Proxy advisors update executive compensation measures for 2018

Human Capital Bulletin Prominent proxy advisors Institutional Shareholder Services (ISS) and Glass Lewis recently released updated proxy voting guidelines ahead of the 2018 proxy season. Revised policies for ISS will apply to votes held on or after Feb. 1, while Glass Lewis's revised policies took effect for votes on or after Jan. 1.

In general, policy updates for both advisors build upon trends from prior years – an emphasized importance of shareholder rights, an improved quality and clarity of proxy statement disclosures, and a continued focus on connecting pay and performance. For 2018, both ISS and Glass Lewis have chosen to address growing societal concerns such as board gender diversity and risks related to climate change.

This Grant Thornton Human Capital Bulletin, however, will highlight the key updates related to executive compensation and provide initial guidance for next steps that should be taken as companies begin to prepare for the 2018 proxy season.

Notable ISS policy updates ISS's updates pertaining to executive compensation policies generally focus on three areas: board of director elections, quantitative tests and calculations, and the disclosure of shareholder outreach in response to low “say-on-pay” support.

Director-related updates

The majority of director-related updates deal with strengthened language concerning when ISS will recommend “Against” or “Withhold” at director elections, such as:

  • Directors at companies that fail to include say-on-pay or say-on-pay frequency votes when required under SEC regulations
  • Compensation committee members at companies who demonstrate a pattern of approving excessive director compensation
  • Committee members in charge of stock pledging policies where directors or executives have a significant level of pledged stock.

Executive compensation

ISS’s 2018 policy changes regarding executive compensation concern their new Financial Performance Assessment (FPA) and updated calculations of their three traditional quantitative tests.

The FPA, introduced in 2017, compares the relationship of CEO pay and financial performance over a three-year period relative to an ISS-selected peer group. The FPA was initially included in all ISS reports, but not formally incorporated into ISS's three standard quantitative tests (Relative Degree of Alignment, Multiple of Median, and Pay-TSR Alignment), or used to influence voting recommendations. ISS initially considered seven metrics for the “performance” component of the FPA, with the ranking and weighting of each metric determined by a company's industry. In their annual "Preliminary Frequently Asked Questions," a document that discusses methodological changes to their quantitative assessments for the coming year, ISS announced they will now include the FPA as a secondary screen after their three traditional tests have been calculated.

Results from the FPA tests will be used to “identify certain companies that resulted in a ‘Medium’ level of concern on the primary screens, but had relatively strong fundamental financial performance, and may reduce the final level of quantitative concern to ‘Low’” (also, the FPA may conversely be applied to companies with a “Low” concern on the primary screens with weak financial performance). Additionally, ISS reduced the number of metrics considered for financial performance from seven to three or four, varying by industry.

ISS also made technical updates to calculations used in their standard quantitative tests. The threshold for a “Medium” concern on the Multiple of Median test, which calculates the multiple of a company's CEO pay relative to the median of an ISS-selected peer group over a one-year period, was lowered from 2.33 to 2.00 for constituents of the S&P 500. Separately, ISS will now smooth total shareholder return (TSR) calculations, which are used in the Relative Degree of Alignment and Pay-TSR Alignment tests, by averaging a company's share-price at the beginning and end of the month closest to their fiscal year end.

Shareholder outreach

ISS issued new guidance on the disclosure of shareholder engagement efforts for companies with recent Say on Pay struggles. ISS will now assess the disclosure of shareholder outreach for both compensation committee member and Say on Pay recommendations for companies that received less than 70% support in their most recent Say on Pay vote by considering three factors: the timing and frequency of outreach efforts, whether specific shareholder concerns are disclosed, and whether any actions were taken as a result of engagements.

Notable Glass Lewis policy updates Compared to ISS, Glass Lewis issued far fewer updates to their voting guidelines for 2018. While Glass Lewis generally focused on board gender diversity and the disclosure of board responsiveness to votes with low shareholder support, only a few updates addressed executive compensation.

The first compensation related update discussed the CEO pay-ratio disclosure, which will be reported in proxies in 2018 for the first time. Glass Lewis announced that reported ratios will now be included in its annual reports as a way to provide additional insight into a company’s pay practices. The ratio, however, will not be used to impact voting recommendations.

Glass Lewis also clarified the grading of their traditional Pay for Performance assessment, done using an A/B/C/D/F scale, saying that a grade of a “C,” for example, does not indicate a disconnect between pay and performance. Glass Lewis has intentionally distanced their scale from the standard school grading structure, commenting that “Unlike a school letter system, however, the letter ‘C’ in the Glass Lewis grade system does not indicate a significant lapse; rather, a ‘C’ in the Glass Lewis grade system identifies companies where the pay and performance percentile rankings relative to peers are generally aligned.” As such, “A’s” and “B’s” indicate lower pay levels relative to peers and high financial performance, while “D’s” and “F’s” represent companies with high levels of pay and low performance.

Conclusion and next steps As they do each year, ISS and Glass Lewis have updated their policies ahead of the coming proxy voting season. Both proxy advisors touched on a number of common issues, such as board gender diversity, the disclosure of board responsiveness to shareholder concerns, and the connection of pay and performance. Executive compensation related updates, however, were generally unique to each advisor.

As a matter of next steps, companies should first prepare for their 2018 annual meeting by reviewing the proxy advisor updates relative to the items on their voting ballot. Where changes deal with proxy advisor’s quantitative calculations (i.e., ISS’s standard tests, the FPA, or Glass Lewis’s Pay for Performance test) companies should rely on their finance and human resource departments to update their test projections so that there is minimal surprise when the reports and their recommendations are released. With all of these preparations, companies and their boards should continue to engage and consult with their outside advisors to assure they are as prepared as possible.

Contact Eric Gonzaga
Principal, Compensation Consulting
T +1 612 677 5336

Eric Myszka
Senior Manager, Human Capital Services
T +1 312 602 8297

Rob Storrick
Senior Associate, Compensation Consulting
T +1 612 677 5105

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