Proxy Advisors’ Impact on Executive Pay Decisions by Directors

Joseph E. Bachelder is special counsel in the Tax, Employee Benefits & Private Clients practice group at McCarter & English, LLP. The following post is based on a column by Mr. Bachelder which first appeared in the New York Law Journal. Andy Tsang, a senior financial analyst with the firm, assisted in the preparation of this column. The complete publication, including footnotes, is available here.

Proxy advisors have been giving advice to their shareholder clients for many years. This includes advice regarding, among other things, proposals put before annual shareholders’ meetings by management and by shareholders themselves. Beginning with the 2011 proxy season (as a result of the Dodd-Frank legislation in 2010) proxy advisors added say-on-pay votes to their portfolio of advice to shareholders. Shareholders (primarily institutional shareholders), for a fee, can receive a proxy advisor’s recommendation on whether to vote “for” or “against” a say-on-pay resolution (among other resolutions, as just noted), together with a report that includes explanation of the bases for the proxy advisor’s recommendations. The two largest proxy advisors are Institutional Shareholders Services, Inc. (ISS) (founded in 1985) and Glass, Lewis & Co., LLC (Glass Lewis) (founded in 2003). Together, these two proxy advisors represent over 90 percent of the proxy advisory business in the United States.

This post discusses the impact on public company directors of proxy advisors’ executive pay guidelines and their reports and recommendations on executive pay made to shareholders, as noted, in connection with say-on-pay votes. Comments are made on the role played by directors in supervising executive pay, on the processes followed by proxy advisors in their “rulemaking” on executive pay and, finally, the impact on directors of proxy advisors’ “rulemaking.” Suggestions are also made as to how to reduce the inhibiting effect on directors of having to “look over their shoulders” at the “rulemaking” of proxy advisors.

The Role of Directors

Directors, especially members of the compensation committee, must take into account many facts and circumstances relevant to the executive pay program they oversee. These facts and circumstances go beyond pay data. They include the company’s business strategies, developments occurring within and outside the industry, personalities within the company, risks of losing key executives, attempts to attract executives from outside the company, succession planning and many other factors.

Directors also must take into account the complex legal infrastructure within which executive pay exists. This includes rulemaking from “the top down” by Congress and federal executive agencies (such as the Securities and Exchange Commission (SEC) and the Internal Revenue Service) as well as by state legislatures and state executive agencies. It includes rulemaking from “the bottom up” (meaning decision-making based on facts and circumstances in specific cases) by courts and, to a certain extent, executive agencies. In addition, publicly traded corporations listed on stock exchanges work within the framework of the rules of those exchanges.

The factual and legal circumstances noted in the preceding two paragraphs are half the story. The other half of the story is the process of decision-making by the directors based on these circumstances. In reaching their decisions on executive pay matters directors consult with management at the company and work with outside consultants and counsel to assist them in reaching their decisions.

In their corporate governance role directors must be free to deliberate—both as to the facts and circumstances as to which they are making their decisions and as to the legal framework within which they function—without fear of being subjected to “virtual law.” As used here, “virtual law” means “top down rulemaking” by proxy advisors. It is “virtual” because it is not within the legal framework described above. But its impact is very significant as discussed below.

“Rulemaking” by Proxy Advisors

Proxy advisors collect data and issue reports on executive pay at thousands of corporations. Most of this is done during a three-month period in the spring of each year based primarily on proxy statements.

A proxy advisor compares the proxy statement data of each issuer with proxy statement data of other issuers. It also looks at stock prices and publicly available financial data. The information the proxy advisor analyzes does not include all the facts and circumstances of each issuer taken into account by directors as discussed above.

In order to illustrate how a proxy advisor works in its “rulemaking” process we look at the largest proxy advisor, ISS. ISS develops guidelines, reports and voting recommendations on executive pay as follows:

  1. It publishes guidelines as to what, in its judgment, constitutes good practices in executive pay.
  2. It publishes “frequently asked questions” (FAQs) as to its executive pay guidelines and reports.
  3. It issues reports containing its analysis and recommendations on each of several thousand public corporations. The preparation period for a substantial portion of each report occurs between the time the issuer in question issues its proxy statement and the time the report by ISS on the issuer is sent to shareholders in advance of the annual shareholders’ meeting. In that period ISS not only reviews the proxy statement of the issuer but compares that data with similar data as to other issuers. After preparing the report on an issuer ISS distributes the report to subscribers (principally institutional shareholders) prior to the annual meeting at which the say-on-pay vote takes place.

Corporations included in the S&P 500 have an opportunity to review and comment on the conclusions reached as to the company in question prior to the distribution of the report to the institutional shareholders. Even for these larger corporations, however, there is little time to review and comment to ISS on the report before its distribution to shareholders. Quite typically, the review and comment period is less than 48 hours and sometimes it is less than 24 hours. Companies below the S&P 500 generally do not even have the opportunity to review and comment before a report is issued.

Impact of Proxy Advisors on Directors

It is clear that proxy advisors impact say-on-pay vote results. What is not so evident is the proxy advisors’ impact on the executive pay decisions of directors.

In congressional testimony, Darla C. Stuckey, Senior Vice President, Policy and Advocacy, Society of Corporate Secretaries & Governance Professionals, said:

Corporate boards and committees spend an inordinate amount of time ensuring their policies and practices fall neatly within proxy advisory guidelines in order to avoid unfavorable vote recommendations [from] these firms. This is particularly the case with respect to decisions on executive compensation design, a key driver in the achievement of corporate success and long-term shareholder return. Society members say that in considering executive compensation, directors increasingly ask, ‘What will ISS say?’

In the same testimony, Stuckey quotes a study conducted by David F. Larcker, Allan L. McCall and Gaizka Ormazabal in 2013. That study concluded:

We also find that … a significant number of boards of directors change their compensation programs in the time period before the formal shareholder vote in a manner that better aligns compensation programs with the recommendation policies of proxy advisory firms… . We interpret our result as evidence that boards of directors change executive compensation plans in order to avoid a negative [say-on-pay] recommendation by proxy advisory firms… . The stock market reaction to these compensation program changes is statistically negative… .

A paper published by the Mercatus Center at George Mason University in 2013 notes an incident approximately a decade before when ISS opposed the re-election of Warren Buffett as a director of Coca-Cola’s board. The ISS position, at least in part, appears to have been based on Buffett’s being “an affiliated outsider [who] sits on the Audit Committee of the Board.” The Mercatus paper notes that a reason behind ISS’s recommendation was the fact that “some of Berkshire [Hathaway]’s companies, like Dairy Queen, sell Coke products, thus creating what ISS saw as a conflict.” The paper also notes Buffett’s comment, “I think it’s absolutely silly… . Checklists are no substitute for thinking.”

The mind-set encouraged by proxy advisors may be described aptly as a “checklist” mentality. The Mercatus paper observes that “the checklist item fails to take into account the possibility that directors may have more information or wisdom than shareholders, or that events have occurred in the intervening year that supersede the original vote.” In consequence, directors may, in some cases, comply with proxy advisors’ viewpoints, as expressed in guidelines and reports, even though the directors have sound underlying reasons for favoring a particular pay package or design contrary to the proxy advisors’ viewpoints. An example of why directors have concerns regarding proxy advisors’ viewpoints is contained in a provision in the ISS proxy voting guidelines stating that if there are compensation practices that ISS considers unsatisfactory ISS may recommend to shareholders to vote against, or withhold a vote from, “the members of the Compensation Committee and potentially the full board.”

At the proxy advisory roundtable held by the SEC in December 2013, panelists’ comments on proxy advisors’ influence on directors included the following:

Michael Ryan, Vice President, Business Roundtable:

I think it’s really important … to think deeply about the impact the proxy advisory firms have on board decision making; that there’s a lot sort of under the water. Think of it as an iceberg. The impact on the voting decision is what’s above the water, but the impact on board decision making is below the water, and you can’t see it.

Hoil Kim, Vice President, Chief Administrative Officer, General Counsel, GT Advanced Technologies:

I’m in contact … with my counterparts in many, many companies, and every minor signal that comes out of ISS or Glass Lewis is completely over read, and so the compensation committees in particular are looking over their shoulders at every possible indication that comes out… .


Following are three recommendations directed at proxy advisors’ “over the shoulder” impact on directors’ exercise of their responsibilities in overseeing executive pay.

1. Create an “Executive Compensation Standards Board” that would establish guidelines for good practices in the design and implementation of executive pay. A committee to establish and monitor the standards would be selected under the auspices of the SEC. The committee would include representatives of the parties involved in the proxy voting process: shareholders, issuers, proxy advisors, compensation consultants and others. Proxy advisors would be required to apply these independently established guidelines. (Proxy advisors could continue to publish their own guidelines but could not apply them in a manner inconsistent with the executive compensation standards without explaining why.)

The executive compensation standards would include criteria going beyond pay data and stock price that might be relevant to a particular situation. These would include (as noted in the beginning of the column) the issuer’s business strategies, developments occurring within and outside the issuer during the preceding year and needs to attract and retain key executives. Any such disclosure, of course, would have to be consistent with protection of proprietary and confidential information of the issuer. The proxy advisor would be expected to protect any such information and to discuss its protection prior to publication of the proxy advisor’s report.

2. Set the frequency of say-on-pay votes at one vote every two years. Currently (in part due to pressure from proxy advisors) the predominant practice is a vote every year. Proxy advisors should include their executive pay analysis in their reports each year, both in the year of the say-on-pay vote (when the proxy advisor would provide both the analysis and the vote recommendation in the report) and in the off-year (when the proxy advisor would provide only its analysis in the report).

This alternating year arrangement would give directors a reasonable time to absorb the report being made by proxy advisors in the off (non-voting) year. This would help directors anticipate and understand the voting-year report which, as already discussed, gives them very limited time for review before the say-on-pay vote.

3. Require that a copy of each proxy advisory report be filed with the SEC no later than 90 days following the end of the fiscal year in which the report is delivered to the proxy advisor’s clients. This would protect, for a reasonable period, the proxy advisor’s proprietary interest in the report, for which its clients pay a fee, while providing that, ultimately, the report becomes available to the public.

Both comments and trackbacks are currently closed.