Compensation Season 2011

Jeremy Goldstein is a partner at Wachtell, Lipton, Rosen & Katz active in the firm’s executive compensation and corporate governance practices. This post is based on a Wachtell Lipton firm memorandum by Mr. Goldstein, Michael J. Segal, Jeannemarie O’Brien, Adam J. Shapiro and David E. Kahan.

For many public companies, the new year marks the beginning of compensation season. Setting pay and targets for the new year, determining achievement of performance objectives for the past year and preparing the annual proxy statement contribute to a busy first quarter for compensation committees and management teams working with them. In 2011, companies will undertake these activities in a fluid environment, with executive compensation continuing to receive significant attention from shareholder activists, the government and the media. As companies prepare for the upcoming compensation season, they should consider the following items.

“Say on Pay”. Dodd-Frank mandates a non-binding shareholder vote on the compensation of the named executive officers of a public company in the company’s first proxy statement for a shareholder meeting occurring after January 21, 2011, and no less frequently than triennially thereafter. The say on pay vote will serve as an important barometer of shareholder views of a public company’s compensation practices. In preparation for the say on pay vote, public companies should review the voting guidelines of significant shareholders and coordinate with proxy solicitors. Companies should consider advance communication with significant shareholders or shareholder advocacy groups whose guidelines suggest a risk of a negative vote. Companies must use the CD&A as a platform for explaining why their programs and decisions serve the best interests of shareholders. An executive summary at the beginning of the CD&A will be an effective means to communicate in succinct terms the relationship between a company’s pay programs and performance.

“Say on Pay” Frequency. Dodd-Frank requires a non-binding shareholder vote, at least once every six years, regarding the frequency of say on pay votes (i.e., annual, biennial or triennial). Perhaps the most pressing question for many companies for the 2011 proxy season is whether to recommend an annual, biennial or triennial say on pay vote. From a policy perspective, we believe that a triennial vote is superior to annual and biennial votes. In particular, a triennial vote helps align say on pay with a long term view of corporate governance matters and executive pay arrangements. On the other hand, an annual vote is the stated preference of some influential shareholder advisory groups, and provides shareholders with an avenue other than director elections to express dissatisfaction with pay practices. Ultimately, the decision regarding say on pay frequency will depend in part on whether recommending a triennial vote will result in negative consequences for a company. ISS recently stated in its Frequently Asked Questions that a management recommendation of a biennial or triennial vote will not trigger a negative vote recommendation from ISS on other proxy items, notwithstanding ISS’s categorical support of annual say on pay votes. Moreover, through January 14, 2011, 63 companies have recommended a triennial vote, while only 35 have recommended an annual vote. Before making a final determination as to a company’s recommendation on the frequency vote, a company should take into account its particular circumstances including: (1) year over year consistency of pay structures and amounts, (2) the quality of its relationships with shareholders, (3) the nature of its shareholder base, and (4) significant shareholder views regarding say on pay and the frequency vote.

ISS. Management and compensation committees should stay abreast of ISS’s positions on good and bad pay practices, as vote recommendations by ISS may influence the outcome of shareholder votes on director elections, say on pay referendums and equity compensation plan proposals. If a company has a say on pay vote, ISS generally will use that vote as the primary avenue to address what it deems “problematic pay practices.” However, even for companies that include a say on pay proposal on their ballots, ISS may recommend a negative vote for compensation committee members and/or other directors if ISS considers pay practices “egregious,” or in instances in which directors have failed to respond to concerns raised in prior ISS say on pay evaluations. While directors should understand the potential consequences of their decisions under applicable ISS policies, they should not lose sight of the underlying goal of executive compensation, i.e., recruiting and retaining a talented work force. Finally, it is noteworthy that in 2010, ISS recommended against company compensation programs under say on pay votes at 43 of the 299 companies it evaluated, but only three of those companies received less than majority support from shareholders and the average result was an 89.6% favorable vote.

Change of Control Arrangements. Pressure from governance activists has led some companies to curtail their change of control protections by, among other things, reducing severance multiples, eliminating single-trigger equity vesting, eliminating “golden parachute” excise tax gross-ups and applying non-competes and other restrictive covenants upon terminations following changes of control. While in isolation any one of these changes may not appear damaging to the interests of a company or its shareholders, in the aggregate they can undermine the very purpose of change of control protections by weakening retentive tools designed to keep the company intact during a time of uncertainty and creating disincentives for executives to pursue change of control transactions that are in the best interests of a company and its shareholders. While it may be tempting for companies to follow the herd and water down executive change of control arrangements in order to avoid criticism, before reducing change of control protections, companies should carefully consider whether their executives have sufficient incentives to pursue transactions that are in the best interest of the company and its shareholders or to remain independent if the company’s long-term interests warrant.

Compensation Clawbacks. Clawback policies provide companies with the ability to recoup incentive-based compensation in certain circumstances, such as a financial restatement, commission of an act detrimental to the company or a reversal in company performance. Dodd-Frank requires companies to adopt a clawback policy applicable in the event of an accounting restatement due to material noncompliance with financial reporting requirements and providing for the recovery of amounts in excess of what would have been paid under the restated financial statements from any current or former executive who received incentive compensation during the 3-year period preceding the date of the restatement. The SEC has not issued rules implementing the Dodd-Frank clawback, and many questions remain unanswered. Companies should understand that if they adopt or amend a clawback prior to the issuance of rules, they may be required to amend the policy again after the rules are adopted.

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The ever escalating pressure on directors to reign in executive compensation has resulted in a challenging dynamic in matters of executive compensation. Making compensation decisions that are both consistent with the needs of the company and take account of the various legislative, regulatory and “best practice” mandates is a balancing act. Achieving these goals while maintaining collegiality between members of compensation committees and senior management is one of the greatest challenges facing the compensation committee today. Sensitivity in taking into account these various considerations is paramount in matters of executive compensation.

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  1. […] HLS Forum on Corporate Governance & Financial Regulation: Compensation Season 2011 – In this post Jeremy Goldstein of Wachtell, Lipton, Rosen & Katz discusses the top […]

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