Say-on-Pay: Maximizing Your Company’s Results
Shareholder engagement has become the new ‘it’ topic in corporate governance and executive compensation circles and with good reason. While building strong relationships with shareholders can help companies successfully win shareholder votes on a range of issues, it has become a particular focus with regards to the non-binding say-on-pay votes held annually by most US companies.
The reputational risks for companies and directors alike associated with a weak or failed say-on-pay vote are high and have prompted companies to focus on ways in which they can inoculate themselves from poor results. Although much has been written about the ways in which companies can best engage with shareholders, less has been written about the tactical approaches they can take to help address shareholder concerns that might lead to poor vote tallies.
The good news is that most companies, even those who have suffered an outright fail on a say-on-pay vote, are able to successfully recover in the subsequent vote. Among the 66 companies that failed a say-on-pay vote in 2014, only 12 have failed again in 2015, while 16 have passed with greater than 90 per cent ‘for’ votes. However, this reversal is often the result of both increased shareholder engagement, as well as modifications to the company’s pay programs and governance policies.
When confronted with the task of improving shareholder support for the say-on-pay vote, there are a number of approaches that companies should consider.
Identify the Issues
The first step is to develop a plan of attack upon which all parties within the company agree. This begins as a fact-finding endeavor.
- Review proxy advisory firm reports
Reports from proxy advisory firms, such as ISS and Glass Lewis, provide important insight into the concerns of shareholders as both of these organizations make vote recommendations based on methodologies that are reflective of the concerns of their respective constituencies. Even write-ups in support of favorable say-on-pay vote recommendations can include important warning signs. Although these reports can provide a catalogue of concerns, they are not always helpful in prioritizing changes. Companies should evaluate these reports in the context of other information gleaned directly from shareholders and an understanding of how influential each of these organizations is within their shareholder base.
- Engage shareholders
Before implementing any changes, it’s important to understand shareholders’ concerns, both published guidelines and company-specific feedback, as well as their past voting history. Most shareholders are receptive to engagement on executive compensation and corporate governance issues. Meeting one-on-one with major shareholders, either in person or over the phone, not only helps generate a list of issues that shareholders would like addressed, but also a sense of the magnitude of their concern for any particular issue. Although a shareholder may dislike several aspects of the program, it may be that one of them is critical. Knowing this can be helpful in prioritizing program changes. These meetings can also make shareholder concerns more concrete and can provide useful ammunition for the committee in the event of management opposition to change. It is important to note that this should not be the only engagement with shareholders. Once the program has been finalized, another round of outreach should be conducted in anticipation of the upcoming say-on-pay vote.
- Recognize the influence of non-compensation factors
Finally, companies should recognize that there are instances where the say-on-pay vote is used to express dissatisfaction with other aspects of company performance or actions. Poor stock price performance, even if temporary, increases scrutiny of pay programs.
Once a list of issues has been compiled, solutions should be identified and prioritized.
Pick the low hanging fruit
In general, the easiest fixes a company can make are those related to corporate governance, in large part because they have minimal impact on affected executives. While many companies have already addressed these issues, a weak say-on-pay vote can serve as the needed impetus to finally effect the changes.
- Eliminate tax gross-ups
This expensive perquisite is reviled by many shareholders and it’s a protection that is often unnecessary in well-balanced programs. Design modifications, such as changes in vesting schedules, also can help address the problem.
- Establish a clawback policy
Although SEC rules on clawbacks as mandated under the Dodd-Frank Act have not yet been finalized, many companies have already implemented these provisions proactively, with the knowledge that they will need to be modified once the SEC releases the final rule. If a company hasn’t yet taken this proactive step, it can be an effective demonstration of a commitment to governance best practices.
- Anti-hedging/pledging policies
This issue has become increasingly prominent since ISS changed its voting methodology to label significant pledging by executives or directors to be a failure in risk oversight and cause for potential against/withhold vote recommendations for directors. Executives and directors are already prohibited from hedging activities and very few executives and directors have pledged shares owned as collateral for other obligations, making these policies relatively painless to implement.
- Double triggers
Implementing double triggers for equity awards (such that vesting of equity awards will accelerate only if an executive loses his/her job in conjunction with a change in control) are increasing in prevalence in response to shareholder pressure.
- Increase/establish executive share ownership guidelines
While these are easy to implement, many companies hesitate to increase ownership guidelines for fear that it will create hardship for executives, who are suddenly out of compliance with the new guidelines. One common solution is to rewrite the policy to require executives to hold 50 per cent of after-tax shares until the guideline is met, thus effectively guaranteeing that all executives are in compliance with the new program over time via their annual long-term incentive grants of equity.
- Review comparator group
Shareholders and shareholder advisory firms now review company-selected comparators very carefully, with a particular focus on the inclusion of much larger companies, as these are viewed as contributors to pay ratcheting. While it is important to note that shareholders and shareholder advisory firms have differing methodologies for evaluating the appropriateness of the group, as a general rule, comparators should fall within the range of approximately .5 to two times the size of your company. Definitions of size vary, but are most typically revenues, assets and/or market capitalization.
In instances where important competitors fall outside these parameters, one approach might be to remove the company from the summary statistics used to define the market reference point. This ensures that the data is reviewed, but explicitly demonstrates that it is not part of the comparator group. Additionally, companies should remain mindful that comparator groups are typically only useful for assessing market pay levels for a few positions at best and careful consideration should be given to whether or not companies deemed ‘inappropriate’ by shareholders or shareholder advisory firms are really informing the compensation committee’s assessment of the competitive market for these executives. Alternatively, it may be possible to rely exclusively on survey data and internal considerations for these positions, eliminating the debate altogether.
Review Long-Term Incentive Plans
Given the relative size of long-term incentive compensation for top US executives as a percentage of total compensation, such programs are frequently subjected to shareholder scrutiny. One of the most common critiques is that the program is not sufficiently performance-oriented and companies anxious to court shareholder approval often implement changes designed to enhance the performance profile of the program.
- Alter the vehicle mix
Adding performance shares to a program that doesn’t currently have them or, increasing the percentage of the vehicle in the overall long-term incentive mix to ensure that at least 50 per cent of the value is delivered in performance-vested stock, are among the most common of all changes.
- Select different performance metrics
Modifying performance metrics is another common change, with approaches varying, depending upon the existing program.Using the same performance metric in both the annual and long-term incentive program, or ‘double-dipping’, is frowned upon by shareholders and shareholder advisory firms. Instead, consideration should be given to the selection of different but complementary performance metrics for each program.It is also important to keep in mind that when performance metrics are an issue for shareholders, they frequently have specific ideas about which metrics they would prefer. Of course, management and the board have often considered and vetoed these metrics for valid business reasons (difficulty or inability to forecast future performance or concerns about incentivizing the ‘wrong’ performance, for example), making this one of the most intractable of problems. If, after careful consideration, the board decides that the incorporation of a particular metric just doesn’t make sense, candid discussions of the rationale for the decision with shareholders may be helpful.Finally, it may be helpful to incorporate a relative performance metric into the program. While many companies are reluctant to use programs based entirely on relative total shareholder return, using the metric as a performance modifier may be a better alternative. Under such a program, payouts are determined based first on performance against absolute operational or financial targets and then adjusted, either up or down, based upon relative total shareholder return (e.g. increase payout by 25 per cent for top quartile relative total shareholder return or decrease payout by 25 per cent for bottom quartile performance).
- Adjust performance metric weightings
Another alternative is to modify the weightings associated with each performance metric to address shareholder concerns.
- Increase performance period/vesting
In general, increasing performance or vesting periods, particularly when shorter than market practice, will be viewed positively by shareholders and shareholder advisory firms.
Review Annual Incentive Plan
Changes in short-term incentive programs in response to shareholder concerns are typically less prevalent than modifications to the long-term program. However, some of the most common changes include:
- Adjustments to performance metrics
This typically involves either adding or removing a performance metric, usually in response to shareholder preference for a different metric or concerns over use of the same metric in both short- and long-term incentive programs. Additionally, adjustments to the weightings of performance metrics may help mitigate shareholder concerns.
- Modify pay opportunities for executives
In our experience, modifications like this are particularly difficult to make, since they are almost always perceived as ‘take-aways’ by management and today’s environment makes it virtually impossible to provide ‘make-ups’ in other areas. One solution is to reduce the target annual incentive opportunity while simultaneously increasing the maximum award opportunity for stellar performance. Another common adjustment is to cap previously uncapped award opportunities (for example a fixed percentage of sales or operating income). This is best practice from a risk mitigation perspective, as it also addresses shareholder concerns about uncapped awards.
Consider the Quantum of Pay
Finally, it should be noted that even if a company takes all the above steps, it still risks future failed votes if the company’s stock is underperforming and/or CEO pay is viewed as excessive relative to performance and comparator CEOs. While persistently high pay relative to peers is typically the result of special circumstances and can be difficult to correct in the short-term, recognizing the issue can help committees and executives begin to readjust their expectations regarding appropriate pay.
Make sure no good deed goes untold
Changes to compensation programs are only effective in reversing votes if shareholders understand and appreciate them.
Changes to the program in response to the vote should be prominently featured in discussions with shareholders and the compensation discussion and analysis of the company’s annual proxy filing. In situations where problematic practices were identified but not changed, be proactive in explaining why no changes were made. Today’s shareholders are increasingly sophisticated and hoping that they won’t notice the continuation of a practice they dislike is naïve. However, companies should take heart in the fact that with this sophistication comes an increased understanding of the pros and cons of various design features. Persuasive cases grounded in decisions made in the best interests of shareholders are often successful.
While the say-on-pay vote is non-binding, it certainly warrants a thoughtful response from the company. Complete and candid proxy disclosure of the outreach process, as well as all steps considered and taken in response to the vote can also go a long way in ameliorating shareholder concerns and ensuring a more positive vote result the next year. However, when considering these changes, companies should remain vigilant against allowing the tail to wag the dog. Boards should not hesitate to hold firm against changes that they do not believe to be in the best interests of shareholders.
By Michael Sherry and Nora McCord
Article originally appeared in Ethical Boardroom Magazine