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Executive Compensation – The Activist Battleground For 2009…

By Reid Pearson, Managing Director, The Altman Group, Inc.

Executive compensation has always been an important issue in investor’s minds. However, many corporations will experience a new level of scrutiny on their compensation practices in 2009. In the court of public opinion many people blame excessive compensation and pay-for-failure models as one of the causes of the current financial turmoil. Despite the fact that the vast majority of compensation committees and executives performed their duties with the best interests of shareholders in mind, many of these same parties will be under increased shareholder pressure this coming proxy season. Many companies will experience increased activism in the form of shareholder proposals and targeted campaigns against the Compensation Committee members and possibly new regulations.

Say on Pay

One of the hottest governance topics over the past few years has been say on pay, which appears in the form of a shareholder proposal requesting an advisory vote on executive compensation. This advisory vote would be included in the company’s proxy on a yearly basis, and would give shareholders the ability to express their approval of a company’s compensation practices. A similar practice has existed in some Western European markets for a number of years. On the one hand, supporters of say on pay argue an advisory vote would give shareholders a greater voice in pay related issues. On the other hand, opponents argue that such a vote does not provide the company with any detail as to the areas of the pay practices with which shareholders find fault.

Say on pay is a fiercely debated topic between its proponents and opponents. While many corporations were willing to adopt majority voting (another recent hot governance topic), they are digging their heels in when it comes to an advisory vote on pay. To date, approximately eleven companies have adopted a say on pay policy. As noted below, voting statistics for say on pay shareholders proposal have stayed relatively flat in 2007 and 2008: It is expected that support levels for say on pay proposals will rise in 2009, but will they rise enough that we start seeing the same degree of widespread support that majority vote proposals have received in recent years? There are two signs that point to yes.

First, the two largest proxy advisory firms – RiskMetrics Group and Glass Lewis – support say on pay shareholder proposals. In contrast, several of the largest institutional investors that have their own internal proxy voting guidelines have shied away from supporting the proposal in recent years. If one or two of these large institutional investors change their policy and start supporting these proposals, the overall support levels for these proposals will increase dramatically at many companies. In recent conversations with The Altman Group, several of these institutional investors have stated they are reviewing their policy with respect to say on pay proposals and may support them in the future. Although that is no guarantee of a policy switch, it presents a strong argument for companies to start preparing for an advisory vote on their compensation practices.

Second, much of this institutional shareholder sentiment might be attributable to recent political developments. With Barack Obama’s stated support for say on pay and little, if any, appetite for organized resistance in the current economic environment, it will almost surely become a regulatory mandate.

In fact some companies have begun to take matters into their own hands. In a unique response to say on pay, Schering- Plough will send shareholders a survey on executive and director compensation with its 2009 proxy material. The results of that survey will be available in the company’s 2010 proxy statement. While the survey will provide some level of detail to the company as to investor sentiment on the various components of its compensation practices, it has nonetheless received a very lukewarm “it’s a good start” response from many supporters of say on pay.

Activism – Shareholder Proposals

Many compensation related shareholder proposals decreased in both number and average support levels in 2008. Do not expect this trend to continue in 2009. With the financial turmoil and subsequent bailout package, many activist investors feel that now is the time for major changes in the compensation arena. In addition to say on pay proposals, we are likely to see more shareholder- sponsored proposals such as pay-for performance, pay-for-superior-performance, and claw-backs for “unearned” bonuses.

The traditional pay-for-performance shareholder proposal requests that companies adopt either performance vesting options or indexed options. These proposals have been around for a number of years and have fared well. In 2007 there were 28 proposals with an average support level of 31.4 percent. In 2008 there were 6 proposals with an average support level of 33 percent.

The pay-for-superior-performance proposal is a recent variant of the traditional model. The proposal asks the company to define a very specific peer group and performance metrics and requires that the company outperform its peer group in order for bonuses to be paid. One criticism of the traditional pay-for performance proposal is that it is not specific enough, which cannot be said about the pay-for-superior-performance proposal. In fact, the pay-for-superior performance proposal is criticized as being too restrictive on the company. In 2007 there were 37 of these proposals with an average support level of 30.8 percent. In 2008 there were 21 proposals with an average support level of 26.8 percent.

We are also likely to see a significant increase in the number of claw-back proposals, which request that the company reclaim “unearned” bonuses in the face of a financial restatement. This is one of the provisions in the bailout package and several labor union affiliated funds are expected to sponsor a number of these proposals in 2009. Claw-back proposals first appeared in 2004 as the options backdating issue came to light. There were 10 proposals in 2007 with an average support level of 28 percent. In 2008 there were 6 proposals with an average support level of 10.3 percent. One reason for the major drop in the average support level was that in 2007 backdating was still a major issue with a number of institutions. By 2008, backdating had become yesterday’s news and was no longer on the radar screen of the major institutional investors.

Claw-back proposals have once again become a hot topic. At the October 10th International Rectifier annual meeting, shareholders approved a claw back proposal. Surely the vote was amplified because the company was involved in a proxy contest; nonetheless, expect average support levels for claw back proposals to increase.

Activism – Targeting Compensation Committees 

In addition to shareholder proposals, activists are also targeting compensation committees with “just vote no” campaigns. Although these campaigns are not as common as shareholder proposals, we expect to see more of them in 2009 as governance activists scored a number of successes in 2008.

In 2008, Change to Win Investment Group (CtW), a labor union affiliate, targeted Washington Mutual with a “just vote no” campaign against two of the directors. Another labor union targeted four other directors. The complaint of these activists was that the company planned to eliminate subprime losses from the equation when determining executives’ bonuses. The vote no campaign

was successful for the activists. Mary Pugh, chair of the finance committee for the company, received a 49.9 percent withhold vote and resigned. Two other directors received withhold votes totaling over 40 percent.

Washington Mutual’s decision to change its bonus pay-out formula is something shareholders do not like even in the best of times, but doing so in the current environment is one reason the vote no campaign was so successful. Companies need to be aware that changing performance metrics during the performance cycle will be problematic from the point of view of most shareholders.

The Bailout

One thing that all sides of the pay debate can agree upon is that the financial turmoil has changed the pay debate. Proponents of pay reform argue that excessive pay played a large part in the current final mess and thus change is needed. Companies in the banking sector will worry about how to keep top talent from leaving for hedge funds and private equity firms. Companies in other sectors will be concerned about how increased shareholder scrutiny will impact their ability to get equity plans approved.

Firms participating in the bailout must conform to certain restrictions on executive pay: no golden parachutes, no tax deductions for compensation over $500,000, claw-back features will be in play, and incentive compensation cannot “encourage unnecessary and excessive risk that threatens the financial institution.” There is uncertainty around these new restrictions. On the one hand, experts argue that the restrictions are vague and hard to enforce. On the other hand, the very vagueness of the restrictions may allow the government to have a greater say in the company’s pay practices.

One thing is certain: companies are still going to have to face shareholders who will be able to gauge their pay practices. Shareholders will still apply pay tests of cost, dilution, burn rate, and pay for- performance. Firms that do not meet these tests will be faced with irate shareholders who will vote against compensation plans or against the re-election of compensation committee members.

Underwater Options

Given the recent downturn in the market, many companies are faced with underwater employee stock options (where the exercise price is below the market price thus making the options worthless). In 2009, companies will be faced with how to address these underwater options as they seek to attract and keep high performing employees.

Companies are tackling the issue in a number of ways, including: greater use of employee stock purchase plans, targeting performance grants, and greater use of cash bonuses.

One of the most common inquiries that The Altman Group receives is how shareholders will react to an option exchange program, also known as options repricing. In an exchange program, plan participants exchange current underwater options for another option with a lower exercise price, restricted stock unit, or cash. Given that shareholders cannot reduce their cost basis when a stock declines, exchange programs are viewed with some skepticism.

However, if the exchange program is properly structured, it will generally receive shareholder support. The “must-haves” to any exchange program include:

  • Senior executives and directors cannot participate in the program;
  • The exchange must be value-for value, which means the aggregate value of the awards immediately after the exchange must be the same or less than the value of the options before the exchange; and
  • The company must demonstrate that the exchange program is not a knee-jerk reaction to a sudden drop in stock price. The company must also show that the drop in stock price is industry-specific and not just company-specific.

One unknown at this point is how the current financial turmoil will impact institutional investor’s views on exchange programs. In talking to a number of large institutional investors The Altman Group has found some indication that these shareholders will take a more critical view of these programs.


What are companies to do in this current environment? Unfortunately, there is no magic answer to this question. However, The Altman Group feels there are three broad themes that companies should include in pay related decisions:

  • Understand who your shareholders are and how they are likely to view pay issues.
  • Good disclosure of pay practices is paramount. Make sure that shareholders can understand the disclosure and that it is written in plain English.
  • Companies should link pay to performance. Disclose the goals and what the pay-out will be if those goals are met.

Regardless of industry, companies’ pay practices are going to be under increased scrutiny in 2009. Quality disclosure, linking pay and performance, and engaging your shareholders are ways to help minimize the scrutiny.