On October 18, 2018, Institutional Shareholder Services (ISS) commenced a two-week consultation period on potential updates to its benchmark voting policy for 2019. There are a total of nine U.S. and international draft policy updates for consideration, of which two relate to U.S. governance matters: Financial Performance Assessment methodology and Board gender diversity.
Financial Performance Assessment Methodology
For the 2018 proxy season, ISS introduced an additional modifier, the Financial Performance Assessment (FPA) as part of its pay-for-performance screen. The FPA is a secondary screen that provides an assessment of company performance currently based on unadjusted GAAP accounting data.
ISS proposes to modify the FPA methodology to use Economic Value Added (EVA) metrics in place of unadjusted GAAP metrics. This change is not unexpected given ISS’ acquisition of EVA Dimensions earlier in 2018. “EVA Spread,” “EVA Margin,” and “EVA Momentum” will replace ROA, ROE, ROIC, EBITDA growth and cash flow growth. Specifics as to how these EVA concepts will be calculated are not provided in the announcement; however, based on our understanding of the metrics and prior information on EVA published by EVA Dimensions, we expect them to be roughly defined as follows:
- Economic Value Added (EVA) = a dollar value representing a company’s profit after deducting its weighted-average cost of capital
- EVA Spread = the difference between a company’s weighted-average cost of capital and return on invested capital, or EVA divided by capital
- EVA Margin = EVA divided by sales
- EVA Momentum = the change in EVA over a period divided by sales in the prior period
These definitions will rely on GAAP adjusted metrics. The details of those adjustments have not yet been disclosed, but it is safe to assume a series of adjustments will be made to GAAP financial statements to better understand the economics of the business.
ISS believes that using EVA measures for FPA creates a more reliable and accurate view of company performance. ISS also believes that this change will simplify the FPA approach as each EVA metric will be weighted equally, and the weightings will be the same for all companies in all industries, in contrast with the current FPA methodology where GAAP measures and weightings vary by four-digit GICS industry group, and not all industries use all available metrics.
We note that the proposed FPA update will not mitigate poor total shareholder return (TSR)-based results as companies that receive a “high” concern on the primary TSR-based screens will continue to receive a final concern level of “high.”
ISS does not expect the implementation of the EVA-based measures to have a significant impact on the number of companies that receive “low” and “medium” quantitative concern level results. ISS estimates that the size of the impact of the EVA-based FPA should be approximately the same as the current assessment using GAAP-based measures. In the 2018 proxy season, fewer than five percent of companies with a “cautionary low” concern level were upgraded to “medium” concern, and a similar number of “medium” concern companies were downgraded to “low” concern.
ISS is specifically seeking feedback on the following:
- Under this proposed update, the framework of the primary ISS pay-for-performance model methodology is unchanged and will continue to use TSR as its main performance metric. Does your organization agree with that approach? If not, please explain.
- If the existing FPA screen performance measures are replaced with EVA-based measures, would you prefer that ISS continue to display GAAP performance data for informational purposes?
It is important to recognize that TSR remains the primary measure of performance for ISS and that this proposal solely modifies the metrics used under the secondary FPA screen, which impacts a limited number of pay-for-performance assessments.
Board Gender Diversity
In 2018, ISS proxy research reports began noting where a company's board lacked gender diversity. However, no adverse recommendations were issued on directors’ elections for this reason. In response to investors' strong support for diversifying the composition of corporate boards, ISS is proposing a new voting policy on directors for companies with no female directors serving on their boards.
The proposed new ISS policy is stated as follows:
For companies in the Russell 3000 or S&P 1500, effective for meetings on or after Feb. 1, 2020, generally vote against or withhold from the chair of the nominating committee (or other directors who are responsible for the board nomination process on a case-by-case basis) at companies when there are no female directors on the board. Mitigating factors that may be considered include:
- a firm commitment, as stated in the proxy statement and/or other SEC filings to appoint at least one female director to the board in the near term (before the next annual general meeting);
- the presence of at least one female director on the board at the immediately preceding annual meeting; and/or
- any other compelling factors considered relevant on a case-by-case basis.
ISS is explicitly requesting feedback on the following:
- Under what circumstances should ISS consider recommending against directors other than the chair of the nominating committee (e.g., full nominating committee; full board; board chair, controlling shareholder)?
- What mitigating factors other than those specified in the proposed policy would temporarily excuse the absence of a female director on a company’s board? What weight would your organization give to those factors?
- What should be considered to be an appropriate time commitment to appoint a female director to an all-male board? Why?
- Does your organization agree with the one-year transition period to implement the proposed policy? If not, please explain.
As proposed, there would be no impact on vote recommendations in 2019 for directors as a result of the policy.
Comment Period; Final Policy Updates
The comment period is open until 5:00 PM (Eastern) on November 1, 2018. If adopted, the policies would take effect for meetings on or after February 1, 2019. Click here to access the policy drafts from the ISS website.
The final ISS policy updates, which may extend beyond the policies open for comment, are expected to be announced during mid-November. Note that certain other voting policy details for 2019 (e.g., burn rate thresholds and pay-for-performance quantitative concern thresholds) are expected to be announced through updated ISS FAQs in December.
Joe Sorrentino has over 20 years of executive compensation consulting experience. His client assignments have been with both public and privately-held companies in industries including: chemicals, consumer products, financial services, health care, manufacturing, pharmaceuticals, real estate/REITS and utilities. His consulting engagements often focus on the development of executive compensation strategy, design of annual and long-term incentive programs, and ISS equity plan modeling, compensation and governance policies.
Michael R. Marino
Mike Marino has over 19 years of combined corporate and consulting experience. He has extensive experience working with board compensation committees and generally attends or participates in over 80 committee and/or board meetings annually. A frequent writer and speaker on emerging issues in the field, Mike has consulted with a diverse group of clients ranging from large industrial, financial and service-based companies to small public and private companies. In addition, Mike works with many private equity firms and their portfolio companies across a variety of industries.