The primary proxy advisor firms, Institutional Shareholder Services (ISS) and Glass Lewis, recently announced changes to their governance evaluation policies and processes for the 2017 proxy season. The following is a summary of the ISS changes for 2017, with a focus on those changes relating to compensation and its governance.

QualityScore

ISS has renamed its general corporate governance scoring tool. The 2017 system, called the QualityScore, replaces the ISS Governance QuickScore 3.0. The tool is to identify, monitor and assess governance risk.

The QualityScore appears to be a modification of the previous tool, with only marginal improvements. Like the QuickScore 3.0, the QualityScore evaluates a company on 107 corporate governance factors that fall within four categories or “pillars”: audit and risk oversight, shareholder rights, board structure, and compensation.

Each factor is assigned a score based on the overall significance ISS attaches to the factor as well as the company’s actual practice. ISS weighs and sums each factor within the four pillar categories, scoring each category independently with scores ranging from 1 (best) to 10 (worst). ISS then assigns one composite QualityScore using the same 1-10 grading system. The overall score and the category scores are relative based on comparisons to other U.S. publicly listed companies.

New factors: The following are new factors in the QualityScore that apply to U.S. companies:

1. Proportion of the board that is women directors;
2. Proportion of non-executive directors who have served fewer than six years;
3. Mechanisms to encourage director refreshment;
4. Adequacy of the board’s response to low support for any management proposal;
5. Inclusion of at least one metric that compares company performance to an external group, such as a peer group, an index or competitors, in determining incentive compensation;
6. Tenure of the external auditor;
7. Exclusive venue or forum provision, fee-shifting provision (to an unsuccessful plaintiff) or limitation on shareholder litigation in the charter or bylaws;
8. Proxy access policy details;
9. Power of the board to classify itself or materially modify its capital structure without shareholder approval;
10. Power of the shareholders to amend the bylaws; and
11. Confirmation of a formal CEO succession and key executive officer succession plan.

Alvarez & Marsal Observations Regarding QualityScore

The QualityScore uses ISS methodology. It will create questions or concerns for companies that receive lower scores than expected. Among the concerns, the weighting of factors is based on the ISS subjective view of what is important. The 1-10 scoring is on a relative basis and uses the raw score calculations of the other companies in the relative index or region. This process is conducted at each pillar and the overall score levels. Each pillar, as well as the overall score, generates an independent range of scores and the resulting decile rankings. A reviewed company will not have a transparent view as to which factors are most heavily weighted and which policies are most affecting its score. This information can be obtained by retaining ISS consulting services for a fee.

The QualityScore comparison is on a relative basis. This requires ISS to identify and organize a peer group, which can be contentious. The comparison to all companies in a peer group, which may be an index, may be too broad when comparing governance items that are not prone to quantitative rigor. The ISS relative rating approach implies more rigor and differentiation than is always the case, and one governance standard may be appropriate for all companies and not necessarily or easily differentiated into deciles. Also, relative comparison implies a “force ranking” — some companies may have perfectly acceptable governance practices but are forced to be below median ranking simply because of ISS’s methodology.

Pay-for-Performance Analytics

The pre-2017 ISS pay-for-performance analytics included a quantitative comparison of CEO total pay and company performance with total shareholder return (TSR) measured over various periods as the performance metric for judging pay and performance (called the quantitative analysis). The tests include multi-year comparisons of pay and TSR performance on a relative and absolute basis.

If the pay and TSR performance test shows a significant pay misalignment, ISS performs a more extensive analysis considering other factors to determine if the company’s pay practices are misaligned (qualitative analysis). Both the quantitative and qualitative analyses are used to inform ISS’s say-on-pay voting recommendation to shareholders.

In 2017, ISS will include in its qualitative analysis up to six financial metrics of performance for the peer companies selected using the company’s four-digit Global Industry Classification Standard (GICS) code. The evaluation will include the following financial metrics measured on a three-year basis:

1. Return on equity;
2. Return on assets;
3. Return on invested capital;
4. Revenue growth;
5. EBITDA growth; and
6. Cash flow (from operations) growth.

In 2018, ISS will include the financial measures in the new standardized quantitative comparison of the subject company’s CEO pay.

Alvarez & Marsal Observations Regarding Pay and Performance Analytics

The results will include an overall, weighted financial performance metric result, with industry (i.e., four-digit GICS code) being the factor as to the weighting. If done in typical ISS fashion, the weighting will not be transparent, and there is the possibility of disagreement by the company with the ISS weighting. And, of course, there are factors that vary between companies, such as capital structure, position in business life-cycle, competitive approaches and other strategic differences, etc. Comparisons of performance are not as simple as they sound.

We expect ISS to use GAAP metrics for its analysis, which are not commonly used by companies for compensation purposes or for shareholder presentations and broader discussions about performance and expectations. This may put companies in a position of needing to reconcile what the company is saying to what ISS is saying. This may bring the use of non-GAAP measures in compensation programs into focus and create a dialogue or more disagreement between companies and ISS about the use of non-GAAP measures and analysis.

Shareholder Ratification of Non-Executive Director (NED) Pay

Some companies have begun the practice of requesting shareholders to approve non-executive director compensation. There has been recent litigation challenging director pay, especially since most director compensation (i.e., amount and form) previously had not been subject to shareholder approval or ratification. A relatively significant settlement involving the Facebook company has caused some firms to seek shareholder approval of their director pay programs.

Because a NED compensation proposal is part of the annual proxy, ISS has developed guidelines for director pay review as well as voting recommendation. ISS will assess director pay proposals seeking shareholder approval and, in certain cases, NED-specific equity plan proposals using the following qualitative factors:

• The relative magnitude of director compensation compared to companies of a similar profile;
• The presence of problematic pay practices relating to director compensation;
• Director stock ownership guidelines and holding requirements;
• Equity award vesting schedules;
• The mix of cash and equity-based compensation;
• Meaningful limits on director compensation;
• The availability of retirement benefits or perquisites; and
• The quality of disclosure surrounding director compensation.

Alvarez and Marsal Observations Regarding NED Pay:

We suspect director compensation program ratifications will become a majority practice as more companies consider the cost-benefit calculus. NED compensation programs that are drawn closely to market for the industry should be recommended by ISS and approved by shareholders.

Equity Plan Scorecard

Equity plans seeking approval, including approval of an increase in the plan’s share reserve, are reviewed by ISS using its Equity Plan Scorecard (EPSC) policy. The more significant changes for 2017 include an evaluation of the payment of dividends on unvested awards. Under the new factor, full points will be earned if the equity plan expressly prohibits for all award types the payment of dividends before the vesting of the underlying award. The accrual of dividends payable upon vesting is acceptable. No points are earned if this prohibition is absent or incomplete. Just declaring it as the company’s general practice and not including it in the stock plan document will not suffice.

Changes were also made to the minimum equity vesting requirement. A plan must specify a minimum vesting period of one year for all award types under the plan to receive full points for this factor. No points will be earned if the plan allows for the use of an individual award agreement that reduces or eliminates the one-year vesting requirement.

Alvarez & Marsal Taxand Says:

Executive compensation and corporate governance constantly evolve — seemingly unable to reach a steady state. Given the constant dynamic, A&M advises its clients to take a practical approach to ensuring executive compensation programs adhere to effective governance practices and meet the business’s unique objectives. Human resource executives and compensation committees should adopt a reward strategy that provides stability and should follow governance processes that are relevant to the company. While the guidance from the proxy advisors needs to be understood and applied, the proxy advisors’ methodologies should be subordinate to the organization’s unique business objectives and people strategies. Specifically, ISS methodologies are designed for its business model and strategy and not necessarily for the companies it reviews.

As the demands for executive compensation programs focus on business results, human resource executives and committee members should search to strike the right balance between proxy advisors’ recommendations, executive engagement and delivering sustainable business results.

Disclaimer

The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.

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