With proxy season just around the corner, ushered in with a flurry of annual shareholder meetings that begin in April, the annual tradition of assessing the mood of investors has begun.
On tap, experts say, are demands for improved transparency and communication, better disclosures, and a continuing scrutiny of directors—including how (and how much) they and their C-suite cohorts are compensated.
“We are going to continue to see shareholders seeking a greater voice at the companies in which they are invested,” says David Connolly, a partner with law firm Shearman & Sterling. Those demands will manifest themselves, in part, though proxy access proposals.
In 2010, the SEC proposed a rule that would have allowed shareholders owning at least 3 percent of a company for at least three years the ability to propose director nominees, for up to 25 percent of the board, in proxy materials. The rule was struck down by the D.C. Circuit after a legal challenge, but has since seen new life through both shareholder resolutions and voluntary by-law changes. The long march to proxy access ubiquity will continue, if not intensify, this year.
Another broad theme in play this year is a debate over corporate short-termism. It is hardly a new discussion, but the catalyst for fresh consideration was a Feb. 1 letter to nearly 500 companies where Laurence Fink, co-founder and CEO of BlackRock, urged shareholders to resist the temptation to use short-term thinking to dictate larger corporate behavior. And Fink did not stop there; he also stated Blackrock’s intent to ask every CEO to lay out for shareholders an annual strategic framework for long-term value creation.
“When you think about the different types of investors that own the equity of public companies, there are those who are only it for a short time and others investing for the long term,” Connolly says. “Companies have many different types of investors to think about as they manage their business. There is a lot of short-termism in the press that puts pressure on companies to manage to the short term, but they also need to articulate their long-term vision to the investing public as a way of supporting their business plan and, maybe, moving away from quarter-to-quarter management.”
Aside from juggling short-term and long-term expectations, executive compensation plans face new and pending SEC regulations. Among the most controversial is the “pay-ratio” rule. It requires that, with annual reports and proxy statements for fiscal year 2017, most public companies must disclose a ratio of CEO pay to that of the median employee.
“There is a lot of short-termism in the press that puts pressure on companies to manage to the short term, but they also need to articulate their long-term vision to the investing public as a way of supporting their business plan and, maybe, moving away from quarter-to-quarter management.”
David Connolly, Partner, Shearman & Sterling
It is a rule many are still digesting, says Doreen Lilienfeld, practice group leader of Shearman & Sterling’s compensation, governance & ERISA Group. “Companies are doing their homework and modeling what it might look like if those rules were in place. People are spending their time crunching the numbers at this stage, so I don’t think we will see much voluntary reporting.”
In Lilienfeld’s view, companies this year will continue to heed the advice of SEC staff for streamlining disclosures and slow the ever-expanding proxy. “As various regulations have been added to Item 402, the lynchpin of executive compensation disclosure under Regulation S-K, there are 23 separate requirements,” she says. “We are now up to 402(u) and going to get into double letter sections soon. That is a lot of data and information. Issuers are going through their historical disclosures, looking at what they have done in the past, and trying to figure out what is really necessary for investors to get an understanding of their pay program.” That push, this year, is likely to include more companies adding an executive summary, either at the beginning of the proxy itself or the compensation disclosures, to provide easy-to-read highlights of pay programs.
On March 1, EY’s Center for Board Matters released a preview of the coming proxy season, based on conversations with more than 50 institutional investors, investor associations, and advisers. Among the findings: proxy access, thus far, is the most commonly submitted shareholder proposal; and environmental and social matters accounted for 54 percent of all proposals, followed by board-focused (30 percent) and compensation proposals (9 percent).
TOP 2016 PROXY ISSUES
Charts from EY's recently released 2016 proxy season preview illustrate what respondents to its survey had to say about proxy access and top issues for shareholders this year.
Breakdown of proxy access bylaw terms adopted by more than 180 companies so far:
Top three 2016 shareholder proposal categories to date (based on proposal submissions):
Participating investors said they view how companies address climate change and other environmental and social challenges as a proxy for the strength of the board and management and a metric for measuring governance risk. “The language they are using establishes a broader context to the viability of the company’s business model,” says Jamie Smith, assistant director for the center. “Is the business model sustainable, given the impact of new, renewable technologies? How is the company positioned relative to climate change? How is the company overseeing and managing its supply chain? The language is very much focused on being about the business itself. If there is a positive impact for society as well, all the better.”
Expect increasing scrutiny of board members. Do they have adequate expertise? Are they under- or over-compensated, over-worked or under-worked? What is the best approach to maintaining experience and rewarding tenure without locking out new faces and fresh ideas? Even adding targeted expertise—in cyber-security, for example—can prompt questions, Smith says. If a specific expert is named to the board, does that mean the other directors are off the hook on those issues, or will they defer to this expert? Do you want experts on the board or well-rounded directors who ask tough questions and know when to hire outside expertise?
Other shareholder proposals to watch for this season concern stock buybacks. In December, the AFL-CIO’s Equity Index Fund announced plans to target “companies where CEOs stand to collect a bundle as a result of large stock buyback programs.” In a stock buyback, a company buys its own shares to reduce the number of shares outstanding. This can prop up companies’ stock prices in the short term, benefitting stock-compensated executives and directors. Thus far, the fund has filed shareholder proposals at 3M, Xerox, IBM, and others asking those companies to exclude stock buyback programs from the financial metrics on which CEO pay is based.
“What we have heard, at least anecdotally, is that some companies are willingly engaging on this and already have something in their pay plans to prevent it from happening,” Smith says. “They just haven’t disclosed it yet.”
What should companies do in preparation for this proxy season, in particular if they face activist shareholders? Dave Brown, a partner in Alston & Bird’s securities group, suggests that boards implement and follow strong governance rules, communicate with shareholders throughout the year, and take the time to understand the tactics potential activists have used in the past. “When an activist comes knocking on your door, you really need to have a good response team that includes the CFO, investor relations, and legal,” he says. “You need to have a good assessment of who that activist is. Some have long-term interests; others have a short-term focus on dividends or share repurchases.”
Also beneficial: regularly scheduled board audits, conducted by an external organization, to help ensure member tenure and skill diversity. This not only benefits oversight of the company, it may further dissuade shareholders from their perception of an under-qualified board. These audits are not yet very common, although some boards have engaged outside law firms, with the added benefit of establishing attorney-client privilege, Brown says.
Just as there is a scrutiny on executive pay, prepare for a spotlight on board compensation. Recent legal cases should prompt companies to ensure “that directors, especially because they are approving their own compensation, are doing it in a way that doesn’t look completely self-interested,” Brown says. “There should be a rational basis for the compensation that considers peer groups. When they are granting themselves equity, as part of the compensation equation, are they are putting limits on the amount of equity they get? You really want to make sure the disclosure of your director compensation program is clear so that you don’t have those questions and issues come up.”