The inaugural voting season for say-on-pay may be over, but the long war for better shareholder relations over executive pay is just beginning.
In the last proxy season, more than 276 companies in the Russell 3000 received negative recommendations from proxy advisory firm ISS Corporate Services. Of the 276 companies that suffered the bad marks, 36 of them flunked their say-on-pay advisory votes from shareholders—a 13 percent failure rate. Nay votes from the last proxy season signaled increased shareholder concerns over company pay practices.
The correlation of ISS's negative recommendations and failed votes are significant. Thirty two percent of companies that received negative recommendations by the firm saw their compensation plans struck down by shareholders compared to 10 percent of companies with positive recommendations that failed to get shareholder approvals. Companies that received negative recommendations have an average of 32 percent against votes on their say-on-pay compared to 10 percent against votes from shareholders in companies that received a “for” recommendation from ISS.
That's not all. Based on a study by Deloitte seven say-on-pay lawsuits have been filed so far at companies that reported less than 50 percent shareholder support. “It is a sign of increasing shareholder activism in executive compensation and should not be ignored,” says Michael Kesner, a principal in Deloitte's executive compensation practice.
The Myth of Total Shareholder Return and Proxy Advisory Firms
Proxy firms consider a wide range of factors before issuing a recommendation on executive pay; the most popular metric, total shareholder return (TSR), is only one of them.
“Total shareholder return is a very misunderstood portion of ISS's pay-for-performance approach,” says Carol Bowie, head of compensation policy development at ISS. Shareholders might use TSR to gauge how well companies perform overall, Bowie explains, but evaluation policies adopted by ISS are divided into three categories based on pay-for-performance, problematic pay practices, and board effectiveness and communication.
The pay-for performance analysis looks at the alignment of a company's performance against peers and the pay executives receive for delivering that performance. If the granted pay is inconsistent with performance, ISS will further examine whether the equity grants are strongly performance based. Problematic pay practices that will set off red flags for closer scrutiny include excessive perks, excise tax gross-ups, and severance payments indicative of performance issues. Disclosure quality and a board's responsiveness to shareholders' votes on compensation issues are also considered, Bowie says.
Bowie says that if a company's TSR consistently lags the median of its peers, ISS will look at the company more closely—but that won't necessarily lead to a negative recommendation. The firm's approach is to examine a company's TSR and executive pay together. “If TSR is down, is the executives' pay also going down? More importantly, can we conclude their compensation is performance-based?” she says.
Another significant issue with companies' compensation disclosures last season was companies' inability to show their long-term performance incentives, says David Eaton, assistant vice president of compensation at proxy advisory firm Glass-Lewis & Co. “We do not consider a stock option as a true long-term performance,” he says. Companies should disclose their threshold targets and how those targets translate to payments received by executives to help proxy advisory firms and shareholders in understanding their overall pay practices, Eaton says.
The qualitative discussion of pay packages is an important factor. “We are looking at companies to use their Compensation Discussion and Analysis to tell a story on why compensation committees make certain decisions,” Eaton says. Statements made in CD&A must convey to proxy advisory firms and ultimately to shareholders the rationality behind their adopted compensation practices. In preparing their CD&A statements, companies should pay attention to their selections of performance metrics and ensure the metrics used are challenging enough to justify their pay practices.
“There is no reason for companies to receive negative recommendations if they have set an appropriate strategy to deliver shareholders' values.”
—Carol Bowie,
Head of Compensation Policy Development,
ISS Corporate Services
In next year's proxy season, Glass Lewis would like to see improvements on how companies present their compensation disclosure in the CD&A. Companies should include information that will provide some insights into their equity award amount, financial metrics used, and how compensation committees defer performance-based awards should the targets not be achieved, Eaton says.
According to Bowie, all companies need to do is ensure that compensation reflects performance and avoid problematic pay elements. “There is no reason for companies to receive negative recommendations if they have set an appropriate strategy to deliver shareholders' values,” Bowie says.
Companies should also hone the art of benchmarking their own pay practices against those of their peers, Bowie says. ISS tries to determine peers by performance and industry size, Bowie says; the firm has avoided using companies' recommended peer groups, since they tend to benchmark their pay to comparable peers to make their compensation practices look better.
Advice From Experts
Deborah Lifshey, managing director at compensation consulting firm Pearl Meyer & Partners, suggests that companies go through ISS's checklist and avoid certain pitfalls such as tax gross-ups, single-trigger severance packages during a change in control, and option re-pricing without the approval of shareholders. “Focus on ISS. They have become very powerful. Whenever possible, restructure and clean up pay practices according to the ISS checklist,” she says. Critiquing ISS's model won't change that reality, she adds.
KEY TAKEAWAYS
Below are some significant findings from the ISS “Preliminary 2011 U.S. Postseason Report”:
During the first year of advisory votes on executive compensation under the Dodd-Frank Act, investors overwhelmingly endorsed companies' pay programs, providing 91.2 percent support on average.
Shareholders voted down management “say on pay” proposals at 37 Russell 3000 companies, or just 1.6 percent of the total that reported vote results. Most of the failed votes apparently were driven by pay-for-performance concerns.
“Say on pay” votes increased investors' workloads, but spurred greater engagement by companies and prompted some firms to make late changes to their pay practices to
win support.
Investors overwhelmingly supported an annual frequency for future pay votes. As of June 30, annual votes had garnered majority (or plurality) support at 1,792 companies
in the Russell 3000 index, as compared to triennial votes, which won the greatest support at 412 companies.
Among governance proposals, the biggest story of this year was the greater support for shareholder proposals that seek board declassification. These resolutions averaged
73.5 percent support, up more than 12 percentage points from 2010, and won majority support at 22 out of 23 large-cap firms.
Majority voting proposals averaged almost 60 percent support, while proponents reached settlements with more than 30 firms. Independent chair proposals fared better this year, winning majority support at four companies.
There were fewer shareholder proposals to repeal supermajority rules, as more companies put management proposals on the ballot.
Investor support for shareholder resolutions on environmental and social (E&S) issues continues to rise. This year, there was a 20.6 percent average approval rate for these proposals, the first time this support level had reached the 20 percent mark. Five proposals received a majority of votes cast, a new record.
The arrival of "say on pay" contributed to a significant decline in shareholder opposition to directors. As of June 30, just 43 directors at Russell 3000 firms had failed to win majority support, down from 87 in the same period in 2010.
Poor meeting attendance, the failure to put a poison pill to a shareholder vote, and the failure to implement majority-supported shareholder proposals were among the reasons that contributed to majority dissent against board members this year.
Source: ISS: Preliminary 2011 U.S. Postseason Report.
Other methods companies have chosen to improve voting results include hiring proxy solicitors and increasing outreach to shareholders. According to Lifshey, outsiders say companies don't truly “pass” say-on-pay unless they received at least an 80 percent approval rate. Meanwhile, shareholders will have more time to review compensation plans in the next season. “Figure out what the votes in the past proxy season mean, and reach out to shareholders and ask the question why they are not voting for yes,” she says.
Aside from shareholders' outreach and post-mortem discussion of votes, companies should begin working on their pro-forma analysis of next year's compensation plans, says Doug Friske, global head of Towers Watson's executive compensation consulting practice. “Identify unusual events of payments and unaddressed poor pay practices,” he says. Companies should also plan responses to this year's negative votes in the next CD&A statements.
In next year's proxy season, use the CD&A to explain to shareholders your pay practice against performance, create your own charts to show the relation between pay and performance, and present alternative tables and analysis beyond what is required, Friske says. “Although proxy advisory firms have some weight in influencing the outcome of say-on-pay votes, many shareholders do not strictly follow their guidance,” he says. Companies can present their own performance measures such as profitability, return on capital, and operations metrics that include customer satisfaction, innovations, and new market penetrations to help shareholders better understand their pay-to-performance policies, Friske adds.
Critics, however, doubt the significance of proxy advisory firms' influence on investors' opinions. “Proxy advisors do not have nearly as much influence as companies think they do,” says Amy Borrus, deputy director at the Council of Institutional Investors.
Borrus says institutional investors have their own resources to measure companies' performances. “They may look at proxy advisers' recommendations but it is not an automatic factor to influence their votes,” she says. Recommendations from advisory firms are just another data point for institutional investors to look at, in addition to their proprietary analysis. Often, investors will screen out poor performers against their peers.
“What companies need to do is focus on addressing investors' concerns,” she says.
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