Lessons from proxy season 2012

There are a number of lessons companies should have learned from the 2012 proxy season, when pressure from shareholder activists and proxy advisory firms forced all companies to rethink their approaches to governance. While not everyone had to make major changes, all companies were very aware of how investor unrest, changing regulations and new standards put in place by ISS and Glass Lewis could hurt them on a number of corporate governance and proxy issues.

Here we present a round-up of some of the key themes that surfaced in 2012, with some advice from proxy adviser memos on what companies should do going forward into 2013.

Proxy firm influence

The growing influence of proxy advisory firms is driving significant change in how companies are approaching proxy season. ISS began implementing its ‘yellow card, red card’ system in 2012, awarding a failed say-on-pay vote with a red card or penalty, which could result in the ISS issuing a ‘no’ vote recommendation against members of the company’s compensation committee. Additionally, any company that receives less than 30 percent support for a say-on-pay vote is likely to receive a ‘no’ vote recommendation against directors. Glass Lewis will do the same for companies that receive less than 35 percent support.

Jim Barrall, partner at Latham & Watkins, says the more stringent rules had an affect in 2012 – ISS recommended ‘no’ say-on-pay votes at 14 percent of companies it reviewed, up from 12 percent in 2011. ‘On average, shareholder support was 30 percent lower at companies with ISS ‘against’ recommendations versus 25 percent lower support in 2011,’ he notes. ‘Glass Lewis’s influence is not as clear because it does not publish its numbers quite as handily, but its influence is apparently growing.’

What is clear is that the big proxy advisory firms make voting recommendations that can affect the fortunes of many companies – issuers must abide by their guidelines on everything from pay policies to governance and compliance codes, or risk negative consequences. 

Executive compensation

Pay issues dominated the 2012 proxy season landscape. Companies were dealing with everything from trying to improve their performance on say-on-pay votes to figuring out how to justify their pay-for-performance calculations in corporate disclosures. With ISS and Glass Lewis announcing changes to the criteria they will use to determine a number of issues regarding executive compensation, pay policies continue to be a major concern for companies. Disagreement over the type of peer group that should be used to compare proper levels of pay is a major point of angst for issuers. There is also confusion over what type of pay-for-performance calculations will be acceptable in 2013.

Issuers have long complained that ISS often uses industry peers that aren’t appropriate when comparing pay policies; instead, they want to be judged by the peer groups that they select. It’s an argument issuers are likely to lose.

‘Regardless of a company’s perspective on the role of third parties in peer formulation, keeping track of peers used by proxy advisors – and beginning a process of communication, if need be – should be a basic part of preparing for the upcoming year’s annual meeting,’ states Eagle Rock Proxy Advisors managing director Bradley Robinson in a post on the Eagle Rock website.

‘When preparing for the annual shareholder meeting, companies should be aware of how their pay stacks up to peers on an ‘as granted’ basis,’ Robinson warns. ‘If those numbers offer an unflattering view of the company’s pay, issuers should be prepared to say (preferably in the proxy statement or an earlier filing) why the company used [its] own calculation and why it offers a more accurate picture of pay vs. performance than alternatives.’

Robinson also advises issuers to refer to previous reports of how leading proxy advisory firms believe pay calculations should be handled as they calculate their pay-for-performance policies. ‘Just because pay has not been an issue in the past doesn’t preclude problems down the line due to different calculation methods, even where a company does not perceive a significant change in pay from one year to the next,’ he writes.

More companies failed say-on-pay votes in 2012 than in 2011, but the rise in the percentage of failures wasn’t alarming (as of October, 55 companies had received negative say-on-pay votes as compared to 44 for all of 2011). Whether the higher number of failures in 2012 was due to the changes in criteria used by proxy advisory firms remains to be seen. Analysts expect that the number of negative recommendations on pay policies from ISS and Glass Lewis might increase as companies have trouble reacting to changing criteria, but many companies that received negative recommendations in 2011 were able to correct their situation in 2012, proving that companies are learning how to adapt faster.

However, referring to one of AST Phoenix Advisors’ client update newsletters, senior vice president Ron Schneider notes that no company should assume the pay policies they had in place last year will be in line with what the proxy advisers expect next year. ‘Whether the potential new criteria result in 12 percent, 14 percent or higher average rates of ISS negative say-on-pay recommendations, these ‘new negatives’ may ensnare a somewhat different group of companies than would have received negative recommendations under their prevailing polices, thus increasing the level of uncertainty over which companies will receive a negative recommendation and related risk.’

Pay for failure

Yet another topic involving executive compensation that came up in 2012 involves what to pay the CEO or other high-ranking executives when they are terminated due in part to poor shareholder returns. The so-called ‘pay for failure’ issue is important to the pay-for-performance discussion, but shareholders and issuers have different opinions about compensation levels, even though studies show they agree that ‘cash severance exceeding three times base salary and target bonus and a new severance agreement entered immediately prior to departure would be inappropriate.’

Other issues connected to severance, such as large pension payouts and the acceleration of unvested equity grants, can also be deemed inappropriate because they aggravate investors, thereby having an affect on whether the overall pay policy receives a positive or negative recommendation. Companies must be very careful deciding whether to include these measures, because overpaying an executive who has cost shareholders money can lead to a failed say-on-pay vote. ‘It is always necessary to be aware how the company’s shareholder’s will view the board’s decisions [on compensation],’ Robinson notes. ‘In such cases as this, further explanation, at minimum, may be needed prior to this becoming an issue during the lead-up to the annual meeting.’

Independent chair

Another major governance issue that remained in the spotlight in 2012 was whether a company should use a board structure with an independent chair. Many companies operate with a combined CEO and chairman role, but increasingly, governance experts suggest that an independent chair reduces the risk of the board favoring management’s positions on corporate strategy, executive compensation and other issues at the expense of the interests of shareholders.

According to GMI Ratings, there has been a slow but steady decline in the number of companies that have continued to operate with a combined CEO/chairman board structure. The percentage of S&P 500 companies with a combined CEO/chair model decreased from 73.4 percent of the index (367 companies) in 2004 to 57.2 percent (283 companies) in May 2012. Shareholders continue to file proposals calling for the separation of the chief executive and chair roles, but in 2012 the majority of those proposals did not receive more than 50 percent voter support.

While some argue that the combined CEO/chair role is bad for governance, others claim it is good for profits. Since each company will have to determine what type of board structure works best, Robinson says companies that insist on a combined CEO/chair ‘will have to justify their positions and address the issues important to shareholders.’

Proxy access

As shareholder activism became much more prominent in 2012, the issue of proxy access took on greater importance. While only two of the nearly two dozen proposals filed won majority votes, the framework for what may be more acceptable to regulators and investors was likely established. Issues regarding whether proposals should be binding or non-binding and what the ownership threshold of shareholders offering proposals should be are not settled, but there is a much better idea of what might be acceptable next year.

Francis Byrd, leader of Laurel Hill Advisory Group’s corporate governance/risk advisory practice, says most companies shouldn’t have to worry about proxy access unless they have a record of failure to address problems with governance or stock performance. ‘If a company does not have performance problems, doesn’t have governance problems and has good relationships with its shareholders, this isn’t going to take root,’ says Byrd. ‘It can only take root where there are governance problems.’

Schneider says the limited success of proxy access will nonetheless move disgruntled shareholders to target companies that have failed to enact non-binding approved shareholder proposals such as separating the chair and CEO roles, and those that have poor compensation policies, poor growth performance, failed say-on-pay votes or even lack of quality disclosure.

‘This was an experimental year, and we fully expect that next year the pool of proponents using proxy access will expand, as will the targets,’ Schneider says. He projects that there could be as many as 50 proxy access proposals next year: ‘We expect it to become increasingly prevalent.’

Shareholder engagement

While shareholder engagement is not an SEC rule that companies must comply with, it has become such an important element in garnering a positive say-on-pay vote that some experts believe it should be a part of the normal compliance process during proxy season.

Towers Watson senior consultant Jim Kroll says that a number of things motivated companies to invest time and resources in shareholder engagement strategies in 2012 – some companies naturally expanded their culture of inclusiveness, some needed to repel possible takeover attempts, and others were motivated by a desire to recover from failed say-on-pay votes in 2011. But all companies are gaining a better understanding of the benefits of reaching out to shareholders.

‘When it comes to shareholder engagement, you’re going to find that one of the very effective ways to mitigate the chance of a very poor vote is to speak with your shareholders,’ says Kroll. ‘As more and more leading firms do this, it will expand to other companies.’

Kroll, who specializes in executive compensation issues for Towers Watson, says he has seen how a critical mass of companies who had problems last year have begun to speak up about how effective shareholder engagement has been in their process this year, and he expects that to continue into 2013. Before shareholder proposals begin surfacing, ‘directors may ask the corporate secretary or HR, Have you spoken to shareholders about this issue?’ he notes.

While engagement is not required, how can companies write governance policies and disclosures that shareholders will support if they haven’t spoken to those shareholders?

During a November webinar co-sponsored by Latham & Watkins, Rhonda Brauer, senior managing director of corporate governance at Georgeson, outlined steps companies can take to engage both investors and proxy advisory firms ISS and Glass Lewis during next year’s proxy season. First, she said companies should review any prior voting results and proxy advisory firm recommendations, and then begin engaging the proxy firms and large shareholders with the assistance of advisers.

‘Figure out who the right people are that you should be talking to,’ Brauer stated. ‘Consider what type of changes you may be planning for 2013 and really come up with a roadmap between now and your annual meeting so that you can make sure that you’ve got all the information that you need so that your board and committees can be making the [right] decisions.’

Brauer also reminded companies that their proxy statements are more important than ever before. ‘Complying with the SEC disclosure rules is no longer enough,’ she said. ‘You still have to stick with the truth, but it’s a sales document, and you really have to think of it as one, and think how you are going to develop your story.’

For those companies that do receive a negative vote recommendation from proxy advisory firms next year, Barrall encourages them to respond with supplemental proxy solicitation materials that explain the individual circumstances of their situation. As of September, 112 companies had filed such documents making a case for why they believed their approach to pay for performance or other issues was right. That number was substantially higher than the nearly 80 filings in 2011.

Barrall also says companies should reach out to shareholders before, during and after proxy season. ‘Looking forward, companies need to continue to engage with their most important investors on pay matters, address those investors’ concerns and reflect their decisions and analytics in company proxies in order to have more successful votes and avoid filing supplemental solicitation materials,’ he concludes.