The answer: when ISS is evaluating a public company’s corporate governance under its revised policies for the 2013 proxy season. We previously blogged about the potential insider trading issues that could theoretically arise when insiders pledge company stock to secure loans. Now, with the implementation of the revised ISS governance standards, there are additional reasons for publicly traded companies to implement antipledging and antihedging policies.
ISS specifically addressed hedging and pledging activity in its 2013 U.S. corporate governance policy updates, which were posted in November of last year. In these updates, ISS included a footnote to its policy on voting for director nominees in uncontested elections in circumstances where there are perceived corporate governance failures. Under the new policy, ISS will recommend “against” or “withhold” votes for directors (individually, committee members, or, in extreme cases, the entire board) due to “[m]aterial failures of governance, stewardship, risk oversight, or fiduciary responsibilities at the company”. The new footnote cites hedging and significant pledging of company stock as examples of activities that will be considered failures of risk oversight. Other cited examples of risk oversight failures include bribery, large or serial fines or sanctions from regulatory bodies, and significant adverse legal judgments or settlements.
The rationale behind this new update seems to be based on ISS’s belief that pledging any amount of company stock by insiders for a loan is not a responsible use of equity and could have a detrimental effect on shareholders if, for example, the insider is forced to sell a significant amount of company stock to meet a margin call. ISS points out that such a sale might not only place downward pressure on the company’s stock price, but could also violate corporate insider trading policies since these types of forced sales could be beyond the control of the insider. However, not all pledging may negatively impact companies. ISS revised its policy from its original proposal, which would have prohibited all pledging, to include only significant pledging of company stock. This was in response to comments from the Society of Corporate Secretaries & Governance Professionals (the “Society”) in a comment letter on the ISS proposals. In that comment letter, the Society argued that in some instances, company stock ownership by founders in smaller public companies often represents a majority of these founders’ net worth and an across-the-board antipledging policy would not be appropriate in all instances. Under the revised policy, ISS will examine whether pledging is significant on a case-by-case basis, taking into account all relevant factors. As pointed out by Wachtell attorney David Katz, this approach provides for greater flexibility in cases where some pledging of company stock would not constitute a failure of risk oversight rather than a one-size-fits-all approach that might be over inclusive.
In determining vote recommendations for election of directors of companies who currently have executives or directors with pledged company stock, ISS will consider the following factors:
- Presence in the company’s proxy statement of an antipledging policy that prohibits future pledging activity;
- Magnitude of aggregate pledged shares in terms of total common shares outstanding or market value or trading volume;
- Disclosure of progress or lack thereof in reducing the magnitude of aggregate pledged shares over time;
- Disclosure in the proxy statement that shares subject to stock ownership and holding requirements do not include pledged company stock; and
- Any other relevant factors.
In addition to pledging of company stock, ISS believes that hedging or other monetization strategies, such as prepaid variable forward contracts could also be problematic from a governance standpoint. For example, these types of activities could potentially insulate insiders from the economic effects of poor stock performance. Because of these strategies provide for, to some extent, a decoupling of the insider’s economic interest from company stock performance, these activities could cause an insider’s interest and long-term shareholder return to be out of alignment.
Although I’d argue that bribery and pledging or hedging of company stock are on completely different levels as far as corporate risk oversight is concerned, there is a sound argument to be made that these activities may detract from a company’s effectiveness in terms of corporate governance and risk management. In light of these ISS updates, public companies should examine their internal policies and procedures in advance of the mailing of their proxy statements to analyze the possible effects of these updated policies on ISS voting recommendations. As we have noted before, proxy advisory firms have gained significant influence at annual meetings, particularly in the wake of Dodd-Frank. As a result, public companies may be at the mercy of these firms’ policies for the foreseeable future, for better or for worse.