Institutional Shareholder Services (ISS) released its 2011 policy updates on November 19, 2010. These updates apply to shareholder meetings that will be held on or after February 1, 2011.

ISS is the largest and most influential of the proxy advisory firms. Recently, there has been increased debate about the role of ISS, including whether it wields too much power and whether appropriately screens from conflicts. In the SEC concept release on proxy plumbing, the SEC solicited comments on potential conflicts of proxy advisory firms (which give vote recommendations on proposals of the same companies that may hire them to provide governance consulting services). On the other hand, some investors argue that ISS practices are transparent as to dealing with conflicts and that the greater internal cost to institutional investors to analyze proposals and make vote determinations, without the recommendations of proxy advisers, would be detrimental to shareholders.

Regardless of the pros and cons of proxy advisory firms, ISS currently exercises a broad influence over institutional investors. One study found that a negative ISS recommendation in uncontested director elections is correlated with a 20.3 percent drop in favorable votes by shareholders. Other studies have found that ISS is able to influence shareholder votes by 6 percent to 19 percent. Companies should therefore consider these policy updates when preparing for the upcoming proxy season. If there is a possibility of any "Against" recommendations, particularly as a result of ISS's more holistic review of problematic executive compensation practices, companies should start a dialogue with ISS to determine how to avoid an "Against" recommendation. Also, immediately after ISS issues its report on a company's proposals, the company should review it for any factual errors and request corrections.

New Policies

Frequency Votes – Each public company is required by the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) to include a non-binding say-on-pay proposal in its proxy statement during 2011. The Dodd-Frank Act also requires a proposal on the frequency (whether every one, two or three years) of the company's say-on-pay advisory votes. ISS has issued a new policy that recommends a vote in favor of holding the say-on-pay vote annually. In the explanation for this policy, ISS makes an analogy between annually elected boards and annual say-on-pay proposals, explaining that a more frequent vote provides the clearest form of communication and most direct accountability between shareholders and management. A less frequent say-on-pay vote may confuse management as to whether shareholders were approving or rejecting pay practices in the most recent year, the whole period, or another prior term.

The drafting of this new policy was closely watched—and it received the most comments. If a two or three year period may be more appropriate in conjunction with a company's compensation practice, management should begin discussions with their large institutional investors and explain their basis for recommending less frequent votes in the proxy disclosure.

Golden Parachutes in Mergers and Acquisitions – The Dodd-Frank Act also implements a requirement that a company seeking approval of a merger, acquisition, or other fundamental transaction, must submit a proposal for shareholder approval of associated executive compensation (golden parachute payments). The new policy adopted by ISS will consider these proposals on a case-by-case basis, consistent with ISS's current policy on severance packages, which focuses on inappropriate windfalls and tax coverage of executives. Some factors that may lead to a recommendation to vote "Against" include:

  • Excise tax gross-up provisions;
  • Modified single-trigger payments;
  • Single-trigger payments immediately upon a change in control (including cash and acceleration of performance-based equity);
  • Single-trigger acceleration of equity grants if the "change in control" definition only requires shareholder approval (rather than the effectiveness of the transaction);
  • Potentially excessive severance;
  • Golden parachute arrangements that would influence the merger agreement and may not be in the best interests of shareholders (presumably because the executive would act in his or her own self-interest, rather than negotiating the best deal for the company); and
  • A proposed transaction that is conditioned on shareholder approval of the golden parachute arrangement through the advisory vote.

In the event that a company voluntarily includes its golden parachute arrangements in its annual say-on-pay vote, ISS has publicly indicated that it will only recommend a positive vote on the say-on-pay proposal if both the golden parachute arrangements and the company's overall compensation program meet ISS standards. Therefore, voluntary inclusion of the golden parachute arrangements in order to avoid a later separate vote could backfire and result in a negative say-on-pay vote.

Revised Policies

Problematic Pay Practices – The revised policy shortens the list of problematic pay practices that are serious enough to warrant, in and of themselves, a recommendation to vote "Against" the election of directors who serve on the compensation committee and "Against" say-on-pay proposals. These "egregious" practices include the repricing or exchange of stock options without shareholder approval; paying excessive perquisites or tax gross-ups; and new agreements or extensions that provide for any of the problematic change in control features (such as those discussed above under the new policy on golden parachutes) in accordance with ISS's policy aimed at curtailing the perpetuation of such features. Also, ISS will no longer give a favorable recommendation based on a commitment by the company regarding future pay practices. Outside of these "egregious" practices, ISS will continue to look at a company's complete approach to compensation for problematic practices and may issue an "Against" recommendation based on a holistic view.

Director Attendance – ISS updated its director attendance policy, which recommends an "Against" or "Withhold" vote for a director who attends less than 75 percent of board and committee meetings without an acceptable excuse. The new policy has a narrower category of acceptable reasons (medical or illness-related, family emergencies, and missing one of three or fewer meetings) and requires disclosure of the reasons for the director's absences in the company's proxy statement or other SEC filing.

Failure to Act on Majority-Supported Shareholder Proposals – ISS updated its policy on responsiveness to majority-supported shareholder proposals. The policy recommends an "Against" or "Withhold" vote for the entire board of directors (except new nominees) for failure to act on majority-approved shareholder proposals. The policy continues to apply to proposals that received approval from the majority of the shares outstanding in the previous year. In addition, the new policy applies to failure to act on shareholder proposals that received approval from the majority of the votes cast in the last year and in one of the two previous years. This is a broader application than the prior policy, which applied to shareholder proposals that received approval from the majority of the votes cast in the last two years. ISS states that the change is meant to sweep in shareholder proposals the SEC may allow to be excluded for a year from the company's proxy.

NOL Protective Amendments and NOL Poison Pills – The policies on net operating loss (NOL) protective amendments to a company's charter or bylaws and on NOL protective shareholder rights plans were updated to recommend an "Against" vote if the amendment or plan would remain effective after the NOLs are used or for more than three years. If this term restriction is met, ISS will consider these proposals on a case-by-case basis, considering various factors. The policy change is consistent with ISS recommendations in prior years for NOL proposals without a three-year limit.

Shareholder Action by Written Consent – ISS recommends "Against" votes for proposals that restrict shareholders' ability to act by written consent and generally recommends "For" votes for proposals that provide the right to act by written consent. With the 2011 policy updates, ISS will now review proposals that provide the right to act by written consent by making a more holistic evaluation of the company's overall governance practices. Specifically, ISS will now review shareholder proposals on a case-by-case basis if the company has a majority vote standard for directors; has an annually elected board; allows shareholders holding 10 percent of the vote to call a special meeting; and does not have a poison pill in place that has not been approved by shareholders. ISS explains this change by recognizing that some shareholder proposals to act by written consent may not be in the best interest of all the shareholders, especially in a hostile situation.

Increasing Authorized Stock – ISS revised its policy for case-by-case voting on proposals requesting an increase in authorized stock. ISS will now recommend "Against" votes for proposals to increase authorized capital if there is also a proposal for a reverse stock split on the same ballot, which would also effectively increase the common stock available for issuance. Although a reverse stock split may be a valid action for a company facing delisting risk with an exchange, ISS does not believe two measures to simultaneously increase the authorized stock is appropriate. The new policy clarifies that proxy disclosure is essential and must describe the specific risks to investors if the measure is not approved; it also provides a new method to determine allowable increase amounts.

Reverse Stock Splits – In connection with the revised policy on increased authorized capital, ISS also revised its policy to recommend a vote "Against" proposals for a reverse stock split when the authorized capital is not also proportionately decreased, unless the company has received notice of potential delisting from an exchange and the effective increase in authorized shares would be allowable under the new methodology to evaluate the increase. In the past, ISS recommended votes "For" reverse stock splits to avoid delisting, regardless of the extent of the potential increase in authorized stock.

Equity Compensation Plan Burn Rates – ISS continues to recommend votes "Against" equity plans for companies with an average three-year burn rate that exceeds the limits. The policy update adds a requirement that the allowable burn rate caps do not change year-over-year by more than 2 percent in either direction. This is to account for recent market volatility that may heavily impact annual burn rate caps and may not actually reflect average usage. An updated burn rate chart will be available when the ISS 2011 Summary Policies are released.

Miscellaneous – The 2011 policy updates also implement some minor changes. ISS generally supports shareholder proposals to restore or provide cumulative voting, subject to exceptions. The 2011 update removes the exception for companies that had a "similar structure" to proxy access, which allowed shareholders to nominate directors to the company's ballot. ISS explained that the language was unnecessary because companies do not use this approach and, once the court challenge is resolved, the SEC may lift its stay on federal proxy access. An additional change is that ISS will now apply its U.S. policies to companies that are incorporated outside of the U.S. but are listed on a U.S. exchange and considered domestic issuers by the SEC. This change is expected to affect 74 companies. Finally, ISS updated the language—though not the substance—of its policy regarding proposals to link executive compensation to environmental or social practices.

A copy of the ISS 2011 policy updates can be found at: http://www.issgovernance.com/files/ISS2011USPolicyUpdates20101119.pdf .

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