Preparing the Compensation Discussion & Analysis in a public company’s proxy statements has largely been the province of legal and human-resources departments. However, changes by Institutional Shareholder Services (ISS) to its proxy-voting guidelines suggest that finance departments may need to play a larger role in CD&A disclosure next year.

The guidelines, where were updated last month (see http://www.issgovernance.com/policy), apply to shareholder meetings held on or after February 1, 2012. The most significant is that ISS is replacing its current system for evaluating pay for performance. ISS will no longer give an issuer a pass if its one-year and three-year total shareholder return (TSR) is greater than the median at other Russell 3000 companies sharing the same Global Industry Classification Standard code. (The TSR, as defined by ISS, is the annualized rate of return as measured by stock price appreciation plus reinvestment of monthly dividends [on a compounded basis] in issuer stock over a designated period.)

Going forward, ISS will evaluate an issuer’s TSR performance and CEO pay on a relative basis against a peer group, as well as the issuer’s long-term CEO pay and performance trends. The purpose of this change is to “identify . . . strong (as well as weak) pay-for-performance alignment over a sustained time horizon.”

The so-called peer group alignment test evaluates the issuer’s CEO pay rank against its TSR rank (on a weighted one-year and three-year basis) within a 14-to-24-company peer group. The so-called absolute alignment test measures the difference between the trend in the issuer’s annual CEO pay changes and the trend in its annualized TSR over a five-year period.

If the results from the peer group alignment and absolute alignment tests demonstrate “significant unsatisfactory long-term pay-for-performance alignment,” ISS will perform additional qualitative analyses “to determine how various pay elements may work to encourage or undermine long-term value creation and alignment with shareholder interests.”

The catch is that much of the detail about how these quantitative tests will apply is unknown. Key open issues include:

  • How ISS will pick an issuer’s peer group (it likely won’t be the same peer group used by the issuer’s compensation committee)
  • How ISS will measure and rank “trends” in an issuer’s CEO pay and TSR
  • What weighting will be given to the results of the peer group alignment and absolute alignment tests
  • What circumstances will result in “unsatisfactory long-term pay for performance alignment”

ISS has stated that it will provide a technical update this month addressing how these tests will be applied.

Even if these updates provide useful clarifications so that issuers can run the tests themselves (or with assistance from others), it will likely take several weeks to complete this process. An issuer might not know whether the results of the quantitative tests will suggest satisfactory pay-for-performance alignment until just before the proxy is to be filed.

What’s clear at this point is that a favorable say-on-pay voting recommendation from ISS last year does not guarantee the same will be true this year. That is so even if there has been no change to the issuer’s corporate performance or its executive-compensation program.

Because of that uncertainty, it will be prudent for many issuers to begin the qualitative analysis suggested by the 2012 updates well in advance of the proxy-filing deadline. Performing the analysis at a sophisticated level will likely require financial knowledge and skills within the CFO’s bailiwick.

The 2012 updates list as qualitative factors the actual results of financial/operational metrics, such as growth in revenue, profits, and cash flow, both absolute and relative to peers; and the rigor of designated performance goals. CFOs have unique insight into evaluating the issuer’s financial performance and identifying what’s important about it from a shareholder perspective.

Financial skills may also be needed to spot weakness with ISS’s quantitative tests that could produce unwarranted rankings. For example, proxy rules require that issuers report the entire fair value of an equity award in the year of grant even though it may never be earned. In addition, what is actually earned by an executive under an equity award can be dramatically different from what is reported in the proxy. It is unclear how ISS is going to handle this disconnect, and an issuer may want to disclose how reported proxy figures compare with actual equity-compensation gains.

None of this means to suggest that issuers change their compensation programs to bend to ISS. What’s important to understand is that ISS’s voting recommendations can significantly influence say-on-pay voting results. Whereas the overall level of shareholder support during the 2011 proxy season was more than 90% with a favorable ISS voting recommendation, shareholder support dipped to less than 70% without it.

Directors may feel compelled to change compensation programs if there are high levels of say-on-pay opposition. If an issuer receives support of less than 70% of the votes cast, ISS will “take into account” what steps were taken to identify the reasons for low support and to address the practices that prompted the low level of support when making its recommendations on compensation-committee members (or, in exceptional cases, the entire board).

Executive compensation will continue to be in the spotlight during the 2012 proxy season. Being prepared to better tell the story about an issuer’s financial performance is more important than ever given the emphasis on pay for performance, the uncertainty resulting from the 2012 ISS updates, and the potential consequences of high say-on-pay opposition by shareholders.

Andrew Liazos heads the executive-compensation practice at law firm McDermott Will & Emery.

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