ISS Releases Final Voting Policy Changes for 2018 Proxy Season

On November 16, 2017, Institutional Shareholder Services (ISS) released the final changes to its 2018 U.S. voting policies, which will be effective for meetings on or after February 1, 2018. ISS’s final changes include all of the changes that it had previously proposed, which relate to non-employee director compensation, poison pills and gender pay shareholder proposals, as well as additional changes relating to ISS’s quantitative pay-for-performance test, say-on-pay responsiveness, director voting recommendations at companies that have opted into, or not opted out of, state laws mandating classified boards and other matters. These changes are summarized below.

1. Quantitative Pay-for-Performance
   
   

   For 2018, ISS adopted a change to its quantitative pay-for-performance test, which is one of the primary inputs that ISS uses in determining its recommendations for say-on-pay proposals. Under the new policy, ISS’s pay-for-performance test will include a new assessment that compares the company’s rankings to a peer group with respect to (i) CEO pay and (ii) financial performance in three or four metrics (which will vary depending on industry), in each case as measured over three years. The financial performance metrics to be used by ISS could potentially include one or more of the metrics that ISS began disclosing in company reports in 2017 (i.e., cash flow growth, revenue growth, EBITDA growth, return on invested capital, return on equity and return on assets) or other metrics. ISS has not yet released specific details as to how this new test will be incorporated into its overall methodology, but did indicate that further details will be provided in an updated publication by ISS regarding the mechanics of its quantitative pay-for-performance test.

   Because of the importance of ISS’s quantitative pay-for-performance test, almost any change in methodology has the potential to be significant to companies. How significant the introduction of this new assessment will prove to be will depend on how ISS incorporates this new test into its overall methodology and the financial performance metrics that are used.

   Currently, ISS’s quantitative pay-for-performance test is based on the following three assessments:

   • the degree of alignment between the company’s annualized total shareholder return (TSR) rank and the CEO’s annualized total pay rank within a peer group, each measured over a three-year period;
     
     
   • the multiple of the CEO’s total pay relative to the peer group median in the most recent fiscal year; and
     
     
   • the absolute alignment between the trend in CEO pay and company TSR over the prior five years.

   ISS uses the numerical scoring from these assessments to group companies into three general categories – low concern, medium concern or high concern. The level of concern translates into the level of scrutiny that ISS places on a company’s executive compensation programs to determine voting recommendations for say-on-pay proposals and the reelection of compensation committee members. The end result is that companies raising greater levels of concern based on the quantitative pay-for-performance test are more likely to receive negative voting recommendations from ISS. For example, based on data from the first half of 2017 as reported by ISS in its 2017 Proxy Season Review: Compensation, ISS recommended votes against say-on-pay proposals at 51% of companies where there was a high concern based on the quantitative pay-for-performance test, as compared to 26% of companies receiving medium concern and only 4% of companies receiving low concern.

   ISS’s current methodology for measuring quantitative pay-for-performance has suffered from significant limitations due to its exclusive reliance on TSR for measuring company performance. TSR can be influenced by many factors that are outside of the control of company management and may bear little correspondence to company financial performance, even when measured on a relative basis against companies deemed to be peers by ISS. The addition of a quantitative test based on company performance metrics has the potential to address some of these limitations. However, in order to do so, the selection and calculation of the company performance metrics utilized need to be handled carefully to provide meaningful comparisons (e.g., to appropriately take into account the impact of unusual events). Given the complexity involved in appropriately analyzing financial performance of individual companies, the addition of a new test also creates the possibility that companies will be required to spend more time explaining to investors why ISS’s recommendation should not be followed due to the fact that it was based on concerns raised from a relative financial performance analysis that is not relevant to a company or its investors. Ultimately, the impact of ISS’s change in its quantitative pay-for-performance test will not be known until additional details are released and ISS begins actually applying its new policy in practice in its 2018 voting recommendations.



2. Say-on-Pay Responsiveness
   
   

   ISS has also revised its policy on say-on-pay responsiveness to clarify the manner in which it will consider say-on-pay responsiveness in making voting recommendations. Overall, ISS’s voting policies that apply when the company’s previous say-on-pay proposal received the support of less than 70% of the votes cast generally remained the same (i.e., voting recommendations for say-on-pay proposals and compensation committee members are to be made on a case-by-case basis considering the company’s response as well as several other factors). However, ISS’s revised policy will specifically note that ISS’s consideration of the company’s response will include consideration of disclosure regarding (i) the timing and frequency of engagements with major institutional investors and whether independent directors participated in these engagements, (ii) the specific concerns voiced by dissenting shareholders that led to the say-on-pay opposition and (iii) specific and meaningful actions taken to address shareholders’ concerns. In explaining its rationale for the revised policy, ISS noted, among other things, that independent director participation in engagement efforts is preferred, ISS looks for disclosure of the feedback received from the investors voting against the previous say-on-pay proposal and ISS considers the quality of changes made by a company relative to the feedback received.

   This revised policy further highlights the often frustrating situation in which a company can find itself when its say-on-pay proposal passes, but receives support of less than 70% of the votes cast. ISS places significant weight on what the company has done to address the views of the minority of shareholders who did not support the say-on-pay proposal and very little weight on the fact that a majority of shareholders supported the company’s executive compensation as it was.



3. Non-Employee Director Compensation 
   
   

   As proposed, ISS has adopted a new policy that explicitly provides for adverse vote recommendations for board committee members who are responsible for approving or setting non-employee director compensation when there is a pattern (i.e., two or more consecutive years) of “excessive” non-employee director pay without a compelling rationale or other mitigating factors. Because the new policy requires two or more consecutive years of excessive pay, there will be no impact on vote recommendations for directors in 2018 as a result of this policy because 2017 would be the first year measured under the policy.

   The new policy does not specify quantitative metrics or otherwise indicate how ISS intends to determine whether non-employee director pay is excessive. However, ISS’s current practice for identifying what it considers to be non-employee director pay outliers is to review director pay relative to other companies with the same broad-based index and four-digit GICS industry group. Additionally, ISS’s policy survey for 2017-2018 identified these comparisons as the most important factors for both investor and non-investor respondents in determining whether the magnitude of non-employee director pay presents a governance concern. As a result, we would not be surprised to see ISS employ one or both of these relative metrics to determine whether non-employee director pay is excessive.

   Going forward, ISS indicated that the impact for boards was expected to be minimal as the policy is focused on “extreme director pay outliers.” Nevertheless, the introduction of a voting policy focused on non-employee director compensation is notable given that non-employee director compensation has historically not been factored into ISS’s voting recommendations.



4. Poison Pills
   
   

   As proposed, ISS has altered its voting policy on director elections at companies that maintain a poison pill with a term longer than one year, which ISS considers a long-term poison pill. Under the new policy, ISS will recommend votes against all board nominees, every year, at companies that maintain a long-term poison pill that has not been approved by shareholders. Previously, ISS had grandfathered companies that had put their poison pill in place on or before November 19, 2009 and, for companies where all board members were elected annually, had only recommended against board nominees once every three years. In addition, companies with a newly adopted poison pill previously could potentially avoid adverse recommendations by committing to submit the poison pill to a binding shareholder vote at the next annual meeting. ISS has eliminated all of these exceptions.

   ISS is generally maintaining its existing policy with respect to the adoption of short-term poison pills, except that it will place greater focus on the company’s rationale for adoption and lesser focus on the company’s governance and track record of accountability to shareholders than it does currently in its case-by-case analysis. Renewals and extensions of short-term poison pills without shareholder approval will continue to be treated in the same manner as the adoption of a long-term poison pill.

   ISS did not adopt any changes to its current voting policies regarding shareholder approval or ratification of a poison pill, whether adopted to preserve net operating losses or for other reasons. As a result, ISS’s existing voting policies on these topics will remain in place



5. Classified Board (Opting into, or Failing to Opt out of, State Laws)
   
   

   ISS adopted a new policy to recommend against the reelection of all directors at a company if the company has opted into, or failed to opt out of, state laws requiring a classified board structure.

   Based on ISS’s stated rationale for this change, it appears primarily to be a memorialization of ISS’s existing practices as opposed to a new policy. ISS noted that for several years under its material governance failure policy it has been recommending against the reelection of directors at a number of companies incorporated in Indiana that have not opted out of the state law requiring a classified board and a company incorporated in Iowa that has a state law-mandated classified board. As written, this new policy would not apply to companies incorporated in Maryland where the board retained the ability to classify itself without shareholder approval (i.e., companies that had not permanently opted out of MUTA), but would appear to apply to companies that classified their board by opting into MUTA.



6. Gender Pay Gap Shareholder Proposals
   
   

   As proposed, ISS adopted a new policy regarding what it characterizes as gender pay gap shareholder proposals. Under the new policy, ISS will make voting recommendations on a case-by-case basis on shareholder proposals requesting reports on a company’s pay data by gender, or a report on a company’s policies and goals to reduce any gender pay gap, taking into account the following factors:

   • the company’s current policies and disclosures related to its diversity and inclusion policies and practices, its compensation philosophy and fair and equitable compensation practices;
     
     
   • whether the company has been the subject of recent controversy or litigation related to gender pay gap issues; and
     
     
   • whether the company’s reporting regarding gender pay gap policies or initiatives is lagging its peers.

   Currently, ISS does not have a specific policy with respect to these types of shareholder proposals. As a result, ISS has analyzed these proposals under its global policy for social and environmental issues, which provides that recommendations will be made on a case-by-case basis taking into consideration whether implementation of the proposal is likely to enhance or protect shareholder value and considering a number of other factors, such as: whether the proposal is more appropriately dealt with through legislation or government regulation; whether the proposal is unduly burdensome; whether sufficient information is already available or the request would require disclosure of proprietary information that could place the company at a competitive disadvantage; and how the company’s approach compares to industry standard practices. ISS indicated that the new policy on gender pay gap shareholder proposals provides more specificity regarding its approach, but is not a major shift from its current policy.
   
   

7. Other Changes
   
   

   ISS also made a number of other changes to its voting policies for 2018, including the following:

   • Board Diversity. ISS adopted a specific policy to highlight in its reports boards that do not have any female members. This policy specifically states that no adverse recommendations will be made due to any lack of gender diversity. However, ISS did add a sentence to its discussion of the four fundamental principles that it applies when determining votes on director nominees (accountability, responsiveness, composition and independence) stating that “[b]oards should be sufficiently diverse to ensure consideration of a wide range of perspectives.” Regardless of whether ISS’s actual voting recommendations are impacted, these changes reflect increasing investor focus on board diversity and, in particular, gender diversity on boards.
     
     
   • Pledging. ISS added a new policy addressing pledging of company stock that incorporates guidance previously included in its published 2017 FAQ document. ISS will continue to recommend against the members of the committee that oversees risk related to pledging or the full board where a significant level of pledged stock by executives or directors raises concerns. The new policy does not represent a substantive change from ISS’s existing policy as it had been applied.
     
     
   • Say-on-Pay Frequency. ISS changed its voting policies to make clear that it expects companies to adopt the say-on-pay voting frequency approved by a plurality of shareholders. In doing so, ISS eliminated the distinction in its voting policies between situations where one of the choices (e.g., every year) received a majority of the votes cast and situations where one of the choices received a plurality of the votes cast, but none of the choices received a majority of the votes cast. In practice, it has been very rare for none of the choices to receive a majority of the votes cast and, as a result, ISS’s elimination of this distinction is unlikely to impact many companies.
     
     
   • New Director Attendance. ISS changed its voting policies to provide that it will no longer recommend against new directors (i.e., directors appointed subsequent to the most recent prior annual meeting) based on their attendance of board and committee meetings. Previously, ISS would exempt new directors from its attendance policy only if the company disclosed that the absences resulted from schedule conflicts due to commitments made prior to their appointment to the board. Under ISS’s existing director attendance policy, ISS will generally recommend against the reelection of directors who have attended less than 75% of the meetings of the board and committees on which they served unless an acceptable reason for the absences is disclosed. Acceptable reasons are generally limited to medical issues, family emergencies and missing only one meeting.
     
     
   • SPAC Extension Proposals. ISS adopted a new policy relating to proposals by special purpose acquisition corporations (SPACs) to extend the length of time they have to enter into a definitive agreement and complete an initial business combination. ISS’s policy is to make its recommendations on a case-by-case basis taking into account the length of the requested extension, the status of any pending transactions or the progression of the acquisition process, any added incentive for non-redeeming shareholders and any prior extension requests.
     
     
   • Climate Change Shareholder Proposals. ISS expanded its existing policy in favor of shareholder proposals requesting climate change related disclosure. ISS’s existing policy is to generally recommend votes for shareholder proposals requesting that a company disclose information on the risks related to climate change on its operations and investments. ISS expanded this policy to also cover shareholder proposals requesting disclosure on how a company identifies, measures and manages such risks.

A full description of the final changes to ISS’s 2018 U.S. voting policies, which includes a blacklined comparison showing the changes made and a description of ISS’s rationale for the various changes, is available on ISS’s website.