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E-MailDavid A. Katz is a partner at Wachtell, Lipton, Rosen & Katz specializing in the areas of mergers and acquisitions, corporate governance, and complex securities transactions. This post is based on a Wachtell Lipton memorandum by Mr. Katz, Sabastian V. Niles, and Francis J. Stapleton; the complete publication, including annex, is available here.
Institutional Shareholder Services Inc. (ISS) has announced the governance factors and other technical specifications underlying its new Governance QuickScore 2.0 product, which ISS will apply to publicly traded companies for the 2014 proxy season. Companies have until 8pm ET on Friday, February 7th to verify the underlying raw data and can submit updates and corrections through ISS’s data review and verification site. ISS will release company ratings on Tuesday, February 18th, and the scores will be included in proxy research reports issued to institutional shareholders. While previous QuickScore ratings remained static between annual meeting periods, ISS has now committed to update ratings on an on-going basis based on a company’s public disclosures throughout the calendar year.
We have listed the individual factors used by QuickScore 2.0 in Annex A. However, the specific weightings and balancing between quantitative and qualitative factors remain undisclosed, and companies will not be able to calculate scores on their own. As we have previously noted, the relationship between ISS’s governance metrics and company financial performance has been dubious at best, and we continue to urge companies and boards to see QuickScore for what it is—a data point generated by an artfully marketed product, rather than a target or an ideal—and to consider their individual circumstances in establishing and evaluating appropriate corporate governance practices and compensation policies for their companies. No single metric or bundle of metrics can substitute for the informed business judgment of a well-advised board as to what is necessary to promote corporate and shareholder interests in dynamic, real-world circumstances.
Scoring under QuickScore 2.0 will continue to use the familiar “four pillar” approach that analyzes governance across Audit, Board Structure, Compensation/Remuneration and Shareholder Rights categories, and company-level and underlying pillar scores will continue to be presented on a 1 to 10 scale, relying upon “decile” comparisons of a company’s raw scores against the scores of other companies within the applicable index and region. Accordingly, ISS’s QuickScore 2.0 unfortunately continues to deploy an unproven and opaque methodology that reduces the complex realities of corporate governance into an easily digestible, but inherently misleading, decile system. Given the success to date of governance activists in driving companies towards one-size-fits-all governance structures, it is likely that only minor differences will separate the deciles, resulting in companies with no serious governance concerns receiving an unjustified “taint” by virtue of a lower score.
Although the new specification builds mostly upon the methodology used in previous years (which began as the CGQ Corporate Governance Quotient and then evolved into the GRId Governance Risk Indicators in 2010, which was then supplanted by QuickScore 1.0 in 2013), several new factors will be incorporated into the overall scoring model and a few additional “zero-impact” factors will be disclosed in the QuickScore report for informational purposes but will not, at this point, impact ratings.
New Factors that Impact Scoring
“Excessive” Director Tenure. Tenure of more than nine years will be considered “excessive” by QuickScore 2.0 on account of “potentially compromis[ing] a director’s independence” and negatively factor into weightings depending on the proportion of directors with such tenure. Given that ISS had recently announced a longer-term review of this issue for possible application to the 2015 proxy season and beyond, its inclusion in QuickScore for the 2014 proxy season may signal that ISS has already prejudged the issue. As we have previously stated, we do not believe that there is a sufficient basis to consider an extended tenure of board service in and of itself as indicative of a lack of director independence. Given the significant differences in companies’ needs and directors’ attributes and experiences, this is a clear instance where a company-specific approach is superior to a rigid rule.
Director Approval Rates. In addition to continuing to consider whether one or more directors received 50% or greater “against” or “withhold” votes, QuickScore 2.0 will now consider the percentage of directors who receive “less than average” levels (as measured against the company’s industry index) of shareholder support for their election.
Compensation of Outside Directors. How a company’s outside director compensation compares to median levels of the ISS-determined peer group will now be considered. Specifically, QuickScore 2.0 will measure the prior year’s average outside director’s pay (based on total compensation reported for each director in the company’s proxy statement) as a multiple of the median pay of its ISS-determined comparison group for the same period.
Alignment between Pay and TSR. Consistent with ISS’s 2014 voting policy updates, QuickScore 2.0 will now incorporate the relative degree of alignment (RDA) between compensation and TSR based on a single, annualized RDA measure for a three-year measurement period, instead of the previous 40/60 weighted average of one- and three-year RDA. The previous QuickScore factors of three- and one-year RDA will still be included for informational purposes only and will be zero-weight factors on the scoring model.
Say-on-Pay Support. The level of shareholder support on the company’s most recent say-on-pay proposal and how such support compares to industry-index levels will also affect ratings.
New Informational Factors with No Impact on Scoring
Three new board composition-related factors will be included in the QuickScore report for informational purposes. According to ISS, these factors, however, will not currently impact overall scoring for the issuer.
Board-Level Gender Diversity. According to ISS, some academic and other studies have shown that increasing the number of women on the board correlates with better financial performance. As a result, QuickScore will now begin analyzing the number of female directors as well as the relative proportion of male to female directors on the board.
Number of Financial Experts on Audit Committee. QuickScore will provide information on the number of financial experts that serve on the board’s audit committee. This is a zero-weight issue for U.S. companies, most of which are required to have at least one financial expert serving on the audit committee due to stock exchange listing requirements.
Board Size. QuickScore will begin providing information on the number of directors on the board. According to ISS, boards should generally have no fewer than six directors and no more than 15. A board composed of nine to 12 directors is considered by ISS to be optimal.
