In today’s post Dodd-Frank executive compensation market, most companies are familiar with, and many have implemented, “shareholder-friendly policies” such as clawbacks, hedging/pledging, and stock ownership guidelines. Further, companies have grown increasingly savvy on the executive compensation policies of shareholder advisory firms such as Institutional Shareholder Services (ISS) and Glass-Lewis—specifically as they relate to Say on Pay resolutions (SoP). Most executive compensation professionals—ourselves included—do not deny the influence on voting results when a company receives the dreaded Against recommendation from one or more of the proxy advisory firms. Our research shows that when ISS and Glass-Lewis recommend Against an SoP resolution, there is an approximate 20-30% and 5-15% reduction in the voting results, respectively.

Is this causation or simply correlation? Perhaps that question cannot be answered so easily, but it is possible to study how large institutional shareholders vote on SoP in order to try and understand what factors influence their voting. Companies are already aware of who their largest shareholders are, but an understanding of their voting policies and practices can provide insights on potential shareholder reaction to executive compensation program design, program modifications, and company performance.

To gain a deeper understanding of how large institutional shareholders tend to vote on SoP, CAP compiled a list of the top 25 institutional shareholders (in terms of assets under management) that were invested in at least 250 of the companies in the S&P 500 (“Institutional Shareholders”). CAP collected voting data from Proxy Insight, a leading provider of global shareholder voting analytics.

Among these Institutional Shareholders, 92% (23 out of 25) have their own “in-house” voting policies. What that means, is that even if ISS or Glass-Lewis makes a recommendation, the Institutional Shareholder will make the final determination on its voting decision. Based on 2016 voting results, Institutional Shareholders voted Against SoP 6.6% of the time, at median, for S&P 500 companies. When we expanded the scope of our review to all U.S. public companies, we found that Institutional Shareholders voted Against SoP 8.2% of the time, at median.

Source: Proxy Insight

Why do Against votes occur more frequently among all U.S. public companies compared to S&P 500 companies? This outcome could reflect that S&P 500 companies, in the aggregate, are larger and tend to have the resources to develop and maintain more balanced compensation programs. For example, a long-term incentive (LTI) program that is composed of a portfolio of time- and performance-based awards is viewed positively by institutional shareholders and is more common among S&P 500 companies versus all U.S. Companies. S&P 500 companies also have the capacity to lead more extensive shareholder outreach campaigns, which allows them to explain the rationale for their programs.

Although most Institutional Shareholders vote For SoP in most cases, there are some that will vote Against SoP 10% of the time or more. When voting on S&P 500 Companies, 5 out of 25 of the Institutional Shareholders vote Against 10% of the time or more. When voting on all US companies, 11 out of 25 vote Against 10% of the time or more.

Institutional Shareholder

Percent of Time Voting Against SoP

Institutional Shareholders Voting Against S&P 500 Companies 10% of the Time or Greater

Robeco/RobecoSAM

30%

BNY Mellon

27%

Dimensional Fund Advisors, Inc.

18%

California Public Employees’ Retirement System (CalPERS)

16%

Schroders

10%

Institutional Shareholders Voting Against U.S. Companies 10% of the Time or Greater

BNY Mellon

44%

Robeco/RobecoSAM

28%

Dimensional Fund Advisors, Inc.

23%

California Public Employees’ Retirement System (CalPERS)

20%

Canada Pension Plan Investment Board (CPPIB)

13%

Schroders

13%

AllianceBernstein LP

12%

T. Rowe Price Associates, Inc.

10%

AXA Investment Managers

10%

Principal Global Investors LLC

10%

RBC Global Asset Management, Inc.

10%

Source: Proxy Insight

CAP suggests that companies should track the voting tendencies of their major institutional shareholders, particularly if they vote Against more frequently. Companies may want to look at historical voting on SoP and should review their institutional shareholders’ proxy voting guidelines—particularly as it relates to compensation. For example, BNY Mellon voted Against SoP at 27% of S&P 500 companies and Against SoP at 44% of all U.S. companies. A review of BNY Mellon’s proxy voting guidelines states that they “consider proposals on a case-by-case basis in situations where:”

  • There are tax gross-ups or make-whole provisions in CIC/severance agreements
  • The company has poor relative stock performance, especially when compensation is deemed excessive compared to peers
  • The company fails to address compensation issues identified in prior meetings
  • There appears to be an imbalance between performance-based and time-based long-term incentive awards

Therefore, if one of your company’s major shareholders is an institutional investor that supports SoP less frequently, it is important to understand their voting guidelines, especially if your executive compensation program has practices or includes features that are viewed negatively (i.e. tax gross ups, 100% time-based LTI program, etc.).

Although most Institutional Shareholders have in-house voting policies, they do still subscribe to proxy advisory research from ISS and Glass-Lewis. Among Institutional Shareholders, 88% (22 out of 25) subscribe to ISS and 48% (12 out of 25) subscribe to Glass-Lewis. While there is only one out of these 25 Institutional Shareholders that generally automatically-votes with ISS (Principal Global Investors LLC), CAP determined that there is a correlation between an ISS or Glass-Lewis Against recommendation and voting results. When subscribing to ISS or Glass-Lewis, we found that Institutional Shareholders’ voting aligns with an Against recommendation, at median, 62% of the time for ISS subscribers and 31% of the time for Glass-Lewis subscribers. The data exhibits a greater correlation (approximately double) of vote alignment with an Against recommendation from ISS than Glass-Lewis. This may occur because Glass-Lewis recommends Against about twice as often as ISS does (16% of companies receive an Against recommendation from Glass-Lewis vs. 8% from ISS).

Source: Proxy Insight

As mentioned above, it is not easy to confirm whether the alignment of an Against recommendation from ISS or Glass-Lewis and voting outcomes is the result of causation or simple correlation—perhaps it is a bit of both. However, when companies are trying to understand the voting practices of their institutional shareholders, knowledge of how their institutional shareholders vote in relation to an ISS or Glass-Lewis Against recommendation is a valuable input, particularly in cases where the alignment is very consistent. Since the recommendation from ISS and Glass-Lewis precedes voting, companies can predict potential outcomes based on shareholder tendencies—particularly in cases where the institutional shareholders voting tendencies are correlated with an Against recommendation a high percentage of the time.

Institutional Shareholder

Percent of Time Voting with Rec.

Institutional Shareholders Voting with ISS Against Rec. Greater than 85% of the Time

Deutsche Asset & Wealth Management

99%

Principal Global Investors LLC

98%

Canada Pension Plan Investment Board (CPPIB)

97%

RBC Global Asset Management, Inc.

97%

Dimensional Fund Advisors, Inc.

96%

AllianceBernstein LP

91%

BNY Mellon

87%

Institutional Shareholders Voting with Glass-Lewis Against Rec. Greater than 50% of the Time

California Public Employees’ Retirement System (CalPERS)

75%

Dimensional Fund Advisors, Inc.

60%

BNY Mellon

57%

Source: Proxy Insight

In examples where Institutional Shareholders do not have a high correlation of voting with an ISS or Glass-Lewis Against recommendation, this can generally be attributed to those Institutional Shareholders that vote For SoP a high percentage of the time in line with their own voting policies.

In our view, it is important for companies to develop a compensation program that aligns with the business strategy, promotes shareholder growth while minimizing risk, and attracts and retains key talent. Once a framework is established, companies can then overlay an understanding of the voting practices of their institutional shareholders, including specific proxy voting guidelines, voting history, as well as the alignment of voting results with ISS or Glass-Lewis recommendations. This becomes more important in cases where the institutional shareholder votes Against SoP more frequently than the norm or follows ISS and Glass-Lewis recommendations a very high percentage of the time. While some companies may engage in comprehensive shareholder outreach programs, other companies do not have the resources for large-scale shareholder engagement. For these companies, an understanding of their institutional shareholder voting policies and practices becomes an important consideration when it comes to compensation program plan design.

Appendix

Institutional Shareholders Used in this Analysis

AllianceBernstein LP

Legg Mason Partners Fund Advisor, LLC.

AXA Investment Managers

MFS Investment Management, Inc.

BlackRock

Morgan Stanley Investment Management, Inc.

BNY Mellon

Norges Bank Investment Management

California Public Employees’ Retirement System (CalPERS)

Northern Trust Investments

Canada Pension Plan Investment Board (CPPIB)

Principal Global Investors LLC

Deutsche Asset & Wealth Management

RBC Global Asset Management, Inc.

Dimensional Fund Advisors, Inc.

Robeco/RobecoSAM

Federated Investment Management Co.

Schroders

Fidelity Management & Research Co.

SSgA Funds Management, Inc. (State Street)

Fidelity SelectCo

T. Rowe Price Associates, Inc.

Franklin Templeton Investments

Vanguard Group, Inc.

Goldman Sachs Asset Management LP

ISS released the results of its 2016-2017 policy survey on September 29, 2016. The survey results will play an important role in shaping ISS’ policies for the 2017 proxy season. ISS Indicated that a draft of their 2017 policy updates will be published in late October, subject to public comment. Final policy updates are scheduled for publication in mid-November, with policy updates effective February 1, 2017. 

417 organizations participated in ISS’ survey, including 115 institutional investors and 270 corporate issuers. 33% of investor responses came from institutions with $100 billion in assets or more, while 25% came from institutions with $10 – $100 billion in assets.

Highlights of the survey results related to U.S. executive compensation and corporate governance topics are summarized below:

Say on Pay Frequency: Survey participants were asked whether they favored annual, biennial or triennial say on pay proposals. Fully 66% of investors favored annual say on pay votes. Corporate issuers were more likely to favor biennial or triennial votes, but fully 42% voted for annual say on pay proposals. Based on the results of the survey, we do not expect ISS to make any changes to its existing policy of supporting annual say on pay vote frequency.

Metrics for Pay-for-Performance Alignment: ISS currently uses Total Shareholder Return (“TSR”) to assess pay-for-performance alignment, measuring relative TSR performance compared to peers over 3 years and measuring the absolute trend in TSR over 5 years. Survey participants were asked if other metrics should be incorporated in the initial screen. High levels of support were recorded for metrics other than TSR, with 79% of investors and 68% of corporate issuers voting in favor.

Investors identified Return on Investment metrics, such as Return on Invested Capital (ROIC), as the best metrics to be incorporated into pay-for-performance alignment screens. Detailed results are shown below:

Metrics

% of Investors Favoring

% of Non-Investors Favoring

Return on Investment metrics

47%

23%

Other Return metrics (i.e, ROA or ROE)

35%

18%

Earnings metrics

26%

38%

Cash Flow metrics

25%

20%

Economic Profit metrics

22%

9%

Revenue metrics

18%

24%

Other metrics

16%

10%

We suspect that ISS may modify its pay-for-performance model to incorporate additional measures in the future, based on this feedback. However, it may be challenging to implement for the coming year as it is difficult to find a single financial performance measure that is useful for performance comparisons in all industries. We will closely monitor ISS’ proposed policy revisions to see what changes, if any, that they make to the pay-for-performance assessment.

Board Refreshment: Lack of board refreshment is viewed as problematic by more than 50% of investors. Refreshment measurements that caused concern include lack of newly appointed directors (i.e., within the last 5 years), average tenure greater than 10 or 15 years and/or a high proportion of directors with long tenure.

Overboarding: More than 60% of investors indicated a preference for applying the same standard for overboarding to active executive chairs as currently applies to active CEOs – no more than three total boards. A minority supported the more lenient standard applicable to non-executive directors – no more than five total boards.

Next Steps

We will monitor ISS’ draft policy proposal (expected in October) and final policy issuance (expected in November) and will provide an updated CAPflash highlighting any material changes from ISS’ current policies. Based on this year’s survey results, there is potential for significant changes from the current policy, particularly for Pay-for-Performance alignment. Movement away from TSR as the sole metric would be welcomed by many companies as well as by most investors.

Full results of ISS’ policy survey can be found at www.issgovernance.com. If you wish to discuss the results, you can reach us at 212-921-9350.

We believe Mr. Fink raises an important point on linking incentives to business strategy. A clearly communicated business strategy would help to avoid pitfalls that we see frequently today. These include incentives that are designed primarily to respond to pressure from proxy advisory firms, often driving a “one size – fits all” approach or encouraging short-term thinking.

“We are asking that every CEO lay out for shareholders each year a strategic framework for long-term value creation. Additionally, because boards have a critical role to play in strategic planning, we believe CEOs should explicitly affirm that their boards have reviewed those plans. BlackRock’s corporate governance team, in their engagement with companies, will be looking for this framework and board review.”
Larry Fink, BlackRock CEO

As highlighted by our articles Are You Rewarding Short-Termism? in The Corporate Board and Balancing pay for performance with shareholder alignment in the Ethical Boardroom, it is important that compensation, in particular long-term incentive compensation, links directly to the company’s strategy. We agree that providing shareholders with a voice on compensation programs through Say on Pay has been beneficial, but we have observed a chilling effect on creative compensation programs. Today most public companies are very reluctant to be an outlier on compensation. If we look at CAP’s sample of 100 large market cap companies, 51% use Total Shareholder Return (TSR) and 34% use EPS as metrics in their long-term incentive plans. Are these universal metrics appropriate in almost any situation? We question that premise. Why do so many companies have similar metrics when they have unique business strategies, operate in diverse industries and are positioned at different points in their lifecycle?

The good news is that we have observed modest increases in the use of return metrics, from 41% in 2011 to 47% in 2014 (e.g., return on assets, return on capital and return on equity). In several cases, activist investors have intervened to champion the adoption of return metrics. Traditional institutional investors with concerns over the effectiveness of corporate business strategies have also been vocal in encouraging companies to focus on returns. Both camps frequently push companies to move to adopt balanced metrics that encourage profitability in combination with growth as opposed to growth alone.

The chart below provides a snapshot of how long-term incentive plan metrics have evolved over time. Use of TSR has grown most since 2011, from 36% to 51% and this is after dramatic increases prior to 2011. We believe this is the direct outcome of the influence of proxy advisory firms, who have pushed hard on companies to incorporate relative TSR in their programs. The good news is that since 2011, the number of companies relying on a single metric has declined, with over 1/3 of companies using 3 or more metrics which may indicate they are tailoring plans more to their specific situation.

# of Metrics

2011

2014

1

33%

26%

2

40%

37%

3 or More

27%

37%

While EPS and TSR may make sense for many companies, companies should consider various factors when selecting measures, including:

  • Is relative TSR the best answer for your company? We see it as an outcome-oriented metric that lacks a clear linkage to strategic priorities and is not well suited to driving behaviors that create shareholder value.
  • Does over-reliance on TSR encourage risk-taking behaviors? Companies may make decisions that drive TSR in the short-term (e.g., share buybacks or higher dividends), rather than identifying better uses of capital that can lead to sustained long-term growth.
  • Does an EPS metric create an incentive to buy back shares rather than re-investing for growth? Financial experts have mixed views on the utility of share buybacks. The jury is still out.
  • Are the current time horizons for TSR performance optimal? Almost all plans measure TSR over 3 years. Why is a 3-year time frame the default for most companies? Since TSR is usually defined as a relative metric, eliminating the need to set goals in advance, should companies be evaluating longer timeframes that align with their business cycles?
  • If relative TSR is your company’s metric, where are you in the cycle? Companies and boards need to ask and analyze whether relative TSR goals will pay out for sustained long-term stock price appreciation or for volatility in relative stock price performance. Companies and boards need to understand whether the stock is only recovering from earlier losses that occurred prior to the start of the performance period.

We don’t believe that either EPS or TSR are inherently poor metrics. In many cases, it makes sense for companies to incorporate these metrics into their overall incentive framework. However, it is critical to determine if these metrics are right for a particular company at a -particular time in its life cycle. Keep in mind that long-term incentives are the largest component of pay for many executives. As companies and boards design long-term incentives, they should consider the following questions:

  • Does the compensation program support our strategy and do the metrics and goals align with our long-term business plan?
  • Can we communicate clearly and succinctly how the program ties to our strategic framework for both shareholders and program participants?
  • What behaviors, good or bad, could the design encourage? For example:
    • Does it send clear signals throughout the organization on the strategic priorities?
    • Is short-term upside emphasized at the expense of long-term sustained value?
    • Do we encourage growth at the expense of returns that exceed our cost of capital?
  • Does the program encourage excessive or inappropriate risk-taking?
  • For metrics other than TSR, will achievement of goals lead to company and shareholder value creation?
  • Are there alternative metrics, including strategic metrics (e.g., increase in market share, diversification of revenue, etc.) that might be better indicators of successful execution of the strategy?

Overall, we think Mr. Fink’s commentary on the importance of defining and communicating a company’s strategic framework for value creation serve shareholders well. His comments point to a fundamental principle of compensation design: incentive compensation should be used to reward the company’s success in achieving its strategy and creating long-term value for shareholders. The performance measures used to determine incentive compensation need to track progress on the strategy over the near term and over the long-term. We believe we will see a migration in this direction as long-term incentives evolve, companies continue to dialogue with their shareholders and perhaps as they enhance disclosure around their strategic framework as Mr. Fink suggests.

In our experience, “activist investors” were more vocal and influential in boardrooms during 2015 than during other recent years. As a result, Compensation Advisory Partners (“CAP”) analyzed circumstances at nine companies that had proxy contests in 20151 where in each case, one area of activist focus was executive compensation. We found that executive compensation issues were often supportive and complimentary to other, larger internal issues at the target companies. While these activists may have targeted executive compensation, this was not the main driver in engaging with the company. Activist complaints tend be more focused on strategic/financial issues and they use compensation as a point of discussion to identify where their views differ. For example, if return on capital is not a utilized metric in incentive plans and the company has completed several low return acquisitions, the activist may use this as support that strategy is flawed and that compensation reinforces that flaw.

“Activist investors” are individuals (i.e. hedge fund managers) or groups (i.e. alternative investment companies) who purchase a stake in a target company’s outstanding equity shares with the end-goal of influencing company decision making by acquiring seats on the Board of Directors. Once on the Board, activists will try to effect changes (i.e., by divesting or acquiring a business segment, cutting expenses, increasing distributions to shareholders, etc.) that ultimately increase the company’s value and the value of the activist’s investment.

What We Found

Compared to prior years, 2015 saw an increase in proxy contests. Among companies in the Russell 3000 Index, there were 20 proxy contests initiated by activist investors during 2015. This compares to 14 proxy contests in 2014 and 16 in 2013.

Of the 20 proxy contests initiated by activist investors in 2015, nine (45 percent) specifically took issue with the executive compensation program at the target company. In each case, “issues” with executive compensation were a part of the supporting statements for the dissident slate of directors. This is a stark contrast to 2014 and 2013, where 4 (29 percent) and 1 (6 percent) proxy contests took issue with executive compensation, respectively.

Specific compensation practices highlighted in 2015 include:

Executive Compensation Issue

Number of Companies (n=9)

Percentage of Companies

Pay for Performance Misalignment

7

78%

High CEO Compensation

4

44%

Choice of / Adjustments to Performance Metrics

4

44%

Weak Corporate Governance Structure

3

33%

High / Increase to Board of Director Compensation

3

33%

Awards of Special Grants to Executives

2

22%

Outsized Peers

1

11%

Ultimately, we found that activist investors frequently use executive compensation and pay for performance disconnect as levers to bolster their argument for receiving seats on the target company’s Board of Directors.

Target Companies

Of the nine activist campaigns which specifically took issue with executive compensation practices, the companies that were being targeted generally had lagging TSR performance, both in absolute terms and relative to competitors. Further, low Say on Pay results in 2014 also provided activists with an additional reason for targeting certain companies.

As the below table demonstrates, where activists were successful in securing Board seats, the most recent Say on Pay support was generally low and either the company’s 1-year TSR, 3-year TSR, or both were relatively low.

Successful Activist Campaigns

Of the nine proxy contests that specifically targeted aspects of executive compensation, four ultimately resulted in the activist investor gaining Board seats at the target company. The four companies, which are noted in the chart below, include: Myers Industries, Imation Corp., The Children’s Place2 and Shutterfly, Inc.

The main common denominator, from a compensation perspective, among the successful activist campaigns was a perceived disconnect between executive pay and financial performance at the target company. More specifically, at Myers, Imation and The Children’s Place, the activists were able to show that, despite poor TSR (in both absolute and relative terms), the executives at these companies were still being rewarded either through salary increases, above target annual incentive payouts or equity grants.

Company Name

Say on Pay Results

Total Shareholder Return

2013

2014

2015 (Year of Proxy Contest)

1 Year *

3 Year CAGR *

Activist Gained Board Seat (n=4)

Myers Industries Inc.

75%

75%

60%

-17.8%

12.6%

Imation Corp.

95%

50%

34%

-17.8%

-12.9%

The Children's Place, Inc.

17%

61%

94%

13.8%

6.3%

Shutterfly, Inc.

55%

50%

22%

-18.3%

22.4%

Activist Did Not Gain Board Seat (n=5)

Hill International, Inc.

n/a (triennial)

54%

n/a (triennial)

-0.3%

-9.3%

Ethan Allen Interiors Inc.

86%

92%

80%

-14.1%

5.1%

E. I. du Pont de Nemours and Company

95%

98%

96%

14.4%

17.3%

Biglari Holdings Inc.

33%

31%

50%

-21.7%

2.8%

Select Comfort Corporation

98%

93%

96%

26.9%

6.7%

* As of Fiscal Year End

Further, with regard to Shutterfly’s executive compensation program, activists made the case that executives were being rewarded for performance against metrics that were not “shareholder friendly” (i.e. metrics focusing on top line growth as opposed to earnings growth). In response to the activist criticism, Shutterfly’s Compensation Committee established several changes to their 2015 and 2016 executive compensation program performance targets to “further reflect shareholders views”. However, the lead activist investor (Marathon Partners) ultimately deemed these changes inadequate and requested further, more fundamental, adjustments to the entirety of the compensation program, namely, to begin prioritizing profit over scale.

It is not surprising that activist investors are most successful at winning Board seats at their target companies when they can tie executive compensation to the poor financial performance of the company. If shareholders are not realizing a desired return on their investment in any given company, it is reasonable to expect that they would show more support for an activist investor hoping to gain access to the target’s Board if it could potentially lead to financial improvement. When executive compensation can be tied to poor financial results, it simply provides activists, and shareholders alike, with another reason as to why a shift in leadership could be desirable or change in strategy could be advisable (e.g. CEO change).

ISS also tends to influence the outcome of these proxy contests. ISS supported at least one of the nominees on the dissident slate of directors at each of the four companies that lost at least one Board seat to the activist investor.

Ultimately, of the four companies who lost Board seats to activist investors, three companies (Imation Corp., Myers Industry and Shutterfly) have made changes to their executive leadership teams as these CEOs have stepped down. Further, while DuPont was able to win its proxy contest and keep dissident nominees off of its Board, five months after the Annual Meeting, the CEO announced her retirement.

Conclusion

We are seeing increased activity where activist investors are accumulating stakes in companies with the intention of agitating for change. Their hope is to make changes that will enhance the company’s value. While our analysis reflected proxy contests specifically focusing on executive pay (e.g. pay for performance misalignment), there are a number of circumstances where companies settle with the activist investors, avoiding a contentious public battle, and allow the activist a seat or multiple seats on the Board. Some examples include Baxter International settling with Third Point LLC, Freeport McMoRan settling with Icahn Enterprises and Citrix Systems settling with Elliott Management.

In order to be well positioned, Boards and Compensation Committees should be proactive:

  • Ensure the Company and Board have a clear strategic focus and stick to it
  • Make sure the metrics used in incentive plans align with the company’s strategic vision
  • Confirm the Board has a game plan for shareholder and activist engagement
  • Encourage the Company and Board to use external advisors to provide guidance
  • Highlight company performance against goals
  • Emphasize pay for performance relationship through the validation of relative performance and pay positioning
  • Proactively seek feedback from shareholders throughout the year
  • Assess program features which may not have a lot of value to executives but are viewed as problematic pay practices (i.e., eliminate excise tax gross-up, eliminate / reduce perquisites, move from single to double trigger equity vesting in the event of a change in control)

It is critical for the Board to work with management to ensure pay practices are defensible and supportable in light of company performance and good governance standards.

Appendix

Summary of Activist Campaigns

Company

Activist

Executive Compensation Issue Highlighted By Activist

Contest Result

Hill International, Inc.

Program and project management company

Bulldog Investors, LLC

ISS supported both dissident director nominees

  • Felt that executive officer compensation is not truly aligned with the interests of shareholders
  • Between June 2010 and May 2015 the company stock had decreased by 8%. Over this time period the two top executives “received a total of $25 million in compensation or about 50 cents per share”; further, between 2007 and 2014, “Board of director compensation has increased by 183%”
  • Concerned that executives are being too generously compensated while shareholder value is declining

No dissident nominees elected to the Board

Ethan Allen Interiors

International interior design and manufacturing company

Sandell Asset Management Corp

ISS supported 3 of 6 dissident director nominees

  • Concerned with the length of the CEO’s most recent employment contract given that he has been in the position for 27 years
  • Concerned with “narrow” performance metrics; adjusted operating income and adjusted operating income per share
  • CEO’s compensation is not tied to total shareholder return
    • Company’s stock price has “underperformed its peers by 119% over a 10 year timeframe”
    • Felt that CEO compensation should be tied to TSR and not operating income metrics

No dissident nominees elected to the Board

E.I. Du Pont

International science and technology company

Trian Fund Management

ISS supported 2 of 4 dissident director nominees

  • Compensation program does not properly align management compensation with stockholder value creation
  • “Despite bottom quartile relative TSR performance against peers, 2013 performance share unit payout (PSUs) was 113% of target” due to top quartile relative revenue performance
  • “Prioritizing revenue growth without regard to return on capital incentivizes management to grow revenue recklessly and often results in long-term value destruction”
  • High annual Incentive payouts despite poor performance
  • “Revenue and EPS fell short of long-term targets but short-term incentive payouts have been 86-87%” in 2012 and 2013, respectively
  • Trian sought to end “crony” compensation
  • “In 2014, the Board acknowledged poor operating performance and gave management a 0% payout factor for corporate performance under DuPont’s short-term incentive. However, individual performance ratings ranged from 80% to 100%”

No dissident nominees elected to the Board

CEO stepped down 5 months after the conclusion of the contest

Biglari Holdings

Owns and operates Steak N’ Shake

Groveland Capital

ISS did not support dissident director nominees

  • CEO received “outsized compensation in 2014 despite poor performance”
  • Flaws with company’s corporate governance practices
    • CEO would be entitled to a “golden parachute” of approximately $100M as part of a naming rights deal if the CEO were forced out of the company
  • From 2009 to 2014 “Biglari underperformed the S&P 500 Index by 40.2%, the S&P 500 Restaurant Index by 57.6%, the Russell 3000 Restaurants by 77.6%, and its ISS Peer Group by 214.5%”

No dissident nominees elected to the Board

Myers Industries

International manufacturing and distribution company

GAMCO Asset Management

ISS supported 1 of 3 dissident director nominees

  • Management pay rose in 2014 despite poor operating performance
    • CEO and CFO base salaries increased 3% and 8%, respectively
  • Proxy statement indicates that bonuses and long-term compensation are based on a variety of factors that do not take into account the effectiveness of acquisitions and divestitures as well as capital allocation
  • “Concerned about the integrity of the Company’s Financial Controls and Reporting”. GAMCO took issue with the apparent adjustments being made to performance metrics
  • Board approved increases to the cash retainer and stock grants of 31% and 25%, respectively, in 2015
    • “Concerned with minimal board ownership levels (<4%)”
  • Poor financial performance
    • 1-year total shareholder return (-14.2%) lagged the market
    • Revenue grew mainly due to an acquisition

Three dissident nominees elected to the Board

CEO stepped down

Imation Corp.

Data storage and information security company

Clinton Group

ISS supported all dissident director nominees

  • Since 2010, “Named Executive Officers and directors have collected $48M in compensation compared to a market value decline of -$301M during the same period”
    • “Company paid bonuses of 126% of target to the top three executives in 2014, a year in which the Company suffered a cash flow decline of -$38M”
    • “At 2014 Annual Meeting, company received a 50% voting approval on say on pay and responded by increasing executive compensation from $6.2M in 2013 to $11.2M in 2014”
    • “Company executives have single trigger golden parachute payments”
    • “Directors earned an average of $316K in 2014, far excess of their peers”
  • During CEO’s tenure, company has “underperformed” and has “destroyed shareholder value”
    • “Stock price is down 70% during CEO’s tenure”
    • “Net revenue is down 44% from 2010-2014”
    • “Deployed $174M in four acquisitions during CEO’s tenure, with poor results”

Three dissident nominees elected to the Board

CEO stepped down

Select Comfort Corporation

Designer, manufacturer, retailer and services of a Sleep Number beds

Blue Clay Capital

ISS did not support dissident director nominees

  • Board has “rewarded executives” for sagging stock price and failure to meet goals
    • Special stock awards: “Despite the fact that company’s stock has lagged major indices and its peers, the Board granted special performance awards to the CEO and other executives”
      • Special awards had “a grant price of $17.77 and was fully earned at $23.10, providing an additional $2.9M in compensation. Grant date and target prices were 35.1% and 15.6%, respectively, below the $27.36 price” when CEO was promoted to current position
    • Changing performance metrics: Company did not grow operating margins as forecasted and changed 2014 annual incentive plan metric from net operating profit, which has been a metric since 2001, to EBITDA, “resulting in aggregate cash incentive payments of $2.1M to the company’s executives”
  • Company has a classified Board and the activist felt that the Board “had grown stale and is entrenched”

Activist dropped proxy contest before it went to shareholder vote

The Children’s Place

(settled proxy fights prior to Annual Meeting)

Children’s specialty apparel retailer

Macellum Advisors GP and Barington Capital Group

ISS supported 1 of 2 dissident director nominees

  • “Company’s executives have received generous compensation despite poor results, reflecting a lack of alignment of pay with performance”
    • “CEO has been richly compensated despite poor operating performance; compensation has been egregious”
    • CEO total compensation the last 3 years has been $35.1M, which was “50% greater than the CEO of Carter’s”; Carter’s has a market cap 4x The Children’s Place and its stock price has “outperformed the company by 130% over a 3 year period” (2011-2013)
    • CEO compensation is “2x the median target compensation” of peers (or the 100th percentile)
    • Company uses a peer group that has a median market cap of greater than $2B, or double the company
    • CEO was “awarded $6.8M in 2013 despite missing the company’s original target for adjusted operating income by 9.5%”
  • “The Company’s stock price has significantly underperformed its peers and the market as a whole over the past 1-, 3- and 5-years as well as during the CEO’s tenure”

Settled prior to contest – activist received one Board seat

Shutterfly, Inc.

Manufacturer and retailer of photo-based products

Marathon Partners

ISS supported 2 of 3 dissident director nominees

  • Company has “a compensation scheme that had run amok”
  • Activist felt that compensation should focus on shareholder-friendly metrics such as EPS and free cash flow rather than revenue and EBITDA growth
  • Cited excerpts from ISS and Glass Lewis reports on executive compensation issues
  • CEO received a special RS award of approximately $7M
  • Sought improvements to executive compensation. Board proposed the following changes, which were ultimately rejected by Marathon
    • Increase 2015 EBITDA trigger goal
    • Increase 2015 target revenue goal for 100% funding of the performance-based restricted stock units
    • Increase the minimum target for free cash flow per share in 2017 for executive compensation purposes to a minimum of 50% over free cash flow in 2015

Two dissident nominees elected to the Board

CEO stepped down

Note: The comments in the above chart are paraphrased or direct quotes from activist investors’ proxy contest materials/filings and do not reflect the view of CAP.

Say on Pay Update

On January 25, 2011, the SEC issued final rules implementing Section 951 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), which generally provides shareholders of US public companies with the right to cast three types of advisory votes related to executive compensation:

  1. A vote to approve the compensation of the Named Executive Officers (NEOs), effective for shareholder meetings occurring on or after January 21, 2011;
  2. A vote on the frequency with which shareholders should be entitled to cast Say on Pay votes (every one, two or three years), effective for shareholder meetings occurring on or after January 21, 2011; and
  3. A vote on golden parachute arrangements for NEOs related to a sale, consolidation or merger, effective April 25th, 2011.

To date, 419 of the S&P 500 companies included Say on Pay resolutions in either a preliminary or definitive proxy statement. Vote results from annual meetings are available for 290 of these companies.

CAP Comment: While these votes are non-binding, we expect that most companies will carefully evaluate their vote results, taking some action if there is low shareholder support (not just in the limited cases where a majority of shareholders did not support the company’s executive compensation program).

Say on Pay Frequency Vote Results

An annual vote frequency is emerging as the clear shareholder preference. Among 94% of S&P 500 companies reporting vote results, a majority of shareholders supported annual Say on Pay vote frequency. This differs from vote recommendations, where only 67% of the companies had recommended an annual vote.

Company Recommendation (n=419)
Vote Frequency # of Companies % of Companies
Annual 281 67%
Biennial 13 3%
Triennial 108 26%
No Recommendation 17 4%

Vote Results: Received Majority Shareholder Support (n=290)
Vote Frequency # of Companies % of Companies
Annual 272 94%
Biennial 1 0%
Triennial 12 4%
None (only plurality)* 5 2%

The strong support for annual votes is not a surprise. 39 institutional investors, representing more than $830 billion in assets, issued a public call for companies and investors to support annual advisory votes on executive compensation in 2011 proxy statements. Similarly, a number of major mutual funds have also indicated support for the annual Say on Pay votes, and ISS’ policy recommends that shareholders support annual votes (Glass Lewis has indicated a similar preference)[1].

CAP Comment: As the 2011 proxy season continues, we expect the prevalence of annual vote frequency recommendations to increase.

CAP Comment: Following the frequency vote, the SEC rules mandate disclosure through an 8-K of how often the company will hold future Say on Pay votes[2]. Issuers must also provide proxy-based disclosure of the current frequency of Say on Pay votes and when the next scheduled Say on Pay vote will occur.

CAP Comment: When companies conduct their Say on Pay vote in line with the frequency preferred by a majority of shareholders, they may exclude shareholder frequency proposals from the proxy for six years.

Say on Pay Vote Results

Say on Pay resolutions received majority shareholder support at all but five S&P 500 companies, with support ranging from 55% to 100%[3]. The five companies where a majority of shareholders did not support the executive compensation program were Hewlett-Packard, Jacobs Engineering, Janus Capital Group, Masco Corp. and Stanley Black & Decker.

% in Favor # of Companies % of Companies
90% – 100% 192 66%
80% – 90% 43 15%
70% – 80% 26 9%
50% – 70% 24 8%
0% – 50% 5 2%

CAP Comment: While a company does not “fail” its Say on Pay vote unless a majority of shareholders vote against the compensation program, an “acceptable” shareholder support threshold is likely to emerge. To-date, results indicate this threshold will be around 80% shareholder support.

CAP Comment: The final SEC rules require additional disclosure in the CD&A regarding whether, and if so how, companies have considered the results of the most recent Say on Pay vote.

Some notable companies have been proactive during this proxy season, filing supplementary soliciting materials. Select examples include: General Electric, Disney, ExxonMobil, Johnson & Johnson, Hewlett-Packard, and Northern Trust. While these filings were generally in reaction to negative vote recommendations from shareholder advisory services such as ISS, ExxonMobil went a step further by filing supplementary materials (essentially an executive pay brochure) on the same day as the proxy. ExxonMobil still received a negative vote recommendation from ISS, and later filed additional soliciting material rebutting ISS’ vote recommendation.

New Fidelity Compensation-Related Voting Guidelines

Fidelity recently released revised proxy voting guidelines that are effective immediately[4]. Our discussion below focuses on guidelines for Say on Pay proposals and new share requests[5].

Say on Pay Proposals

Fidelity will generally vote for proposals to approve executive compensation unless such compensation is misaligned with shareholder interests or otherwise problematic[6]. In determining any misalignment, Fidelity will take into account, among other factors, whether:

  • A company has an independent Compensation Committee
  • The Compensation Committee engaged independent compensation consultants
  • The Compensation Committee waived equity vesting restrictions
  • The company adopted or extended a golden parachute without shareholder approval[7]

Fidelity will also:

  • Support annual advisory votes on executive compensation
  • Generally vote against proposals to support golden parachutesix

Equity Plan Votes – New Share Requests

The guideline for determining votes related to new share requests is now based on a company’s three-year average burn rate, instead of the dilutive effect of the proposed plan (the basis for the previous guideline)[8]. The guidelines state that Fidelity will generally vote against approval of additional shares if a company’s three-year average burn rate exceeds certain caps.

Companies 3-Yr. Avg. Burn Rate
Large Capitalization
(A company included in the Russell 1000 Index)
1.5%
Small Capitalization
(A company not included in the Russell 1000 Index that is not a Micro-Capitalization Company)
2.5%
Micro Capitalization
(A company with market capitalization below US $300 million)
3.5%

CAP Comment: Similar to the prior dilution caps, if a burn rate exceeds the caps Fidelity will consider circumstances specific to the company or plans that lead it to conclude the burn rate is acceptable; details on mitigating factors not yet available.

CAP Comment: While Fidelity will be reviewing historic burn rate, it is not clear if they will consider prospective burn rate in terms of how many years the shares are expected to last. A duration of greater than five years is considered problematic by ISS. Glass Lewis has a similar policy, but uses a three-to-four year threshold.

CAP Comment: The guidelines do not make allowances for companies in industry groups that have historically had higher burn rates, such as technology. In contrast, ISS does vary burn rate caps by industry.

CAP Comment: Unlike ISS, Fidelity will not use a multiplier for full-value awards in its burn rate calculation. Since the calculation does not differentiate stock option awards and full-value stock awards, it could encourage greater use of full-value stock awards and less use of stock options.

Additional equity plan voting guidelines include:

  • Vote against equity plans where:
    1. Stock option exercise price is less than fair value on the grant date, unless the discount is 15% or less and is expressly granted in lieu of salary or cash bonus
    2. The plan’s terms allow repricing of underwater stock options
    3. The Board or Compensation Committee has repriced outstanding options in the past two years without shareholder approval
  • Vote against equity plans that include an evergreen provision[9]
  • Vote against equity plans that provide for acceleration of equity award vesting without an actual change-in-control occurring
  • Require a restriction period of no less than three years for time-based share awards and a performance period of no less than one year for performance-based awards[10]

Conclusion

A clear shareholder preference for an annual Say on Pay vote frequency has emerged. In terms of the actual Say on Pay vote, it will be interesting to see what level of shareholder support becomes viewed as “acceptable,” likely a higher hurdle than simply a pass / fail test. Based on current results, the acceptable “threshold” will be near 80% support, but that may change as the proxy season continues. Differences among industries may also emerge.

Where Fidelity’s support is desired for Say on Pay votes or new share requests, it will be important to take their policies into account when: making compensation-related decisions, putting together the Compensation Discussion and Analysis, and preparing shareholder proposals (Say on Pay, new long-term incentive plans and/or share requests, etc.).

Please contact us at (212) 921-9350 if you have any questions about the issues discussed above or would like to discuss your own executive compensation issues. You can access our website at www.capartners.com for more information on executive compensation.

[1] For additional detail, see 12/5/10 CAPFlash: “ISS 2011 Policy Updates – Here Comes Say on Pay.”

[2] Required no later than 150 calendar days after the date of the annual meeting in which the vote took place, but in any event no later than 60 calendar days prior to the deadline for submission of Rule 14a-8 shareholder proposals for the subsequent annual meeting.

[3] Outside of the S&P 500, an additional 18 companies did not receive majority shareholder support for their NEO compensation program (as of 5/20/11): Ameron International, Beazer Homes, Cincinnati Bell, Cogent Communications, Curtiss-Wright, Dex One Corporation, Helix Energy Solutions, Hercules Offshore, Intersil Corp., M.D.C. Holdings, Navigant Consulting, NutriSystem, NVR, Inc., Penn Virginia Corporation, PICO Holdings, Shuffle Master, Stewart Information Services Corporation and Umpqua Holdings Corporation.

[5] The guidelines also cover additional compensation-related topics, such as: bonus plan proposals (162m), equity exchanges/repricings, and employee stock purchase plans.

[6] Fidelity funds sub-advised by Geode Capital Management LLC, which discloses its own set of proxy voting guidelines, will generally vote for proposals to approve executive compensation unless it believes the company has engaged in poor compensation practices (similar to Fidelity’s general guidelines) or provided poor compensation disclosure (different from Fidelity’s general guidelines).

[7] Fidelity defines a “golden parachute” as: “employment contracts, agreements, or policies that include an excise tax gross-up provision; single trigger for cash incentives; or may result in a lump sum payment of cash and acceleration of equity that may total more than three times annual compensation (salary and bonus) in the event of a termination following a change-in-control.”

[8]Fidelity funds sub-advised by Geode Capital Management LLC, which discloses its own set of proxy voting guidelines, will continue to focus on the dilutive effect of the plan; dilution may not be greater than 10% (15% for companies with a smaller market capitalization). If the plan fails this test, the dilution effect may be evaluated relative to any unusual factor involving the company.

[9] A feature which provides for an automatic increase in the shares available for grant under an equity plan on a regular basis.

[10] Shorter periods are permitted for up to 5% of a plan’s shares for Large-Capitalization companies (10% for Small- or Micro-Capitalization companies).