Say-on-Pay Rulebook – “Do’s and Don’ts” from an Investor Perspective

• The vast majority of companies provide for annual votes.
• “Pay for performance” assessments underlie most investor voting.
• Each year the overall support level averages more than 90 percent, while about only about 2 percent of companies fail to receive majority support for their pay programs.
• Another 5 to 10 percent pass with what is deemed mediocre backing – below 70 or 80 percent support per proxy advisor policies (ISS and Glass Lewis, respectively) and in the eyes of many investors – resulting in expectation that the compensation committee will demonstrate a substantive level of responsiveness to the relatively low vote.
• Increasingly important, low support for say on pay can be a red flag to activist investors who closely monitor shareholder dissatisfaction at potential targets.

In today’s environment, boards are hard pressed to follow the traditional approach of utilizing pay and benefits as they see fit to “attract, retain, and motivate” the managers who, in their view, will ensure the corporation’s success. Proxy advisors -- and many institutional shareholders -- rely on quantitative models to filter for companies that appear to have pay-performance disconnects or certain unacceptable practices. Both ISS and Glass Lewis follow their filtering with a qualitative assessment that takes into account a variety of company-specific factors; but the advisors and many investors are obligated to follow a consistent framework in applying their policies, sometimes leaving little room for the nuances of business exigencies. The proxy advisors also regularly evolve their policies to reflect new regulations and new thinking (that stock hedging and even pledging by executives and directors raises risks to shareholder value, for example). Even the new CEO-to-median-employee pay ratio that will emerge in 2018 proxies may eventually make its way into advisor and mainstream investor policies, though neither of those groups appears to have formalized public guidelines as yet.

Much has been written about the contribution of say on pay to the drive for companies to deliver short-term results that may be at the expense of long-term progress. The yearly focus on pay programs may well contribute to a perception that shareholders care mainly about annual results, but that is largely a misperception. Both major proxy advisors base their quantitative models on a 3-year performance period (albeit point-to-point, which may be misleading in some cases). Both also largely focus on pay and performance relative to peers rather on absolute levels. But when the model results in additional scrutiny of the program, the onus falls on the company to demonstrate a strong link between its executive pay and long-term company performance -- and increasingly, to demonstrate that their programs are specifically designed to support sustained growth in shareholder value, not simply to reward it.

Mathematical probability suggests that most companies will “fail” the quantitative test at some point, as their results fluctuate, so they should be prepared to validate the soundness of their pay programs each year. A few rules of thumb – “do’s and “don’t’s” if you will – that directors should keep in mind when making decisions about program and pay approvals, and their disclosure, bear repeating:

Don’t leave shareholders wondering . . . connect the key dots in the Compensation Discussion & Analysis (CD&A):

• Enumerate year-over-year changes to the program
• Explain why any incentive plan metrics were changed or adjusted relative to prior periods, and
• Clarify why any goals are not disclosed (note that investors generally expect to see goal disclosure on a retrospective basis for all plans).

Describe how incentive plans are used to focus management on achieving specific accomplishments that advance the company’s annual and long-term business objectives – and how each year’s goals are set. Institutional investors are increasingly sophisticated comparing industry metrics and those used for incentive plan goals. If they do not align, it raises questions about the soundness of the program. Qualitative metrics should be measurable in a way that can be communicated and demonstrated.

Consider best practices when designing incentive structures. Investors expect executive pay to be both transparent and effective in linking awards to the company’s business strategy, rather than simply rewarding its success:

• Avoid reliance on a single metric for either the annual or long-term incentive programs, as it provides a narrow focus.
• By the same token, avoid (or limit) overlap of metrics across the annual and long-term programs, as this suggests that multiple awards are paid for the same performance.
• Don’t use solely internal, absolute goals -- at least one metric should assess performance relative to peers (and be measured on a comparable basis, such as growth or TSR metrics), to provide transparency and demonstrate outperformance.
• Avoid a design that allows “retesting” of goals if they are not met by the end of the established performance period, including designs that can generate maximum payouts based on accomplishment of “either/or” goals, as they may be perceived as designed to help ensure payouts regardless of overall company performance. Matrix and incremental earn-out designs can achieve a desired outcome without appearing to permit “retesting.”

Clarify non-GAAP metrics, especially when GAAP results differ markedly or when the nature of the non-GAAP metrics has changed from prior performance periods. Shareholders understand that GAAP measures do not necessarily reflect the ongoing business results that management controls, or the company’s long-term prospects. However, they may question the use of adjustments that are markedly out of line with GAAP measures, or for items that are arguably within management’s control, barring a compelling explanation.

Recognize that top executives’ payouts should reasonably reflect shareholders’ experience – for example, if shareholder return is deeply negative during a performance period, many companies limit payouts to target level, even if it outperformed a peer group.

Be aware that institutional investors may be skeptical of certain incentive approaches – for example, those that rely on achieving a relatively low “Section 162(m)” performance threshold to generate maximum (i.e., outsized) award levels, which are then reduced by the compensation committee’s use of “negative discretion.” Many companies have utilized this approach, enshrined in the tax code’s “million-dollar compensation cap” rule, to preserve the board’s flexibility to determine final awards based on non-formulaic criteria. Routine use of negative discretion suggests a poorly designed plan, however, that may ultimately pay substantial awards that cannot be linked to sustained company performance. As an alternative, most investors are comfortable with a degree of board discretion that can be incorporated into “individual” or other more qualitative assessments, as long as they are well communicated and do not comprise too large a component of the total award (e.g., should generally comprise 40 percent or less). Reserve negative discretion to impose reductions that reflect exceptional circumstances, such as a severe reputational crisis or an extraordinary windfall unrelated to operating results.

Provide an explanation or rationale for any numbers that may appear exceptional, including the newly required CEO-to-median-employee pay ratio. The latter may be reported numerically (e.g., 1:250) or in narrative (e.g., 250 times the median), or both, and among other things, must include a brief description of methodology used and any subsequent changes to it. Most institutional investors understand that this statistic is both industry specific and highly influenced by a company’s business model; few will use it as a say-on-pay voting factor, at least initially. Over time, however, some investors are likely to incorporate it and will want to understand what drives year-to-year changes in the ratio and how it compares to peers.

Ensure that outsize awards in recruitment packages are substantially performance-based and aligned with shareholders’ interests. Explain how any large “make whole” awards were determined, and repayment features that protect shareholder assets.

Don’t assume that the key to a positive vote is getting ISS to align with the company’s compensation peer group. The proxy advisors’ pay-for-performance models have grown more sophisticated since the early days of say on pay; however, they continue to rely on a standard and consistent approach that does not always account for nuances such as a narrow Standard & Poor’s industry code for a complex business. A better approach is to ensure that the CD&A demonstrates strong pay-for-performance linkage underlying the program, and that the compensation committee is considering changes if the program is not delivering enhanced value over time.

Engage regularly with the proxy voting staff of your major shareholders (not always the portfolio managers), to ensure they understand the compensation committee’s expertise and involvement in the executive pay process, as well as the pay-for-performance underpinning of the program. And to stay abreast of their feedback on pay or other issues.