Editor: Welcome back, Ken. Please start our discussion with an overview of some of the key governance considerations for compensation committees during this year’s proxy season.
Kopelman: Thanks. Let’s focus today on three items I think directors, and especially compensation committee members, may want to give special attention to as this year’s proxy season approaches. They are (a) say on pay and shareholder outreach, (b) the new generation of compensation lawsuits, and (c) the new compensation committee and advisor independence rules.
As a general matter, I see a single governance question that threads through all these issues: what is the appropriate balance of power between boards and shareholders? After decades of a director-centric model, we've seen quite a heavy trend of late towards the shareholder side. The issues that we’ll discuss below find shareholders and directors somewhat on different ends of this seesaw.
My personal view is that in terms of governance reforms and empowering shareholders, as compared to boards, we may have reached the point of the so-called "minimum effective dose," i.e., the point at which enough medicine has been administered to achieve the desired effect. To mix the metaphor, if the goal is to boil water, once you get to 212°, applying additional heat doesn’t improve the result. The governance reforms over the past decade – especially executive sessions of the board – have truly transformed the boardroom dynamic. But the sense in the boardroom today is that directors are spending too much of their time on governance-related tasks that are not particularly value-creating. When we look at the overall cost/benefit of, for example, say on pay here in the U.S., I have to wonder if we’ve reached the point of diminishing returns, and will discuss that later. Of course, having said that, directors do need to be mindful of the realpolitik of today’s governance landscape, and be prepared to balance theoretical or ideological considerations against the practical imperatives of fulfilling the legal obligations that are part and parcel of public company status in the U.S.
Editor: What are your expectations regarding the 2013 say on pay season?
Kopelman: 2013 is our third year of experience with universal mandatory say on pay. Also, the initial two-year exemption for smaller reporting companies has now expired, so we’ll see an uptick of somewhere around 20 percent in the number of companies under the say on pay regime. It’s pretty obvious that say on pay’s impact in the U.S. has thus far not been all that dramatic. In fact, although 2012 saw roughly double the number of failed votes than in 2011, all in all we’re still only talking about two or three percent of public companies that failed – not exactly earth shattering. Given how say on pay has turned out here in the U.S., I think it’s reasonable to question whether, on a cost/benefit scale, the whole exercise has been worth the tens of millions of dollars that have been spent to fuel the sizable industry that say on pay has quickly become. Those dollars – paid to lawyers, compensation consultants, governance specialists and proxy advisory services – might have ended up in shareholders’ pockets or otherwise been put to better use. It can surely be argued that the historical approach – where shareholders could identify companies with egregious pay practices, and offer a targeted shareholder proposal to require a say on pay vote at this or that company – was a more focused and efficient response to the issue than the universal mandatory approach we have today. The lesson? Never underestimate the popular politics of executive compensation.
On the other side, some believe that say on pay in the U.S. is still in its infancy. These commentators – including among them some of those who stand to benefit most from the current system – believe that say on pay will continue to evolve and grow, and its true impact won’t be felt for at least a few years. It certainly continues to evolve across the international scene, with binding (as opposed to advisory) say on pay votes under consideration in the UK and recently adopted in a number of jurisdictions – including Switzerland, which went so far as to include criminal penalties for noncompliance. Israel recently adopted a “say before pay” law, and Australia has rules that in essence mandate putting an entire board up for reelection if a company’s say on pay resolution fails to get at least 75 percent support for two years in a row. My bottom line is that I don’t believe the say on pay movement in the U.S. has yet reached its ultimate expression. My sense is that the “no” vote percentage will start to creep up in 2013 (even given what should be a relatively high degree of shareholder satisfaction in light of the generally stellar performance of the equity markets over the last few months).
Editor: How are compensation committees preparing for their upcoming say on pay vote?
Kopelman: Although say on pay votes are purely advisory, they do carry substantial clout. In terms of activities aimed at securing a positive say on pay vote, boards pay attention and are engaged. The general mantra in terms of company/shareholder interaction has become “communicate, communicate, communicate.” It’s well-settled advice that better proxy disclosure can help, especially if it includes a crisp and focused CD&A, complete with an executive summary. My experience has been that the best route includes a more hands-on, direct approach to shareholders; however, before embarking on such an outreach program, companies need to make sure that (a) they have a compelling story to tell, (b) they know how, where and when their story will have the most impact, and (c) probably most important, they decide who is best positioned to tell that story.
I’ve heard institutional investors informally suggest some loose guidelines for these interactions, including that a company should not expect to engage with them during the middle of the proxy season (except, perhaps, in extreme circumstances). It’s much better to come to them in the fall or early winter when they have the time and bandwidth to engage.
They also generally suggest not including the CEO, or even a corporate communications executive, in the discussion. Institutional investors seem much more receptive if the company team is headed by an outside director, hopefully a member of the compensation committee, who can represent the company’s viewpoint articulately, who is knowledgeable about the company’s compensation approach and programs, and who is otherwise “camera ready.” Ensuring that the discussion includes a company staff person who is directly responsible for executive compensation – somebody who really knows the nooks and crannies of the programs – is another plus, especially as opposed to an outside compensation consultant. Institutional investors generally don’t want to talk to consultants if they can help it.
Editor: Now that companies have had some practical experience, what’s your general sense of how proxy advisory firms have influenced the say on pay process and of what’s in store for 2013?
Kopelman: Say on pay has obviously been a boon for the proxy advisory services. A good many of the smaller institutional investors in effect outsource their say on pay votes to ISS or Glass Lewis. And from a cost/benefit point of view that probably makes sense. (Whether or not smaller institutional investors should in fact be required as fiduciaries to cast all of their say on pay votes – as they effectively are today – is an issue we’ll leave to another time.) The larger institutional investors also subscribe to these services, but only to add another data point to their own internal analysis. So providing say on pay advice appears to be a pretty good business. ISS and Glass Lewis have a vested interest in keeping say on pay front and center. Their current focus seems to be keeping the heat on, if you will, the “bottom ten percent of the class” by seeking to effectively raise the “passing grade” for a say on pay vote to 70 percent (even though, say, 63-37, is still a healthy margin).
In terms of ISS’s influence: ISS recommended a “no” vote against approximately 11 percent of companies in 2011; this percentage increased to approximately 14 percent in 2012. Notwithstanding this, as we know, the vast majority of companies still passed. All this by way of saying that a “no” recommendation from ISS is far from a “death sentence.” Companies have been able to overcome “no” recommendations via a variety of routes. These include analyzing the historical voting patterns of their larger shareholders vis-à-vis ISS (and Glass Lewis) recommendations, engaging directly with these shareholders (especially those who appear likely to follow the ISS recommendations), and considering a public campaign that might include a supplemental proxy filing to present the company’s case. Getting back to influence: There is a study out there that suggests that a negative ISS recommendation in 2012 correlated with an approximate 30 percent drop in shareholder support (compared with a 25 percent drop in 2011). As the previously exempted smaller companies come under the say on pay regime, I’m assuming ISS’s influence, as a statistical matter, will only grow, as most institutional investors will not deem it worth their while, cost/benefit-wise, to devote their scarce resources to doing their own separate compensation analysis on smaller companies that don’t represent a significant part of their portfolio.
Editor: So is it safe to say that, in spite of the rather benign effects of the say on pay experience to date, the stakes remain fairly high?
Kopelman: Yes. Although the vast majority of companies have sailed through, they can’t be confident that one of the proxy advisory services won’t take a closer look in future years. In fact, of the 56 companies who experienced their first failed vote in 2012, 13 of them had received 90-plus percent approval in 2011, and another 23 had received 80-plus percent approval. And many of these first-time failed votes occurred at companies that made scant changes in their year-over-year pay practices. So right now, companies shouldn’t get too comfortable or take success for granted. In addition, there is a small handful of companies – those whose votes failed two years in a row – that are now facing the true power that the say on pay vote can wield: the real possibility of having some of their directors voted off the board. Certainly, these companies would tell you that say on pay has real impact. Like many issues, it really depends on where you’re standing.
Editor: What is the current tenor of shareholder disputes and/or lawsuits pertaining to executive compensation? We understand, for example, that the recent plethora of actions relating to say on pay disclosures has produced mixed results for plaintiffs.
Kopelman: Soon after the adoption of mandatory say on pay, over a dozen notable lawsuits, including Cincinnati Bell and Beazer, were brought in which plaintiffs argued that shareholder disapproval of a company’s executive compensation plan – i.e., a majority “no” vote on say on pay – supports a claim that the directors breached their duty by approving allegedly excessive compensation payments – and because of that were no longer able to claim the protections of the business judgment rule.
But during the last year, there has been a growing consensus, at least under Delaware law, that a failed say on pay vote does not in and of itself rebut the presumptions of the business judgment rule, and further, that directors who are free of conflicts and acted with informed good faith, believing that their actions were in the best interests of the company, will usually be able to prevail.
Starting last year, as this first generation of lawsuits waned to some degree, a new wave of lawsuits started taking a different tack. These suits generally claim that the proxy statement lacked certain material disclosures in the say on pay context, and was therefore materially deficient. These actions usually were joined with claims of breaches of fiduciary duty, of care, loyalty, candor and good faith by the directors. These suits – there have been somewhere in the neighborhood of 25 brought – were typically launched after the proxy statement filing but before the shareholder meeting. The goal was to enjoin the upcoming say on pay vote until the allegedly incomplete or misleading proxy statement could be remedied through additional disclosure. In some of these cases, plaintiffs attacked not only the say on pay vote but also (or instead) a company proposal for a new authorization for shares under an employee plan – either increasing shares available under an existing plan or adopting a new one. In addition to the filed lawsuits, these same plaintiffs’ law firms (and there are a growing number of them) have announced investigations of close to 50 (including over 20 in 2013) additional companies, effectively reserving the option to sue them as well.
In at least two of the earlier new-generation cases (including Brocade, in California State Court), the plaintiffs prevailed, and the court granted the injunction. This was obviously a terrific result for the plaintiff, and significantly upped the ante for company defendants. Now faced with the real possibility of having their say on pay vote enjoined and the related disruption and expense of defending the lawsuit, at least six other companies settled prior to their meeting date by agreeing to provide supplemental disclosures. These settlements also included paying attorney’s fees that ranged from the low six figures well into the half-million-dollar neighborhood.
When the first of these cases was filed, the courts were writing on a blank slate, without much, if any, precedent; it seems clear in hindsight that a couple of cases (Brocade, most notably) were decided incorrectly. Over the last few months, a number of companies have stood their ground and been successful in defeating injunction motions. Companies that have fought off injunctions include Clorox, Symantec and Hain Celestial, and our firm mounted a successful defense for Globecomm. Today, there is a growing body of decisions denying injunctive relief and dismissing complaints. As a result, we think it is less likely that, going forward, this type of case will be successful.
Editor: Clearly, these injunction attempts imply a delay of game for companies seeking to meet deadlines for scheduled shareholder meetings. How does this play out in real time?
Kopelman: Proxy statements are usually filed around six weeks or so in advance of the meeting. After the proxy is out, the plaintiffs bring their suit and seek an injunction. Companies are then forced to assess, within a very compressed timeframe, whether they should allocate the time and resources required to fight in court – which may end up leading to a delay of the annual meeting – or settle quickly, by providing additional disclosure language and paying attorney’s fees. All of this plays out against a loudly ticking clock, and companies are left to determine, on balance, their best course of action. But yes, more companies seem to be fighting; stay tuned.
Editor: In light of the June 20, 2012 adoption of new SEC rules – and subsequent rules adopted by the NYSE and NASDAQ – is there now a settled definition of “independence” as it pertains to compensation committee members and compensation advisors?
Kopelman: Since 2003, we’ve had very strict independence rules applicable to audit committee members. Now, as compensation has come squarely into the governance spotlight, Section 952(b) of the Dodd-Frank Act has applied a somewhat analogous independence approach to compensation committee members.
The new SEC and stock exchange rules adopted to implement § 952(b) extend the independence notion to apply to outside advisors, including compensation consultants and outside lawyers. Thus, while compensation committees may continue to receive advice from outside advisors of their choosing, the new listing standards require them to first consider six independence factors. If, after considering these independence factors, the engagement of an advisor raises a conflict of interest question, the company must disclose the nature of the conflict and measures to address it. That’s really brand new.
Where the compensation committee, after doing its conflict assessment, finds that no conflict exists, there is no obligation to include any particular disclosure in the proxy. I have seen a few companies who, presumably under the banner of “good governance” and “transparency,” have nevertheless listed the independence factors, the fact of the assessment and the “no conflict” finding. However, most have chosen to remain silent.
Viewed through a governance lens, these rules effectively wag a finger at compensation committees saying: “You have been hiring compensation consultants and outside counsel without making sure that they are free from conflicts – and therefore allowing them to provide you with advice that may be slanted in favor of management. So be careful!” On the other hand, say on pay voting has been overwhelmingly supportive of compensation decisions made by the very same committees. A bit counter-intuitive, some might say. We’ll see how this develops, but so far there has been scant disclosure surrounding the judgment calls that compensation committees are making in selecting their advisors.
Editor: How do these new independence rules with regard to compensation committee members/advisors dovetail with the rules around the number of independent directors on the board?
Kopelman: The issue of director independence has been a lodestar of the good governance movement since its inception, with the Enron and WorldCom scandals as poster children. As this movement gained momentum, two rules – in my mind, perhaps the most transformative that the governance movement has produced – were adopted: that public company boards have a majority of independent directors, and that the outside directors meet periodically in executive session. As boards implemented these new directives, some naturally began to think that if having a majority of directors being independent was good, then an entirely independent board was even better. (Is the “minimum effective dose” ever enough?) This soon became a rallying cry – all directors except the CEO need to be independent – even though there was no hard evidence that independent boards produced any better corporate performance or governance (in fact, a few studies indicated the opposite).
Pretty soon, directors were being named to the board who had no background in the company’s industry, no meaningful financial stake in the company’s success (either directly though equity ownership, or indirectly by being a provider of goods or services), no knowledge about the company (or any incentive to learn) and ultimately, some would argue, an aversion to risk-taking. Put another way: their principal qualification was that they were independent. And instead of promoting tough and challenging, give-and-take discussions that are critical to board processes, the CEO became the sole conduit through which industry information was passed to the board. In terms of a board composed solely of independent directors, I’m happy to say that it appears the pendulum is swinging back somewhat, and the importance of factors other than independence – like industry background and expertise – is once again being recognized.
In contrast, in the context of board decisions (as opposed to board composition), however, independence is really one of the few “non-negotiables.” The business judgment rule provides the board with very broad and important protections for its decisions, provided those decisions are (among other requirements) made by directors who are free of conflicts of interest. Obviously, there is a clear conflict, for example, if a director sits on the board of both companies in an M&A transaction, and many recent cases have revolved around the independence (or lack thereof) of the advice provided to boards by their investment bankers (will they, for example, be more interested in providing financing than giving independent advice to the board; will they favor one bidder over another due to undisclosed historical relationships). So I think it’s important not to conflate the notion of populating the board with a majority of independent directors, on the one hand, and that of director independence with respect to certain decisions, such as compensation, on the other. Both are important, but they’re really two different things.