The clearest conflict: How executive compensation sets off alarms

by Ronald Orol in Washington  |  Updated 03:36 PM, May-08-2015 ET

A big negative shareholder vote on CEO pay, a few red flags from a proxy adviser and an economic thesis to unlock value may be all that is needed to bring an activist fund into the fray. At least that's how Peter Michelsen views activism.

He should know. Michelsen, a managing partner at San Francisco-based CamberView Partners LLC, is a veteran adviser to companies targeted by insurgents. He spent nine years at Goldman Sachs Group Inc. (GS), including five years in the big bank's unit that was established to advise companies besieged by activist investors and hostile takeover threats. Last year, Michelsen joined CamberView to advise management and boards of public companies with the goal of trying to keep activist shareholders away or at least at bay. At CamberView, which was formed in 2012, Michelsen joins a cast of institutional investor and proxy adviser heavyweights, including former heads of governance at BlackRock Inc. (BLK), Vanguard, State Street Corp.(STT), Wellington, TIAA-CREF, Morgan Stanley Investment Management and Institutional Shareholder Services.

In an interview, Michelsen discussed some of the often misunderstood connections between shareholder votes on executive compensation and activism.

The Deal: Do you believe that companies that receive particularly negative 'say on pay' votes from shareholders expose themselves to a potential attack from activists down the road?

Michelsen: Yes, absolutely. Executive compensation is perhaps the clearest potential principal-agent conflict in a public company. In many cases, 'say on pay' is the only thing on the ballot where the investors are making a clear, substantive up-down vote on management, and because of that it is often positioned by activists as a proxy for the level of shareholder confidence or support for management.

Q: But a big negative vote on executive pay isn't enough, right? Doesn't there need to be some sort of financial catalyst that the activist can identify at the company?

A: An activist will target a company if they can establish two things-one, that there is a strong economic thesis and two that there is a key governance hook. A poor 'say on pay' outcome is an objective, highly visible governance hook. In most recent activist fights, compensation structure is an important element of the argument attempting to undermine investor confidence in the management and the board. Open up a recent white paper or proxy fight presentation and you will typically find several pages devoted to compensation issues. And on the pension fund side, it tends to precipitate additional pressure on governance structure-for instance, the New York Comptroller used poor 'say on pay' votes as one of the selection factors for its 2015 proxy access initiative.

Q: How do the two proxy advisory firms play into all this?

A: Given the average 'say on pay' vote is greater than 90%, this vulnerability exists even if the proposal passes. ISS and Glass Lewis have set the threshold for an automatic review [by the advisory firms] in the subsequent year at 70% and 75% respectively, and these thresholds have become somewhat of a break point for when you have a poor vote.

Now, a negative 'say on pay' vote alone will not create activist exposure. However, this is a strong indicator for an activist with an economic thesis to dig in.

Q: What will an activist say to management at companies with poor 'say on pay' votes?

A: They'll say, I can go to your top five long-only shareholders and tell the voters: The company underperformed, the board didn't hold management accountable and did not pay for performance, and you voted against them at the last AGM. I can generate significant returns for you and the company clearly needs new oversight. I will get their support.

Q: Can an activist with a small stake succeed at a company where there is a major negative say on pay vote?

A: A significant governance concern, like a poor 'say on pay' vote, acts as a force multiplier for an activist if they are reputable and have an attractive thesis. While they may have a small stake, if the broader shareholder base and the proxy advisers don't trust the board, the activist will have a significant number of the governance-driven funds and pension funds on their side of the ledger-this is often the swing vote that will determine success or failure for the activist, and is much more likely to impact the outcome than the difference between a 2% and a 6% stake.

Q: Can you give me an example of the kind of advice you give companies to make sure they don't ever get targeted by an activist?

A: Build a relationship with the teams at your investors who will make voting decisions. Consider that many of the activists are iterative players with these teams because they are in front of them multiple times a year-corporates are inherently at a disadvantage, so there is an urgent need to close that gap. For large institutions, these teams will cover thousands of companies in the portfolio, and it is often too late to reach out to them to ask for a favor when you have a problem like an activist or challenging pay vote.

There is real interest at these teams to engage with their portfolio companies-a letter sent by Vanguard earlier this year encouraging engagement with companies and directors on strategic and governance issues is a prominent example. And when you do reach out, understand your audience and what they care about-they do not want a traditional IR presentation to talk about the quarter. Companies should focus on drivers of long-term value and proof points of effective independent oversight by the board.

Q: Who at the company should talk to the institutional shareholders?

A: While this once was primarily an interaction between the finance/investor relations teams and portfolio managers/analysts, the growth of investor engagement on governance issues has significantly broadened the role of other key groups.

Depending on the company, we also see general counsel and corporate secretaries heavily involved, chief HR officers are involved in challenging 'say on pay' situations, and selectively directors in areas where board oversight is important.

While director involvement is not pervasive at this point, it is increasing and we anticipate director/shareholder interaction to be prevalent in the next several years.

Q: Can you talk about proxy access and what happened over the past 12 months?

A: Companies must understand emerging trends. The New York Comptroller's submission of proxy access proposals at 75 companies in 2015 is a watershed event and this is likely the first step toward proxy access becoming common across U.S. companies.

Initially, companies took an approach of attempting to exclude the shareholder proposals by adopting more stringent provisions-similar to how companies responded to proposals seeking a special meeting right. Shareholders were acutely aware of the implications of letting these tactics play out and moved aggressively to pressure the SEC to prevent their exclusion.

So, many proposals are going to a vote this year, and companies are taking a range of actions in response, including fighting the proposals and adopting or submitting to a vote proxy access proposals at ownership thresholds higher than the shareholder proponent's proposal. Many votes still need to occur, but results have been mixed thus far, demonstrating that shareholders are not all supportive of proxy access and, in particular, proxy access requiring a low level of ownership.

Q: What do the voters at institutions want?

A: It depends on the institution, but for the most part the teams that are controlling the voting decisions, and therefore the leverage in an activist situation, want to make sure that the company is being run for the benefit of shareholders, the right strategy is in place for generating long-term shareholder value, the board is providing appropriate oversight of management, and that risks are being appropriately managed. This sort of messaging isn't always a key component of typical investor relations efforts, and so a concerted effort needs to be made to get that message out through shareholder engagement and shareholder communications.