Listed companies share a growing sense of frustration about the pressure to align with an artificial list of “best practices” defined by governance professionals who may not adequately understand the unique challenges facing a business.
The discussion that follows is not about the creative designs that compensation professionals can craft. Rather, it focuses on establishing an environment in which deviation from “best practice” is less likely to be condemned by shareholders, thereby enabling a company to use creative compensation systems to best support business strategy.
There are two key elements. First, rely less on market precedent as support for provocative compensation policy and avoid taking actions that can’t be defended as promoting shareholder interests. By mitigating entitlement and promoting accountability, investor goodwill is preserved and can be called upon when the need to be “different” is truly significant. Second, establish a relationship of trust with investors via a proactive, open-minded dialogue in which compensation is continuously discussed as a value driver within the broad business strategy. The underlying purpose should not be to pull a specific idea across the goal line or convince investors to ignore the vote recommendations of the proxy advisory firms after an action is taken; rather, it is to establish an understanding that compensation design is a unique element being used by the company to foster competitive advantage versus industry peers and drive transformative change and growth.
Bespoke versus Homogeneous Compensation Systems
Over the past several years there has been a growing sense of frustration, especially among listed companies, of the perceived need to standardize compensation programs and align with an artificial list of “best practices” defined by governance professionals and regulators. Private companies and recent IPOs have more latitude, and this increases the challenge for listed companies that are constrained by the influence of the proxy advisory firms and governance staff at the large institutional investors. In some cases, the pressure to align with “best practices” and homogenize the system can disable a company’s ability to effectively use compensation to support legitimate business challenges.
As an advisor to the Board Compensation Committees of many high profile, multinational companies, I am often asked whether the governance professionals and, in particular, the two major proxy advisory firms have accumulated more power. Here are some relevant data points:
- In 2022, an “against” recommendation from ISS correlated with an approximately 38% slip in support versus 2021. This compared to 30% and 35% drops in 2020 and 2021, respectively.
- The Say-on-Pay failure rate in 2021 and 2022 exceeded 4% among the S&P 500, significantly outpacing the historic level of approximately 1% in prior years.
Many might interpret the above as evidence that the influence of ISS has grown. There is no way to know for sure, but there are several issues to consider:
- First, the percentage of companies receiving an “against” recommendation from ISS has held steady at approximately 12%. Notwithstanding the challenges associated with the pandemic and other geopolitical and macroeconomic issues that have resulted in numerous actions by organizations deemed to be inconsistent with “best practice,” ISS has not targeted a larger number of companies.
- Second, virtually all of the major institutional investors have developed their own set of vote policies, and each states definitively that they follow this policy rather than that of the proxy advisory firms. My experience indicates this to be true.
- Third, the globalization of the shareholder base has resulted in an inconsistent set of “best practice” standards based on geography. The preferences of the major US firms, for example, do not necessarily align with those in Europe and, as a result, it is becoming increasingly more difficult to satisfy all investors. Slippage in TSR therefore creates more downward pressure on Say-on-Pay since investors are less likely to accept practices they deem non-ideal when stock price is down.
In my view, the influence of the proxy advisory firms has not increased. Instead, shareholders have developed a consensus view that certain practices, especially when coupled with weak stock price performance, are inherently inappropriate in the absence of a strongly compelling business rationale. When companies embrace these practices there is an immediate negative bias that is difficult to overcome.
This leads to two important questions: what are the practices driving the material increase in failed Say-on-Pay proposals, and what can companies do to mitigate the pressure to standardize and embrace artificially defined “best practices”?
Here is a concise list of what I believe rank highest from a shareholder concern perspective:
- Special equity awards rationalized as necessary to support talent retention goals for the CEO and other proxy officers;
- “Excessive” severance payments, which include those made to executives who “retire” from the company or are involuntarily severed and receive amounts that exceed typical market norms;
- Use of Compensation Committee discretion to uplift incentive payouts that would otherwise be lower, especially with regard to long-term incentives; and
- Failure to set “robust” performance targets, which might reflect (i) an historic pattern of above-target payouts when TSR versus peers is weak or (ii) overachievement of target performance goals that were set below the prior year actual results.
In many cases, the above actions are appropriate and supportive of shareholder interests, but in some cases they do not support a true performance-oriented culture. Further, there are often ways to support critical HR objectives in a challenging environment without directly poking the bear. As examples, talent retention goals might be equally supported via higher ongoing ordinary compensation in lieu of special awards, and carefully drafted proxy disclosure can enable severance benefits to officers asked to leave prematurely without categorizing the exit as either a firing (which creates embarrassment to the executive) or a retirement (which triggers the “against” votes on Say-on-Pay).
It is important to consider that once a challenged Say-on-Pay occurs, the pressure to align with “best practices” grows immensely because failure to demonstrate responsiveness to shareholder concerns can result in “against” or “withhold” recommendations on the reelection of Compensation Committee members. So, what is a company to do in this unique environment to both avoid Say-on-Pay challenges and enable use of creative, bespoke compensation policy and incentive structure. I have two suggestions.
First, avoid over-reliance on market practice and competitive precedent as the basis for action. All compensation professionals are guilty of this to some degree, and it is important to recognize that precedent set by other companies does not automatically provide support for another to take similar action. In this regard, it is important to recognize that every company has a certain amount of goodwill accumulated with investors, so care should be taken in how this is expended. Each provocative compensation action increases the likelihood that investors react negatively to the next.
Second, and most importantly, companies need to establish an open channel of communication with key investors. Virtually all my clients have a robust and well-developed investor outreach program. These are not campaigns initiated to pull a specific idea across the goal line or convince investors to ignore the vote recommendations of the proxy advisory firms. Rather, they represent formal processes of engaging in a constructive dialogue that involves compensation policy, among numerous other governance matters, on an ongoing basis. This process leads to trust and, in my experience, a higher likelihood that investors will support unique compensation policies or, when needed, side with the company when the proxy firms recommend “against.”
Over time, I anticipate that further development of the engagement process on both sides will lead to greater open-mindedness on compensation policy and a willingness to embrace ideas that may not align with “best practice” but do support strategic initiatives that are unique to specific companies. Those making the effort now are finding it easier to craft bespoke compensation programs and rationalize them as consistent with long-term shareholder value goals.
The number of “creative” ideas that can be crafted by compensation professionals is limitless, and I tell my clients frequently that “different is not bad, it just requires incremental explanation.” However, the willingness of investors to embrace the explanation is dependent on both the logic and rationale underlying the decision and the degree to which there is trust in the relationship. The business rationale is best supported by avoiding actions that appear to promote an “entitlement” rather than performance-oriented culture, and trust can be gained through a robust engagement process in which compensation is an open topic even when Say-on-Pay is not at risk.
Daniel J. Ryterband
Chairman & Chief Executive Officer
Dan Ryterband consults to organizations on all aspects of executive compensation strategy and design, including the related tax, accounting, and securities law implications, as well as matters of corporate governance and investor relations. He has over 30 years of consulting experience and his clients include U.S. and overseas multinationals in a variety of industries, as well as smaller start-up organizations. Dan has extensive experience working with Board Compensation Committees and is a frequent speaker in industry and academic forums.