Introduction

Institutional Shareholder Services Inc., formerly known as RiskMetrics Group ("ISS"), recently released its annual U.S. Corporate Governance Policy Update for the 2011 proxy season, announcing changes to the policies that ISS will use in formulating its voting recommendations. The 2011 Policy Update is effective for annual meetings of shareholders held on or after February 1, 2011. To view the full text of the 2011 Policy Update, please see: http://www.issgovernance.com/files/ISS2011USPolicyUpdates20101119.pdf .. ISS has also issued a set of Frequently Asked Questions (FAQs) providing additional guidance on its positions related to certain executive compensation and shareholder advisory vote issues. To view the full text of the 2011 Compensation FAQs, please see: http://www.issgovernance.com/policy/2011/USCompensationFAQ .

This year's update is important for public companies because it addresses the new advisory shareholder votes related to executive compensation that are required under The Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"). The 2011 Policy Update also outlines changes in ISS's policies with respect to voting on director nominees in uncontested elections and proposals relating to certain shareholder rights and defenses. The most significant changes reflected in the 2011 Policy Update include the following:

  • ISS will recommend annual (rather than biennial or triennial) advisory voting for future advisory shareholder votes on executive compensation;
  • ISS will evaluate advisory vote proposals to approve a company's "golden parachute" or change-in-control compensation packages on a case-by-case basis;
  • ISS has revised its list of egregious executive pay practices that could give rise to negative vote recommendations, and has indicated that it will no longer accept future commitments on problematic pay practices as a way of precluding or reversing a negative vote recommendation;
  • ISS will recommend against reelection of director nominees who attend fewer than 75 percent of their board and applicable committee meetings unless they have a valid publicly disclosed excuse under ISS's revised policy guidelines;
  • ISS generally will continue to recommend voting in favor of management and shareholder proposals to allow shareholders to act by written consent, but it will now consider shareholder proposals on a case-by-case basis if the company has certain other shareholder rights provisions in place; and
  • ISS will recommend against proposals to adopt poison pills or charter amendments designed to protect a company's net operating losses ("NOLs") if their term of application exceeds three years or the exhaustion of the NOLs.

The following is a summary of the most significant changes to the voting recommendation guidelines contained in the 2011 Policy Update.

Shareholder Votes Relating to Executive Compensation

Implementing Dodd-Frank Act Provisions

On October 18, 2010, the Securities and Exchange Commission (the "SEC") proposed rules to implement certain provisions of the Dodd-Frank Act mandating advisory "say-on-pay" votes (the "Proposed Rules") at U.S. public companies. The Proposed Rules require that:

  • At least once every three years, a public company must include in its proxy statement a proposal for an advisory, nonbinding, shareholder vote to approve the compensation of its named executive officers as disclosed in the company's proxy statement in accordance with the SEC's executive compensation disclosure rules (the "Say-on-Pay Proposal");
  • At least once every six years, a public company must include in its proxy statement a proposal for an advisory, nonbinding, shareholder vote on whether the company's future Say-on-Pay Proposals should be included in the proxy statement every one, two or three years (a "Frequency Proposal");
  • In any proxy or consent solicitation to approve certain merger or acquisition transactions, companies must disclose and include a proposal for a separate advisory, nonbinding, shareholder vote on golden parachute or other compensation arrangements triggered by the transaction, unless such payments have previously been approved as part of a Say-on-Pay Proposal (a "Golden Parachute Proposal"); and
  • Additional disclosure must be provided in conjunction with these advisory shareholder votes.

For an in-depth analysis of the Proposed Rules, please see Fried Frank Memorandum ;Dodd-Frank Say-on-Pay Proposed Rules.

Frequency Vote

The Dodd-Frank Act (as interpreted by the SEC) requires that a company's proxy statement, for its first annual meeting (or other meeting of shareholders at which the topics for discussion trigger executive compensation disclosure in the proxy materials under SEC rules, such as the election of directors) on or after January 21, 2011, include a Say-on-Pay Proposal and a Frequency Proposal. Going forward, companies must give shareholders an opportunity once every six years to vote on the frequency of their Say-on-Pay Proposals by including a Frequency Proposal in their proxy statements. A company may recommend its preferred frequency in the proxy proposal, but under the Proposed Rules, the Frequency Proposal must allow shareholders to vote for one of four options including whether future Say-on-Pay Proposals should occur every one, two or three years or whether the shareholder abstains from voting on this issue. With respect to the Frequency Proposal, ISS has adopted a policy to recommend voting for future Say-on-Pay Proposals to appear every year. This policy demonstrates ISS's continued support of practices that it believes provide the highest level of accountability for management. In recent policy updates, ISS has identified the Say-on-Pay Proposal as the primary communication vehicle for expressing dissatisfaction with compensation practices. In ISS's view, companies that hold annual advisory votes on compensation will provide shareholders with a more direct opportunity to communicate their concerns about companies' executive pay programs than if the votes were held only every two or every three years. In its FAQs, ISS clarified that it has no policy concerning a management recommendation that may be included as part of a company's Frequency Proposal, regardless of whether or not the management recommendation is for future votes on an annual basis and, further, ISS currently has not determined its position for future recommendations if a company's board of directors decides to adopt a frequency voting policy that does not follow the frequency interval that garnered the most support of the company's shareholders.

Golden Parachute Vote

Unlike the Say-on-Pay and Frequency Proposals, the Golden Parachute Proposal will not be required to be included in a proxy statement until the SEC's final rules become effective. As proposed, a Golden Parachute Proposal would be required to be included in a proxy statement for a solicitation in connection with certain merger or acquisition transactions unless the golden parachute arrangements were previously approved as part of a Say-on-Pay Proposal. If there are changes to the golden parachute arrangements that were previously approved as part of prior Say-on-Pay Proposals, a Golden Parachute Proposal will be required regarding those changes and disclosure of both the old and the new arrangements will need to be provided. Concerning a Golden Parachute Proposal, ISS has adopted a policy to review and recommended voting for or against these proposals on a case-by-case basis. In the FAQs, ISS notes that if a "Golden Parachute Table" has been included in the company's proxy disclosure (whether the proxy is for an annual meeting or meeting where shareholders are also voting on a change in control transaction), the Golden Parachute information would carry more weight in ISS's overall Say-on-Pay Proposal recommendation. Consistent with its existing policy on problematic pay practices, ISS disfavors severance packages that it believes provide inappropriate windfalls and cover certain tax liabilities of executives. Some of the compensation design features that may lead to a negative voting recommendation on a Golden Parachute Proposal (or, perhaps, on a Say-on-Pay Proposal, depending on the circumstances) include agreements adopted or materially amended since the prior annual meeting that include excise tax gross-up provisions or modified single triggers (meaning, generally, providing payment if an executive voluntarily leaves employment during a defined "window" period following a change in control), single-trigger payments that will be made immediately upon a change in control (including any cash payments or the acceleration of performance-based equity despite the failure to achieve performance measures), potentially excessive severance payments, amendments or changes that make packages so attractive as to influence merger or transaction agreements that may not be in the best interests of shareholders, and any assertion by the Company that the proposed transaction is contingent on shareholder approval of a Golden Parachute Proposal.

Problematic Pay Practices

ISS evaluates executive pay and practices on a case-by-case basis, considering a company's specific pay practices in the context of its overall pay program demonstrated pay-for-performance philosophy. Where a company maintains problematic pay practices, ISS will generally recommend a vote against a Say-on-Pay Proposal. In addition, ISS may recommend a vote against an equity-based incentive plan proposal if excessive non-performance-based equity awards are the major contributor to a pay-for-performance misalignment, and may recommend a withhold vote or a vote against compensation committee members (or, in cases where the full board is deemed responsible, all directors, including the CEO) in egregious situations, when no management Say-on-Pay proposal is on the ballot, or when the board has failed to respond to concerns raised in prior management Say-on-Pay evaluations.

For the 2011 Policy Update, ISS has revised its list of egregious pay practices. Although ISS stated in its FAQs that there is no "automatic" negative recommendation, if a company utilizes a particular problematic pay practice, these practices may, when considered in the context of the company's policies lead to adverse recommendations. ISS will consider all relevant aspects of the use of the practice(s) that are explained in the company's disclosure. The practices considered to carry the most weight in ISS's overall analysis include:

  • Repricing or replacing of underwater stock options or stock appreciation rights without prior shareholder approval (including cash buyouts and voluntary surrender of underwater options);
  • Excessive perquisites or tax gross ups; and New or extended agreements that provide for (i) change in control payments exceeding three times base salary and average/target/most recent bonus, (ii) change in control severance payments without involuntary job loss or substantial diminution of duties (single or modified single triggers); and (iii) change in control payments with any excise tax gross ups.

For a detailed list of the specific pay practices that ISS has identified as potentially problematic, and additional information on ISS's position on certain specific practices, please see the 2011 Compensation FAQs, last updated by ISS on December 14, 2010, available at the link above.

Commitments

In the past, when ISS identified a problematic pay practice, it would, under certain circumstances, refrain from making, or reverse, a negative voting recommendation if the company made a commitment to eliminate the offending pay practice on a going forward basis. Effective immediately, subject to limited exceptions, ISS will cease accepting future commitments on problematic pay practices as a way of preventing or reversing a negative voting recommendation. ISS has stated that exceptions to this new position include, generally, commitments regarding certain pay-for-performance measures and burn-rate caps for which ISS's policy benchmarks are not disclosed until late in the year, as well as commitments related to plan amendments to modify certain equity grant practices.

Voting on Director Nominees in Uncontested Elections

Director Attendance

ISS believes directors cannot be effective representatives of the shareholders if they have poor attendance records at board and committee meetings. Accordingly, ISS policy will now be to recommend against directors who attend fewer than 75 percent of their board and relevant committee meetings without a valid excuse. In the past ISS would typically evaluate the information on a case-by-case basis if the absences were due to unavoidable conflict and the company provided meaningful public or private disclosure explaining the director's absences. In appropriate circumstances companies would privately provide information to ISS if a particular director attended fewer than 75 percent of the meetings in the prior year. In the 2011 Policy Update, ISS has eliminated the private disclosure option, indicating that it will only consider reasons for directors' absences that are disclosed in the company's proxy statement or other SEC filings, and then only to the extent that the absences are due to medical issues/illness or family emergencies (or if the director's total service was three meetings or fewer and the director only missed one meeting). Furthermore, if the public disclosure is insufficient to determine whether the director attended at least 75 percent of board and committee meetings, ISS will recommend a withheld vote or a vote against that director.

Responsiveness to Majority-Supported Shareholder Proposals

ISS policy is to recommend against an entire board of directors (except new nominees, who should be considered on a case-by-case basis) if the board failed to act on a shareholder proposal that received the approval of either (i) a majority of the shares outstanding the previous year or (ii) the majority of the shares cast for the previous two consecutive years. In formulating its recommendations, ISS will now recommend against an entire board of directors (except new nominees, who should be considered on a case-by-case basis) if the board failed to act on a shareholder proposal that received the approval of the majority of the shares cast in the last year and one of the two previous years. Under this formulation, application of the policy will not be precluded if, for example, a shareholder proposal is absent from the ballot in one year due to an exclusion allowed by the SEC. There is no change to the ISS policy of recommending against an entire board of directors (except new nominees, who should be considered on a case-by-case basis) if the board failed to act on a shareholder proposal that received the approval of a majority of the shares outstanding the previous year.

Shareholder Rights and Defenses

Shareholder Ability to Act by Written Consent

ISS has historically recommended voting against management and shareholder proposals that restrict or prohibit shareholders' ability to act by written consent and for proposals that remove such restrictions or affirmatively provide shareholders with the ability to act by written consent, taking into consideration the shareholders' then-current right to act by written consent, the consent threshold, the inclusion of exclusionary or prohibitive language, the investor ownership structure, and shareholders' support of (and management's response to) previous shareholder proposals. ISS, in acknowledging the potential risk of abuse associated with the right to act by written consent and recognizing that there are alternative mechanisms for shareholders to express concern and act between annual meetings, has updated its policy and will consider as an additional factor the company's overall governance practices and takeover defenses. Applying this new factor, ISS will now recommend voting on a case-by-case basis on shareholder proposals if, in addition to the foregoing considerations, the company has an annually elected board, has a majority-vote standard in uncontested director elections, does not have a non-shareholder-approved rights plan, and gives shareholders an unfettered right to call special meetings at a 10 percent threshold (with "unfettered" meaning there are no restrictions on the number of shareholders who can group together to reach the 10 percent threshold, no restrictions on agenda items, and only reasonable limits on when a meeting can be called (no greater than 30 days after the last annual meeting and no greater than 90 days prior to the next annual meeting)).

Net Operating Loss (NOL) Poison Pills and Protective Amendments

Last year ISS adopted a new policy that it would evaluate management proposals to adopt ownership limitations intended to protect the value of NOLs on a case-by-case basis. In evaluating a proposed amendment, ISS determined that it would consider factors similar to those considered when evaluating management proposals to adopt an NOL poison pill. Because of the low threshold involved (typically NOL pills and NOL-protective amendments prohibit stock ownership transfers that would result in a new 5 percent owner or increase the stock ownership percentage of an existing 5 percent owner), ISS believes such poison pills and amendments should not remain in effect permanently. Accordingly, ISS has revised its policy to specify that the NOL poison pills and NOL-protective amendments should last no longer than three years. ISS will vote against proposals to adopt a poison pill or adopt an NOL-protective amendment if the effective term would exceed the shorter of three years and the exhaustion of the NOL. In light of this new policy, if a company has an NOL poison pill with an effective term exceeding three years, it may want to reconsider the length of the effective term

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