Davis Polk and Semler Brossy Offer an Update on Say-on-Pay

Davis Polk and Semler Brossy Offer an Update on Say-on-PayZoom inDownload PDF

By Kyoko Takahashi Lin, Ning Chiu, Alicyn Gilbert, Blair Jones and Kathryn Neel

The proxy season is just around the corner for calendar year public companies, and, ahead of the season, two major proxy advisory firms, Institutional Shareholder Services (ISS) and Glass Lewis, recently released their 2019 policy updates. ISS’s 2019 policy updates and Glass Lewis’s 2019 policy guidelines, which are generally consistent with the 2018 versions, provide guidance on how ISS and Glass Lewis will make recommendations on companies’ “say-on-pay” vote. As a reminder, the say-on-pay vote is a non-binding advisory vote by shareholders of public companies on the compensation of the CEO, CFO and three other “named executive officers” whose compensation is disclosed in the proxy statement.[1] Although a non-binding vote, performing poorly on a say-on-pay vote is not only disheartening, but can impact shareholder votes on election of directors (particularly compensation committee members), result in greater scrutiny of CEO performance, and require management and compensation committee members to expend significant time and resources to address concerns reflected by the vote.

This memorandum provides an overview of the say-on-pay evaluation processes of ISS and Glass Lewis. In this vein, Appendix A explains a possible future shift in ISS’s quantitative analysis of say-on-pay proposals from GAAP-based metrics to metrics based on Economic Value Added, which, if applicable, may apply as early as the 2020 proxy season. In addition, this memorandum outlines strategies for companies facing a possible negative say-on-pay recommendation by these firms.

One thing to note—as influential as these proxy advisory firms’ voting guidelines are, it is just as, if not more, important to review the voting guidelines of the company’s actual institutional shareholders.

How does ISS evaluate say-on-pay proposals?

ISS’s process for assessing companies’ pay-for-performance mechanics comprises an initial set of quantitative screens followed by a set of qualitative screens.

The quantitative screens are designed to identify outlier companies that have demonstrated significant misalignment between executive pay and company performance over time. If so identified, outlier companies are subject to in-depth qualitative screens to determine:

All companies, whether identified as an outlier or not, are subject to general qualitative screens that include the examination of, for example, the compensation policies and practices disclosed in the Compensation Discussion and Analysis section of their proxy statements.

The results of all applicable qualitative screens ultimately determine ISS’s recommendation for or against companies’ say-on-pay proposals.

What metrics does ISS use in the quantitative screens?

ISS’s quantitative screens consist of three primary screens and a secondary screen. ISS focuses on CEO pay in the quantitative screens, because it considers CEO pay to set the compensation pace at most companies, and the compensation committee and board are most directly involved in decisions regarding the CEO’s pay. The metrics used for each screen are as follows:

Primary Screens:

Secondary Screen:

In October 2018, ISS proposed modifying the FPA to replace GAAP-based metrics with metrics based on Economic Value Added (EVA). However, in the recently released updates to its 2019 benchmark proxy voting policies, ISS chose not to incorporate EVA-based metrics into the FPA for the 2019 annual meeting season. Instead, the FPA will continue to use GAAP-based metrics for the 2019 season and, for informational purposes, ISS will feature EVA-based metrics in its research reports on a phased-in basis during this period. ISS has indicated that it will continue to explore the potential for future use of EVA metrics as part of the FPA, so companies may wish to familiarize themselves with the EVA methodology over the course of the next year. For more detail on the EVA framework, please see Appendix A.

How does ISS apply the quantitative screens?

ISS applies the primary quantitative screens and, where applicable, the secondary quantitative screen (i.e., the FPA), as follows:

What factors does ISS consider in the qualitative screens?

ISS does not provide an exhaustive list of factors that it considers in the qualitative screens. Some of the factors include:

It is worth emphasizing that the above is not an exclusive list of qualitative factors. Importantly, companies’ institutional shareholders may focus on other factors that differ from or are in addition to the above, such as the total quantum of executive pay, excessive severance payouts or the use of retention awards, inducement grants or one-time bonus awards.[3]

What are some examples of pay practices that might result in a negative recommendation from ISS?

ISS evaluates pay practices that are not directly based on performance in its qualitative screens, taking into account the company’s overall compensation program and philosophy. Pay practices that ISS considers to be highly problematic and sufficient to result in a negative recommendation include:

Does ISS’s Governance QualityScore, which in part evaluates companies’ compensation practices, impact ISS’s say-on-pay vote recommendations?

ISS uses the Governance QualityScore to evaluate the corporate governance practices of widely held companies, primarily those listed on major stock indices. Under the Governance QualityScore framework, a company receives an overall score and separate scores in the following four categories: (i) board structure, (ii) compensation and remuneration, (iii) shareholder rights and (iv) audit and risk oversight. Governance QualityScore is a decile-based measure with “1” representing the highest quality of governance practices and the lowest level of governance risks, and “10” representing the opposite.

ISS includes companies’ Governance QualityScores in its proxy reports that provide the proxy advisor’s say-on-pay vote recommendations. However, according to ISS, the Governance QualityScores have no impact on the vote recommendations.[4]

Where can companies find more information about ISS’s methodology?

ISS maintains the following resources on its Policy Gateway webpage to help companies navigate its methodology for evaluating say-on-pay proposals:

ISS updates its evaluation methodology on an annual basis. It generally announces proposed updates (and solicits comments to those proposals) to the evaluation methodology of a given year’s proxy season during the September or October immediately before that year, and then finalizes the changes in December or the following January.

The commenting period has concluded for the 2019 proxy season. ISS has announced that updated Proxy Voting Guidelines and FAQs will be published on December 7 and 31, 2018, respectively. We expect updated Pay-for-Performance Mechanics to be published in December 2018 as well. In the meantime, ISS has released an executive summary of the changes to its Proxy Voting Guidelines, as well as preliminary FAQs on U.S. compensation policies.[5]

How does Glass Lewis evaluate say-on-pay proposals?

Like ISS, Glass Lewis’s process for assessing say-on-pay proposals comprises a quantitative and a qualitative component.

How does Glass Lewis conduct the quantitative assessment?

Under the quantitative assessment, Glass Lewis evaluates the alignment between executive compensation and company performance by applying a proprietary pay-for-performance model that compares, relative to its peer group as determined by Glass Lewis over a weighted 3-year period, a company’s (i) compensation paid to its named executive officers (i.e., not only the CEO) and (ii) stock and business performance.

Depending on the company’s relative percentile rank in executive compensation and company performance and the magnitude of the gap between these measures, Glass Lewis assigns a letter grade between A and F, as follows:

How does Glass Lewis conduct the qualitative assessment?

Under the qualitative assessment, Glass Lewis evaluates the structure and disclosure of the company’s executive compensation program and assigns a grade of “Good,” “Fair” or “Poor” to each. The grades have the following meanings:

Glass Lewis takes a holistic approach in its assessment of say-on-pay proposals. As a result, although a company receiving a “D” or an “F” under the quantitative assessment is more likely to receive a negative recommendation, such a grade does not automatically result in a negative recommendation. Similarly, an “A” does not guarantee a positive recommendation. Glass Lewis weighs all of its findings under the quantitative and qualitative assessments to determine a final recommendation on a say-on-pay proposal.

What are some examples of pay practices that Glass Lewis considers deficient?

Examples of deficiencies in executive compensation program structure and disclosure that, individually or weighed together with other findings (including a finding of disconnect between pay and performance under the quantitative assessment), may cause Glass Lewis to issue a negative say-on-pay recommendation include:

How can companies obtain a copy of ISS’s and Glass Lewis’s say-on-pay vote recommendations?

ISS’s say-on-pay vote recommendations are contained in ISS proxy reports. For a company in the S&P 500 index that has registered with ISS, ISS will provide to the company, on a “best efforts” basis, a draft of the ISS proxy report approximately two to four weeks before the shareholder meeting. The company will then have one or two business days to verify the information in the draft report. ISS publishes the final proxy report approximately 13 to 30 calendar days before the shareholder meeting. All companies can access their final ISS proxy report without charge through ISS’s Corporate Analytics online platform.

Glass Lewis provides a participating company with a data-only version of Glass Lewis’s proxy report, the Issuer Data Report (IDR), approximately 16 to 28 calendar days before the shareholder meeting. Participation is free, through Glass Lewis’s Meetyl platform. The IDR contains data central to Glass Lewis’s analysis of the company’s compensation practices, but does not contain the proxy advisor’s analysis or voting recommendations. When the IDR is available for viewing, the company will have one or two calendar days to comment on the IDR for factual inaccuracies or relevant omissions. The final Glass Lewis proxy report will be available for purchase after it is published in advance of the shareholder meeting. Glass Lewis will notify the company of the availability of the final Glass Lewis proxy report at the company’s request.

Suppose either ISS or Glass Lewis issues a negative say-on-pay recommendation . . .

What can companies do before the shareholder vote?

Companies that receive a negative say-on-pay recommendation from either ISS or Glass Lewis may wish to consider the following responses:

What can companies do after the shareholder vote?

ISS and Glass Lewis consider a company to have received low shareholder support on a say-on-pay proposal if more than 30% and 20% of shareholders, respectively, voted against the proposal. Low shareholder support can have implications for the proxy advisory firms’ recommendations for re-election of board members in subsequent years. If ISS and Glass Lewis do not believe a company has been sufficiently responsive to the shareholder concerns relayed by the say-on-pay vote, they may recommend against the re-election of compensation committee members or the entire board.

To avoid a negative ISS or Glass Lewis recommendation in future years and be responsive to low shareholder support from the previous year, companies may wish to consider the following strategies:


What is Economic Value Added (EVA)?

ISS explains in its literature that EVA is equal to a company’s net operating profit after tax (NOPAT), less a charge on its debt and equity capital (capital charge).[9] The capital charge is equal to the company’s weighted average cost of capital (WACC) multiplied by its total invested capital. EVA represents the after-tax profit that the company must earn to cover its interest expenses and to provide a minimally acceptable return to shareholders. According to ISS, EVA measures are preferred over GAAP measures in the evaluation of companies’ financial and operational performance, because they measure economic profit rather than bookkeeping profit.

How does EVA differ from GAAP metrics?

EVA is focused on the total cash amount investors can take out of a company versus the total cash amount investors have invested in the company. It differs from GAAP metrics in the following important respects:

What are the components of the EVA framework?

When discussing proposed changes to its 2019 proxy voting guidelines, ISS indicated that it intended to focus on the following components of the EVA framework: EVA Spread, EVA Margin and EVA Momentum:

What types of business activities generate EVA?

According to EVA Dimensions, business activities that generate EVA include the following:

If ISS does modify its Financial Performance Assessment (FPA) to replace GAAP-based metrics with EVA-based metrics, what impact should companies anticipate?

Will companies be provided their EVA data?

When discussing proposed changes to its 2019 proxy voting guidelines, ISS indicated that EVA data would be provided free of charge to all covered issuers for their own company. Such EVA data would be provided in advance of their annual meeting and ISS analysis. This data would include EVA metric results, basic benchmarking data and selected data points along with a data dictionary to help understand the information.

Does ISS anticipate that the change to EVA would have a significant impact on companies?

When discussing proposed changes to its 2019 proxy voting guidelines, ISS stated that it did not expect that the implementation of the EVA-based measures would have a significant impact on the number of companies that receive “low” and “medium” quantitative concern levels as part of ISS’s analysis. It expected that companies that receive a “high” concern on the primary TSR-based screens would continue to receive a final concern level of “high,” and the FPA screen would not contain a provision to mitigate the most severe concerns on the initial TSR-based assessment.

ISS stated that the size of the impact of the EVA-based FPA should be approximately the same as the current assessment using GAAP-based measures. ISS noted that, in the 2018 proxy season, fewer than 5 percent of companies with a “low” concern level were upgraded to “medium” concern, and a very similar number of “medium” concern companies were downgraded to “low” concern.

Should companies address EVA in their proxy statement?

Companies typically use their proxy statement disclosure to describe their pay-for-performance philosophy. Unless a company has already been using EVA as part of how it has granted compensation or measured performance, we would recommend that companies continue to describe the fundamentals of their compensation program. That said, to the extent that a company could demonstrate strong financial and operational performance in EVA-based metrics, it might wish to emphasize those points.

Proactive disclosure of which aspects of a company’s business model and strategy make it different from peers can also be helpful. This discussion helps explain why the company uses the metrics it does and not other common metrics, as well as provide context for why results may vary from peers (for example, frequent or significant M&A or effecting a turnaround). This additional context would be helpful with the current FPA, but could be more pressing should the less well-understood EVA measures become more prominent in ISS’s evaluations.

As companies consider potential changes to their compensation program, is it recommended that they change their performance metrics to be based on EVA?

Companies typically review the design of their compensation program and the selection of performance metrics on a periodic to ensure they continue to effectively align executive pay with the company’s strategic plan. If performance metrics continue to drive the company’s fundamental levers of performance, particularly growth and returns, then, at least in theory, the company’s EVA should increase accordingly.

We suggest that companies work with their finance groups to better understand EVA and the EVA component metrics in order to help the management team and the compensation committee better understand how the company might be evaluated with an EVA lens. It may also be helpful to start to consider what comparisons against peers might look like, including the factors that might contribute to significant differences from peers, and how EVA comparisons would differ from the current FPA comparisons. This analysis will help companies consider how to better explain why they have selected the metrics they have, how their incentive metrics create long-term value and why their measurement approach might differ from peers.


[1] Emerging growth companies and foreign private issuers are exempt from the requirement to conduct the say-on-pay vote.

[2] ISS does not consider time-based options to be performance-based awards.

[3] For example, Vanguard and Capital Group have both indicated that they expect executive pay to be reasonable on an absolute basis, regardless of how the companies’ compensation plans may be designed to reward performance. Vanguard has also expressed concern over excessive severance payments, and Blackrock has cautioned against an overreliance on discretion or extraordinary pay decisions (e.g., severance, retention awards, inducement grants and/or one-time bonus awards).

[4] In February 2018, ISS introduced the E&S QualityScore to measure the quality of disclosure regarding environmental and social issues for companies operating in industries such as energy, materials, and consumer durables and apparel. Like the Governance QualityScore, the E&S QualityScore is disclosed alongside ISS proxy reports but has no impact on ISS’s vote recommendations.

[5] The preliminary FAQs covered three topics. First, ISS noted that they will not be using EVA as part of their quantitative screens for the 2019 proxy season. Second, ISS noted that they will not be issuing adverse recommendations in connection with director pay for 2019. Third, ISS provided a non-exhaustive list of updates to their Equity Plan Scorecard methodology for 2019.

[6] For companies in the banking, diversified financial and insurance sectors, change in operating cash flow is replaced by tangible book value per share growth. For REITs other than mortgage and specialized REITS, change in operating cash flow is replaced by growth in funds. ROA and ROE are calculated for the year under review. The other three metrics are based on weighted average data of the year under review plus the previous two years. Glass Lewis does not disclose the weightings.

[7] Glass Lewis recently clarified that it considers a “C” to represent alignment between pay and performance (i.e., a grade of C or above would be considered as a “good” grade by Glass Lewis).

[8] Like ISS, Glass Lewis does not consider time-based options to be performance-based awards.

[9] ISS has disclosed that, in February 2018, it acquired the business of EVA Dimensions LLC, a business intelligence firm that measures and values corporate performance based on the EVA framework. ISS describes EVA as “an established standard in measuring, analyzing, projecting, valuing and discounting a firm’s underlying economic profit rather than its bookkeeping profit.” It acknowledges that several providers, other than ISS, produce EVA measurements, with a methodology similar to the one used by ISS.

This post is based on the memorandum from Davis, Polk & Wardwell and Semler Brossy Consulting Group titled, “A Say-on-Pay Update — Plus Strategies for Responding to a Negative Recommendation by a Proxy Advisory Firm,” dated November 29, 2018. Download the memorandum at the top of this post.