November 20, 2005
On Friday, November 18, Institutional Shareholder Services (ISS), a leading proxy advisory firm, released its U.S. and international corporate governance policy updates for the 2006 proxy season. With ISS’s permission, a copy of the ISS U.S. Corporate Governance Policy 2006 Updates (2006 Policy Updates) is available with this client alert through the following link: ISS U.S. Corporate Governance Policy. Among other new policy positions:
ISS will consider recommending a vote "Against" a shareholder proposal seeking implementation of a majority voting standard in the election of directors if a company has adopted a corporate governance principle that addresses certain key points and the company satisfies other criteria.
ISS will factor in long-term stock price performance when determining voting recommendations on director nominees in uncontested elections.
ISS will consider recommending "Withhold" votes from director nominees who serve on audit committees where the company has serious internal controls issues and from nominees who serve on compensation committees where the company has poor compensation practices. ISS is also encouraging compensation committees to include "tally sheet" or other total compensation disclosures with respect to CEO compensation.
Also on November 18, Mr. John Connolly and Dr. Martha Carter, ISS’s President and CEO and its Senior Vice President and Director, U.S. Research, respectively, discussed the 2006 Policy Updates at an American Bar Association meeting in Washington, D.C. This client alert reviews the most significant policy updates, reflecting commentary from ISS, and briefly addresses recent revisions to the ISS Corporate Governance Quotient, as well as recommended practice points.
Shareholder Proposals on Majority Voting Standards
Majority Voting Policies: For 2006, ISS will generally support "reasonably crafted" shareholder proposals (regardless of whether binding or non-binding) asking a company to implement a majority voting standard in uncontested director elections. However, ISS will consider recommending votes "Against" this type of shareholder proposal if the company has adopted formal corporate governance principles that "present a meaningful alternative to the majority voting standard and provide an adequate response to both new nominees as well as incumbent nominees who fail to receive a majority of votes cast." At a minimum, such principles should:
apply to each nominee in an uncontested election who fails to receive affirmative votes of a majority of the votes cast in the election (i.e., not a majority of outstanding shares standard);
contain guidelines that are disclosed annually in the company’s proxy statement;
provide a clear and reasonable timetable for all decision-making regarding the status of a nominee who does not receive a majority vote;
state that the process for determining the nominee’s status will be managed by independent directors, excluding the nominee in question;
detail the range of remedies that can be considered concerning the nominee (e.g., accept a resignation from the nominee, cure issues underlying the voting results, etc.);
commit to prompt disclosure of the nominee’s status via an SEC filing; and
describe the timeline for disclosing the directors’ decision regarding a nominee’s status and explaining how the decision was reached.
The ISS representatives emphasized that the new policy is intended to be flexible (as opposed to a "check the box" approach), that ISS is not endorsing any one company’s policy or approach and that it is very important for a company to explain why any policy it adopts is appropriate for that company. The 2006 Policy Updates reflect this last point where they state that "In addition, the company should articulate to shareholders why this alternative [implementing a corporate governance policy on majority voting as opposed to changing the voting standard] is the best structure at this time for demonstrating accountability to shareholders." Finally, in considering its voting recommendation, ISS will also evaluate the company’s accountability to shareholders, including whether it has a classified board or a history of not responding to shareholder proposals that received a majority vote.
Voting Recommendations on Director Nominees
Performance Test for Directors: ISS will determine on a case-by-case basis whether to recommend "Withhold" votes from directors at a company where weighted one-, three- and five-year total shareholder return is at the low range within the company’s industry peer group. In evaluating the voting recommendation for nominees at such companies, ISS will take into account:
any performance improvement in the current year;
changes in management or board composition;
recent transactions at the company;
the company’s overall governance practices; and
the company’s financial health.
Overboarded Directors: ISS will continue to recommend "Withhold" votes from a director who serves both as a CEO of a publicly-traded company and on more than three public company boards (including his or her own company’s board), but will only make that recommendation with respect to the CEO’s service on other company’s boards. ISS will also continue to recommend "Withhold" votes from any director nominee who is not an active CEO and serves on more than six public company boards.
Director Independence Definition: ISS categorizes directors as "inside directors," "affiliated outside directors" or "independent outside directors" and applies these categories for various purposes in its voting recommendations. For example, ISS will recommend "Withhold" votes from director nominees it classifies as "affiliated outside directors" if such directors serve on a company’s audit, compensation or nominating committee. ISS updated its definition of an "affiliated outside director" to include:
an interim CEO who served longer than 18 months (if such service lasted between 12 and 18 months, ISS will assess the interim CEO’s employment agreement);
one of the company’s founders; and
a nominee with "[a]ny material financial tie or other related party transactional relationship to the company."
Director Term Limits: When making voting recommendations on director nominees, ISS will now include "cautionary language" in its voting recommendation report if the average tenure for the entire board exceeds 15 years.
Failure to Respond to Shareholder Proposals that Receive Majority Support: ISS recommends "Withhold" votes from incumbent director nominees at companies who have ignored a shareholder proposal that either (i) was approved by a majority of the votes cast for two consecutive years, or (ii) was approved by a majority of the shares outstanding at the last shareholders’ meeting. Some companies have attempted to avoid the ISS recommendation by proposing action to implement the shareholder proposal but not recommending that shareholders vote for the action. ISS clarified that this approach will not avoid a "Withhold" recommendation.
Audit Committee Members
Companies with Internal Controls Problems: In considering whether to recommend "Withhold" votes from directors who serve on a company’s audit committee, ISS will assess on a case-by-case basis whether the company is one where (i) a material weakness in internal controls over financial reporting rises to a level of a "serious concern," (ii) there are "chronic" internal control issues, and (iii) there is an "absence" of established effective control mechanisms.
Compensation Committee Members
"Poor" Compensation Practices: ISS will recommend "Withhold" votes from directors who serve on a company’s compensation committee (and, if applicable, may recommend votes "Against" an equity compensation plan proposal), if the company has poor compensation practices. ISS representatives indicated that its clients have expressed an almost universal concern over executive pay practices and that, while many shareholders wish to defer to directors’ determinations as to how best to structure compensation, the shareholders believe they must become proactive against abusive pay. ISS notes that poor disclosure of compensation practices compounds the problem of excessive pay. ISS’s non-exclusive list of "poor" pay practices includes:
egregious employment/severance agreements;
excessive perks that dominate compensation;
huge bonus payouts not sufficiently linked to performance;
performance metrics that are changed during the performance period;
egregious Supplemental Executive Retirement Plan (SERP) payouts;
a new CEO with an overly generous new hire package; and
internal pay disparity.
Tally Sheets for CEOs: While not adopting a formal "Withhold" vote policy, ISS is "strongly encouraging" companies to disclose "tally sheet" or other total compensation information on the CEO’s pay. The disclosure should itemize base salary, stock options, restricted stock, performance shares, deferred compensation, SERPs, perquisites, tax gross-ups, various forms of severance and any post-retirement pay package. ISS’s 2006 Policy Updates include an example of the items that might be covered by a "tally sheet." Although this sample tally sheet reflects the difficulty in developing a uniform "total compensation" calculation by encompassing both grant and payout valuations, the ISS representatives stated that they are sensitive to concerns about double-counting. For those companies that do not meet a minimum standard of tally sheet disclosure, ISS will note the deficiency and provide cautionary language in its voting recommendation report.
Company Compensation Proposals
New Voting Criteria: In considering whether to recommend votes "For" an equity compensation plan, ISS will no longer evaluate voting power dilution under the plan and instead will measure plan cost only through the ISS Shareholder Value Transfer (SVT) calculation. ISS will view the ability to provide dividend equivalent rights under a plan as increasing SVT. ISS has also made it easier for a company with a high burn rate to nevertheless obtain a "For" recommendation on an equity plan proposal by committing to lower the burn rate in the future. In addition, ISS will not apply its burn rate standard to certain types of plan amendments.
Treatment of Transferable Stock Options (TSOs): ISS expects that companies may increasingly implement, on either a one-time or an on-going basis, a program that permits options to be transferred for value to a third party (along the lines of the option transfer program that Microsoft announced in late 2003). ISS will recommend "Withhold" votes from compensation committee members if they fail to seek shareholder approval of a one-time TSO program. On the other hand, ISS will recommend votes "For" a one-time TSO program if it meets certain standards (including that executives and directors not be able to participate), and it will not recommend votes against a stock plan or plan amendment solely on account of a TSO feature.
Other Types of Company Proposals
ISS’s 2006 Policy Updates include new and/or revised voting policies on company proposals to ratify poison pills, to increase the authorized number of shares of common stock and to engage in a transaction that will allow the company to cease to be an SEC reporting company ("going dark" transactions).
Voting Policies on Shareholder Proposals
ISS also announced new and/or revised voting policies on a variety of shareholder proposals, including cumulative voting proposals, proposals seeking to restrict or eliminate poison pills, and proposals on a number of corporate responsibility issues. The latter include statements on when ISS will recommend a vote against proposals on disclosure of political contributions and proposals addressing policies on nuclear safety, toxic chemicals, drug reimportation, animal testing and drug pricing.
ISS Corporate Governance Quotient (CGQ)
The ISS CGQ is a benchmarking tool that rates the corporate governance structures and policies of nearly 7,500 companies worldwide. Covered companies receive two scores in percentiles relative to the scores of other covered companies in their index and industry groups, respectively. A covered company’s CGQ scores are posted on Yahoo! Finance and are featured on the front of each company’s ISS proxy analysis issued in advance of the company’s shareholders’ meeting.
ISS revised the CGQ in June 2005 and, as a result, many company CGQ scores decreased. For example, companies no longer receive CGQ points for having a lead independent director, but a company will receive additional CGQ points if it commits to conduct individual director performance reviews annually and includes only financial experts on its audit committee. Moreover, CGQ scores fluctuate as companies in an index or peer group revise their corporate governance practices. We encourage companies to check their CGQ scores, to consider what, if any, changes in their corporate governance practices are appropriate and to reflect those changes in their proxy or governance policies.
The ISS 2006 Policy Updates reflect significant feedback from ISS’s clients, from the corporate community and from others. They reflect increased focus from institutional shareholders on board governance and director independence issues and on executive compensation practices. At the same time, ISS has stated that an increasing number of its institutional shareholder client base – particularly the largest institutional shareholders – have implemented or are working with ISS to implement customized voting guidelines that reflect particular concerns of the client’s proxy voting committee. The ISS representatives indicated that in some cases these policies apply stricter standards than are reflected in the 2006 Policy Updates. In addition, it is important to note that ISS’s voting policies are extensive and continue to cover many issues in addition to those addressed in the 2006 Policy Updates.
The 2006 Policy Updates and the voting policies of other proxy advisory firms and of institutional shareholders can significantly impact the vote that companies receive on matters presented to their shareholders. Thus, companies must carefully review the voting policies of ISS and other proxy advisory firms and maintain open communications with shareholders well in advance of the annual meeting. In addition, companies should consider the following steps.
Consider the discussions and policy issues that are raised by director majority vote proposals and the new ISS voting policy. Evaluate what approach, if any, may be appropriate for the company to adopt. See that the board has a clearly articulated basis for any policy that it adopts.
Consider the nature and relevance of any material financial ties or other related party transactional relationships between the company and its director nominees, and whether those relationships will affect the vote on a director who serves on the company’s audit, compensation or nominating committee.
Use the 2006 directors’ and officer’s questionnaire to address all issues of interest to proxy advisory firms. For example, determine if any director will be considered "overboarded" by ISS and, if relevant, discuss the situation with the director (and the nominating committee) before finalizing proxy materials.
The compensation committee should carefully review and make sure that the proxy discloses all elements of compensation. If applicable, the committee should explicitly describe the manner in which compensation payouts have been tied to company performance, including how that performance was measured. Clarity and precision in the compensation committee report is increasingly important.
Companies should highlight in their proxy statements or governance policies steps that have been taken or are being implemented to respond to poor corporate performance or the perception of poor governance or compensation practices.
Reevaluate how ISS will view the company’s equity compensation plans in light of the new SVT and burn rate calculations. Also, reconsider whether ISS will recommend "Withhold" votes from compensation committee members because of the "pay for performance" criteria that ISS adopted in 2005 or the "poor" compensation practices standard included in the 2006 Policy Updates.
Gibson, Dunn & Crutcher lawyers are available to assist clients in addressing any questions they may have regarding these issues. Please contact the Gibson Dunn attorney with whom you work, or John F. Olson (202-955-8522, firstname.lastname@example.org),
Brian Lane (202-887-3646, email@example.com), Ronald O. Mueller (202-955-8671, firstname.lastname@example.org), Amy L. Goodman (202-955-8653, email@example.com), Gillian McPhee (202-955-8230, firstname.lastname@example.org, Elizabeth Ising (202-955-8287,
email@example.com, or Ashley Wright (202-887-3770,
firstname.lastname@example.org in the firm’s Washington, D.C. office.
© 2005 Gibson, Dunn & Crutcher LLP