ISS Updates Policy on Stock Ownership Guidelines
May 18, 2021
In late April, ISS updated its U.S. Procedures & Policies (Non-Compensation) FAQ to note the following change to its policy on stock ownership guidelines (see question #19):
If [stock ownership] guidelines allow for the inclusion of unearned performance awards or unexercised options (or any portion thereof, such as the current "in the money" value) towards meeting the guidelines, the company will no longer receive credit for having stock ownership guidelines.
My first thought upon reading this was “Credit for what?” My second thought was “How does ISS think it is going to find out about these policies?” For answers to these questions, I reached out to Laura Wanlass of Aon.
Credit for What?
Laura explained to me that ISS takes ownership guidelines into account for four purposes:
- Governance QualityScore: ISS assigns companies a numeric score between 1 and 10 based on the quality of their governance policies, including (among many other factors) whether a company imposes stock ownership guidelines on its CEO and directors. A company’s QualityScore does not affect ISS’s vote recommendations, although it may impact how institutional investors view the company.
- Say-on-Pay: When making a recommendation on a company’s Say on Pay proposal, ISS notes the presence of executive stock ownership guidelines as a risk mitigation practice, but ownership guidelines are not a material factor in the overall Say-on-Pay analysis.
- Nonemployee Director Compensation: When evaluating stock plans for nonemployee directors and director Say-on-Pay proposals, ISS evaluates whether any holding periods or stock ownership guidelines exist for nonemployee directors. This is, however, just one of many factors that ISS considers.
- Shareholder Proposals on Executive Holding Periods: ISS evaluates the presence and level of stock ownership guidelines or holding periods when determining whether to support such a shareholder proposal. Here again, this is just one of many factors that ISS considers.
This new ISS policy could be problematic for those industries where options are the predominant equity vehicle used to compensate executives. Executives and directors in these companies may have few other opportunities through which to acquire company stock (other than buying stock on the open market) and thus may find it difficult to achieve the mandated ownership levels.
Think about it: if most of the equity awards executives receive are stock options and they don’t count towards the ownership guidelines, how will the execs acquire enough stock to meet the ownership guidelines? This could effectively force the execs to exercise their stock options immediately upon vesting and hold the acquired stock, which could require a significant cash outlay from execs and isn’t always the smartest investment strategy.
Not counting unexercised stock options towards ownership is even more problematic if the options are underwater—would execs be required to exercise underwater stock options simply to achieve their ownership target? It seems unlikely that companies would force executives to do so. In practice, what would probably happen is that the companies would exempt the execs from having to comply with the guidelines or would grant more options or awards to them—neither of which is likely the outcome ISS is looking for here.
What About the Equity Plan Scorecard?
Ownership guidelines are not a factor in ISS’s Equity Plan Scorecard, so this new policy doesn’t affect that analysis.
How Will ISS Know Which Equity Awards Are Counted in Ownership?
This is a great question. While Reg. S-K Item 402(b)(2)(xiii) encourages companies to disclose their ownership guidelines, the SEC has not stipulated any specific disclosure (other than to suggest that companies disclose the amounts required and forms of ownership).
In their Executive Compensation Disclosure Treatise, David Lynn and Mark Borges note that the majority of disclosures on ownership guidelines “simply state the existence of the policy, indicate the required ownership level for the company’s executive officers, set out the period for achieving this ownership level, and indicate whether each executive officer has met or is on the way to meeting in a timely manner his or her ownership level.”
Laura confirms that, in her experience, most companies don’t provide detail as to what equity vehicles count when describing their ownership guidelines. But she also notes that some institutional investors have recently started asking companies to clarify their policies and are pressuring companies to impose a retention ratio or holding period on a meaningful portion of equity compensation grants (at least until stock ownership guidelines have been met). It is hard to say whether ISS’s new policy is merely reflective of growing investor concerns or raising investor awareness of this issue.
Should Companies Disclose Their Policy?
ISS doesn’t specify how they will count ownership guidelines when companies don’t disclose whether unexercised options and unearned performance awards are counted in ownership levels. Perhaps there will be an FAQ added on this in the future.
In the meantime, companies that currently don’t count unexercised options and unearned performance awards in ownership have nothing to lose by updating their disclosures to include this information. If they don’t disclose their policy, it’s possible that ISS would refuse to give them credit for their guidelines due to the lack of information.
Conversely, companies that do currently count unexercised options and unearned performance awards have nothing to gain by disclosing this. Without this information, there is a chance ISS will continue to credit them for having ownership guidelines.
To Count or Not to Count—What Is Most Common?
ISS notes in its FAQ that only “a small number” of companies count unexercised options and unearned performance awards toward ownership guidelines; they are correct that this is not the dominant practice but I’m not sure I would go so far as to say it is a small number of companies.
According to the NASPP/Deloitte Consulting 2020 Domestic Stock Plan Administration Survey:
- A third of companies that grant performance awards count the unearned awards towards ownership levels.
- Over a quarter of companies that grant stock options count at least a portion of unexercised options towards ownership levels.
Should Companies Change Their Ownership Policy?
Not necessarily. Laura notes that, for QualityScore and Say-on-Pay, the impact of not getting credit for their ownership guidelines will likely not be significant.
Having ownership guidelines is more important for proposals related to nonemployee director compensation and shareholder proposals on holding periods, but even here, it is just one of many factors. Companies could compensate for the lost credit by tightening up other policies. It’s also possible that their other policies are already solid enough that they can weather the hit on their ownership guidelines.
Companies that offer full value awards (whether service or performance-based) to executives and directors are better positioned to cease counting unexercised options toward ownership levels. Where executives and directors can acquire stock through full value awards, those shares would typically be counted in ownership levels upon vesting.
Full value awards typically are at least partially vested in three years or less (in plenty of time for ownership guidelines, which typically provide five years to comply), require little cash outlay on the part of award holders, and, of course, are never underwater. Thus, companies that are not going to count unexercised options towards ownership levels may want to consider a more mixed portfolio of awards for executives and directors.
Thanks to Jason Weakland of Lowe’s Companies for bringing this policy change to my attention and to Laura Wanlass of Aon for helping me understand the implications of it.