RiskMetrics issued its 2010 Policy Updates on November 19. The interesting thing is that there aren’t that any significant policy changes for 2010. I view the 2010 policy updates as more of a refinement of the existing policies than a dramatic evolution. That being said, the trouble as many folks know, is often in the details. Interestingly, RiskMetrics issued its Frequently Asked Question on U.S. Compensation on the same day, and, unfortunately, some of the responses to the questions posed are significant changes from prior understandings of how the RiskMetrics’ policies operated.
First, let’s review the U.S. Corporate Governance Policy 2010 updates for Compensation. The 2010 Policy Updates will apply to all shareholder meetings on or after February 1, 2010. RiskMetrics is combining three of its existing policies into a new framework to provide a more integrated and holistic Executive Compensation Evaluation Policy. This new policy will combine RiskMetrics’ prior considerations regarding (1) pay-for-performance, (2) pay practices, and (3) board responsiveness and communication on compensation issues. Along with this re-structuring RiskMetrics will re-order the Compensation Section of its Voting Manual into four policy areas:
- Executive Pay Evaluation,
- Equity-Based and Other Incentive Plans,
- Director Compensation, and
- Shareholder Proposals.
Additionally, RiskMetrics is making a few tweaks to the existing policies that will underlie the Executive Pay Evaluation policy. These key changes are as follows:
- Pay-for-Performance – RiskMetrics will now consider the alignment of a CEO’s total direct compensation (TDC) and total shareholder return (TSR) over a period of at least five years. As is currently the case, the first portion of this policy looks at a company’s one- and three-year TSR versus its four digit GICS industry group’s medians. If a company’s one- and three-year TSR bothare below its industry group median, then RiskMetrics will now look to see if the CEO served in that position for at least two consecutive fiscal years, and, if so, whether his/her TDC is aligned with the company’s TSR over time, including both recent (1- and 3-year periods) as well as long-term (at least 5 years) periods. Furthermore, RiskMetrics will consider the mix of performance-based compensation to total compensation. But RiskMetrics did not indicate how this consideration will be weighed or factor into its analysis. RiskMetrics’ draft policies indicated that it is no longer simply a matter of ensuring that a CEO’s pay has not increased in order to avoid application of the policy. Companies now must consider cases where the CEO’s compensation remained the same or even decreased slightly if the company’s one- and three-year TSR were both below its industry group medians. RiskMetrics has not offered much guidance on what level of decrease will avoid application of the policy.
- Problematic Pay Practices – RiskMetrics will now re-order how it will express displeasure with a company having problematic pay practices. If a company maintains a problematic pay practice(s), RiskMetrics will generally: (1) first vote AGAINST a management say on pay (MSOP) proposal, (2) then AGAINST/WITHHOLD on compensation committee members in (i) egregious situations, or (ii) when no MSOP item is on the proxy, or (iii) when the board has failed to respond to concerns raised in prior MSOP evaluations; and/or (3) AGAINST an equity-based incentive plan proposal if excessive non-performance-based equity awards are the major contributor to a pay-for-performance misalignment.
RiskMetrics has indicated that certain adverse practices carry more weight on a stand-alone basis in its evaluation, and may result in negative recommendations on a stand-alone basis, i.e., “problematic pay practices,” which include:
- Multi-year guarantees for salary increases, non-performance based bonuses, and equity compensation;
- Including additional years of unworked service that result in significant additional benefits, without sufficient justification, or including long-term equity awards in the pensions calculation;
- Perquisites for former and/or retired executives, and extraordinary relocation benefits (including home buyouts) for current executives;
- Change-in-control payments exceeding three times (3x) base salary and target bonus;
- Change-in-control payments without job loss or substantial diminution of duties (“Single Triggers”);
- New or materially amended agreements that provide for “modified single triggers” (under which an executive may voluntarily leave for any reason and still receive the change-in-control severance package);
- New or materially amended agreements that provide for an excise tax gross-up (including “modified gross-ups”);
- Tax reimbursements related to executive perquisites or other payments such as personal use of corporate aircraft, executive life insurance, bonus, etc.;
- Dividends or dividend equivalents paid on unvested performance shares or units;
- Executives using company stock in hedging activities, such as “cashless” collars, forward sales, equity swaps or other similar arrangements; or
- Repricing or replacing of underwater stock options/stock appreciation rights without prior shareholder approval (including cash buyouts and voluntary surrender/subsequent regrant of underwater options).
[see the FAQ section below for information on “minor” problematic pay practices.]
RiskMetrics announced that it will also assess company policies and practices related to compensation that could incentivize excessive risk-taking, including:
- Guaranteed bonuses;
- A single performance metric used for short- and long-term plans;
- Lucrative severance packages;
- High pay opportunities relative to industry peers;
- Disproportionate supplemental pensions; or
- Mega annual equity grants that provide unlimited upside with no downside risk.
RiskMetrics has indicated that some factors that potentially mitigate the impact of risk incentives are rigorous claw-back provisions and robust stock ownership/holding guidelines.
Equity-Based and Other Incentive Plans
In the area of equity-based and other incentive plans, RiskMetrics has tweaked its policies regarding volatility and the stock price used in its Shareholder Value Transfer (SVT) and Burn Rate analyses. Last year in the face of the steep market decline, RiskMetrics announced that for the December 1, 2008, March 1, June 1, and September 1, 2009 quarterly download dates it would use the 400-day volatility and the 90-day average stock price for the SVT and burn rate policies. For the December 1, 2009 and subsequent quarterly data download dates (which means this will apply to companies having their next shareholder meeting on or after February 1, 2010), RiskMetrics announced it will revert to using the 200-day volatility and 200-day average stock price. Given the volatility in the stock markets last fall and again this year, most companies will be evaluated using a significantly higher volatility. This will cause companies’ outstanding stock options, even those that are underwater, to carry a higher valuation, as well as any shares available for grant and any newly requested shares grantable as stock options. This higher valuation for stock options will limit the size of acceptable share proposals for most companies in 2010 compared to what they would have been able to achieve using the 400-day volatility and 90-day stock prices.
RiskMetrics also updated its Burn Rate Table for 2010, which is detailed on page 28 of the U.S. Corporate Governance Policy, 2010 Updates (November 19, 2009).
RiskMetrics’ Compensation FAQs
RiskMetrics also released its 2010 Corporate Governance Policy Updates and Process, Frequently Asked Questions on U.S. Compensation (November 19, 2009). As mentioned previously, the FAQs are where some real changes got introduced for 2010.
The first group of questions (designated with a number, i.e. Q1.#, in the PDF version only) all involve the newly introduced Executive Compensation Evaluation policy. These questions and answers (Q&As) give some guidance on how RiskMetrics will apply this new policy analysis.
In Q1.4, RiskMetrics lists additional problematic pay practices that may receive a withhold/against vote recommendation or cautionary language upon a case-by-case analysis. This list expands the list consolidated into the new Executive Compensation Evaluation policy. The way I read it, none of these practices standing alone generally would be sufficient to trigger a withhold/against vote recommendation, unlike the practices detailed in the 2010 Policy Updates which could. Of course, in cases where a company has a history of problematic practices or does something RiskMetrics views as an egregious compensation practice, I’d imagine that RiskMetrics could apply the against/withhold vote recommendation if even a single one of these more “minor” problematic practices was present.
Q1.7 addresses how companies might be able to overcome an against/withhold vote recommendation on their compensation committee or a negative recommendation for their MSOP or equity plan proposal on the basis of a CEO pay for performance disconnect. RiskMetrics indicates that any action to try and overcome such a vote recommendation must be tailored according to the underlying issues identified in RiskMetrics’ analysis, and should be a recommitmet/commitment to performance. Examples of the types of underlying issues RiskMetrics could identify and how they might be overcome in a performance commitment are:
- The primary source of pay increase is due to time-vested equity awards, a renewed commitment could be for a company to commit to making a substantial portion (at least 50 percent of the shares awarded) of equity awards to named executives officers performance-based.
- The primary source of pay increase is due to discretionary bonus, a renewed commitment could be to award only performance-based bonuses.
RiskMetrics also indicates that companies making such commitments should be sure to disclose the performance measures and goals, including at least the following:
- the measure(s) used (and rationale for the selections);
- the goal(s) that were set for each metric and the target (and, if relevant, threshold and maximum) payout level(s) set for each NEO;
- the reason each goal was determined to be appropriate for incentive pay purposes (including the expected difficulty of attaining each goal);
- the actual results achieved with respect to each goal; and
- the resulting award (or award portion) paid to the NEO with respect to each goal.
RiskMetrics clarifies that the actual performance results and the resulting award do not need to be disclosed until the performance cycle is complete
Qs2.3-2.8 deal with how RiskMetrics will apply its stock option carve-out policy. Basically, prior to this guidance, this policy was generally thought to provide that if stock options have been outstanding for more than 6 years and are in-the-money, RiskMetrics might exclude such stock options from its SVT analysis for a new share proposal if certain additinal information was disclosed in the proxy proposal concerning these and other outstanding stock options. Among other things, these Q&As place the following constraints on companies ability to use the stock-option carve out exemption:
- Companies must have sustained positive stock performance, i.e., positive 5-year TSR as well as positive year over year performance for the past five fiscal years at the time of the analysis. Exceptions may be made if TSR was negative for the first two years and then strongly positive for the remaining three years, but vested grants that were underwater for a substantial time during the five years are not eligible for the carve-out.
- Companies must have high overhang costs attributable to in-the-money options outstanding for more than six years. High overhang cost means that the sum of outstanding stock options and stock awards and remaining shares available under existing equity plans should exceed or approach a company’s specific allowable cap, and that outstanding stock options and stock awards must be a significant driver of the high overhang, i.e., in the range of 75 to 100 percent of the total overhang. I’m assuming this means that the SVT attributed to the outstanding stock options and stock awards must be 75% to 100% of a company’s allowable cap.
- The dilution caused by any new share request must be reasonable. However, RiskMetrics has not offered any guidance on what would be considered a reasonable amount of dilution in this context.
When a company wants to try and utilize the stock-option carve-out policy exception, it should keep in mind that this is applied by RiskMetrics on a case-by-case basis. RiskMetrics has also indicated that simply stating the number of stock options that have been outstanding for more than six years and are in-the-money is insufficient. Instead, companies should disclose much more information about such options as well as additional information about all the other outstanding stock options in order to enable RiskMetrics to assess whether and how the policy might be applied. As an example of the type of information that it is looking for, RiskMetrics cited Myriad Genetics’ DEFA 14A filed October 28, 2009.
In analyzing whether the stock option carve-out policy should be applied, RiskMetrics will look at a company’s concentration ratio for equity awards, i.e., the total equity grants to the top five executives divided by total equity grants to employees and directors. Concentration ratios greater than 50 percent to NEOs could concern RiskMetrics. Finally, RiskMetrics heads off further questions and requests for exceptions for application of the policy for companies that may not have experienced positive TSR lately. RiskMetrics believes that strong performing companies have experienced significant market rebound and should reflect that the stock price decline is temporary.
In Q2.9, RiskMetrics addresses a timing issue some companies may have with compensation decisions and RiskMetrics’ Pay for Performance policy. Specifically, if a company makes equity grants near the beginning of a year based on an evaluation of the company’s and/or an executive’s performance in the immediately preceding year, such equity grant information then appears in the following years’ proxy (because the proxy disclosure rules dictate that only equity awards granted in the year covered by the proxy are to be included). The question some companies have faced is whether RiskMetrics will take into account the timing og such equity awards and make adjustments to the top executives’ total compensation when conducting its pay-for-performance analysis? RiskMetrics may consider the timing of equity awards at the beginning of a fiscal year if complete disclosure and discussion is made in the proxy statement about such awards. But, RiskMetrics cautions that such additional information needs to be provided in a shareholder-friendly manner, such as through an alternative Summary Compensation Table that reflects compensation payable based on performance achieved for the year and including details of the equity awards granted after the end of the fiscal year covered by the proxy tables.
As you can probably tell, there are still a few details to be worked out with these new policies and revisions. Hopefully RiskMetrics will issue some additional guidance (or more FAQs) addressing these ambiguous issues to help give issuers more certainty about how RiskMetrics will apply its policies going forward.
The revised 2010 compensation policies coupled with the FAQs for 2010 generally will mean more companies will run afoul of these policies, fewer companies will be able to take advantage of the small exceptions that do exist, and companies overall will see lower share authorizations that pass the SVT model (if they do at all). Finally, these trends coupled with the decline in equity grants during 2009 will most likely lead to lower SVT allowable caps for the 2011 proxy season. Of course, RiskMetrics may also introduce new requirements for the 2011 proxy season, which could further exacerbate the difficulties companies face in requesting shareholder approval of additional shares for equity compensation plans in 2011.