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.

– Broc Romanek, CompensationStandards.com

As noted in this blog from Bill Tysse, the IRS recently proposed new regulations under Section 83 of the Internal Revenue Code that would consolidate the IRS’s position from an earlier Revenue Ruling (Rev. Rul. 2005-48) and, in effect, cabin-in a First Circuit Court of Appeals decision (Robinson v. Commissioner) handed down over 25 years ago to its specific facts. Here are a few firm memos on the new proposal.

– Broc Romanek, CompensationStandards.com

On TheCorporateCounsel.net’s “Q&A Forum” last year, Dave answered a question (#6407) that I thought was worth repeating:

Question: While the say-on-pay and say-on-frequency proposals are now being described as advisory, why aren’t companies doing the same thing re the auditor ratification proposal? This proposal really is also advisory as most companies describe in the proposal that if shareholders do not ratify the appointment the Audit Committee will consider that fact in determining whether to select new auditors (and vice versa – if the selection is ratified e AC may nonetheless determine to select new auditors).

This issue is especially pronounced when companies include disclosure in Q&A or another section at the beginning of the proxy statement regarding the various proposals included in the proxy statement and describe the say on pay and say on frequency as advisory but not auditor ratification. This implies to me that auditor ratification must then be considered binding by these companies. My guess is that is not really the case.

If you ask shareholders to ratify the selection and ratification is not approved by a majority of the shares, it doesn’t mean the audit committee has to select new auditors (i.e., the auditor’s selection is not conditioned on shareholder ratification). Given this, isn’t it necessarily advisory even if “advisory” is not in the title of the proposal? Any views?

Dave’s Answer: I agree, this is a good point, it is in reality an advisory vote cast as ratification of the auditor. I think that leads to the language included in the proposal which describes the advisory nature in that the Audit Committee may determine that it is not advisable and in the best interests of the stockholders to replace the auditor if the ratification is not obtained. I guess I wouldn’t go as far to say that if the proposal language is adequate as to the meaning of the vote, you necessarily would need to indicate in the title of the proposal or otherwise that the vote is advisory.

– Broc Romanek, CompensationStandards.com

I’ve added 10 more companies to our failed say-on-pay list for 2012! We are now at 49 companies that have failed to garner major support – with Nabor Industries becoming the fourth company to fail for two consecutive years (and the first company to fail a proxy access by-law vote). Hat tip to Karla Bos of ING Funds for keeping me updated!

– Broc Romanek, CompensationStandards.com

Sure, people in the US are angry about excessive executive pay. And even though there are more failed say-on-pay votes already this year compared to all of last year, it still isn’t a wave of failures as might be expected. In comparison, it has been quite a show in the UK this year, with CEOs resigning after an adverse say-on-pay vote. I can’t imagine that happening in the States.

The latest in the United Kingdom is the WPP saga. Last week, WPP’s CEO – Sir Martin Sorrell – wrote an op-ed in the Financial Times defending his pay and calling the controversy over his compensation “deeply disturbing.” As could be expected, WPP shareholders are now even more up in arms.

Although some write that Sir Sorrell was brave to speak out, it seems that B-School Lesson # 1 would be “do not write op-ed pieces defending your pay.” WPP’s shareholder’s meeting is on Wednesday and it should be a hoot…

– Broc Romanek, CompensationStandards.com

I know I’ve blogged before about this topic, but it’s an important item – so I refer you to this Davis Polk blog which includes a link to the March consultation paper from the UK’s Department of Business Innovation & Skills (BIS).

– Broc Romanek, CompensationStandards.com

I’ve added 7 more companies to our failed say-on-pay list for 2012! We are now at 39 companies that have failed to garner major support – with Digital River garnering support only in the teens (19.2%; going even lower than Chiquita Brands)! And Safety Insurance Group became the first company to fail after receiving a ‘For’ recommendation from ISS, as noted in this Semler Brossy blurb. Hat tip to Karla Bos of ING Funds for keeping me updated!

– Broc Romanek, CompensationStandards.com

I’m still in the camp that peer group surveys aren’t an inherently evil thing in isolation – but that the heavy reliance on boards on them to pay CEOs in the top quartile over many years has unfortunately tainted the pay databases so much that the data is useless unless there is some sort of reboot. That’s why this blog by Steven Kittrell about how some New York agencies have proposed the use of benchmarking to limit pay made me smile. The proposal is that if pay exceeds $199,000, the total pay cannot be greater than the 75th percentile of comparable executives of comparable companies (as to size and services) in a comparable geographic area. The slippery slope downwards.

I imagine that if this type of proposal was ever floated for public companies, many of those that blindly follow benchmarking today would suddenly find religion and claim that boards should have the discretion to set pay levels based upon their own circumstances and that benchmarking should barely even be considered…

– Broc Romanek, CompensationStandards.com

Last year, I was shocked to read Mike Melbinger’s blog that a major insurance broker plans to begin offering “policies that would cover financial firms against both their legal costs in the event that they underwent investigation by the FDIC and any compensation that their executives had to hand back as a result of action by the agency.” Yesterday, as noted in this article, Rep. Barney Frank introduced a bill that would bar executives at financial firms from being able to buy insurance to protect themselves against compensation clawbacks or civil penalties. Here’s analysis of the bill from the D&O Diary Blog.

– Broc Romanek, CompensationStandards.com

We are very excited to announce that Corp Fin Director Meredith Cross will be part of our “7th Annual Proxy Disclosure Conference” on October 8th in New Orleans (and by video webcast). Just look at this beautiful baker’s dozen of panels for this Conference:

1. An Interview with Meredith Cross, Director of the SEC’s Division of Corporation Finance
2. Say-on-Pay Disclosures: The Proxy Advisors Speak
3. The Executive Summary & Other Ways for Disclosure to Facilitate Solicitation
4. The Latest SEC Actions & CD&A Developments: Compensation Advisors, Clawbacks, Pay Disparity & More
5. Refining Your Pay-for-Performance Message & Addressing the Impact of Your Vote
6. Getting the Vote In: The Proxy Solicitors Speak
7. Dealing with the Complexities of Perks
8. Conducting – and Disclosing – Pay Risk Assessments
9. Overcoming Form 8-K Challenges
10 Handling the Golden Parachute Requirement
11. Challenges for Smaller Companies: Their First Year
12. How to Handle Preliminary Proxy Statements
13. How to Handle the ‘Non-Compensation’ Proxy Disclosure Items

Register Now for Early Bird Rates – Act by May 31st: For the early bird discount rate, register by May 31st. This Conference is paired with “Say-on-Pay Workshop: 9th Annual Executive Compensation Conference” and they will be held October 8-9th in New Orleans and via Live Nationwide Video Webcast.