By Cydney Posner
Here's an interesting discussion from two Compliance Week columnists who are trying to make sense of the say-on-pay voting results this season. As of mid-May, 21 companies had failed say-on-pay votes. There were some obvious reasons why these companies failed, such as poor stock price performance. But, the authors argue, thousands of companies were poor performers, but were still able to garner a majority favorable vote on executive pay. Why were these 21 so special? It turns out that their compensation practices included many of the most common compensation hot buttons: poor pay-for-performance alignment, tax gross-ups, single-trigger change-in-control provisions and high dilution rates. Why, the authors ask, did the compensation committees of these companies not recognize or address these issues?
While the authors explore and discard a number of theories (or straw men, depending on your point of view), there's one piece of spaghetti that does stick to the wall: "According to the National Association of Corporate Directors, the median tenure for all public company directors in the United States is less than 7.5 years. Yet the median board tenure for the compensation committee chairs at the companies with failed say-on-pay votes is approximately eight years, and the mean is 10 years….Put another way: Statistically, the average chair of the compensation committees at those companies with failed say-on-pay votes should already be retired from the board. And the figures probably understate the issue, since two of the long-tenured chairs—one with 12 years, the other 17—have been with their respective companies since the initial public offerings. One compensation committee chair has served on his company's board for an eye-popping 39 years!"
Instead of attributing experience, wisdom and judgment to these long-tenured committee members, the authors suggest that their longevity on their committees may be responsible for the continued presence of these compensation red flags. The authors offer two hypotheses, one drawn from organizational theory and the other from behavioral science: "The first is ‘client capture.' Organizational theorists describe client capture as the development of long-term, close relationships in the regulatory world, that allow the regulated to gain influence over those who are supposed to regulate them. The result is that the regulators try to please the regulated, rather than guard against abuse.
"That analogy isn't perfect. Directors are not regulators; one of their critical functions is to counsel and advise management, not simply to oversee and govern it. But that dual role might facilitate client capture over time, as the close working relationship encourages a desire to please. That is why Britain's Combined Code, that country's corporate governance standard, suggests that directors who have more than nine years of tenure should no longer be considered independent.
"Behavioral science suggests another reason for concern. Long-tenured directors may ‘anchor' their vision of what should be to what has been. As a result, they may resist change because they see that change as an implicit repudiation of how they have operated in the past. From their point of view, there is no reason to shift just because the world's expectations have changed. Alternately, they may be blinded by habit, and so remain unaware of the need to modernize compensation standards. From the perspective of institutional investors, either explanation is problematic: The compensation committee is either resistant to change, or has been asleep."
From their interviews with institutional investors, the authors report that investors have had more opportunities than in the past to engage with companies and, after losing say-on-pay votes, many companies have been more willing to change compensation plans. However, investors also made clear their intent next season to vote against compensation committee members at companies that lost say-on-pay votes but are recalcitrant about addressing the issues.
The authors suggest that compensation committees first consider whether the hot-button features of their compensation programs are really necessary for the company. If so, the reasons should be clearly articulated in the proxy statement. If the problem is instead a misalignment of pay and performance, the committee will need to consider whether and how best to accomplish a re-alignment. A remedy here may be especially problematic to the extent that performance is measured by total shareholder return (TSR), which may or may not be related to the company's operating performance.
Looking to the audit committee as a model, the authors recommend that, to create a more proactive environment, companies need to encourage a new dynamic among the compensation committee, management, consultants and stockholders, including a more assertive leadership role for compensation committee chairs in "understanding investor expectations, crafting credible policies, and explaining them persuasively to a broad constituency." In addition, committee membership must be "refreshed" from time to time.