Background. As we approach the second year (for most companies) of shareholder Say-on-Pay (SOP) voting, it might be useful to discuss the methodology used by one of the most important proxy advisory firms, ISS, in evaluating the alignment of executive pay with corporate performance. The following is an excerpt (which I have edited slightly) from a recent Update on ISS Policy issued by Frederic W. Cook & Co., Inc.
Evaluation of Executive Pay. “Under current ISS policy, pay-for-performance alignment for Russell 3000 companies is assessed by examining a company’s one- and three-year total shareholder return (“TSR”) relative to all Russell 3000 companies in the same 4-digit GICS industry group [fn 1] and year-over-year change in CEO compensation for CEOs who have served at least two consecutive fiscal years. Generally, if both one- and three-year TSR are below median and there has not been a meaningful year-over-year reduction in CEO compensation (e.g., 10% or more), the company is deemed to have a pay-for-performance disconnect. This subjects the company’s overall executive compensation program to greater scrutiny and raises the likelihood that ISS will recommend “against” the company’s management say-on-pay (“MSOP”) proposal.
Methodology. The updated policy for 2012 refines the methodology for determining pay-for-performance alignment as follows:
Peer Group Alignment:
- The peer group for the relative TSR calculations will no longer be all Russell 3000 companies in a company’s 4-digit GICS industry group. Instead, this peer group will be the same as ISS’ pay comparison peer group, which will be formed on a new basis.
- The peer group will generally consist of 14-24 companies (vs. 8-12 under the current policy) that are selected based on size using market cap, revenue (or assets for financial firms) and GICS industry group. ISS clarified that it will seek to position the company being evaluated close to the median.
- Both CEO pay and TSR will be evaluated on a relative basis compared to a company’s peer group over one and three years, weighted 40% and 60% respectively.
- The weighted CEO relative pay rank will then be compared to the company’s weighted TSR rank. The system for evaluating the ranks was not included and will be provided in the additional guidance to be issued in December.
- The multiple of CEO total pay to the peer group median, which is a qualitative consideration based on the most recent year’s pay under the current policy, will become quantified. Clarification was not provided whether this comparison will be expanded to include three-year CEO pay in addition to one-year pay.
1 GICS refers to the Global Industry Classification Standard (“GICS”) developed and maintained by Standard & Poor’s for the purpose of classifying companies into 2-digit sectors, 4-digit industry groups, 6-digit industries, and 8-digit sub-industries.
- CEO pay alignment will also be evaluated on an absolute basis against TSR over a five-year period. This analysis will assess the difference between the trend in annual pay changes and the trend in annualized TSR during the period.
- The system for evaluating differences in rates of change to identify strong alignment and weak alignment was not included and will be provided in the additional guidance to be issued in December.
- The updated policy did not indicate whether a change from using grant-date fair values for equity compensation to earned values would be made. However, we expect that ISS will continue to use grant-date fair values and continue to value stock options assuming the maximum term rather than actual experience of how long options are outstanding prior to exercise, as used for accounting and disclosure purposes. Thus, companies granting options will be even more disadvantaged under the new methodology.
Consequences of Poor Alignment. Companies with unsatisfactory alignment will be subject to further qualitative analysis that considers the following:
- The ratio of performance-based to time-based equity awards;
- The overall ratio of performance-based compensation to overall compensation;
- The completeness of disclosure and rigor of performance goals;
- The Company’s peer group benchmarking practices;
- Actual results of financial/operational metrics, such as growth in revenue, profit, cash flow, etc. both absolute and relative to peers;
- Special circumstances related to, for example, a new CEO in the prior fiscal year or anomalous equity grant practices (e.g.; biennial awards); and
- Any other factors deemed relevant.
The updated policy did clarify that a new CEO will not exempt a company from evaluation under the new methodology.”
Conclusion. For larger public companies, we can expect increasingly close scrutiny of executive pay and greater criticism of perceived poor practices by proxy advisors. Smaller public companies can expect an inevitable “trickle down” effect, even if it is watered down. Our approach to advising compensation committees uses a similar (but simpler) methodology, understanding that our clients generally have boards that include major shareholders who are well-attuned to shareholder interests.
Robert L. Musick, Jr. Richard Deutsch
(804) 249-6027 (804) 249-6026