Executive Compensation Going Forward
By Jeremy L. Goldstein, Jeremy L. Goldstein & Associates, LLC
Over the past several decades, one of the most potent arguments for board primacy – and against increased shareholder input – in the arena of corporate governance has been concern about the impact of divergent views among different groups of shareholders on the management of the firm. Critics of increased shareholder involvement in the governance of corporations have long argued that director primacy was the ideal model because an independent board of directors is uniquely situated to mediate these differing and sometimes conflicting views. As shareholders have gained increased levels of input on corporate governance and – largely through the advisory vote on executive compensation – executive compensation, variances in shareholder views is becoming increasingly problematic. Going forward, these variances will have important consequences for the process and substance of designing executive compensation programs. Set forth below are the ways in which we anticipate that the rising tension among shareholders will manifest itself with respect to executive compensation in the years to come.
In the early years of say on pay, proxy firms and institutional shareholders focused primarily on specific features of compensation programs such as “golden parachute” excise tax gross-ups, so-called “single trigger” severance rights (i.e., provisions that allow executives to quit for any reason following a change of control and receive severance benefits), credited service under pension plans for years that the executive did not actually serve, and the like. More recently, as the agenda of the governance community with respect to these issues has been largely realized and the existence of these features has largely faded among public corporations, the governance industry has shifted its focus to the relationship between pay and performance. Going forward, we anticipate that this trend will continue and accelerate.
More specifically, we expect an increased focus on the individual performance goals that companies adopt both in terms of the rigor of such goals and the appropriateness, in the eyes of individual shareholders, of the categories of goals selected. This increased focus on goal setting will place directors in an increasingly difficult position as finer lines begin to be drawn among different categories of shareholders and individual shareholders within each category. Activists and other short term investors continue to demand that companies forego long-term investments in favor of near-term capital returns via dividends, share buybacks and the like. Conversely, institutional investors and other long-term holders of firm capital are increasingly focusing their attention on the deleterious effects of nearterm returns of corporate capital on the long-term health of America’s corporations. Divergent views on use of corporate capital will place increased pressure on boards with respect to corporate strategy and the incentives that are created to advance these strategic priorities.
The tensions around this issue are perhaps most clearly ex-emplified by the debate over the use of stock options and earnings per share goals in executive compensation plans. Certain shareholders have questioned the effect of the use of stock options on management incentives to engage in share buybacks when not in the best interest of the company. Other shareholders, most notably CtW Investment Group, have questioned the advisability of the use of earnings per share and similar goals as performance metrics because they claim that (1) such goals do not hold executives accountable for the size and sustainability of cash flows generated for reinvestment and for capital investments that they make and (2) executives can manipulate EPS targets via large-scale buybacks and earnings management. These criticisms may result in greater tension among individual, and groups of, shareholders, which in turn, may put pressure on directors involved in pay decisions to take into account an ever increasing number of divergent viewpoints on these matters.
Regardless of where institutional shareholders land on this particular issue, we expect that institutional shareholders will continue the recent trend of bulking up their internal governance resources and – by extension – will continue to develop their own governance policies as they relate to executive compensation. Large institutional shareholders such as BlackRock, State Street and Vanguard have already articulated sophisticated policies with respect to executive compensation matters. Over they years to come, we anticipate that, in an effort to address concerns that are particular to long-term holders, more institutions will follow suit. We expect that this will lead to a reduction in the influence in proxy advisory firms and an increase in the diversity of views among shareholders with respect to executive compensation depending on, among other things, the specific investment goals and horizons of the institutions.
Relatedly, while shareholder engagement has been the mantra over the past few years among those seeking to help companies improve relations with shareholders generally, public companies will need to dedicate ever-increasing resources to ensure that they understand individual shareholder policies and have a means of communicating with institutional governance personnel as each major institutional shareholder develops its own governance and executive compensation policy. Forward thinking companies are well-advised to make increased investment in human capital that has the skill and experience to communicate effectively with institutional shareholders.
On a separate note, since the enactment of the Dodd Frank Act of 2010, there has been little regulatory activity in the area of executive compensation. Instead, most major trends in executive compensation have originated from the system of private ordering in which the corporate governance community has created what effectively amounts to a “shadow” regulatory system for executive compensation. We see the potential for this trend to reverse itself after this year’s election cycle as politicians are increasingly drawn to populist themes and are increasingly focused on issues of income inequality. In addition, on November 17, 2015, the Director of the Division of Corporate Finance of the Securities and Exchange Commission delivered a speech at the National Institute on Executive Compensation of the American Bar Association entitled “Executive Compensation: Looking Beyond the Dodd-Frank Horizon” in which he addressed potential changes in the rules applicable to the way that companies convey executive compensation and corporate governance information that populates proxy statements. While the speech was qualified by the general disclaimer that his remarks are his own views and do not necessarily reflect the views of the SEC or the rest of the staff of the SEC, it provides insight into the types of issues that we are likely to see the SEC address in the years to come. Among the topics for potential regulation raised by the Director in his speech were changes to: (1) the type of information required to be disclosed by companies when seeking shareholder approval of compensation plans, (2) the requirements of Form S-8, (3) the prescriptiveness of disclosure rules that apply to the CD&A, (4) the tabular information required to be provided in annual proxy statements, and (5) the compensation committee report.
Whatever the eventual changes in executive compensation in the years to come, one thing is clear: the executive compensation landscape will continue to evolve as the dynamic between companies and their shareholders continues to change.