Once-Sleeping Giants Awake

Mention Institutional Shareholder Services (ISS) to a board member of a publicly held corporation, particularly a corporation with significant institutional ownership, and the reaction will undoubtedly be mixed. Why? Just as the takeovers of the 1980s spurred institutional stockholders into taking a greater role in corporate governance, so too have the corporate scandals of recent years caused a stir among once-passive institutional stockholders. They increasingly use ISS recommendations to vote their stock holdings, and as a result, ISS's recommendations are garnering a fair amount of attention in corporate board rooms.

ISS Voting Policies

The ISS Corporate Governance Policy Committee annually reviews its voting policies in light of the latest trends and developments in corporate governance, and recently revised several of its proxy voting policies for the 2004 proxy season. The following is an explanation of some of the more significant ISS policy changes applicable for the 2004 proxy season. It is important, however, to read these updates in conjunction with the ISS policy guidelines that remain in effect.

ISS has made a number of changes to align its policies with the new NYSE and NASDAQ corporate governance listing standards, but in too many instances, the ISS policies go beyond the new NYSE and NASDAQ requirements. This proliferation of standards is unfortunate and adds an additional level of complexity without creating any real marginal value improvement.

For example, ISS now recommends that stockholders withhold votes from insider and affiliated outside director nominees if the corporation's board is not at least a majority independent (Institutional Shareholder Services, The ISS Proxy Voting Manual (3d ed. 1993). The apparent harmony between the ISS recommendation concerning an independent board and the new NYSE and NASDAQ requirements is tempered, however, by a definition of “independent director” that goes well beyond that found in the corporate governance listing standards, namely that an “independent director” must have no connection to the corporation other than the board seat (Id.). Such a definition does not account for the myriad of possible relationships that may exist between an outside director and the corporation, and makes the search for competent, outside directors even more difficult for public companies.

Growing Skepticism

Some of the changes to the ISS policy guidelines reflect the growing skepticism of routine director elections among institutional stockholders. ISS changed its policy guidelines to recommend against the routine election of directors at corporations that have inadequate or untimely public disclosure, questionable finances or financial statement restatements, questionable transactions involving conflicts of interest, a record of abuses against minority shareholder interests, the bundling of director elections, or any other egregious corporate governance practices (Id.).

Surprisingly, however, ISS now recommends withholding votes from directors who sit on more than six boards (Id.). The logic behind such a policy, that board members who sit on too many boards cannot effectively satisfy their oversight responsibilities owed to the stockholders of so many corporations, seems plausible on its face. A closer look reveals that such a bright line test may be problematic. For example, the ISS policy would not penalize the chief executive officer of a large, public company, whose time is inevitably taxed, from serving on six boards, but would penalize a “full-time” director who serves on more than six boards. In other words, the bright-line test severely discounts qualitative judgments concerning a director's effectiveness. It remains to be seen whether public companies will lose the service of some of their most competent, informed directors as a result of this policy.

Executive and Employee Compensation

In keeping with the increased public scrutiny of the compensation packages granted to directors and officers, ISS has also made changes to its policies concerning executive and employee compensation. For example, ISS now recommends that stockholders vote for any proposal to exclude pension fund income in the calculation of earnings used to determine executive compensation and bonuses (Id.). ISS also supports stockholder proposals seeking stockholder approval of SERPs (non-qualified, executive-only retirement plans under which the corporation provides an additional retirement benefit to the executive to supplement that offered under employee-wide plans). It also covers broad-based employee share purchase plans, not including stock option or restricted share plans, with dilution up to 10% of outstanding share capital, as long as discounts do not exceed 15% (Id.). Moreover, ISS is supportive of proposals advocating the use of performance-based equity awards, including indexed options, premium-priced options and performance-vested awards, unless the proposal is overly restrictive or the corporation demonstrates that at least 50% of the shares awarded go to the top five most highly compensated officers. All of this is an indication of the increasing role institutional stockholders may play in the near term in determining corporate compensation packages (Id.).

ISS recommendations may have a lasting impact on the governance of certain corporations for years to come as a result of the SEC's recently proposed proxy rules. In October 2003, the SEC proposed new proxy rules to give significant, long-term shareholders greater ability to include their director nominees in management's proxy statement. The SEC proposal includes a two-step, 2-year process. In the first year (2004), one of two triggering events must occur:

One or more directors receive withhold votes of 35% or more of the votes cast; or: A shareholder proposal asking for open access, which is submitted by holders of at least 1% of the shares (owned for at least 1 year), is approved by a majority of the votes cast.

If the SEC's proposed proxy rules are approved, then a shareholder proposal asking for open access, which is submitted by holders of at least 1% of the shares (owned for at least 1 year), and approved by a majority of the votes cast at the 2004 annual meeting, will trigger the company's obligation to include in its proxy materials for 2005 and 2006 one or more board nominees, depending on the size of the board, proposed by holders of at least 5% of the shares (owned for at least 2 years). ISS indicates that it will encourage such proposals where there is a valid complaint concerning board or director conduct (Id.).

Conclusion

Regardless of how many institutional stockholders cast their votes in strict accordance with the ISS policy guidelines, it is unmistakable that the once sleeping giants are awake, and they are willing to actively participate in the oversight of public corporations. This willingness to participate has led to institutional stockholders' increased reliance on ISS and its policy guidelines. Indeed, corporate clients are taking notice, and for that reason, it is imperative that corporate counsel do the same.

Mention Institutional Shareholder Services (ISS) to a board member of a publicly held corporation, particularly a corporation with significant institutional ownership, and the reaction will undoubtedly be mixed. Why? Just as the takeovers of the 1980s spurred institutional stockholders into taking a greater role in corporate governance, so too have the corporate scandals of recent years caused a stir among once-passive institutional stockholders. They increasingly use ISS recommendations to vote their stock holdings, and as a result, ISS's recommendations are garnering a fair amount of attention in corporate board rooms.

ISS Voting Policies

The ISS Corporate Governance Policy Committee annually reviews its voting policies in light of the latest trends and developments in corporate governance, and recently revised several of its proxy voting policies for the 2004 proxy season. The following is an explanation of some of the more significant ISS policy changes applicable for the 2004 proxy season. It is important, however, to read these updates in conjunction with the ISS policy guidelines that remain in effect.

ISS has made a number of changes to align its policies with the new NYSE and NASDAQ corporate governance listing standards, but in too many instances, the ISS policies go beyond the new NYSE and NASDAQ requirements. This proliferation of standards is unfortunate and adds an additional level of complexity without creating any real marginal value improvement.

For example, ISS now recommends that stockholders withhold votes from insider and affiliated outside director nominees if the corporation's board is not at least a majority independent (Institutional Shareholder Services, The ISS Proxy Voting Manual (3d ed. 1993). The apparent harmony between the ISS recommendation concerning an independent board and the new NYSE and NASDAQ requirements is tempered, however, by a definition of “independent director” that goes well beyond that found in the corporate governance listing standards, namely that an “independent director” must have no connection to the corporation other than the board seat (Id.). Such a definition does not account for the myriad of possible relationships that may exist between an outside director and the corporation, and makes the search for competent, outside directors even more difficult for public companies.

Growing Skepticism

Some of the changes to the ISS policy guidelines reflect the growing skepticism of routine director elections among institutional stockholders. ISS changed its policy guidelines to recommend against the routine election of directors at corporations that have inadequate or untimely public disclosure, questionable finances or financial statement restatements, questionable transactions involving conflicts of interest, a record of abuses against minority shareholder interests, the bundling of director elections, or any other egregious corporate governance practices (Id.).

Surprisingly, however, ISS now recommends withholding votes from directors who sit on more than six boards (Id.). The logic behind such a policy, that board members who sit on too many boards cannot effectively satisfy their oversight responsibilities owed to the stockholders of so many corporations, seems plausible on its face. A closer look reveals that such a bright line test may be problematic. For example, the ISS policy would not penalize the chief executive officer of a large, public company, whose time is inevitably taxed, from serving on six boards, but would penalize a “full-time” director who serves on more than six boards. In other words, the bright-line test severely discounts qualitative judgments concerning a director's effectiveness. It remains to be seen whether public companies will lose the service of some of their most competent, informed directors as a result of this policy.

Executive and Employee Compensation

In keeping with the increased public scrutiny of the compensation packages granted to directors and officers, ISS has also made changes to its policies concerning executive and employee compensation. For example, ISS now recommends that stockholders vote for any proposal to exclude pension fund income in the calculation of earnings used to determine executive compensation and bonuses (Id.). ISS also supports stockholder proposals seeking stockholder approval of SERPs (non-qualified, executive-only retirement plans under which the corporation provides an additional retirement benefit to the executive to supplement that offered under employee-wide plans). It also covers broad-based employee share purchase plans, not including stock option or restricted share plans, with dilution up to 10% of outstanding share capital, as long as discounts do not exceed 15% (Id.). Moreover, ISS is supportive of proposals advocating the use of performance-based equity awards, including indexed options, premium-priced options and performance-vested awards, unless the proposal is overly restrictive or the corporation demonstrates that at least 50% of the shares awarded go to the top five most highly compensated officers. All of this is an indication of the increasing role institutional stockholders may play in the near term in determining corporate compensation packages (Id.).

ISS recommendations may have a lasting impact on the governance of certain corporations for years to come as a result of the SEC's recently proposed proxy rules. In October 2003, the SEC proposed new proxy rules to give significant, long-term shareholders greater ability to include their director nominees in management's proxy statement. The SEC proposal includes a two-step, 2-year process. In the first year (2004), one of two triggering events must occur:

One or more directors receive withhold votes of 35% or more of the votes cast; or: A shareholder proposal asking for open access, which is submitted by holders of at least 1% of the shares (owned for at least 1 year), is approved by a majority of the votes cast.

If the SEC's proposed proxy rules are approved, then a shareholder proposal asking for open access, which is submitted by holders of at least 1% of the shares (owned for at least 1 year), and approved by a majority of the votes cast at the 2004 annual meeting, will trigger the company's obligation to include in its proxy materials for 2005 and 2006 one or more board nominees, depending on the size of the board, proposed by holders of at least 5% of the shares (owned for at least 2 years). ISS indicates that it will encourage such proposals where there is a valid complaint concerning board or director conduct (Id.).

Conclusion

Regardless of how many institutional stockholders cast their votes in strict accordance with the ISS policy guidelines, it is unmistakable that the once sleeping giants are awake, and they are willing to actively participate in the oversight of public corporations. This willingness to participate has led to institutional stockholders' increased reliance on ISS and its policy guidelines. Indeed, corporate clients are taking notice, and for that reason, it is imperative that corporate counsel do the same.