January 2 0 1 1

Say-on-Pay 2011 - The Investor’s Viewpoint

On October 18, 2010 the SEC issued rules in response to Section 951 of the Dodd-Frank Act which would now require companies to include a mandatory “say-on-pay” advisory vote on the ballot for shareholder meetings taking place on or after January 21, 2011. In addition, as part of its rulemaking, the SEC also introduced the separate concept of shareholder advisory votes on the timing of advisory votes on compensation plans, or what is often derisively referred to as “say-on-say-on-pay.” Issuers were given the option of offering annual, biennial, or triennial advisory compensation votes, but were required to offer this decision out to shareholders as an advisory vote beginning in the 2011 proxy season. Management of calendar-year fiscal year companies is now tasked with coming up with the best approach to this issue prior to the upcoming proxy season – and it’s on the minds of nearly every US IRO at this point.

Depending on the structure of the company, proxy issues sometimes fall under the domain of the corporate secretary instead of the IRO. However, this year in particular, it’s important that the IRO have the complete picture of the investor base not just from an investment standpoint, but also from a voting standpoint.

History

Investors have long demanded more control over issuers’ activities, and through much of the decade the SEC has considered one form of proposal or another that would expand investor input into corporations. However, the movement to give shareholders a direct (though nonbinding) vote on executive compensation in the United States first truly took hold in 2007, when Aflac became the first U.S. issuer to voluntarily provide its shareholders with a say-on-pay vote.

Note that although say-on-pay voting is a new instrument to U.S. companies, the United Kingdom has mandated say-on-pay votes since May of 2003. Within the first year of voting, a major company failed the majority vote; GlaxoSmithKline. The pharmaceutical giant became the first company whose executive compensation failed approval from shareholders (the “against” vote was only 50.7%). Upon the failing of GlaxoSmithKline, many U.K. companies began to openly solicit shareholder feedback to ensure that there was full consensus on what executive compensation would look like for the year, thus limiting the probability of a surprise rejection of their compensation package.

While in 2008 a smattering of companies offered voluntary say-on-pay votes to issuers, the first U.S.-government mandated say-on-pay votes took place during 2009, with legislation requiring all companies receiving funds from the U.S. Treasury (through the TARP program and other activities) to offer an advisory compensation vote to shareholders.

2009 / 2010 Say-on-Pay Votes

During 2009 and 2010, with the prevailing winds suggesting its eventual broader adoption, a number of major issuers began to offer voluntary say-on-pay votes to their investors. According to ISS, 28 issuers offered say-on-pay votes to shareholders for the first time in 2010, and in total the average level of support for management say-on-pay votes in 2010 rose to 89.6% from 87.4% in 2009.

Say-on-pay votes are typically technically non-binding, but a decisive vote against a compensation scheme can be a very negative outcome for a company. During 2010, three issuers saw their say-on-pay votes fail to produce a majority in support: Key Corp, Motorola, and Occidental Petroleum. Key Corp’s vote was required as part of the conditions of the U.S. government’s TARP program, while Motorola and Occidental Petroleum held voluntary say-on-pay votes. ISS recommended against each of the advisory votes these issuers conducted. As the vast majority of institutional investors do tend to side with management on most votes of any kind, it’s particularly interesting to analyze the voting records of investors with respect to these votes, which led to a negative outcome for all three issuers.  

Figure 1 shows the set of the 25 US mutual funds that were the largest mutual fund holders of the group of three issuers in aggregate; it displays this information by fund family (given that only very rarely do mutual funds operated by the same manager direct their votes in opposing directions on the same issue). Notably, despite the negative recommendation, index managers Vanguard Group and State Street Global Advisors voted with management in each case. However, Blackrock Fund Advisors (the former Barclays Global Investors), which often follows ISS recommendations, chose to vote in favor of Motorola and Occidental, while voting against Key’s comp plan.

Investor Reaction – Portfolio Managers vs. Proxy Governance Specialists

So far in 2011, it appears issuers are split on how often to propose their say-on-pay votes; a December Towers Watson survey of 135 U.S. public companies showed 51% of issuers expecting to hold annual votes, 10% of issuers expecting to hold biennial votes, and 39% of issuers expecting to hold triennial votes. ISS announced in November 2010 that it would favor annual votes for public companies, leaving a significant obstacle for issuers seeking to hold less-common votes to explain their reasoning for doing so.

Despite what many of the institutional investment community organizations (CFA Institute, Council of Institutional Investors, Managed Funds Association) have said in public statements, it appears there may be more internal disputes about the expression of shareholder power within investors’ organizations than you might think. Particularly on the question of the timing of a say-on-pay vote, there are many individuals within the investment community that believe a less-common vote is more in line with long-term shareholder interests than a more-common vote.

During December 2010 and January 2011, Ipreo polled contacts from a set of 44 large active U.S. institutional investors with regards to their views on say-on-pay voting. Notably, though, Ipreo specifically spoke to investment decision-makers (analysts and portfolio managers, often the individuals most familiar with the issuer) at each firm, instead of proxy governance specialists.

For all of the talk that has been devoted to the subject as of late, there is little consensus amongst this community as to what the ideal frequency for holding a say-on-pay vote is

v 32% of the survey population believed that a say-on-pay vote should be held annually because of new scrutiny on the subject of executive compensation and because they feel it will enhance management accountability.

v 23% of respondents felt this vote should be held every other year because they do not want management to be distracted by short-term goals, but they also think that three years is too long between votes.

v 20% of investors favor voting on a three-year basis because they felt that management teams should be focused on their companies’ long-term strategies and their compensation programs should reflect those plans.

A diverse set of opinions were expressed in the study. While an annual vote was supported by a plurality of investors expressing a preference (in the words of a growth fund analyst, “an across-the-board say-on-pay vote should be held every year because there has been quite a bit of backlash against Wall Street, and against CEO and CFO pay in particular. Even if they were still being compensated handsomely, I think that any company that is willing to be transparent about it would gain shareholder trust”), some investors believe they already have a say-on-pay vote. One analyst summed up this viewpoint by stating, “At the end of the day, we vote for the compensation committee, so if the compensation committee is competent and independent, then we don’t need to vote on management pay, unless there is a big change in management compensation.”

In summary, don’t assume that investors are entirely in lockstep with ISS and other governance consultants on this topic; listen to what your shareholders have to say on the topic. In the end, it’s the analysts and portfolio managers that drive the investment committees at major investors, not the proxy governance teams, and the communication between the two may be less than you think. You may be surprised what your investors have to say on either side.

Preparing for a Say-on-Pay Vote – Know Your Shareholder Base

In much the same way that accountants adjust for the different sets of rules between IFRS treatment and GAAP treatment, many of the best IROs keep “two sets of books” with respect to their ownership bases – one associated with the goals of growing and diversifying the shareholder base, and one with the goals of anticipating any risks from a proxy standpoint. Marrying the information provided from a market surveillance perspective with the knowledge set of a proxy advisor is the most complete and accurate way to do this, but even without this set of tools there’s a lot you can do to gauge your proxy/ governance risk level, particularly with required say-on-pay votes that may have a higher profile than routine proxy matters.

First off, view your ownership base not just from an “investment” standpoint, but from a “voting” standpoint. Each investor that files a quarterly Form 13F disclosing its holdings in your (U.S.-listed) security is required to disclose not just the dispository power it has, but also the voting power for the shares it holds discretion over – either “sole”, “shared”, or “no” voting power, depending on the type of arrangement it has with the institutional client it manages your position on behalf of. One useful exercise is to look at the raw filings for many of your largest investors and identify those that leave voting discretion outside their firms (and potentially beyond the direction of the firm’s proxy governance teams).

Figure 3 below shows the set of investors with the largest investments in US stocks. For each firm, the percentage of its total disclosed holdings that has outside voting authority (either “shared” or fully “external”, is displayed). Note that some major institutional investors do not retain the voting rights on the securities that they have investment power over. In particular, note investors such as Northern Trust and Wellington Management that leave the voting rights in the hands of their clients. As a clarification – Fidelity is one investor that reports having no voting authority for most of its positions, but it structures the firm such that a separate legal entity internal to Fidelity conducts the voting for all of its positions (leaving all voting authority inside Fidelity anyways).

Public pension fund clients (such as California State Teachers’ Retirement and Massachusetts State Pension Fund) are among the most likely to retain their voting rights, potentially based on political / civic requirements. Be aware of the relationships that pension fund managers have with outside managers; for example, the City Of New York pension and group trust accounts use managers such as Thornburg Investment Management, Acadian Asset Management, and GE Asset Management as outside investment managers, but often retain the voting rights internally. You won’t ever see this manager on an ownership list displayed by descending investment discretion, but displayed by voting authority of its shares it can become a notable investor.

Of particular note – one of the components of the Dodd-Frank legislation requires all 13F-filing institutions to disclose their votes on each issuer’s say-on-pay votes in an annual filing (forcing increased transparency on investors in addition to issuers). This vote disclosure will allow issuers the full view of an institution’s voting record, and may for the first time offer transparency on hedge funds’ voting practices; previously only mutual fund managers were required to make any public disclosure of their voting records, leaving out most hedge fund managers.

Second, communicating with your ownership base from a voting standpoint is important, particularly in 2010. As noted above, much of the time the investment analyst responsible for maintaining coverage of your company is not fully aware of the investor’s view on your company from a corporate governance standpoint. Some investors such as TIAA-CREF will have two completely separate teams conducting research on your company, and in some cases the communication between these teams is far from perfect. Don’t assume that a good relationship with your investment analyst or portfolio manager will translate into a vote in support of management in the upcoming season – make sure to seek out the individuals that maintain proxy coverage of your company and make sure your story is in front of them.

Authors: Michael Mougias, Michael Byrne, and Brian C. Matt, CFA

Michael Mougias is an Analyst with Ipreo’s Corporate Analytics Group. Michael Byrne is an Analyst in Ipreo’s Perception Research Team. Brian C. Matt, CFA, is Director of Data Strategy & Analytics with Ipreo.

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