As someone who has been working in executive compensation for the better part of 30 years, I was keen to see how the new Dodd-Frank Wall Street Reform and Consumer Protection Act would impact proxy season 2011. Advisory shareowner votes on executive compensation were the big story of this proxy season, the inaugural year for "Say on Pay" at most U.S. public companies. As most of us know by now, the legislation, which President Obama signed into law in on July 21, 2010, requires U.S. public companies to provide their shareholders with a non-binding vote to approve the compensation of senior executives.
Say on Pay gives shareholders a voice in how the top five named executive officers (NEOs) are paid. These votes are also a way for a corporate board to determine whether investors view the company's compensation practices to be in the best interest of shareholders.
The Council of Institutional Investors (CII), a leading advocate for Say on Pay, was eager to gather input from investors on what motivated them to cast Say on Pay votes against particular companies' executive compensation. CII engaged my company, Farient Advisors, an executive compensation and performance advisory firm, to investigate why some companies failed to win majority support in 2011. Our research findings may help investors target initiatives for improved pay practices and provide useful input for structuring their voting policies. Companies, too, will benefit from knowing which compensation practices their owners think are detrimental to building long-term shareholder value.
Between January 1 and July 1, 2011, 37 companies' compensation of their top executives fell short of majority support. Another 37 companies garnered significant though less than majority opposition, with "against" votes of 40 percent to 50 percent. While 37 "failed" votes is a tiny fraction (less than two percent) of the 2,340 Say-on-Pay votes at U.S. companies in the first half of the year, the total was large compared with the track record of Say-on-Pay in other countries and the expectations of corporate governance professionals.
Farient focused its investigation on advisory votes that failed to win majority shareholder support. We interviewed representatives from 19 CII member organizations (including public employee pension funds, mutual funds, and union pension funds, whose combined assets approach $8 trillion) about how they cast their Say-on-Pay votes generally, as well as specifically for the 37 failed-vote companies. We also interviewed proxy advisors and solicitors, and consulted Farient's extensive database on the alignment between executive pay and performance at these companies. We found that investors voted "no" on Say on Pay for four primary reasons:
- A disconnect between pay and performance (92 percent), with performance generally defined as relative and absolute Total Shareholder Return (TSR) over one, three, and five years; or financial performance, such as revenue and earnings growth, over multi-year timeframes.
- Poor pay practices (57 percent), including (but not limited to) such practices as: special awards (particularly when performance was poor); targeting executive pay at the 75th percentile; a poor choice of performance measures; tax gross-ups; lack of clawbacks; and excessive termination awards.
- Poor disclosure (35 percent), usually centered on a lack of transparency around performance measures and goals
- Inappropriately high level of compensation (16 percent), as indicated by notably high numbers that "didn't look right."
- Investors define and apply their criteria independently - No failed Say-on-Pay company received over 70% no votes, meaning that while investors generally cited the reasons above for voting "no," they defined and applied their criteria independently
- Proxy advisors played an important screening role - No failed Say-on-Pay company received a "no" vote unless Institutional Shareholder Services (ISS, an advisor to many large institutional investors) had recommended a "no" vote. However, the proxy advisor recommendation was merely a screen. ISS recommended "no" votes for approximately 13% of companies, while investors cast a majority "no" vote for 2%
- Company size provides no immunity - Company size was not a factor, with the no-vote companies at a $1 billion median revenue size, with a wide distribution of revenues ranging from the smallest public companies (i.e., less than $100 million in revenue) to the largest (i.e., over $100 billion in revenue)
One thing that really struck me when doing the research was how thoughtful investors were in the voting process. Most of the large investors had more than 600 proxies to review in less than eight weeks' time. Given that some companies have a triennial Say on Pay vote, investors will vote on fewer companies in 2012. Not surprisingly, they anticipate having more time to spend analyzing each company, and plan to sharpen their processes. Farient's own analysis of the pay and performance alignment at pubic companies, and the failed Say-on-Pay vote companies in particular, also suggests that there is room to improve the voting processes. Some potential avenues for improvement earmarked by investors include:
- Moving away from TSR as a primary screen, since high-performing companies might not perform well in the future and are not immune to poor pay practices
- Improving their pay and performance alignment analysis by advancing analytic methodologies (i.e., adjusting the value of equity for performance, rather than using grant date equity values) and evaluating company behaviors over the long-term (e.g., 10 years)
- Ensuring appropriate engagement with companies that have troublesome executive pay arrangements
- Determining whether companies earmarked for improvement offer a satisfactory response (or any response, for that matter) to "no" votes
Many investors said that they focused their "no" votes on the worst offenders with the belief that this would sharpen the effectiveness of Say on Pay. They said that Say on Pay would be meaningless, for example, if 30 percent of companies failed the vote. However, while a two percent "no" vote may seem rather benign, investors caution that they were judicious with their "no" votes this year. In a poll taken at the recent CII conference in Boston (where my colleague Dayna Harris and I presented our white paper), investors explicitly indicated that corporations should not interpret the two percent "no" vote as an indication that they are doing a good job on executive compensation. Moreover, an overwhelming 76 percent predicted that the proportion of "failed" Say-on-Pay companies will increase in 2012.
No doubt, the first year of mandatory Say on Pay has been a learning experience for all of us. 2012 will tell us how well we have learned our lessons.
This blog first appeared on Harvard Business Review on 10/03/2011.