Many companies have restructured their executive pay-for-performance programs to prepare for the first “say on pay" vote in the 2011 proxy season. Experts from consulting firm PricewaterhouseCoopers detail concrete preparations and advice for companies to reform their executive compensation practices in anticipation of what promises to be an even tougher shareholder vote in 2012.

When the Securities and Exchange Commission enhanced disclosures from 2010’s Dodd-Frank Act, the law’s "say on pay" vote provision gave shareholders new perspective into the workings of companies’ executive compensation programs, especially the pay for performance relationship.

"These enhanced disclosures have given not only shareholders, but other stakeholders, such as the media, proxy advisers and employees, new insight into the executive compensation program, and very specifically whether they are pay for performance oriented," explained PwC Director Steven Slutsky during a recent webcast.

"Many companies have made changes to their program, particularly in the executive compensation area in 2011 in anticipation of the first round of shareholder advisory 'say on pay’ votes," he added.

Proxy advisory firms recommended “against” votes for approximately 250 companies in 2011, and 38 companies failed "say on pay" votes. PwC found that shareholders followed proxy advice with a majority of “No” votes at only 2% of companies.

However, proxy advisors recommended that shareholders vote against the executive compensation program at all the companies that had a majority of “No” votes. Also, the percentage of shareholders that voted to approve companies' executive compensation programs against the advice of advisers (69%) was significantly less than for those shareholders whose advisers recommended a "Yes" vote (94%).

Many companies made changes to their compensation programs before filing their 2011 proxies due to the "say on pay" requirements. PwC uncovered the following compensation changes:

  • Proactive elimination of gross up provisions
  • Reductions in executive benefits and perquisites      
  • Establishment of performance conditions on long-term incentive grants
  • Tighter alignments between annual incentive payouts and performance

Further spurred by fear of shareholder resistance to current executive compensation practices, some companies made unprecedented changes to previously-granted equity programs or contractual rights including:

  • Changing previously-issued stock option grants to make them performance-based
  • Rescinding contractually agreed-to change in control gross-up provisions for senior executives
  • Adding multi-year performance periods to prior equity grants

Though most companies claimed they did not spend more time on their proxies this year than last, PwC found that many companies did enhance their disclosures in 2011 proxies by:

  • Adding an "Executive Summary"
  • Enhancing the peer group discussion 
  • Describing the pay-for-performance relationship 
  • Better explaining why severance and change-in-control programs were necessary

Looking ahead to 2012

Employers must remain vigilant in the new year because, according to a recent poll, institutional investors said they reserved their "No" votes for particularly egregious compensation practices. They felt that too many "No" votes would "dilute the effectiveness of voting against the pay plans," explained Steven Slutsky. Further, an overwhelming majority expects the number of companies with majority "No" votes to increase in 2012. 

Among those boards whose companies received a majority “Yes” vote in 2011, 72% are reviewing the results carefully to discern if there is any concern over any part of the compensation program, according to PwC’s 2011 Annual Corporate Director Survey. Approximately one-half of boards are considering changes to their executive compensation programs for 2012 as a result of "say on pay."

Companies must report in the 2012 proxy how the prior year’s "say on pay" vote impacted policies and decisions and how say on pay results affected policies and decisions.

To provide insight into what may need changing, PwC found that shareholders voted “No” in 2011 for the following reasons:

  • Disconnect between pay for performance, or a "cherry-picking" of performance metrics from year to year. This was the most common reason, cited by almost all investors as the key factor for their "No" vote.
  • "Make-up" cash and equity awards when the plans do not pay out because executives didn’t reach performance targets.
  • Executive perquisites, especially with personal aircraft travel coming under extra scrutiny.
  • Tax gross-ups and excessive severance agreements/awards.
  • Proxy disclosures that disguise the pay-for-performance relationship of the program.
  • Compensation levels that are facially "too high."

For 2012, The Institutional Shareholder Services (ISS) will continue to analyze how companies link pay and performance. To that end, they will be using peer groups that may vary from company-sought peer groups, with a focus on revenue and industry, without considering the market for executive talent.
ISS also has eliminated the exception for CEOs with less than two years tenure after they found too many companies were falling into that group. In general, ISS will more intently scrutinize companies that received less than 70% “Yes” votes on their executive compensation programs. Approximately 15% of companies fell into that category.

Despite glaring attention from regulators, employers should remember the purpose of incentives, and the full opportunity they provide. Companies should not implement pay for performance tactics to mimic other companies or satisfy regulations, but to spur business growth. Committees are meant to be hands on and employers must find a way to use executive pay to fuel the executives and the company's goals.

"There's no one-size-fits-all formula for the design of incentives, or measurement of performance or for the evaluation of pay for performance. Payouts should be linked to proper business goals, not just to the stock price," explained Rick Ericson, managing director, PwC. "Design changes in this area should be guided by overarching principles. That seems to be a general expectancy."

Modeling an executive compensation structure on stock-based gains doesn't work because very few people have significant impact on stock gains and losses. Instead, Boards must now use, and be able to defend, explicit metrics and goal elections. PwC experts explained that bonuses can focus more on sustained value creation. For example, long-term incentives can propel executive performance with goal-based incentives that look to the company’s future.

"Overall, setting multi-year goals and using those practicably within a long term incentive program is probably an area where many companies could make some improvement and expect some improvement in the efficacy of their incentive program," suggested Ericson.  

In order to comply with regulations, satisfy shareholders and prosper in a "say on pay" world, the SEC recommends Boards consider the following:

  • Disclosure must include a description of the performance goals in the incentive plans, how the company performed against those aims, and how the actual compensation metrics were determined.
  • Add more detail about the compensation decision-making process. Explain why decisions were made, not simply what they were.
  • Include detailed information about those participating in the process and their roles, especially management.

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