Shareholders Are Scrutinizing Compensation Practices. Are You?

This proxy season shareholders are continuing to pressure companies to adopt more “pay-for-performance” practices. And with changes to proxy advisers' voting recommendation policies, the evolution of “say-on-pay” lawsuits, and other factors—including  declining stock prices at some companies—many are feeling the heat.

The use of effectively structured engagement programs, however, combined with strategic proxy statement disclosure can significantly aid companies in successfully navigating these challenges this proxy season.

Each year, proxy advisory firms like Institutional Shareholder Services and Glass Lewis, exert substantial influence on compensation matters. Several large institutional shareholders rely heavily on proxy advisory firm recommendations to determine how they will vote millions of shares each year. Therefore, it is critical to understand the processes these firms use to determine voting recommendations.

ISS, for example, will generally issue negative vote recommendations on practices it views as egregious or if it finds some type of “misalignment” between pay and performance. As part of its process, ISS will initially conduct a quantitative pay versus performance analysis, such as comparing pay trends to total shareholder return versus that of peers over a certain period of time. ISS will then perform a more thorough qualitative assessment of a company's pay practices, if the results of the quantitative analysis reveal significant misalignment between pay and performance.  Notably, for 2013, ISS has amended its guidelines by incorporating a new methodology for determining comparative peer groups and applying the concept of “realizable pay” to its qualitative analysis.

Though pay-for-performance alignment is the most common reason proxy advisory firms recommend a negative vote, certain aspects of employment agreements also cause negative recommendations. Executive employment agreements that contain provisions related to overly generous severance provisions—tax gross-ups, for example—or plans that allow excessive dilution or single-trigger change-in-control payouts are probably going to attract negative attention from proxy advisers and shareholder groups. Additionally, large institutional shareholders, including pension funds, have their own internal voting policies. Companies should review the voting policies of these funds and proxy advisers annually to assess any changes and to see how, or if, the company's compensation policies differ. 

The Say-on-Pay Effect

Though only entering its third year, the Dodd-Frank Act mandated “say-on-pay,” which is an advisory shareholder vote regarding a company's executive compensation, has greatly increased shareholder influence on compensation decisions. Additionally, smaller reporting companies, such as those with a public float below $75 million, will be subject to say-on-pay requirements for the first time this year. Therefore, in 2013, shareholders arguably will have the largest direct role ever regarding executive compensation matters.

Proxy statement disclosure with an emphasis on transparency, board independence, and compensation disclosure that is clear, concise, and conspicuous enables shareholders to best understand how the company's compensation program operates.

Aside from giving shareholders a more prominent voice in compensation decisions, say-on-pay has created an avenue for plaintiff law firms to file various lawsuits. After the 2011 and 2012 proxy seasons, several companies that failed to get at least a 50 percent favorable say-on-pay vote ended up getting targeted with shareholder lawsuits. Generally, the lawsuits alleged that the executive compensation disclosures by the targeted company  or equity compensation plan proposal was not sufficient to allow for an informed shareholder vote and argued consequently that the shareholder vote or annual meeting should be enjoined. These lawsuits were initiated after the company in question had filed its proxy statement which put those companies in the position of having to either delay the annual meeting, submit more disclosures via an “amended” proxy statement, or both. So far, the lawsuits have been largely unsuccessful and many have been dismissed or settled for minimal amounts. In light of the potential impact of these lawsuits, however, companies should consider reviewing peer company executive compensation disclosure to ascertain whether a relative alignment disconnect exists, since the lawsuits have often based their claims of inadequate disclosure on comparisons of peer company disclosure.

Effective Shareholder Engagement

Active shareholder engagement benefits companies by establishing the groundwork for substantive dialogue with shareholders. Shareholder outreach can also prevent or cure misconceptions and facilitate future shareholder support of the company and its board of directors on a variety of issues.

The proxy statement is among the most effective tools in the general engagement process, and specifically in relation to executive compensation. Proxy statement disclosure with an emphasis on transparency, board independence, and compensation disclosure that is clear, concise, and conspicuous enables shareholders to best understand how the company's compensation program operates. Proxy statement disclosure should also use descriptive text as well as tables, charts, or graphs, as necessary, to illustrate the objectives of the compensation program and how it (hopefully) creates incentives for executives to produce long-term value while also reinforcing accountability. The disclosure should demonstrate comparative data benchmarking compensation against peers, use of tally sheets, compensation consultant independence, and executive bonus target opportunities.

In addition, the proxy statement disclosure may also use executive summaries that identify key governance changes and operational accomplishments and “realized pay” tables regarding pay-for-performance alignment in years of bad performance.  Companies should consider describing an annual “scorecard” of criteria and goals used to evaluate executive performance and also stating how the company actually performed compared to those criteria and goals to demonstrate executive officer accountability.

Once the proxy statement sets forth a clear description of the rationale and basis for compensation decisions, the company can implement an engagement program that fits the particular shareholder base and specific circumstances of the company. The engagement should be continuous all year and should treat shareholder proposals as an invitation to a discussion. Depending on the particular circumstances, it might be advantageous to go beyond the 10 or 15 largest shareholders in order to get a good idea of which governance issues are of concern to shareholders. Some commentators also have suggested utilizing various methods to reach shareholders, such as integrating governance and investment analyst conversations or road shows centered on governance topics, which might be useful.

As an offshoot of its shareholder engagement activities, companies should also determine a strategy to interact with proxy advisory firms. For instance, companies should use the limited time allotted to review and comment on the proxy advisory reports that will be generated after the proxy statement is filed. If the compensation practices have been misinterpreted in the report, prepare a clear explanation of the proper interpretation of the compensation program and practices. Most likely, the report may not be corrected prior to the annual meeting, therefore, companies will have to determine whether it is in their best interests to prepare and disclose a “public rebuttal” of the report. The public rebuttal can take the form of a supplemental proxy statement filing, a letter to shareholders, or disclosure on a Form 8-K or other periodic report of the Securities and Exchange Commission.  

Different factors, including the state of the economy, legislative and regulatory actions, stock market performance, proxy advisory firms, and overseas governance trends affect the major issues each proxy season. In order to have the best results possible, management and boards of companies should always remain cognizant of these developments and devise and integrate appropriate changes to proxy statement disclosure as well as the shareholder engagement strategy.