Backed by Dodd-Frank, activists are coming on stronger than ever. With the new Say-on-Pay stipulation, all shareholders will have a voice in the issue of executive compensation (even if they’re not binding). What other issues will you face and how should you deal with them?
January 10 2011 by William J. Holstein
Occidental Petroleum’s Ray Irani may have had a taste of the future facing American CEOs. His pay package of $31.4 million for 2009 sparked opposition from the California State Teachers’ Retirement System, as well as by Relational Investors, the San Diego asset management firm run by activist Ralph Whitworth. Between them, CalSTRS and Relational owned 10.1 million Occidental shares, representing 1.24 percent of the company’s total outstanding, and launched a non-binding “Say-on-Pay” vote in the 2010 proxy season. Occidental lost the vote, one of three companies, along with Keycorp and Motorola, to do so.
Result: The company announced in October 2010 that Irani, 75, will step down as CEO and become executive chairman of the company, handing the reins to his chosen successor, COO Steve Chazen. It also announced that it would cut executive salaries “substantially” to bring them more in line with those of peers.
Irani may have been ready for a reduced workload and a reduced salary as chairman won’t put a dent in his lifestyle, but CalSTRS and Relational also proclaimed that they expected one of their directors to be elected to the board by year’s end. With the two current directors who are retiring, that will significantly alter the board’s composition. Anne Sheehan, CalSTRS’s director of corporate governance, said the agreement was an “excellent example” of cooperation between shareholders and a board of directors.
Excellent or not, the Occidental fight suggests that the 2011 proxy season will be a particularly tough one for CEOs and boards targeted by a kaleidoscope of shareholder activist groups and the big investors who sometimes team up with them. The Securities and Exchange Commission’s ruling that shareholder groups can list their board candidates in the company’s own proxy materials will not be a factor in 2011, because the U.S. Chamber of Commerce and Business Roundtable have filed suit against the rule and seem prepared to fight it all the way to the Supreme Court.
Even in the absence of shareholder access, the Dodd-Frank financial reform law mandates that all publicly traded companies, large and small, must hold Say-on-Pay votes and also ask shareholders how often they want those votes, which are being called Say-on-When votes. Even though these votes are non-binding, they create openings for shareholder activists to bring pressure to bear in very public ways. Activists also will insist that directors should be elected by a majority of all shareholders voting, not just a plurality. Specific directors, particularly those on compensation committees, will be subjected to campaigns to withhold votes for their re-election. Fewer boards will have staggered membership, meaning that an entire slate of directors could be defeated. And brokerages, which ordinarily vote the shares they hold on behalf of individual investors in favor of management, can no longer vote the shares without specific instructions. Meaning: Large blocks of stock that once favored management may be absent, depriving CEOs and boards of crucial swing votes.
Add it all up and it appears that the forces of “shareholder democracy,” which have been gathering strength for years, will be cresting in 2011 and forcing the fundamental question about who controls American corporations. CEOs who can’t increase their companies’ share price or find ways to create top-line growth in an anemic economy will find themselves marginalized in boardroom fights. CEOs’ ability to receive large pay packages or to create compensation packages for their top performers also will be sharply circumscribed as compensation committees hire their own compensation advisers and lawyers. As boardrooms become increasingly politicized, some CEOs may even be toppled amid populist anger of the sort that turned the tables on President Obama’s Democrats in the mid-term elections in November. “It all fits together in a new environment in which shareholders, with the means, can exert a lot of influence over corporations,” says Robert S. Reder, partner at Milbank, Tweed, Hadley & McCloy, which typically defends boards.
Two companies that face potential challenges are Keycorp and Motorola, because they lost Say-on-Pay votes in 2010. “If they don’t take steps, they could find themselves in the headlines again,” warns Amy Borrus, deputy director of the Council of Institutional Investors in Washington, D.C., which represents large union and public pension funds. The Change to Win Investment Group, representing union pension funds, is targeting Massey Energy on environmental and safety grounds after the explosion at its West Virginia mine, and environmental issues will once again loom large.
Smaller companies are going to face shareholder pressure. In previous years, activists have targeted mostly the Standard & Poor’s 500, but CalSTRS’s Sheehan and others are signaling that this season, they are going to expand their efforts to the Russell 2000.
The range of issues also seems to be expanding: Executive compensation will remain a hardy perennial, but shareholder groups also want boards to disclose a company’s political contributions, rein in relocation packages for executives and promise greater diversity on boards.
Say-on-Pay votes will be the most powerful weapon, partly because they attract the attention of the proxy advisory firms, particularly the 800-pound gorilla, Institutional Shareholder Services (ISS), a unit of Risk Metrics. Even a 30 to 40 percent vote to reject a company’s compensation plan, short of a majority, could set the stage for trouble down the road. “ISS will use those votes,” says Milbank’s Reder. “If you get a negative vote and you do nothing, that will have an impact on future elections.”
If a board gets a “no” vote and does not take corrective action, it is required to explain why it chose not to respond in the Compensation Discussion and Analysis portion of the proxy statement. These torturous CD&A statements have grown in length and contain an avalanche of detailed information, so it isn’t always clear why shareholders are voting against a compensation package. Is it the CEO’s restricted stock grants or the CFO’s relocation bonus? “It’s one vote on a massive disclosure,” Reder says. If a company does poorly on a Say-on-Pay vote, management will be best advised to begin talking to shareholder groups to find out why.
The vision that some activists are pursuing might seem radical to CEOs and directors. CalSTRS, with assets of $141 billion, has invested in about 4,000 U.S. companies of all sizes. Aside from Say-on-Pay votes, it is pushing the concept of majority votes for directors. Some two-thirds of S&P 500 companies have adopted that method, which is why Cal- STRS and others also will be pushing smaller companies to adopt it. In addition, CalSTRS wants more declassified boards, meaning all members are elected in one vote. “The whole board should be up for a majority vote every year,” says Sheehan. “That’s fundamental shareholder democracy 101.”
That would mean that CEOs could be facing board shakeups every year. Ultimately, if shareholder access to the proxy is approved, CEOs could be facing more single-cause directors on those boards who have been nominated by shareholder activists. “Any given year, a CEO may have to accept a short slate of directors who are put up and have a good chance of success,” says James C. Woolery, a partner at Cravath, Swaine & Moore, which typically represents boards. The reason they will be only short slates is that shareholder coalitions will be able to include only a handful of directors on a company’s proxy because they will be barred from seeking a change in control.
What’s a CEO to do? Whether a CEO is subject to activism depends at least in part on how well the company and its stock are performing. That may set the stage for a supremely difficult balancing act for many CEOs. “The real issue for CEOs as it relates to this season is how to stay ahead of the curve,” Woolery says. “CEOs will be thinking, ‘I have to move forward from a growth point of view. If not, I’m going to be much more vulnerable to activism and my fate could be taken out of my hands.’”
So CEOs will have to give some carefully selected ground to the activists on certain issues while taking greater risks to achieve organic growth or to launch acquisitions to keep the company’s top line growing. “Stay conservative and prudent on the governance side and take the risk on the business side,” Woolery advises. “That’s the tradeoff.”
The bottom line? The CEO’s job, never easy, is getting harder even still.