Activism & Engagement | Executive Pay
Patrick Haggerty & Ira T. Kay
Patrick is a Partner & Ira is Managing Partner at Pay Governance in New York
Activist shareholders and executive compensation Activist shareholders often apply pressure to curb remuneration levels and plans Broadly speaking, hedge funds have one common goal – to maximise returns to their investors. Some hedge funds use an investment strategy called activist investing, which involves buying a relatively large stake in a company to pressure management to make changes, such as cost savings, spin-offs and hire new management. In some cases, management will negotiate with the activist shareholders. In other situations, activist shareholders conduct proxy contests to gain control. CEO pay is an easy and obvious target for many activist shareholders as a lever to pursue their broader agenda that includes a desire for more board seats, changes in top management, or the pursuit of strategic change. The involvement of activist shareholders exacerbates the risk of ‘high pay and low performance’ situations for compensation committees. Creating aligned CEO pay for performance is very challenging in the current macroeconomic and regulatory environment. Each company has its own set of circumstances to ensure that the executive team is motivated and shareholders are satisfied (expressed via successful say-on-pay votes). This alignment frequently requires careful private analysis, negotiations and resolution under uncertainty. New shareholders with perfect hindsight may not agree with the prior decisions. Thus, good corporate governance and careful decisions about CEO compensation will be needed to withstand the potential pressure imposed by this type of investor. We base this assessment on our direct experience with roughly 10 activist 104 Ethical Boardroom | Summer 2017
shareholders, plus a review of proxy statements where activist shareholders are compensation committee members. Each situation is unique, but there are some common themes. First, we provide our observations regarding an activist shareholder’s pitch to a target company’s shareholders to solicit votes for their recommended board slate. Next, we provide commentary regarding actions taken by activist shareholders when they become members of the target company’s compensation committee. In these circumstances, management and existing board members need to be open to valid suggestions regarding potential improvements to its executive compensation programme. However, we also provide strategies and analysis that can help provide justification for the executive compensation programmes and decisions.
Activist shareholder pitch documents
Typical activist solicitations involve requests for board seats so they can influence strategy and tactics, including executive compensation. However, occasionally, activists use proxy contests to solicit votes to increase their board membership. Proxy contests receive a considerable amount of press coverage due to the high stakes and personal criticisms that activist shareholders often make against the company, its board of directors and its chief executive officer. When activist shareholders directly pitch their rationale to a company’s shareholders to vote for their proposals, they provide the business case for change that often focusses on executive compensation and governance issues. Common executive compensation-related themes that we have observed in these pitch documents are detailed below. Identifying pay-for-performance misalignment Activist shareholders generally start out identifying a
pay-for-performance misalignment with a variety of analyses. The most common approach is to simply comment on the history of annual bonus payouts expressed as a percentage of target compared against year-over-year total shareholder return (TSR) and/or key financial results. This type of analysis can be compelling to show pay-for-performance misalignment if annual bonus payments have paid above target year-over-year while annual TSR declined during the same period. The compensation committee is generally criticised for making consistently poor choices of paying incentives when TSR is declining. In a related analysis used by activist shareholders, they show realised pay compared to TSR. While definitions of realised pay varies, a common definition of realised pay equals sum of salary, bonus paid, earned performance shares, vested restricted stock and the gain from stock option exercises. Realised pay is generally calculated over the CEO’s tenure or over a three-year or five-year period. This type of analysis can be compelling to illustrate a pay-for-performance misalignment if the CEO is realising pay above target levels while TSR declined during the same period. Activist shareholders will also show cumulative CEO pay over his or her tenure compared to TSR over the same period. The optics of this analysis can be embarrassing because the information is gathered from the summary compensation table (SCT) of proxies, which is mostly comprised of target pay as opposed to realised pay. The graphic typically shown by activist shareholders shows SCT pay increasing while TSR is declining. And finally, we have seen examples where activist shareholders challenge the appropriateness of non-generally accepted accounting principles (GAAP) adjustments that are applied to incentive metrics. Activist shareholders will challenge adjustments to non-GAAP metrics especially if they significantly increase incentive www.ethicalboardroom.com
