New Investor Power
Companies waiting until proxy season to engage investor issues may find themselves scrambling to address concerns that have been festering for months.
Imagine a company that always waited until a product was launched before finding out why customers would or wouldn’t buy it. Or a company that started its tax planning in the last two weeks of the tax year. Highly unlikely. Yet when it comes to shareholders, most companies wait until the hectic proxy season to engage the concerns of these powerful stakeholders.
The shift in power from management to shareholders is inexorable and, most recently, has been furthered by the 2010 Dodd-Frank Act. The era of the proxy process as an annual rubber-stamping ritual of a company’s policies and actions has passed.
Investor actions on a myriad of issues such as Say on Pay (SOP) and Say on Frequency (SOF) are growing. Investor concerns aren’t seasonal. Trying to influence or change investor votes during proxy season is risky at best. It is too late in the game to capture investors’ attention and change their minds. Companies need to engage shareholders systematically throughout the year to understand and address their concerns.
Companies May Have Gotten a Break in 2011
By many broad measures, it might seem as though the 2011 proxy season passed without the storms that SOP and SOF votes threatened. Most executive pay plans were approved, even the majority of plans that received negative recommendations from proxy advisers. According to the global law firm Latham & Watkins, only 2% of the companies that filed proxy statements by June 23, 2011, failed SOP votes — 71% of the Russell 3000 secured more than 90% approval.
However, the 2011 proxy season may not have fully reflected the depth of investor sentiment and the pressure that investors will continue to apply. Research conducted by FTI Consulting (“What Are Investors Saying About Say-On-Pay?” February 2011) found that investors viewed SOP votes as more than an issue of pay. Many saw SOP as a referendum on company and executive performance and a forum to air their displeasure. This past year, investors had to digest thousands of compensation packages. We suspect that they didn’t have sufficient time to fully digest the implications of SOP and SOF. Nevertheless, their strong preference for annual SOP votes clearly indicates a desire to keep management on a tight leash. We expect investors to keep leveraging their newly acquired rights — and for them to be better prepared to do so in the future.
Companies were not sufficiently prepared for SOP and SOF votes either. Many were surprised by shareholder pushback and negative recommendations from the proxy advisory firms. A key factor in the negative recommendations was a disconnect between compensation and performance as measured by total shareholder return. A prominent financial services company, for example, received a recommendation against the chief executive’s pay. Although it finally passed, it did so with less than 60% of the vote. And three other management recommendations (of eight) were thwarted.
The 2011 proxy season did not fully reflect the depth of investor sentiment and the pressure that investors will continue to apply.
Other companies with negative recommendations passed the vote. But average support was only 72% vs. 92% for those with a favorable recommendation. Companies with pay/performance disconnects and subpar shareholder support (70% is generally regarded as the inflection point) are essentially “on notice.” Support for their SOP votes could erode next year if management doesn’t discover and remedy the issues.
It is important to note that although SOP and SOF votes are “advisory,” they have teeth. Their influence extends into boardrooms and legal domains. Negative investor sentiment on SOP can be directed at compensation committee directors. To wit, at companies where SOP votes failed, these members garnered an average of 13.5% fewer votes than other directors on the ballot. Furthermore, losing a vote on pay can expose a company to damaging litigation. Four companies that failed to secure SOP approval had shareholder derivative lawsuits filed against them, alleging breach of fiduciary duty and corporate waste.
More Investor Concerns Are Brewing
Historically, strong recoveries following recessions have generally produced a calming of the public mood and dissipation of the rancor previously targeted at those institutions perceived to be poor corporate citizens. Given the muted economic recovery, corporate performance may not sustain its current pace, fracturing business confidence and undermining shareholder returns. Public angst, represented by the Occupy Wall Street protests, along with regulatory agency actions and government legislation, may continue to influence investors and drive demands for more influence over corporate affairs.
Some areas to watch
Oversight of Political Spending
Support for disclosure and oversight of corporate political spending is surging on the heels of the 2010 U.S. Supreme Court Citizens United decision. While a high-profile proposal at Home Depot was soundly defeated, a corporate political disclosure and accountability resolution captured a majority vote — at Sprint Nextel the resolution passed with 53% of votes cast. Close on these heels, resolutions from the U.S.-based Center for Political Accountability, which requires companies to divulge details of their political contributions, gained more than 40% of the vote at the annual meetings of four more companies. Proposals concerning the oversight of political spending are multiplying, and support for them is rising:
- In the first half of 2011, according to Institutional Shareholder Services, shareholders filed 78 proposals seeking disclosure and oversight of corporate political spending, up from 48 during the first half of 2010.
- According to the Council of Institutional Investors, the average support for the 39 proposals that came to vote as of June 2, 2011, was 31%. Six years ago it was 9%.
While not enacted as planned by the Securities and Exchange Commission, proxy access is back. Companies will have to allow shareholders to submit proposals requesting that the board implement proxy access or that the company’s bylaws be amended to implement proxy access.
The consequences are difficult to anticipate. It is likely that some companies will be targeted by investors in 2012, particularly poorly performing ones with long-standing governance issues or those with weak or shareholder-unfriendly boards. The chairman of the SEC supports broad-based proxy access, so there might be further developments.
For most companies the window for shareholder proposals opens in November. The next few months should provide some visibility into whether activists will avail themselves of this opportunity. Given the time lines for distributing proxy materials, managements will not have much time to evaluate and craft responses to these proposals. Companies that might be vulnerable should preempt the situation — they should start the process early and be prepared to respond if necessary.
Environmental Sustainability Measures
Investor concerns over corporate responsibility and the environment have been nascent for some time. It is difficult to know when an idea reaches an inflection point and becomes front and center, but these topics may have already done so:
- A record 109 proposals were filed with 81 companies in the United States and Canada during the 2011 proxy season.
- Ernst & Young reported that corporate social responsibility proposals grew to 40% of all shareholder proposals in 2011, vs. 30% in 2010.
Other issues on our watch list include:
- Shareholder actions by written consent
- Shareholder power to call special meetings
- Forthcoming SEC regulations on the ratio of CEO pay to median employee wages (which are strongly supported by the public sector, unions and socially responsible investors)
Although shareholder proposals on these topics are generally rejected, a few have passed and may be indicative of growing support. We expect that more will pass.
Many corporate governance protocols being implemented in the United States, such as SOP, were adopted in Europe years ago. Companies should be attuned to developments in the European Union. The United Kingdom is instituting the Stewardship Code, requiring institutional investors to attest to their responsibility for the companies in which they invest. A key provision of the Corporate Governance Code requires annual re-election of all directors. Gender balance on boards is being debated, and the European Commission is examining how corporate governance overall can be improved.
Keeping Shareholders onBoard
It’s essential that companies engage shareholders throughout the year to address concerns. Ongoing engagement can yield dramatic improvements to a company’s credibility with investors, as the Dow Chemical Co. experienced between 2008 and 2011.
Dow was hit by a near “perfect storm” of events that shook investor confidence and drove its stock price down 60% from late 2008 to the market bottom in early 2009. Immediately upon Dow’s commitment to the large and transformational acquisition of Rohm & Haas, the global economy plunged, causing uncertainty in the credit markets, unprecedented low demand for chemical products and ultimately the collapse of a $17.4 billion joint venture in Kuwait just 48 hours before its expected close.
To rebuild investor confidence and build support for the transformation story, Dow launched an investor engagement program. Milestones for execution were laid out, and as each one was met, Dow communicated to investors that it was following through on its near-term strategic objectives and executing ahead of schedule. As performance strengthened, the company expanded its dialogue with investors and the media to include the more innovative aspects of the company’s transformation and to highlight the growing investment and value of its R&D portfolio, which long-term would play a major role in the company’s transformation. To ensure that Dow’s message was resonating with investors, the investor relations team regularly measured the impact of its communications on different stakeholder groups and refined the message when needed. The team also provided greater transparency through more detailed operating information, access to more of the company’s leadership and use of more pervasive, digital communications methods. Dow ultimately succeeded in restoring investor confidence — its stock price recouped the losses of late 2008, and 87% of Dow’s shareholders approved of the company’s executive compensation, a strong endorsement.
Few companies manage investor sentiment as well as this, and yet many could easily do much better. In our experience, companies that build investor confidence and manage their concerns follow these practices and recommendations:
Understand the Company’s Points of Vulnerability
The 2011 proxy season provided a number of indicators of what investors view as good practices regarding compensation. Highly desired: transparent disclosure of how compensation is determined, performance-based compensation and longer vesting periods. Large severance payments and “golden parachutes” are objectionable (McCahery and Suatner, Tilberg University research paper). Ahead of the next proxy season, companies should analyze their compensation plans to identify disconnects between pay and performance and identify best practices.
The 2011 proxy season provided a number of indicators of what investors view as good practices regarding compensation.
Understand the Composition and Sentiment of the Shareholder Base
It is critical to know which shareholders are influenced by proxy advisers. Companies should target new shareholders who have a history of filing proposals or who take social issues into account when investing; in particular investor classes most likely to take their governance grievances public, such as socially responsible investors; activists; foundations; faith-based organizations; special interest groups; and state, municipal and union pension funds. Companies can also revisit the 2011 votes to identify the active shareholders and determine where the company’s responses were weak.
Work with the Proxy Advisers
If a company received a negative recommendation on SOP from the proxy advisers, it should consider engaging with them during the off-season to make its case. Companies subjected to inappropriate peer group comparisons, incorrect compensation calculations or any other inaccuracy should attempt to resolve the issues. An early resolution or correction is less stressful than tackling the issue during proxy season.
Companies should engage shareholders and stimulate a dialogue on policy changes and the reasons driving them. Management should put mechanisms in place to hear investor concerns and respond with communications that explain decisions and demonstrate that it listens to investors. If shareholder sentiment on an issue is strong and broad-based, management should consider changing policy.
It is important to know how shareholders evaluate performance. In our research we have found that investors prefer measures related to value creation and executive stewardship, such as return on invested capital and free cash flow generation. They are less interested in earnings per share or overall growth statistics. This may not apply to all shareholder bases, but it pays to ask the question.
Shareholders have spoken. They want to vote on SOP every year. As proxy season approaches, companies need to articulate their compensation strategy and how pay is determined. The proxy is the selling document. It should present the case completely to avoid additional filings. Supplementary filings can be perceived as evidence of shareholder resistance.
Proxy season is not the beginning and end of a company’s engagement with its shareholders. It is a point in time that reflects the effectiveness of management’s relationship with its investors.
Even now shareholder advocates are working to exploit the shifting balance of power and taking on more corporate governance issues. They are using the off-season to shape the discussions and air their side of the debate. If companies wait until the 2012 proxy season to air their positions, they could very well find themselves scrambling to respond to concerns that have been festering for months.