The Closer Look series is a collection of short case studies through which we explore topics, issues, and controversies in corporate governance. In each study, we take a targeted look at a specific issue that is relevant to the current debate on governance and explain why it is so important.
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Institutional Shareholder Services: The Uninvited Guest at the Equity Table
1. stanford closer look series 1
Institutional Shareholder Services:
The Uninvited Guest at the Equity Table
Approval of Equity-Based Compensation
The compensation committee of the board of di-
rectors is tasked with designing the compensation
package of the CEO and other senior officers of
the company.1
The committee informs its decision
in part based on market data and advice provided
by the internal human resources department or a
third-party advisor. The compensation package is
then approved by a vote of the full board. Equity-
based compensation (including stock options, re-
stricted shares, and performance shares/units grant-
ed to all employees) requires approval by a vote of
shareholders. This is because the issuance of new
shares dilutes the ownership interest of sharehold-
ers, and therefore cannot be affected without their
consent. Approval is solicited through the annual
proxy statement.
institutional shareholder services
In recent years, Institutional Shareholder Services
(ISS) has played an influential role in the proxy vot-
ing process.2
Founded in 1985, the firm provides
recommendations to institutional investors on how
to vote the annual proxy. Prior to the firm’s found-
ing, institutional investors often voted in accor-
dance with management recommendation, or did
not vote at all. As a result, most items on the proxy
were approved, with little regard for their impact
on governance quality.
ISS’s proxy advisory services are intended to give
shareholders greater influence over management by
providing an independent assessment of the impact
of proxy items. These include director election, rat-
ification of the public auditor, equity-based com-
pensation plans, merger approvals, and charter and
bylaw amendments that impact everything from
By David F. Larcker and Brian Tayan
May 17, 2010
voting procedures, to shareholder rights, to antita-
keover protections. ISS formulates its recommen-
dation based on proprietary proxy voting guide-
lines which it updates each year.
Over time, ISS increasingly has assumed a cen-
tral position in the proxy voting process. It counts
over 1,700 institutional investors as clients, manag-
ing an estimated $25 trillion in equity securities.3
Its opinions are cited in the media. According to
some estimates, a recommendation by ISS can sway
a proxy vote by 15 to 20 percent.4
iss Analysis of Equity Plans
ISS uses four tests to inform its recommendation
on a company’s equity compensation plan:
1. Burn Rate: A calculation of the number of shares
granted through equity-based plans annually
over the previous three years, as a percentage
of average shares outstanding. A company fails
this test if its burn rate is one standard deviation
higher than the industry average, as computed
by ISS.
2. Pay for Performance: A determination of wheth-
er the company has generated positive total
shareholder return over the previous one-year
period or three-year period, and whether it has
increased the total direct compensation of the
CEO in the previous year. A company fails this
test if total shareholder return is negative over
both of these periods and the company has
raised CEO compensation.
3. Shareholder Value Transfer (SVT): A calculation
of the value of equity that has been paid to all
company employees and still stands to be paid
to employees under both existing and proposed
equity plans, as a percentage of the total market
Topics, Issues, and Controversies in Corporate Governance and Leadership
S T A N F O R D C L O S E R L O O K S E R I E S
2. stanford closer look series 2
institutional shareholder services: The Uninvited Guest at the Equity Table
capitalization of the company. A company fails
this test if SVT exceeds an industry specific cap
that is determined by a proprietary calculation of
SVT among companies at the top quartile of the
industry in terms of shareholder returns.
4. Poor Pay Practices: A company fails this test if
it engages in compensation practices that ISS
generally deems to be “poor,” such as option re-
pricing, high concentration of grants to senior
executives, egregious employment contracts, ex-
cessive benefits and perquisites, poor pay disclo-
sure, internal pay inequity, and other.5
ISS recommends a vote in favor of a company’s pro-
posed equity plan only if it passes all of these tests
(see Exhibit 1). According to one compensation
consultant, “Companies look very carefully at those
caps, and I have a lot of clients who are reluctant
to exceed them.”6
In order to gain approval, some
companies instead choose to adjust their plans to
conform to ISS’s models (see Exhibit 2).
Several companies are highly critical of the
proxy advisory firm’s influence. For example Tesco,
the British retail chain, wrote a letter to regulators
expressing “concern about unengaged fund manag-
ers increasingly delegating voting decisions.”7
Oth-
ers question ISS’s methodology. The chairman of
Kingsgate Consolidated called the firm’s analysis
of his company’s compensation plan “particularly
flawed” and indicative of a “tick-a-box mentality.”8
For its part, ISS believes that its methodology
is both rigorous and objective. According to ISS,
its recommendations “serve as an industry standard
and best practice guide to corporate governance.”
Its analyses are “based on rigorously formulated
voting policy, reflecting institutional investors’ per-
spectives.”9
Why This Matters
1. ISS has a high level of influence on voting out-
comes. Is this appropriate?
2. Companies question whether ISS recommen-
dations are a best practice or not. What is the
evidence that ISS’s recommendations actually
improve corporate outcomes?
3. ISS is not transparent about how it calculates
industry caps on burn rate and SVT. Do share-
holders and boards have a right to know how
these caps are precisely computed?
4. Companies curtail their equity plans to conform
to ISS models. Is this good for shareholders (be-
cause those grants would be too large and de-
stroy value) or is it bad for shareholders (because
those grants provide important incentive to em-
ployees)?
5. The credit rating agencies are regulated by the
Securities and Exchange Commission and in-
ternational regulators. Should ISS be similarly
regulated?
1
This Closer Look was originally titled: “RiskMetrics Group: The Un-
invited Guest at the Equity Table.”
2
For more on this topic, see also: David F. Larcker and Brian Tayan,
“There’s a New Sheriff in Town: Institutional Shareholder Services,”
GSB Case No. CG-07, Oct. 15, 2007; David F. Larcker and Brian
Tayan, “Corporate Governance Ratings: Got the Grade… What
Was the Test?” GSB Case No. CG-08, Oct. 15, 2007. Available at:
https://gsbapps.stanford.edu/cases/. Robert Daines, Ian Gow,
and David F. Larcker, “Rating the Ratings: How Good are Commer-
cial Governance Ratings?” (September 4, 2009), Stanford Law and
Economics Olin Working Paper No. 360; Rock Center for Corpo-
rate Governance at Stanford University Working Paper No. 1. Avail-
able at SSRN: http://ssrn.com/abstract=1152093.
3
U.S. Government Accountability Office, “Report to Congressional
Requesters: Corporate Shareholder Meetings; Issues Relating to
Firms That Advise Institutional Investors on Proxy Voting,” June
2007. Accessible at: http://www.gao.gov/new.items/d07765.pdf.
4
Shawn Tully, “Proxy Muses,” Fortune, Dec. 25, 2006.
5
Institutional Shareholder Services, U.S. Proxy Voting Manual of ISS.
6
“Proxy Muses,” loc. cit.
7
Mike Foster, “Tesco Calls on Fund Managers to Drop Proxies,” Fi-
nancial News, May 4, 2010.
8
Barry Fitzgerald, “Kingsgate Boss Criticises Pay Vote,” The Age, Nov.
10, 2009.
9
RiskMetrics Group, ISS Governance Services, “Proxy Research Ser-
vices for Institutional Investors Worldwide.” Available at: http://
www.riskmetrics.com/proxy_advisory/benefits.
David Larcker is the Morgan Stanley Director of the Center
for Leadership Development and Research at the Stanford
Graduate School of Business and senior faculty member
at the Rock Center for Corporate Governance at Stanford
University. Brian Tayan is a researcher with Stanford’s Cen-
ter for Leadership Development and Research. They are
coauthors of the books A Real Look at Real World Cor-
porate Governance and Corporate Governance Matters.
The authors would like to thank Michelle E. Gutman for
research assistance in the preparation of these materials.
The Stanford Closer Look Series is a collection of short case
studies that explore topics, issues, and controversies in cor-
porate governance and leadership. The Closer Look Series
is published by the Center for Leadership Development
and Research at the Stanford Graduate School of Business
and the Rock Center for Corporate Governance at Stan-
4. stanford closer look series 4
institutional shareholder services: The Uninvited Guest at the Equity Table
Exhibit 1 — iss: Methodology on Equity Based Compensation
Test 1: Burn Rate
Test 2: Pay for Performance
• Burn rate equals the adjusted shares (restricted stock and options) granted in a year, divided
by the average shares outstanding.
• Restricted shares are adjusted by a multiplier to translate them into an equivalent number of
options.
• The size of the multiplier varies according to the company’s annual stock price volatility.
• The company’s burn rate is compared to an industry cap rate. The industry cap rate is one
standard deviation over the industry average (but not less than 2 percent).
• ISS calculates the industry cap based on its own proprietary models.
• ISS recommends a vote against the compensation plan if the company’s average burn rate
over the previous three years is greater than the cap.
• ISS evaluates the following three questions:
1. Has the company generated positive total shareholder return over the previous year?
2. Has the company generated positive total shareholder return over the previous three years?
3. Did the CEO’s total direct compensation increase over the previous year?
• ISS recommends a vote against the plan if the answer to the first two questions is “no” and
the answer to the third question is “yes.”
Test 3: Shareholder Value Transfer (SVT)
• SVT includes the total value of equity-based grants that have been awarded and may still be
awarded to employees under all existing and proposed equity compensation plans.
• ISS values options using a proprietary binomial pricing model.
• Vested, in-the-money options are included in the computation but previously exercised op-
tions are excluded.
• SVT is then expressed as a percentage of the company’s market capitalization.
• SVT is compared against an industry cap. The industry cap is determined by calculating the
SVT of the companies that are in the top quartile of the industry in terms of total shareholder
returns.
• ISS calculates the industry cap based on its own proprietary models.
• ISS recommends a vote against the plan if SVT exceeds the industry cap.
Test 4: Poor CEO Pay Practices
ISS recommends a vote against the plan if the company has poor or questionable CEO pay prac-
tices. Examples include:
1. Option repricing
2. Option backdating
3. High concentration of grants made to senior executives
4. Employment contracts with egregious clauses.
5. Excessive benefits, bonuses, pensions, signing provisions, or change-in-control protections.
6. Poor disclosure on pay policies
7. Large internal pay inequity between the CEO and other senior executives
Note: These criteria are strictly adhered to. ISS will not make an exception based on a company’s specific situation.
Source: Institutional Shareholder Services, U.S. Proxy Voting Manual of ISS.
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institutional shareholder services: The Uninvited Guest at the Equity Table
Exhibit 2 — Disclosure on Equity-Based Compensation Plans
Iberiabank Corporation
After giving consideration to comments from Institutional Shareholder Services (“ISS”) and in
order to facilitate approval of the Plan, on January 18, 2010, upon the recommendation of the
Compensation Committee, the Company’s Board of Directors (the “Board”) amended the Plan to
(i) reduce the maximum number of shares of the Company’s common stock available for issuance
under the Plan from 600,000 shares to 500,000 shares, and (ii) limit to 250,000 common shares the
maximum number of shares that the Company may issue as full value awards (i.e., awards, such as
restricted stock awards, for which the recipient gets “full value” of the stock, rather than awards
based on future appreciation in stock value, such as options).
In order to minimize the dilutive impact on the Company’s existing shareholders of grants of
equity-based awards, the Board has committed that, with respect to the 500,000 shares of com-
mon stock being reserved for issuance under the Plan, the average burn rate of equity awards will
not exceed a three-year average of 2.18% through the Company’s fiscal year ending December 31,
2012. The Company’s burn rate will be recalculated following the end of each fiscal year during
this period.
Pinnacle Entertainment, Inc.
Following the Company’s review of the recently published analysis of this proposal by Institutional
Shareholder Services and in order to facilitate stockholder approval of the amendment to the
2005 Plan, the Company is amending the proposed amendment to the 2005 Plan to reduce the
proposed increase in the number of shares subject to the 2005 Plan from 1,500,000 to 1,100,000.
Headwaters, Inc.
In response to external feedback and concerns voiced regarding the Company’s equity “burn rate”
of its stock-based compensation awards, on February 17, 2010, the Company determined that it
will take appropriate steps to control its equity burn rate. Equity burn rate analysis is a measure
of dilution that shows how rapidly a company is using its shares reserved for equity compensation
plans. This analysis is frequently used by institutional investors to determine whether they should
support or reject equity compensation proposals submitted to a company’s stockholders for ap-
proval. […]
In connection with the proposed Plan approval, the Company commits to maintain an average
annual equity burn rate for the fiscal years ending September 30, 2010, 2011 and 2012 not ex-
ceeding an average of 2.07% per year (which is the blended average of Institutional Shareholder
Services’ published burn rate thresholds for 2009 and 2010), excluding equity incentives assumed
in connection with any future acquisitions by the Company.
Source: Equilar. Iberiabank, Form 8-K filed Jan. 19, 2010; Pinnacle Entertainment, Form 8-K filed May 3, 2010; Headwaters,
Form 8-K filed Feb. 18, 2010, with the SEC.
Note: To avoid confusion, the proxy advisory firm’s name has been updated in these filings from its previous “RiskMetrics
Group” to the current “Institutional Shareholder Services” when necessary.