Say-on-Pay Year Two: a Planning Primer

Annette Nazareth is a partner in the Financial Institutions Group at Davis Polk & Wardwell LLP. This post is based on a Davis Polk client memorandum by Ning Chiu, Edmond T. FitzGerald, William M. Kelly, Richard J. Sandler, and Ron M. Aizen.

For most companies 2011 was the first year for say-on-pay. The good news is that most emerged from the process unscathed. Only a relative handful (38 of the Russell 3000, including eight in the S&P 500) failed to receive majority support as of October, and those companies are part of a small number (157 and 42, respectively) that received less than 70% of the votes cast.

Shareholders also displayed a strong preference for annual votes, which means that year two is almost upon us. Companies with failed or close votes in 2011 know that they will face heightened scrutiny, particularly as to whether changes were made in response to the vote. But all public companies should consider the lessons learned from year one and make say-on-pay assessment part of their regular annual planning process.

Here are some suggestions to keep in mind.

Know the policies that govern shareholder voting. ISS’s influence, whether or not regrettable, is a fact of life. There may be circumstances under which a board concludes that it should adopt a policy or individual practice that is at odds with ISS’s view, but it is important that these decisions be made with open eyes. The best prepared companies bake the ISS standards into their compensation planning process, not for the purpose of uncritical acceptance but rather so that the board and management can avoid surprises. Being familiar with ISS’s new pay for performance tests (which we discussed recently in our memorandum) is the first step in that direction.

The Glass Lewis tests are more of a black box, but looking at last year’s report should help. In addition, you should review the voting policies of major institutional investors, which are publicly available, as they sometimes contain detailed perspectives. If you are calling your major shareholders, they will expect you to have studied their policies in advance and to be able to speak about them.

Identify possible criticisms and prepare responses. Review carefully the executive compensation that you will be disclosing in the proxy statement in light of your company’s performance for 2011 in order to identify possible criticisms. In particular, if you might fail the ISS pay-for-performance tests, now may be the last time you can seriously consider certain actions, including:

  • If 2011 annual bonuses won’t be paid until 2012, companies may be able to increase the portion paid in stock, which will decrease the amount of compensation disclosed for 2011. Keep in mind, however, that this will subsequently be disclosed in future proxies.
  • Recognizing that it may be too late to change 2011 compensation, companies could address anticipated concerns by making commitments about future periods, such as modifying or adding performance goals or eliminating so-called “poor pay practices” (e.g., single triggers or gross-ups) in new agreements.

Use CD&A disclosure to your advantage. Too many companies still present their CD&A as an endurance test and miss the opportunity to use CD&A as an advocacy piece for the say-on-pay vote. An executive summary and graphs will usually help tell your compensation story. If you’re aware of potential weaknesses, address them directly because both the proxy advisory services and your major shareholders will be looking for those explanations and will otherwise assume the worst. Addressing these issues in additional soliciting materials may be too late.

If you fail the ISS quantitative pay for performance tests, your proxy disclosure is the only place where you can provide the reasons that ISS should nonetheless recommend in your favor. If they are inclined to support you, ISS needs the rationale in your proxy disclosure to include in their reports. ISS will not speculate and will not give you the benefit of the doubt. Even if ISS goes against you, your major shareholders may need explanations from your proxy disclosure to give their proxy committees in order to justify ignoring ISS’s recommendations.

As you consider presentation strategies, remember that the summary compensation table will receive disproportionate attention. If there are mitigating factors (e.g., if the equity awards include performance elements, or the incentive awards are less leveraged than those of your peers), you should find a way to present this in or adjacent to the table.

Conduct a forensic analysis of 2011 negative votes. If you received negative votes from major shareholders, even in the context of a strong overall vote, contact those shareholders to understand what prompted the negative vote. Say-on-pay is a communications tool, albeit a crude one, and it’s worth understanding the message that these shareholders have tried to send you.

Stay in touch with major shareholders. Regardless of prior votes cast, there are many advantages to engaging now with your major investors. The relationships you develop now could become key near the annual meeting if the proxy advisory services recommend against you on say-on-pay. At that point there is little time to make initial contacts, and you may waste precious time just figuring out the right person to call. Investors also can react badly when their initial contact with a company is a panicked call just prior to the annual meeting.

Another reason to speak to major shareholders is that the one new proxy disclosure for next year concerns whether the 2011 say-on-pay vote had any impact on your executive compensation program. We believe that it will help to be able to state that you had those discussions.

Develop a quick response contingency plan. Even if you expect all to go well, develop a plan for responding quickly to negative recommendations from the proxy advisory services. All companies need to be certain that they have signed up to receive their ISS reports. Only the S&P 500 companies have the luxury of receiving draft reports in order to point out errors within 24 to 48 hours. Other companies can only wait and get their reports after they have gone out to ISS clients. Identify a team that is prepared with contact information for your major shareholders and themes for additional soliciting materials if you decide to use them.

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