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For the previously posted copy of the report summarized below, see:
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The Harvard Law School Forum on Corporate Governance and Financial Regulation, April 8, 2012 posting
The Influence of Proxy Advisory Firm Voting Recommendations This report examines current evidence regarding the influence of third-party proxy advisory firms’ voting recommendations on shareholder proposal voting outcomes, particularly say-on-pay votes. It also presents the findings of a study, conducted by The Conference Board, NASDAQ, and the Rock Center for Corporate Governance at Stanford University, which shows that proxy advisory firms have a substantial impact on the design of executive compensation programs. However, the impact of those firms on governance quality and shareholder value is still unknown. A growing body of evidence demonstrates the influential role that third-party proxy advisory firms play in affecting the voting outcome of proposals made to shareholders in the annual proxy, particularly say-on-pay votes, which became mandatory for most public companies in 2011. There is less evidence, however, to establish the extent to which companies respond to this influence by changing the size and structure of executive compensation plans to conform to proxy advisor voting polices. A recent study conducted by The Conference Board, NASDAQ, and the Rock Center for Corporate Governance at Stanford University found that proxy advisory firms have a substantial impact on the design of executive compensation programs. Say on Pay and Proxy Advisory Firms The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) requires that public companies allow shareholders the opportunity to cast an advisory vote on executive compensation—a process known as say on pay (SOP). Depending on how that voting information is used by the board of directors, SOP can have an important influence on a company’s compensation policies. While a shareholder vote against the executive compensation program does not obligate a company to make changes, rejection of a plan or low levels of shareholder approval can bring increased scrutiny of the program and governance practices overall by institutional shareholders, the media, proxy advisory firms, and corporate governance activists. In addition, several companies that failed SOP votes have had shareholder derivative lawsuits filed against them, including Cincinnati Bell, KeyCorp, and Occidental Petroleum. For these reasons, companies and boards of directors care greatly about the outcome of SOP votes. Also important is the role that proxy advisory firms play in assisting institutional investors in their determination of shareholder votes. Institutional shareholders have a fiduciary duty to vote their shares on all proxy items, including SOP, and are required to disclose their voting policies and their actual votes to the public. To ensure that their voting policies and process are not in conflict, many institutional investors subscribe to third-party proxy advisory firms such as Institutional Shareholder Services (ISS) and Glass Lewis to receive research, analysis, and vote recommendations on proxy proposals—and in many cases, to determine whether they should vote for or against a proposal. These voting recommendations are developed based on a set of criteria considered by proxy advisory firms to be desirable structural features for elements of corporate governance or executive compensation. Institutional Shareholder Services examines the following attributes in formulating its recommendation on SOP:
Institutional Shareholder Services also offers consulting services through which companies can receive feedback and guidance on ways to improve their executive compensation program and increase the likelihood of a favorable SOP recommendation. Access to ISS’s recommendations is made available on a subscription basis, so firms and their advisors as well as academics can research recommendations made for other firms. Glass Lewis generally provides less public detail of the implementation of its policies. However, they use criteria similar to ISS in forming their recommendations:
It should be noted that Glass Lewis does not offer consulting services to companies and does not generally provide access to their recommendations to corporate issuers or to the academic community. Among the survey respondents, ISS and Glass Lewis made the same recommendation 75.0 percent of the time. However, ISS was generally more likely to recommend voting against management’s SOP proposal, doing so in 19.2 percent of cases, while Glass Lewis recommended a vote against management in approximately 16.5 percent of cases. These figures are consistent with the overall proxy season statistics of 17.5 percent and 12.5 percent respectively, recommended by Glass Lewis and ISS in 2011. Evidence suggests that institutional investors respond to the voting recommendations of proxy advisory firms. For example, a negative recommendation from ISS, the largest proxy advisory firm, has been shown on average to influence between 13.6 percent and 20.6 percent of votes cast on management- sponsored proposals. During the 2011 proxy season, no company that received a positive recommendation from ISS failed its SOP vote, and 12.0 percent of companies that received a negative recommendation from ISS failed their SOP vote. The evidence is considerably less established, however, about whether companies themselves respond to the policies and voting recommendations of proxy advisory firms as they relate to SOP. Companies might be more likely to change their executive compensation plans if they believe that a major proxy advisory firm is poised to issue a negative recommendation, given the influence that these recommendations have on voting outcomes. Furthermore, ISS provides extra scrutiny to companies that receive less than 75 percent support for SOP, and Glass Lewis provides extra scrutiny for companies that receive less than 80 percent support for SOP. Companies might make changes to their compensation plans to secure the positive recommendation of these firms with the hope of keeping support above these thresholds. For example, following criticism from ISS in 2011, The Walt Disney Company removed tax gross-up provisions from the employment agreement of four senior executives, and General Electric voluntarily changed the structure of the equity incentive program offered to CEO Jeffrey Immelt. As a result of the changes, ISS reversed its negative voting recommendation on both companies’ SOP proposals. In 2012, Shuffle Master specifically referenced ISS’s negative vote recommendation during the previous year as the reason for its decision to amend the change-of-control provision in the employment agreement of Chief Operating Officer David Lopez. The Conference Board, NASDAQ, and the Rock Center for Corporate Governance at Stanford University survey found that proxy advisory firms had a very direct influence on the compensation structures employed by companies, and that the policies and recommendations of these firms compelled many companies to make changes to their executive compensation programs that they would not have otherwise made. During the 2011 proxy season, 72.0 percent of companies reviewed the policies of a proxy advisory firm or engaged with a proxy advisory firm to receive feedback and guidance on their proposed executive compensation plan. A large majority of companies (70.4 percent) reported that their compensation programs were influenced by the guidance received from proxy advisory firms or by the policies of these firms. Companies reported making a broad range of changes to their compensation program in response to proxy advisory firm policies. Roughly a third (31.7 percent) enhanced disclosure in the annual proxy, and 23.8 percent reduced or eliminated certain severance benefits. In addition, 15.8 percent reduced other benefits and perquisites, 12.9 percent adopted stock ownership guidelines or retention guidelines, and 8.9 percent introduced performance-based equity awards. Approximately half of companies (51.2 percent) anticipate making changes to their executive compensation program for the 2012 proxy season. Companies are most likely to make changes to their disclosure policies and practices, to introduce performance-based equity awards, and to change to the peer group used for benchmarking purposes. Companies that received low support for their SOP proposal in 2011 are more likely to make changes in 2012, whereas those who received high support are significantly less likely to plan to make changes. These companies are much more likely to engage the consulting division of a proxy advisory firm to receive feedback and guidance on their proposed executive compensation plan. They are also much more likely to reduce overall pay levels, introduce performance-based equity awards, make changes to the target level of their pay relative to their peer group, and enhance disclosure. Conclusion The survey results clearly show that companies do respond to the SOP policies adopted by proxy advisory firms. The majority of companies determine in advance whether their executive compensation programs are likely to receive a favorable recommendation from ISS or Glass Lewis; and companies are likely to make changes to a program in anticipation of a negative recommendation from these firms. All areas of the compensation program are affected, including disclosure, guidelines, and plan structure and design—although the degree to which these areas are affected varies considerably. While the evidence suggests that companies are aware of and react to proxy advisory policies as they relate to SOP, the evidence does not speak to whether these changes are positive or negative for shareholders. Until proxy advisory firm methodologies are vetted by third-party examiners, it cannot be determined whether these changes are beneficial to companies and their shareholders. However, proxy advisory firms are an important influence on compensation plan design.
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