On November 19, 2009, RiskMetrics Group (RiskMetrics), a leading proxy advisory firm, released its U.S. and international corporate governance policy updates for the 2010 proxy season. Please see the U.S. Corporate Governance Policy 2010 Updates (2010 Policy Updates) for details. The 2010 Policy Updates apply to annual meetings held on or after February 1, 2010. This client alert reviews the most significant U.S. policy updates and analyzes related matters for companies to consider now.
Many institutional investors follow or at least consider RiskMetrics’ proxy voting recommendations when voting their shares, and concerns raised by RiskMetrics – particularly as they relate to governance practices that reflect or affect accountability to shareholders – often are shared by a broader class of institutional investors. Three other developments will make it a crucial year for companies to evaluate the potential for concerns raised by RiskMetrics to affect voting results at 2010 annual meetings. First, the impact of RiskMetrics’ voting recommendations likely will be magnified during the 2010 proxy season as a result of the Securities and Exchange Commission’s approval of amendments to New York Stock Exchange (NYSE) Rule 452, under which brokers will not be able to vote customers shares in uncontested director elections unless the customer returns voting instructions. Second, RiskMetrics has reported that the number of directors who failed to be re-elected by a majority vote in the 2009 proxy season, even prior to the amendment of Rule 452, approximately equaled the number of shareholder proposals that passed. Finally, based on shareholder proposals received by companies to date, it appears that fewer proposals will be excludable in 2010, as a result of changed SEC staff interpretations, experience gained by proponents in developing proposals that satisfy SEC rule standards and increased coordination by proponents in submitting shareholder proposals.
Each of the foregoing issues means that many companies are likely to face a difficult proxy season. As a result, companies with significant institutional investor ownership, companies with majority voting in uncontested director elections and companies with certain disfavored executive compensation practices in particular should review these updates carefully. By proactively addressing potential concerns when appropriate or providing appropriate disclosures, companies may be able to respond to or reduce the likelihood of receiving negative voting recommendations by RiskMetrics.
Summary of Significant RiskMetrics Policy Changes for the 2010 Proxy Season
Framework for Executive Compensation Evaluation. RiskMetrics will unify under a new Executive Compensation Evaluation policy its existing pay-for-performance, options backdating, and poor pay practices policies, as well as its guidelines for evaluating company say on pay proposals. The Executive Compensation Evaluation policy will have three prongs, each of which RiskMetrics previously applied to some aspect of executive compensation voting decisions: (1) evaluating the connection between CEO pay and company stock price performance; (2) evaluating whether the company engages in problematic pay practices; and (3) evaluating board responsiveness to shareholder concerns over executive compensation practices (such as responses to shareholder proposal votes) and board communication on compensation issues.
Recommendations issued under the Executive Compensation Evaluation policy may apply to any or all of the following items, depending on the issue: election of directors (primarily compensation committee members), company say on pay proposals, and/or equity compensation plan proposals. Where RiskMetrics identifies concerns with a company’s executive compensation practices, RiskMetrics voting recommendations will depend on whether the company has provided for a shareholder advisory vote on executive compensation (company say on pay):
- For companies that provide an advisory vote on executive compensation, RiskMetrics will address what it views as problematic executive compensation practices by recommending an Against vote on the advisory vote, and will recommend withhold or against votes on such companies’ compensation committee members (and in some instances the full board or equity compensation plans) only in response to “egregious” pay practices.
- Where a company does not provide an advisory vote on executive compensation, which is the case for most companies, RiskMetrics will continue to respond to problematic executive compensation practices by recommending withhold or against votes on such companies’ compensation committee members (and in some instances the full board or equity compensation plans).
Pay-for-Performance. One element of RiskMetrics’ Executive Compensation Evaluation policy will involve evaluating the connection between CEO pay and company stock price performance. Under this prong, a company is evaluated for a potential pay-for-performance disconnect if its one-year and three-year total shareholder returns (TSRs) are in the bottom half of its four-digit Global Industry Classification Group. If a company falls within the bottom half, then RiskMetrics will evaluate whether changes in the CEO’s total compensation are aligned with TSR. In conducting that evaluation, RiskMetrics considers the following factors in conducting its pay-for-performance evaluation – with the third factor new for 2010:
- whether the CEO’s total compensation (as calculated by RiskMetrics) has increased or decreased in the most recent year-over-year comparison, and the magnitude of the change;
- the reason for the change in pay with respect to the pay mix (i.e., performance- versus non-performance-based elements) and whether the elements of pay create or reinforce shareholder alignment; and
- the long-term (at least five years) alignment of the CEO’s total direct compensation with the company’s total shareholder returns, with particular focus on the most recent three years.
Significantly, RiskMetrics will conduct this evaluation even if the CEO’s total direct compensation for the most recent year has stayed relatively constant or even declined from the previous year. RiskMetrics may not issue a negative voting recommendation if a company can demonstrate that the CEO’s compensation has changed in a manner that enhances its alignment with shareholder returns or if a company makes a renewed commitment to pay-for-performance arrangements.
“Poor” Pay Practices. Another element of RiskMetrics’ Executive Compensation Evaluation policy is to evaluate whether a company engages in what RiskMetrics views as poor or problematic pay practices. RiskMetrics updated its guidance regarding examples of poor pay practices which standing alone may result in negative voting recommendations, which we have set forth in Exhibit A to this Client Alert. In addition, in evaluating whether a company has problematic pay practices, RiskMetrics will now also assess “risk-motivating” incentive practices, including:
- guaranteed bonuses;
- a single performance metric used for short- and long-term plans;
- lucrative severance packages;
- high pay opportunities relative to industry peers;
- disproportionate supplemental pensions; and
- “mega” annual equity grants that provide unlimited upside with no downside risk.
In this regard, RiskMetrics also will consider factors that may mitigate the impact of risky incentives, such as rigorous claw back provisions and robust stock ownership/holding guidelines.
Majority Votes Against Director Nominees. As noted above, during the 2009 proxy season, a record number of directors failed to receive a majority of “For” votes (although many of these occurred at companies that do not have majority voting standards). In commentary, representatives from RiskMetrics have observed that these situations typically did not arise due to a single factor, but instead a “layering” of issues that cumulatively resulted in one or a few director nominees at a company failing to receive a majority of “For” votes. The most common factors contributing to withhold or against votes for director nominees were:
- directors ignoring previous year majority votes in favor of shareholder proposals or, at smaller cap companies, ignoring high “withhold” or “against” votes against other directors;
- directors adopting poison pills without a shareholder vote, as discussed below, or approving an option exchange without a shareholder vote;
- directors serving on the compensation committee where there are egregious pay practices;
- an “affiliated outside director” serving on a company’s audit, compensation or governance committee, as discussed below;
- a director with an excessive and unexplained number of meeting absences;
- an “over boarded” director; and
- directors serving on the audit committee at companies that do not provide detail as to services underlying high tax services fees paid to the independent auditor or where the company has experienced a restatement that raises concerns regarding the audit committee’s oversight.
Director Independence Definition. RiskMetrics applies its own independence criteria to categorize director nominees as “inside directors,” “affiliated outside directors” or “independent outside directors” and recommends “withhold” or “against” votes for inside directors or affiliated outside directors who serve on a company’s audit, compensation or governance committee. RiskMetrics is revising its independence definition to change when transactional relationships or the provision of professional services by a director or an organization with which he or she is affiliated will result in RiskMetrics considering the director to be an “affiliated outside director” as opposed to an “independent outside director”:
- Transactional Relationships: RiskMetrics announced that it will evaluate transactional relationships between the company where the director serves and an organization only if the director or an immediate family member of the director is a partner in, a controlling shareholder of or an executive officer of the organization. RiskMetrics will not consider other relationships material.
- Transactional Relationships: Until now, RiskMetrics has applied the NASDAQ-based materiality test to all companies when evaluating whether there are transactional relationships (including charitable contributions) that impact director independence. Going forward, RiskMetrics will apply the transactional test to a company’s directors based on where the company is listed. Specifically: (1) companies that follow the NYSE/AMEX listing standards now will be subject to an NYSE-based test of the greater of $1 million or two percent of the recipient’s gross annual revenues; and (2) companies not listed on NYSE will continue to be subject to a NASDAQ-based test of the greater of $200,000 or five percent of the recipient’s gross annual revenues.
- Professional Services: When assessing whether a director’s relationship with an organization that provides “professional services” to the company, the definition of professional services currently includes services that are “advisory in nature.” RiskMetrics is clarifying that such services “generally involve access to sensitive information or to strategic decision-making, and typically having a commission- or fee-based payment structure.” As a result, professional services may include insurance services, information technology services, marketing services, lobbying services, executive search services, and property management and realtor services. On the other hand, the provision of educational services no longer will make a director an affiliated outside director.
Voting on Directors – Adoption or Renewal of Non-Shareholder Approved Poison Pills. RiskMetrics currently recommends “Against” or “Withhold” votes for all nominees on a board of directors (except new nominees) if the board adopts or renews a poison pill without shareholder approval and does not commit to putting it to a shareholder vote within 12 months of adoption. Under its policy:
- RiskMetrics will initially recommend “Against” or “Withhold” votes for directors if the board does any of the following after November 19, 2009 without shareholder approval: (a) adopts a long-term poison pill (i.e., with a term of more than 12 months), although this recommendation may be offset if the board commits to put the newly adopted pill to a binding shareholder vote; (b) renews any poison pill; or (c) makes a material, adverse change to an existing poison pill.
- If a company continues to maintain a long-term poison pill not approved by shareholders, RiskMetrics will review the company every three years (or annually if the company’s board is classified) and recommend or continue to recommend “Against” or “Withhold” votes for the director nominees. This represents a shift from RiskMetrics’ previous policy, under which it did not continue to review a company once a poison pill was in place.
- RiskMetrics will make a case-by-case recommendation on director nominees if a board adopts a short-term poison pill (i.e., with a term of 12 months or less), taking into account: (a) whether the company had time to seek shareholder ratification of the poison pill; (b) the company’s rationale; (c) the company’s governance structure and practices; and (d) the company’s track record of accountability to shareholders. This case-by-case assessment also takes into account RiskMetrics’ new policy on NIL protective provisions, discussed below.
Voting on Directors – “Egregious Actions.” RiskMetrics will recommend “Against” or “Withhold” votes on individual directors, a board committee or the entire board as a result of what it considers “egregious actions.” Under its new policies, RiskMetrics is expanding the circumstances it will take into account when making such recommendations, including examining directors’ actions at other companies. Specifically, while RiskMetrics in the past has made negative voting recommendations when a board failed to replace management in circumstances when RiskMetrics would consider such action appropriate, it now also will apply this policy in the event of:
- “[m]aterial failures of governance, stewardship, or fiduciary responsibilities at the company;” and
- “[e]gregious actions related to the director(s)’ service on other boards that raise substantial doubt about [their] ability to effectively oversee management and serve the best interests of shareholders at any company.”
Shareholder Rights and Defenses
Net Operating Loss (NOL) Protective Amendments and Poison Pills. Recognizing the high potential value of net operating losses (NOLs), the 2010 Policy Updates set forth new, parallel policies on protective amendments to company governing documents and poison pills that are intended to protect a company’s NOL. Specifically, RiskMetrics will evaluate company proposals with respect to these amendments and poison pills on a case-by-case basis considering: (a) the ownership threshold/trigger; (b) the value of the NOL; (c) for poison pills, the term; (d) shareholder protection mechanisms (such as a sunset provision); (e) the company’s existing governance structure (including board independence and existing takeover defenses); and (f) any other factors that RiskMetrics determines to be applicable.
Proposals Allowing Shareholders to Call Special Meetings or Act by Written Consent. RiskMetrics currently recommends “For” votes on company or shareholder proposals that remove restrictions on the rights of shareholders to call special meetings or act by written consent. RiskMetrics generally will continue to recommend voting “For” these proposals, but will take into account the following factors: (a) shareholders’ current rights to call a special meeting or act by written consent; (b) the minimum ownership threshold required to call a special meeting (with 10% of outstanding shares being RiskMetrics’ preferred standard) or act by written consent; (c) the existence of exclusionary or prohibitive language that imposes procedural limitations on shareholders’ right to call a special meeting or act by written consent; (d) the company’s ownership structure; and (e) shareholder support of and management’s response to previous shareholder proposals.
Supermajority Vote Requirements. The 2010 Policy Updates amend RiskMetrics’ voting recommendations with respect to proposals that reduce supermajority vote requirements. Responding to a concern that removing supermajority voting provisions may harm minority shareholders when an individual or group has a majority ownership position in the company, RiskMetrics will now make a case-by-case assessment of such proposals for companies with significant shareholders.
Proposals to Increase Common Stock and Preferred Stock Authorizations. The 2010 Policy Updates expand RiskMetrics’ existing policies with respect to proposals to increase the number of shares of common stock or preferred stock authorized for issuance. RiskMetrics will continue to make voting recommendations on these proposals on a case-by-case basis, but will now emphasize the company’s disclosure of specific reasons for the proposed increase, the company’s historical use of its authorized shares and recent total shareholder return.
RiskMetrics revised several policies regarding shareholder proposals that address corporate responsibility:
Greenhouse gas (GHG) emissions. RiskMetrics will now determine voting recommendations on a case-by-case basis (as opposed to generally recommending votes against) on shareholder proposals that request the adoption of GHG reduction goals. RiskMetrics will consider various factors as part of their analysis, including whether the proposal is too restrictive, the feasibility of GHG reductions at the company and the company’s current GHG disclosures.
Board diversity. RiskMetrics generally recommends votes for shareholder proposals asking for reports on efforts to diversify the board and on a case-by-case basis on shareholder proposals asking the company to increase the representation of women and minorities on the board. For 2010, RiskMetrics will clarify that references to diversity mean “gender and racial minority representation” and, with respect to proposals requesting increased board diversity, whether the proposal includes an overly prescriptive request to amend nominating committee charter language.
Linking executive compensation to corporate responsibility. The 2010 Policy Updates amend RiskMetrics’ voting recommendations with respect to proposals asking to link, or report on linking, executive compensation to environmental and social criteria (such as corporate downsizings, customer and employee satisfaction, community involvement, human rights, environmental performance, or predatory lending). As opposed to its previous case-by-case analysis, RiskMetrics will now generally recommend “Against” votes on such proposals. However, RiskMetrics will consider the following factors in making its recommendation: (a) whether the company has significant and persistent controversies or violations regarding social and/or environmental issues; (b) whether the company has management systems and oversight mechanisms in place regarding its social and environmental performance; (c) the degree to which industry peers have incorporated similar non-financial performance criteria in their executive compensation practices; and (d) the company’s current level of disclosure regarding its environmental and social performance.
Other RiskMetrics Changes for the 2010 Proxy Season
RiskMetrics also announced that it will reformat and revise the cover page of its proxy advisory reports for companies when issuing its voting recommendations, beginning with the 2010 proxy season. Most notably, the cover page will now include a summary of key corporate governance and executive compensation concerns with respect to that company, as well as a chart comparing CEO total compensation and total shareholder return over the past five years. In addition, we understand that RiskMetrics expects to replace its Corporate Governance Quotient (CGQ) by mid-year. CGQ is a benchmarking tool that rates the corporate governance structures and policies of nearly 8,000 companies worldwide. A company’s CGQ scores are included in the RiskMetrics proxy advisory report for that company, posted on Yahoo! Finance and distributed to RiskMetrics’ institutional investor clients.
What Companies Should Do Now
In light of the RiskMetrics 2010 Policy Updates, companies should consider the following steps.
1. After fiscal year-end, assess whether RiskMetrics considers the company to have failed the one, three and/or five-year performance test (based on total shareholder returns in the bottom half of the company’s four-digit Global Industry Classification Group). If so, examine the RiskMetrics policies that incorporate this corporate performance test, including the pay-for-performance criteria.
2. Examine whether RiskMetrics will consider your company to have any of the poor pay practices described in Exhibit A or other disfavored governance practices that may result in RiskMetrics recommending “Against” or “Withhold” votes on directors up for election in 2010.
3. Discuss with your compensation committee whether to adopt claw back provisions and/or stock ownership/holding guidelines to mitigate the impact of executive compensation incentives that RiskMetrics may view as risky, and provide enhanced disclosure of the committee’s assessment of risk incentives in the executive compensation programs.
4. Consider enhancing disclosures of performance-based compensation elements in executive compensation, discussing trends in the mix of elements of executive compensation and providing more information on issues that may raise concerns regarding a director’s qualifications.
5. Review last year’s proxy voting recommendations by proxy advisory firms like RiskMetrics and consider addressing practices or concerns that were noted in those reports, regardless of whether they resulted in negative recommendations in the previous year, and determine whether there are any other issues that the company should address in advance of the 2010 proxy season in light of RiskMetrics’ 2010 Policy Updates.
Pay practices that alone may trigger a negative RiskMetrics voting recommendation:
- Egregious employment agreements: for example, agreements containing multi-year guarantees for salary increases, non-performance based bonuses, and equity compensation.
- New CEO with overly generous new-hire package: for example, excessive “make whole” provisions without sufficient rationale.
- Abnormally large bonus payouts without justifiable performance linkage or proper disclosure: includes performance metrics that are changed, canceled or replaced during the performance period without adequate explanation of the action and the link to performance.
- Egregious pension/SERP (supplemental executive retirement plan) payouts: for example, inclusion in new agreements of additional years of service not worked that result in significant benefits provided in new arrangements and inclusion of performance-based equity awards in pension calculations.
- Excessive perquisites: for example, perquisites for former and/or retired executives (such as lifetime benefits, car allowances, personal use of corporate aircraft or other inappropriate arrangements) and extraordinary relocation benefits (including home buyouts).
- Excessive severance and/or change in control provisions: including (1) change in control payments exceeding three times of base salary and bonus, (2) change-in-control payments without loss of job or substantial diminution of job duties (single-triggered), (3) new or materially amended employment or severance agreements that provide for modified single triggers, under which an executive may voluntarily leave for any reason and still receive the change-in-control payments, and (4) new or materially amended employment or severance agreements that provide for an excise tax gross-up (including modified gross-ups).
- Tax reimbursements: reimbursement of income taxes on executive perquisites or other payments (e.g., personal use of corporate aircraft, executive life insurance, bonus, etc; see also excise tax gross-ups above).
- Dividends or dividend equivalents paid on unvested performance shares or units.
- Executives using company stock in hedging activities, such as “cashless” collars, forward sales, equity swaps or other similar arrangements.
- Repricing or replacing of underwater stock options/stock appreciation rights without prior shareholder approval (including cash buyouts).
Additional pay practices that may trigger a negative RiskMetrics voting recommendation or cautionary language in combination with other practices:
- Excessive severance and/or change in control provisions: for example, payments upon an executive’s termination in connection with performance failure and a liberal change in control definition in individual contracts or equity plans which could result in payments to executives without an actual change in control occurring.
- Overly generous perquisites, which may include, but are not limited to personal use of corporate aircraft, personal security systems maintenance and/or installation, car allowances and executive life insurance.
- Internal pay disparity: excessive differential between CEO total pay and that of next highest-paid named executive officer (NEO).
- Voluntary surrender of underwater options by executive officers: may be viewed as an indirect option repricing/exchange program especially if those cancelled options are returned to the equity plan, as they can be regranted to executive officers at a lower exercise price, and/or the executives subsequently receive unscheduled grants in the future.
Other pay practices deemed problematic but not covered in any of the above categories.