Equity Compensation Plans

That’s a FAQ, Jack! – New Interpretations from ISS

On December 19, 2016, ISS issued updates to several of its key FAQs, including those on Equity Compensation Plans, Executive Compensation Policies, and also the explanation of ISS’ Pay-for-Performance Mechanics. Below I look at the specific updates under each FAQ and the P4P Mechanics.

U.S. Equity Compensation Plans

FAQ #19 If a company grants performance-based awards, how will the shares be counted for the purposes of calculating burn rate?

ISS makes clear that unless a company provides disclosure of the performance-based awards that vest and are earned in each year during the past three years, ISS will use the number of performance-based awards that are granted in each year when calculating its burn rate for a company.

FAQ #28 How does ISS evaluate an equity plan proposal seeking approval of one or more plan amendments?

If there is not a request for additional shares (or other modification that is deemed to potentially increase the plan’s cost), ISS will review the overall impact of the amendments to shareholders. If beneficial, ISS will support the proposal; if detrimental, then ISS will oppose the proposal.

If there is a request for additional shares (or other modification that is deemed to potentially increase the plan’s cost) or this is the first time public shareholders will have an opportunity to opine on the plan, then ISS will consider both the Equity Plan Scorecard (EPSC) score as well as an analysis of the overall impact of the amendments to shareholders (as above). But the EPSC score is more heavily weighted. If the EPSC score is such to warrant a positive vote recommendation, ISS will only recommend against the proposal if the amendments represent a substantial diminishment to shareholders’ interests.

See FAQs #29 and 30 for proposals seeking approval only for Section 162(m) purposes.

FAQ #30 How are proposals that include 162(m) reapproval along with plan amendments evaluated?

The general ISS positive override for Section 162(m) proposals does not apply to bundled amendments. For bundled amendments, even those that include Section 162(m) reapprovals, ISS will evaluate the plan proposal in terms of the impact to shareholders and/or the EPSC score as detailed above under FAQ #28.

FAQ #32 How does ISS view a plan amendment to increase the tax withholding rate applicable upon an award settlement?

Generally, ISS views such a change as neutral to shareholders’ interests. However, if the plan also has a liberal share recycling feature, ISS will view the amendment negatively. But, if this is the only amendment being made to the plan, by itself it would not be sufficient for ISS to recommend against the plan (see my blog post on this). If this is bundled with other amendments, then ISS will review it using its EPSC policy framework discussed in FAQ #28.

FAQ #36 What changes were made to the EPSC policy for 2017?

Effective for shareholder meetings on or after February 1, 2017, the EPSC policy generally remains the same, though ISS did make the following adjustments:

  • A new factor was added to the Plan Features pillar that looks at whether the plan permits the payment of dividends or dividend equivalents on unvested awards. Full points are awarded if the plan expressly prohibits, for all awards, the payment of dividends and dividend equivalents before the vesting of the underlying awards; however, accrual of dividends and dividend equivalents payable upon vesting is acceptable. No points will be awarded if the plan does not include an express prohibition on the current payment of dividends and dividend equivalents.
  • The minimum vesting factor is updated so that full points are only awarded if the plan specifies a minimum vesting period of one year for all equity awards. Further, no points will be awarded if the plan permits the administrator, through individual award agreements or other mechanisms, to reduce or eliminate the one-year vesting requirement beyond the allowable 5% carve-out.
  • Companies that have 33 or more months of trading history as of the applicable lock-in date (QDD or quarterly data download date per ISS) will have burn rate incorporated into their EPSC evaluation if they disclose three years of burn rate data. For companies with 32 or fewer months of trading history, ISS will continue to evaluate them under its Special Cases models, see FAQs #37, 38 and 41.
  • Finally, ISS adjusted certain factor scores under its proprietary EPSC score model.
  • The EPSC threshold number of points remains at 53.

FAQ #41 How will equity plan proposals at newly public companies be evaluated?

Companies that are newly public will continue to be evaluated under an EPSC model that includes fewer factors. As previously was the case, the burn rate and plan duration factors will not apply if the company has less than 3 years of disclosed grant data. ISS will use its Special Cases models in two cases: (1) company has less than or equal to 32 months of trading history as of the QDD date, or (2) company has between 33 and 36 months of trading history and there is less than 3 years of burn rate data.

FAQ #42 What factors are considered in the EPSC, and why?

The EPSC has three categories/pillars under which ISS conducts its analysis: Plan Cost, Plan Features, and Grant Practices. This FAQ has been updated to reflect the updates to the EPSC model mentioned in FAQ #36.

FAQ #43 Are the factors binary? Are they weighted equally?

The EPSC factors are not weighted equally. Each factor is assigned a maximum number of points and the total maximum number of points is 100. A passing score remains at 53 points. This FAQ then includes a table with the factors, a definition of the factor, and information on how it is scored for purposes of the EPSC model (but not the actual maximum number of points for the factors).

FAQ #47 How does ISS assess a plan’s minimum vesting requirements for EPSC purposes?

In order for a plan to receive full points for the minimum vesting factor, it must require a vesting of at least 1 year for all equity award types and cannot permit individual award agreements to reduce or eliminate this minimum vesting requirement. This minimum vesting requirement must apply to at least 95% of the shares authorized for grant under the plan, i.e., the plan can permit up to 5% of the authorized shares to be granted without complying with the minimum vesting requirement.


U.S. Executive Compensation Policies

FAQ #3 How is Total Compensation calculated?

Total Compensation = Base Salary + Bonus + Non-equity Incentive Plan Compensation + Stock Awards* + Option Awards** + Change in Pension Value and Nonqualified Deferred Compensation Earnings + All Other Compensation.

  • * The value of all stock-based awards – both time- and performance-vesting) are calculated by multiplying the number of underlying shares (target number for performance awards) by the closing stock price on the date of grant.
  • ** The value of option and SAR awards is calculated using ISS’ Black-Scholes option pricing model.

FAQ #20 What are the factors that ISS considers in conducting the qualitative review of the pay for performance analysis?

Some of the key factors ISS considers in conducting its qualitative review of the P4P analysis include:

  • Ratio of performance- to time-based equity awards
  • Overall ratio of performance-based compensation
  • Completeness of disclosure
  • Rigor of performance goals
  • Application of compensation committee discretion
  • Magnitude of pay opportunities
  • Company’s peer group benchmarking practices
  • Results of financial/operational metrics both absolute and relative to peers
  • Special circumstances related to CEO and executive turnovers or anomalous equity grant practices
  • Realizable and realized pay compared to granted pay
  • Any other factors deemed relevant

FAQ #22 What is the Relative Pay and Financial Performance Assessment included in research reports?

ISS introduced a Relative Pay and Financial Performance Assessment for Russell 3000 companies for meetings on or after February 1, 2017. ISS will compare the long-term CEO pay and financial/operational performance rankings relative to a company’s ISS peer group. Financial/operational performance will be assessed across up to 6 financial metrics and TSR, depending on the company’s GICS industry group. The potential metrics include:

  • Cash flow (from operations) growth
  • EBITDA growth
  • Return on assets
  • Return on equity
  • Return on invested capital
  • Revenue growth
  • Total shareholder return

FAQ #23 How will ISS use the Relative Pay & Financial Performance Assessment (RPFPA) in its analysis?

For 2017, the RPFPA is part of the qualitative P4P assessment and not included in the quantitative P4P assessment.

Note: ISS seems to be using 2017 as an information-gathering year and will be evaluating the RPFPA information collected. I expect after this analysis, ISS may move the RPFPA into the quantitative P4P assessment in a subsequent year.

FAQ #34 If a company has not been publicly traded for at least three or five years, does the relevant quantitative pay for performance evaluation still apply? Does this affect whether a company would be used as a peer?

If a company has not been publicly traded for 5 fiscal years, the relative measures, specifically the 3-year Relative Degree of Alignment (RDA) and the multiple of pay against the ISS peer median will still apply. But if the company has been publicly traded for less than 3 years, the RDA measure will be based on 2 years of data. If less than 2 years of data is available, RDA will not be run.

ISS will generally only include a company as a peer company if it has 3 full years worth of data.

FAQ #48 What is ISS’ Problematic Pay Practices evaluation?

ISS has identified certain practices that are contrary to a performance-based pay philosophy, and evaluates these practices on a case-by-case basis:

  • Egregious employment contracts
  • New CEO with overly generous new-hire package
  • Abnormally large bonus payouts without justifiable performance linkage or proper disclosure
  • Egregious pension/SERP payouts
  • Excessive perquisites
  • Excessive severance and/or change in control (CIC) provisions:
    • CIC cash payments exceeding 3x base salary + target/average/most recent bonus
    • New or materially amended arrangements that provide for CIC payments without job loss or substantial diminution of job duties
    • New or materially amended arrangements that provide for an excise tax gross-up (regardless of whether full or modified)
    • Excessive payments upon an executive’s termination in connection with performance failure
    • Liberal CIC definition in individual contracts or equity plan which could result in payments to executives without an actual CIC occurring
  • Tax reimbursements: excessive reimbursement of income taxes on executive perquisites or other payments
  • Dividends or dividend equivalents paid on unvested performance shares or units
  • Repricing or replacing of underwater stock options/stock appreciation rights without prior shareholder approval
  • Other pay practices that may be deemed problematic in a given circumstance but are not covered in the above categories

FAQ #61 What is ISS’ policy on say-on-pay frequency?

ISS will generally recommend in favor of annual say-on-pay votes.

FAQ #63 In the event that a company does not present shareholders with a say-on-pay (SOP) vote where one would otherwise be expected, what are the vote recommendation implications?

If there is no SOP or SOP frequency vote on the ballot where one otherwise would be expected, and the company does not provide an explanation for the omission, ISS will generally recommend against the compensation committee chair (or full committee, as appropriate) until the company presents shareholders with an advisory vote on executive compensation.

FAQ #64 How does ISS evaluate the treatment of equity awards upon a change-in-control (CIC)?

Single trigger vesting of equity awards upon a CIC is viewed as a poor practice. ISS believes vesting acceleration should require both a CIC and a qualifying involuntary termination event (double trigger CIC vesting). ISS considers the potential windfall payments when evaluating equity award treatment upon a CIC. The factors ISS considers include:

  • Maintaining of vesting criteria
  • Pro rata vesting
  • The elapsed vesting period
  • Magnitude of accelerated awards

FAQ #67 How does ISS evaluate management advisory proposals seeking shareholder approval of non-employee director pay?

ISS looks for reasonable practices that adequately align the interests of directors with those of shareholders. ISS considers director pay composition, magnitude, and other qualitative features. ISS believes a director pay program should incorporate meaningful director stock ownership and/or holding requirements (i.e., at least 4x the annual cash retainer). When equity is a much larger component of director pay, the ownership and holding requirements should be more robust. ISS consider directors receiving performance-vesting equity awards, retirement benefits, or other perquisites to be a problematic practice. ISS also considers the magnitude of director pay, and the presence of a meaningful limit on annual director pay is a positive.

FAQ #68 How does ISS approach U.S.-listed companies with multiple executive compensation proposals on the ballot as a result of the company’s incorporation in a foreign country?

For U.S.-listed proxy (DEF 14A) filers that have multiple executive pay proposals on the ballot as a result of the company’s foreign incorporation, ISS will generally align the vote recommendation of the foreign compensation proposal to the U.S. management say-on-pay (SOP) recommendation so long as the foreign proposal is reasonably analogous to the SOP. Foreign Private Issuers are exempt from the U.S. SOP requirements.


Pay-for-Performance Mechanics

This document reviews ISS’s quantitative and qualitative approach to pay-for-performance (P4P) assessments.

On the quantitative P4P assessments, ISS has left the current concern thresholds that became effective February 1, 2015 unchanged:

  • Relative Degree of Alignment:
    • Medium Concern Threshold: -40
    • High Concern Threshold: -50
  • Multiple of Median:
    • Medium Concern Threshold: 2.33x
    • High Concern Threshold: 3.33x
  • Pay-TSR Alignment:
    • Medium Concern Threshold: -20%
    • High Concern Threshold: -35%

The major update for shareholders meetings on and after February 1, 2017 involves the addition of the relative pay and financial performance assessment (RPFPA). The document gives a sample of what the RPFPA disclosure will look like in the ISS proxy report.  Additionally, the Appendix gives the weightings of the various financial/operational metrics and TSR for each GICS industry group based on rank of the metric, not its exact weight.

The Appendix also details the Data Download Date for the TSR and financial/operational metrics used when ISS will conduct this analysis.

  • Shareholder Meeting Date Range -> Data Download Date
    • March 1 through May 31 -> December 1
    • June 1 through August 31 -> March 1
    • September 1 through November 30 -> June 1
    • December 1 through February 29 -> September 1

Note: Given the timing of things, ISS will use a common date for the subject company and the ISS peers, but it is unlikely to track to the company’s fiscal year end in most cases. Additionally, ISS will pull the information from the Compustat database and may not track to what a company used, especially if a company uses adjusted figures.

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Maximum Tax Withholding and Liberal Share Counting – A Deadly Combination

Note: The conclusions reached in this post are no longer valid given a clarification from ISS Research. See my blog post of January 5, 2017, Maximum Tax Withholding and Liberal Share Counting – NOT So Deadly A Combination – UPDATE,  for full details.

This past week I learned that ISS will be issuing a set of equity compensation plan FAQs that will address a new combination of share provisions in equity plans: a plan having both liberal share counting (including the adding back of shares withheld to satisfy taxes) and permitting the withholding of shares at the maximum tax rate (as the change in accounting rules now permits).

As ISS stated in its proxy report for Coach, Inc., “Moving to a maximum withholding rate would be problematic for a plan with liberal share recycling, as this would exacerbate concerns regarding diminished transparency of share usage.” [emphasis added]  So what is the consequence of this being classified as a problematic?  Well, under ISS’s Equity Plan Scorecard policy, there are certain overriding features that would cause ISS to recommend against a plan proposal.  These overriding features include:

  • Ability to reprice underwater equity awards without shareholder approval
  • Ability to conduct a cash buyout of underwater equity awards without shareholder approval
  • Liberal Change-In-Control Vesting Risk (e.g., a CIC definition that could be triggered short of consummation of the deal)
  • Equity-related pay-for-performance (P4P) disconnect, i.e., ISS finds a P4P disconnect to exist and it is mainly attributed to equity awards to the CEO and the proposed plan permits the CEO to participate
  • Equity-related problematic pay practices, which include:
    • Excise tax gross-ups in the plan
    • Reload stock options permitted by the plan
    • Ability to transfer awards for value to a third-party (see Caution on Transferable Equity Plan Provisions), and now
    • Ability to withhold taxes at the maximum tax withholding rate coupled with liberal share counting which would add back shares withheld at the maximum tax rate to the plan’s share authorization

The odd thing is that it is a complete override.  If the plan has the ability to withhold at the maximum tax rate and liberal share counting to add back shares withheld at the maximum tax rate, then regardless of whether the plan scores above the ISS threshold (currently 53 points), ISS will recommend against the plan.

So everyone that thought they could simply amend their equity plans to take advantage of the ability to withhold at the maximum tax rate and gain a little benefit from their liberal share counting provision (which would add back those shares to the plan’s share authorization) are in for a shock.  Right now, without seeing what the specific ISS FAQs say, there appears to be only two alternatives for companies to address this issue:

  • Completely remove the liberal share counting with respect to adding back shares withheld for taxes, or, slightly better,
  • Revise the liberal share counting provision to only add back shares withheld to satisfy taxes but only up to the minimum tax withholding rate– the plan could still permit withholding at the higher rate, but the shares withheld in excess of the minimum tax withholding rate could not be added back to the share authorization.

UPDATE: ISS issued its new FAQs regarding equity compensation plans this morning (December 19, 2016).  FAQ #32 deals with the issue of withholding at the maximum tax rate coupled with liberal share counting which permits shares withheld to be added back to the plan’s share authorization. The FAQ confirms the details provided above, but does not flat out state that such a combination of provisions would be viewed as a problematic pay practice that would cause ISS to recommend against a plan proposal. But, when I take FAQ #32 along with the ISS statement from its Coach proxy report (along with comments I have received from ISS Corporate Solutions),  I come to the consluion that this combination will cause ISS to recommend against a plan proposal. Hopefully ISS will clarify this portion of its Equity Plan Sscorecard policy in an update to the policies and/or the Equity Compensation FAQs. The full set of the Equity Compensation Plan FAQs can be found at: https://www.issgovernance.com/file/policy/1_u.s.-equity-compensation-plans-faq-dec-2016.pdf

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Dividend and Dividend Equivalent Plan Provisions

One important change in the 2017 ISS policy updates with respect to ISS’ Equity Plan Scorecard (EPSC) policy is with respect to dividend and dividend equivalent provisions.  Until the 2017 policy updates, ISS policy had been to recommend against equity plans that permitted the current payment of dividends or dividend equivalents on performance-based awards prior to the vesting of such awards.  The policy permitted companies to accrue such dividends and dividend equivalents and pay them out when the performance-based award vested.

Now under the 2017 ISS policies (effective for shareholder meetings occurring on or after February 1, 2017), ISS will include a new factor under the Plan Features portion of its EPSC policy that will look to see whether dividends or dividend equivalents can be paid on any award under the plan prior to the vesting of the underlying shares/award. Companies that do not prohibit the payment of dividend and dividend equivalents on all plan awards before the awards vest, will receive no points under this factor. Companies that prohibit the payment of dividends and dividend equivalents until the awards vest (and can allow for accrual of such dividends/dividend equivalents), will receive full points under this factor. Because the ISS policy permit for the accrual of dividends and payment when the award vests, many companies will view complying with this prohibition to gain the points under the EPSC policy will make sense, and may enable them to gain a few additional shares in their request everything else being equal.

ISS has not yet released its FAQs on the new EPSC policy, but I expect that the FAQs will indicate that the old dividend/dividend equivalent policy with respect to performance-based awards has been supplanted by the new EPSC factor and anything less than a complete prohibition of the payment of dividend/dividend equivalents on all unvested awards will not provide any points under the EPSC policy.

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Caution on Transferable Equity Award Provisions

As companies begin to get their equity plan proposals ready for the 2017 proxy season, it is an appropriate time to review those equity plan proposals to see if they contain or permit the transfer of equity awards to third parties for value, e.g., the ability of participants to sell stock options to an unrelated investor, such as was done at Microsoft in 2003. If companies review ISS’s Equity Plan Scorecard Policy, there is not a specific mention of any concern over transferable stock awards.  Instead, companies need to review the ISS policy on Transferable Stock Option (TSO) Programs.  Under that policy, ISS indicates that it will recommend against equity plan proposals if the details of an ongoing TSO program are not provided to shareholders.

This is significant because the specific criteria that ISS expects companies to detail are not those ordinarily include in a typical equity plan proposal seeking shareholder approval of a new or amended equity plan, and include, but are not limited to, the following:

  • Eligibility
  • Vesting
  • Bid-price
  • Term of options
  • Cost of the program and impact of the TSOs on a company’s total option expense, and
  • Option repricing policy.

If a company’s equity plan provides for the transferability of equity awards to third parties, and the above TSO disclosure are not made (which ISS will then evaluate on a case-by-case basis), then the company can expect a negative ISS vote recommendation on their equity plan proposal even if they have run the ISS Equity Plan Scorecard model and believe the plan will pass muster.

Source: ISS United States Proxy Voting Manual, 2016 Benchmark Policy Recommendations, Effective for Meetings on or after February 1, 2016, Published February 23, 2016,  p. 187

This very scenario just played out at Thor Industries, Inc. Thor had an equity plan proposal in its proxy filed October 27, 2016 (https://www.sec.gov/Archives/edgar/data/730263/000119312516748833/d251706ddef14a.htm#tx251706_29 ) that provided for transferability of equity awards to third parties (see Section 6.6 of the Thor Industries, Inc. 2016 Equity and Incentive Plan). “A Nonstatutory Stock Option may, in the sole discretion of the Administrator, be transferable to a permitted transferee, as hereinafter defined, upon written approval by the Administrator to the extent provided in the Option Agreement.” The plan goes on to define permitted transferree to include “(b) third parties designated by the Administrator in connection with a program established and approved by the Administrator pursuant to which Participants may receive a cash payment or other consideration in consideration for the transfer of such Nonstatutory Stock Option.” [emphasis added]

As a result of this language, ISS found that the proposed plan permitted the transfer of stock options to financial institutions without prior shareholder approval.  ISS classified this as a problematic equity-related provision under its list of overriding features and practices.  As a result, even though the plan scored sufficient points under the ISS Equity Plan Scorecard to warrant ISS support, ISS nevertheless recommended against the proposed plan in its November 22, 2016 report. Thor announced it would amend its proposed equity plan to remove this transferability feature (https://www.sec.gov/Archives/edgar/data/730263/000114420416136370/v453873_defa14a.htm) and then filed the updated proxy with the amended proposed plan that had removed this transferability feature on November 28, 2016 (https://www.sec.gov/Archives/edgar/data/730263/000119312516777872/d301535ddefa14a.htm). Then on November 29, 2016, ISS released an updated Proxy Report Alert in which it changed it recommendation to support Thor’s proposed equity plan.

The odd thing in all this? None of Thor’s current named executive officers hold any stock options and stock options are not part of the long-term incentive program disclosed for fiscal 2016. This case serves as a good reminder to check equity plans being taken to shareholders to ensure that they do not permit such TSO programs without shareholder approval.

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Equity Plan Proposal Failures of the S&P 1500: 2014-2016YTD

Using the ISS Voting Analytics database, I recently looked at failed equity plan proposals at S&P 1500 companies to see how this group of companies fared during the past 3 years and found the failure rate was less than 1% (and generally less than 0.3% in the two most recent years). 



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