Corporate Governance: proxy advisory guidelines and the shifting landscape of benchmarking executive compensation

By Guest Contributor
January 30, 2012

By Alex Lee

NEW YORK, Jan. 30 (Business Law Currents) – Last year’s introduction of say-on-pay regulations via Dodd-Frank helped to arm shareholders with the capacity to disapprove compensation policies, but the SEC’s evolving compensation disclosure regulations and recent updates from proxy advisory firms’ guidelines indicate that executive compensation remains a key issue. While the post-Lehman headlines of public outrage and calls for legislative scrutiny over executive compensation may have waned, now more than ever, companies need to exercise great care when considering executive compensation policies.

Boards are stuck between a rock and a hard place. On one hand, they must recruit, retain, incentivize, and properly compensate prized executives. On the other, the must deal with a growing public animosity towards excessive executive compensation and shareholder unrest, especially in periods where companies are not performing optimally.

During the 2011 proxy season, shareholders and boards braced themselves for the initial Securities and Exchange Commission (SEC) mandated say-on-pay regulations regarding executive compensation. All branches of corporate governance guidance had their hands to the pump, as proxy advisors and law firms were all actively involved in providing advice to companies’ compensation committees and boards. With the wave of changes that came, particular emphasis was placed on board communication to shareholders. One primary area where corporate governance concerns were flagged was in regard to benchmarking executive compensation.

Executive compensation has always been a thorny issue, not only amongst shareholders, but now increasingly with the American public at large. Corporate boards often times actively seek to pay their executives at or above the median in relation to equivalent companies. The principle here is referred to as “benchmarking” and it is utilized in theory to adequately compensate capable and talented executives to entice them to remain in their posts.

There are, however, some serious risks in this type of model. The method of attempting to meet or exceed median pay means that compensation will inherently increase. This is irrespective of the performance output, and companies have a vested interest in protecting their corporate image by compensating executives in a manner that is in-line with their peer groups. This is no doubt also fueled by the fact that corporate board members are not always entirely independent of each other. Many boards are intertwined with members having close business connections or personal relationships.

While the above issues are not new, the current Presidential primaries and the upcoming election have added another dimension to the executive compensation debate. Along with public concerns over the benefits provided by private equity activity, there is an increasing uproar over executive compensation and the divide between the wealthy and the working class. If nothing else, executive compensation with likely be firmly entrenched in the corporate headlines in 2012.

As advisory votes regarding executive compensation plans became required in 2011 for public companies, a significant spotlight was placed on the outcomes of the votes. Although the vast majority of companies won their say-on-pay votes, continued engagement with shareholders is still a critical issue.

Active communication and the hammering out of any policy differences between boards and shareholders will be essential to ensure that votes in 2012 do not fail. Last year was the very first time that shareholders could voice their approval or disapproval with executive compensation packages and the voices will likely grow louder in the years to come.

According to GovernanceMetrics International (GMI): 38 Russell 3000 companies failed say-on-pay votes through October 2011; 157 additional Russell 3000 companies failed to receive at least 70 percent shareholder support for compensation plans; eight S&P 500 companies failed say-on-pay votes through October 2011; and 42 S&P 500 companies failed to receive at least 70 percent shareholder support for compensation plans. Not surprisingly, the companies that failed to reach the 70 percent threshold are the most likely to face vote failure in the upcoming proxy season.

Of the 42 S&P 500 companies that failed to reach the 70 percent threshold, 17 of them did not reach 60 percent. Companies such as Safeway Inc. and Vornado Realty Trust failed to even reach the 55 percent mark. On the opposite end of the spectrum, companies such as NVIDIA Corporation, Big Lots, Inc. and Yahoo! Inc. look better placed to reach the 70 percent finish line in 2012 as all were above the 68 percent threshold last year.

These figures are made all the more significant in light of Institutional Shareholder Services’ (ISS) 2012 Corporate Governance Policy Updates. ISS will now begin to evaluate recommendations on say-on-pay proposals on a case-by-case basis in situations where a company did not reach the 70 percent threshold last year with potentially greater focus on disclosure to remedy any perceived problems. ISS’ evaluations will concentrate on disclosed engagement efforts with shareholders and a company’s response to their concerns.

A majority vote that is less than the recommended 70 percent will effectively be treated as a loss. No longer is a majority vote a sign of a mandate, instead, anything less than 70 percent will be likely viewed as a serious exhibition of dissatisfaction with a company’s handling of compensation issues. Now more than ever, it is absolutely critical for companies to have in place a properly conceived strategy to maximize their chances of winning say-on-pay votes by the widest margins possible.

ISS has made major alterations to how they measure pay for performance alignment. Their new policy means that applied peer groups will be much more narrowly construed. Instead of rigidly sticking to a Global Industry Classification Standard (GICS) group for a benchmark, going forward, peer groups will now include 12 to 24 companies (utilizing applicable guidelines include market capitalization, revenues or assets). This is designed in order to select peers that are most similar to a subject company, and also where the subject company is near to median in revenue/asset scope. These changes should have a positive effect on increasing benchmarking transparency and ensuring that more appropriate peer groups are selected.

Further, relative alignment evaluation will take into account a company’s rank in both pay and total shareholder return (TSR) within a peer group for one and three year periods. There will be a weighting scheme with a 40 percent emphasis on the one year period and a 60 percent concentration on the three year period. There will also be an absolute alignment between CEO pay trends and company TSR over a prior 5 year period (the differential between annual pay change trends and annualized TSR trends). These alterations may provide an avenue for linking executive performance output to compensation on a more realistic basis.

In the complete context, last year’s say-on-pay vote results were very positive for companies (the vast majority of compensation policies were approved) and this helped to alleviate the uncertainty that the regulatory changes brought, especially in light of various shareholder lawsuits that were brought for improper compensation practices. However, in a win for corporate boards everywhere, a recent Oregon decision affirmed that executive compensation is determined by directors’ authority.

A majority vote in support is no longer sufficient and in no way represents a positive endorsement of company compensation policies. Shareholders can change their minds on a whim and the 800 pound gorilla in the room will always be maximizing shareholder value.

It is no surprise that those companies with significant approval rates also exhibited excellent performance. In a world of short term investment outlooks, stock price levels will likely dictate shareholders’ tolerance of large executive compensation packages. Companies should act to engage shareholders prior to the proxy season to establish a bridge of understanding with shareholders with respect to compensation strategies.

Proxies will be an increasingly important tool in increasing transparency and engaging shareholders, particularly in terms of the compensation discussion and analysis (CD&A) drafted by management. One recommended method of increasing communication with shareholders is to include a summary section in a proxy statement as exhibited by Prudential Financial and General Electric. Boards that did not obtain a 70 percent vote last year should reevaluate their practices and put their compensation committees on high alert as unpopular practices will need to be adjusted to suit the demands of shareholders and proxy advisories.

Compensation committees will likely find it imperative to reach out to shareholders and engage them to avoid adverse effects. ISS recommendations on the selection and application of peer groups for benchmarking as well as pay for performance output may help provide the necessary guidelines to achieve these goals. A negative vote on executive compensation proposals can portend seriously negative consequences including the filing of derivative lawsuits, and as a result, avoiding a negative vote on say-on-pay is absolutely essential. Companies will be wise to keep in mind the omnipresent shareholder concern of what the company has done for them lately.

 

(This article was first published by Thomson Reuters’ Business Law Currents, a leading provider of legal analysis and news on governance, transactions and legal risk. Visit Business Law Currents online at http://currents.westlawbusiness.com. )

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