United States: As 2015 Proxy Season Looms, Companies Should Consider Scrutinizing Stock Incentive Plans And Equity Grant Practices In Light Of New ISS Equity-Based Compensation Plan Scorecard Policy

As discussed in our October 21, 2014 blog article, Institutional Shareholder Services Inc. ("ISS"), a proxy voting advisor, instituted changes in its process for evaluating equity incentive compensation plan proposals which are being submitted for shareholder approval. These changes were effective for shareholder meetings occurring on or after February 1, 2015. ISS has released a FAQ on its new process which we discuss in this blog article.

Among other things, ISS provides its institutional investor clients with recommendations on how to vote on issuer proposals (such as the adoption of (or amendment to) equity compensation plans) that are submitted to the issuer's shareholders for their approval. So, the views of ISS typically are of relevance to most issuers.

In particular, ISS has adopted a "balanced scorecard" approach (called the "Equity Plan Scorecard" ("EPSC")) for evaluating compensation plan proposals that gives weight to various factors under three categories (such categories are referred to as "pillars"). These three pillars are (1) plan cost, (2) plan features, and (3) issuer grant practices. With a few exceptions, in lieu of the prior ISS policy of a series of pass/fail tests, the total EPSC score will generally determine whether a "For" or "Against" recommendation is warranted. The EPSC has a scale of 0 to 100 total points and an equity compensation plan must receive 53 or more points in order to garner a "For" recommendation.

It is still true, however, that even with a passing grade on the EPSC, ISS will nevertheless recommend against an equity compensation plan proposal if there are certain overriding, egregious factors including the following:

• Liberal change in control definition which can allow for vesting of awards other than on a double trigger basis
• Ability to reprice or cash-out underwater stock options without shareholder approval
• The equity plan is a vehicle for problematic pay practices or pay-for-performance disconnect
• Any other plan features or issuer practices (e.g., tax gross-ups or provisions for reload options) that can have a detrimental impact on shareholders

The EPSC's three pillars are briefly summarized below:

1. Plan Cost: The total potential cost of the issuer's equity plans relative to benchmarks for industry/market cap peers, measured by the issuer's estimated Shareholder Value Transfer ("SVT"). The SVT estimates the cost to shareholders of the transfer of equity from shareholders to employees. ISS uses its own proprietary SVT model to perform this assessment. The EPSC measures the SVT relative to (i) new shares requested plus shares available for future grant plus outstanding unexercised/unvested awards and (ii) only new shares requested plus shares available for future grant.
2. Plan Features: The equity compensation plan would be reviewed with a focus on provisions that would negatively impact the EPSC score including:
   
   
   • automatic single-triggered award vesting upon a change in control;
   • broad discretionary vesting authority (outside of change in control or death or disability);
   • liberal share recycling on various award types; and
   • absence of minimum vesting period (at least one year) for grants made under the plan.
3. Grant Practices: The issuer's equity grant practices would also be evaluated for possible positive impact on the EPSC score including:
   
   
   • the issuer's three-year burn rate relative to its industry/index peers;
   • the estimated duration of the plan based on the sum of shares remaining available and the new shares requested, divided by the three-year annual average of burn rate shares;
   • the vesting requirements in the most recent equity grants during the prior three years to the issuer's chief executive officer;
   • the proportion of the chief executive officer's most recent equity grants/awards which are subject to performance conditions;
   • whether the issuer maintains a claw-back policy that includes equity awards; and
   • whether the issuer has established post exercise/vesting share-holding requirements.

The EPSC further provides that scorecard factors and weightings will be keyed to issuer size and status. Below are the maximum possible points that can be earned in each pillar (i.e., reflects the relative weighting of each pillar).

For the grant practices pillar, only burn rate and duration factors will be considered for non-Russell 3000 issuers whereas the factors are the same in each of the other two pillars regardless of issuer status. Neither burn rate nor duration factors apply for issuers with less than three years of disclosed grant data.

Individual factors within a pillar are not all weighted the same. The ISS FAQ provides fuller details on the various factors and their point scoring basis but does not specify the actual number of points that are at stake with respect to a particular factor within a pillar.

Some of the factors (e.g., the SVT and three year average burn rate) award points on a scaled basis depending on the degree of achievement. Maximum points can be received for the SVT factors if the plan total costs are less than or equal to approximately 65% of the ISS benchmark SVT for the issuer. Maximum points can be received for the burn rate factor if the issuer's three-year average burn rate is at or below 50% of the applicable ISS benchmark for this factor.

Some other factors are graded on an all or nothing basis and some factors provide for three possible outcomes as to the number of points that can be received. For example, maximum points will be awarded with respect to each of the below discrete factors if the answer for the respective factor is affirmative (and no points for a factor if the answer is negative for such factor):

• the issuer has a clawback policy for recoupment of equity award gains in the event of certain financial accounting restatements;
• the plan imposes vesting conditions of at least one year in duration;
• the plan does not provide for automatic vesting upon a change in control;
• the plan does not permit the plan's re-issuance of shares which are withheld (or tendered to the issuer) for vesting or exercise purposes or which are not issued to the grantee in connection with a stock appreciation right exercise;
• the plan administrator does not have discretion to accelerate vesting of awards (outside of change in control, death, or disability).

The FAQ also provides for three alternative levels of points that can be awarded on the following pillar factors:

Plan Duration – Maximum points will be awarded for the plan duration factor if the plan duration is less than or equal to five years (half of maximum points if the duration is between five and six years) and no points if duration exceeds six years.

CEO Grant Vesting – Maximum points if the duration for full vesting of the issuer's CEO's equity grants awarded within the prior three years was more than four years (half of maximum points for full vesting between three and four years) and no points if full vesting was less than three years.

Proportion of Performance Awards – Maximum points if 50% or more of the CEO's most recent fiscal year equity awards (with three year look-back) were conditioned on achievement of a disclosed performance goal (half of maximum points if proportion was between 33% and 50%) and no points if proportion was less than 33%.

Holding Period – Maximum points if issuer requires that shares acquired from plan grants be held for at least 12 months after exercise or vesting or to end of employment (half of maximum points if holding period is less than 12 months or until ownership guidelines are satisfied) and no points if no minimum holding period or there is silence on this factor.

What's Next?

All publicly held companies which maintain an equity compensation program, whether or not they are submitting their equity compensation plan for shareholder approval in 2015, may want to examine and evaluate their equity grant practices in light of the grant practices pillar of the EPSC. Companies which are planning to submit an equity compensation plan for shareholder approval in 2015 or in the foreseeable future will presumably also want to review their particular plan provisions and any requested share plan increase in light of the other two EPSC pillars. Companies that are submitting an equity compensation plan for shareholder approval may also want to consider registering for and participating in the ISS Equity Plan Data Verification portal. Participation in this relatively new program is optional but is intended to ensure that ISS is utilizing the issuer's current and correct information in connection with formulating its voting recommendations. And, companies with an equity compensation plan proposal may also want to consider engaging with ISS Corporate Solutions in connection with developing their equity plan proposal in order to have their plan costs and features evaluated before actually filing their proxy solicitation.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.