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Topics, Issues, and Controversies in Corporate Governance and Leadership

Institutional Shareholder Services: The Uninvited Guest at the Equity Table

By David F. Larcker and Brian Tayan May 17, 2010

Approval of Equity-Based Compensation

The compensation committee of the board of directors is tasked with designing the compensation package of the CEO and other senior officers of the company.1 The committee informs its decision in part based on market data and advice provided by the internal human resources department or a third-party advisor. The compensation package is then approved by a vote of the full board. Equitybased compensation (including stock options, restricted shares, and performance shares/units granted to all employees) requires approval by a vote of shareholders. This is because the issuance of new shares dilutes the ownership interest of shareholders, and therefore cannot be affected without their consent. Approval is solicited through the annual proxy statement.
institutional shareholder services

voting procedures, to shareholder rights, to antitakeover protections. ISS formulates its recommendation based on proprietary proxy voting guidelines which it updates each year. Over time, ISS increasingly has assumed a central position in the proxy voting process. It counts over 1,700 institutional investors as clients, managing an estimated $25 trillion in equity securities.3 Its opinions are cited in the media. According to some estimates, a recommendation by ISS can sway a proxy vote by 15 to 20 percent.4
iss Analysis of Equity Plans

In recent years, Institutional Shareholder Services (ISS) has played an influential role in the proxy voting process.2 Founded in 1985, the firm provides recommendations to institutional investors on how to vote the annual proxy. Prior to the firms founding, institutional investors often voted in accordance with management recommendation, or did not vote at all. As a result, most items on the proxy were approved, with little regard for their impact on governance quality. ISSs proxy advisory services are intended to give shareholders greater influence over management by providing an independent assessment of the impact of proxy items. These include director election, ratification of the public auditor, equity-based compensation plans, merger approvals, and charter and bylaw amendments that impact everything from

ISS uses four tests to inform its recommendation on a companys equity compensation plan: 1. Burn Rate: A calculation of the number of shares granted through equity-based plans annually over the previous three years, as a percentage of average shares outstanding. A company fails this test if its burn rate is one standard deviation higher than the industry average, as computed by ISS. 2. Pay for Performance: A determination of whether the company has generated positive total shareholder return over the previous one-year period or three-year period, and whether it has increased the total direct compensation of the CEO in the previous year. A company fails this test if total shareholder return is negative over both of these periods and the company has raised CEO compensation. 3. Shareholder Value Transfer (SVT): A calculation of the value of equity that has been paid to all company employees and still stands to be paid to employees under both existing and proposed equity plans, as a percentage of the total market
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institutional shareholder services: The Uninvited Guest at the Equity Table

capitalization of the company. A company fails this test if SVT exceeds an industry specific cap that is determined by a proprietary calculation of SVT among companies at the top quartile of the industry in terms of shareholder returns. 4. Poor Pay Practices: A company fails this test if it engages in compensation practices that ISS generally deems to be poor, such as option repricing, high concentration of grants to senior executives, egregious employment contracts, excessive benefits and perquisites, poor pay disclosure, internal pay inequity, and other.5 ISS recommends a vote in favor of a companys proposed equity plan only if it passes all of these tests (see Exhibit 1). According to one compensation consultant, Companies look very carefully at those caps, and I have a lot of clients who are reluctant to exceed them.6 In order to gain approval, some companies instead choose to adjust their plans to conform to ISSs models (see Exhibit 2). Several companies are highly critical of the proxy advisory firms influence. For example Tesco, the British retail chain, wrote a letter to regulators expressing concern about unengaged fund managers increasingly delegating voting decisions.7 Others question ISSs methodology. The chairman of Kingsgate Consolidated called the firms analysis of his companys compensation plan particularly flawed and indicative of a tick-a-box mentality.8 For its part, ISS believes that its methodology is both rigorous and objective. According to ISS, its recommendations serve as an industry standard and best practice guide to corporate governance. Its analyses are based on rigorously formulated voting policy, reflecting institutional investors perspectives.9
Why This Matters

these caps are precisely computed? 4. Companies curtail their equity plans to conform to ISS models. Is this good for shareholders (because those grants would be too large and destroy value) or is it bad for shareholders (because those grants provide important incentive to employees)? 5. The credit rating agencies are regulated by the Securities and Exchange Commission and international regulators. Should ISS be similarly regulated?
This Closer Look was originally titled: RiskMetrics Group: The Uninvited Guest at the Equity Table. 2 For more on this topic, see also: David F. Larcker and Brian Tayan, Theres a New Sheriff in Town: Institutional Shareholder Services, GSB Case No. CG-07, Oct. 15, 2007; David F. Larcker and Brian Tayan, Corporate Governance Ratings: Got the Grade What Was the Test? GSB Case No. CG-08, Oct. 15, 2007. Available at: https://gsbapps.stanford.edu/cases/. Robert Daines, Ian Gow, and David F. Larcker, Rating the Ratings: How Good are Commercial Governance Ratings? (September 4, 2009), Stanford Law and Economics Olin Working Paper No. 360; Rock Center for Corporate Governance at Stanford University Working Paper No. 1. Available at SSRN: http://ssrn.com/abstract=1152093. 3 U.S. Government Accountability Office, Report to Congressional Requesters: Corporate Shareholder Meetings; Issues Relating to Firms That Advise Institutional Investors on Proxy Voting, June 2007. Accessible at: http://www.gao.gov/new.items/d07765.pdf. 4 Shawn Tully, Proxy Muses, Fortune, Dec. 25, 2006. 5 Institutional Shareholder Services, U.S. Proxy Voting Manual of ISS. 6 Proxy Muses, loc. cit. 7 Mike Foster, Tesco Calls on Fund Managers to Drop Proxies, Financial News, May 4, 2010. 8 Barry Fitzgerald, Kingsgate Boss Criticises Pay Vote, The Age, Nov. 10, 2009. 9 RiskMetrics Group, ISS Governance Services, Proxy Research Services for Institutional Investors Worldwide. Available at: http:// www.riskmetrics.com/proxy_advisory/benefits.
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1. ISS has a high level of influence on voting outcomes. Is this appropriate? 2. Companies question whether ISS recommendations are a best practice or not. What is the evidence that ISSs recommendations actually improve corporate outcomes? 3. ISS is not transparent about how it calculates industry caps on burn rate and SVT. Do shareholders and boards have a right to know how

David Larcker is the Morgan Stanley Director of the Center for Leadership Development and Research at the Stanford Graduate School of Business and senior faculty member at the Rock Center for Corporate Governance at Stanford University. Brian Tayan is a researcher with Stanfords Center for Leadership Development and Research. They are coauthors of the books A Real Look at Real World Corporate Governance and Corporate Governance Matters. The authors would like to thank Michelle E. Gutman for research assistance in the preparation of these materials. The Stanford Closer Look Series is a collection of short case studies that explore topics, issues, and controversies in corporate governance and leadership. The Closer Look Series is published by the Center for Leadership Development and Research at the Stanford Graduate School of Business and the Rock Center for Corporate Governance at Stan-

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institutional shareholder services: The Uninvited Guest at the Equity Table

ford University. For more information, visit: http://www.gsb.stanford.edu/cldr. Copyright 2012 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved.

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institutional shareholder services: The Uninvited Guest at the Equity Table

Exhibit 1 iss: Methodology on Equity Based Compensation Test 1: Burn Rate

Burn rate equals the adjusted shares (restricted stock and options) granted in a year, divided by the average shares outstanding. Restricted shares are adjusted by a multiplier to translate them into an equivalent number of options. The size of the multiplier varies according to the companys annual stock price volatility. The companys burn rate is compared to an industry cap rate. The industry cap rate is one standard deviation over the industry average (but not less than 2 percent). ISS calculates the industry cap based on its own proprietary models. ISS recommends a vote against the compensation plan if the companys average burn rate over the previous three years is greater than the cap.
Test 2: Pay for Performance

ISS evaluates the following three questions: 1. Has the company generated positive total shareholder return over the previous year? 2. Has the company generated positive total shareholder return over the previous three years? 3. Did the CEOs total direct compensation increase over the previous year? ISS recommends a vote against the plan if the answer to the first two questions is no and the answer to the third question is yes.
Test 3: Shareholder Value Transfer (SVT)

SVT includes the total value of equity-based grants that have been awarded and may still be awarded to employees under all existing and proposed equity compensation plans. ISS values options using a proprietary binomial pricing model. Vested, in-the-money options are included in the computation but previously exercised options are excluded. SVT is then expressed as a percentage of the companys market capitalization. SVT is compared against an industry cap. The industry cap is determined by calculating the SVT of the companies that are in the top quartile of the industry in terms of total shareholder returns. ISS calculates the industry cap based on its own proprietary models. ISS recommends a vote against the plan if SVT exceeds the industry cap.
Test 4: Poor CEO Pay Practices

ISS recommends a vote against the plan if the company has poor or questionable CEO pay practices. Examples include: 1. Option repricing 2. Option backdating 3. High concentration of grants made to senior executives 4. Employment contracts with egregious clauses. 5. Excessive benefits, bonuses, pensions, signing provisions, or change-in-control protections. 6. Poor disclosure on pay policies 7. Large internal pay inequity between the CEO and other senior executives
Note: These criteria are strictly adhered to. ISS will not make an exception based on a companys specific situation. Source: Institutional Shareholder Services, U.S. Proxy Voting Manual of ISS.

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institutional shareholder services: The Uninvited Guest at the Equity Table

Exhibit 2 Disclosure on Equity-Based Compensation Plans Iberiabank Corporation

After giving consideration to comments from Institutional Shareholder Services (ISS) and in order to facilitate approval of the Plan, on January 18, 2010, upon the recommendation of the Compensation Committee, the Companys Board of Directors (the Board) amended the Plan to (i) reduce the maximum number of shares of the Companys common stock available for issuance under the Plan from 600,000 shares to 500,000 shares, and (ii) limit to 250,000 common shares the maximum number of shares that the Company may issue as full value awards (i.e., awards, such as restricted stock awards, for which the recipient gets full value of the stock, rather than awards based on future appreciation in stock value, such as options). In order to minimize the dilutive impact on the Companys existing shareholders of grants of equity-based awards, the Board has committed that, with respect to the 500,000 shares of common stock being reserved for issuance under the Plan, the average burn rate of equity awards will not exceed a three-year average of 2.18% through the Companys fiscal year ending December 31, 2012. The Companys burn rate will be recalculated following the end of each fiscal year during this period.
Pinnacle Entertainment, Inc.

Following the Companys review of the recently published analysis of this proposal by Institutional Shareholder Services and in order to facilitate stockholder approval of the amendment to the 2005 Plan, the Company is amending the proposed amendment to the 2005 Plan to reduce the proposed increase in the number of shares subject to the 2005 Plan from 1,500,000 to 1,100,000.
Headwaters, Inc.

In response to external feedback and concerns voiced regarding the Companys equity burn rate of its stock-based compensation awards, on February 17, 2010, the Company determined that it will take appropriate steps to control its equity burn rate. Equity burn rate analysis is a measure of dilution that shows how rapidly a company is using its shares reserved for equity compensation plans. This analysis is frequently used by institutional investors to determine whether they should support or reject equity compensation proposals submitted to a companys stockholders for approval. [] In connection with the proposed Plan approval, the Company commits to maintain an average annual equity burn rate for the fiscal years ending September 30, 2010, 2011 and 2012 not exceeding an average of 2.07% per year (which is the blended average of Institutional Shareholder Services published burn rate thresholds for 2009 and 2010), excluding equity incentives assumed in connection with any future acquisitions by the Company.
Note: To avoid confusion, the proxy advisory firms name has been updated in these filings from its previous RiskMetrics Group to the current Institutional Shareholder Services when necessary. Source: Equilar. Iberiabank, Form 8-K filed Jan. 19, 2010; Pinnacle Entertainment, Form 8-K filed May 3, 2010; Headwaters, Form 8-K filed Feb. 18, 2010, with the SEC.

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