The 2012 proxy season will likely be remembered as an evolutionary, rather than revolutionary, year at the corporate ballot box. Many of the trends seen in 2011—the first year of mandatory say-on-pay—continued in 2012, with the vast majority of companies again receiving strong support for their compensation programs. As companies look toward 2013, they should continue to refine their understanding of the process that proxy advisory firms use to generate voting recommendations1 and, more generally, take a fresh look at how their disclosures stack up against evolving best practices. On the shareholder proposal front, proxy access proposals met with very limited success, although proponents gained important intelligence about the support for proxy access among institutional shareholders. Voting results on other shareholder proposals were generally consistent with prior years, with governance-related proposals again predominating.
Results from 2012
Overall voting results on say-on-pay were not meaningfully different in 2012 as compared to 2011, with shareholder support averaging around 90 percent across all companies, as well as for companies in each of the Russell 3000, S&P 1500, and S&P 500 indices. Approximately 10 percent of companies received less than 70 percent approval (a key threshold for a closer examination of the company’s pay practices in future years by ISS). Say-on-pay proposals failed (that is, did not receive the favorable vote of a majority of votes cast) at just over 60 companies (or approximately 3 percent of companies), which is up from the 40 failed votes (or less than 2 percent of companies) in 2011. Interestingly, and in something of a surprise, the overwhelming majority of companies with a failed say-on-pay vote in 2012 received at least majority (and often significantly more) support for their say-on-pay proposal in 2011—proving once again that investor sentiment can change quickly.
Influence of Proxy Advisory Firms
Say-on-pay voting results continued to demonstrate the significant influence of voting recommendations from proxy advisory firms, particularly ISS and, to a lesser extent, Glass, Lewis & Co. (Glass Lewis). Across all companies in 2012, a positive recommendation from ISS resulted in average shareholder support of more than 90 percent, while a negative recommendation resulted in average shareholder support of approximately 65 percent; by one estimate, shareholder support was 30 percent lower at companies that received a negative ISS recommendation. Of the companies receiving a negative recommendation from ISS, approximately 15 percent ultimately lost their say-on-pay vote. Although ISS issued fewer negative recommendations at large companies in 2012 than in 2011, these negative recommendations appear to have resulted in a greater decrease in shareholder support for the company’s compensation practices in 2012 than in 2011. Put differently, a negative recommendation from ISS translated into more shareholder votes against approving the company’s pay practices in 2012 than it did in 2011.2
Effect of ISS’s New Methodology
ISS used its new methodology for evaluating pay-for-performance as part of its review of a company’s executive compensation practices for the first time in 2012. ISS’s methodology uses a quantitative analysis of both relative and absolute alignment of pay-for-performance, and adds a qualitative analysis to companies where the quantitative assessment reflects an apparent pay-for-performance disconnect.3 Unsurprisingly, in most cases where ISS made a negative recommendation, the company scored poorly with respect to ISS’s pay-for-performance criteria, with the most significant factor in this assessment being the alignment of CEO pay (as reported in the Summary Compensation Table in the company’s proxy statement) and total shareholder return (TSR) in relation to the ISS-determined peer group.4 The vast majority of companies that received negative ISS recommendations, as well as the vast majority of companies that lost their say-on-pay vote, received a “high concern” rating from ISS on the one- and three-year alignment of CEO pay and TSR versus peer group. Other issues, such as problematic change-in-control arrangements, concerns with peer-group benchmarking, non-performance-based compensation elements, and concerns with compensation committee effectiveness, were important but did not demonstrate the significance of (mis)alignment of CEO pay and TSR. On the qualitative side, the most common issues were failure of incentive compensation to be rigorously performance tested and benchmarking above a peer-group median.
From 2011 Failure to 2012 Success
For most companies with a failed say-on-pay vote in 2011, the result this year was much better: of the 40 companies that failed the say-on-pay vote in 2011, only four failed again in 2012. However, this success was not achieved without effort: companies that were able to secure a successful say-on-pay vote this year after having lost last year typically engaged in some combination of (i) increased shareholder engagement; (ii) enhancement of performance-based aspects of compensation, including shifting service-based vesting equity awards to performance-based vesting equity awards, reducing the use of board discretion in determining whether performance goals were achieved, and limiting stock options; and (iii) remedying practices identified by ISS as problematic, such as tax gross-ups, above-median benchmarking versus peers, excessive perquisites, and certain types of severance arrangements. Those companies that provided clear, prominent disclosure in their proxy statements that explained their shareholder outreach efforts and the steps taken to adjust compensation practices in response to shareholder concerns seemed to have the most success in reversing negative investor sentiment.
Looking Ahead to 2013
The second year of generally positive say-on-pay results should be encouraging news for most companies and boards of directors. However, say-on-pay is a year-to-year item and companies should not become complacent, even if they have enjoyed two years of strong support. Next year is also the first year of mandatory say-on-pay for smaller reporting companies (those with market capitalizations of less than $75 million), so there will be an increase in the universe of companies holding say-on-pay votes. To be ready for the 2013 say-on-pay vote, companies should consider taking the following steps:
Engage with shareholders about compensation throughout the year. Frequent engagement with shareholders on compensation matters is now a year-round activity, and direct communication plays a key role in winning the say-on-pay vote.5 Shareholders may be more inclined to support a company’s pay practices—even in the face of a negative recommendation from one or more of the proxy advisory firms—if the company has been in regular contact and has consistently communicated its compensation rationale and how its compensation practices support its business strategy. In addition, a proxy advisory firm’s analysis may ignore or minimize certain factors or circumstances, and companies can use this outreach as an opportunity to explain why a past recommendation (or a negative component of a past recommendation) does not reflect the full reality of the company’s circumstances or pay practices. Companies should approach shareholders who voted against say-on-pay this year to engage in a frank and open dialogue, with the goal being to understand their concerns and, if appropriate, provide the company’s viewpoint.6 Shareholders can also change their minds about compensation practices from one year to the next, particularly if the company has performed poorly, and continuous engagement can help a company see that support among shareholders is eroding well in advance of the annual meeting. Even if a company has finalized its compensation policies for next year, it is not too late to conduct outreach for the 2013 proxy season. In thinking further ahead to the 2014 proxy season, companies may find that late summer and early fall are ideal times for substantive engagement with shareholders on compensation issues, since such timing gives the company an opportunity to consider shareholder feedback and adjust compensation policies well in advance of preparing its proxy statement.
Understand ISS’s methodology. Have a firm understanding of ISS’s executive compensation analysis. Particular focus should be placed on understanding ISS’s CEO pay-for-performance assessment and the alignment of CEO pay and TSR. ISS has released a significant amount of information that companies can use to assess how their pay practices will be viewed, including a white paper in December 2011 detailing the implementation of its pay-for-performance test. Every company should have its independent compensation consultant run a simulation of ISS’s CEO pay-for-performance test to help gauge its possible exposure to a negative vote recommendation. Make sure that the company has signed up to receive its ISS reports.
Understand the shareholder base and plan for contingencies. Companies should understand the makeup of their institutional shareholder base, including which proxy advisory firms are generally influential at each institutional shareholder. The goal of this process is to be able to roughly model the impact of a negative say-on-pay recommendation (e.g., if ISS were to issue a negative recommendation for the company in 2013, how might that impact the result of the say-on-pay vote? Could the company still retain enough support for a positive outcome?). Even if the company expects things to go well, develop a plan for responding quickly to negative recommendations from the proxy advisory firms. Identify a team that is prepared with contact information for the company’s major shareholders and prepare themes for additional solicitation materials, should they be needed.
If warranted, engage with proxy advisory firms. If the company has concerns with the substance of a proxy advisory firm’s analysis in 2012, it should consider engaging with the advisory firm now in order to address any future misconceptions and discuss issues that may be relevant in 2013. Both ISS and Glass Lewis have specific policies for engagement with a company during the solicitation period prior to its annual meeting, meaning that “off season” engagement may permit a broader discussion with the advisory firm in addition to potentially providing the company with time to consider and implement any compensation changes.
Review compensation policies in light of proxy advisory firms’ voting policies. Take a fresh look at compensation policies to be sure that, wherever possible, they follow the best practices recommended by the proxy advisory firms. Examine new compensation policies, including employment agreements with executives, through the lens of the proxy advisory firms’ say-on-pay policies before they are adopted to understand how they might be viewed in connection with future say-on-pay recommendations. Of course, compensation practices should continue to be designed in a manner that the board of directors believes serves the best long-term interests of the company, but there may be instances where the company can reduce or eliminate problematic pay practices (such as eliminating tax gross-ups and revising single-trigger severance arrangements) without much cost or effort, thereby helping to ensure future favorable say-on-pay recommendations. The compensation committee’s independent compensation consultant can be a valuable resource in this exercise.
Describe compensation changes and shareholder engagement. Ensure that the proxy statement clearly describes any steps taken to address compensation concerns as well as the company’s shareholder outreach efforts. ISS’s policies state that companies do not get credit for compensation changes or shareholder outreach that they do not disclose in their proxy statements. Remind compensation committees of the requirement to disclose whether the 2012 say-on-pay vote had any impact on the company’s executive compensation program so that their deliberations can, if they so choose, specifically address the results of the vote.
Proxy statement drafting tips:
When drafting the Compensation Discussion & Analysis (CD&A) section of the proxy statement, approach it as a strategic work of advocacy for the company’s say-on-pay proposal and not simply a description of compensation policies. Use the CD&A as a way for the board of directors to tell its story about the company’s compensation practices in a comprehensive and integrated fashion. Many companies have begun to include executive summaries at the start of the CD&A in an effort to highlight key messages, especially the pay-for-performance link. To be most effective, this summary should be short and crisply describe the company’s compensation philosophy and practices and, if applicable, how those practices changed in response to shareholder concerns.7 Charts and graphs can be effective in communicating the company's message visually. At a minimum, the summary should address (i) the company's performance in 2012; (ii) how the company adjusted its pay practices in response to its performance; (iii) the company's shareholder engagement efforts and steps taken to address compensation concerns (this item is particularly important for companies with less than 70 percent approval of say-on-pay in 2012); and (iv) how the company's executive pay has been aligned with TSR and other financial metrics over the last three- and five-year periods. A well-crafted executive summary can ease some of the burden on overtaxed institutional shareholders and proxy advisory firms, which are faced with a tidal wave of proxy statements to review and analyze each year. With all public companies required to conduct a say-on-pay vote in 2013, the need to quickly and clearly communicate compensation policies will only increase.
For companies that fail the ISS quantitative pay-for-performance tests, the proxy statement is the only place where the company can provide the reasons that ISS should nonetheless recommend in the company's favor. ISS will not speculate and will not give companies the benefit of the doubt: it needs the rationale in the proxy statement to include in its reports. Even if ISS issues a negative recommendation, major shareholders may need explanations from the proxy statement to give to their proxy committees in order to justify ignoring ISS's recommendations.
The summary compensation table will receive disproportionate attention. Consequently, make sure to include any mitigating factors (e.g., if the equity awards include performance elements or the incentive awards are less leveraged than those of the company's peers) in, or in close proximity to, the table.
Realizable pay disclosure. An increasing number of companies are providing supplementary disclosure, usually in tabular form, disclosing realized or realizable pay for their named executive officers, and this trend is likely to continue in 2013. When companies believe that their summary compensation table overstates executive pay due to the values ascribed to stock options and unvested equity awards, this disclosure may be helpful in assisting shareholders in understanding the executive compensation value actually transferred during a fiscal year. The Securities and Exchange Commission (SEC) has informally cautioned issuers to make sure that their alternate disclosure is not misleading to investors.
Say-on-Pay and Related Litigation
The potential for litigation around say-on-pay has created anxiety in a number of boardrooms, as a failed say-on-pay vote has sometimes been quickly followed by a shareholder lawsuit. To date, this type of litigation has been mostly unsuccessful, with a growing number of federal courts concluding that, under Delaware law, a failed say-on-pay vote is not sufficient to rebut the business judgment rule’s deference to directors’ decision making. Although sufficiently bad facts could result in a contrary outcome, directors of Delaware companies should generally take comfort that, if they act in good faith and with appropriate care, their compensation determinations will not be second-guessed or the subject of significant enhanced liability.
After the dismissal of several say-on-pay lawsuits on procedural grounds—specifically, that the shareholder did not make a demand on the board of directors before bringing the suit—the plaintiff’s bar became more creative in the latter half of the 2012 proxy season. Class action lawsuits were filed at more than 20 companies alleging that boards of directors breached their fiduciary duties by approving purportedly deficient disclosure and claiming that shareholders needed more information in order to cast an informed vote.8 In some instances, these lawsuits challenged disclosures in connection with required votes to amend equity incentive plans, such as increasing the number of shares available for issuance or renewing senior executive bonus plans9; in other cases, the lawsuits challenged disclosure in connection with a company’s say-on-pay shareholder vote. Plaintiffs typically bring these cases in state court where the company’s principal place of business is located and seek an injunction against the upcoming vote. The threat of an enjoined annual meeting pushed several companies into providing additional disclosures, thereby justifying a fee award to plaintiff’s counsel. Although plaintiffs have had only mixed results with these lawsuits, there have been enough successes to believe that this trend will continue in 2013. Companies with a low or negative say-on-pay vote and companies seeking authorization for additional share issuances pursuant to equity incentive plans should take a careful look at their disclosure to ensure that it complies with Items 402 and 407 of Regulation S-K and Item 10 of Schedule 14A, as well as consider enhanced disclosures to reduce the possibility of litigation. This enhanced disclosure could include, for example, more information on the company’s internal equity usage calculations and planning. In this regard, companies should also be mindful that the new disclosure requirements related to compensation consultant conflicts of interest in Item 407(e)(3) of Regulation S-K are effective as of January 1, 2013.
The Seinfeld Case and Director Equity Compensation Limits
One 2012 Delaware Chancery Court case, Seinfeld v. Slager,10 successfully withstood the defendant’s summary judgment claim (meaning the case was allowed to proceed) on the grounds that the defendant directors awarded themselves excessive equity compensation pursuant to the company’s equity compensation plan. In its ruling, the Delaware court noted: “Though the shareholders approved this plan, there must be some meaningful limit imposed by the shareholders on the Board for the plan to be consecrated by 3Com [a prior Delaware case upholding director equity compensation under the business judgment rule] and receive the blessing of the business judgment rule, else the ‘sufficiently defined terms’ language of 3Com is rendered toothless.” Based on the Seinfeld ruling, companies may wish to consider seeking shareholder approval to amend their equity plans to impose annual limits on the number of shares or dollar value of equity awards that each non-employee director may receive, or include these limits in new plans under consideration.
Proxy access, which allows shareholders meeting certain ownership criteria to include their director nominees in the company’s proxy statement and form of proxy, faced its first major test in 2012. The D.C. Circuit’s decision to strike down proposed Rule 14a-11,11 which set out the SEC’s criteria for mandatory proxy access, did not disturb the amendments to Rule 14a-8 that permit shareholders to submit their own proxy access proposals—so-called “private ordering” proxy access. In 2012, more than 20 proxy access proposals were submitted to companies through the Rule 14a-8 process and generally fell into one of three buckets.
Norges Bank Binding Proposal. Norges Bank Investment Management, the manager of the Norwegian government pension fund, submitted binding bylaw amendments to several companies that, if approved, would have provided proxy access to a shareholder or group of shareholders holding 1 percent of the company’s outstanding stock for at least one year. Each eligible shareholder or group would be permitted to include candidates representing up to 25 percent of the board of directors, with no overall limit on the number of nominees, although the number of proxy access nominees actually elected could not exceed 25 percent of the board. Most companies receiving the Norges proposal sought no-action relief from the SEC to exclude the proposal from their proxy statements as impermissibly vague and indefinite; only one company was successful in this process and that was only because of a company-specific drafting error in the proposal. Despite a fairly robust publicity effort by Norges, including a unique website for each company with extensive, company-specific arguments in support of the proposal, and recommendations in favor of each proposal from ISS, none received majority support. At each of the four companies where the proposal went to a vote, however, it received support from over 30 percent of the votes cast.
U.S. Proxy Exchange. The U.S. Proxy Exchange, a group of shareholder advocates, developed a model proxy access proposal that it submitted to a number of companies. The proposal, which was non-binding, requested a bylaw amendment permitting shareholders who have owned 1 percent of the outstanding stock of the company for at least 2 years, or 100 shareholders who satisfy the Rule 14a-8 eligibility requirements, to include candidates in the company’s proxy statement. Each eligible shareholder or group would be permitted to nominate candidates for up to one-twelfth of the board, but there would be no overall limit on the number of nominees or elected access directors. Every company that sought no-action relief on this proposal was successful, with the SEC concluding that the proposal (i) constituted multiple proposals due to the inclusion of a provision specifying that none of the company, its board of directors, or management could consider the election of a majority of access nominees to be a “change in control” of the company and (ii) was vague and indefinite because it made reference to eligibility requirements of Rule 14a-8 without explaining those requirements. The proposal did not receive majority support at the two companies where it came to a vote.
The U.S. Proxy Exchange revised its model proposal late in the proxy season but in time to submit it to a few additional companies. The revised proposal eliminated the problematic “change in control” language and the reference to Rule 14a-8’s eligibility requirements, in addition to reducing the number of required shareholders to 50. Companies receiving this proposal were not successful in obtaining no-action relief. The revised proposal, which was not supported by either ISS or Glass Lewis, failed to receive majority support at any company where it went to a vote.
Pension Fund Coalition. A coalition of state and municipal pension funds submitted non-binding proxy access proposals at Nabors Industries Ltd. and Chesapeake Energy Corporation seeking to create a proxy access right for 3 percent shareholders (or groups) who have held their stakes for at least three years, which are the same thresholds that would have applied pursuant to Rule 14a-11. Neither company sought no-action relief to exclude the proposal, and it received over a majority of votes cast at both companies. A similar proposal was submitted to Hewlett-Packard Company but was withdrawn after the company agreed to put its own 3 percent/three-year proposal to a shareholder vote in 2013.
Overall, proxy access shareholder proposals enjoyed very modest success in 2012, but shareholder proponents gained valuable intelligence about how institutional shareholders are going to approach future votes on proxy access. It appears that most institutional shareholders view a 1 percent ownership threshold as too low, but are more comfortable with a 3 percent threshold, which reflects the threshold proposed in Rule 14a-11. The well-publicized issues at both Nabors Industries and Chesapeake Energy—the two companies where proxy access proposals did pass—make it difficult to extrapolate the votes at these companies with confidence. Shareholder proponents also gained valuable intelligence on the SEC’s views on proxy access shareholder proposals through the no-action process, which should enable them to submit proposals that are less likely to be excluded from proxy statements in 2013.
Many of the companies that were the target of proxy access proposals were perceived to have corporate governance or serious executive compensation issues. No one practice appears to make a company more vulnerable to receipt of a proxy access shareholder proposal, but some or all of the following appear to be influential: (i) significant executive compensation not aligned with stock performance; (ii) failure to act on shareholder proposals that have previously received majority support; (iii) combined roles of chairman and CEO; (iv) continued re-nomination of directors who have received low levels of shareholder support over several years; (v) weak TSR over one-, three-, or five-year periods as compared to the peer group; (vi) a classified board of directors; (vii) lack of a shareholder right to call a special meeting or act by written consent; and (viii) previous circumvention of a shareholder proposal (e.g., submitting a company-endorsed proposal to allow 25 percent of shareholders to act by written consent when a shareholder submitted a proposal with a 10 percent threshold).
In preparation for 2013, companies and boards of directors should spend time considering how they would determine the views of their largest shareholders on proxy access, including with respect to appropriate ownership thresholds, as well as specific proxy access provisions that the company and the board of directors would or would not support. The U.S. Proxy Exchange announced in October 2012 that it was suspending “central operations,” but not before publishing a further revised draft of its proxy access proposal that included changes designed to address the concerns of ISS and Glass Lewis.12 However, at this time there remain no material benefits to a company proactively adopting proxy access—it is better to let a market practice develop before voluntarily moving in this direction.
Other Shareholder Proposals
Voting on other shareholder proposals was generally consistent with prior years, with governance-related proposals being both the most common and the most likely to achieve majority shareholder approval.
Board declassification. Shareholder proposals to declassify boards of directors were up markedly at S&P 500 companies in 2012. This was primarily due to the efforts of the Shareholder Rights Project at Harvard Law School, which, in cooperation with at least six prominent pension funds, submitted declassification proposals to about 90 S&P 500 companies. The Shareholder Rights Project reached negotiated agreements with 48 of these companies, with the agreements committing the company to bring company-sponsored proposals to declassify their boards to a vote in the near future.13 For the 38 companies where Shareholder Rights Project declassification proposals went to a vote, average passage rates were around 80 percent, and these proposals are estimated to represent over one-third of all shareholder proposals receiving majority support during 2012.
Independent chair. Shareholder proposals to split the role of board chair and CEO at S&P 500 companies were up significantly in 2012, although support averaged around 35 percent and only two such proposals passed. This may signal that, at the moment, a substantial number of shareholders believe that existing governance structures utilizing a strong independent director are sufficient. In this regard, ISS, subject to certain conditions, will generally recommend a “no” vote on independent chair proposals if the company has an effective lead director.14
Shareholder right to call a special meeting and act by written consent. Shareholder proposals to provide shareholders with the right to call a special meeting at S&P 500 companies were down slightly from 2011. Support for these proposals averaged around 50 percent. For S&P 500 companies that already provide shareholders with a right to call special meetings, proposals to adopt a lower threshold on the percentage of outstanding shares necessary to call a special meeting were down significantly, with support averaging around 35 percent. The number of proposals to allow shareholders the right to act by written consent at S&P 500 companies also declined, with support averaging around 45 percent. The declines in the number of these proposals likely reflect both (i) the fact that many companies have already adopted these measures and (ii) some companies preempting the shareholder proposal by submitting a management-sponsored alternative to a shareholder vote.
Other governance proposals. At S&P 500 companies, the number of shareholder proposals to adopt majority voting and to eliminate supermajority voting provisions in a company’s organizational documents was consistent with 2011. Both of these proposals typically receive strong support from shareholders, with average support rates of approximately 57 percent and 70 percent, respectively. Proposals to repeal exclusive forum provisions, which establish the company’s state of incorporation as the exclusive forum for specified litigation, including shareholder class actions and derivative suits, were voted on at two companies but, despite recommendations from ISS in favor of both proposals, did not pass.
Compensation-related proposals. In 2012 the primary focus of compensation-related proposals was a topic not covered by the say-on-pay vote: executive stock retention polices, which typically call for executives to retain a certain amount of shares acquired through compensation plans for a specified period. At S&P 500 companies, support for these proposals averaged around 25 percent. Other subjects of compensation-related proposals were limits on golden parachutes and initiatives to link pay and performance. As in past years, all of these proposals received meaningful shareholder support (often in the 30 percent range) but rarely passed.
Environmental and social policy proposals. As in 2011, environmental and social policy issues continued to be a frequent source of shareholder proposals. There was a noticeable increase in proposals relating to political issues (generally, requests for additional disclosures on political spending or lobbying costs, but in a few instances proposals were submitted for an advisory vote or prohibition on political spending) at S&P 500 companies. Other frequent sources of shareholder proposals were sustainability reports, labor issues, human rights, and animal rights. Consistent with past years, support for these proposals varied widely, and no environmental or social policy proposal passed at an S&P 500 company.
Over the past 10 years a certain amount of homogeneity in governance practices at larger companies has developed, driven at least in part by companies responding to ISS’s policies on shareholder proposals.15 Classified boards are now the exception at S&P 500 companies, and many have also adopted majority voting and provide shareholders with a right to call a special meeting or act by written consent. Having achieved many of their governance objectives at the largest companies, it remains to be seen whether shareholder proponents—particularly large and well-financed proponents like the Shareholder Rights Project—will now turn their attention to smaller companies. In 2012, there was some evidence that this is indeed occurring in connection with the most significant corporate governance topics, especially the elimination of classified boards and the implementation of majority voting. Regardless of size, every company with a classified board or plurality voting in director elections must give some thought as to how it would respond to a shareholder proposal to modify these practices.
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For any questions or for more information on these or any related matters, please contact your regular Wilson Sonsini Goodrich & Rosati attorney or any member of the firm’s corporate and securities practice.