Alert November 29, 2017

ISS Releases Compensation-Related Preliminary Frequently Asked Questions for 2018 Proxy Season

Summary

On November 27, 2017, Institutional Shareholder Services (ISS) released Preliminary Frequently Asked Questions (Preliminary FAQs) for its 2018 U.S. compensation policies. The Preliminary FAQs apply to annual meetings held on or after February 1, 2018. ISS published the Preliminary FAQs in response to questions regarding upcoming changes to the quantitative pay-for-performance screening methodology and the Equity Plan Scorecard (EPSC). Importantly, the Preliminary FAQs related to the EPSC specifically note that the Preliminary FAQs do not represent an exhaustive list of the EPSC updates, but may be useful in understanding some of the more significant changes to the EPSC. Consistent with prior years, ISS expects to publish more detailed information in an update to the Preliminary FAQs and a methodological whitepaper in mid-December 2017.

Quantitative Pay-for-Performance Screens

Financial Performance Assessment (FPA). As described in our recent alert, ISS Releases Final Voting Policy Changes for 2018 Proxy Season, ISS adopted a change to its quantitative pay-for-performance test, which is one of the primary inputs that ISS uses to determine recommendations for say-on-pay proposals. For 2018, ISS will implement the FPA test as a secondary measure following calculation of the traditional three screens (Multiple of Median (MOM), Relative Degree of Alignment, and Pay-Total Shareholder Return (TSR) Alignment). ISS clarified that the FPA test will be used to identify certain companies with a “medium” or “low” level of concern, based on the primary screens, that should be moved up or down (i.e., from “medium” to “low” or vice versa) based on the company’s fundamental financial performance.

FPA Metrics by Industry. ISS identified the following metrics for use in connection with the FPA test:  return on invested capital, return on assets, return on equity, EBITDA growth, and operating cash flow growth. ISS assigned four (or, in two instances, three) metrics for each industry based on the applicable four-digit GICS code. Within each industry, ISS also prioritized the metrics on a scale from one to four (or, if applicable, three). A full summary of the FPA metrics for each industry is available in the Preliminary FAQs.

Quantitative Pay-for-Performance Screen Thresholds. For S&P 500 companies, the threshold for a medium level of concern on the MOM quantitative screen will change from 2.33 to 2.00. ISS expects that all other quantitative thresholds in the pay-for-performance screen will remain unchanged for 2018.

TSR Calculation. In an effort to reduce potential distortion caused by measuring TSR using stock prices from a single day at both the beginning and end of a particular period, ISS will instead calculate TSR using average stock prices. ISS will determine the average stock price at the beginning and end of each period by averaging the beginning and ending stock price for the month closest to the fiscal year end of a company. The impact of dividends and stock splits during the averaging period will be factored into the TSR calculation.

Equity Plan Scorecard

EPSC Passing Score. The passing score for companies subject to the S&P 500 scoring model will increase from 53 points out of 100 (the current passing score applicable to all companies) to 55 points out of 100. For other companies, 53 points out of 100 will continue to constitute a passing score.

The Preliminary FAQs did not identify any changes to the overall EPSC structure, although it is possible that changes will be made. As described below, in order to simplify EPSC scoring for 2018, ISS will not award partial credit for any of the four factors below; companies will receive either full or no credit for each factor.

Change in Control Vesting. Companies will earn full credit if the company’s equity plan contains both of the following provisions relating to change in control vesting:

  • Performance-based awards – either the award is forfeited or, acceleration is limited to (1) the portion of the award that would have been earned based on actual performance achieved, (2) the amount of the award that would have been earned if target performance was achieved, prorated based on the portion of the performance period that elapsed through the change in control, or (3) a combination of the actual and pro-rata acceleration described in (1) and (2) above; and
  • Time-based awards – acceleration upon the change in control is not automatic single-trigger or discretionary.

If a company does not have performance-based awards, then points for this factor will be determined solely on the treatment of time-based awards.

Discretion to Accelerate Vesting. Consistent with the current methodology, companies will earn either full or no credit. Significantly, however, if an equity plan gives the company discretion to accelerate awards in connection with a change in control, the company will not receive any credit under this factor. Full credit will only be given where discretion to accelerate awards is limited to death and disability.

CEO Award Vesting. Companies will earn full credit where the period required for full vesting of equity awards received by the CEO is at least three years from the date of grant (the current methodology requires at least four years for full credit and at least three years for half credit).

Post-Vesting/Exercise Holding Requirement. Companies will earn full credit where shares received from grants under the plan are required to be held following their vesting/exercise for at least 12 months or until the end of employment (the current approach requires 36 months). A holding period of fewer than 12 months or until share ownership guidelines are met will result in no credit (these grant practices earn half credit under the current methodology).