Institutional Shareholder Services (ISS) has announced its updates to its proxy voting recommendation policies. The updated policies will apply to meetings held on or after February 1, 2017. As discussed in more detail below, the 2017 U.S. updates include negative voting recommendations for directors in the following cases, among others:
- companies that restrict the ability of shareholders to amend the company’s bylaws, which is particularly relevant for real estate investment trusts (REITs) and other companies incorporated in Maryland, where state corporate law permits such restrictions;
- newly public companies that do not have a sunset on materially adverse provisions such as supermajority voting requirements, or that have classes of stock with unequal voting rights; and
- non-CEO directors who sit on more than five public company boards and CEO directors who sit on more than two public company boards in addition to their own company, reflecting the end of the transition period for overboarding included in ISS’s 2016 policy updates.
ISS has also clarified its policies on approval or amendment of non-employee director compensation plans, and has added payment of dividends prior to vesting as a plan feature that ISS will consider when evaluating proposals to approve or amend equity-based compensation plans.
1. Restricting Binding Shareholder Proposals
ISS has adopted a new policy under which ISS will generally recommend voting against or withholding votes from members of a company’s governance committee on an ongoing basis as long as the company imposes “undue restrictions” on the ability of shareholders to amend the bylaws. The new ISS policy specifies that these restrictions include, but are not limited to, (1) an outright prohibition on the submission of binding shareholder proposals or (2) share ownership requirements or time holding requirements in excess of Rule 14a-8, the SEC rule governing inclusion of shareholder proposals in companies’ proxy statements.
This new policy is of potential significance to companies organized in states such as Maryland that permit restrictions on shareholders’ abilities to amend the bylaws. This includes most REITs. For additional discussion, please refer to our November 21, 2016 and November 2, 2016 client alerts on this new policy.
2. Unilateral Bylaw and Charter Amendments and Problematic Capital Structures – IPO Companies
Beginning in 2016, ISS started focusing on the charter and by-law provisions for newly public companies which ISS believed contained provisions which were “materially adverse to shareholder rights.” While ISS was not specific on the precise provisions which would lead to an adverse vote recommendation for directors, for the first time in its policies for 2016 meetings, ISS indicated that it would recommend against or withhold votes for directors of newly public companies whose charter and bylaws were deemed “problematic.”
Consistent with its 2016 policies, for 2017 ISS has added more specificity to the types of provisions contained in a newly public company’s charter or bylaws which will lead to an adverse or withhold vote recommendation. In particular, if a company implemented a multi-class capital structure in which classes have unequal votes, ISS will generally issue against or withhold recommendations for director nominees, at least in the first year following the IPO. For 2017, ISS has indicated that unless the “adverse provision and/or problematic capital structure” is reversed or removed, its recommendation on director nominees will be on a case-by-case basis in subsequent years.
The 2017 policies continue ISS’s policy that newly public companies that place limitations on the ability of shareholders to amend the charter and bylaws or impose supermajority vote requirements on the ability of shareholders to amend the charter or bylaws will receive against or withhold recommendations on its directors in the first year following the IPO and on a-case-by-case thereafter. It is unclear whether having a staggered board of directors in and of itself will lead to an adverse vote recommendation. The 2017 policies also indicate that ISS may issue adverse vote recommendations if the charter and bylaws contained provisions “materially adverse to shareholders rights” after considering the following factors:
- the level of impairment of shareholders’ rights;
- disclosed rationale for the adverse provision;
- ability to change governance structure;
- annual director elections or classified board structure;
- reasonable sunset provisions; and
- other relevant factors.
It is unclear whether having a staggered board of directors in and of itself will lead to an adverse vote recommendation. In its 2017 voting policies, ISS has eliminated the ability of companies to avoid an adverse vote recommendation by agreeing to put the provisions up to a shareholder vote within three years of the date of the IPO. Instead, ISS indicated it could be sufficient to include a “reasonable sunset” provision for these provisions (presumably within this same three-year period) to avoid an adverse voting recommendation.
3. Overboarded Directors
The one-year transition period for implementing the 2016 ISS voting policy on overboarding is ending. Starting with meetings that occur on or after February 1, 2017, ISS will recommend voting against or withholding votes from an individual director who:
- sits on more than five public company boards (down from six in 2016); or
- is the CEO of a public company and sits on more than two public company boards (down from three in 2016) in addition to the CEO’s own company, in which case, ISS will recommend an against or withhold vote only for the CEO’s outside boards.
4. Approval of Equity-Based and Other Incentive Plans
ISS has updated its policy on voting recommendations for equity-based compensation plans. This generally includes stock option plans, restricted stock plans and omnibus stock incentive plans for employees and/or employees and directors.
The principal change for 2017 is adding payment of dividends on unvested awards as an evaluation factor. ISS believes that dividends on unvested awards should be paid only after the underlying award has been earned, and not during the performance/service vesting period. If the plan does not prohibit payment of dividends on unvested awards of all types under the plan, the plan will not earn any points for this factor when ISS calculates the “equity plan scorecard,” or EPSC, for the plan. ISS has specifically advised that it will not take into account a company’s general practice of not paying dividends on unvested awards when it determines EPSC scores. However, in ISS’s view, paying accrued dividends upon vesting is still acceptable and will not result in a plan failing to receive points for this factor.
Companies seeking approval of equity plans in 2017 should consider the new factor – payment of dividends on unvested awards – when they evaluate how to structure a plan to arrive at a favorable EPSC. Depending on other plan features, companies may not need to eliminate payment of dividends on unvested awards in order to obtain a favorable recommendation from ISS.
5. Approval of Director Pay Programs by Shareholders
ISS’s 2017 policies include two changes relating to director compensation, described in this and the following section of this client alert. The 2017 changes principally provide clarity on how ISS will evaluate non-employee director compensation programs that are submitted to shareholders for approval. These types of proposals have become more common as a result of recent litigation alleging excessive non-employee director compensation, which is what caused ISS to publish their new voting policy on this topic. ISS indicated that this new policy was simply formalizing the criteria that ISS previously used to evaluate these proposals and, as a result, companies should expect ISS to take the same approach that it took in 2016.
Under this new formal policy, ISS will evaluate management proposals seeking shareholder approval of non-employee director compensation based on the following factors:
- if the equity plan under which non-employee director grants are made is on the ballot, whether or not it warrants support based on ISS’s separate voting policy applicable to these types of plans; and
- assessment of the following qualitative factors: (1) the relative magnitude of director compensation as compared to companies of a similar profile; (2) the presence of problematic pay practices relating to director compensation; (3) director stock ownership guidelines and holding requirements; (4) equity award vesting schedules; (5) the mix of cash and equity-based compensation; (6) meaningful limits on director compensation; (7) the availability of retirement benefits or perquisites; and (8) the quality of disclosure surrounding director compensation.
Companies considering submitting director compensation programs to shareholders for approval will likely want to consider these factors in deciding how to structure their program and whether or not to seek shareholder approval.
6. Equity Plans for Non-Employee Directors
ISS has updated its policy to clarify and broaden the factors that ISS will consider when assessing the reasonableness of non-employee director equity plans, and has added two new factors: relative pay magnitude and meaningful pay limits. On a case-by-case basis, ISS will evaluate the total estimated cost of the company’s equity plans relative to industry/market cap peers, measured by the following factors:
- the company’s estimated shareholder value transfer based on new shares requested plus shares remaining for future grants, plus outstanding unvested/unexercised grants;
- the company’s three-year burn rate relative to its industry/market cap peers; and
- the presence of any “egregious” plan features (such as an option repricing provision or liberal change-in-control vesting risk). ISS will take into account additional qualitative factors in cases where the plan will exceed the plan cost or burn rate benchmarks when combined with other company employee or executive stock plans.
7. Updated Pay-for-Performance Methodology
Separately from its 2017 policy updates, ISS has updated the methodology underlying its pay-for-performance models. Effective February 1, 2017, ISS will include relative evaluations of return on equity, return on assets, return on invested capital, revenue growth, EBITDA growth and cash flow from operations growth in its pay-for-performance reviews. The additional financial measures will supplement ISS’s continuing use of total shareholder return as a key metric for assessing corporate performance when ISS evaluates executive compensation.
ISS has indicated that this information will not impact the quantitative screening results during the 2017 proxy season, but ISS may refer to the new metrics in its qualitative review and its consideration may mitigate or heighten identified pay-for-performance concerns. ISS has also stated that these metrics and weightings will be based on a company’s four-digit GICS industry group, and will be based on extensive back-testing by ISS over multiple years, and that some weightings may be as low as zero. The financial performance and pay ranking information will be displayed for all companies subject to ISS's quantitative pay-for-performance screens.
Companies should be aware that these relative metrics may be considered by ISS in its pay-for-performance analysis and, depending on how relevant these metrics are to the company, may want to consider discussing one or more of these additional metrics in their disclosures regarding executive compensation.
Mark T. BettencourtPartnerManaging Partner, Goodwin
Joseph L. Johnson IIIPartner
John O. NewellCounsel