RiskMetrics’ Draft 2010 Policy Updates

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Last week RiskMetrics (RMG) released its Draft 2010 Governance Policy Updates.  These can be found at:


RMG is taking comments on these draft policy updates through November 11, 2009.

The draft US policy updates include possible revisions to the following policies:

  • Adoption or Renewal of Non-Shareholder Approved Pills
  • Director Independence
  • Long-Term Pay for Performance Alignment
  • Pay Riskiness

Adoption or Renewal of Non-Shareholder Approved Pills
RMG is suggesting the following changes to this policy:

  1. Clarify that short-term pills (those with a term of 12 months or less) adopted without shareholder approval will cause RMG to consider the recommendation for director elections on a CASE-BY-CASE basis taking int account certain specified factors. Additionally, any long-term pills (those with a term of more than 12 months) adopted or renewed without shareholder approval will cause RMG to recommend a WITHHOLD/AGAINST vote on the full board of directors (except new nominees, who will be considered on a CASE-BY-CASE basis).
  2. RMG will review companies that adopt long-term pills at least once every three years and may recommend (or continue to recommend) that shareholders vote AGAINST or WITHHOLD votes from the entire board if the pill is still maintained.
  3. Clarify that if a board makes a material, adverse change to an existing poison pill without shareholder approval, RMG will recommend an AGAINST or WITTHOLD vote for the directors.

Director Independence

  1. RMG proposes to bifurcate the materiality test it applies (currently applies the NASDAQ-based materiality test) on transactional relationships, so that companies that follow NYSE listing standards will be subject to the NYSE-based test of the greater of $1 million or 2% of the recipient’s gross annual revenues, and that non-NYSE listed companies will continue to be subject to the NASDAQ-based test of the greater of $200,000 or 5% of the recipient’s gross annual revenues.
  2. RMG is proposing to define “professional services” as “advisory in nature, generally involving access to sensitive company information or to strategic decision-making, and typically have a commission or fee-based payment strusture.”

Pay for Long-Term Performance Alignment
RMG is proposing to slightly modify its Pay for Performance Policy that is applied to equity compensation plan proposals to determine if there is a disconnect between CEO pay and company performance (measured by 1- and 3-year TSR compared to the company’s 4-digit GICS industry group’s medians):

  1. RMG wants to modify the policy so that a company can be identified as having a potential pay-for-performance disconnect if it has unchanged or marginally decreasing CEO pay in conjunction with below-industry-median 1- and 3-year TSR.
  2. Furthermore, when further analyzing companies after finding a potential disconnect exists (i.e., the company’s 1- and 3-year TSRs are below their industry group’s medians), RMG want to assess the alignment of the CEO’s total direct compensation and total shareholder return over a period of at least 5 years.

Comment: If these policy changes are implemented, many more companies will be found to have a disconnect between their pay and performance. It is not clear what would constitute “marginally decreasing” CEO pay, so it is a bit difficult to offer specific comments.  On a relative basis, one might think that this could refer to some type of de minimis decline in pay, but without guidance as to where the line will be, it is impossible to get an idea of how this policy change could impact companies.  If, for example, RMG decides that a decline of 15% or less is “marginally decreasing” I’d imagine many companies could be pulled into a further review under this policy.

As for exapnding the period used to see if there has been a disconnect between CEO pay and company performance to at least 5 years, I think this may prove troublesome for some companies. What would RMG do if the CEO had not been in that position for the past 5 years?  Would the policy not apply? Or, would RMG use whatever data is available? I’d argue that in such a case the policy should not be applied since the CEO has not been there for the performance period. Based on how this policy change is described, it appears that the initial screen would still be 1- and 3-year TSR, and you’d only get to look at 5 year performance if the first screen was failed.

Pay Riskiness
RMG is proposing to address pay riskiness in its policies (not currently done).  RMG is proposing the inclusion of an assessment of company pay practices that may incentivize inappropriate risk-taking under the overall executive compensation evaluation of “problematic pay practices” policy. RMG indicates that such practices could include, but not limited to, guaranteed bonuses, single performance metric used for short- and long-term plans, high severance packages or high pay opportunities relative to industry peers, mega annual equity grants and disproportionate level of supplemental pensions. Additionally, RMG will take into account mitigating factors, such as rigorous claw-back provisions and robust stock ownership/holding guidelines.

Comment: The pay riskiness comments are somewhat unsettling given the early nature of risk assessments as applied to compensation generally.  I don’t know that there is sufficient data or generally acceptable practices as far as riskiness of pay is concerned.  Additionally, while RMG has indicated some mitigating factors it will take into account, it is unclear what practical steps companies will be able to undertake to avoid being branded as risky payers. If concern of being stuck with that moniker is wide-spread, we might end up in a situation where compensation practices that serve the attainment of legitimate corporate strategic goals could be discarded entirely due to the perception of such practices.  Such a rush to judgment may not be warranted and could hurt companies (and their shareholders) trying to craft compensation policies and programs that serve their corporate strategic goals. Assuming RMG includes this as a narrative piece of its proxy analysis and this does not control any vote recommendation, the policy would be more palatable, but RMG will need to work on developing a sound and well-explained and supported rationale for labeling certain pay practices as risky and should provide for exceptions when such practices can and should be undertaken by companies in the pursuit of their goals.

Open Issues

What About the Tax Gross-Up Policy?
As you may recall, this past proxy season, RMG announced a revision to its poor pay practices policy that indicated that if a company adopts a change-in-control or severance arrangement that provides an excise tax gross-up, RMG would consider that a poor pay practice and could recommend against the CEO, Compensation Committee, or the entire board.  RMG applied this policy to a number of companies in 2009 that adopted or renewed contracts or arrangements that contained excise tax gross-ups.  Some companies eliminated these provisions entirely to avoid the policy while other companies committed to not adopting any new agreements with such provisions.

However, I’ve heard from several folks that RMG may be issuing a clarification of this policy for 2010 that will indicate that the policy only applies to the election of directors in the year after a company adopts, renews or modifies an agreement or arrangement containing an excise tax gross-up provision, and that in the subsequent years, the policy will not be applied to the election of directors unless the company subsequently adopts, amends or renews an agreement or arrangement with such a provision.  If this is the case, then the policy is a bit more manageable and companies’ board might decidethat from a business-perspective they want their executives to have an excise tax gross-up and that they’ll take their lumps in the following year’s elections, but thereafter would not have to worry about the policy until another agreement or arrangement with such a provision is adopted, amended or renewed. I don’t know for certain that this policy will be released.  But if it is, it will definitely provide something for companies to contemplate when trying to figure out a response to WITHHOLD/AGAINST director vote recommendations from RMG for violation of the poor pay practices policy due to an excise tax gross-up.

What about companies that reincorporated to Switzerland?
Will such companies, even though primarily traded on US exchanges and markets, still be subject to RMG’s International Proxy Voting Guidelines? RMG Research changed to this policy early this year, and a number of folks – issuers and institutions — were a bit upset.  Consequently, the final 2010 Corporate Governance Updates might address the Switzerland reincorporation issue.  RMG left that possibility open in the last FAQ it posted about the topic back in April 2009:


Disturbing Trends from RiskMetrics’ Model

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Well, I’ve now seen enough RiskMetrics (RMG) models after the 9/1/2009 quarterly lock-in date that I can tell you that there is trouble brewing.

First, the valuation of stock options (and SARs) under RMG’s binomial option pricing model has climbed dramatically in relation to the stock price.  Just what exactly do I mean by that??? Well, what we’re talking about is the economic value assigned by the RMG model to shares available for grant as stock options under new or existing and continuing plans.  Primarily due to the surge in volatility both in late 2008 and then again through 2009 as the market regained 10,000, the value generated by the binomial model has grown. Volatility is one of the key inputs into the binomial model and as it increases, so does the value of the stock option.

OK, so how bad are things looking? Well, based on the companies I’ve worked with so far, I have yet to see a company where one full value award (an award other than a stock option or SAR that is settled with shares) equaled 2 or more stock options.  Put another way, in all the companies I’ve seen so far, less than 2 stock options equal the value of one full value award (which is set at the 3 month closing stock price). Note that last year, seeing this equation at just 2 stock options equal to 1 full value award was almost unheard of, the vast majority of companies’ had 2+ stock options equal 1 full value award.

In practical terms, as the value of stock options has grown (on a relative basis compared to the stock price) the number of new shares that companies can get approved under the RMG model has dropped. So many companies are in a real share squeeze under the RMG model, that I think RMG will be forced to make some major concessions again this year and tweak the operation of its policies in order to avoid the loss of credibility.

Last year, as you’ll recall, as a result of the precipitous stock price decline of many companies, RMG revised its methodology for determining volatility and stock price:

  • Volatility – prior to 12/1/08 RMG used the 200-day volatility, annualized in its model. After 12/1/08, RMG used the 400-day volatility, annualized in the model.  This change helped by generally lowering volatility (but volatility still increased compared to that measured on 9/1/08).
  • Stock Price – prior to 12/1/08, RMG used the 200-day average closing stock price. After 12/1/08, RMG used the 3-month closing average stock price. This generally caused companies to have lower market values under the model, and helped lower the valuation of stock options and full value awards alike.

I’ve heard a rumour that RMG might be looking at pushing out the period of time it uses to measure performance from 3 years to 5 years.  It is unclear which of the many performance measurements this would impact, but it could include: the 3-year TSR performance used within each4-digit GICS industry group to help determine the top quartile performers upon which RMG bases its regression formulas for determining companies’ allowable caps; it could be the performance measured in the pay for performance policy (1- and 3-year TSR compared to 4-digit GICS industry median); or something entirely different. Apparently RMG received feedback from the survey it conducted this past summer that indicated a number of its clients regarded 5 years as the proper measure of long-term performance.

Even if this change does not get made, RMG still must determine what to do concerning the stock price and volatility.  Last year when RMG modified the way it calculated these figures, it indicated that it would revisit them in a year and determine what it would do, i.e., keep the new methodology, return to the old methodology, or, perhaps, do some further modifying of things (the last is only my speculation at this point).  We’ll have to wait until RMG releases its policy updates (hopefully the week before Thanksgiving this year) to see just exactly what will change, but I bet that the methodology for determining these and other figures must change or RMG could be in a position where its model would otherwise recommend against the majority of companies, instead of just the 30% or so of proposals that it tries to target for failing the model. So stay tuned, as new developments come in, I’ll blog about them here.

Second, the allowable caps being generated by the model when coupled with the high amounts of overhang at many companies are causing much pain when it comes to seeking additional shares.  In many cases companies could not even pass with the shares they currently have available.  In other words, most companies are looking at not being able to get any additional shares and have the RiskMetrics model approve of the share request. I have dealt with some that the model would permit to get additional shares, but for the most part, the amounts that pass the model are down from prior years. Specifically, in my experience, the 15% simple dilution threshold often was far below the shares that the RMG model would approve.  Now the reverse is true.  This puts companies in a precarious position – they’re unable to ask shareholders to approve shares with a proposal that will receive a FOR vote recommendation from RMG.  What to do? There are a number of strategies to consider.  I will discuss several of the more significant ones at the upcoming NASPP conference in San Francisco with a panel of other experts in our presentation, Top Tips to Ensure Shareholder Approval of Your Stock Plan (on November 10 at 2:00 pm local). For more information about the NASPP conference, please visit: www.naspp.com

Next week I’ll take a look at some of the plan features that can cause problems with RMG, as well as some of the other policies you should be aware of for the 2010 proxy season.


Launching 9/8/2009!

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Best regards,
Ed Hauder