Executive Compensation

by Joseph E. Bachelder

This article is reprinted with permission from the
December 1, 2011
edition of the
New York Law Journal.
© 2011 NLP IP Company.

Say-on-Pay: An Update

Thus far during the 2011 proxy season approximately 2500 of the Russell 3000 index companies have reported a Say-on-Pay vote. Say-on-Pay is a nonbinding vote by a company's shareholders on its executive pay program.1 A majority of the votes cast at approximately 98½ percent of these companies was favorable to the executive compensation program at the company. In fact, at the companies with favorable say-on-pay votes an average of 90 percent of the votes cast were in favor of the compensation program under review.

Those favorable votes occurred at the same time that large institutional shareholder advisors such as Institutional Shareholder Services Inc. (ISS) and Glass, Lewis & Co., LLC (GL) were recommending that shareholders vote against executive pay at hundreds of these public companies. ISS recommended negative votes at 340 companies (as of Sept. 1) and GL recommended negative votes at 474 companies (as of June 30).

Approximately 40 public companies have had a majority of votes cast at their shareholder meetings held during 2011 that were negative on executive pay programs. Shareholders at approximately 10 of these companies have brought lawsuits based on these negative votes.

Concerns About Say-on-Pay

While there has been widespread support of say-on-pay by institutional shareholders, institutional shareholder advisors, academics and others, a number of concerns have been expressed about say-on-pay. These concerns include the following:

1. In many cases, say-on-pay is more a say-on-current-stock-performance than it is a say on pay. For example, there is a high correlation between a company's having poor current stock performance and its having a majority of its say-on-pay votes be negative.

2. The "voice" of say-on-pay is really the voice of large institutional shareholders who, in many cases, are short-term shareholders (e.g., mutual funds, which hold shares, on average, less than one year). These shareholders, who own 75 percent of the equity of public corporations, owe no fiduciary duty to other shareholders such as individuals who have invested with long-term goals in mind, including their children's education and their own retirement.

3. Advising these institutional shareholders are institutional shareholder advisors, like ISS and GL. Their advice on say-on-pay is generally included as part of a broader range of proxy voting and advisory services that they provide institutional shareholders. Giving corporate governance advice has become a big business, but these institutional shareholder advisors have no fiduciary duty to the shareholders to whom they are giving their advice on how to vote on say-on-pay. And the criteria they use are often unclear and confusing.

4. It is the compensation committee of the public company holding the say-on-pay vote that has the fiduciary responsibility to see that the executive pay process functions appropriately for the company and its shareholders. In that process the compensation committee addresses many aspects of compensation and corporate management, not all of which are quantitative. Compensation committees, already facing considerable demands on their time, must now reconcile their executive pay decisions with what are often short-term, stock-price-driven views of institutional shareholders and their advisors. It is not surprising that members of compensation committees feel besieged. An illustration of the dilemma is discussed below.

A Look Ahead

ISS has announced criteria2 it will be using in advising shareholders how to vote for the 2012 proxy season. According to its announcement, ISS will look at "Peer Group Alignment" and "Absolute Alignment"—both "quantitative" tests. If not satisfied that there is "alignment" based on these two "quantitative tests," ISS will apply "qualitative tests" (as discussed below).

Following is how ISS describes the "quantitative tests."

1. Peer Group Alignment3 is looked at from two perspectives.

(a) For each company, this perspective involves a comparison of the company's Total Shareholder Return (TSR) rank and its CEO's "total pay" rank within a peer group of companies.4 This comparison is made over one-year and three-year periods.

(b) The second perspective on Peer Group Alignment involves comparison of

• "total pay" of the CEO at the company in question with

• median "total pay" of the CEOs at the peer group of companies

2. Absolute Alignment involves alignment of the company's own performance in terms of change in the "CEO's pay" and the company's TSR over the prior five fiscal years. According to ISS this means "the difference between the trend in annual pay changes and the trend in annualized TSR during the period."

According to the ISS announcement, if the foregoing quantitative analyses (Peer Group Alignment and Absolute Alignment) demonstrate, in the case of any Russell 3000 index company, "significant unsatisfactory long-term pay-for-performance alignment," then qualitative tests will be applied to such a company. In its announcement of the 2012 guidelines, ISS lists six specific standards among those it will consider.5

Comment and Caveat

The author has a problem with the sheer volume of factors that companies (and compensation committees especially) are expected to take into account in evaluating whether they may be subject to a negative vote recommendation by ISS.

Caveat to those companies with less than a 70 percent favorable vote. If a company received less than a 70 percent favorable vote in the prior year's say-on-pay vote, ISS may not only recommend another negative say-on-pay vote but also may recommend votes against individual directors, especially those on the compensation committee, unless ISS is convinced that the company has made a satisfactory response to the negative vote.6

The remainder of the column includes consideration of how say-on-pay relates to the fiduciary duties of directors and will provide an illustration of the type of problem facing directors in taking into account issues raised by say-on-pay. It will conclude with suggestions for directors in the context assumed in the illustration.

Fiduciary Duties of Directors

How does a say-on-pay vote affect the fiduciary responsibilities of directors? Under the "business judgment" rule, a cornerstone of corporate law, directors are insulated from liability in regard to their decisions on the setting of executive pay provided that they: 1) have acted in good faith (including with loyalty); 2) have exercised reasonable care; and 3) have not engaged in "corporate waste" (an extreme circumstance in which there is a failure of consideration for what the corporation is providing). How is this analysis impacted by the enactment of Dodd-Frank Section 951? In theory, the answer should be that there is no impact at all, since Section 951(c)(2) expressly states that the say-on-pay vote may not be construed "to create or imply any change to the fiduciary duties of [the] issuer or board of directors" and Section 951(c)(3) indicates that the say-on-pay vote may not be construed "to create or imply any additional fiduciary duties for [the] issuer or board of directors."

In practice, the legal ramifications of Dodd-Frank are not limited to legal considerations noted in Section 951(c)(2) and (3). A negative say-on-pay vote can be introduced (and, in fact, has been introduced in the current "sue-on-pay" litigation) as evidence of breach of one or more fiduciary duties, which may overcome the presumption of the "business judgment" rule. In fact, in one recent case, NECA-IBEW Pension Fund, Derivatively on Behalf of Cincinnati Bell, Inc. v. Cox, Case No. 1:11-cv-451 (S.D. Ohio Sept. 20, 2011), the court concluded that a negative say-on-pay vote, together with other allegations, provided a sufficient basis for allowing plaintiffs' claim to survive the defendants' motion to dismiss. Although several commentators have expressed the view that Cincinnati Bell represents an anomaly, it is troubling nevertheless. Commentators point out that a negative say-on-pay vote, in and of itself, should not properly constitute sufficient evidentiary grounds for allowing such cases to proceed to trial but the fact is that the law regarding this is not yet settled.

In response to the presence of the say-on-pay vote in the corporate governance process, compensation committees should prepare the record carefully to reflect their consideration of the say-on-pay vote. This should not be limited to cases in which a majority negative shareholder vote occurred.

Problems Facing Committees

Assume a meeting of a compensation committee of a Russell 3000 index company with a calendar fiscal year takes place in February 2012. Also assume the meeting covers three elements of pay for the CEO: setting of salary, finalization of his bonus for 2011 and equity awards. Equity awards will be in the form of stock options and/or restricted stock. (Other elements of the CEO's pay are assumed not to be before the committee and are not included in the following discussion).7

In this illustration, a problem for the committee is that say-on- pay will be a vote on two very different forms of compensation: current compensation (salary and the bonus to be paid in 2012 for 2011) and long-term incentive awards that will not be earned out (if at all) until future years. The proxy statement for 2011, to be distributed in the spring of 2012, will include equity awards made in 2011, a year before, under different circumstances from those the committee faces in February 2012. In fact, the shareholder vote in 2012 will not address the committee's decision in February 2012 to grant long-term awards of stock options and stock awards. (Further complicating the board's analysis of the implications of what it is doing for purposes of the say-on-pay vote, the "dollars" of currently spendable salary and bonus awards are treated by ISS on the same basis as the assumed present value of future-looking long-term awards.)

Another problem for the committee in making stock option and other equity awards at its February 2012 meeting is that in trying to apply the first of ISS's Peer Group Alignment tests, as discussed above, the TSR for 2012 (the year in which it is making its grant) cannot be determined at the time of grant. (It cannot be determined until Dec. 31, 2012).8 In fact, the committee's decision to make payments in February 2012 will not be subject to a say-on-pay vote until the 2013 proxy season (again, under circumstances that the committee in February 2012 can hardly foresee).

Suggestions for Committees

The following analyses are not suggested as part of the disclosure required in the proxy statement. (In the case of some companies, discussion in the proxy statement of such subject matter, in some form, may be necessary. General practice, however, is to avoid discussion in the proxy statement of projected performance, including future stock price.) The analyses described in paragraphs 1-4 below are suggestions to assist the committee in its own thinking at its assumed February 2012 meeting regarding the described long-term awards.

1. The committee should consider preparing an analysis that aligns long-term awards such as stock options and restricted stock with projected TSR for the periods over which they will vest or are otherwise to be earned out. In this connection, the committee could develop alternative rates of growth in company stock value, showing how the values of these awards in the future relate to alternative assumptions as to future stock values (based on TSR under the assumed future stock value alternatives).

2. For long-term awards previously made, using three-year periods ending with the first, second and third years before the year of award, the committee could do the same analysis as described in paragraph 1 and show TSR for each period measured against historic "realizable values" for these long-term awards for each of these three previous periods. This could provide a basis for the committee to explain its thinking regarding the February awards taking into account both historical performance as described in this paragraph 2 and possible future performance as described in paragraph 1.

3. If, in addition to these "alignment issues," there are potential "qualitative issues" (as that term is used by ISS as discussed above), explanations addressing these "qualitative" points should be prepared. For example, does the incoming CEO have a contract providing for a large non-performance based stock option grant (e.g., a "make-whole" grant for options forfeited at his prior employer)? Are there special perquisites covered by existing agreements? There may be legitimate reasons for these existing agreements and for continuing them, at least at the present time. These should be explained.

4. The analyses in paragraphs 1 to 3 should take into account the prior year's say-on-pay vote and any relevant comments in connection with that vote made by shareholders and/or their advisors.


1. The say-on-pay votes, as described in the column, are votes required under Section 951 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, §951, 124 Stat. 1376, 1399 (2010). The Final Rules adopted by the SEC are found in SEC Release No. 33-9178 (Jan. 25, 2011). For prior discussions on say-on-pay developments, see this column (NYLJ) June 19, 2009, Aug. 26, 2009, June 28, 2010, and Aug. 25, 2011.

2. The criteria discussed in the text are contained in an announcement by ISS dated Nov. 17, 2011, titled "U.S. Corporate Governance Policy—2012 Updates." In the introduction, the report indicates that the new policies (presumably including those referring to executive pay) will be effective for meetings "on or after Feb. 1, 2012." The author has not reviewed any similar announcements for 2012 that may have been made by GL or other institutional shareholder advisors.

3. In its Nov. 17 announcement (see Footnote 2 above), at p. 9, ISS has revised its definition of "peer group." The range of companies has increased from 8-12 to 14-24, and companies are to be "selected using market cap, revenue (or assets for financial firms), and GICS industry group…."

4. ISS appears to use the following definitions of "TSR" and "total pay" for purposes of its analyses:

(a) "TSR": For the applicable performance period: the annualized rates of return reflecting price appreciation plus reinvestment of dividends (calculated monthly) and the compounding effect of dividends that would be paid on reinvested dividends. For discussion, see http://www.issgovernance.com/policy/CompanyFinancialsFAQ

(b) "Total pay": In its use of the term "total pay" ISS generally appears to mean the compensation covered by the Summary Compensation Table in the proxy statement. The items in the Summary Compensation Table that make up "total pay" are: Salary, Bonus, Stock Awards, Option Awards, Non-Equity Incentive Plan Compensation, Change in Pension Value and Nonqualified Deferred Compensation Earnings and All Other Compensation.

5. These specific qualitative tests, together with a statement that ISS will consider "any other factors deemed relevant," are contained at page 10 of the Nov. 17 announcement (see Footnote 2).

6. According to its Nov. 17 announcement (see Footnote 2), at p. 8, ISS, in the case of a less-than-70 percent favorable vote, will consider various circumstances in determining whether to recommend another negative vote and/or a vote against certain directors. These circumstances include the extent to which the company has engaged in discussing the say-on-pay issues with major institutional investors, whether special actions have been taken to address points receiving low levels of support from shareholders, whether the issues involved were recurring or isolated and other circumstances noted at page 8 of the announcement.

7. The author expresses his appreciation to Charles G. Tharp, president of the Center on Executive Compensation, for ideas in connection with Section D. As noted in the text, the example does not include all components of the CEO's "total pay" within the meaning of say-on-pay. For discussion of the meaning of "total pay," see Footnote 4 above.

8. For further discussion of this and related points, see Letter from the Center on Executive Compensation to Martha Carter, Chair, Global Policy Board, ISS (Nov. 7, 2011) (http://www.issgovernance.com/files/Comment-44.pdf). It is also noted that comparing TSR among companies that have different fiscal years further confuses the Peer Group Alignment test in its use of TSR as one of the metrics.