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L&A Original Article: 2018 Proxy Season Preparations

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December – a time for reflection on the year that was, review of company performance…and a first look at the latest policy updates from proxy advisory firms like Institutional Shareholder Services Inc. (“ISS”) and Glass, Lewis & Co., LLC (“Glass Lewis”). While it may seem like the 2017 proxy season was just yesterday, we are looking ahead to what’s in store for proxy season 2018 – changes to proxy advisor policies, trends in Compensation Discussion and Analysis (“CD&A”) disclosures, and Say on Pay outcomes. Our prediction? A continued transformation of CD&A disclosures and an uptick in the number of qualitative assessments of Say on Pay and negative recommendations. Let’s discuss why.

As is the norm now, the past year produced some interesting contexts that we think will carry forward in 2018.

Enhanced proxy disclosure.
We saw more proxies with refreshed formats and greater detail, lending themselves to look more like marketing communications as opposed to the proxies of old. As investors ramp up focus on their portfolio companies’ corporate governance practices, companies have responded by expanding proxy disclosure to effectively tell their story. Nowhere was this more evident than in the breakdowns on executive compensation. Investors are becoming more sophisticated, and more vocal when evaluating compensation programs and their effectiveness in paying for performance. The best-received proxy disclosures outlined company strategic business goals and illustrated a linkage to performance measures and targets intended to drive achievement of such goals. For readers in the oil and gas industry, we expect this search for connection to be magnified as investors seek change in the design of executive incentives, as noted in recent articles in the Wall Street Journal and others.

Lessening influence from proxy advisors.
The failure rate for Say on Pay proposals in 2017 for Russell 3000 companies is on par with the lowest rate observed since the introduction of Say on Pay. Meanwhile, the average vote result of ~92% is the highest level of support the market has seen. While data suggests negative recommendations from ISS and Glass Lewis still influence vote outcomes by 20%-30% and 10%-15%, respectively, the quantity of such negative recommendations has remained relatively stagnant while voting results have improved as noted previously.

Increasing engagement of shareholders.
Whether a result of ISS policy (evaluating Compensation Committee responsiveness to low Say on Pay vote outcomes) or boards getting more in tune with shareholders, more companies are disclosing their shareholder engagement efforts to discuss compensation decision-making. With more focus on compensation practices, we expect this practice to expand in 2018.

Along with the trends and lessons from the 2017 proxy season, updated policies from ISS and Glass Lewis always need to be considered as companies begin proxy preparations. While further disclosure is expected on certain changes from ISS, there are certain changes worth noting. ISS released a number of updates highlighted below, while Glass Lewis had no policy changes related to compensation.

Non-employee director compensation.
ISS announced a new policy dictating adverse vote recommendations for board committee members directly responsible for setting non-employee director compensation if such compensation is deemed to have a pattern (two or more years) of being excessive without compelling rationale. L&A notes this change will not impact vote recommendations in 2018.

Quantitative pay-for-performance evaluation.
There are a few tweaks to the quantitative pay-for-performance assessment process ISS utilizes to develop levels of concern:

  • The threshold for “medium” concern on the multiple of median test has been lowered for companies in the S&P 500 from 2.33x to 2.00x.
  • Total shareholder return performance will now be calculated using monthly average prices at the beginning and end of the performance period to reduce the impact of short-term stock price fluctuations.
  • Following its introduction of relative financial performance evaluations in its qualitative pay for performance assessment process, ISS will now be including these comparisons as part of the quantitative assessment. It will be used as a modifier to determine levels of concern where companies are in the upper threshold of “low” concern and lower threshold of “medium” concern calculations. Further detail on this update is expected in the next ISS disclosure.

Equity Plan Scorecard.
Similar to the changes to the quantitative pay-for-performance assessment, minor adjustments are being applied to ISS’ Equity Plan Scorecard model:

  • For S&P 500 companies, the threshold score to receive a positive vote recommendation has increased from 53 points to 55.
  • Points application for Change in Control vesting provisions is simplified, whereby a company can only receive full points or no points. The update has eliminated the opportunity for partial scoring. To receive full points, a company must have both of the following provisions, otherwise it receives no points:
    1. Performance-based awards (i) accelerate performance-based awards based on actual performance, (ii) accelerate pro rata based on target performance, (iii) accelerate pro rata based on actual performance, or (iv) are forfeited; and
    2. Time-based awards do not automatically accelerate or accelerate based on committee discretion.
  • If a company allows broad discretion to accelerate vesting, its chances of receiving points under the EPSC have slimmed. Under the new policy, a company will receive points only if the plan limits discretion to accelerate awards in circumstances of death and disability.
  • CEO vesting requirements are eased slightly. Each vehicle is now evaluated and scored separately (options/SARs, time-based restricted stock/RSUs, and performance-based equity), and a company will receive full points if a CEO’s award ratably or cliff vests at least three years from the grant date.

Gender pay gap.
ISS will review shareholder requests for gender pay related disclosures on a case-by-case basis. When considering a vote, the firm will take into account the following: (i) current company policies and communications related to diversity, inclusion policies and compensation philosophy; (ii) whether the company has been the subject of recent controversy or litigation related to gender pay gap matters; and (iii) company reporting on gender pay gap relative to peers.

Board to low support.
Lastly, ISS has updated its existing policy on committee responsiveness to low voting outcomes on Say on Pay proposals. ISS will consider the following when assessing the adequacy of actions in response to such votes:

  • The company’s response, including disclosure of:
    1. Engagement efforts with major institutional investors, the timing and frequency of such efforts and if independent directors played a role;
    2. Specific concerns voiced by shareholders that led to vote opposition; and
    3. Specific and meaningful actions taken to address concerns;
  • Other compensation actions taken;
  • Characteristics of the issues of concern (is there a pattern or are they isolated); and
  • Stock ownership structure (consolidated ownership, dual voting structures, etc.).

With these trends and updates, what should companies consider doing for 2018? We recommend one place to start – engage with shareholders. Whether via one-on-one engagements or through enhanced proxy disclosure, effectively telling the story to investors will be increasingly critical. Institutional investors are trending from passive to active and keying in on issues like performance and pay misalignment. Make sure to understand major investor voting guidelines to help game plan for various scenarios.

We look forward to seeing more information in the coming days from ISS on their policy changes. If you have questions on the information included in this article, including potential implications of proxy advisor policy updates, please let us know.