Category Equity Compensation Plans

ISS Guidance on COVID-19 Compensation Issues

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ISS first provided guidance regarding compensation issues related to COVID-19 back in April 2020 (Annual General Meetings & COVID-19: A Review of the Regulatory Landscape, April 1, 2020; and Impacts of the COVID-19 Pandemic, April 8, 2020). Since then ISS representatives have spoken on webinars about COVID-19 and compensation, and likely fielded many questions about how ISS will apply its policies and view actions taken with respect to compensation. Just last week ISS released an early set of FAQs to address the issues it sees regarding compensation actions taken regarding COVID-19 (U.S. Compensation and the COVID-19 Pandemic, Frequently Asked Questions, October 15, 2020).

Key issues and ISS positions from the FAQS:

  • Base salary reductions—temporary salary reductions will be given mitigating weight if they decrease total pay. Given more weight if targeted incentive payout opportunities are decreased to reflect the reduced salary.
  • Change to bonus/annual incentive awards—suspending program and making one-time discretionary payments may be viewed as reasonable so long as the justifications and rationale are clearly disclosed, and the resulting outcomes appear reasonable.
  • Disclosure needed if make COVID-related changes to bonus/annual incentive awards—the key disclosure items that would help investors evaluate the actions taken are:
    • specific challenges and how they rendered the original program design obsolete or the original performance targets impossible to achieve; should address how the changes are not reflective of poor management performance.
    • For mid-year changes—explain why that approach was taken and how the changes further investors’ interests.
    • One-time discretionary awards should carry performance-based considerations, with underlying criteria being disclosed.
    • How resulting payouts appropriately reflect both executive and company annual performance. Should clarify or estimate how the payouts would compare with what would have been paid under the original program design.
    • If have designed the subsequent year’s (ex. 2021) annual incentive program, encouraged to disclose information about positive changes made to the prior year design.
  • Lowered financial or operational targets below prior year’s actual levels achieved—If reflect external factors, maybe a reasonable explanation. Should be accompanied by disclosure as to how the board considered corresponding payout opportunities, especially if such payout opportunities are not commensurately reduced.
  • Changes to outstanding performance-based equity/long-term incentive awards—Such awards should be designed to smooth performance over a long-term period. Changes to in-process performance cycle awards will be viewed negatively, especially for companies that exhibit a quantitative pay-for-performance (P4P) misalignment under the ISS quantitative P4P tests.
  • Changes to outstanding equity/long-term incentive awards granted in 2020—Investors do not want to see drastic changes to awards unless the underlying business strategy has fundamentally changed. However, more modest changes to the incentive program could be viewed as reasonable. Should clearly explain any changes.
  • COVID-related retention or other one-time awards—If grant these types of awards, should clearly disclose the rationale for the award, including the magnitude and structure, and describe how the awards further investors’ interests. Vesting term should be long-term and vesting conditions should be strongly performance-based and clearly linked to the underlying concerns the awards aim to address. Such awards should also contain shareholder-friendly guardrails to avoid windfalls.
  • COVID-related retention or other one-time awards with forfeited awards—Investors do not expect such awards to be granted merely as a replacement for forfeited performance-based awards. If a one-time award is granted in the year or following year in which incentive awards are forfeited, companies must explain the specific issues driving the decision to grant the awards and how awards further investors’ interests. If a company indicates that the one-time awards were granted in consideration of forfeited performance awards, it must explain how such awards do not merely insulate executives from lower pay.
  • ISS’s board/committee responsiveness policy (when say-on-pay vote receives less than 70% support) in light of COVID-19—The ISS responsiveness policy generally requires companies in their next proxy to: (1) disclose the board’s engagement efforts, (2) disclose specific feedback from shareholders, and (3) disclose any actions or changes made to pay programs and practices to address shareholders’ concerns. In light of COVID-19, if a company is unable to implement changes, the proxy should disclose specifically how the pandemic has impeded the company’s ability to address shareholders’ concerns. If changes are delayed or do not fully address shareholders’ concerns, should disclose a longer-term plan on how the company intends to address shareholders’ concerns.
  • ISS policies unchanged by COVID-19—No changes to ISS’s equity plan scorecard (EPSC), problematic pay practices, or option repricing policies in light of the pandemic.
    However, ISS increased the passing scores (thresholds) under the EPSC model to 57 points for S&P 500 companies (was 55 points) and 55 points for Russell 3000 companies (was 53 points) and kept the score at 53 points for all other companies.

    Note: If your company is going out to shareholders to request approval of a new or amended plan in 2021, the above changes to the EPSC model likely mean that only a reduced number of shares will pass compared to 2020, everything else remaining the same. Increasing the thresholds for the S&P 500 and Russell 3000 will make it more likely that companies can request fewer shares and, thus, most likely will need to go back to shareholders sooner than they otherwise would after 2021 to request more shares.

So, if your company is even considering making changes to outstanding awards or making special one-time grants, you should also develop the proxy disclosure explaining the change(s) or one-time awards concurrently so that it is ready for your next proxy. Preparing draft proxy disclosure may also enable you to refine any changes or one-time awards to help anticipate how ISS may react.

Time to Check Your Shares!

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We are just now starting to get ready for the fall compensation committee meetings cycle for calendar-year companies. If your company’s stock price has been negatively impacted by the COVID-19 pandemic, now is a good time to look at your equity plans. You need to see how many shares are available and figure out how long those shares are likely to last given both current stock prices and potential changes in stock prices that might affect the size of your future annual equity grants.

I have already worked with several companies that undertook this exercise. Several companies have determined they have just enough shares to make it until their 2022 annual meeting, so they will continue on as normal until then. For others, they realized they might not have enough shares available after their 2021 annual grant, so they have started the process of going back to shareholders for approval of additional shares at their 2021 annual meetings.

It is better to test the waters on this before you get swamped with year-end duties. If you find you may need more shares after your 2021 annual grants, you can then calmly start the process for going to shareholders in 2021 for approval of more shares.

ISS Issues FAQs and Burn Rate Benchmarks for 2019

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In November, ISS issued a set of preliminary Compensation FAQs (see http://edwardhauder.com/2018/11/21/iss-issues-preliminary-faqs-on-compensation-policies-for-2019/). Then on December 14, 2018, ISS issued its final set of Compensation FAQs for 2019, U.S. Compensation Policies, Frequently Asked Questions, Updated December 14, 2018. ISS then issued a set of updated FAQs for equity plans on December 19, 2018, U.S. Equity Compensation Plans, Frequently Asked Questions, Updated December 19, 2018.U.S. Compensation FAQs

U.S. Compensation FAQs

Below are the questions and answers that were updated by ISS in this set of Compensation FAQs.

19. Any changes in the quantitative Pay-for-Performance (P4P) for 2019? No, the quantitative P4P screens will remain the same for 2019.

21. Does ISS prefer companies to use TSR as an incentive program metric? ISS does not endorse the use of TSR or any specific metric in executive incentive programs.

42. How does ISS analyze “front-loaded” awards intended to cover future years? ISS is unlikely to support grants that cover more than four (4) years (i.e., the grant year plus three future years) because such grants limit the board’s ability to meaningfully adjust future pay opportunities in the event of unforeseen events or changes in either performance or strategic focus.

47. Which problematic practices are most likely to result in an adverse recommendation? The list includes:

  • Repricing or replacing underwater stock options/SARs without shareholder approval
  • Extraordinary perquisites or tax gross-ups
  • New or materially amended agreements that provide for:
    • Excessive termination or CIC severance payments
    • CIC severance payments without involuntary job loss or substantial diminution of duties or in connection with a problematic Good Reason definition
    • Problematic “Good Reason” termination definition that present windfall risks, such as definitions triggered by potential performance failures
    • CIC excise tax gross-up entitlements
    • Multi-year guaranteed awards that re not at risk due to rigorous performance conditions
    • Liberal CIC definition combined with any single-trigger CIC benefits
  • Insufficient executive compensation disclosure by externally-managed issuers (EMIs) such that a reasonable assessment of pay programs and practices applicable to the EMI’s executives is not possible
  • Any other provision or practice deemed to be egregious and present a significant risk to investors

48. How does ISS evaluate “Good Reason” termination definitions? Such definitions should be limited to circumstances that are reasonably viewed as an adverse constructive termination, and should be tailored to preclude potential windfall risk.

50. If a company becomes a “smaller reporting company” under the SEC’s revised definition, how will ISS assess reduction in compensation disclosure? Companies with scaled compensation disclosure requirements should continue to provide sufficient disclosure to enable investors to make an informed say-on-pay vote; ISS typically wants the disclosure to be sufficient for it and investors to meaningfully assess the board’s compensation philosophy and practices.

59. How would ISS view any compensation program changes made in light of the removal of 162((m) deductions? Shifts away from performance-based compensation to discretionary or fixed pay elements will be viewed negatively.

67. How does ISS apply its policy around “excessive” levels of non-employee director pay? If a company has excessive non-employee director (NED) pay without a compelling rationale in two or more years, it could cause ISS to recommend against directors. This policy will not be applied until February 1, 2020. If ISS identifies excessive NED pay at a company it will undertake a qualitative review to determine if concerns are adequately mitigated. In evaluating a company’s disclosed rationale, the following circumstances, if within reason and adequately explained, would typically mitigate concern around high NED pay:

  • Onboarding grants for new directors that are clearly identified to be one-time in nature
  • Special payments related to corporate transactions or special circumstances, or
  • Payments made in consideration of specialized scientific expertise.

ISS will evaluate payments made in connection with separate consulting agreements on a case-by-case basis. ISS will generally not view payments to reward general performance/service as compelling rationale.

68. What is ISS’ methodology to identify NED pay outliers? ISS will compare individual NED pay total within the same index and sector. Directors will be compared to other directors within the same two-digit GICS group and within the same index grouping. Index groupings for purposes of this policy are: S&P 500, combined S&P 400 and S&P 600, remainder of the Russell 3000 index, and the Russell 3000-Extended. The methodology will also recognize board-level leadership positions, limited to non-executive chairs and lead independent directors and individuals in these roles will be compared to others in the same role in their index and sector. The methodology will also recognize cases where there is a narrow distribution of NED pay within a particular sector-index grouping, i.e., where there is not a pronounced difference between the top 2-3% and the median director, this may be considered as a mitigating factor.

U.S. Equity Compensation Plans FAQs

Below are the questions and answers that ISS has updated with respect to this set of Equity Compensation Plans FAQs:

26. How will ISS treat plan proposals that are only seeking approval in order to qualify grants as “performance-based” under IRC Section 162(m)? Proposals that only seek approval to ensure tax deductibility of awards pursuant to Section 162(m) – now under the “grandfather rule” – and that do not seek additional shares for grants or approval of any plan amendments, will generally receive a favorable recommendation regardless of Equity Plan Scorecard (EPSC) factors (“positive override”), provided that the board’s Compensation Committee or other administering committee is 100% independent according to ISS standards.

27. How will ISS consider plan revisions relating to the 162(m) tax code changes? Plan amendments that involve the removal of general references to 162(m) qualification will be viewed as administrative/neutral. But, if a plan contains provisions representing good governance practices, even if no longer required under the revised 162(m) code, their removal may be viewed as a negative change in a plan amendment evaluation.

34. What changes were made to the EPSC policy for 2019? Beginning February 1, 2019, the following updates will apply:

  • The change-in-control vesting factor is updated to provide points based on the quality of disclosure of CIC vesting provisions, rather than based on the actual vesting treatment of awards. Full points will be earned if the plan discloses with specificity the CIC vesting treatment for both time- and performance-based awards. But no points will apply if the plan is silent on the CIC vesting treatment for either type of award or if the plan provides for merely discretionary vesting for either type of awards.
  • There is a new negative overriding factor for excessive dilution–greater than 20% for S&P 500 companies and greater than 25% for the Russell 3000 companies (other than the S&P 500).
  • Certain factor scores have been adjusted in accordance with ISS’ proprietary (black box) scoring model.

45. When will excessive dilution have an adverse recommendation implication for the equity plan proposal? Excessive dilution is an overriding factor that can be applied to S&P 500 and Russell 3000 companies. For S&P 500 companies, this override will be applied if dilution is greater than 20%. For Russell 3000 companies (excluding S&P 500), this override will be applied if dilution is greater than 25%. For this policy, ISS defines “dilution” as (A + B + C) / CSO, where A = number of new shares requested; B= number of shares that remain available for grant; C = number of unexercised/unvested outstanding equity awards; and CSO = common shares outstanding.

2019 Burn Rate Benchmarks

See Appendix A of the U.S. Equity Compensation Plans FAQs for a full list of ISS’ 2019 burn rate benchmarks for the S&P 500, Russell 3000 (excluding the S&P 500), and the Non-Russell 3000.

Dilution & Equity Plan Proposals

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If you are taking an equity plan proposal to shareholders during the 2019 proxy season, you really need to know what your dilution is and will be at fiscal year-end. Why? First, it could impact the vote recommendation from ISS on your equity plan proposal. Second, it could negatively impact shareholder support for your equity plan proposal.

ISS

For 2019 shareholder meetings held on or after February 1, 2019, ISS has adopted a new “override” factor for its Equity Plan Scorecard (EPSC) model/policy. Regardless of how a proposed plan scores under the EPSC model, if the plan would cause dilution to be “excessive” ISS will recommend against it. For S&P 500 companies, excessive dilution means dilution greater than twenty percent (20%) and for other Russell 3000 companies it means dilution greater than twenty-five percent (25%). In some industries, this could be more of an issue than in others.

ISS is calculating dilution on a simple basis (as I explained in this Blog Post).

Shareholder Support

Based on prior research that I have conducted, the line in the sand for dilution that starts to see increased shareholder resistance, leading to less support for equity plan proposals, starts at about twenty percent (20%). As dilution goes above 20%, shareholder vote support starts to decline significantly, and then drops again once the 25% dilution level is passed.

Conclusion

Ensure that you have calculated your dilution currently and projected as of fiscal year-end, and also including any proposed equity plan share request. That way you will be alerted to whether dilution could cause an issue for your plan proposal. If so, it may necessitate some additional disclosures to illustrate why the request is sound and also require engaging with shareholders about the company’s need for shares in its equity compensation plans.