Shareholders strike back

Shareholder actions are rattling US boardrooms in 2012, not only indicating some of investors’ greatest concerns but also pressuring directors into making changes on a number of significant fronts.

Since the proxy season began, shareholders have flexed their muscles and gained influence at major corporations in a number of different ways.

Behind-the-scenes talks with public service workers’ union AFSCME persuaded Goldman Sachs to adjust its board structure in March by promoting John Bryan from presiding director to lead director, a major concession from the iconic investment bank.

While it is not the best practice of separating the role of board chairman and CEO that governance advocates prefer, most have conceded that Goldman’s move is ‘a step in the right direction’, including AFSCME president Gerald McEntee. Lloyd Blankfein remains Goldman’s CEO and chairman and will be evaluated by new lead director Bryan.

But perhaps the biggest development this year has been Citigroup shareholders’ negative say-on-pay vote rejecting CEO Vikram Pandit’s pay package in April. According to news reports, Citi’s compensation plan received only 45 percent of the vote, the first time a major bank has had its pay plan rejected by investors.

Citigroup must now decide what to do about investors sending the message that management’s compensation has not been properly aligned with company performance. Since the say-on-pay vote is non-binding, Citigroup could simply ignore it and allow Pandit to keep the $15 million he has already been paid for 2011. That option, however, would prolong a public relations disaster for the embattled bank and almost certainly ignite additional investor lawsuits to the one filed by Stanley Moskal seeking damages that would recoup some or all of Pandit’s compensation. Analysts suggest that a series of lawsuits will force a financial settlement of some sort and adjustments to how long-term compensation is measured at the bank.

For those in governance circles, the development at Citigroup could represent a major shift in how shareholders will deal with boards in the future.

The significance of Citigroup

‘The significance of the say-on-pay vote at Citigroup is that shareholders are no longer going to stand for poorly structured pay packages that unfairly enrich executives at the expense of shareholders,’ says CalSTRS director of corporate governance Anne Sheehan. ‘Given that this was the first year financial companies were out from under the purview of the pay czar since the financial crisis, it is the first opportunity shareholders have been given to judge these pay packages.’

Sheehan says the Citigroup board missed the mark in a number of areas. She points out that Pandit was only making $985,000 prior to receiving bailout funds from the US government, yet his base salary jumped to $1.75 million last year after he received a salary of $1 in 2009 and 2010 while under the government’s pay czar.

She also notes that bonuses paid were 70 percent discretionary and not tied to any performance requirements. The small percentage (30 percent) that was tied to performance was a simple absolute hurdle (not a peer comparison) of achieving pre-tax net income of over $12 billion. Pandit received a bonus under this structure despite Citigroup’s abysmal -44.3 percent one-year return. In fact, Citigroup’s long-term performance of -44.6 percent over the past five years is one of the lowest in its peer group.

‘What Citigroup shareholders seem to have said in respect to Vikram Pandit’s pay package was that there were real issues there in terms of what the metrics were and the alignment of pay with long-term performance,’ says Damon Silvers, associate general counsel for the AFL-CIO. ‘It is unquestionably a positive thing for the advisory say-on-pay process to not be a rubber stamp – and I think it is clear from the Citigroup vote that it is not a rubber stamp. Institutional investors are taking it seriously and looking closely at pay packages.’
 
Compensation issues at the fore

Robin Ferracone, executive chair of executive compensation firm Farient Advisors, says pay will always be at the top of shareholders’ list of concerns, which is why it is the area where they seem to have made the first major breakthrough in their many clashes with boards.

‘Now that they’ve had a year of say on pay under their belt and this is the second year they are doing it, they’ve gotten smarter about it,’ says Ferracone.

She notes that there are several important differences in how shareholders are addressing compensation plans this year. First, shareholders are reassessing the ‘peer group’ they compare the company against for pay fairness and competitiveness. Last year most shareholder groups used ‘peer group’ as defined by proxy advisory firms ISS and Glass Lewis; ‘This year they are saying, Let’s see how they do against the company-defined peer group,’ Ferracone explains.

She adds that her firm and Equilar have tools that allow you to ‘see how your pay is stacking up relative to your selected peer group or a peer group that we would choose for you – not one that ISS chooses for you.’

The second big difference this year, according to Ferracone, is that companies are taking a forward look at this year’s compensation, not just evaluating the past year’s pay. ‘It’s one thing to say, How did I pay for performance and how did that look in the past year?’ she explains. ‘It’s quite another to say, How is this going to look when the pay plan that we’ve put in place plays out over the next couple of years?’ The third major difference in evaluating pay packages this year involves how equity grants, which are the biggest pieces of the executive pay packages, are evaluated.

Ferracone says investors are looking ‘at what the grants you made two or three years ago, or five years ago, are worth today, and whether or not pay is in fact linking to performance – not what you said the grants were going to be worth on the day of the award, but what the expected value is now.’

Ferracone, who authored the study Say on pay: identifying investor concerns in cooperation with the Council of Institutional Investors, believes these evaluation concepts – determining peer group based on business model more than just size, taking a forward rather than just a backward look at pay, and using performance-adjusted equity values rather than grant date values – are here to stay. ‘Investors didn’t have the tools to assess those things before, but now they do,’ she says.
 
Ongoing battles with boards

After compensation issues, perhaps the next biggest area of concern for shareholders is board accountability. Shareholders would love to be on the same page as company directors, but they also want some way to get things moving back to what they consider their best interests when plans go awry.

‘If a board is truly representing its shareholders, it will implement properly constructed pay packages; it will implement proposals that are passed by a majority of shareholders; it will build governance structures that suitably align shareholders and the company, such as majority vote, declassified boards and one-share-one-vote standards; and lastly it will engage shareholders when necessary to seek their input,’ Sheehan says.

Silvers says the AFL-CIO and worker pension funds continue to be focused on strengthening boards, strengthening the audit process and addressing issues of systemic risk in the financial system. ‘These are some of the major themes of our concerns in the year to come,’ he states.

Neil Hennessy, portfolio manager and chief investment officer of publicly traded mutual fund company Hennessy Funds, says he deals with shareholder concerns all the time because he must distinguish his business from all the other funds institutional investors can purchase. One thing he believes hasn’t changed this year is that the companies that engage their shareholders in the right way will generally have fewer problems. In fact, he has no voicemail at his company because he wants his entire staff interacting with investors.

‘I want my CFO, my CCO, my controller – I want everybody answering shareholder questions because the shareholders are the ones who are paying us,’ says Hennessy, who runs nine no-load mutual funds. ‘And I don’t want my people saying I don’t need to know how the money is managed or I don’t need to talk to shareholders. I want everybody to understand the frustrations of our shareholders as well as their successes.’

Many more boards are likely to follow that way of thinking in the near future.
 
Shareholder concerns for 2012

Damon Silvers, associate general counsel for the AFL-CIO, recently spoke to Corporate Secretary editor Matthew Scott about shareholder actions and concerns for the current proxy season.
 
Is Citigroup’s negative say-on-pay vote a positive development for investors?

It is unquestionably a positive thing – from the perspective of worker pension funds that are long-term investors and investors who are broadly diversified across the economy, we hope that Citigroup will understand the vote to be a vote that encourages executive pay packages that have robust metrics behind them, and not a vote to force Citi to pay out cash to shareholders and weaken the company’s capital structure.

There were some people who were unhappy with Vikram Pandit because he was unable to pay a larger dividend. There isn’t a pension fund in the country that would be benefitted by weakening Citi’s capital structure. It is not in the interests of diversified long-term investors to see that happen.
 
What are shareholders’ greatest concerns, and why?

Many institutional investors are still seeking some greater level of explanation as to what happened in the financial sector during the economic crisis, which did so much damage to investors. In addition, a lot of institutional investors are very focused on how we’re going to get sustained economic growth on a global basis, without which it is going to be very difficult for anyone to make any money.

I think institutional investors are very wary of being asked to pay alpha prices for beta investment performance, or being asked to leverage beta investment performance – and these things are all tied up with one another.
There have been some substantial improvements on the governance front, partly as a result of Dodd-Frank and partly as a result of the growing popularity of good governance measures such as separating the chair and CEO, but there is a lot of ground to cover.

The rule-making process for Dodd-Frank is only half-done, and the SEC has a lot of work in front of it. Investors want to be operating in a market environment that is more soundly structured than the market environment prior to the crash and the crisis of 2008. All of those things are in play in Washington right now.
 
How do you achieve a sounder market environment – through regulation, or through shareholder actions?

I think they complement each other. Corporate governance activism requires a legal structure that gives investors usable rights, and there are certain things that investors need very badly that they cannot achieve through governance – for example, a stable banking system. Private ordering among the capital structure of banks is just not likely to produce that outcome by itself.
 
Is shareholder activism concentrated in the financial sector, or do you believe it’s broader?

There is a lot of investor focus on large financial institutions, partly because they are a disproportionate part of market-cap-weighted equity portfolios. More importantly, as we learned in 2008 and 2009, dysfunction in the financial system and weaknesses in large financial institutions have systemic consequences. From the perspective of an investor, they have portfolio-wide consequences.
 
Are there any special issues you expect to tackle this year as a member of the SEC Investor Advisory Committee?

I don’t want to prejudge what the agenda of the committee might be – I assume the SEC is going to be interested in the committee’s views on Dodd-Frank implementation, and as long as that remains a large part of the SEC’s work flow, it’s going to be something that’s on our agenda.

I think a lot of investors are unhappy with the so-called JOBS Act, and there are implementation issues associated with that which could mitigate the potential for problematic outcomes for investors. And then there is the ongoing corporate governance agenda and debate; there are also separate conversations about the regulation of markets and the regulation of financial intermediaries on which the SEC has formally and informally sought the views of investors. I assume that those will be things that we will be talking about as well.

I am honored to have been appointed to the committee, and pleased to be in the company of my fellow investors. I’m looking forward to trying to assist the SEC in its work.