What You Need to Know about ISS’ 2019 Policy Updates
ISS released two sets of policy updates this month. One is its proxy voting guidelines update and the other is a preliminary FAQ on compensation policies. There are a handful of changes to take note of, but nothing unexpected—in fact, there’s as much to be said for what didn’t happen as for what did.
While overall the 2019 updates seem minor, keep careful watch. As we’ll explain, there could be some major revisions on the horizon that fundamentally change the handling of say-on-pay and equity plan proposals. Meanwhile, bipartisan momentum is building to regulate proxy advisors, which we discuss toward the end of this blog.
Here are the highlights.
EVA Isn’t Part of the Financial Performance Assessment…Yet
In October, ISS proposed a change to its quantitative financial performance assessment (FPA) test that would replace the current return metrics with economic value added (EVA) measures.
Roughly this time last year, we blogged about the new FPA test and its introduction of various financial metrics, including:
- Return on invested capital (ROIC)
- Return on equity (ROE)
- Return on assets (ROA)
- Earnings before interest, tax, depreciation and amortization (EBITDA) growth
- Operating cash flow growth
Back then, we brought up a number of concerns about the FPA test, such as problems associated with using as-reported GAAP results and how cross-firm comparisons can be less meaningful than firms’ abilities to beat expectations of their own performance.
We’re worried that EVA measures may exacerbate these problems. EVA attempts to relate a company’s performance to its use of capital. Unfortunately, it’s not very transparent. It might even bring greater subjectivity and black-box assumptions into the calculation process. Noteworthy is that ISS acquired a firm called EVA Dimensions earlier this year and is likely trying to integrate this firm’s models. There’s a classic Catch-22 problem here: Either ISS makes its methodologies perfectly transparent such that they can be reverse engineered (which would solve the subjectivity problem) or it holds back intermediary calculations to preserve the proprietary nature of the model.
It seems we’re not alone in our concerns. ISS’ proposal to overhaul the FPA with EVA measures may well have been too much, too soon. Even those who didn’t object to last year’s metrics hesitated to jump in this year.
The verdict: The FPA test will remain the same for 2019. However, ISS noted that they’ll “continue to explore the potential [of EVA] for future use,” including phasing in its calculation for some companies starting this year. As with ISS’ addition of non-TSR-based FPA, we expect that this year’s trial balloon is an indicator that EVA will make its way into the quantitative assessment sooner rather than later.
Minor but Notable Updates to the EPSC
The Equity Plan Scorecard (EPSC)—ISS’ framework for vetting equity plan proposals—will mostly just see the usual sorts of reallocations of points among categories, without any change to the overall required level to pass. However, there are two noteworthy changes.
The first is a new “overriding factor.” Overriding factors are major issues, such as the ability to reprice underwater options without shareholder approval, that can cause ISS to recommend a negative vote even if the EPSC would otherwise have enough points to pass. The new overriding factor is driven by what ISS refers to as “excessive dilution.” For these purposes, dilution is calculated as the sum of shares requested, shares remaining available for issuance, and shares unvested or unexercised, all divided by common shares outstanding. If this percentage exceeds a certain threshold—20% for the S&P 500 or 25% for the Russell 3000—then the overriding factor is triggered.
The second change affects how points are awarded for change-in-control (CIC) provisions. Now, rather than awarding points based on the actual provisions, ISS will award points based on disclosure quality. Specific disclosure of the CIC vesting treatment (for both performance-based and time-based awards) results in full points. Silence or discretion receives no points.
We like this approach. For one thing, having worked with many companies going through corporate transactions with little clarity around award treatment, the discipline that comes with providing specific disclosures yields added benefits if a transaction does take place. More broadly, we applaud the shift from “one size fits all” to a “sunlight is the best disinfectant” philosophy of promoting greater clarity for shareholders.
Gender Diversity Hits the Boardroom
Gender diversity and equity is one of the most important—but nebulous—issues that companies of all sizes face today. We’ve written extensively on pay equity issues. Diversity at the board level is yet another frontier.
ISS’ new policy will be to vote against the chair of the nominating committee (and other board members on a case-by-case basis) for S&P 1500 or Russell 3000 companies with no women on their board. This policy will take effect in 2020. However, note that Glass Lewis has a near-identical policy that takes effect in 2019.
Another board composition update concerns absenteeism. Going forward, ISS will vote against absentee directors as well as related members of the nominating and governance committee, effectively taking the view that the nom/gov committee should be accountable for filling the board with engaged members. This is basically a codification of policy on a topic that ISS previously dealt with on a case-by-case basis.
In the related area of social and environmental issues, ISS made a small update to their case-by-case considerations that will take into account the presence of any significant controversies, fines, penalties, or litigation the company faces.
ISS’ updates touch on a handful of other areas. These include revisions to their approach for analyzing excessive director pay or poor attendance, plus some clarification around how they consider reverse stock splits.
There was also a series of updates meant to comprehensively address perceived abuses of bylaw or charter ratification procedures. The way these situations would play out against shareholders is this. Consider a company whose existing bylaws require a 25% ownership stake to call a special meeting and whose shareholders submit a proposal to lower the threshold to 10%. Put simply, companies can exclude the 10% proposal from the ballot by instead asking shareholders to vote to ratify the existing 25% threshold, under the logic that the two items are mutually exclusive and therefore only one or the other is needed. This approach effectively sweeps the shareholder proposal under the rug and prevents a vote from being held on a potentially shareholder-friendly bylaw amendment. ISS made several policy updates to address their stance on these ballot items and related issues of board accountability and responsiveness stemming from these items.
Regulation of Proxy Advisors?
This isn’t an ISS policy update, it’s the possibility of regulation driven by legislation. On November 14, a bipartisan team of six senators introduced the Corporate Governance Fairness Act. The bill will direct the SEC to regulate proxy advisory firms under the Investment Advisers Act (IAA), but of course has yet to be passed in the Senate or taken to the House. Meanwhile, in 2017, the House passed the Corporate Governance Reform and Transparency Act (H.R. 4015), which never gained traction in the Senate.
A day later (November 15), the SEC held the 2018 SEC Staff Roundtable on the Proxy Process, devoting considerable time to the topic of proxy advisors.
Talk of regulating proxy advisors is hardly new, but there does seem to be new momentum. Areas of focus include conflicts of interest, transparency into policy development, and the accuracy and treatment of errors in reports. The central question in any regulation will be how far to go. For example, the House legislation proposes giving companies a pre-review of reports, which was among the more controversial elements.
Net-net: Keep watch, because 2019 might bring about some change. If it does, we’re curious how that might affect the landscape. Will it encourage new firms to crop up with alternative business models? Will it prompt institutional investors to invest in building their own models they can exercise more control and accountability over? Most importantly, how will all this affect decision-making in the boardroom? We’ll be paying close attention to all these questions.
As always, ISS will be issuing a comprehensive FAQ and related policy documents later in December. We’ll post further as that information becomes available. In the meantime, please don’t hesitate to contact us if you’d like to discuss any of these updates.