voting practices of their institutional shareholders, knowledge of how their institutional shareholders vote in relation to an ISS or Glass-Lewis Against recommendation is a valuable input, particularly in cases where the alignment is very consistent. Since the recommendation from ISS and Glass-Lewis precedes voting, companies can predict potential outcomes based on shareholder tendencies—particularly in cases where the institutional shareholders voting tendencies are correlated with an Against recommendation a high percentage of the time.

Institutional Shareholder

Percent of Time Voting with Rec.

Institutional Shareholders Voting with ISS Against Rec. Greater than 85% of the Time

Deutsche Asset & Wealth Management

99%

Principal Global Investors LLC

98%

Canada Pension Plan Investment Board (CPPIB)

97%

RBC Global Asset Management, Inc.

97%

Dimensional Fund Advisors, Inc.

96%

AllianceBernstein LP

91%

BNY Mellon

87%

Institutional Shareholders Voting with Glass-Lewis Against Rec. Greater than 50% of the Time

California Public Employees’ Retirement System (CalPERS)

75%

Dimensional Fund Advisors, Inc.

60%

BNY Mellon

57%

Source: Proxy Insight

In examples where Institutional Shareholders do not have a high correlation of voting with an ISS or Glass-Lewis Against recommendation, this can generally be attributed to those Institutional Shareholders that vote For SoP a high percentage of the time in line with their own voting policies.

In our view, it is important for companies to develop a compensation program that aligns with the business strategy, promotes shareholder growth while minimizing risk, and attracts and retains key talent. Once a framework is established, companies can then overlay an understanding of the voting practices of their institutional shareholders, including specific proxy voting guidelines, voting history, as well as the alignment of voting results with ISS or Glass-Lewis recommendations. This becomes more important in cases where the institutional shareholder votes Against SoP more frequently than the norm or follows ISS and Glass-Lewis recommendations a very high percentage of the time. While some companies may engage in comprehensive shareholder outreach programs, other companies do not have the resources for large-scale shareholder engagement. For these companies, an understanding of their institutional shareholder voting policies and practices becomes an important consideration when it comes to compensation program plan design.

Appendix

Institutional Shareholders Used in this Analysis

AllianceBernstein LP

Legg Mason Partners Fund Advisor, LLC.

AXA Investment Managers

MFS Investment Management, Inc.

BlackRock

Morgan Stanley Investment Management, Inc.

BNY Mellon

Norges Bank Investment Management

California Public Employees’ Retirement System (CalPERS)

Northern Trust Investments

Canada Pension Plan Investment Board (CPPIB)

Principal Global Investors LLC

Deutsche Asset & Wealth Management

RBC Global Asset Management, Inc.

Dimensional Fund Advisors, Inc.

Robeco/RobecoSAM

Federated Investment Management Co.

Schroders

Fidelity Management & Research Co.

SSgA Funds Management, Inc. (State Street)

Fidelity SelectCo

T. Rowe Price Associates, Inc.

Franklin Templeton Investments

Vanguard Group, Inc.

Goldman Sachs Asset Management LP

Today, Institutional Shareholder Services (ISS) announced a methodology update to its CEO pay-for-performance assessment for U.S. companies. Beginning February 1, 2017, ISS proxy research reports will include a new standardized comparison of a company’s financial performance relative to its ISS-defined peer group.

This is a departure from ISS’ sole reliance on Total Shareholder Return (TSR) as a metric. ISS will measure multiple financial metrics which may include Return on Equity, Return on Assets, Return on Invested Capital, Revenue growth, EBITDA growth and Cash Flow (from Operations) growth; these metrics will supplement TSR, but only in the qualitative assessment. ISS will calculate a weighted average of select financial metrics; measures (and weightings) will be based on a company’s four-digit GICS industry group. For 2017, the new financial assessment will not be included in the quantitative assessment although ISS may incorporate a company’s relative financial performance in its qualitative discussion.

This is a significant change to ISS’ pay-for-performance methodology which primarily assesses performance based on Relative TSR. While the additional financial metrics will not be included in the quantitative assessment for the 2017 proxy season, it can provide shareholders with additional context of a company’s overall financial performance. The implication is that TSR will still drive a company’s specific level of concern in the quantitative tests. However, if the company’s financial metrics are not aligned with their stock performance, it could weigh heavily on whether they receive a “For” or an “Against” recommendation from ISS on the Say on Pay vote. Examples where this new policy could help a company is if the market has overreacted to news or industry shifts, but the underlying financials are still relatively strong. When ISS releases the details on the definition and weightings of each financial metric, it will be important for a company to model the financial performance relative to the ISS-defined peer group to understand how its performance will be viewed relative to comparators.

With this updated methodology, however, realizable pay will become increasingly more important in a company’s overall pay-for-performance assessment. By taking a more holistic look at stock and financial performance, ISS may more appropriately capture the linkage between actual compensation earned and the underlying financial performance.

Additionally, ISS has historically relied on S&P to provide financial data, which does an effective job at creating comparability across companies financials. However, they are typically limited in the adjustments they can make across companies (ISS will likely use GAAP definitions, where applicable) and, therefore, a company’s view of its relative performance (which may include adjustments) could differ from ISS. This could be true where there are significant differences between a company’s peer group and the ISS peer group, particularly for companies with a cross-industry peer group (which are more commonly used with large cap companies).

In addition to incorporating financial performance metrics, ISS also announced that it will no longer include companies with less than two years of TSR and pay data in the Relative Degree of Alignment (RDA) assessment. This change will only impact newly public companies.

ISS released the results of its 2016-2017 policy survey on September 29, 2016. The survey results will play an important role in shaping ISS’ policies for the 2017 proxy season. ISS Indicated that a draft of their 2017 policy updates will be published in late October, subject to public comment. Final policy updates are scheduled for publication in mid-November, with policy updates effective February 1, 2017. 

417 organizations participated in ISS’ survey, including 115 institutional investors and 270 corporate issuers. 33% of investor responses came from institutions with $100 billion in assets or more, while 25% came from institutions with $10 – $100 billion in assets.

Highlights of the survey results related to U.S. executive compensation and corporate governance topics are summarized below:

Say on Pay Frequency: Survey participants were asked whether they favored annual, biennial or triennial say on pay proposals. Fully 66% of investors favored annual say on pay votes. Corporate issuers were more likely to favor biennial or triennial votes, but fully 42% voted for annual say on pay proposals. Based on the results of the survey, we do not expect ISS to make any changes to its existing policy of supporting annual say on pay vote frequency.

Metrics for Pay-for-Performance Alignment: ISS currently uses Total Shareholder Return (“TSR”) to assess pay-for-performance alignment, measuring relative TSR performance compared to peers over 3 years and measuring the absolute trend in TSR over 5 years. Survey participants were asked if other metrics should be incorporated in the initial screen. High levels of support were recorded for metrics other than TSR, with 79% of investors and 68% of corporate issuers voting in favor.

Investors identified Return on Investment metrics, such as Return on Invested Capital (ROIC), as the best metrics to be incorporated into pay-for-performance alignment screens. Detailed results are shown below:

Metrics

% of Investors Favoring

% of Non-Investors Favoring

Return on Investment metrics

47%

23%

Other Return metrics (i.e, ROA or ROE)

35%

18%

Earnings metrics

26%

38%

Cash Flow metrics

25%

20%

Economic Profit metrics

22%

9%

Revenue metrics

18%

24%

Other metrics

16%

10%

We suspect that ISS may modify its pay-for-performance model to incorporate additional measures in the future, based on this feedback. However, it may be challenging to implement for the coming year as it is difficult to find a single financial performance measure that is useful for performance comparisons in all industries. We will closely monitor ISS’ proposed policy revisions to see what changes, if any, that they make to the pay-for-performance assessment.

Board Refreshment: Lack of board refreshment is viewed as problematic by more than 50% of investors. Refreshment measurements that caused concern include lack of newly appointed directors (i.e., within the last 5 years), average tenure greater than 10 or 15 years and/or a high proportion of directors with long tenure.

Overboarding: More than 60% of investors indicated a preference for applying the same standard for overboarding to active executive chairs as currently applies to active CEOs – no more than three total boards. A minority supported the more lenient standard applicable to non-executive directors – no more than five total boards.

Next Steps

We will monitor ISS’ draft policy proposal (expected in October) and final policy issuance (expected in November) and will provide an updated CAPflash highlighting any material changes from ISS’ current policies. Based on this year’s survey results, there is potential for significant changes from the current policy, particularly for Pay-for-Performance alignment. Movement away from TSR as the sole metric would be welcomed by many companies as well as by most investors.

Full results of ISS’ policy survey can be found at www.issgovernance.com. If you wish to discuss the results, you can reach us at 212-921-9350.

ISS released their finalized 2016 policy changes, which are consistent with the proposed changes previously announced. The changes are relatively minor and the key changes are related to

  • Director Overboarding
  • Negative director election vote recommendations for directors that have taken unilateral board actions
  • Proxy Access
  • Compensation-related votes at externally-managed issuers and Shareholder Proposals related to equity retention
  • Shareholder Proposals: Hold Equity Past Retirement or for a Significant Period of Time

The changes are as follows:

  1. Director Overboarding
    • Previously, ISS recommended an “Against” or “Withhold” for a director if the director sits on more than 6 public company boards or 2 public company boards for the CEO (besides their own for CEOs)
    • ISS changed the threshold to 5 for a regular board member and made no changes for CEOs, though they did propose reducing the CEO threshold to 1 in the draft guidelines
    • This change will be in effect for meetings on or after Feb. 1, 2017
  2. Negative director election vote recommendations for directors that have taken unilateral board actions
    • ISS clarified that it will generally issue “Against” vote recommendations for directors, committee members or entire board for bylaws amendments, without shareholder approval, calling to classify the board or introducing supermajority vote requirements (policy will also apply if directors amended the bylaws immediately prior to an IPO)
    • Negative vote recommendations will be issued until the unilateral reduction is reversed or approved by a shareholders vote
  3. Proxy Access
    • ISS clarified current policy that vote recommendations for directors nominated using proxy access will be evaluated using similar criteria to those used in proxy contests
  4. Compensation-related votes at externally-managed issuers
    • ISS will generally recommend “Against” say-on-pay proposals if there is insufficient disclosure for ISS to perform a comprehensive pay-for-performance analysis [limited situations and often impacts externally managed issuers like REITs]
  5. Sharholder Proposals: Hold Equity Past Retirement or for a Significant Period of Time
    • ISS has broadened the policy to encompass executive retention proposals more generally, eliminating the need for a separate policy covering the proposals seeking retention of 75% of net shares
    • The proposed retention ratio and required duration of retention are just some of the several factors that ISS will consider in its case-by-case analysis

 For further details on the updated policies for 2016, please visit https://www.issgovernance.com/file/policy/2016-americas-policy-updates.pdf

  • Cost of Plan (45% Weighting) – This component will be driven by the SVT model, though ISS will be looking at the cost of plans based on two approaches
  • Grants outstanding + shares available for grant + new shares being requested
  • Shares available for grant + new shares being requested
  • ISS is using this dual approach so as not to put companies who have significant options outstanding at a disadvantage when requesting new shares
  • Grant Practices (35% Weighting) – This component will consider burn rate as well as the form of recent grants for the CEO as well as other factors (see ISS link below for complete list)
  • Plan Features (20% weighting) – This component will consider factors such as single vs. double trigger on change in control, minimum vesting period, authority for Board to use discretion to vest equity (see ISS link below for complete list)

The results of the scorecard will be compared to relevant benchmark comparison groups[2]. For further details on the EPSC and non-compensation related policies, please visit http://www.issgovernance.com/file/policy/2015USPolicyUpdates.pdf. In addition, to read about CAP’s views on these policies, you can review the comment letter we submitted to ISS at: https://www.capartners.com/news/194/61/Comments-on-ISS-Draft-2015-Proxy-Voting-Policies-U-S

Glass Lewis Released Additional Context and Expectations For “One-Off” Awards

In its 2015 U.S. policy updates related to compensation, Glass Lewis included discussion of how it will analyze special “one-off” awards (e.g., special grants of long-term incentives). While being “wary” of such awards, Glass Lewis has left room to find such awards reasonable with robust disclosure.

“We generally believe that if the existing incentive programs fail to provide adequate incentive to executives, companies should redesign their compensation programs rather than make additional grants…In certain circumstances additional incentives may be appropriate… companies should provide a… convincing explanation of their necessity…”

In its 2015 policy release, Glass Lewis also included some clarification regarding its qualitative and quantitative Say on Pay analysis. For the complete guidelines, visit: http://www.glasslewis.com/assets/uploads/2013/12/2015_GUIDELINES_United_States.pdf

[1] Shareholder Value Transfer assesses the cost of an equity plan relative to a company’s market cap and then compares the cost to industry benchmark

[2] S&P 500, Russell 3000, Non-Russell 3000, Bankrupt companies, recent IPOs as applicable. Burn rate / SVT will be industry specific

 


ISS Policy Update – RDA Test

For the past two years ISS has used three quantitative pay vs. performance tests related to CEO pay and company performance (absolute Pay-TSR Alignment / PTA; Multiple of Median / MOM; and Relative Degree of Alignment / RDA) to screen for companies where a potential pay-for-performance misalignment may exist. In addition to the quantitative screen, ISS will always conduct a qualitative analysis of the pay program. If Medium or High concern is identified through the quantitative pay vs. performance screen, the qualitative analysis will be more robust.

For 2014, ISS modified the RDA test. In the past the RDA screen had been calculated as the difference between the company’s TSR rank and the CEO’s total pay rank within a peer group, as measured over one-year and three-year periods. The one-year and three-year periods were weighted 40% and 60%, respectively. The new methodology is focused on three years only. In addition, the RDA policy updates indicates that companies with less than three years of pay and performance data will still be subject to the RDA test, which reflects a change versus past practice.

CAP Perspective: We agree with ISS’ decision to apply a longer-term focus to the quantitative RDA test; i.e., solely a three-year timeframe for both pay and performance. However, we believe that recent Committee decisions best relate to company performance over time.

Board Response to Majority Supported Shareholder Proposals

For 2014, ISS made three changes to its policy on Board responsiveness to majority-supported shareholder proposals.

  1. ISS will review the responsiveness of a Board to any shareholder proposal that receives one year of a majority of votes cast support (rather than the previous “triggers” of either two years of a majority of votes cast in a three-year period, or one year of a majority of shares outstanding);
  2. ISS adopted a case-by-case approach, including a list of factors for Analysts to consider, for assessing implementation of majority vote proposals;
  3. Finally, ISS provided Analysts with broader discretion when determining which directors to hold accountable in the event the level of responsiveness is found to be insufficient.

We note here that ISS included “the Board’s rationale as provided in the proxy statement” as one of the factors in the case-by-case analysis.

CAP Perspective: Using the proxy statement as a communication (marketing) document in addition to a compliance document has been an often stated best practice over the past few years, which gains additional support from this ISS policy update.

This “comply or explain” policy update from ISS encourages the Board to enact a majority supported shareholder proposal, but gives an important second route. We believe there are instances where the Board should be able to exercise its discretion to respond in a manner that it believes is in the best interest of the company. However, we believe that providing rationale in these instances is also important.

Conclusion

ISS policies and tests should not determine, but rather be one input to the compensation program design and annual decision making process. Therefore, an understanding of ISS’ policies and tests, both retrospectively and prospectively (projection) is important. We encourage our clients to review how ISS’ 2014 policy updates are likely to impact them.

CAP submitted comments to ISS on the draft policy updates, which can be found at: http://www.issgovernance.com/2014draftpolicycommentperiod.

Reflecting a change with past practice, ISS is opening a new consultation period on approaches to certain benchmark policies for consideration for longer term policy changes (beyond 2014). An example of the type of area that this will cover is evaluation of new share requests. As more information on the consultation period and related topics becomes available, we will update our clients. The current consultation period closes in February 2014, which will eventually be followed by the more traditional process which includes a policy survey followed by release of draft policies for comment.