Understanding ESG & Annual Incentive Plan

ESG refers to a series of environmental, social and governance criteria taken into consideration by the funds during the investing process. Investing in ESG funds allows shareholders to support companies in transition, that wish to act and develop in a more sustainable and responsible manner.

In practice, many indicators are analyzed to determine whether a fund and a company in which shareholders invests meet ESG criteria. The strategic importance of ESG issues can vary greatly depending on the company in question and its sector of activity. A company active in mining, for example, will be more exposed to ESG issues than a company in the service sector. But in any case, investing in ESG means investing in companies with good environmental, social and governance practices. As Larry Fink stated earlier this year, “the evidence on climate risk is compelling investors to reassess core assumptions about modern finance”. And in that same momentum, large companies have also started reassessing how to link performance to the remuneration of their executives using lucid, relevant ESG metrics.

Using their strong set of governance data, CGLytics’ has built an in-depth analysis of how different sectors are behaving regarding consideration of ESG metrics in their remuneration plans, for six markets: France, Germany, Switzerland, UK, the Netherlands and Sweden. The following chart shows the number of ESG KPIs incorporated by industry; all previous countries taken together.

The three top performing industries in terms of ESG incorporation in remuneration plans are Financials (66 KPIs), Industrials (53 KPIs) and Materials (38 KPIs) whereas the three main laggards are Utilities (8 KPIs), Health Care (9 KPIs) and Information Technology (10 KPIs). Scrutinizing Financials and the 66 KPIs found; the data suggests that although this industry is performing the best compared to the others in terms of number of ESG KPIs, the chart below shows that only a small percentage of companies within the industry uses ESG in their remuneration plans:

The same applies to the Industrials sector, for which only 21% (of the 69 companies in scope) have incorporated ESG metrics in their plans. On the other hand, Utilities and Energy who were both considered laggards in absolute number of KPIs, show that the sectors are more widely involved in the incorporation of ESG metrics within executive pay plans with respectively 29% and 52% of companies using ESG KPIs. Attention can be brought to the fact that among the top performers are industries for which ESG concerns derive directly from the nature of their activities.

A breakdown by country allows to see how companies behave geographically, in the universe selected for the analysis:

France appears to be the leader when it comes to implementing ESG metrics in executive pay models, with 51% (or 62 companies) using these metrics. In percentage, France is followed by the Netherlands with a 30% (or 32 companies) of the 106 companies in the market following the ESG trends on remuneration. At the third place in this ranking comes Switzerland, which has 15% of its 47 companies using ESG KPIs. In number of companies, the United Kingdom is however doing quite well with a 13% of the 386 companies we used for the sake of the analysis in our universe, which sums it all up to 50 companies.

The total number of ESG KPIs used in each country appears to be in line with the previous trends for France and the Netherlands showing the highest numbers once again. However, the United Kingdom is disclosing a disproportional amount of ESG KPIs with 84, almost at the level of France with 91 found metrics.

Sweden, with its relatively small total scope of 30 companies, will not be considered a laggard despite its low ranking in ESG KPIs captured and the 10% of ESG-oriented companies. Germany however, with a total scope of 139 companies, tends to manifest a certain delay in its ability to follow this global trend. Not more than 18 KPIs were found and only 10% of companies of the German market has so far linked the remuneration of their executive directors to ESG metrics.

As interesting as it may be to look at country breakdowns of the situation of remuneration plans around Europe, the data points out that the evolution is improving each year. This trend is confirmed by the remuneration policy data gathered by the Research Department at CGLytics, disclosed in the following table:

The numbers are evolving in the right direction and play as a solid proof of how real and immediate the ESG concerns are to the markets.

The performance comparison over three years of all companies of the six countries of your analysis disclose that both TSR and EPS are showing smaller results when remuneration is linked to ESG KPIs. Even though ESG performance goals are known to drive performance up, the conclusion we draw through our analysis does not lead to the same results. Indeed, the EPS and TSR scores of the chart below seem to decrease with the inclusion of ESG metrics within remuneration plans. Since driving performance through ESG performance indicators is new to the markets, it is possible to assume that there is still improvement to make to structure these plans in the most effective way.

The messages sent by shareholders through their votes during General Meetings is also not to be undermined. Voting is one of the means for shareholders to express their opinions and exercise their shareholder rights/duties. The following chart shows the percentage of companies in which a shareholder revolt (> 10% votes against) happened regarding the adoption of the remuneration report, or any form of remuneration policy.

This chart demonstrates that moving towards ESG standards in remuneration policies has not been easy everywhere. Over the last three years, no less than 44% of the Swiss companies in our scope have witnessed a shareholder revolt, followed by the UK (33%) and France (26%). This represents quite well how diverging the opinions can be within Board of Directors in terms of remuneration strategy. The priorities that ESG concerns bring with them are yet to convince everyone, with an open door to mistakes in compensation models. For Germany and Sweden, the revolt rate is quite low, just like the previous results of ESG KPIs inclusion. It is important to keep in mind that some companies do not disclose extensively about their remuneration metrics and therefore will not show accurate reflection in our analysis.

This last chart, disclosing the number of resolutions receiving shareholder revolt by country, shows that the UK and Switzerland are in two different situations. In the UK it seems that despite the greater number of companies in scope, there are still proportionally more remuneration-oriented resolutions receiving more than 10% opposing votes.

The results of our analysis allow you to obtain a good idea of where the markets are currently standing and how the trend evolves and is evolving. Besides that, every year companies are making progress in their disclosure quality and begin to understand how it benefits the market.

Pay for Performance: The Largest Institutional Investors’ View

Executive compensation has been one of the trickiest issues within the corporate governance space as of late. Across the board, there seems to be no end in sight to finding the perfect compensation package or philosophy for corporate executives.

In this article, we will discuss the evolution of pay for performance and the KPIs organizations should be considering to measure performance effectively.

The evolution of pay for performance

The theme of executive compensation came to the forefront following the 2008 financial crisis when senior management at Merrill Lynch got a payout of about $2.5 billion. After running the bank to the ground, the United States Treasury had to force the bank’s assets on other banks. This led several groups to calling for better, more appropriate compensation packages for executives. For instance, in the Netherlands the government passed a law that short term incentive (STI) package for executives within the Financial Services sector shall not be more than 20% of the base salary. In the United States, this led to the enactment of the Dodd Frank Act of 2012, which over the years has ensured accountability in executive compensation practices. For instance, it has led to adoption of double trigger acceleration, rather than single trigger, and virtually eliminated the once prevalent golden parachute within the American corporate culture.

Despite the changes in executive compensation in the last decades, which have led to more companies adopting performance based compensation and discretionary compensation awards, the question has become: What are the right key performance indicators (KPI) for companies to adopt to inform performance based compensation? Over the years, we have seen increases in pay for executives, especially within the large firms, and in some cases, mid-sized companies. The next question is: Do companies have the right KPIs, or have investors not been paying attention to these pay practices?

KPIs to effectively measure performance

In recent years, major institutional investors have put emphasis on having the right KPIs to accurately measure performance. For example, in 2019, the Council of Institutional Investors (CII) adopted a new executive compensation policy, which stated that:

1. Executive compensation should be designed to attract, retain and incentivize executive talent for the purpose of building long-term shareholder value and promoting long-term strategic thinking.

2. Executive compensation should be tailored to meet unique company needs and circumstances. A company should communicate the board’s basis for choosing each specific form of compensation, including metrics and goals.

3. Compensation committees should make compensation disclosures (including those in the U.S.-style Compensation Disclosure & Analysis), as clear, straightforward, and comprehensible as possible. Each element of pay should be clear to shareholders, especially with respect to any goals, metrics for their achievement and maximum potential total cost.

4. Descriptions of metrics and goals in the proxy statement should be at least as clear as disclosures described in other investor materials and calls.

A look at the voting result for remuneration policy of companies between 2018-2020 seem to portray a picture of what the CII is saying.

The graph above shows that overall, shareholders have consistently voted in favor of executive compensation policies put before them, with support growing by 3% from 2018-2020. However, there is a note of caution when it comes to executive pay with respect to performance. Executives tend to have more information than board members and may have more knowledge about the workings of the sector in which they operate. In some cases, they may use this information to their advantage.

This has made institutional investors frown on issuers retrofitting peer groups to make executive compensation decisions. For example, BlackRock notes that while its efficient to track performance of company executives using performance peer groups, companies should endeavor to outperform their respective peer group. In some cases, companies are choosing peer groups that are largely underperforming to improve the view on their own performance. This increases the importance of proxy advisor defined peer groups, such as those by Glass Lewis.

Another challenging issue over the years has been institutional investors’ position towards shareholder proposals to make changes in executive compensation policy. Though there has been continued conversation around this topic, voting results seem to show something different. In 2018, shareholder proposals from some large companies were rejected by an average of 89% of shareholders voting. These proposals were geared towards creating limits to executive compensation and including additional conditions for executive compensation.

There is a need for institutional investors and groups of shareholders to have common stance on executive compensation—more particularly pay for performance—to effectively engage with companies. This includes ensuring the right set of individuals are appointed to the board and the compensation committee.

How to design your peer group for compensation benchmarking

Given the scrutiny on executive compensation in recent years, it is critical to make sure that your company’s executive pay reflects its performance and aligns with the market. Therefore, it is essential for companies to have an appropriate peer group for performance benchmarking, compensation program design and other compensation decisions.

There are two types of peer groups companies should consider: compensation peer group and performance peer group. Compensation peer group is used as an input to design short- and long-term pay programs, to determine base salary ranges, annual incentive targets and long-term incentive award mix, to assess the competitiveness of total direct compensation awarded to executives, and sometimes, to assess the talent and recruitment practices. The performance peer group is used to measure the company’s relative performance to determine the payout of awards, typically long-term incentives. Whether a company uses only the compensation peer group or both compensation and performance peer group, it is important that the company select the appropriate criteria to form a peer group that reflects the company’s business.

How to select an appropriate peer group

Firstly, the company should start with a group of direct competitors in their sub-industry, using the Standard & Poor’s Global Industry Classification Standard. After this step, it is also useful to look at the peers of these competitors (peers of peers) since they will most likely compete with the company in some ways. However, this practice can lead to industry-wide executive compensation levels being dependent on companies referencing each other, creating a “vicious-cycle” where it is difficult to crack down the high compensation levels in perpetually overpaying industries.

Next, the company should extend its search to the related industries or the general industry to gather a list of companies which has operationally similar business models and might compete with the company for talents.

These potential peers should then be refined by size, which can be market capitalization, total revenue or, in case of financial services companies, asset base. These peers should fall into an appropriate range in terms of size, typically 0.5 to 2 times the size of the company, to be a suitable comparator. Having several “too large” companies compared to your own in the peer group may lead to executive compensation being inflated since larger companies tend to grant larger amount of pay. The opposite holds true when peer companies used are “too small.”

The peers can also be refined further by country, number of employees, EBITDA, and/or other financial metrics. Unsuitable companies should be removed from the list and the company would end up with an appropriate peer group for compensation decision-making. If the list is too small for any meaningful comparison, the company can expand the search to include companies outside of the company’s industry, refine them using the criteria mentioned above and add them to the first list of peers. The final peer group should generally consist of 12 to 20 companies.

How often should you review?

This peer group should be reviewed annually to ensure it remains appropriate, especially when the company or its peers have gone through major mergers, acquisitions, and divestitures. The company will have to re-evaluate its current peers in terms of industry fit and size in order to determine their appropriateness and subsequently replace some peers or add new peers if necessary.

How to compose your performance peer group

The steps in composing a performance peer group is like that of compensation peer group. The company can choose to use the same compensation peer group for performance evaluation. However, since relative performance is often measured over a period, M&A activities within the peer group may create issue for performance comparison. Therefore, the company should consider using an index as a comparator given its dynamic nature. The index could be a broader index of which the company is a part, such as the S&P 500, or a sub-index of which the company is a part, such as S&P 500 Financials, S&P 1500 Media, etc.

Takeaways on Peer Groups

Peer group selection is an important but often challenging part of the executive compensation process. Given the close attention to executive compensation from investors, regulators, and the public as well as the increase in transparency of disclosure, companies should be mindful when choosing the criteria used in selecting peers. A good peer group used in compensation benchmarking will establish executive compensation that aligns with the market and reward high performing executives, rather than rent-seeking ones. Nevertheless, companies should realize that there is no “perfect-match” for peers. Hence, companies should try their best to compose a peer group that reflects their business as closely as possible to ensure the appropriateness of any compensation benchmarking resulting from such peer group and ultimately, the appropriateness of the executive compensation.

Learn about the impact of COVID-19 on executive pay

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5 Long Term Incentive Plans Overwhelmingly Voted by Investors

Executive’s remuneration consists of fixed and variable elements. The fixed element component of Executive compensation consists of the base salary and pension of the executives. This element of pay is usually independent of performance, meaning that they will be paid regardless of the executive’s performance. Due to the agency cost, companies would like to offer a contract to executives in order to align the companies’ interest with their executives. A Long Term Incentive Plan (LTIP) is one of the variable elements of executive remuneration. Specifically, LTIP is an incentive-based plan which rewards the executives based on the strategic goals and objectives a company has set. Incentives aim at motivating executives to maximize company’s value which reduces the conflict between executives and shareholders. Long term incentive plans are usually in the form of shares, options or cash and usually vests within a period of three years.

With this blog, CGLytics aims to identify and review five UK LTIPs which received overwhelming approval from shareholders. To identify these companies we have highlighted the remuneration resolutions that received the five highest approval by shareholders using CGLytics’ database, and thereafter check the historical resolutions on remuneration reports for each company and make short commentary.

Understanding the long term incentive plan structures and designs

The methodology used for identifying the five long term incentive plans from the largest UK companies in 2020 which received overwhelming approval from shareholders is by looking at the Annual General Meeting (AGM) results for the companies which constitute the FTSE 100. From the AGMs, the resolution regarding the approval of directors’ 2020 remuneration policy is collected and ranked. We have decided to investigate companies from the FTSE 100 when selecting long term incentive plans, as they are attracting a lot more attention and have a bigger impact. Moreover, the approval of directors’ 2020 remuneration policy was selected in order to give the most recent picture. Based on the aforementioned criteria, the companies that had the top five highest approval rates of the resolution regarding the directors’ 2020 remuneration policy are Polymetal International (99.90%), DCC (99.19%), Taylor Wimpey (98.65%), Antofagasta (98.17%) and Smith & Nephew (97.71%).

Figure 1 illustrates the historical votes in favour of the approval of directors’ remuneration policy for Polymetal International, DCC, Taylor Wimpey, Antofagasta and Smith & Nephew for the years 2014, 2017 and 2020. From the graph it is evident that Polymetal International, DCC and Taylor Wimpey had stable high approval rates on the directors’ remuneration policy during those years.

This means that no major conflict arose between executives and shareholders. However, in the cases of Antofagasta and Smith & Nephew in 2014, the picture is slightly different. Nevertheless, with no significant points such as to cause disapproval of the directors’ remuneration policy. The low percentage rates of votes against the remuneration policy of Antofagasta and Smith & Nephew might be viewed as a concern from the shareholders, and as the graph indicates this led to significant improvements in the policy for 2017 and 2020 for both companies.

approval of remuneration policy

Figure 1

Source: CGLytics data and analytics

Looking a little closer at the five LTIPs in 2020 which received overwhelming approval, we find that all five LTI plans include malus and claw back. This means that companies have the right, prior or after the vesting period, to reduce all or part of the vesting shares in the event of material misstatement of the company’s accounts, error misconduct and/or failure of risk management. Moreover, all five companies have the provision that in the event of excess or inadequate payment of the LTIP, the remuneration committee has the discretion to adjust the awards that vest to make sure that the outcomes are fair and appropriate, and that it is in line with the company’s performance. Companies, by applying malus and claw back to their plans and committee discretion, are protecting the interest of the company and reducing any conflict of interest that might occur.

Another trend that is apparent when analysing the five LTIPs, is that three of the LTIPs are awarded in shares, namely Smith & Nephew, Antofagasta and Polymetal International Plc, while DCC has options and Taylor Wimpey has nil-cost options. All five LTIPs are performance-based incentive plans, with four LTIPs having a three-year performance period and the last LTIP having a four-year performance period. However, the final release of the awarded plans is after five years from the date of grant since all plans include a holding period. In the case of Antofagasta’s LTIP, a performance awards plan and restricted awards plan are included. The performance awards plan weighs 70% and the restricted awards plan weighs 30% of the LTIP. The restricted shares plan refers to a plan which vests after some years (depending on the remuneration policy) without any performance and usually there is a condition to be employed. Antofagasta’s LTIP might be viewed as a less risky plan because in “crucial times” the executive will not take risky actions in order to benefit from the LTIP and will thus take actions that will benefit the company rather than harm it. However, the UK Corporate Code does not provide any preference between performance based LTIP awards and restricted shares.

All five LTIPs have one common metric, which is the relative Total Shareholder Return (TSR). TSR weighs from 20-100% among the plans. Metrics such as Return on Capital Employed, Earning Per Share, Return on Net Operating Assets, Sales Growth etc. are used in these five LTIPs. Furthermore, all five LTIPs have the indicators of each metric in detail, as for example, at which range the metric is vesting and how much of it. In this way, the company is much more transparent towards its shareholders.

Finally, how much LTIP the companies are granting to their executives might be the most interesting and crucial part of the remuneration. Three of the LTIPs have a maximum grant value equal to 200% of base salary. The remaining two LTIPs grant the respective award at a maximum value of 125% and 275% of base salary. In their reports, all five companies are stating the expected (target) percentage of the awards, which will be paid out after the completion of the performance period. Figure 2 illustrates the base salary of the five CEOs plus the median CEO salary in the FTSE 100 between 2014-2019. Since the values mentioned previously concern the base salary for the next three years, Figure 2 sheds light on what was previously paid out. Smith & Nephew pays its CEO more than the median CEO in the FTSE 100 and from 2015 there is an increasing trend of its base salary. For the 2019 financial year, Smith & Nephew offered a base salary 1.62 times more than the median CEO in the FTSE 100. Between the years 2014-2019, Polymetal International, DCC, and Antofagasta appeared to report lower base salaries compared to the median CEO in the FTSE 100. The data and analysis also suggest that Taylor Wimpey pays its CEO close to the median CEO base salary in the FTSE 100. Interestingly, Smith & Nephew, which reports the highest base salary over time among the five companies, has a 275% maximum grant value for its 2020 policy. While Polymetal International, which has the lowest base salary over time, also has the lowest maximum grant value for its 2020 policy (which equals to 125%).

Are companies incorporating ESG factors into executive remuneration?

FTI & CGLytics have conducted an analysis to determine whether those two topics are increasingly converging. Read the guide to learn how your company can be socially responsible.

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How to Design your Annual Incentive Plan During a Pandemic

annual incentive plan

How to design your annual incentive plan during a pandemic

The novel COVID-19 pandemic has impacted many areas of the current landscape, including the socio-economic landscape and macroeconomic environment. Initially it was difficult to predict how long the pandemic was likely to last, however it has certainly continued longer than initial indications led us to believe. This has necessitated a refocus and directional change in executive compensation, among which is the annual incentive plan. Remuneration Committees (RemCos) have been reassessing and are discussing calculating bonuses by taking all stakeholders concerns into account.

Despite the pandemic, we witness several companies that are experiencing either a neutral or even a positive impact. Therefore, for some of these companies, executives may still get their Executive pay puts including their annual bonuses, as incentives plans are likely to be above target (even if not achieved at maximum). What must be noted, however, is that Chairs of Remuneration Committees (RemCos) should exercise discretion to reduce incentives to avoid ‘over-rewarding’ during a pandemic. With regards to companies that have experienced a moderate to negative impact, there are some issuers where we have witnessed a fight for survival as variable incentives have been cancelled. We expect that for many of these companies, pay negotiations will be focused on the future of a post-pandemic world.

Issuers issue cancellations to Annual incentives in the face of the plan

In the Russell 3000, our analysis showed that FedEx disclosed that it will not have an annual incentive plan for executive officers in FY21. Capri Holdings has also proceeded to changes, where it suspended its annual incentive plan for FY21 and will re-evaluate in order to determine whether any additional payments are necessary based on the performance for FY21 (the company actually also proceeded to change its KPI matrix and disclosed the performance metrics and goal-setting process that will be implemented when the plan is re-established post-FY21)

In Australia, four companies in the ASX 300 (Flight center, Auckland Airport, Vicinity center, IOOF Holdings) cancelled or suspended their 2020 Annual incentives. However, News Corp announced a 75% reduction in their annual incentive for the CEO.

For the TSX 250, we found that Ivanhoe Mines Ltd suspended short-term incentives for the year 2020 after cutting CEO pay up to 35%.

In the DAX, we saw that Adidas’ CEO also surrendered his bonus for the year 2020.

Current state of play to STI plans

Our data suggests that profitability measures (Cash Flow, EBITDA) remain the most used metrics by companies with specific disclosed plans, or followed by revenue, sales measures. Also, quite prevalent are returns/growth measures, such as ROCE, ROIC and ROE.

% of companies

top 5 financial STI KPIs used

Changes to KPIs observed

Market findings suggests that a significant number of companies have reduced target or max payout opportunities for Annual incentive plans.

One of the most common changes to the annual incentive plan by issuers has been to add new non-financial strategic metrics. Profitability measures and revenue KPIs are likely to be less used post-pandemic.

Some issuers have been forced to reset performance goals based on updated forecasts, while others have also delayed goal setting for their Annual incentive plans.

One size may not fit all for annual incentive plans

Though we appreciate that the key to designing annual incentive plans may not necessarily be standard across all issuers, for industries such as tourism and airlines (that have been impacted the most by the pandemic) the 2020 annual plan is essentially not redeemable at this point. Executives would have to strive to work hard to operate the business and respond to an unusually difficult atmosphere. The Boards, of course, need to maintain the focus of its Executives and create incentives for them that will align their interests with that of the stakeholders of the companies. With the financial plans being affected (and being subject to many unknown factors soon) the Boards need to decide what the best approach is in order create the incentives for the year.

More than Seven months into the pandemic, there is still a degree of vagueness and uncertainty around Executive pay and annual incentives remains high for many companies and industries across various jurisdictions. In line with expectations, adjustments to executive pay plans and short-term incentives, will be subject to challenges. For some issuers, there may be no opportunity to pay bonuses in 2020 because of their inability to meet KPIs. However, we recommend that it may be prudent for RemCos to reset new objectives and/or KPIs for the year 2021. As 2020 is almost complete, it may not be feasible for Boards to adjust goals for the remaining part of the year. Despite this, management and their boards should be able to preserve the entities’ ability to survive during this pandemic and into the foreseeable future.

Per our assessment, incorporating KPIs around some of these measures may be useful for 2020/2021 financial years respectively:

Benchmarking

One measure that we recommend is for issuers to incorporate relative performance to their closest peers in their annual incentive plan designs. Prior to the pandemic, peer benchmarking was mostly limited to the long-term incentive plans of the companies. It can be shown that including similar benchmarks to the annual incentive plans might be useful and serve the purpose of avoiding over-compensating the executive, while at the same time still incentivizing them. Across our universe, we have found that only nine companies had peer benchmarking in their annual incentives for the year 2019. Additionally, benchmarking company performance to pre-crisis levels may also be beneficial to all stakeholders.

Measures to help safeguard investor interest

Perhaps one of the roads to recovery is to incorporate stock price performance relative to pre-crisis levels. Another KPI, which may be useful and appealing to shareholders, is how soon issuers are able to bounce back to dividend payments and share buybacks. This is centered around cash back to investors, which signifies a strong liquidity.

Emphasis on display of Crisis management in leadership

For all other stakeholders such as employees, it will be useful to see how executives apply more agility in decision making, retain jobs for employees and restore broad-based reductions.

Conclusion

For many companies, the current uncertainty seems likely to continue until the end of 2020 and possibly into 2021. It has therefore become necessary that RemCos consider all stakeholder interests in designing short term plans (Annual Bonus). This should be geared at incentivizing executives to steer recovery plans for companies to safeguard all stakeholders’ (investors, employees, government) welfares.

Learn about the impact of COVID-19 on executive pay

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How the SEC’s new proxy voting rules will impact executive compensation

There are many software applications and tools now available to support compensation decisions, but what should be taken into consideration before purchasing? This 5-minute guide details what Compensation Committees, Heads of Reward and Compensation Professionals should take into account when selecting software and tools for Say-on-Pay decisions.

How the SEC’s new proxy voting rules will impact executive compensation

In July of 2020, the Securities and Exchange Commission (SEC), under pressure from public companies (Issuers) and their lobbyists voted to tighten regulations affecting proxy advisory firms, like Institutional Shareholder Services (ISS) and Glass Lewis & Co., who provide proxy research services and voting recommendations to investor groups large and small. The new proxy voting rule changes were justified based on allegations, mostly made by corporate managers, that proxy advisor recommendations are error prone, rife with conflicts of interests and that proxy advisors wield outsized influence over the shareholder voting process. In response, Advisors claim that the allegations are not only false, but that they represent an effort on the part of Issuers to reign in what is seen as troublesome shareholder activism. That is attempts by shareholders to insert environmental, social and governance initiatives into the corporate voting agenda. The new regulations came as amendments to section 14a of the 1934 Securities Exchange Act and are the latest development in a long running controversy over the role of Proxy Advisors and the future of corporate accountability.

The New SEC Proxy Voting Rules

The SEC has stated that the new regulations are needed in order to “ensure that clients of proxy voting advice businesses receive more transparent, accurate and complete information on which to make voting decisions”. Although the new changes to the law appear to be providing public companies with a greater means of challenging the advice of Proxy Advisors. Highlights include:

Redefinition of “Solicitation”

Rule 14a-1(l) has been amended to expand the definition of solicitation specifically to include proxy advice. Solicitation, usually taken to mean an act of enticement or inducement, is now defined as any communication to shareholders “… reasonably calculated to result in the procurement, withholding or revocation of a proxy”.

Changes to Filing Exemptions

Rules 14a-2(b)(1) and 14a-2(b)(3) have been altered to place new requirements on solicitor exemptions. To avoid the information and filing requirements the SEC places on solicitors, Proxy Advisors have historically relied on two exemption provisions. To be eligible for those exemptions they must now meet new disclosure and policy requirements:

Proxy Advisors must provide specified conflicts of interest disclosure in their recommendations to shareholders. And …

They must adopt policies and procedures to ensure that voting recommendations are made available to Issuers at the same time that they are provided to shareholders, at no cost. They must also …

Provide shareholders with a means to be made aware of any written statements from Issuers regarding the recommendations of Proxy Advisors.

Anti-Fraud Provisions

Rule 14a-9 has been modified to include examples of compliance failure. Should Proxy Advisors fail to disclose certain material information, e.g. business methodology, information sources and conflicts of interest, their recommendation may be considered misleading under the Rule.

The new regulations are effective 60 days after publication in the Federal Register. However, the new disclosure requirements will not be in effect until December 1, 2021, making the 2022 Proxy season the first regulated under these laws.

Implications of New Proxy Voting Rules

The new SEC proxy voting rules have implications for all parties involved.

Implications for Issuers

The new SEC rules certainly offer public companies a greater opportunity to dispute the recommendations of proxy advisors. However, the ultimate impact on the accuracy of proxy advisor reports and the overall effect on shareholder behavior is likely to be negligible. Whereas shareholders will ostensibly become “better informed” by being provided greater access to counter arguments, they are not in any way guaranteed to a heed this information or to take additional time to deliberate. Not to mention they may very often simply disagree with management’s position. Such is the nature of the franchise. For Issuers, the opportunity to have a better window into proxy advisor methodology will be instructive and perhaps lead to more effective shareholder relations. In the end however, the realities of the investment business and evolving sensibilities on governance will guide voting behavior. That said, significant concessions have been won and public companies can count the July decision as a victory.

Implications for Proxy Advisors

The new policy requirements on solicitor exemptions, specifically to include Issuer messaging into proxy reports will likely increase the strain on publication timelines and voting operations. Thus, it may not be unreasonable to expect complications during the 2022 proxy season as the industry adjusts to the new rules. However, the full implications for proxy advisors remain to be seen and will probably only become fully understood after the implementation.

Implications for Shareholders

The SEC’s July decision, because of the disruptions it will create by placing added requirements on proxy advisors, could potentially add costs and delays to the proxy voting process. Should Institutional Investors wish to avoid any added expenses or complications it is unlikely proxy research will move to an in-house model. This is due to the very large diversification of Institutional portfolios, which are prohibitively expensive to research to the level needed and in the timeframe required. This is partly the reason why Institutional Investors outsource this work to proxy advisory firms that can take advantage of economies of scale. Without a proxy advisor Investor groups will either abstain from voting entirely or vote in accordance with management’s recommendations, known as the Wall Street Rule—as was the case before the rise of the proxy advisor business. The overall impact on shareholders is that voting has become more costly and more difficult. And it may be worth considering whether this effect is the intention? As well as what this means from a governance standpoint?

Summary of New Proxy Voting Rules

The actions taken by the SEC to increase regulation of Proxy Advisors has come primarily at the prompting of corporate leadership and lobbyist firms such as the Business Roundtable (BRT) and the American Council for Capital Formation (ACCF) that have cited concerns over accuracy and excessive reliance. In an ACCF study that was cited in the Harvard Law School Forum on Corporate Governance, researchers found that “175 asset managers managing over $5.0 trillion in assets have historically voted consistently with ISS recommendations 95% of the time” illustrating that the biggest asset managers vote with proxy advisors 100% of the time, seeming to show evidence of over reliance. Another report cited in the same article found that numerous errors were reported by public companies.

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Latest Industry News, Views & Information

Understanding ESG & Annual Incentive Plan

Understanding ESG & Annual Incentive Plan ESG refers to a series of environmental, social and governance criteria taken into consideration by the funds during the investing process. Investing in ESG funds allows shareholders to support companies in transition, that wish to act and develop in a more sustainable and responsible manner. In practice, many indicators … Continue reading “Understanding ESG & Annual Incentive Plan”

Pay for Performance: The Largest Institutional Investors’ View

Pay for Performance: The Largest Institutional Investors’ View Executive compensation has been one of the trickiest issues within the corporate governance space as of late. Across the board, there seems to be no end in sight to finding the perfect compensation package or philosophy for corporate executives. In this article, we will discuss the … Continue reading “Pay for Performance: The Largest Institutional Investors’ View”

How to design your peer group for compensation benchmarking

How to design your peer group for compensation benchmarking Given the scrutiny on executive compensation in recent years, it is critical to make sure that your company’s executive pay reflects its performance and aligns with the market. Therefore, it is essential for companies to have an appropriate peer group for performance benchmarking, compensation program … Continue reading "How to design your peer group for compensation benchmarking"

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Activist Investor Focus in 2020

View the facts and figures of activist investor campaigns in 2020. What have been the key target areas and how can companies be better prepared?

Activist Investor Focus in 2020

08.13.2020

Activist investor campaigns have increased, and activist numbers are growing. In 2020 campaigns have almost doubled compared to four years prior with majority of activist campaigns targeting specific areas of corporate governance.

Click below to see the facts and review the key target areas.

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