Introduction

On December 8, 2011, Institutional Shareholder Services, Inc. ("ISS") broadcast a webinar ("Webinar") to provide color on its 2012 Corporate Governance Policy Updates, which were published on November 17, 2011. ISS is a provider of corporate governance solutions, and provides voting recommendations to institutional investors on proposals included in public company proxy statements.

Each year1, ISS reviews and updates its proxy voting guidelines, taking into account emerging issues and trends, the evolution of market standards, regulatory changes, and feedback provided by ISS' institutional clients. ISS' 2012 Corporate Governance Policy Updates will apply to publicly traded companies with shareholder meetings on or after February 1, 2012.

This memorandum summarizes the key 2012 policy updates applicable to U.S. companies, together with some additional commentary provided by ISS during the Webinar. To view the full text of the ISS proxy voting updates for U.S. companies, please see: http://www.issgovernance.com/files/ISS_2012US_Updates20111117.pdf. 2

The key changes are as follows:

Evaluation of Executive Pay (Say-on-Pay)

The Dodd-Frank Wall Street Reform Act (the "Dodd-Frank Act") now requires every publicly traded company to include in its proxy statement every one, two, or three years, as determined by the company, an advisory (non-binding) shareholder proposal pursuant to which the company's shareholders have the right to vote on the compensation of the company's named executive officers as described in its proxy statement (a "Say-on-Pay Proposal").

Previously, as long as a Say-on-Pay Proposal was on the ballot, ISS' recommendation was to vote against the reelection of compensation committee members (or, in exceptional cases, the full board) only in egregious situations, or when a board of directors had failed to respond to concerns raised by the shareholder vote on the prior Say-on-Pay Proposal.

A Say-on-Pay Proposal is generally considered to be "approved" if it received more than 50% of the shareholder vote. However, under its updated policy, if a company's previous Say-on-Pay Proposal received less than 70%3 of the shareholder vote, ISS will make its recommendation with respect to reelection of compensation committee members (or, in exceptional cases, the full board) and the company's current Say-on-Pay Proposals on a case-by-case basis, taking into account:

  • The company's response to investor input, including:
  • Disclosure of engagement efforts with major institutional investors regarding the issues that contributed to the low level of support;
  • Specific actions taken to address the issues that contributed to the low level of support;
  • Other recent compensation actions taken by the company;
  • Whether the issues raised are recurring or isolated;
  • The company's ownership structure; and
  • Whether the support level was less than 50%, which would warrant the highest degree of responsiveness by the company.

ISS also stressed that companies that have received a low level of support for previous Say-on-Pay Proposals should refrain from providing boilerplate disclosure in the CD&A, and instead should provide information that enables shareholders to gauge the level of effort taken by the company to address the compensation issues that contributed to the low level of support.

Board Response to Advisory Shareholder Vote on Frequency of Say-on-Pay Proposals

The Dodd-Frank Act also requires companies to submit to shareholders, at least once every six years, a proposal providing for an advisory (non-binding) vote with respect to whether shareholders would prefer to vote on Say-on-Pay Proposals every year, every other year, or every three years. Under the Dodd-Frank Act, the company is to consider and adopt the Say-on-Pay Proposal frequency it believes is appropriate.

As companies were required to implement the advisory (non-binding) vote with respect to the frequency of future Say-on-Pay Proposals for the first time at shareholder meetings occurring on or after January 21, 2011, ISS is newly implementing a policy with respect to such proposals in its 2012 policy updates.

Under the new ISS policy, if a company's board of directors implements a frequency for future Say-on-Pay Proposals that is less frequent than the frequency that received the majority of shareholder votes, ISS will recommend an against or withhold vote for the entire board of directors (except for new nominees, who should be considered on a case-by-case basis). ISS reiterated this policy during the Webinar, highlighting that the annual frequency was the most widely selected frequency for this past year and, in most cases, selected by a majority of shareholder votes. Therefore, when a board of directors implements a frequency that is less frequent than the frequency which received the majority of shareholder votes, ISS believes the board of directors should be held accountable.

In the event that no frequency interval received a majority of votes, if the company's board of directors implements a frequency for future Say-on-Pay Proposals that is less frequent than the frequency that received a plurality of the shareholder votes, ISS recommends that shareholders consider their votes on a case-by-case basis, taking into account the following:

  • The board's rationale for selecting a frequency that is different from the frequency that received a plurality;
  • The company's ownership structure and vote results;
  • ISS' analysis of whether there are compensation concerns or a history of problematic compensation practices; and
  • The previous year's support level on the company's Say-on-Pay Proposal.

Implementation of a Say-on-Pay Proposal frequency that is more frequent than that which received the majority or plurality of shareholder votes is not an issue for ISS, since a more frequent vote is seen as a good corporate governance practice.

Pay-For-Performance Alignment

Previously, ISS evaluated the alignment of chief executive officer ("CEO") pay and a company's performance by looking to the company's total shareholder returns ("TSR") for the previous one-year and three-year periods against those of other companies in its Global Industry Classification Standard industry group (its "GICS Group"), as well as evaluating the alignment of the CEO's total compensation with the company's TSR, over both recent and long-term periods. The prior methodology focused particularly on companies that had underperformed their peers over a sustained period.

ISS' updated approach is more comprehensive; in addition to identifying companies that have demonstrated weak alignment between TSR and CEO pay over an extended period, it will also identify strong or satisfactory pay-for-performance alignment. Additional guidance on ISS' 2012 Pay-for-Performance methodology is scheduled for release this December 2011. As reiterated during the Webinar, ISS has updated its approach in response to survey feedback indicating that an overwhelming majority of institutional shareholders consider pay-for-performance to be a critical or important consideration in their vote determinations. ISS also clarified during the Webinar that while pay-for-performance alignment will continue to be an important part of its analysis of a company's pay practices, it does not anticipate that this change in approach will have a significant impact on the mix of recommendations for the upcoming year, as compared with the mix of recommendations for this past year.

With respect to companies in the Russell 3000 Index, the revised analysis will consider the following factors:

Peer Group Alignment

  • The degree of alignment between the company's TSR rank and the CEO's total pay rank within a peer group, as measured over one-year and three-year periods (weighted 40% and 60%, respectively).
  • The multiple of the CEO's total pay relative to the peer group median.

ISS notes that the peer group generally consists of 14-24 companies that are selected on the basis of market cap, revenue (or, for financial firms, assets), and a GICS Group selected through a process designed to identify peer companies that are closest to the subject company and where the subject company is close to the median in revenue/asset size. The evaluation will consider the company's rank for both pay and TSR within the peer group (for one-year and three-year periods), and the CEO's total pay relative to the median pay level for the peer group.

Absolute Alignment

  • The absolute alignment between the trend in CEO pay and company TSR over the prior five fiscal years – i.e., the difference between the trend in annual pay changes and the trend in annualized TSR during the period.

In cases where alignment is perceived to be weak, ISS will consider how the following factors affect alignment of pay with shareholder interests:

  • The ratio of performance-based to time-based equity awards;
  • The ratio of performance-based compensation to overall compensation;
  • The completeness of disclosure and rigor of performance goals;
  • The company's peer group benchmarking practices;
  • Actual results of financial/operational metrics, such as growth in revenue, profit, cash flow, etc., both absolute and relative to peers;
  • Special circumstances related to, for example, a new CEO in the prior fiscal year or anomalous equity grant practices (e.g., biennial awards); and
  • Any other factors deemed relevant.

During the Webinar, ISS emphasized that the focus of its updated pay-for-performance approach will be to identify companies which are outliers with respect to either peer group alignment or absolute alignment, or outliers with respect to multiple factors in either category. ISS also indicated that it would be publishing a White Paper which will further clarify its updated approach to pay-for-performance alignment on or around December 16, 2011.

Proxy Access Proposals

On September 20, 2011, the SEC adopted an amendment to Rule 14a-8(i)(8), providing that U.S. public companies are generally required to include shareholder proposals in their proxy materials that either request the board to implement proxy access or to amend the company's bylaws to implement proxy access. Consequently, several investors have indicated their intent to submit proxy access shareholder proposals.

ISS' former case-by-case policy on proxy access shareholder proposals did not incorporate certain expected core features of such proposals, and overemphasized the proponents' rationale given ISS' support in principle for these proposals. Under the updated policy, ISS will maintain a case-by-case approach, but will expand and refine the core factors it will consider for voting purposes. ISS will now consider a range of company-specific and proposal-specific factors, including the ownership thresholds proposed in the resolution (i.e., percentage and duration), the maximum proportion of directors that shareholders may nominate each year, and the method of determining which nominations should appear on the ballot if multiple shareholders submit nominations, as well as any other factors deemed relevant.

Incentive Bonus Plans and Tax Deductibility Proposals – Post-IPO Companies

Previously, ISS generally recommended that shareholders support proposals that sought approval for a company's incentive plan that had been amended simply to comply with Section 162(m) of the Internal Revenue Code ("Section 162(m)") because of the beneficial tax deduction a company may take on compensation paid to named executive officers if it is considered "performance-based" pursuant to the Section 162(m) rules. With respect to equity plans that were amended to comply with Section 162(m) but that also were amended to increase the shares reserved under the plan, the recommendation was considered on a case-by-case basis using ISS' quantitative model.

Under the updated policy, the first time an equity plan is submitted for a shareholder vote following an IPO for approval of Section 162(m) amendments, ISS will evaluate the full plan to determine if any problematic features exist, even if the number of shares available under the plan is not being increased. In addition, ISS will evaluate amendments with respect to Section 162(m) compliance with a more nuanced approach, looking more specifically at the types of amendments being proposed.

Under the updated policy, ISS will generally recommend to vote for proposals to approve or amend executive incentive plans if the proposal:

  • Is only to include administrative features;
  • Places a cap on the annual grants any one participant may receive to comply with the provisions of Section 162(m);
  • Adds performance goals to existing compensation plans to comply with the provisions of Section 162(m), unless they are clearly inappropriate; or
  • Covers cash or cash and stock bonus plans that are submitted to shareholders for the purpose of exempting compensation from taxes under the provisions of Section 162(m), if no increase in shares is requested.

ISS will recommend to vote against proposals if:

  • The compensation committee does not fully consist of independent outsiders, per ISS' director classification; or
  • The plan contains excessive problematic provisions.

ISS recommends a case-by-case review of proposals if:

  • In addition to seeking 162(m) tax treatment, the amendment may cause the transfer of additional shareholder value to employees (e.g., by requesting additional shares, extending the option term, or expanding the pool of plan participants). ISS will evaluate the shareholder value transfer (SVT) in comparison with the company's allowable cap; or
  • A company is presenting an equity plan to shareholders for Section 162(m) favorable tax treatment for the first time after the company's initial public offering. ISS will perform a full equity plan analysis, including consideration of total SVT, burn rate (if applicable), repricing, and liberal change in control provisions. Other factors, such as pay-for-performance or problematic pay practices as related to Say-on-Pay Proposals, may be considered if appropriate.

Business Development Companies – Authorization to Sell Shares of Common Stock at a Price Below Net Asset Value

Business Development Companies ("BDCs") are exchange-traded, closed-end funds that typically invest in private companies. BDCs may be internally or externally managed.

BDCs are subject to specialized SEC regulation as set forth in the Investment Company Act of 1940 (the "1940 Act"). Section 63 of the 1940 Act requires BDCs to obtain shareholder approval to issue equity at a discount to net asset value ("NAV"), which approval must be granted at a meeting held within one year immediately prior to such issuance. Though Section 63 does not limit the magnitude of the discount to NAV, it requires that the directors of the BDC, in consultation with the underwriters, determine that the share price closely approximates the market value of the shares as of the pricing, which limits the dilutive effect on existing shareholders.

Prior to the 2012 policy updates, ISS had not published a policy regarding BDCs. The 2012 policy update is intended to prevent open-ended authorizations to issue stock at a discount to NAV, and to ensure that the discounts are not excessive.

Under the new policy, ISS recommends voting for proposals authorizing the board of a BDC to issue shares below NAV if:

  • The proposal to allow share issuances below NAV has an expiration date that is less than one year from the date shareholders approve the underlying proposal, as required under the 1940 Act;
  • A majority of the independent directors who have no financial interest in the sale have made a determination as to whether such sale would be in the best interests of the company and its shareholders prior to selling shares below NAV; and
  • The company has demonstrated responsible past use of share issuances, by either:
  • Outperforming peers in its 8-digit GICS group, as measured by one- and three-year median TSRs (calculated quarterly); or
  • Providing disclosure that its past share issuances were priced at levels that resulted in only small or moderate discounts to NAV and economic dilution to existing non-participating shareholders.

Political Spending & Lobbying Proposals

ISS formerly considered proposals relating to both corporate political spending and lobbying activities on a case-by-case basis. Under its updated policy, ISS is generally in favor of these proposals, and notes that disclosure of oversight mechanisms is explicitly included as a point of consideration.

Conclusion

Because ISS policy updates have such great influence in the investing community, companies should familiarize themselves with the circumstances in which ISS may issue a negative vote recommendation regarding director reelections and other proposals included in their proxy statements. Companies should take the updated ISS policies into account when considering future corporate action, and potentially consult with shareholders prior to proxy voting so as to avoid election issues. Companies may also engage with ISS representatives regarding policy updates or otherwise through its website.

Footnotes

1.For an in-depth analysis of proxy voting guidelines issued by ISS in prior years, please see the following past Fried Frank memoranda: A Look at the ISS Policy Update for the 2011 Proxy Season, available at http://www.friedfrank.com/siteFiles/Publications/1-6-2011%20-%20TOC%20Memo%20-%20ISS%20Policy%20Update%20for%20the%202011%20Proxy%20Season.pdf ; A Look at Risk Metrics Group's Policy Update for the 2010 Proxy Season, available at http://www.friedfrank.com/siteFiles/Publications/2848BDFEB5BAF9C4004C1184ADCAA4AD.pdf ; and What You Need to Know About RiskMetrics' Updated Compensation Guidelines for the 2009 Proxy Season, available at http://www.friedfrank.com/siteFiles/Publications/BFF374635DD12D058365F7EB26309E26.pdf.

2 The full text of the ISS proxy voting guidelines for non-U.S. companies is available at http://www.issgovernance.com/policy.

3 During the Webinar, ISS reiterated that the 70% threshold was set in response to survey feedback from institutional shareholders, and further clarified that companies with approval percentages below this threshold ought to make meaningful responses, either through action or by disclosure of the board of directors' consideration of feedback from shareholders, and future plans for improvement. ISS emphasized that the average approval percentage for companies that had their Say-on-Pay Proposals approved was above 90% of the shareholder vote.

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