‘Earnings Hysteria’ Pits ISS Against Clinton and Fink on CEO Pay
August 23, 2016 — 5:00 AM EDT
► Proxy firm
endorses link between compensation, stock returns
► Some say ‘lazy
man’s metric’ won’t drive company performance
Institutional Shareholder Services has
unintentionally taken on Hillary Clinton and Larry Fink.
At the moment, ISS is winning.
The proxy adviser, whose customers
control a combined $25
trillion in assets, has helped drive the trend toward
rewarding executives for share-price gains. Today, more than half the
chief executive officers of S&P 500 companies receive compensation
partly determined by shareholder return, according to Equilar Inc.
That’s doubled since non-binding “say-on-pay” shareholder votes on
compensation were introduced in 2011.
“ISS has been a major influence,” said
Joe Sorrentino, managing director at executive compensation firm
Steven Hall & Partners.
Both Clinton and Fink have called on
companies to focus on long-term growth rather than stock moves. The
Democratic presidential nominee has criticized short-term thinking as
capitalism’’ while the CEO of BlackRock Inc., the world’s
largest asset manager, has
it as “earnings hysteria.”
In its recommendations to subscribers,
ISS compares a company’s CEO pay and its total shareholder return
-- the change in stock price plus dividends paid -- to those of
competitors. A mismatch between pay and three-year relative stock
performance can result in ISS urging clients to vote against the
company’s pay plan and reject directors serving on the board’s
Big investors such as BlackRock employ
their own proxy analysts to comb through compensation data to prepare
for shareholder meetings. Smaller money managers, on the other hand,
tend to rely on advisers. ISS’s recommendations aren’t binding, but
research suggests that ISS reports can affect as much as
of the shareholder vote, according to David Larcker, a professor of
accounting at Stanford University.
That would worry any director. “Against”
votes can draw the attention of reporters, help fuel activist investor
campaigns and embarrass directors. That’s made Rockville,
Maryland-based ISS a force in U.S. boardrooms and resulted in stronger
ties between executive pay and stock returns.
A spokesman for the 900-employee firm
declined to comment. Its voting recommendations for say-on-pay
elections are also based on factors including the company’s financial
results, the share of pay tied to goals, and company-specific
variables. The firm is soliciting feedback from clients on whether its
quantitative assessment of corporate performance should be based on
measurements in addition to stock performance.
Boards typically link shareholder return
to a portion of CEOs’ long-term awards, which often consist of equity
that’s earned over three years. Stock grants tied to performance have
become common in the last decade as directors and investors
communicate more closely about pay.
Supporters say it helps align the
interests of management and shareholders. Executives typically benefit
doubly since strong stock-price growth boosts both the number of
shares they receive and the value of each security.
But Michael Sirkin, an executive
compensation partner at law firm Proskauer Rose LLP, says stock return
is a “lazy man’s metric” better suited for measuring performance than
driving it. Focusing on desired financial outcomes is a better way to
drive long-term shareholder value since share prices are in many
instances outside executives’ control, he said.
Linking CEO pay to stock return can also
encourage managers to focus on short-term gains rather than building
the business for the long haul, according to William Lazonick,
co-director of the Center for Industrial Competitiveness at the
University of Massachusetts at Lowell.
“You’re incentivizing executives to do
whatever they can to get the stock price up,” he said.
Evidence of corporate America’s efforts
to buoy share prices, sometimes at the expense of a wider vision, is
Mergers and acquisitions, popular with
hit a peak
globally in 2015. S&P 500 companies spent
more than $2
trillion purchasing their own shares since 2009, dwarfing
every other buyer in the equity market. U.S. businesses in June funded
buybacks with debt
at the highest rate since 2001, according to data compiled by JPMorgan
Chase & Co. and Bloomberg.
In a February letter to U.S. CEOs,
BlackRock’s Fink discouraged the practice of returning cash to
shareholders “at the expense of value-creating investment” and pointed
out that dividends paid by S&P 500 companies in 2015 amounted to the
highest proportion of earnings since 2009.
While buybacks and dividends can give
temporary bumps to stock prices, they can also come in lieu of efforts
that might be better for a company’s long-term health and the U.S.
economy in general, such as investing in research and development,
building new factories or hiring and training workers.
Companies should develop financial
metrics “that support a framework for long-term growth” and link them
to long-term compensation, Fink
But how? Many boards struggle to set
financial targets for performance periods that last several years,
said Amy Wood, a partner at law firm Cooley LLP in San Diego.
Determining payouts by using shareholder return relative to a group of
peer companies can be a middle-way solution that satisfies both
investors and proxy advisers despite falling short as a motivational
metric, she said.
Another potential snag: Executives can
exceed financial targets and still be punished because their success
isn’t reflected in the share price, according to Ira Kay, managing
partner at compensation consultant Pay Governance.
“You can have perfectly good financial
performance but your stock price happens to be off, so you fall below
the peer group’s median return, fail ISS’s quantitative test and all
of a sudden 30 percent of shareholders go against you,” Kay said.
“It’s very frustrating to board members and executives.”