by Joseph E. Bachelder
This article is reprinted with permission from the
July 3, 2012
edition of the
New York Law Journal.
© 2012 NLP IP Company.
Institutional Shareholders and Their ‘Oversight’ of Executive Compensation
Today's column addresses the increasing influence of institutional shareholders on executive pay. Prior columns have examined the role of proxy advisors in giving advice on how shareholders, especially institutional shareholders, should vote on say-on-pay under Dodd-Frank Section 951.1 Today's discussion focuses on the institutional shareholders themselves.
While institutional shareholders own a major portion of the share value of U.S. public corporations, the "ultimate owners" are, to a large extent, millions of individuals for whose benefit the equity in these corporations is being held by the institutional shareholders. (These individuals will be referred to in the column as "ultimate owners.")
The original setting-aside of the assets that are the source of these investments is made by the individuals themselves or by others on their behalf (such as by their employers). These assets of the ultimate owners are being held for purposes such as educating children, providing for retirement, protecting against casualty and providing health and life insurance.
In the 1950s it was estimated that institutional shareholders held shares representing approximately 10 percent of the wealth invested in publicly traded corporations. By 1990 these estimates were approaching 50 percent. Today, estimates are that approximately 75 percent is in the hands of institutional shareholders.2
Many of the institutional shareholders hold the shares in which they invest for relatively short periods. Institutional shareholders as a whole (excluding high-frequency traders) hold the shares in which they invest for periods that appear to be in the range of 1.5 years.3 Of course, some large institutional shareholders such as major pension funds may hold many of their stockholdings for longer periods. (In a sense, such large institutional shareholders may be "locked in" if they have significant holdings in a single company due to the adverse impact on the market of selling significant amounts of that company's stock at one time.) On the other hand, the average holding period of many shares held by institutional shareholders such as mutual funds and hedge funds is less than 1.5 years.
Many institutional shareholders are under pressure from their own shareholders or unitholders (many of them are other institutional shareholders) to dispose of stocks that appear at a particular point to be underperforming. Such shareholders or unitholders often have short-term investment horizons. This reflects an investor mentality that at least one commentator has described as "quarterly capitalism."4 A 2010 report in a UK financial journal states: "A veteran UK money manager complains that 'fund managers—even seasoned ones—are under intense pressure from colleagues and clients if they experience a string of two to three quarters of underperformance.'"5
Today, in many instances, there are layers of institutional shareholders between the ultimate owners and the public corporations in which investments are made on their behalf. (These public corporations will be referred to as "investee companies.") In 1932, Adolf Berle and Gardiner Means expressed concern about the increasing distance between the millions of individuals who owned, as shareholders, the investee companies and the managers who ran those companies.6 Today, the shareholders of these investee companies, as already noted, are largely institutional shareholders, and the millions of individuals, whom we describe in this column as the ultimate owners, have been pushed "up the chain" away from the investee companies by intermediate levels of investment managers. This has weakened the chain of accountability between the investee companies and the ultimate owners.
A legitimate question may be asked regarding the effectiveness of the "oversight" that institutional shareholders can give to the subject of executive pay. Do they really understand the highly complex circumstances involved in executive pay decisions at investee companies? One very thorough and prestigious report on the subject of institutional investors and corporate governance (published under the joint sponsorship of the Yale School of Management and the Committee for Economic Development) states the issue as follows:
It cannot be that major institutional investors have the same kind of intense role as the board of a corporation in defining the company's mission in the dimensions of performance, risk and integrity; in its articulation of key metrics for operations across the performance, risk and integrity dimensions; in its detailed compensation for top leaders and in its focused oversight consistent with mission and metrics.7
Executive pay decisions include, among other things, (i) performance of individual executives, (ii) appropriate and competitive pay for each executive, (iii) internal equities among executive positions at the company, (iv) appropriate design of compensation programs in motivating executives at the company (including, among other things, the appropriate mixes of short-term and long-term incentives), (v) succession planning, (vi) promotions, (vii) retaining executives receiving competitive offers and (viii) attracting executives from other companies.
In addition to these factors, obviously the performance of the corporation, short-term and long-term, must be taken into account in determining appropriate executive pay at each company. This factor includes much more than simply taking a look at current stock market performance. Corporate performance includes operating earnings, financial soundness of the company, setting and implementing appropriate corporate strategies and many other criteria. Total Shareholder Return (TSR) (meaning, for this purpose, stock gains (or losses) plus dividends) for a fiscal period is one, but only one, of the many considerations in evaluating corporate performance.
Unfortunately, TSR has become a dominant measure in the thinking of institutional shareholders, and their proxy advisors, regarding executive pay. To a significant extent, a stock performance metric has been substituted for the numerous and often complex considerations, as outlined above, necessary to evaluate executive pay programs at investee companies.
The data on say-on-pay votes indicates a correlation between TSR and institutional shareholder thinking on executive pay. (As of the writing of this column, 51 of the Russell 3000 companies holding say-on-pay votes during the 2012 proxy season had received negative votes. Of these 51 companies, 42 had negative TSR for their last fiscal year.)8 The consulting firm of Towers Watson studied the say-on-pay votes of approximately 1,500 companies reporting during the 2012 proxy season. It examined their TSR for 2011 as well as for the three-year and five-year periods ending in 2011.9 Towers Watson then created a subset of these companies which it divided into three categories: "overperformers," "neutral performers" and "underperformers."
"Overperformers" were those companies who were in the top quartile of TSR for each of the one-year, three-year and five-year TSR periods (all ending in 2011). "Underperformers" were those in the bottom quartile of TSR for each of those periods. "Neutral performers" were those companies that for all three TSR periods (one, three and five years) were in between the 25th and the 75th percentile (i.e., neither in the top quartile nor in the bottom quartile for any of the three TSR periods). The number of companies falling into these three categories (overperformers, underperformers and neutral performers, as defined) totaled approximately 350. Based on this data, Towers Watson reports that:
(i) there were no negative say-on-pay votes for the "overperformers" (the top quartile of companies as noted above); and
(ii) "[u]nderperforming companies are about nine times more likely to fail their Say-on-Pay votes than even neutral performers, let alone top-performing companies."
A sporting metaphor would be that of a poll of hometown football fans after an NFL football season asking them to vote on whether the pay of the hometown team was appropriate. The percentage of "no" votes surely would depend, at least in part, on whether the season for the home team was a winning or losing season, and by what margin. It is doubtful that the fans would have much information on which to judge the reasonableness of the compensation arrangements with the team members, individually or as a group.
There are a number of concerns with institutional shareholder "oversight" of executive compensation:
• Many institutional shareholders (with exceptions noted above) do not have a "long-haul" investment interest in investee companies. This is bound to impact on their view of executive pay, as expressed in their voting on say-on-pay at investee companies and, in turn, to influence the management of those companies.
• Another concern, noted above, is the "distance" of institutional shareholders from the specifics of pay decisions. Do they really know enough about executive pay at an investee company to make sound judgments on it? (One might call it "mezzanine oversight," like that of audiences in the mezzanine of a theater—they come and go, watching each performance "from above.") Institutional shareholders cannot have the close, personal and constant contact with an investee company that a Board of Directors does.
• A board of directors of an investee company has a fiduciary duty to all shareholders of that company. Institutional shareholders, on the other hand, have increasing clout but no fiduciary duty to other shareholders of the investee company. In fact, it is unclear what duties they owe their own shareholders in their oversight of pay practices at investee companies.
• On June 20, 2012, the British Business Secretary, Vince Cable, announced a new say-on-pay program which, if enacted, would make say-on-pay votes on executive pay policies in the UK binding. This would raise the level of institutional shareholder impact on executive pay at investee companies in the UK from that of a non-binding advisory vote to that of direct control over key elements of executive pay.10 The author of this column hopes that the UK does not enact this proposed law but, if it does, he hopes that it does not "export" it to the United States. Adoption of such a rule would exacerbate all the other concerns expressed here about institutional shareholders' involvement in executive pay decisions.
• Institutional shareholders' conflicts of interest regarding say-on-pay have been cited frequently. As one example, a short-term institutional shareholder that wants to cash out at a specific price is not necessarily in support of pay programs that are designed to encourage long-term rather than short-term results. This is just one example of a broader issue: Many institutional shareholders in voting on say-on-pay may have their own agenda, unrelated to good corporate governance practices at the investee company.
The following are suggestions on how to reduce the impact of "mezzanine oversight" on executive pay:
• To the extent not already disclosed, the compensation paid to institutional shareholders' top executives, including those responsible for relationships with investee companies, should be disclosed. This would enable the public to determine whether the institutional shareholders' goals and compensation systems are aligned with investee company performance (both short- and long-term) and with the interests of the ultimate owners of the investee companies.
• Consideration should be given to implementing a rule in connection with say-on-pay votes (whether by legislation or regulation) that "weights" each institutional shareholder's vote as to each investee company based on the institutional shareholder's period of holding the shares in the investee company. For example, if an institutional shareholder has held stock three or more years those shares should count more in a say-on-pay vote than shares held for less than one year.
• Congress should consider resetting say-on-pay votes to a cycle of once every two years in all cases. This would give investee companies, in consultation with institutional shareholders, the opportunity to "digest" the result of a say-on-pay vote and to respond to it, where a response is indicated, in a meaningful way.
• Consideration should be given to requiring institutional shareholders to disclose the criteria on which they base their vote as to each investee company. It is important for the public to understand whether a particular institutional shareholder is looking only (or even primarily) to TSR in casting its vote. If it is simply rubber-stamping the proxy advisor's recommendations, that should be made apparent.11 And a proxy advisor should be required to make public disclosure of its report on each investee company no later than 10 days after the investee company's annual shareholders' meeting.
• In a release issued in March, Institutional Shareholder Services (ISS) stated that it "has long been offering draft analyses to S&P 500 companies prior to issuing its final vote recommendations." It would be helpful if a proxy advisor like ISS would give each investee company (not just those in the S&P 500) on which it is issuing a report the opportunity to discuss a draft of its proposed criticisms and recommendations before the final report is issued by the proxy advisor to its institutional shareholder clients.12
• Investee companies should consider providing shareholders who own 1 percent or more of an investee company's shares for at least one year the opportunity to participate with compensation committee members in a "town hall" meeting held once a year.
1. Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, §951, 124 Stat. 1376, 1899 (2010). Dodd-Frank Section 951 amended the Securities Exchange Act of 1934 by adding Section 14A (codified as amended at 15 U.S.C. §78n-1). For prior discussions of say-on-pay developments after Dodd-Frank, see NYLJ columns, Aug. 25, 2011, Dec. 1, 2011, and March 23, 2012.
2. See "The 2010 Institutional Investor Report: Trends in Asset Allocation and Portfolio Composition, published by the Conference Board (November 2010), available at http://www.conference-board.org/publications/publicationdetail.cfm?publicationid=1872. This report (at page 27) indicates that, as of 2009, the average institutional shareholder equity ownership at the top 1,000 U.S. corporations was approximately 73 percent. The report also gives a breakdown of the percentages of ownership according to certain categories of institutional shareholders.
3. Many commentators indicate a much shorter holding period for shareholders generally (that is, both institutional and individual shareholders). See, for example, Dominic Barton, "Capitalism for the Long Term," Harvard Business Review, March 2011 (seven months); John C. Bogle, "Restoring Faith in Financial Markets," Wall Street Journal, Jan. 19, 2010 (five months); and Ben W. Heineman, Jr. and Stephen Davis, "Are Institutional Investors Part of the Problem or Part of the Solution?" published by the Millstein Center for Corporate Governance and Performance at the Yale School of Management and the Committee for Economic Development (Oct. 3, 2011) (seven to nine months, an observation only as to shareholders on the New York Stock Exchange), available at http://millstein.som.yale.edu/sites/millstein.som.yale.edu/files/80235_CED_WEB.pdf. These reports are based on total trading volume, which includes high-frequency trading (i.e., trades that involve holding periods from a few seconds to a few hours and, for the most part, are by traders who "end the day" with their investments virtually liquidated). Published estimates of the percentage of total trading volume on today's stock exchanges that involve high-frequency trading is approximately 70 percent. See Barton above. The holding periods of the other 30 percent of shareholders (i.e., those not engaging in high-frequency trading) may be estimated, using the following steps:
(a) Assume the ratio of institutional shareholders to individual shareholders is 3 (institutional) to 1 (individual), as noted in the text.
(b) Assume seven months as the average holding period for all trades. If one takes out high-frequency trading, then the average holding period for the remainder is approximately 23 months.
(c) Using a range of estimated ratios (we used 2:1 to 5:1) for the relative holding periods of individual shareholders versus institutional shareholders and assuming 23 months as the average holding period for individual and institutional shareholders combined, we determined a range of holding periods for institutional and individual shareholders. On this basis, the average holding period for institutional shareholders is estimated to be approximately 1.5 years.
Obviously, such a calculation produces only an approximation and does not take into account the considerable variations among different institutions in the institutional shareholder group.
4. See Barton, supra note 3, at p. 87. ("[P]erhaps the biggest danger to capitalism is that short-term approaches to running and investing in companies—the 'quarterly capitalism' responsible for the near-meltdown of the financial system—still reign.")
5. Simon CY Wong, "Why Stewardship Is Proving Elusive for Institutional Investors," Butterworths Journal of International Banking and Finance Law, July/August 2010, at p. 407.
6. See Adolf A. Berle and Gardiner C. Means, The Modern Corporation and Private Property (1932).
7. Heineman and Davis, supra note 3, at p. 28. For discussion of this issue in the context of corporate governance generally, see "Overcoming Short-Termism: A Call for a More Responsible Approach to Investment and Business Management," published by the Aspen Institute (Sept. 9, 2009), available at http://www.aspeninstitute.org/publications/overcoming-short-termism-call-more-responsible-approach-investment-business-management; Wong supra note 5, and Barton, supra note 3.
8. See "2012 Say on Pay Results—Russell 3000," published by Semler Brossy (June 27, 2012), available at http://www.semlerbrossy.com/wp-content/uploads/2012/06/SBCG-SOP-2012-06-27.pdf.
9. See Robert Newbury and Jim Kroll, "Say-on-Pay Update: Paying a Price for Poor Performance," published by Towers Watson (June 5, 2012), available at http://www.towerswatson.com/blog/executive-pay-matters/7187.
10. See UK Department for Business, Innovation and Skills, "Government announces far-reaching reforms of directors' pay" (June 20, 2012), available at http://news.bis.gov.uk/Press-Releases/Government-announces-far-reaching-reforms-of-directors-pay-67b96.aspx.
11. See Letter from International Business Machines Corporation to the Securities and Exchange Commission, "Re: Concept Release on the U.S. Proxy System," dated Oct. 15, 2010, available at http://www.sec.gov/comments/s7-14-10/s71410-84.pdf. In the Letter, IBM states: "For IBM, an estimated 13.5 percent and 11.9 percent of the total votes cast in each year were cast lock-step with ISS' recommendations within one business day after the release of ISS' report on IBM in 2009 and 2010, respectively. By comparison, for the previous five business days, no more than 0.20 percent and 0.27 percent of the total IBM votes were cast in any one day in 2009 and 2010, respectively." After noting the fact that "a significant number of shares held by institutions are voted in a lock-step manner (i.e., 100 percent) in accordance with ISS recommendation" IBM concluded that this constituted "evidence of de facto control by ISS of these votes and how institutional holders outsource their voting decisions to ISS."
12. Institutional Shareholder Services Inc., "Institutional Shareholder Services Raises the Bar for Transparency and Responsiveness—Establishes New Feedback Review Board" (March 29, 2012), available at http://www.issgovernance.com/press/frb.