Proxy advisory firms providing voting guidance on Say on Pay proposals offer a potentially important service to institutional investors challenged to make informed decisions on Say on Pay. The advice of proxy advisory firms can be market moving. Yet, while their influence is profound, the majority of shareholders, voting in 2011 and 2012 on Say on Pay proposals, do not agree with the proxy advisors’ recommendations. These advisors, including the most influential, Institutional Shareholder Services (ISS), need to do some soul searching and look at whether their recommendations are appropriately grounded in a level of effort and diligence commensurate with their potential influence.
1.Using Say on Pay as a Cudgel: The apparent motivation of ISS, to use Say on Pay as a cudgel, diminishes its influence. How else can an ISS AGAINST recommendation make sense, for example, at companies that have Governance Risk Indicator (GRid) scores increasing from 68 to 100, or at companies that have implemented successful investor outreach programs on executive pay.
2. Flawed Peer Groups, Flawed Conclusions: Using a “one size fits all” approach to constructing its own peer group, ISS ignores the peer groups approved by a company’s board and uses peer groups with recurring oddities, such as retailers being included in an entertainment company’s peers, or a refining and marketing company in a peer group of an exploration and production-based oil company.
3. More Than Relative Total Shareholder Returns (TSR): While relative TSR is an important measure of long-term value creation, it should be the starting point, rather than the ending point it is for ISS. ISS should also be held to a standard similar to those used by equity research analysts and be expected to factor in abnormalities that occur before of after the measurement period and to exercise some appropriate judgment in determining how a company has performed.
4. Consider the Effects of Timing: Significant grants of LTI made in Q1 are judged against relative TSR through year-end, a significant timing disconnect in the ISS process. Positive prospective changes in pay programs disclosed in the proxy are rarely considered by ISS as a qualitative factor to overrule its backward-looking analytics.
5. Understand Pay: Most institutional investors, compensation committees and executives consider stock options performance-based pay, since they pay only when stock price grows. ISS does not consider an option performance based, nor does it choose to value options in line with SEC-approved GAAP methodology. Rather, it values them at a higher level. ISS also defines pay as the up front mathematical expected value, such as a stock option’s Black-Scholes value. Most institutional investors would prefer to know how much pay executives realize, based on actual results.
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