The two biggest and most influential proxy advisory firms, Institutional Shareholder Services (ISS) and Glass Lewis, recently released policy updates for 2021. In addition, ISS published “U.S. Compensation Policies and the COVID-19 Pandemic — Frequently Asked Questions” (FAQs) to help companies impacted by the pandemic consider and disclose pay actions.
Reflecting two of the major current issues in America this year, ISS and Glass Lewis guidance concentrate on COVID-19’s impact on executive pay decisions, and racial and gender diversity on boards. The ISS and Glass Lewis guidance for COVID-19 pay actions will help companies navigate in the immediate, while diversity-related policy updates — in conjunction with directives from major institutional investors — will drive change in American boardrooms in the years to come.
COVID-19 pay actions
ISS published its COVID-19 FAQs in October to assist companies impacted by the pandemic. Glass Lewis took a different approach to COVID-19: Despite the cautionary warnings provided in April, the company did not publish specific guidance related to the pandemic but codified additional factors companies should consider as they make and disclose executive pay decisions. A key theme from both ISS and Glass Lewis is to disclose the rationale clearly and thoroughly for any COVID-related pay changes. While more explicitly discussed by ISS, we at Compensation Advisory Partners (CAP), also believe companies should carefully consider the reasonableness of total executive compensation decisions for 2020.
Here we break down the different guidance from ISS and Glass Lewis.
ISS: COVID-19’s Impact on the Screening Process. According to its FAQs document, ISS will continue to use quantitative screens as a first look at incentive plans at publicly traded companies. The quantitative screens will not be modified to address the impact of the pandemic. Instead, ISS notes that it will continue to use the quantitative screens to identify elevated concerns that warrant more in-depth qualitative reviews of compensation programs and practices. The qualitative evaluation is where ISS considers the impact of COVID-19.
ISS: Temporary Salary Reductions. Many companies impacted by COVID-19 reduced executive salaries, typically in conjunction with adverse actions affecting employees. The ISS FAQs note that salaries are a small portion of total pay for executives. As a result, the impact of salary cuts will be given mitigating weight to the extent they decrease total executive pay. Salary reductions will be considered more meaningful if they flow through to targeted incentive opportunities.
ISS and Glass Lewis: Annual/Short-Term Incentives. Both ISS and Glass Lewis address what they expect to see included in disclosures addressing any changes to annual or short-term incentives.
- Disclosing specific challenges caused by the pandemic, and how they make the original performance goals impossible to achieve. The disclosure needs to address how plan changes are not paying for poor management performance.
- Companies making mid-year changes should explain the rationale for this approach (vs. one-time discretionary awards) and its benefits to investors.
- Companies making one-time discretionary awards should describe how the decision was made and the performance rationale for the award. Avoid generic descriptions, such as "strong leadership during challenging times.”
- Discuss how the resulting payouts appropriately reflect both executive and company annual performance, and what would have been paid under the original program design. Above-target payouts under changed programs will be closely scrutinized.
- Describe the 2021 annual incentive program, if it has been designed. Positive changes may carry mitigating weight in ISS's qualitative evaluation.
- If financial or operational targets are lowered below prior-year performance levels:
- Lower performance expectations that reflect external factors may be a reasonable explanation for lower goal setting.
- A lower performance target should be accompanied by disclosure as to how the board considered corresponding payout opportunities, particularly if payout opportunities are not commensurately reduced.
Glass Lewis expects clearly disclosed justifications to accompany any significant changes to a company’s short-term incentive plan structure, which includes instances in which performance goals have been lowered from the previous year. Additionally, Glass Lewis has expanded its description of the application of upward discretion to include instances of retroactively prorated performance periods. Glass Lewis indicated that it would expect a robust discussion of why the decision was necessary.
ISS and Glass Lewis: Long-Term Incentives. As with annual incentives, both ISS and Glass Lewis address potential problems with changes to long-term incentives.
ISS breaks its guidance into in-progress vs. go-forward award cycles.
For in-progress cycles, ISS recommends:
- The cycle should not be altered after it begins based on a short-term market shock.
- Changes to the cycle will be viewed negatively, particularly with a quantitative pay-for-performance misalignment.
For go-forward cycles (awards granted in most recent year), ISS recommends:
- No drastic changes to the long-term incentive programs unless the underlying business has changed.
- More modest alterations, such as movement to relative or qualitative metrics to address difficult long-term forecasting.
- No drastic changes, such as shifts to predominantly time-vesting equity or short-term measurement periods.
- Clear disclosure of any changes to the program to convey the compensation committee's actions and rationale.
Glass Lewis defined inappropriate performance-based award allocation as a criterion which may, in the presence of other major concerns, contribute to a negative say-on-pay recommendation. Additionally, any decision to significantly reduce or eliminate performance-based awards will be viewed negatively outside of exceptional circumstances and may lead to a negative recommendation on say-on-pay.
ISS: Retention or Other One-Time Awards. In its FAQs, ISS addresses what companies should disclose related to retention or other one-time awards:
- The rationale for the award (including magnitude and structure) and how it furthers investors' interests.
- Boilerplate language regarding "retention concerns” should be avoided.
- Reasonable awards in magnitude and an isolated practice.
- The award should have guardrails, such as limitations on termination-related vesting, to avoid windfall scenarios.
Also, vesting should be:
- Strongly performance-based and clearly linked to the underlying concerns the award aims to address.
ISS also addresses how companies should think about awards made in the context of forfeited incentives:
- Well-structured retention or other one-time awards may be appropriate in limited circumstances.
- Investors do not expect companies to grant such awards as a replacement for forfeited performance-based awards.
- To the extent one-time awards are granted in the year (or following year) in which incentives are forfeited, companies are expected to explain the specific issues driving the decision to grant the awards and how the awards further investors' interests.
- Companies that indicate that one-time awards were granted in consideration of forfeited incentives, for fairness considerations, lowered realizable pay, etc., also need to explain how such awards do not merely insulate executives from lower pay.
ISS and Glass Lewis: Option Repricing. ISS policies on option repricing programs take a case-by-case approach but generally oppose repricings that occur within one year of a significant stock price drop. Companies that reprice options without seeking shareholder approval are reminded in the FAQs that they may receive unfavorable recommendations under ISS’s U.S. policies on board accountability.
Glass Lewis added language clarifying its approach in evaluating option exchanges and repricing proposals. In its policy updates for 2021, Glass Lewis reiterated its general opposition to such proposals. Glass Lewis also reiterated the importance of the exclusion of officers and board members from repricing programs. A repricing program should be value-neutral or value-creative to shareholders if the company wishes for an exception to Glass Lewis’ general opposition to such programs.
ISS: Responsiveness Policy. In addition to the guidance on incentives, ISS released information about its responsiveness policy in light of COVID-19. When a company receives less than 70% support on a say-on-pay proposal, ISS's responsiveness policy reviews three factors:
- The disclosure of the board’s shareholder engagement efforts;
- The disclosure of the specific feedback received from dissenting investors; and
- Any actions or changes made to pay programs and practices to address investors' concerns.
The guidance notes that the expectations regarding the first two factors will remain consistent with prior years. With respect to the third factor, if a company is unable to implement changes because of the pandemic, the proxy statement should disclose specifically how the pandemic has impeded the company's ability to address shareholders' concerns. If pay program changes are delayed, or do not fully address shareholder feedback, the company should disclose a longer-term plan on how it intends to address investors' concerns.
Gender and racial/ethnic diversity of American boards
The ISS and Glass Lewis gender and racial/ethnic diversity policy actions will have a significant impact on board recruitment and composition in the coming years. In addition, boards will need to address environmental and social risk oversight, and clearly disclose their processes for doing so. The chart below compares the two advisers’ updates.
Board Gender Diversity
· Requirement for 2021: One woman on the board
· Action Taken: Recommend against or withhold votes for the nominating committee chair if no women are on the company’s board
· Companies Impacted: Russell 3000 and S&P 1500
· Policy change was announced in previous updates
· Requirement: One woman (effective for 2021) and two women (effective for 2022 but noted as a concern in 2021 if less than two for boards with greater than six members) on the board
· Action Taken: Recommend against votes for the nominating committee chair if there are no women on the company’s board in 2021 and if there is fewer than two women on the company’s board in 2022
· Companies Impacted: Russell 3000
· Policy change was announced in previous updates regarding one woman and the threshold was raised to two women in the recent update
Board Racial / Ethnic Diversity
All new updates (not previously announced)
· Requirement for 2021: Not required to have a racial / ethnically diverse board member
· Action Taken for 2021: Will highlight in a company’s proxy research report the lack of racial and ethnic diversity (or lack of disclosure of such) on its board
· Requirement for 2022: one racially/ethnically diverse board member
· Action Taken for 2022: Recommend against or withhold votes for the nominating committee chair (or other directors on a case-by-case basis) where the board has no apparent racially or ethnically diverse members
· Companies Impacted: Russell 3000 and S&P 1500
· Requirement for 2021: Follow state law requirements on diversity
· Action Taken for 2021: Assess in a company’s proxy research report company disclosure in the proxy statement relating to board diversity, skills and the director nomination process. Will not be making voting recommendations solely on the basis of this assessment in 2021; however, such ratings will help inform Glass Lewis’ assessment of a company’s overall governance and may be a contributing factor in recommendations when additional board-related concerns have been identified
· Companies Impacted: S&P 500 companies
Environmental and Social Risk Oversight
All new updates (not previously announced)
· Action Taken for 2021: Will note that significant risk oversight failures related to environmental and social concerns may constitute material governance failures, and as such, may trigger vote recommendations against board members
· Companies Impacted: All companies
· Action Taken for 2021: Will note as a concern when boards of companies do not provide clear disclosure concerning the board-level oversight afforded to environmental and/or social issues
· Action Taken for 2022: Will recommend voting against a governance chair who fails to provide explicit disclosure concerning the board’s role in overseeing these issues
· Companies Impacted: S&P 500
Based on these policy updates, diversity, environmental and social risk continue to be prominent topics in U.S. board discussions. Companies should thoroughly disclose their diversity, environmental and social efforts, and look to disclosures by larger companies that have made significant progress in these areas as possible examples to follow.
COVID-19, board diversity, environmental and social oversight continue to be issues of concern for U.S. boards into 2021 and beyond. Policy actions by ISS and Glass Lewis will be just one input into decisions made by U.S. companies that will impact their ability to attract, retain and motivate key talent, and provide strong governance oversight in the future. In terms of the gender and racial/ethnic make-up of corporate boards, it remains clear this is a priority for investors and society today. With various constituencies, such as the proxy advisory firms, legislators, the largest institutional investors, NASDAQ and investor groups intensifying their scrutiny on board diversity, CAP expects boardrooms today to look very different over the next two years. The topics discussed in these boardrooms will continue to be more holistic and focused on broader stakeholder groups.
Shaun Bisman is a principal with Compensation Advisory Partners, LLC, based in New York. Shaun provides compensation consulting services to both public and privately-held companies, assisting with corporate governance, peer group development, performance measurement, pay for performance validation, incentive plan design and director compensation.
Bonnie Schindler is a principal at Compensation Advisory Partners, LLC, based in Chicago. Bonnie helps clients design and communicate compensation programs for executives, boards of directors, and employees. She works with publicly traded and privately held companies and has authored surveys on board pay and incentive pay practices at privately held companies.