• Institutional Shareholder Services Revises Its Corporate Governance Quotient Criteria
  • July 25, 2005 | Author: Jeffrey J. Greene
  • Law Firm: DLA Piper US LLP - Seattle Office
  • Institutional Shareholder Services (ISS) has now released updated methodology for determining its Corporate Governance Quotient (CGQ) of public companies. Changes to its prior methodology were considered necessary in order to conform the CGQ rating system with governance practices mandated by the Sarbanes-Oxley Act of 2002, and also to remove certain criteria that ISS no longer considers relevant.

    Because many companies track their CGQ ratings and use the rating as one way to evaluate their corporate governance policies, practices, and procedures, we are publishing this Alert to update our clients and friends on ISS's latest updates to the CGQ equation.

    Governance As a Measurement of Performance and Risk

    The CGQ, a proprietary rating system developed and marketed by ISS, purports to provide an objective measurement of a public company's corporate governance practices and policies, which ISS believes are closely correlated to corporate performance and shareholder risk. Each company covered by ISS is scored in relation to companies in the S&P 500 and other companies in its industry. For instance, as of July 1, 2005, Microsoft's CGQ rating was higher than 95.7 percent of S&P 500 companies, and higher than 100 percent of software and services companies. ISS uses the CGQ ratings as one of the bases for advising its institutional shareholder clients to vote for or against particular proxy statement proposals, including whether to withhold support for directors.

    While other corporate rating organizations conduct similar corporate governance analysis and offer proxy-related advice to shareholders, the ISS rating system appears to have the widest following among institutional shareholders, who can access CGQ ratings on more than 5,500 U.S. public companies, including all those in the Russell 3000 Index.

    ISS analyzes data from a public company's web site and SEC filings, particularly its annual proxy statement, to generate a CGQ based on ISS's pre-determined criteria. ISS generally updates a company's CGQ on May 1 and November 1 of each year, and in advance of the company's annual meeting of shareholders.

    New Methodology Contains 63 Criteria

    The new CGQ methodology comprises 63 different rating criteria, a slight increase over the 61 criteria employed under the prior methodology. A number of new variables have been added, several have been modified, and a few have been removed altogether. In broad terms, the ratings criteria are grouped into four "significant" subject areas: Anti-takeover, Audit, Board, and Compensation. The Board and Compensation categories are by far the most heavily weighted subject areas, comprising 40 percent and 30 percent, respectively, of the overall CGQ rating. The Anti-takeover and Audit components comprise the remaining 20 percent and 10 percent, respectively.

    The 63 CGQ rating criteria now used by ISS are as follows:


    1 Board Composition -- Modified
    2 Nominating Committee
    3 Compensation Committee
    4 Governance Committee
    5 Board Structure
    6 Board Size
    7 Changes in Board Size
    8 Cumulative Voting
    9 Boards Served On -- CEO
    10 Boards Served On -- Other than CEO - Modified
    11 Former CEOs
    12 Chairman/CEO Separation -- Modified
    13 Governance Guidelines -- Modified
    14 Response to Shareholder Proposals
    15 Board Attendance
    16 Board Vacancies
    17 Related Party Transactions -- CEO
    18 Related Party Transactions - Other than CEO - New


    19 Audit Committee
    20 Audit Fees -- Modified
    21 Auditor Ratification
    22 Financial Expert -- New


    23 Poison Pill Adoption
    24 Poison Pill - Shareholder Approval
    25 Poison Pill - TIDE Provision
    26 Poison Pill - Sunset Provision
    27 Poison Pill - Qualified Offer Clause
    28 Poison Pill -- Trigger
    29 Vote Requirements - Charter/Bylaw Amendments
    30 Vote Requirements - Mergers & Business Combinations
    31 Written Consent
    32 Special Meetings
    33 Board Amendments
    34 Capital Structure -- Dual class -- Modified
    35 Capital Structure -- Blank check preferred -- Modified

    State of Incorporation

    36 State Anti-takeover Provisions
    37 Control Share Acquisition Provision
    38 Control Share Cash-out Provision
    39 Freeze-out Provision
    40 Fair Price Provision
    41 Stakeholder Law
    42 Poison Pill Endorsement

    Executive and Director Compensation

    43 Cost of Option Plans
    44 Option Repricing -- Modified
    45 Shareholder Approval of Option Plans
    46 Compensation Committee Interlocks
    47 Director Compensation
    48 Option Burn Rate - Modified
    49 Performance-Based Compensation -- New
    50 Option Expensing - Modified

    Progressive Practice

    51 Board Performance Reviews
    52 Individual Director Performance Reviews
    53 Meetings of Outside Directors
    54 CEO Succession Plan
    55 Outside Advisors Available to Board
    56 Directors Resign Upon Job Changes


    57 Director Ownership
    58 Executive Stock Ownership Guidelines
    59 Director Stock Ownership Guidelines
    60 Officer & Director Stock Ownership
    61 Mandatory Holding Period for Stock Options -- New
    62 Mandatory Holding Periods for Restricted Stock -- New

    Director of Education

    63 Director Education - Modified

    ISS indicates that the following eight CGQ criteria are the most heavily weighted (in descending order of CGQ importance):

    • Whether the audit committee consists entirely of independent outside directors;
    • The rate at which stock options and other equity compensation are issued (i.e., how quickly a company "burns" through its stock option pool);
    • Whether all audit committee members are "financial experts," based on the SEC's definition;
    • Whether the board of directors is composed of more than 90 percent independent outside directors;
    • Whether the board of directors has only one non-independent director;
    • Whether the board members are required to own stock in the company;
    • Whether the board of directors is composed of between 75 and 90 percent independent outside directors; and
    • Whether the law of the state of incorporation does not contain anti-takeover provisions.

    New CGQ Variables

    The CGQ rating methodology includes the following new variables:

    • Related party transactions, other than the CEO -- Evaluates whether there are related party transactions with directors and officers other than the CEO. Previously, the CGQ only looked at related party transactions involving a company's CEO.
    • Financial expert -- Analyzes the number of financial experts on the audit committee who meet the requirements of Sarbanes-Oxley. A company will score highest if all members of its audit committee are financial experts.
    • Performance-based compensation -- Awards points to companies that grant awards based on performance criteria and disclosed hurdle rates. A company will score more favorably to the extent equity compensation is not earned or vested unless specific performance objectives are met.
    • Individual director performance reviews -- Awards credit to companies that perform periodic performance reviews of individual directors.
    • Mandatory holding periods for stock options -- Awards credit to companies that require their executives to retain what ISS believes is a "meaningful" portion of shares acquired upon exercise of stock options for a specified time after exercise.
    • Mandatory holding periods for restricted stock -- Credits companies that require executives to retain what ISS believes is a "meaningful" portion of their earned restricted shares or performance shares for a specified period after those awards vest.
    • Takeover defenses and capital structure -- Awards additional points for companies that do not have a poison pill and that are not authorized to issue blank-check preferred stock.

    Modified CGQ Variables

    ISS modified the following variables in the new CGQ methodology:

    • Board composition -- Now provides credit only when at least two-thirds of board members are independent outside directors rather than just a majority.
    • Boards served on, other than as CEO -- Redefines the limits on the number of other board memberships that may be held by outside directors.
    • Chairman/CEO separation -- Requires the board chairman to be an independent director who is not the CEO.
    • Governance guidelines -- Credits the practice of publishing corporate governance practices on the corporate website.
    • Audit fees -- Provides additional detail on audit fees.
    • Capital structure, dual class -- Reduces the penalty for dual-class capital structures where anyone can buy shares of the super-voting class.
    • Capital structure, blank check preferred -- Now tracks blank-check preferred separately from poison pills.
    • Option repricing -- Incorporates recent changes in NYSE and NASDAQ listing standards regarding repricing policies and shareholder approval requirements.
    • Option expensing -- Adds an additional category for companies that do not issue stock options.
    • Director education -- Now rewards attendance by board members at accredited director-training programs within the previous two years.
    • Key committee independence, board access to advisors -- Rewards companies when key board committees (e.g., audit and compensation) are comprised of independent directors and have access to their own advisors.

    Deleted CGQ Variables

    The following variables were removed from the CGQ methodology:

    • Disclosure of a policy on auditor rotation
    • History of option repricing
    • Pension plans for non-employee directors
    • Corporate loans
    • Director term limits
    • Mandatory director retirement age

    Prior to releasing its new CGQ methodology, ISS personnel had preliminarily indicated that the new criteria might also include some analysis of director and officer indemnification agreements. However, no such criterion was included in the latest methodology.

    Choose the Proper Assessment Tools for Your Company

    Many public companies are striving to achieve best practice corporate governance policies and procedures. The CGQ, however, is only one potential tool for assessing such practices and procedures. Indeed, the broad applicability and general importance of some of the criteria identified by ISS in its revised CGQ methodology are the subject of debate. Alternative assessment tools are also available. Public companies should note that the need for, and comparative benefits or costs of adopting, particular practices may vary significantly depending on the specific business or other circumstances.