ISS Releases Updates to US Equity Compensation Plans FAQs

Practical Law Legal Update w-018-2757 (Approx. 7 pages)

ISS Releases Updates to US Equity Compensation Plans FAQs

by Practical Law Employee Benefits & Executive Compensation

Updated FAQs on Code Section 162(m)

In its two FAQs on the TCJA's changes to Section 162(m), ISS states:

It expects that equity plan proposals on the ballot for Section 162(m) qualification will continue to appear, although less often than they did before Section 162(m) was changed.
Its evaluation of Section 162(m)-related proposals remains consistent with prior years.
Proposals that only seek approval to ensure tax deductibility of awards under Section 162(m) (now under the "grandfather rule") and that do not seek additional shares for grants or approval of any plan amendments, will generally receive a favorable recommendation regardless of Equity Plan Scorecard factors ("positive override"), provided that the board's Compensation Committee or other administrating committee is 100% independent according to ISS standards. ISS's Section 162(m)-related US Equity Compensation Plan FAQs assume that these proposals are on the ballot under the grandfather rule of Section 162(m) as revised by the TCJA.

Regarding ISS evaluation of equity plan revisions relating to the Section 162(m) changes under the TCJA, the FAQs explain:

If plan amendments involve removal of general references to Section 162(m) qualification, ISS will view them as administrative or neutral. This includes references to approved metrics for use in performance plan-based awards.
ISS encourages companies to maintain plan provisions that represent good governance practices, such as Section 162(m)'s requirements for qualifying performance-based compensation, even if they are no longer required under Section 162(m), because their removal from the plan may be viewed as a negative change in a plan amendment evaluation.

ISS Equity Plan Scorecard

An updated FAQ explains that, effective for meetings as of February 1, 2019, the following updates apply to Equity Plan Scorecard evaluations:

The change in control (CIC) vesting factor is updated to provide points based on the quality of disclosure of CIC vesting provisions, rather than based on the actual vesting treatment of awards. Full points will be earned if the plan discloses with specificity the CIC vesting treatment for both time- and performance-based awards. If the plan is silent on the CIC vesting treatment for either type of award, or if the plan provides for merely discretionary vesting for either type of award, then no points will be earned for this factor.
There is a new negative overriding factor relating to excessively dilutive equity compensation programs, which is triggered when the company's equity compensation program is estimated to dilute shareholders' holdings by more than 20 percent (for the S&P 500 model) or 25 percent (for the Russell 3000 model). This overriding factor does not apply to the Non-Russell 3000 or Special Cases models.
Certain factor scores have been adjusted under ISS's proprietary scoring model, including an increase in weighting on the plan duration factor to encourage plan resubmission to shareholders more often than listing exchanges require (and following the changes to Section 162(m) that diminished the incentive for periodic shareholder reapproval).

However, the maximum of 100 total points and the threshold of 55 points (for the S&P 500 model) or 53 points (for other models) to receive a favorable recommendation (absent overriding and egregious factors) are unchanged for Equity Plan Scorecard evaluations.

Equity Plan Scorecard: Pillars and Factors

FAQ 36 has been updated and provides a table that shows how the five Equity Plan Scorecard models differ. The table includes the maximum score for each model under three different categories ("pillars"): plan cost, plan features, and grant practices (see Practice Note, Shareholder Approval of an Equity Plan by a Public Company: ISS Voting Recommendations on Equity Compensation Plan Proposals). The table also provides comments on the three pillars.

ISS also devotes several updated FAQs to the Equity Plan Scorecard factors. Updated FAQ 41 includes a table that lists the Equity Plan Scorecard factors, defines them, and provides the scoring basis for them. These factors are not equally weighted and most of them are binary, although certain factors may generate partial points or negative points.

The Equity Plan Scorecard factors fall under the three pillars, and the relationship between the factors and the pillars is discussed in an FAQ.

Plan Cost

The plan cost pillar of the Equity Plan Scorecard considers the potential cost of the transfer of equity from shareholders to employees. According to ISS, this is a key consideration for investors who want equity to be used as efficiently as possible to motivate and reward employees. The Equity Plan Scorecard considers the total potential cost of the company's equity plans relative to industry and market cap peers, measured by the Shareholder Value Transfer (SVT). The SVT represents the estimated cost of shares issued under a company's equity incentive plans, differentiating between full value shares and stock options where applicable.

The ISS Equity Plan Scorecard measures a company's SVT relative to two benchmark calculations that consider:

New shares requested plus shares remaining for future grants (from all active plans), plus outstanding unvested or unexercised grants.
Only new shares requested plus shares remaining for future grants (from all active plans). This measure reduces the impact of grant overhang on the overall cost evaluation.

Plan Features

An ISS FAQ also assesses the impact of certain plan features on the Equity Plan Scorecard. According to ISS, investor and broader market feedback indicate that the following factors may have a negative impact on Equity Plan Scorecard results:

The quality of disclosure of award vesting upon a change in control, if the plan does not provide the specific disclosure of the CIC vesting treatment for both time- and performance-based awards (or if the plan merely provides for discretionary vesting of either award type).
Broad discretionary vesting authority. Such authority may result in "pay for failure" or other scenarios contrary to a pay-for-performance philosophy.
Liberal share recycling on various award types. This obscures transparency about share usage and total plan cost.
Absence of a minimum required vesting period (of at least one year) for all equity award types issuable under the plan. This may result in awards with no retention or performance incentives.
The ability to pay dividends before the vesting of the underlying award.

Grant Practices

According to ISS, the following factors, which are based on a company's equity grant practices, may have a positive impact on Equity Plan Scorecard results, depending on the company's size and circumstances:

The company's 3-year average burn rate relative to its industry and index peers.
Vesting schedules and performance measurement periods for the CEO's most recent equity grants during the prior three years.
The plan's estimated duration, based on the sum of shares remaining available and the new shares requested, divided by the 3-year annual average of burn rate shares.
The proportion of the CEO's most recent equity grants and awards subject to performance conditions.
A clawback policy that includes equity grants. Clawback policies potentially mitigate excessive risk-taking that certain compensation may incentivize, including large equity grants.
Post-exercise and post-vesting shareholding requirements.

Overriding Factors

Updated FAQ 42 lists the egregious features that may result in an "Against" recommendation by ISS, regardless of other EPSC factors. These features are also known as the "Overriding Factors":

A liberal change of control definition that could result in vesting of awards by any trigger other than a full double trigger.
The plan permits repricing or cash buyout of underwater options or stock appreciation rights (SARs) without shareholder approval.
The plan is a vehicle for problematic pay practices or a pay-for-performance misalignment.
The plan is estimated to be excessively dilutive to shareholders' holdings.
Any other plan features or company practices that are deemed detrimental to shareholder interests. These may include, but are not limited to, on a case-by-case basis:
- tax gross-ups related to plan awards;
- a provision for reload options (though not the granting of reload options under a plan previously approved by shareholders); or
- a provision for transferability of stock options to third-party financial institutions without shareholder approval.

Dilution

Updated FAQ 45 explains when excessive dilution will have an adverse recommendation implication for an equity plan proposal. ISS may recommend a vote against the equity plan proposal if the program is potentially highly dilutive to shareholders' holdings. This overriding factor:

Will be triggered when the company's equity compensation program is estimated to dilute shareholders' holdings by more than:
- 20 percent (for the S&P 500 model); or
- 25 percent (for the Russell 3000 model).
Does not apply to the Non-Russell 3000 or Special Cases models.

The FAQ also explains how the share capital dilution overriding factor is calculated.

Burn Rate Benchmarks

The FAQs are followed by an appendix that includes 2019 burn rate benchmarks. The appendix includes several tables that list the GICS code, mean, standard deviation, and burn rate benchmark for various sectors in the S&P 500, Russell 3000 (excluding the S&P 500), and the Non-Russell 3000.

Practical Implications

Executive compensation counsel and their clients should be aware of the updated ISS Equity Compensation Plans FAQs. The FAQs discuss how equity plan proposals on the ballot for Section 162(m) qualification have been affected by the TCJA. The FAQs also discuss the various pillars and factors that affect an ISS Equity Plan Scorecard evaluation.

ISS Releases Updates to US Equity Compensation Plans FAQs | Practical Law