The Danger in Director Compensation Scrutiny at Financial Companies

ISS announced its new policy on non-employee director (or “NED”) pay (should you need a quick recap, please see ISS and Director Compensation: New Rules and Associated Predictions). ISS will not issue adverse recommendations prior to annual meetings held on Feb. 1, 2020. While it may seem far into the future and that there is plenty of time to evaluate the potential impact to your organization, think again! Your director compensation paid out this year (2019) will be disclosed in the 2020 proxy season and hence subject to the new rules.

Moreover, you will need to pay close attention to what comparator group ISS considers your company to be a part of. For the director pay analysis, unlike the CEO pay-for-performance analysis, in which ISS picks a specific group of companies with comparable size and industry focus, ISS will use a broader, pre-defined group. ISS comparators are based on the two-digit GICS industry code (GICS Sector) and stock index (S&P 500, combined S&P 400 and S&P 600, remainder of the Russell 3000 Index, and the Russell 3000-Extended) applicable to your organization. Sounds reasonable, right? Well, this may not be the case if your company happens to be one of the S&P 400 or S&P 600 non-banking companies under the financial sector (GICS 40).

The GICS 40 sector includes three major industry groups, banks (4010), diversified financials (4020), and insurance (4030). However, these industries have very different business models and thus, may have very different pay philosophies for NED compensation. Banks, especially small- or mid-cap public banks, typically choose the path of more conservative director pay than their counterparts in diversified financials and insurance industries. It may not be appropriate to compare a diversified financial company or an insurance company’s director pay against a comparator group largely comprised of banks.

Among the 154 financial companies (GICS 40) within the combined S&P 400 and S&P 600 group, a majority, or 90 institutions, are banks. Based on data as of January 31, 2019 (compiled and tabulated by Main Data Group), the 90 banks have 739 non-employee directors in total, which is 65% of the 1,134 NEDs reported by the 154 financial companies within this combined index group.

As a result, director pay levels within the ISS pre-defined comparator group (small- and mid-cap financial companies) is significantly skewed by the typically lower director pay from banks. For instance, the median pay for all GICS 40 companies under this index group is around $129,000, slightly higher than median pay from the banks ($112,000), but significantly lower than the median total NED compensation for insurance companies ($168,000) and diversified financial companies ($191,000).

For non-banking companies included in this pre-defined group, this means a potential disadvantage as their NED pay is likely going to be relatively high versus lower-paid small- and mid-cap banks. The 97^th percentile NED total compensation (ISS is likely to use 97^th or 98^th percentile as a threshold to identify) for the entire group was approximately $301,000, lower than the 97^th percentile of $333,000 and $324,000 of the insurance companies and diversified financial companies, respectively. While NED pay for most companies will be below the 97^th percentile, the ISS-defined comparator group increases the potential for certain companies, particularly those in the insurance and diversified financial industries, to be labeled as “high pay outliers.”   

Let’s assume that a mid-cap insurance company has NED total compensation of $305,000 for one or more directors. This pay range is below the 97^th percentile of the insurance companies within the combined S&P 400 and S&P 600 group by $28,000 and is very likely within a reasonable range when compared with its self-selected compensation peer group of mid- and large-cap insurance companies (as companies typically select their peers primarily based on revenue or asset size, versus market cap). However, as it is above the 97^th percentile among all GICS 40 companies in the index group, it may therefore trigger ISS’ radar for “excessive” levels of NED pay.

So, what potential steps should you consider if your company happens to be one of those non-banking financial companies within this index group that have average NED pay (excluding board leadership roles such as non-executive chairman or independent lead director) around or above $300,000? Possible remedies are listed below:

• Provide compelling rationale, if applicable, for higher than normal NED pay: certain explanations may mitigate ISS concern, especially when the payments or equity awards are clearly non-recurring in nature, such as initial election equity grants, payments for corporate transactions or special circumstances, or payments for special expertise, such as cyber security. Note that ISS will not likely view payments to reward general performance or service as a compelling rationale.
• Implement good director pay practices and program features: ensure your company has a robust stock ownership requirement (at least 4x the annual retainer) and/or holding requirement for NEDs. Further, ensure the presence of a meaningful limit on individual annual director pay (this can be added to your new incentive plan or as an amendment to your existing incentive plan).
• Communicate with shareholders effectively: explain to shareholders that your director pay is reasonable compared with your compensation peer group, in contrast to the pre-defined comparator group selected by ISS that includes many small- and mid-cap banks. Going forward, we expect more companies to include additional proxy disclosure regarding NED pay philosophy and the market benchmarking process and stress the importance of maintaining competitive director pay levels for the board to retain and attract well-qualified outside directors.

*Excludes board leadership roles (e.g., non-executive chairman of the board, lead director, etc.)