Increased Shareholder Engagements and Defining Performance Metrics

C-Suite Insight, June 19, 2014

Kenneth Bertsch, Partner at CamberView Partners LLC

As is commonplace to note, Say on Pay has prompted substantially increased engagement between shareholders and their portfolio companies. As part of this, institutional shareholders have stepped up their understanding of compensation. And corporate directors, as well as compensation, governance finance, and IR executives at corporations, have developed a stronger understanding of investor perspective on pay.

The institutional investor capacity relates, in part, to expanding governance staffs, perhaps most noticeable at large asset managers. But another cause is that companies have become better and more insistent in reaching out. In addition, sophistication at some institutions is promoted by increased integration of investment and governance staff.

As a generalization, institutions do not want to micromanage compensation design and choice of metrics, but they do want comfort that companies are thoughtful in putting metrics in place that relate to the particular company’s strategies. Where investors do comment on metrics used, opinions differ, and appropriate performance measures vary depending on industry and other company-specific factors.

I would have some concern on emphasis on Total Shareholder Return (TSR) as a least-common-denominator performance measure, easily understood as a bottom line for all investors, and in some sense, “objective” and transparent. TSR is removed from financial and other measures more directly linked to company goals. Long-term linking of pay to TSR makes sense as a test and reality check for those outside the company and boardroom, but that does not mean that board compensation committees and their advisors should make it their primary instrumental measurement in incentive pay design.

Ken Bertsch joined CamberView in January 2014 with more than three decades of leadership roles in corporate governance. Previously, Mr. Bertsch led corporate governance teams at Morgan Stanley Investment Management, Moody’s Investors Service Corporate Governance Ratings, and served as Director of Corporate Governance at TIAA-CREF. He most recently served as CEO and President of the Society of Corporate Secretaries and Governance Professionals. Early in his career, he served for 14 years in various capacities at the Investor Responsibility Research Center (a predecessor company of ISS), including as Director of IRRC’s Corporate Governance Service and Director of its Social Issues Service. Mr. Bertsch currently serves as a director on the board of the Investor Responsibility Research Center Institute, and has been named one of the 100 most influential leaders in corporate governance by the National Association of Corporate Directors.

Eric Marquardt, Partner at Pay Governance LLC

Say on Pay and the appointment of an independent board chairman were primary focuses of an increasing level of shareholder engagement activity in 2013. Much of this activity has come from proactive communication by companies, beyond the annual meeting, to explain the rationale behind their executive compensation plans. Poor Say on Pay support in the prior year(s) has also led to more reactive engagement of shareholders.

The advisory Say on Pay vote mandated by Dodd-Frank has been a primary cause of the increased focus on performance in U.S. public company executive pay programs. The percentage of companies with LTI performance plans has risen from roughly 30% prior to Say on Pay to almost 70% today. Shareholder returns are now the primary measure in about half of these LTI performance plans. This is a positive and necessary trend given the corresponding decline in the prevalence of stock options, from almost 90% in 2000, to less than 50% today. Options also required positive shareholder returns to have any value.

Most companies, however, continue to design pay programs that are also in the best interests of the company, strongly aligned to the business strategy, and supportive of talent needs. Shareholder returns are the ultimate arbiter of a company’s success, but in the majority of executive performance plans, shareholder return is just one of a portfolio of metrics including profitability, cash flow, and capital returns – all key metrics in the overall business strategy. Eliminating these other measures in favor of a single shareholder return measure, either absolute or relative, can produce an ineffective homogenization of incentive pay plans and will very likely have negative consequences on executive motivation and encourage excessive risk taking.

Eric advises a wide variety of leading public and private companies on executive and director compensation matters and, in recent years, he has advised many Fortune-ranked companies and their boards. Before joining Pay Governance, Eric spent 11 years as a principal with Towers Watson. Prior to that time, Eric served as the Director of Executive Compensation for Merck & Co and managed the Silicon Valley (Santa Clara, CA) office of another leading consulting firm. Eric earned a Bachelor of Arts degree in Business Administration from the University of Michigan and a Master of Arts degree in Industrial Relations from Michigan State University. He has authored chapters in two recently published books on executive pay. Additionally, Eric teaches courses in leadership and human resource strategy at Washington University in St. Louis.

Mark Rosen, Managing Director at Pearl Meyer & Partners

There’s been a rise in the use of relative shareholder return (TSR) as a metric for aligning executive pay and performance driven by standards used by shareholder advisory firms. While useful, it is more of an outcome-based measure. By defaulting to relative TSR as an incentive measure, many companies miss the opportunity to employ incentive metrics that capture executives’ success in driving business strategies and leadership initiatives – key aspects of performance that are critical to the creation of long-term shareholder value.

We have encouraged companies to customize incentive designs to their specific business needs by retaining internal performance metrics (or introducing them if they were not used before), such as operating earnings, EBIDTA or return measures (ROIC/ROE), and using TSR as an additional performance measure or modifier. In such cases, actual incentive payouts under the plan might ultimately be adjusted upward or downward, respectively, based on whether relative TSR is above median, suggesting the targets were set too high, or below median, suggesting the targets were not sufficiently rigorous. Such an approach provides a broader and more sensitive perspective on aligning executive pay with performance.

Mark Rosen is a Managing Director and head of the Charlotte office at compensation consultancy Pearl Meyer & Partners. He has consulted on executive and Board compensation issues for more than 20 years for a broad range of public companies, as well as tax-exempt organizations and academic institutions. Mr. Rosen has extensive experience with benchmarking, retirement plan design, governance issues, and tax and accounting considerations.

M. Shan Atkins, Compensation Committee Chair at The Pep Boys – Manny, Moe & Jack

I have definitely seen a heightened focus over the past few years on making sure incentive metrics are appropriate to the industry and a particular company’s situation rather than a simplistic focus on EPS, as was more common in the past. However, I’m not sure I’d attribute that only to heightened shareholder engagement. I believe it’s just a continuation of what good boards have been trying to do for a long time:  motivate management to do the things that can drive long-term shareholder value through intelligently designed incentive programs that reward achievement of business results and/or inputs. This makes a real difference.

I have served on public boards in both the United States and Canada for the past decade, and I would say that in Canada, there has been more systematic conversation between shareholders and major issuers on these issues through an organization called the Canadian Coalition for Good Governance (CCGG). CCGG comprises all the major institutional investors in the country, and they have been meeting with every major Canadian public company over the past five years. A major focus of those conversations has been executive compensation – how a company’s incentive compensation programs are designed and why that makes sense for that business.

In the U.S., these conversations have been more bilateral and intermittent, especially in the mid-cap space. Overall, I’d say that although there has been some expressed shareholder interest in the U.S. in discussing this subject, the greater impetus for change has come from boards themselves trying to do the right thing.

Ms. Atkins is a professional corporate director and co-founder of Chetrum Capital LLC, a Chicago-area private investment firm where she presently serves as Managing Director. From 1996 to 2001, she was a senior executive at Sears, Roebuck, & Co., where she led a $2.5 billion hardlines division to record results. Previously Ms. Atkins was a partner and leader in the global consumer and retail practice of Bain & Company, the international management consultancy. Ms. Atkins began her career in public accounting with Price Waterhouse in Toronto.  She holds CPA (Illinois) and Chartered Accountant (Ontario) designations, and is an alumna of Harvard Business School and Queen’s University at Kingston, Ontario.  Ms. Atkins presently serves on four corporate boards:  SpartanNash Company (NASD:SPTN), Tim Hortons (NYSE:THI), The Pep Boys – Manny Moe & Jack (NYSE: PBY), and True Value Hardware (private, member-owned co-op). Ms. Atkins currently chairs the compensation committee at The Pep Boys – Manny, Moe & Jack and the audit committee of True Value Hardware.  She is a prior board member of Shoppers Drug Mart Corporation and Chapters, Inc., two leading Canadian retailers, as well as Newgistics, a PE-backed company in the U.S. logistics industry. Ms. Atkins also presently serves as an independent appointee of the Blue Cross & Blue Shield Association to the board committee overseeing plan financial health and brand standards.

Jonathan Foster, Founder & Managing Director at Current Capital LLC

In recent years, increased pressure from institutional investors, activists and the Say on Pay vote have encouraged an enhanced focus by boards on tying a significant percentage of executive compensation to various metrics. For example, more than 50% of the companies that failed their Say on Pay votes in 2012 changed their performance metrics. Benchmarks can include income statement items such as EBITDA, efficiency items such as return-on-capital, and stock-price-driven items such as a company’s stock price performance.

One significant change in metrics has been the addition of relative performance metrics. For example, an analysis of the 2013 compensation programs of some 300 public companies done by a major compensation consultant showed that Total Shareholder Return (TSR – predominately indexed to peer groups) was used in 58% of the performance-based, long-term incentive plans. In 2012, 61% of the CEOs in the Standard & Poor’s 1500 and about 40% of the companies in the Fortune 100 had TSR-based incentive compensation. Over the past three years, the use of TSR has been growing at about 15% per year. This has been driven by an increasing view that management should have a significant incentive to outperform a reasonable set of industry peers, recognizing that strong performance is that which exceeds median peer group performance. This mitigates the effects of a strong environment where all companies benefit.

Jonathan Foster is the Founder and Managing Director of Current Capital LLC, a private equity investing and management services firm. Jonathan is an experienced corporate board member, including serving as a director at Masonite International Corp., Lear Corp., Chemtura Corp., and Berry Plastics Group. He is the Chair of the Audit Committee at Masonite International, previously served as Chair of the Compensation Committee for Chemtura, and serves on various committees among his other boards. Jonathan is also a Trustee of the New York Power Authority. Previously, from 2007 until 2008, Jonathan served as a Managing Director and Co-Head of Diversified Industrials and Services at Wachovia Securities. From 2005 until 2007, he served as Executive Vice President — Finance and Business Development of Revolution LLC. From 2002 until 2004, Jonathan was a Managing Director of The Cypress Group, a private equity investment firm and from 2001 until 2002, he served as a Senior Managing Director and Head of Industrial Products and Services Mergers & Acquisitions at Bear Stearns & Co. From 1999 until 2000, he served as the Executive Vice President, Chief Operating Officer and Chief Financial Officer of, Inc. Previously, he was with Lazard, primarily in mergers and acquisitions, for over ten years, including as a Managing Director. Jonathan has a bachelor’s degree in Accounting from Emory University, a master’s degree in Accounting & Finance from the London School of Economics, and has attended the Executive Education Program at Harvard Business School.

Michael Kesner, Principal at Deloitte Consulting LLP

Since 2011, most shareholders have been afforded the opportunity to vote on their company’s Say on Pay proxy proposal under Dodd-Frank (some companies have opted for a biennial or triennial vote).  Results indicate shareholders are overwhelming in favor of the compensation arrangements provided to the CEO and other named executive officers (NEOs).

But these positive results did not occur in a vacuum. Companies that received significant opposition to Say on Pay (defined as 25 to 30 percent opposition or more) took the opportunity to engage shareholders to understand what’s working and ask “what can we do better?” Shareholder feedback included the following:

  • Consider using more than one performance measure in the annual and/or long-term incentive plan as no single performance measure captures all aspects of performance.
  • Use multi-year goals (three years or more) to determine long-term incentive award vesting (as opposed to annual performance metrics).
  • Reduce the use of service-based, long-term incentives and adopt performances vested long-term awards.
  • Eliminate non-performance-based compensation arrangements, such as perquisites, gross-ups, and supplemental pension arrangements.
  • Set challenging performance goals (and pay well for achieving them).

In the majority of cases, shareholders did not demand the company adopt a specific type of incentive plan or performance metric. For the most part, institutional investors trust the compensation committee and management to identify the right metrics and to set the bar high enough to be motivating.

Boards have responded positively and improved the design of the incentive plans. There has been a significant increase in the use of performance shares. Also, incentive plans include more shareholder friendly performance metrics, including relative Total Shareholder Return, return on invested capital, and growth over the prior year’s results (including EPS, free cash flow, and revenue).

Another important development is the increased disclosure of the relationship of pay and performance.  Several companies now “connect the dots” to show just how pay relates to performance.

So far, this virtuous cycle seems to be working. Shareholders provide principle-based feedback on compensation concerns, and boards of directors adjust compensation practices in a way that best fits the company’s needs and culture. In turn, shareholders overwhelmingly support the company’s Say on Pay proxy proposal.

Michael S. Kesner is a principal at Deloitte Consulting, LLP. He leads Deloitte’s National Compensation Practice and has more than 30 years’ experience advising boards of directors on executive compensation, including incentive plan design, pay performance and corporate governance issues.

Erica Schohn, Partner at Skadden, Arps, Slate, Meagher & Flom LLP

The definition of “performance metrics” is one of the components of compensation most frequently commented on by shareholders since the adoption of Say on Pay. Common complaints include that the performance metrics are not robust enough, are not sufficiently long-term, or are not significantly varied.

My clients seriously consider the comments received directly from their shareholders and strive to effectively balance the requests of shareholders with what their boards believe, based on experience and intimate knowledge of the company, the best interests are of their companies and those they represent. There are certain shareholder comments that are more easily, and more frequently, addressed. For instance, when companies receive the comment that the goals are not varied enough, my experience is that the boards will act quickly to introduce additional metrics in the following year. In addition, in response to shareholder comments and the comments of proxy advisory firms, most companies now consider Total Shareholder Return (TSR), whether relative or absolute, at least to some extent when measuring long-term performance. However, one difficulty that is not always considered is that the comments of individual shareholders often directly conflict with each other, so even the most responsive companies cannot be responsive to all shareholder comments.

Certainly, there is no one-size-fits-all approach. Shareholders should recognize that companies are more likely to change their metrics in response to individual shareholder feedback when the feedback is tailored to the company rather than simply representative of the shareholder’s across-the-board approach. Erica Schohn’s practice focuses on compensation and benefits arrangements in U.S. and cross-border corporate transactions (including mergers and acquisitions, public offerings and bankruptcy reorganizations), the negotiation of executive employment and severance arrangements, and the drafting and implementation of equity and other compensation programs.

Ms. Schohn frequently advises clients on the U.S. Securities and Exchange Commission (SEC) rules governing executive compensation disclosure and corporate governance matters relating to compensation practices. As part of this practice, Ms. Schohn is a member of panels and committees comprised of leading government and private- and public-company governance professionals, and she speaks regularly with representatives from the SEC, stock exchanges, institutional investor groups and proxy advisory firms on the latest issues in corporate governance. Ms. Schohn also regularly advises clients regarding tax planning with respect to compliance with Internal Revenue Code Section 409A and the tax rules relating to deferred compensation, the excise tax on excess parachute payments, and limits on the deductibility of executive compensation.  Erica received her J.D from Duke University School of Law (magna cum laude) and her B.A from Pennsylvania State University (high honors).