Compensation Committees Caught in the Middle As Pay Collides with Governance

The need to attract, retain, and appropriately compensate top talent sometimes results in tension and even outright conflict. Compensation committees, particularly those serving large-cap companies under scrutiny, are caught in the middle of this “collision course.”

Investors are increasingly concerned about corporate sustainability, including the well-being of the workforce and the retention of high-performing executives. As a result, the oversight responsibilities of compensation committees have expanded to include talent recruitment, training and development, and the key performance indicators that align pay with performance.

Despite the current economic downturn, the competition for top talent remains fierce, especially in highly desirable roles. This sometimes leaves boards with little choice but to meet the market demands for compensation, even if those decisions cause consequences. If companies meet talent demands, they may be criticized by investors and proxy advisors for pay and performance misalignment. On the other hand, if they refuse to meet talent demands, they risk losing valuable assets and suffering subsequent hits to corporate value, reputation, and culture.

Numerous examples during the 2022 proxy season point to a deepening tension between executive pay and defensible pay program design. One barometer of rising shareholder dissatisfaction is the results of Say-on-Pay (SOP) voting. Some of the lowest percentages since the onset of SOP in 2011—mandated by passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act in response to the financial crisis of 2008—were seen last year.

 

Source: Farient Advisors

 

During last year’s proxy season, investors and proxy advisors pushed back on several issues, especially one-time equity awards to such companies as Apple, Coca-Cola, and JPMorgan. Each of these companies scored low on shareholder SOP support. Both Institutional Shareholder Services (ISS) and Glass Lewis (GL) criticized these one-time grants for a number of reasons, including their size (Apple), the lack of clear explanation of the award (Coca-Cola), and the lack of rigorous performance-vesting criteria (JPM). Other reasons for poor SOP votes, according to a Farient analysis, included the lack of rigorous performance metrics, granting a special award despite poor corporate performance, and an inadequate response to the previous year’s poor SOP vote.

 

WHY INVESTORS VOTED NO ON SOP IN 2022

Source: Farient Advisors

 

Clearly, one-off awards and other compensation actions—a lack of alignment between pay and performance, excessive pay relative to peers, and poorly communicated rationales for pay programs—raise the ire of both proxy advisors and investors, resulting in “Against” SOP votes, and eventually, “Against” director election votes for repeated offences and/or lack of responsiveness to investor concerns.

At the peak of last year’s proxy season, a higher number of corporations in the S&P 500 received votes of less than 70%. Historically, it is unusual for companies to receive less than 90% support on these votes, so less than 70% support is reflective of significant investor dissatisfaction.

 

Source: Farient Advisors

 

Rules of the Road

Navigating the collision course will require decisive action by compensation committees to avoid the pitfalls that draw negative reactions from shareholders and proxy advisors. Compensation committees will need to consider broader human capital issues; for example, making sure that succession plans are supported by justifiable pay actions.

The good news is there are constructive actions that compensation committees can take to avoid potential governance minefields. To that end, we encourage compensation committees to follow some rules of thumb when making special awards, including:

• Establish clear performance conditions for earning awards
• Design the program to serve a unique and different function compared to the normal ongoing programs, for example, with different objectives, time horizons, and/or performance measures
• Treat decisions on participation and award quanta as a capital allocation exercise. To do this, analyze the value of each executive to the business; then assess their vulnerability by analyzing each executive’s pay positioning (relative to the job the executive currently holds and the jobs the executive could hold) and assessing the holding power the company has over the executive. This process generally surfaces those who are most vulnerable and suggests which executives will yield the highest returns by participating in a special award program
• Keep awards at reasonable levels
• Explain. Explain. Explain. Be crystal clear as to the rationale for the awards in public disclosures and in shareholder engagement sessions
• Think about excluding the CEO, who is the most visible and scrutinized officer among the Named Executive Officers (NEOs)
• Communicate to shareholders that such awards are intended to be a one-time or infrequent occurrence

As an example, Farient did just that for one of its clients. In conjunction with the compensation committee and management, the company developed a special award program that required investment by select executives, excluding the CEO, in company stock. Investors supported this plan, despite its special nature, because it strengthened the ownership mentality of executives and further aligned executive interests with their interests.

Managing the successful execution of business strategy relies on attracting, retaining, and motivating great talent. That is a given. Navigating compensation decision making within the guardrails of good governance in today’s challenging market is less certain. With incisive analysis and guidance, boards should be able to avoid putting their compensation programs on the collision course.