'Say on pay' is not a 'slippery slope'
By John C. Wilcox

ExEcutiv E c omp Ensation 10 directors & boards S hould shareholders have the right to an advi- sory vote on executive compensation? What would be the consequences? These questions have become the defining issue of the 2008 proxy season in the U.S. The predominant tone of the public discourse over advisory votes has been highly confrontational, treating the issue as a struggle for power between companies and shareholders. The unfortunate consequence of this overheated debate has been to obscure the advisory vote’s most important benefits — its potential to reduce conflict and promote constructive dialogue between companies and shareholders. An annual advisory vote would likely result in the elimination of most compensation proposals under Rule 14a-8 together with the costs and uncer- tainties associated with the shareholder proposal process. In addition, over time an annual vote would shift the focus of the compensation debate to individual company practices rather than broad policy issues. Fortunately, the dialogue at private meetings of companies and institutional investors has been more substantive and nu- anced than the public debate. Here is a look behind the scenes at how some shareholders are responding to com- panies’ questions about the advisory vote and the goals of executive compensation disclosure: 1. Is an advisory vote necessary? The goal of an ad- visory vote is to help ensure that directors pay at- tention to the elements of compensation that matter most to investors: goals, metrics, philosophy, and links to performance and business strategy. Shareholders generally agree that they don’t have the knowledge or inclination to second-guess how or how much senior executives should be paid at specific com- panies. They want board compensation committees to handle this responsibility, provided they act responsibly and explain their decisions. Shareholders also agree with companies that compensation standards should be flexible, strategic, clear, and not standardized or formulaic. If a company’s Compensation Discussion and Analysis (CD&A) makes a convincing case that its compensation program is performance-based and rewards executives for solving business problems and creating long-term value, shareholders will support it even if the amounts paid seem high. Since performance-based compensation implies that exceptional performance deserves exceptional pay, companies should not fear that votes will be consistently negative. 2. If shareholders are given an advisory vote on compensa- tion, won’t they end up micromanaging the company’s busi- ness? The advisory vote on compensa- tion is not a “slippery slope.” Executive compensation is a one-of-a-kind issue for which an advisory vote is uniquely suited. Compensation is an annual con- cern; it involves difficult and sensitive issues; it requires boards to exercise in- dependence, skill, and judgment; it is in- tegral to a company’s long-term strategy and performance. The importance of compensation is further underscored by the SEC’s extensive disclosure require- ments, which are substantially more detailed than for other issues in the proxy statement. For all these reasons, compensation opens a window into the boardroom, revealing how directors set ‘Say on pay’ is not a ‘slippery slope’ An advisory vote on executive compensation makes sense for both companies and shareholders. Here are 10 reasons why. By John c. Wilcox John C. Wilcox is chairman of Sodali Ltd., a firm providing consulting and transactional services to listed companies in Europe, Asia, and developing markets. He is also an in- dependent consultant on corporate governance to TIAA- CREF, where he served as senior vice president and head of corporate governance from 2005 to 2008. Prior to joining TIAA-CREF he was chairman of Georgeson & Company Inc. During his career he has specialized in corporate gover- nance, investor relations, proxy voting, corporate control transactions, capital markets regulation, and director edu- cation.Continued on page 54 ExEcutiv E c omp Ensation 54 directors & boards priorities and balance competing interests. The advisory vote in turn offers a means for shareholders to provide feedback on how the board is handling these duties. An annual advi- sory vote has the potential to increase dialogue and provide companies with early warning of shareholder concerns before a crisis develops. 3. Isn’t an advisory vote misleading, since the vote results may not send a clear message? If compensation programs are ap- propriately customized, the meaning of an advisory vote will be different at every company. Uncertainty can be dealt with in two ways: (1) companies can survey shareholders directly or provide a Web site for their comments; and (2) shareholders can be held to best practice standards that call for diligence in proxy voting, reporting and communication. Responsibil- ity for communicating with shareholders falls squarely on the management and boards of public com- panies. At the same time, shareholders — particularly institutional investors gov- erned by fiduciary standards — should accept full responsibility for their voting decisions and should take advantage of every means available to explain them. 4. Won’t advisory votes weaken boards? A n a d v i s o r y vo t e s h o u l d e m p o w e r b o ards, not weaken them. Account- ability to shareholders should reinforce directors’ independence and strengthen their resolve to deal with compensation strategically. It should reduce directors’ reliance on compensation consultants and benchmarks, en- courage them to customize their programs, and broaden their use of compensation to drive business strategy in addition to attracting and retaining executive talent. 5. Won’t an advisory vote ultimately draw shareholders too deeply into compensation decision making? In the U.K. the advisory vote is credited with increasing dialogue between companies and investors, particularly in the early stages of designing compensation plans. U.S. shareholders are less in- terested in such early-stage engagement, which many would characterize as micromanagement. Instead, they seem willing to defer to the expertise of managers and board compensation committees, while holding them accountable for disclosing, explaining, and justifying their decisions. Judgment after- the-fact is standard practice for U.S. shareholders, who tend to take a long-term view and recognize that improvement in compensation practices will take time. 6. How will proxy advisors handle recommendations on advi- sory votes? Proxy advisors’ compensation analyses and recom- mendations have in some cases utilized “black-box” formu- las and quantitative factors applied uniformly to companies with little regard for context. Such an approach is not suitable for evaluating customized compensation programs and dis- closure. Proxy advisors say they recognize the need to revise their evaluation methodology and are beginning to do so in response to demands from both investors and companies. In any case, companies must recognize that they bear primary re- sponsibility for communicating with shareholders when they believe proxy advisors’ recommendations are wrong. Such communication campaigns are already commonplace when companies are seeking shareholder votes to approve equity compensation plans. 7. Isn’t a vote against directors more effective than an advisory vote? Withhold and vote-no campaigns against directors are a blunt instrument that sends a powerful message. Recogniz- ing that a director’s independence, experience, skill, and con- duct inside the boardroom are difficult to assess from outside the boardroom, many shareholders are reluctant to evaluate directors on the basis of a single issue. Accordingly, their policies recommend that withhold and against votes should generally be reserved for serious cases in- volving violations of fiduciary duty, un- disclosed conflicts of interest, unethical conduct, or failure to protect the interests of shareholders. Under such guidelines a vote against directors based exclusively on a company’s compensation short- comings would be viewed as an overre- action. Particularly since the adoption of majority voting in director elections, best practice standards call for shareholders to exercise restraint in their votes against directors. The advisory vote avoids a heavy-handed approach and provides a moderate response that focuses on compensa- tion concerns. 8. Is legislation or regulation the best way to mandate an ad- visory vote? Since shareholders do not favor a one-size-fits-all approach to compensation, they are concerned that regulation could be overly prescriptive or formulaic. As with the adoption of the majority vote standard, private ordering is a preferred alternative to regulation. Companies should consider volun- tarily amending their charter or bylaws to provide for advisory votes. However, the window of choice for voluntary action may not be open for long — bills are pending in Congress to mandate the advisory vote, and the NYSE, whose listing requirements already mandate a binding shareholder vote on equity compensation, could extend the requirement to other forms of executive pay. 9. Won’t an advisory vote increase companies’ vulnerability to activism and other short-term market forces? An advisory vote ultimately poses the question of trust between compa- nies and their shareholders. Companies are understandably ‘Say on pay’ Continued from page 10 Executive compensation is a one-of-a-kind issue for which an advisory vote is uniquely suited. ExEcutiv E c omp Ensation annual report 2008 55 confuse its role as a market regulator — one that involves es- tablishing rules, including required disclosures, and policing their compliance — with a more normative role that seeks to make qualitative judgments about (otherwise legal) activi- ties in an effort to “name and shame” companies. The SEC, as a market regulator, does not have a foreign policy agen- da and lacks the expertise needed to make qualitative judg- ments about a company’s foreign operations. It should leave this area of operations to those best equipped to deal with it — the State Department, OFAC, and the nongovernmental organizations whose mission is to make qualitative judgments about good and bad business practices. Investors concerned about this issue already have access to the information using the SEC’s Edgar tool to search disclosures already contained within company filings. The less-than-one-month duration of the tool indicates just how much an ill-conceived idea it was. An “F.” 2. New rules on reserves reporting forthcoming C The SEC has signaled that it may update its re- serves reporting requirements, at long last heeding objections from the extractives industries that its methodology was outdated, geared towards Texas- style oil fields (which differ in shape and composition from many fields around the world), and did not take into account the considerable technological advances that had taken place in drilling and extraction since the rules were formulated in 1978. The current methodology is widely considered to under- report a company’s reserves, and is more restrictive than pre- vailing rules worldwide. In a rare, and welcome, sign of humil- ity, the SEC has voted to issue a concept release for updating such rules, and seeks public comment on whether to allow companies to adopt a more flexible approach for estimating reserves, using different technologies, and possibly a differ- ent pricing model. The SEC also seeks comments on whether reserves estimates should be independently confirmed by a third party. Although no changes have yet been made, it is refreshing that the SEC has finally tuned in to what specialists have long complained about: that a reporting system in place 30 years ago is antiquated and inaccurate when it comes to giving inves- tors a true valuation of a company’s assets in an increasingly technology-driven and global industry. The move to reevalu- ate the reserves reporting process, after more than a decade of deafness, earns the SEC a “C” for effort; we will grade the final exam next year. 3. Moving from U.S. to international accounting standards A + Currently, the SEC requires that compa- nies repor t their financials according to the U.S. Generally Accepted Accounting Principles, or GAAP. Foreign companies are usually re- quired to follow International Financial Reporting Standards, or IFRS, in their home jurisdictions, and had to undertake a complicated and sometimes costly reconciliation with U.S. GAAP. In a move that recognizes the increasingly competitive global landscape for securities, Chairman Cox eliminated the reconciliation requirement for foreign companies trading in the U.S. This move will begin to rehabilitate the increasingly pervasive image that U.S. markets carry unwieldy regulatory burdens relative to other highly attractive markets, such as concerned about the diversity of shareholder interests. They are reluctant to give more leverage to aggressive, high-profile investors with short-term financial goals and questionable commitment to the business enterprise. At the same time, responsible, long-term investors rightfully demand a voice in decisions affecting the future of their investment. By defini- tion, an advisory vote is both non-binding and self-limiting. It offers a referendum on compensation, not a forum for ac- tivism or change of control. Advisory votes are not designed to encourage opportunistic short-term strategies, but to sup- port basic corporate governance standards that strengthen economic performance, reward appropriate risk-taking, increase director accountability, and protect the long-term interests of shareholders. 10. Aren’t shareholders expecting too much from compensa- tion disclosure and the advisory vote? Should the CD&A be retrospective or prospective, short-term or long-term, defen- sive or proactive? These questions are being asked by both companies and shareholders as they deal with the complex legal and technical requirements imposed by the SEC disclo- sure rules. While the attention of the SEC staff is focused pri- marily on issues of materiality in pay decisions for the report- ing year, shareholders are equally concerned about the ways in which compensation aligns with business strategy and drives long-term performance. Companies face the admittedly diffi- cult task of both complying with detailed rules and explaining how their decisions serve the long-term interests of owners. The hope is that the SEC and companies will find the right balance of disclosure and narrative that best enables share- holders to evaluate each company’s executive compensation program on the merits. ■ The author can be contacted at jwilcox@tiaa-cref.org. R Egulato Ry ovER sight SEC Report Card Continued from page 12

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