Say on Pay: Identifying Investor Concerns
This post is based on the executive summary of a Council of Institutional Investors white paper which was prepared by Robin A. Ferracone and Dayna L. Harris, Executive Chair and Vice President, respectively, at Farient Advisors, LLC; the white paper is available here.
Advisory shareowner votes on executive compensation were the big story of proxy season 2011, the inaugural year for “say on pay” at most U.S. public companies. The Dodd-Frank Wall Street Reform and Consumer Protection Act, which President Obama signed into law in August 2010, requires U.S. public companies to provide their shareowners with a non-binding vote to approve the compensation of senior executives. The Securities and Exchange Commission’s (SEC) implementing rule, adopted on Jan. 25, 2011, requires say-on-pay votes to approve the compensation of the named executive officers (NEO) at larger companies at least once every three years. The SEC granted smaller companies a two-year exemption.
Say on pay gives shareowners a voice in how top executives are paid. Such votes are also a way for a corporate board to determine whether investors view the company’s compensation practices to be in the best interests of shareowners. Say-on-pay votes are purely advisory; U.S. companies are not required to change their executive compensation programs in response to the outcome. But SEC rules do require that in subsequent proxy statements, companies discuss how the most recent say-on-pay voting results affected their executive compensation decisions and overall programs. Such follow-on comments are to be included in the Compensation Discussion and Analysis (CD&A) section of the proxy statement.
Advisory votes on pay are not a new concept. Say on pay has been widely discussed in the United States as a way to hold directors accountable for runaway executive compensation for close to a decade, ever since the Enron (2001) and WorldCom (2002) scandals. The United Kingdom adopted mandatory say-on-pay votes in 2002, and Australia followed in 2004. Two U.S. companies — AFLAC and RiskMetrics — voluntarily held say-on-pay votes starting in 2008, with Motorola following in 2009, in response to strong investor support for shareowner resolutions requesting annual advisory votes on pay. The U.S. government required more than 350 companies that received federal bailout assistance after the 2008 global financial crisis to give their investors advisory votes on executive compensation, beginning with proxies filed after February 2009.
Analyzing Say on Pay
The Council of Institutional Investors, a leading advocate for say on pay, engaged Farient Advisors to analyze what motivated investors to vote against say on pay at companies where the proposal failed to receive majority support at 2011 annual meetings. The Council believes the report will benefit active investors by identifying compensation practices where support for change is greatest. It also could help them target initiatives for improved pay practices and provide useful input for structuring their voting policies. Companies will benefit, too, from knowing which compensation practices their owners view as detrimental to long-term shareowner value.
Between January 1 and July 1, 37 say-on-pay proposals fell short of majority support. Another 37 companies garnered significant, though less-than-majority opposition, with “against” votes of 40 to 50 percent. While 37 “failed” votes is a tiny fraction (less than 2 percent) of the 2,340 say-on-pay votes at U.S. companies in the first half of the year, the total was surprisingly large compared with the track record of say on pay in other countries.
Public attention has focused on the relatively high number of “failed” say-on-pay votes (proposals that failed to win majority investor support), the impact of proxy advisory firm recommendations on shareowner voting, the reasons for “against” vote recommendations by proxy advisers and, and most recently, shareowner derivative lawsuits at companies where say on pay garnered majority “against” votes. It is clear from our interviews and public filing research that some companies have changed or promised to change their pay levels and programs in anticipation of a strong vote against their say-on-pay proposals, or in response to a substantial percentage of “against” votes.
The report specifically examines:
- The driving factors that fueled majority opposition to say on pay at 37 companies
- The process investors used to determine how they would cast say-on-pay votes
- The influence that say on pay is having on executive compensation
- Potential next steps for shareowners to consider ahead of say-on-pay votes next year
- Potential next steps for companies where investor opposition to say-on-pay proposals was significant
Farient focused its investigation on advisory votes that failed to win majority shareowner support. Farient interviewed representatives from 19 Council member organizations (both U.S. pension fund and other members) about how they cast say-on-pay votes generally and more specifically at the 37 failed-vote companies. These investor participants consisted mostly of public employee pension systems (58 percent), followed by mutual fund firms (32 percent) and union pension funds (11 percent). (The total may not equal 100 percent due to rounding.) Collectively, their assets under management exceed $7.9 trillion. Farient also interviewed proxy advisers and solicitors, and consulted its extensive database on executive compensation.
Farient found that investors cast advisory votes against executive compensation at the 37 companies for a variety of reasons, but the factors most frequently cited were:
- A disconnect between pay and performance (92 percent)
- Poor pay practices (57 percent)
- Poor disclosure (35 percent)
- Inappropriately high level of compensation for the company’s size, industry and performance (16 percent)
Other findings include:
- Investors were extremely thoughtful about evaluating executive compensation for say-on-pay votes
- Due to resource constraints, investors used proxy advisory firms’ analyses to varying degrees
- Investors considered multiple factors as well as inputs from various sources in determining their say-on-pay votes
- Investors evaluated performance and pay over multiple years, and focused primarily on total absolute shareholder return (TSR) over one-, three- and five-year periods
- Investors spent the most time and resources analyzing pay at “outlier” companies: those with large disconnects between pay and performance, high overall pay and/or low TSR in comparison to their industry or peers
- Investors focused on CEO pay, rather than the pay of other NEOs, and on the overall “reasonableness” of the level of compensation in view of the company’s size, industry and performance
- Investors mostly regarded the say-on-pay vote as an opportunity to voice their concerns about a particular pay program, not a referendum on directors’ oversight of compensation
Among majority “against” say-on-pay votes, about two thirds had opposition levels of 50–59 percent. The rest had “against” votes of 60–70 percent. About one-fourth (27 percent) were in real estate, homebuilding or construction-related businesses — industries that were hit hard in the economic downturn and mostly are still hurting. About one-fifth (19 percent) were energy-related companies. Nearly half were large companies, with annual revenues greater than $1 billion.
This first year of mandatory say on pay has been a learning experience for all participants. Farient encourages investors to conduct a “post-mortem” of their voting processes, including an assessment of any additional resources needed to evaluate say-on-pay proposals fairly and efficiently. Concerned investors should follow up to see what steps, if any, companies take in response to failed say-on-pay proposals, and consider appropriate action.
Farient also offers two critical areas for improvement in deciding how to cast a say-on-pay vote:
- TSR should not be the sole filter investors use to determine which companies’ pay plans deserve the most scrutiny. Problematic pay practices lurk at mediocre to modestly performing companies, too
- Assessing performance-adjusted pay — compensation that top executives could receive after performance is taken into account — and in particular the performance-adjusted value of equity — is more appropriate than focusing on the grant date value of equity incentives. The value on the date of grant, as determined by the stock price that day for shares (or options, using an options pricing model), does not reflect the compensation that executives ultimately earn
Companies that failed to win majority support for say-on-pay proposals, or that garnered substantial opposition, should reach out to key investors and engage them in dialogue about executive pay programs. They should also make sure their pay disclosures are clear and thoughtful and that their compensation programs are aligned with company performance. That means having a combination of pay that is sensitive to changes in performance, pay levels that are appropriate overall, and a substantial proportion of pay that is performance-based. In particular, companies should consider setting the magnitude of pay changes in response to performance, so that the changes swing proportionately with strong or weak performance.
Legislation has forced both investors and companies to pay more attention to executive compensation. Compensation committees and boards have become much more thoughtful about their executive pay programs and pay decisions. Companies and boards in particular are articulating the rationale for these decisions much better than in the past. Some of the most egregious practices have already waned considerably, and may even disappear entirely.
Say on pay is a non-binding advisory vote. Investors agree that they do not want to dictate executive pay arrangements. Rather, they want to ensure that the executive pay programs of their portfolio companies incentivize executives to increase shareowner value for the long term. Moreover, if the pay programs are not benefitting long-term owners, investors want the ability to influence their portfolio companies to make the necessary changes. This seems to be what say on pay is all about.
Ann Yerger is Executive Director of the Council of Institutional Investors. This post is based on the executive summary of a CII white paper which was prepared by Robin A. Ferracone and Dayna L. Harris, Executive Chair and Vice President, respectively, at Farient Advisors, LLC; the white paper is available here.
This article was first published on the Harvard Law School Forum on Corporate Governance and Financial Regulation and is re-published with the author's permission.