ISS and Glass Lewis are reviewing policies
09/09/2024
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ISS and Glass Lewis are in the process of reviewing global policies and guidelines, and recently sought submissions from investors. The US$1.7 trillion Norges sovereign wealth fund has had quite a bit to say this time around, and most of it concerns executive pay.

For many years both Institutional Investor Services (ISS) and Glass Lewis have promoted equity grants contingent on 3 or more years of performance as a “good” compensation practice. Norges has 2 issues with this:

  1. It does not work, and
  2. It is expensive.

In their annual process of reviewing policy guidelines, both proxy advisers have now separately asked their clients whether they should abandon their preference for CEO ‘performance shares’ over simpler non-hurdled alternatives. That both proxy advisers are even contemplating this is significant in itself. That such a high-profile shareholder continues to advocate for them to do so compounds this.

In its submissions, Norges has remained consistent with a position paper published in 2017 (SEE HERE) in which it advocates for CEOs being paid in equity that only vests after a minimum of 5 years and preferably 10 years. It would not be contingent on service. It would be just time vested.

Since then, the world has gone the other way. That is, while Australia has always had performance contingent equity, other countries have replaced their service or time based equity with performance stock units, usually at the urging of the 2 proxy advisers and their investors. This is particularly evident in the US. Interestingly, selected Australian companies, with some encouragement from us, have been replacing PSUs with time of service restricted share units. However, given the tone of the Norges paper, probably not quickly enough.

Based on Norges analyses of ISS and BoardEx sourced data (SEE HERE), the growth in PSU grants is arguably the strongest factor behind the growth in US CEO pay since the financial crisis. From 2017 to 2023, granted PSUs made up almost 90% of the growth in the nominal combined value of CEO pay, as reported, across its US portfolio constituents.

But even then the data understates the actual quantitative importance of PSUs. Due to the limitations of US disclosure standards, PSUs are conventionally included in total pay figures on the assumption that the granted PSUs will vest at target performance. Norges analysis of US CEO pay over the last seven pay years demonstrates that PSU vesting is skewed to the upside of the target. Hence, the increased usage of PSUs by American firms has increased the cost of compensating CEOs.

If PSUs increased financial performance the pay increase could be justified. But it did not, so it cannot. (Norges references a research from one of GECN Group’s top US board executive remuneration advisers, Marc Hodak (HERE). When Norges ran its numbers, it actually found an outperformance of the stubborn minority of firms without PSUs.

The reasons for this are complex and many but relate mainly to the relatively short term of PSU LTI plans of just 3 years, and agency issues associated with selection of performance measures and target setting.

Norges’ views echo sentiments we have expressed for decades, but without some of the qualifications we apply to tailor the model to the nature of some industries (for examples those requiring capital intensive investments). Nevertheless, Norges’ sentiments are worth repeating, if only to have other investors to consider and support alternatives to the narrow and often dysfunctional LTI design restrictions they otherwise impose on company boards. Given the attempt to bring some Australian investors around may be a vain one (we have tried many times before), we find we do gain a few more centimetres of support each year.

Providing executives with long term remuneration settled in shares or rights to shares that are restricted for 5-10 years as a replacement or a supplement to more complex and shorter-term 3-year PSUs may discourage executives from making suboptimal decisions on a long term basis that might lead to the PSUs vesting in the short term.

Longer-term restricted shares align management better with long-term shareholder interests. Simple, unconditional restricted share grants also provide transparency.

Despite the common classification of incentive equity grants as ‘time-based’ or ‘performance based’, Norges argues (and we agree) that, over the long haul, all shares are performance shares. Shareholder return is not a perfect measure of management effectiveness, but over extended time periods it is unusual to have share price performance without strong management.

Norges says that proxy advisers’ (and, dare we say it, remuneration consultants’) preference for performance metrics are opposed to aligning CEOs with shareholder interests by paying in simple, long-dated equity.

Norges’s responses to ISS and Glass Lewis are available HERE and HERE.

© Guerdon Associates 2024
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