Annual Say-on-Pay: The Path of Least Resistance May Not be the Path to Success

For U.S. companies that began holding say-on-pay (“SOP”) and say-on-frequency (“SOF”) votes in 2011, the 2017 proxy season begins a new six-year cycle on SOF. In 2017, most public companies will, for at least the second time, formally ask their shareholders how often the SOP vote should occur by holding an SOF vote. If numbers hold, the overwhelming answer for most companies is likely to be annual frequency. Through May 2015, shareholders at over 80 percent of the Russell 3000 companies have expressed their preferences for annual SOP voting.

But is an annual SOP referendum really the right approach for all companies? Or is this simply just the safest approach?

While there are strong arguments for annual SOP voting, we believe annual voting can contribute to short-term thinking by management and boards, as well as detract from long-term interests and goals. A triennial SOP vote, on the other hand, better supports a longer-term focus that aligns company performance and executive pay. It allows the typical three-year long-term performance plans to play out with ample time for management, the board, and stockholders to fully evaluate whether pay practices support long-term strategies.

We acknowledge that annual SOP is the most conservative approach for board members, as it reduces the risk of an “Against” vote for the compensation committee or the board. We also recognize that the annual cadence of SOP voting has served to put pressure on some of the more egregious executive compensation policies and practices, such as excise tax gross-ups. Nevertheless, we believe the time is ripe for companies and their boards to have a robust debate about the pros and cons of triennial SOP for the reasons discussed below.

Annual SOF: The Trend So Far

Under the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”)[1], the SOF vote is required in the first year that SOP applies, and is then required at least once every six calendar years thereafter. The SOF vote allows shareholders to indicate a preference for voting for one, two, or three year periods between SOP votes (or to abstain from voting). Because 2011 was generally the first year of SOP voting, most public companies will now be putting SOF up for a vote in their 2017 proxies.

Annual SOP voting has clearly been the preference of shareholders to date. Since inception in 2011 through May of 2016, over 80 percent of the Russell 3000 companies reported their shareholders voting in favor of annual SOP.

Since 2011, most companies have put their SOF up for a vote to shareholders only once. Through May of 2016, fewer than 100 of the Russell 3000 companies have had multiple votes on SOF.

Of the companies that have held multiple votes, there hasn’t been a lot of change in the results. Sixty-six percent of the companies that have held multiple votes on SOF reported no change in preference, and twenty-seven percent reported a new preference for annual frequency. Only seven percent reported a new preference for three-year frequency, and no companies’ shareholders changed preference to two-year SOP voting.

Looking Behind the Arguments for Annual SOF

Annual SOP Voting is the Safer Bet

Undoubtedly, annual frequency is the path of least resistance. Institutional shareholder proxy advisory services, such as Institutional Shareholder Services (“ISS”) and Glass-Lewis, believe it’s the right approach and generally recommend a vote against any SOF proposal other than annual voting.

Proxy advisory services are not alone in the views they express about this. Current governance guidelines posted for most institutional investors express a preference for annual SOP voting; the Counsel of Institutional Investors recommends annual SOP votes in its Corporate Governance Policies. There are, however, a few influential investors, including BlackRock, Capital Research, Dodge & Cox, and Northern Trust, that have expressed a preference for triennial SOP voting.

Risk adverse management and directors tend to prefer annual SOP voting. Advisors are quick to point out that, not only is it the general view that an annual SOP cadence is a “good governance” practice, annual voting has the added benefit of protecting board members from being fired by disgruntled shareholders. The alternative to annual SOP voting is for shareholders to vote against or abstain from voting for compensation committee members in the re-election process.

However, we think this thinking may be too short-sighted.

Annual SOP has Influenced Recent Changes to Executive Pay

Proponents of annual SOP voting also argue that it has empowered boards and forced a number of recent and positive changes in executive pay. For example, in the last decade, tax gross-ups have all but disappeared as stockholders have expressed disagreement with these provisions through formal voting policies and engagement encouraged by SOP. Similarly, double-trigger equity grants (i.e., those requiring both a change-in-control [CIC] and termination for vesting) have replaced single-trigger equity grants (i.e., where vesting occurs at CIC).

However, annual proxy disclosures now often highlight executive pay practices using language intended to provide the “right story” to institutional advisors and governance groups so that standard governance checklists can be completed with the proper responses (think of the lists found in many proxies nowadays listing “what we don’t do and what we do do”). While many of the pay practices described might be considered best practices, strict adherence fails to demonstrate anything other than “group think” and can result in one-size-fits-all pay programs.

The SOP Conversation Has Shifted—and Become More Robust

When companies engage stockholders on their pay programs, the conversation has shifted from revising poor pay practices (think single-triggers and tax gross-ups) to aligning pay for performance and levels of pay. This conversation will continue to evolve as pay-versus-performance (“PVP”) disclosures soon to be required under SEC rules allow a somewhat consistent analysis across companies.

Annual SOP votes have effected policy changes. But programmatic changes take time to play out.

Pay-versus-performance disconnects are the primary reason companies receive “No” recommendations and/or fail SOP. Current analysis by institutional proxy advisors are blunt instruments that usually fail to assess the adequacy of pay programs. If a company performs well relative to peers, companies are, in practice, given a pass on their pay programs, while companies performing poorly relative to peers can be unfairly punished by institutional advisors irrespective of their pay programs. These results are further complicated by comparisons by institutional advisors that use peer groups that may not always reflect the company’s end markets.

The Case for Triennial Voting

A Triennial Cadence Better Matches Long-Term Performance and Plan Design

Long-term plans are meant to reward long-term performance and, as a result, these types of plans should not be changed frequently. The most prevalent long-term performance cycle is three years, and a triennial SOP vote matches up well with most companies’ performance periods.

Obviously, if a company’s habit is to change the design of their long-term programs regularly, the annual SOP vote would be the more appropriate approach. However, absent unusual circumstances, we do not believe frequent changes to long-term plans to garner shareholder support are in the best interest of any party.

Pay-for-Performance is Not a Short-Term Analysis

The vast majority of long-term performance based plans have a three-year performance period. Long-term incentives make up more than half of an executive’s compensation. While the pay-for-performance relationship is backwards looking, if a company makes changes to improve a plan, the results of these revisions will not be apparent for as many as three years. What value does annual SOP voting have while participants, boards, and shareholders wait for results to be known?

A triennial SOP vote allows both the board and shareholders the time to assess the pay-for-performance relationship.

SOP is Often Just a Referendum on a Company’s Stock Price

Unfortunately, due to proxy adviser influence, SOP results have become a function of granted pay levels (reported in the Summary Compensation Table) and relative three-year total shareholder return (TSR) compared to a group of companies with similar industry sector codes (e.g., GICs codes). This is unfortunate on a number of levels. Companies may be rewarded or punished if their business cycles differ from a group of companies that happen to be categorized together but have, in fact, substantially different end markets.

While a triennial SOP vote is subject to the same year-end stock price as an annual SOP vote, it isn’t an annual analysis, allowing focus on long-term goals and performance rather than on annual year end stock price results.

It Takes More Time than One Year for Change to Occur

The SOP vote is a referendum on pay decisions that are, when voted on, at least a year old. For example, the 2016 SOP vote for calendar year companies reflect a vote on compensation through 2015. While many companies detail changes made in the current year (2016 in this example) prior to the proxy filing date in their disclosures, such changes reported are limited at best and without the benefit of performance detail.

Any changes that results from the SOP vote will be reflected in the following year proxy, but only to the extent the company chooses to disclose those, as changes may not be fully implemented prior to filing the following year proxy.

A triennial SOP vote allows enough time for shareholders to reflect on the changes a company has made to its compensation programs, as well as enough time for the revised plans to play out.

Triennial SOP Voting Allows Stockholders Time for Thoughtful Analysis

While many large institutional investors have increased their governance staffing, the workload is usually too large for an in-depth analysis. Many “outsource” their SOP vote to proxy advisers. For a fee, these advisers recommend how the shareholders should vote and provide a report explaining the basis for the recommendation.

A vote based on the proxy adviser’s recommendation does not mean the shareholder understands the reasons underlying the executive pay decisions at the particular issuer. A triennial SOP reduces the workload for shareholders by two-thirds. Stockholders can then annually look for egregious pay practices and decide if these practices warrant a stern conversation with the company or board, or something more drastic such as a “Withhold” or negative vote on the compensation committee chair and/or committee members.

While larger companies may get adequate attention in shareholder outreach annually, smaller companies often do not. During proxy season, smaller companies can have a difficult time getting the attention of their larger stockholders, or even getting a return phone call. While this may be a function of the company failing to develop the proper relationship with stockholders prior to proxy season, the workload for many corporate governance staff is simply overwhelming.

Final Thoughts

The annual SOP frequency adopted by a majority of public companies since 2011 has served its purpose by applying pressure to egregious policies and practices (e.g., single-trigger CIC equity vesting, excise tax gross ups, etc.) that can be quickly assessed and addressed. Now that this low-hanging fruit has been substantially picked, the focus of SOP evaluations has shifted primarily to the relationship between pay and performance. Accordingly, the frequency of SOP voting going forward should similarly shift from annual to triennial, reflecting a more appropriate time frame for assessing pay and performance alignment and for making any substantive changes to program design needed to achieve stronger alignment. Since 2017 is the year that most companies will reset the frequency of SOP voting for the next six years, we encourage companies, boards, and stockholders to (a) move away from the established market majority practice of annual SOP voting, (b) reject the current views and preferences of the proxy advisory firms for annual SOP voting, and (c) recommend triennial say-on-pay voting for the next six-year cycle. In doing so, we believe that the benefits will outweigh the risks and are supported by sound corporate governance principles.

[1] Pub. L. No. 111-203, §951, 124 Stat. 1376, 1899 (2010)