Editor: Ken, please tell our readers about your practice.
Kopelman: I practice corporate and securities law. I co-chair our firm's Corporate Governance practice - made up of attorneys from within both our corporate and litigation departments - which represents boards, board committees (audit and compensation) and directors on the full range of governance, compliance and disclosure matters, including internal inquiries and investigations. My approach to the work is informed by my own 20-plus years of service as a public company director, including an S&P 500 consumer products company (NYSE), and a computer software firm (NASDAQ). So I bring along that perspective to the table.
Editor: In January 2011, the SEC adopted rules to implement Dodd-Frank's requirements on "say-on-pay" and "say-on-frequency." Since all the votes are non-binding, what do they accomplish?
Kopelman: Just because the votes are non-binding does not mean they are unimportant. Boards today who fail to implement matters recommended by a shareholder vote - even if the vote is "only" advisory - do so at their peril. A board's failure to implement a shareholder vote is a hot button for institutional investors of all stripes. If directors turn a deaf ear to shareholders, they run the ultimate risk - a vote against them in future elections.
A high negative say-on-pay vote will certainly put a board on the defensive. The resulting embarrassment may go so far as to damage a company's reputation. Not to overstate it, but in extreme circumstances, this could exacerbate existing problems, e.g., in attracting and retaining executive talent, or in accessing financial markets. So although these are only advisory votes, they can carry real clout.
Editor: Is it important for boards to express a recommendation on say-on-frequency? What positions have institutional investors and proxy advisors taken on the question?
Kopelman: Since Dodd-Frank recognizes that one, two and three years are all appropriate intervals for say-on-pay votes, a board may think that leaving the choice up to its shareholders is best. However, especially in the current environment, boards are encouraged to be active participants in any governance debate. By making no recommendation, a board may open itself up to charges that it has abdicated its leadership role on governance issues. Also, in the absence of a management recommendation, any signed, but blank, proxy cards can not be voted on the question. Accordingly, we've been advising boards to take a position.
Moreover, in the absence of a board recommendation, a company will be virtually certain to end up with an annual vote. The decision will be defaulted into the hands of larger institutional investors and proxy advisory firms, most of whom (e.g., ISS, Fidelity, CalSTRS and Putnam) are advocating a "one size (i.e., 'one year') fits all" approach.
Editor: Can you give us a snapshot on how say-on-pay recommendations and voting are shaping up so far this year? Have many say-on-pay votes failed?
Kopelman: In terms of board recommendations on frequency, although three years led the pack early on, as of March 18, around 49 percent of companies have recommended annual frequency, with around 44 percent recommending three years. In terms of shareholder voting, about two-thirds of companies are seeing shareholders supporting one year. Only four (most recently, HP) substantive say-on-pay votes have failed. I note that one of the companies experiencing a failed vote - Beazer Homes - was recently sued by shareholders claiming the company's executive compensation program shortchanged investors by rewarding managers for subpar performance. We'll all be watching how that case progresses.
Editor: What were some of the bigger concerns around annual say-on-pay going into this proxy season?
Kopelman: One was that the sheer number of say-on-pay votes - which need to be processed by investors within a very tight time frame during proxy season - would overwhelm the system. Somewhat in response to that concern, the SEC's final rules exempted for two years smaller reporting companies (with less than $75 million in public float) from the requirement to hold say-on-pay and say-on-frequency votes. This reduced the number of 2011/2012 votes investors need to process by about 20 percent.
Editor: Some say that an annual vote on say-on-pay may act as an ongoing safety valve, enabling shareholders to express displeasure over pay without being required to resort to "vote no" campaigns against compensation committee members. Can you comment?
Kopelman: "Vote no" campaigns remain a powerful tool, especially given the degree to which majority voting for directors has taken hold. They can lead directly and fairly immediately to director resignations and replacement, as opposed to say-on-pay votes, which are advisory. The use of "vote no" campaigns in a say-on-pay world is not yet settled; but don't count on investors giving them up simply because you've adopted annual say-on-pay. For example, ISS has stated that even where it recommends a "no" on a substantive say-on-pay proposal, it may go further and recommend a "no" vote for compensation committee members if it deems a company's pay practices "egregious."
Editor: You just mentioned ISS, the largest of the proxy advisory firms. How important are the proxy advisory firms in the say-on-pay equation?
Kopelman: Some historical academic studies indicated that ISS influenced somewhere between 13 to 30 percent of votes; the most recent study I've seen pegs the range between six and 10 percent. In any event, I believe their influence on say-on-pay votes will, in many cases, be quite significant. Each company needs to do a shareholder census and figure out the influence of the proxy advisory firms on their own shareholder population. They can then judge how important the proxy advisory firms are going to be in their own particular circumstances.
If you speak to most of the larger institutional investors, they will tell you they don't rely on the proxy advisory firm reports but rather have their in-house analysts take them into account as data points when arriving at their own voting determinations. Smaller investors - say, the pension fund for a small fire department - who don't have the time or resources to conduct their own analysis might make the perfectly logical cost/benefit decision to rely almost exclusively on the expertise of a proxy advisory firm in determining how to vote. The increased influence conferred on proxy advisors by say-on-pay has further focused the question of whether, and how, these advisors will be regulated going forward.
Editor: Were you surprised by the manner in which say-on-pay has been developing this year?
Kopelman: In a few areas, yes. Everyone always knew that the proxy advisory firms would recommend their clients opt for annual votes and that the public pension funds would go along. The surprise (to me at least) has been that many of the larger fund complexes (e.g., Fidelity, Vanguard and Putnam) have come out with a one-size-fits-all approach to the frequency vote. Perhaps this is an uncharitable characterization, but by taking this tack, the funds seem to be essentially saying to boards, "We don't care if you've never had a compensation or governance issue, or if you've compensated your folks perfectly over the last 10 years - we're voting the same way on everyone in our portfolio, and we really don't care what management is recommending or what their rationale is." And that "one size" has almost invariably been an annual vote. So, for example, at Costco's annual meeting in January, their substantive say-on-pay vote got approval north of 98 percent - signifying that the shareholders strongly endorse the board's compensation choices - but management's recommendation for three-year frequency was a loser, garnering 43 percent support, compared with 53 percent for an annual vote. Boards are - I can tell you - more than just a bit frustrated by this.
Moreover, as a result of where the mutual funds have been coming out, I think the frequency question is getting close to "game over"; although we may not get there this year, pretty soon - certainly once we go through the first six-year cycle - I'm willing to take the bet that virtually all broadly-held companies will end up with annual say-on-pay votes.
As, if not more, important, is that if I am correct in characterizing mutual funds' attitudes towards the recommendations of corporate boards on say-on-pay frequency as dismissive, might it portend a very new and different calculus as we look forward to the implementation of proxy access next year - when actual board seats will be on the line?
Editor: So are you suggesting that the voting patterns of institutional investors on say-on-frequency - where they seem to have ignored management's recommendations - signal a new balance of power in the corporate governance equation?
Kopelman: Twenty years ago, if management proposed something, shareholders went along. Management was viewed as interested, informed, invested in the result, with "skin in the game," and most important, trustworthy - so it seemed logical for shareholders to assume that managers knew what was best. Management's views were the default choice, and, to put a point on it, brokers could (almost always) automatically vote your shares for management's recommendation unless you instructed them otherwise. Now, after Enron, WorldCom, Sarbanes-Oxley, Dodd-Frank and all the focus on governance, we seem to have ended up with the exact same system - except that, now, it is ISS's views that appear to be the default choice.
Along the same lines, many boards continue to be frustrated with the internal split within institutional investors - i.e., the internal wall between the folks making the investment decisions at these funds and those doing the voting. While directors are charged with dealing with both the business and the governance spheres - and seeking to integrate the two - institutional investors, almost without exception, staunchly keep the two spheres separate.
Editor: So what is the true impact that say-on-pay is having in the boardroom, from a governance prospective?
Kopelman: Well, say-on-pay is now the law, and it looks like it's here to stay (it was not among the Dodd-Frank provisions targeted for repeal in recent Republican-introduced legislation). Contrary to the dire predictions, say-on-pay has not heralded the end of the American free market system as we know it. However, it does add another burden, another cost to balance against the benefits of being a public company. All in all, I see it as another arrow in the quiver of institutional and activist investors seeking to shake up boardrooms - in some cases for good reasons, and in other cases for less-than-good reasons.
It is a truism that boards are charged with oversight and governance for the long term. Institutional investors espouse long-term investment themes, but in fact, most have portfolio turnover ratios in excess of 100 percent. This smoldering tension between long and short term is really one of the central issues in governance; it is, among other places, reflected in the steady march away from staggered boards and towards annual elections. The emerging practice of annual say-on-pay votes can be viewed as another log on that fire. Directors will have to be more responsive to day-to-day shareholder pressure; the danger is that, in the bargain, they will be forced to become more like politicians, focusing more on the short term (and "campaigning" consistently to be re-elected). To the extent that a more short-term focus eventually triumphs, I don't really view that development as being in anyone's best interests.
Published April 3, 2011.
