RiskMetrics Group, ISS Governance Services (ISS) Releases Policy Updates for 2008 Proxy Season and Related Developments

November 29, 2007

On November 19, 2007, RiskMetrics Group ISS Governance Services (ISS), a leading proxy advisory firm, released its U.S. and international corporate governance policy updates for the 2008 proxy season.  The ISS U.S. Corporate Governance Policy 2008 Updates (2008 Policy Updates) can be accessed at http://www.riskmetrics.com/pdf/2008ISS_USPolicyUpdates.pdf.  

The ISS 2008 Policy Updates reflect significant feedback from ISS’s clients, from the corporate community and from others.  They reflect increased focus on corporate responsibility, board governance and executive compensation practices. 

The 2008 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 these groups and maintain open communications with their shareholders well in advance of the annual meeting. 

The ISS 2008 Policy Updates apply to annual meetings held on or after February 1, 2008.  This client alert briefly reviews the most significant of these policy updates and sets forth recommended practice points.

ISS 2008 Policy Updates

Board Issues

1.      Voting Recommendations on Director Nominees in Uncontested Elections:  In 2008, if a company has a classified board and a particular director who is not up for re-election is responsible for what ISS views as a problematic governance issue at the company, ISS may recommend a “Withhold” or “Against” vote on any or all of the continuing nominees up for election.

2.      Shareholder Proposals Calling for Independent Chair:  Unless specified criteria relating to an independent lead or presiding director are satisfied, ISS generally recommends “For” shareholder proposals asking that the position of chairman be filled by an independent director.  The ISS 2008 Policy Updates add two additional criteria that must be met in order for ISS to consider making an “Against” recommendation: (i) the company publicly discloses a comparison of the duties of its independent lead director and its chairman; and (ii) the company provides a “sufficient explanation” of why it chooses to combine the chairman and CEO positions.  If the company does make these enumerated disclosures, ISS will consider the proposal on a case-by-case basis.

3.      Performance Test for Directors:  ISS revised the manner in which it will use its corporate performance test in evaluating whether to recommend votes “Against” or that shareholders “Withhold” voting authority from director nominees at Russell 3000 companies.  ISS will continue to use its methodology evaluating the five-year Total Shareholder Return (TSR), sales growth, EBITDA growth, and pre-tax operating Return on Invested Capital (ROIC), each on a relative basis within each four-digit GICS group.  However, instead of focusing solely on the bottom 5% of performers in each GICS when determining its recommendations, ISS will evaluate each company’s overall performance relative to its peers on a case-by-case basis. 

4.      Cumulative Voting Shareholder Proposals:  In the past, ISS generally recommended voting “For” proposals to provide for cumulative voting unless the company satisfied all of ten enumerated criteria.  ISS generally also will recommend “Against” proposals to eliminate cumulative voting.  The 2008 ISS Policy Updates provide that ISS will recommend against such proposals only when (i) the company provides for proxy access or a similar structure to allow shareholders to nominate directors to the company’s ballot, and (ii) the company has adopted a majority vote standard, with a carve-out for plurality voting in situations where there are more nominees than seats, and a director resignation policy to address failed elections.  

5.      Director Independence Definition:  ISS categorizes director nominees as “inside directors,” “affiliated outside directors” or “independent outside directors” and applies these categories for various purposes in determining its voting recommendations.  For example, ISS will recommend votes “Against” or that shareholders “Withhold” voting authority from director nominees it classifies as “affiliated outside directors” if such directors serve on a company’s audit, compensation or nominating committee.  ISS considers a director who is a former CEO of the company to be an “affiliated outside director.”  ISS has revised this standard to clarify that a director that served as CEO of the company even prior to its initial public offering is considered an “affiliated outside director.”  

6.      Voting Recommendations on Director Nominees After Adoption of a Poison Pill:  ISS will recommend a “Withhold” or “Against” vote on an entire board of a newly public company if such company has a poison pill and does not commit to put the poison pill to a shareholder vote within 12 months following the initial public offering.  

Compensation Issues

7.      Advisory Votes on Company Executive Compensation Proposals:  In considering whether to recommend votes “For” a management proposal seeking an advisory vote on a company’s “pay program,” ISS will assess each proposal on a case-by-case basis considering five over-arching global principles that it will apply in all markets: 

• maintaining appropriate pay-for-performance alignment with emphasis on long-term shareholder value (by taking into account links between pay and performance, fixed versus variable pay methods, performance goals and plan costs);
• avoiding arrangements that “pay for failure” (by taking into account the use of long or indefinite contracts, excessive severance amounts and any compensation that is guaranteed);
• maintaining an independent and effective compensation committee (by evaluating the skills and qualifications of the members of the committee);
• providing clear and comprehensive compensation disclosures; and
• avoiding “inappropriate” pay to non-executive directors.

In addition, the ISS 2008 Policy Updates provide additional considerations whenever a U.S. company seeks an advisory vote on its “pay program”: 

• assessing performance relative to the company’s business strategy;
• evaluating whether or not the peer group selected to set target pay is appropriate;
• whether or not pay and performance are properly aligned;
• whether or not there is a great disparity between the total pay of the CEO and the other named executive officers;
• the balance of fixed and performance-based pay;
• whether or not excessive perks, severance, executive pension plans and burn rates exist; and
• the degree and quality of the company’s disclosures regarding compensation.

8.      Company Compensation Proposals and Stock Option Overhang Cost:  In considering whether to recommend votes “For” an equity compensation plan, ISS measures plan cost through the ISS Shareholder Value Transfer (SVT) calculation.  For 2008, ISS has revised its methodology to allow companies that have sustained positive stock performance and high overhang cost attributable to in-the-money options outstanding in excess of six years to carve-out these options from the overhang in certain circumstances.  ISS also updated the burn rate percentages for 2008 and the methodology by which it will calculate allowable burn rate percentages for companies. 

9.      “Poor” Pay Practices:  ISS updated its “poor compensation practices” standard (which it adopted in 2006 and may result in “Against” or “Withhold” recommendations for compensation committee members, the CEO or the entire board) by making four additions/clarifications:

• ISS may recommend “Withhold” or “Against” votes in cases where ISS has issued cautionary language about the company’s pay practices but the poor pay practices have continued;
• ISS added other examples of “poor” pay practices, including guaranteed multi-year base salary increases, perquisites for former executives and “poor disclosure”;
• ISS clarified that base salary will be used as a relative measure to determine whether perks are excessive; and
• ISS provided updated examples of what it considers to be best pay practices regarding employment agreements, severance agreements, change-in-control agreements, SERPs, deferred compensation and disclosure practices.

Audit Issues

10.  Audit Fees:  With respect to the ISS policy of recommending that shareholders “Withhold” votes from or vote “Against” audit committee members and vote against ratification of the auditors if “non-audit” fees are “excessive,” ISS will allow publicly disclosed “other” fees related to initial public offerings, bankruptcy emergence, and spin-offs to be excluded from the formula.

11.  “Poor” Accounting Practices:  The ISS 2008 Policy Updates provide that in addition to internal control problems, other “poor” accounting practices will be taken into account when making a recommendation on audit committee members.  ISS also will focus on fraud, misapplication of GAAP, and material weaknesses in Section 404 disclosures and will provide additional content and information on these problematic practices in its analyses to investors.

Corporate Responsibility

12.  Requested Reports:  ISS will evaluate on a case-by-case basis requests for:

• community impact reports;
• energy efficiency reports;
• facility safety reports;
• internet privacy and censorship reports; and
• operations in high-risk markets (e.g. a terrorism-sponsoring state) reports.

ISS will use criteria specific to each type of report in making its voting recommendation, including, among others, applicable laws and regulations, industry norms, existing company disclosures, and prior controversies and legal problems stemming from the particular area in question. 

13.  Product Safety:  ISS will recommend votes “For” proposals requesting reports outlining a company’s policies related to toxic materials and/or product safety in its supply chain, unless the company: (i) already discloses similar information through existing reports and policies; (ii) has already committed to the implementation of a industry standard toxic materials and/or product safety and supply chain reporting and monitoring program; and (iii) has not been recently involved in any relevant controversies or violations. 

Suggested Practices

In light of the ISS 2008 Policy Updates, companies should consider the following steps.

1.      Examine whether ISS is likely to make an “Against” or “Withhold” recommendation on a particular continuing director due to a governance issue and what steps, if any, should be taken with regard to that director.

2.      If the company combines the chairman and CEO positions and receives a shareholder proposal requesting that the positions of chairman be filled by an independent director, consider providing additional disclosure relating to the duties of the independent lead/presiding director and the chairman and the rationale for combining the roles of chairman and CEO. 

3.      Evaluate whether or not the company’s compensation practices meet the “global principles” ISS lays out, emphasize pay-for-performance and avoid “pay for failure” arrangements.  In addition, carefully review the company’s disclosure of executive compensation, taking particular care with respect to the preparation of the Compensation Discussion and Analysis.  In this regard, the company should consult the two reports issued by ISS related to best practices in executive compensation disclosure.[1]  The company should also evaluate whether it engages in any of the practices ISS has enumerated as “poor” pay practices.

4.      Consider providing the additional disclosure regarding the company’s policies and procedures related to the corporate governance issues identified by the ISS 2008 Policy Updates on the company’s website or through other public documents.   

Gibson, Dunn & Crutcher lawyers are available to assist in addressing any questions you may have regarding these issues. Please contact the Gibson Dunn attorney with whom you work, or John F. Olson (202-955-8522, [email protected]), Brian J. Lane (202-887-3646, [email protected]), Ronald O. Mueller (202-955-8671, [email protected]), Amy L. Goodman (202-955-8653, [email protected]), Gillian McPhee (202-955-8230, [email protected]) or Elizabeth Ising (202-955-8287, [email protected]) in the firm’s Washington, D.C. office.