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An investor, a lawyer, a banker and a consultant weigh in on the effect of shareholder anger over executive compensation.

by Paula Schaap and Ron Orol

Many companies that garnered among the largest protest votes by shareholders against their executive pay plans faced activism in 2015. For example, in June 2014, Staples Inc. (SPLS) executives received only a 46% vote in support of their pay packages; six months later Starboard Value LP launched an insurgency that quickly drove the national office supply chain into a February deal to merge with Office Depot Inc. Similarly, Semiconductor company Qualcomm Inc. (QCOM) narrowly passed its say on pay vote but faced a subsequent attack by dissident Jana Partners. And just recently, after shareholders evinced unhappiness about Rovi Corp.'s (ROVI) executive pay, Engaged Capital LLC's Glenn Welling succeeded in getting himself and another dissident nominee elected to the digital entertainment company's board-even as it made last-minute changes to director pay in an effort to keep him at bay.

Given the seeming correlation between activist investor interest and negative say on pay votes, The Deal asked our expert panel of advisers to weigh in on whether shareholder dissatisfaction with compensation packages presages is, in fact, a predictor of activist involvement.

The Deal: Is dissatisfaction with executive pay packages enough to help an activist's case with institutional investors, or will dissidents need other performance problems to be able to highlight to get shareholders on board? Is there any level of compensation or any degree of shareholder outrage that would be enough, in itself, to draw an activist's attention?

M&A attorney: This whole thing on say on pay is way overblown. The whole key is how does the company perform. Most boards are cognizant of what's reasonable and what's not. But absent bad performance  for a steady period of time it shouldn't be a big issue.

Institutional investor: It is important to remember that it is the intersection of pay and performance that matters. So it is possible that in instances where poor say on pay votes are being driven by declining performance-rather than by increasing pay levels-activists may find fertile ground. But in general, activists will need more than poor say on pay to convince investors that not only are board changes necessary-which may indeed be warranted-but that the activist's specific nominees are the best replacements. And for the activist, you would certainly expect some operational turnaround or strategic alternative to be critical to driving a profitable exit.

Consultant to activists and targets: This really depends on how out-of-line the compensation practices are and what the board has done to remedy the situation.  Most activist investors are drawn to value, so governance practices and compensation arrangements are usually secondary to that.  However, if there are hidden pockets of value to be built or extracted, an activist will certainly highlight poor compensation practices as emblematic of required change.

Investment banker: Dissident shareholders cannot simply lean on dissatisfaction with executive pay and hope that issue alone will be enough to achieve board representation. Taking issue with the executive compensation of a targeted company is, however, one of the most frequently used tools in contested elections-and can even be seen in situations where the targeted company has had decent say-on-pay results. The key for a dissident when criticizing executive compensation is to credibly assert that the poor compensation practices are symbolic of overall poor board oversight.

The Deal: Last year ISS recommended against 13% of the pay packages at US companies it followed and this year the proxy adviser recommended against 7% of companies it assessed. What role, if any, do the proxy advisers play in say on pay votes and do their recommendations factor into whether an activist might decide to target a company?

M&A attorney: I think ISS is an embarrassment. I think what they say is totally irrelevant. As an organization that charges companies subscription fees [for their reports] they really don't understand any of the issues. If you get a negative ISS report, you then have to talk to the funds. So it just takes an extra bit of an effort. But you can show the funds themselves that you have a reasonable case-very few firms don't have the ability to make decisions other than those that ISS proposes.

Consultant to activists and targets: ISS and Glass Lewis wield enormous power over institutional voting decisions on compensation, but these recommendations typically do not influence whether an activist will target a company the following year.  However, if a company gets a negative vote from shareholders and subsequently do nothing about it, you can expect that company to attract additional scrutiny from all shareholders, and probably attract activists.

Investment banker: Obviously if you're drawing a negative recommendation on pay from ISS or Glass Lewis, investors will take a closer look at your compensation practices. [My firm] published a study in 2014 examining whether there is a correlation between negative say on pay and activism and we have found virtually no connection.

When the bullets are flying in a public campaign, activists will most certainly quote ISS or Glass Lewis if they have been critical of their targeted company's compensation in previous years. But we would be surprised if economic activists used these recommendations as a screening tool for finding potential targets.

Institutional investor: Proxy advisory firms do a good job at providing a first cut for investors-highlighting problem companies with both their vote recommendations and accompanying analysis-but they don't determine large investors' vote decisions. However, with pay considered a lens into a company's governance practices, and with many proxy fights coming down to a question of credibility, it makes sense for activists to take the temperature of the advisory firms' concerns at a company by looking at their say on pay recommendations.

The Deal: Who specifically do institutional investors want to hear from at companies that receive negative say on pay votes? Is it good enough to put your investor relations official on the phone to talk about the latest quarter or should the company have compensation committee directors speak directly to funds? And what do the funds want to hear?

Institutional investor: With the vote a black mark against the Compensation Committee's principal body of work, it is vital to hear directly from members of the committee. Not only is this a barometer of the seriousness with which the board is taking the vote, but it also provides the opportunity to probe-and learn from-the committee's view of pay and its connection to long-term strategy. For instance: how is the incentive structure designed to pay through the business cycle, how do vesting periods match up to investment decisions and payoffs, and what are the pros and cons of commonly used metrics such as EPS and Ebitda? At the same time, investors want to hear about the committee's assessment of its own performance and whether it needs new leadership and/or to recruit directors that can offer new perspectives.

M&A attorney: I think it varies. If it's a serious thing, you need to send your CFO or your treasurer, not just your IR person. It also depends on how big your company is. If it's smaller cap, you need a senior person. If it's Apple, I don't know if you need that. As with anybody you're talking to, you will want to have your IR guy plus some senior member of management. As to sending a member of the compensation committee, I can tell you, in the M&A context, you typically wouldn't have a member of a corporate subcommittee talk. I don't see anything wrong with it, but it's not company protocol. And if you get into issues of talking to investors one-on-one then do you have to put it into the proxy statement? Theoretically you have to do that for anything that's material-put it in the compensation statement of the proxy. If you were going to do that, you would probably have to treat it as roadshow material and file with the SEC.

Consultant to activists and targets: It depends on the size of the company, the number of institutional investors in its stock, and the size of the investor's position.  Ideally, you want the Chairman of the compensation committee to speak directly to these issues, but it may not always be practical.

Investment banker: Each situation is unique, but we would suggest that independent directors on the compensation committee would have the most credibility with shareholders. As for what the funds 'want to hear' ...  the fact is that if you're having multiple discussions with large investors about executive compensation, chances are that your company's performance has not been great. These shareholders will want to know that your compensation is largely correlated with the performance of the company and that the incentive components of the plan line up with the same things they care about (e.g., margins, ROIC, EPS) and not potentially conflicting metrics (e.g. revenue or Ebitda).

The Deal: Oracle Corp. (ORCL) failed its executive pay vote two years in a row receiving 46% in 2014 and 43% in 2013, which may have played a part in co-founder Larry Ellison's decision to step down last year. Two pension funds want the technology company to install a proxy access mechanism-is that another indicator, along with the pay issue, that might give an activist fertile ground with institutional investors to launch a campaign?

Consultant to activists and targets: I see these as unrelated. Activists, for the most part, aren't interested in proxy access.

Institutional investor: Proxy access is designed to give long-term investors a clearer voice in nominating directors at companies like Oracle that suffer from persistent governance failures. It is also an alternative and more nuanced means of achieving these changes to the activism of activist hedge funds, which can afford to take concentrated, but short-term bets on a company and its valuation. So it would be somewhat ironic for the proxy access push at Oracle to spark a push from an activist hedge fund.