The board of Portland, Oregon-based Umpqua Holdings Corp. felt satisfied that the $3.7 million compensation package it gave to CEO Raymond Davis in 2010 was in the best interests of shareholders.
The $11.5-billion asset banking company had ridden out the financial crisis relatively well, and even capitalized on it, buying three failed banks from the Federal Deposit Insurance Corp. and establishing a beachhead in the Puget Sound region of Washington.
Directors wanted to reward Davis for good long-term strategic moves in a tough environment and encourage more of the same. They also recognized the importance of financial metrics. How much Davis got paid depended largely on such factors as per-share earnings growth and credit-quality improvements.
Weeks before the company’s shareholder advisory vote on executive compensation, however, Umpqua was blindsided by the two major proxy advisors, Institutional Shareholder Services of Rockville, Maryland, and San Francisco-based Glass Lewis & Co.
Both firms, which issue reports on virtually all public company proxies for their institutional investor clients, recommended voting against Davis’s pay deal.
Umpqua earned 15 cents per share in 2010, compared to a 2009 loss, and saw its non-performers slide to 2.19 percent of assets, versus 3.75 percent a year earlier, according to SNL Financial. But its share price, like those of most other banks, had declined modestly in 2010. Return on equity for the year was just 1.71 percent.
No matter what progress the board had witnessed in other areas, neither ISS nor Glass Lewis thought the returns justified the 61 percent year-over-year increase in Davis’s total compensation.
For a company that’s 86 percent owned by institutions, the negative vote recommendations were bad news. Umpqua made the case for Davis’s pay package to investors, but lost its say-on-pay vote by a 65-35 margin.
According to an in-house analysis, a whopping 32 percent of shares were cast directly on the firms’ recommendation, while an additional 53 percent subscribe to at least one of the services and factored in those opinions.
“There’s no question but that the proxy advisory firms had a large influence on the vote,” says Steven Philpott, Umpqua’s general counsel. “The feeling in our boardroom today is, quite frankly, that we must pay more attention to what they are saying because of that influence.”
Umpqua’s directors aren’t the only ones looking over their shoulders. As proxies grow thicker and more complex, and the importance of shareholder votes—particularly those on say-on-pay resolutions now required by the Dodd-Frank Act—continues to rise, the power of ISS and Glass Lewis is increasing.
The two firms, along with a handful of smaller kin, weigh in with “yea” or “nay” recommendations on any proxy matter that requires a vote—everything from director elections to proposed mergers.
Just how much influence those recommendations carry is subject to debate, but all agree they matter. ISS boasts 1,700 institutional clients that manage combined assets of about $26 trillion, and controls roughly 60 percent of the market, according to a 2009 study by New York University Associate Professor of Law Tamara Belinfanti. Glass Lewis comes in at 500 clients with $15 trillion in assets.
Some investors are said to vote a straight ISS line, though they would never admit it. Others use the recommendations as “rebuttal presumptions:” starting points that require significant persuasion to overcome.
Timothy Smith, senior vice president at Walden Asset Management in Boston, says that some investors “are a little lazy, and tend to carefully track Glass Lewis and ISS.”
But he adds that most, including Walden, use the proxy firms’ recommendations more as a “sorting mechanism” to determine which issues and votes demand more attention. “We would never give away our proxy voting responsibilities,” he says.
George Paulin, chairman of F.W. Cook & Co., a Los Angeles compensation consultant that works with several large banks, says a thumbs-up or thumbs-down from ISS can sway the say-on-pay vote by as much as 30 percent; for Glass Lewis, the figure is somewhere in the 5 to 10 percent area.
“If you get negative recommendations from both of them, it compounds the effect,” he says.
An analysis of 2011 say-on-pay votes by Pearl Meyer & Partners found that companies with ISS support received an average 92.8 percent support for their say-on-pay votes; those with “against” recommendations got 69.1 percent of votes.
Several academic studies have pegged the average percentage of votes influenced by the advisors at around 20 percent, although it can be higher depending on the circumstances. A 2010 study by researchers from the University of Pennsylvania and NYU put the effect at less than 10 percent, after eliminating “company-specific” factors.
“It really depends on your stockholder base,” says Mark Poerio, a Washington, D.C.-based partner with the law firm Paul Hastings, who estimates an average swing in the 15 percent to 25 percent range. “If you have a lot of institutions, it can be higher.”
Another study, conducted in early 2012 by Waltham, Massachusetts, research firm Tapestry Networks for the IRRC Institute, a New York nonprofit that studies investor behavior, found that large mutual funds use proxy advisors primarily to organize huge amounts of proxy data for voting purposes.
They might look at ISS’s voting policies, but ultimately make and follow their own policies.
“Correlation and causation aren’t the same things. Just because investors vote the same way doesn’t mean they are voting with the proxy advisors,” says Tapestry Principal Robyn Bew.
The advisors present themselves as small cogs in a big machine. “Our clients are paying us to give them a meaningful, but fairly digestible, version of the proxy statement so they can make an informed decision,” says Carol Bowie, ISS’s head of compensation policy development.
Robert McCormick, chief policy officer for Glass Lewis, notes that in 2011 his firm recommended against 17.5 percent of all pay packages, while ISS recommended against about 12 percent. Even so, just 1.6 percent of companies, 41 in total, lost their non-binding votes.
“I don’t want to pretend we have zero influence, but there’s a misperception that we have more power than we actually do,” McCormick says.
The proxy firms’ recommendations, he adds, are based on policies that come after meeting with investors and companies. “We don’t set the standards; we’re articulating the standards they set.”
Smith of Walden Asset Management points to Citigroup’s embarrassing 55-45 defeat on its say-on-pay resolution last April. Citi’s stock lost 44 percent of its value in 2011, yet CEO Vikram Pandit received a $14.9 million pay package. Both proxy advisors recommended against it.
“Do you think if they didn’t recommend a ‘no’ vote, that big institutional investors would have voted ‘yes?’” Smith asks. “No. They voted ‘no’ because there wasn’t adequate pay for performance. They didn’t need ISS to tell them that.”
The typical pension fund or asset manager owns shares in thousands of companies. That can translate into well over 20,000 proxy votes per-season, including everything from director elections or the latest governance proposal to say-on-pay.
Even for the most sophisticated funds, it’s impossible to manage that process effectively. So they do what companies everywhere do nowadays, and outsource much of the work.
ISS and Glass Lewis provide time-pressed institutional money managers with complete menus of proxy-related services, ranging from basic data aggregation to voting platforms, to help collecting on securities class-action lawsuits.
They also provide plenty of grist for the voting mill. In director elections, for instance, the advisors tally board member attendance records and ferret out potential conflicts of interest in advance of elections—good information to know, but something few investors have time to seek out.
It’s the actual voting recommendations, displayed boldly in the opening pages of data-laden reports, which get the attention of most boards. Even for investors committed to making their own decisions, the opinions have an effect.
In today’s charged environment, where every proxy vote feels like a referendum on board performance, directors ignore the proxy advisors’ opinions at their own peril.
Losing an important vote can lead to greater scrutiny, opposition to sitting directors in elections and even lawsuits. In 2011, about 20 percent of failed say-on-pay votes resulted in derivative suits against directors and officers, Poerio says.
Winning by a close margin isn’t much better. ISS policy dictates any company that wins its say-on-pay vote with fewer than 70 percent of votes cast will get additional scrutiny the next year; for Glass Lewis, the cut-off is 75 percent.
While it’s possible to win a shareholder vote without their support—in fact, it happens quite often—a resounding victory is tougher to come by.
“There are two piles of proxies: The ones that have ‘for’ vote recommendations from ISS and Glass Lewis, and the ones that have ‘against’ vote recommendations,” says one person familiar with the process among institutional shareholders.
Investors “don’t spend much time on the first group. The second group gets a lot more scrutiny.”
Securing the proxy advisors’ support, on the other hand, is a sort of Good Housekeeping seal of approval, one that can grease the skids to a relatively easy board victory.
(First California Financial Group Inc., based in Westlake Village, California, is a rare exception to the rule: This spring, it became one of a small handful of companies ever to have ISS support for a pay package and lose its shareholder vote. The $2-billion asset company has been squabbling with restive shareholders, and recently hired an investment banker to explore its “strategic alternatives.”)
All that makes winning the firms’ backing a priority in boardrooms around the country. “It’s certainly something we give consideration to,” says Cynthia Hartley, chairman of the compensation committee at SCBT Financial Corp. in Columbia, South Carolina.
“You know it’s a viewpoint you’re going to have to deal with,” Hartley says of the recommendations. “So if you’re talking about making a change or decision, it definitely enters into the conversation.”
According to a 2010 study by the Center on Executive Compensation, 54 percent of companies reported that they had changed something in their pay plans to increase their chances of gaining proxy advisor approval.
David Baris, executive director of the American Association of Bank Directors, says he’s seen clients compromise their stances on governance issues to avoid the hassles and embarrassment of advisor disapproval.
“They might have approved a staggered board, and then ISS opposes it,” says Baris. “The directors might say, ‘Is it really worth the pain of having to fight with these guys? Let’s just get rid of it.’
“If more than 50 percent of your stock is owned by institutions, sometimes you have to capitulate,” he adds.
Advocates credit the advisors for being a counterbalance to board and management power, and for driving the many positive governance trends of recent years.
There are fewer poison pill provisions, lavish perks, tax gross-ups, big severance packages and outsized supplemental employee retirement pensions than before. More pay plans have clawbacks; more boards are talking to shareholders.
But the perception that a couple of self-styled governance watchdogs can hold such sway over their decision-making and voting process sends shutters down the spines of many corporate leaders. The advisors’ perceived power is so great, few board members are willing to air their criticisms publicly, for fear of retribution.
The U.S. Chamber of Commerce and the Business Roundtable, neither known as champions of regulation, have called for the Securities and Exchange Commission to oversee proxy advisors, fearing they’ve become too powerful.
Critics say the advisors have turned a healthy discussion of best practices into a rigid, metrics-driven process, where the value of board judgment gets muted and lost.
Board members chafe at sometimes having to compromise what might be best for the company’s long-term future in order to win positive recommendations. The advisors employ quantitative models that define success in ways that might be different from what the board believes is best.
ISS, for instance, screens pay packages in three ways: How they stack up against peers in terms of relative performance over one and three years; how they rank in absolute terms versus peers; and the change in CEO pay versus the change in total shareholder value over five years.
The three tests are scored, and if there is a high level of concern on one test, or a medium-level concern on two, then there could be a problem. “If you got 90th percentile CEO pay and 25th percentile total shareholder return, you’ve got a disconnect,” F. W. Cook’s Paulin explains.
Directors complain loudly about peer groups, which are inevitably different from the board’s group, and aren’t revealed before the report is issued. They don’t like the way some things are accounted for—ISS, for instance, counts the grant value of options instead of paid delivery.
Many compensation committees feel hamstrung, unable to employ their own creative instincts to craft packages that support long-term strategy.
That’s especially true at banks, where executive pay tends to be more discretionary—weighing things that don’t fall directly to the bottom line, such as credit quality or the operating environment—than many other industries.
With the proxy advisors, “it’s a one-size-fits-all set of rules: Here are your peers. Here is how we value pay. And if you’re not aligned with our rules, then we won’t recommend a positive vote,” Paulin says.
“But most boards will say, ‘Our business objectives justify what we’re doing. That’s our role as directors, to use our judgment to make these decisions in the best interests of shareholders,’” he adds.
ISS’s Bowie acknowledges the frustrations: “A lot of boards don’t like us. They wish that we would sort of pack up and go away.”
Both firms say they have grown more sensitive to the complaints, and are committed to transparency. They collect feedback from investors and issuers each year, and use it to help tweak their approaches. Next year’s evaluations will be different from this year’s at both firms.
But Bowie says there also is more nuance involved than is commonly understood. All pay packages that fail ISS’s quantitative test are subjected to “qualitative” tests that key in on an incentive plan’s goals and metrics.
“We might end up concluding that even though pay and performance have been misaligned in the past, the current decisions are better,” she says.
About 45 percent of packages that fail ISS’s quantitative test receive “for” recommendations after the qualitative examination, Bowie says.
On most issues, boards know instinctively the steps they must take—improve disclosure, eliminate takeover defenses, etc.—to win the proxy advisors’ backing.
Recommendations on accepted governance best practices, such as majority voting in director elections or nixing poison pills, are predictable.
“We look at those issues from the perspective of basic, fundamental good governance,” says Glass Lewis’s McCormick. “Philosophically, if [the proposal is] to have an independent chairman or eliminate anti-takeover devices, we’ll almost always favor it.”
The advisors also issue recommendations on juicier, more subjective issues, such as calls for political spending disclosures, and environmental or hiring policies.
Overall, Glass Lewis supported about 60 percent of political resolutions in the most recent proxy season, with a preference for those that demand greater disclosure. “We’re more inclined to support calls for more information, less inclined to support proposals that say, ‘Don’t do that,’” McCormick explains.
The firms publish annual policy guidelines—ISS’s 2012 release was 73 pages long—that explain in detail how they will vote in most situations.
For boards that need additional help, an army of governance and compensation consultants is on hand to help boards craft proposals and responses that fit into those guidelines.
ISS itself plays both sides of the fence, offering up consulting services to companies that want help winning positive recommendations under the ISS Corporate Services brand.
ISS President Gary Retelny says the firm maintains a strong “firewall” between the two sides, with different people and different systems, but many critics complain about a conflict of interest. That doesn’t stop companies such as Umpqua from doling out five-figure fees in hopes of gaining a glimpse inside the magic box.
“Is it a conflict of interest? Yes. Is that really a bad thing? Not necessarily, as long as people know,” Umpqua’s Philpott says, noting that ISS discloses the relationship in its report to investors. “That’s all investors really need to know.”
Glass Lewis does not have a consulting arm.
Companies that fail to garner support can appeal to the proxy advisors, but getting a recommendation changed is difficult—unless the firms made a mistake, or significant changes are made to fit the firms’ expectations.
And that’s okay. Boards take stands they know won’t pass the proxy advisors’ muster all the time, and win the majority of them. Usually, they have done a good job making their cases.
“You can win a vote without ISS support, but you need to make sure that your large shareholders understand the stances you’re taking, and why,” says Eleanor Bloxham, CEO of The Value Alliance, a corporate governance consultant in Columbus, Ohio.
Communication is crucial. For say-on-pay, the Compensation Discussion and Analysis portion of the proxy should lay out in exacting detail all of the rationales and numbers behind an executive’s pay.
Michael Melbinger, chairman of the executive compensation practice at law firm Winston & Strawn in Chicago, tells his clients to accentuate the positives.
“There are few better ways to get support than to be able to write in the introduction [to the CD&A], ‘We’ve always tried to follow best practices. For example, this year we adopted a clawback policy consistent with the provisions of the Dodd-Frank Act,’” Melbinger explains.
“You want to create a little list so the reader can see it and say, ‘These guys are really up on their jobs,’” he adds.
Some companies issue supplemental proxy materials before shareholder meetings to rebut negative recommendations, taking the case straight to investors.
When ISS recommended an “against” say-on-pay vote last March, Columbus, Ohio-based Huntington Bancshares Inc. fired back with a six-page filing that pointed out what it said were several flaws in the firm’s analysis.
Huntington won its say-on-pay vote, but just barely, with 61 percent shareholder support.
And if you lose? There’s always next year. Most resolutions are advisory votes, which afford time to win over both the proxy advisors and shareholders before it happens again.
Umpqua spent the year after losing its 2010 say-on-pay vote meeting with investors. Compensation committee chairman Peggy Fowler, along with Philpott and Chief Financial Officer Richard Farnsworth, flew to Maryland to meet with ISS officials. Philpott, the point person on the effort, also met with Glass Lewis officials.
The talks and work led to some modest changes, among them equity grants that now vest based, in part, on comparisons to a regional stock index and stronger stock ownership guidelines for executives and directors.
Earlier this year, Umpqua received positive recommendations from both firms for Davis’s $3.4 million package and won 95 percent of the votes cast.
“My primary takeaway from the experience is that the board can’t get ahead of the market when it comes to setting executive compensation,” Philpott says. As Umpqua learned, the proxy advisors are there to apply the brakes, whether the board likes it or not.