The Advisors' Blog

–Subodh Mishra, ISS’s Governance Exchange

This article is drawn from a recent ISS paper exploring trends in CEO compensation at smaller U.S. firms relative to shareholder voting on “say-on-pay” resolutions:

As management “say-on-pay” (MSOP) voting takes hold in the U.S., shareholder concerns over executive pay levels and practices have principally focused on large capital companies where dissent on such resolutions is often disproportionately high compared with smaller peers. Investors’ attention may be shifting down their portfolios, however, as smaller firms come under greater scrutiny and investors appear more willing to challenge pay at such firms, according to an ISS analysis of voting for the 2012 annual meeting season.

As of May 30, Russell 3000 companies falling below the S&P 1500 index (referred to herein as “small” or “smaller” companies) saw average MSOP support decline across eight of 10 2-digit GICS sectors over 2011, while the percentage of ISS recommendations against such proposals has increased two and one-half percentage points to 16 percent overall. A likely driver of the trend is an increase in concerns over pay for performance, with nearly 40 percent of smaller companies exhibiting a “medium” or “high” concern thus far in 2012, compared with just over 25 percent during same period last year.
Trends in Pay

Median CEO pay for smaller companies grew by 10 percent in fiscal 2011 (as filed in 2012) with the typical chief executive taking home just under $2 million. Examined by sector, year-over-year changes in median CEO total compensation varied markedly, declining by 2.7 percent for Consumer Discretionary companies, and spiking by nearly 43 percent for Telecommunication Services firms. Overall, seven of 10 sectors showed growth above the percentage increase in median pay as well as the fiscal 2011 median value.

Telecommunication Services firms saw the greatest proportional growth in pay between fiscal 2010 and 2011, though the jump is largely due to a pay rebound after a 17.3 percent decline evidenced between fiscal 2009 and 2010. Eliminating this anomaly, factors accounting for year-over-year growth in median CEO pay vary by sector, though are driven largely by spikes in bonus awards, as well as the projected value of shares tied to option and stock grants.

Energy company CEOs saw the greatest year-over-year gain behind counterparts in Telecommunication Services, largely on the back of a 52.7 percent surge in the value of bonus awards and 31 percent gain in the value of stock option grants.

With regard to bonuses overall, six of 10 sectors saw bonuses exceed the overall small company median increase of 4.6 percent, including gains among Consumer Staples CEOs of 21 percent and Health Care company chiefs of 17 percent.

Notably, the rise in bonuses belies company performance as measured by 1-year total shareholder return (TSR). Just two of 10 sectors studied had positive median 1-year TSR as of Dec. 31, 2011, with four sectors showing both negative TSR and bonus increases.

Elsewhere, smaller companies overall saw modest year-over-year gains in the median value of stock-based awards with options pushing up by 2 percent and stock awards gaining nearly 7 percent in value over fiscal 2010.

Energy firms stand out for the aforementioned 31 percent increase in the value of option grants to a median value of $1.13 million (by comparison, the figure stood at just $462,000 as recently as fiscal 2009). Similarly, stock grant values for Energy firm CEOs stood at $1.1. million for fiscal 2011, which was tops by value, while firms in the Materials sector saw the greatest percentage gain at 56.5 percent, to a median value of $994,000.

Pay trends over the most recent fiscal year tell some but not the full story. Over a two-year period, the change in median CEO pay at smaller companies is brought into sharp relief as is a potential disconnect with performance when compared with 3-year TSR as of Dec. 31, 2011.

Energy firms’ CEOs saw two-year gains of more than 81 percent in total direct compensation against three-year TSR of 24 percent, while CEOs in the Consumer Staples sector saw gains of 46.1 percent against TSR growth of 10.5 percent. Just three sectors–Telecommunication Services, Consumer Discretionary, and Materials, saw greater gains in 3-year TSR than in median CEO pay, while, overall, smaller companies showed a spread of -22.8 percent between TSR growth and median CEO pay increases.

Mind the Gap

Smaller firms show increases in CEO total direct compensation (TDC) outpacing that for larger peers, potentially suggesting a gap in responses to “say-on-pay” voting, based on company size. S&P 500 firm CEOs saw median CEO TDC increase by 9 percent in fiscal 2011, or one percentage point less than that for smaller firms. Over the two-year period ending Dec. 31, 2011, however, TDC for smaller company CEOs grew by 40 percent, well in excess of the 23.5 percent for larger company counterparts.

While pay gains are ostensibly justifiable against commensurate performance, measures of both 1- and 3-year median TSR suggest gaps between larger, S&P 500 firms and smaller companies’ respective CEO pay increases, which may prove of concern to investors. Over the one-year period ending Dec. 31, 2011, median TSR for larger firms stood at 0.3 percent compared with -7 percent for smaller peers, according to ISS data. By a measure of 3-year TSR, performance is at par, with larger firms seeing gains of 17.3 percent, or 0.1 percent higher than that for smaller firms. Still, the figures would suggest investors may be more receptive to pay increases evidenced this year occurring at larger, rather than smaller, portfolio companies, given performance.

Another potential reason for growing shareholder dissent over smaller companies’ pay practices concerns the breakdown in CEO pay. As noted above, just over one-half (53 percent) of small company CEO total compensation is tied to stock and thereby putatively aligned with shareholders’ interest. By comparison, the figure stands at 64 percent for large capital firms as of Dec. 31, 2011, while, concurrently, the average slice of the CEO pay pie comprised of bonuses and fixed-salary is less than that of smaller peers.