Executive compensation is a perpetual hot-button topic and one that activist investors frequently use to court shareholder support for their proposals. In a recent BoardVision video, Semler Brossy managing directors Roger Brossy and Blair Jones talk with Ken Bertsch, partner at CamberView Partners, about the following questions:
What compensation practices are red flags for activists?
What happens when an activist investor, or their representative, joins a board?
What are some practical considerations for boards and compensation committees?
Here are some highlights from that conversation.
Roger Brossy: [Activists have] $200 billion under management in various funds. We could see, at current pace, as many as 700 campaigns in corporate America led by activists. Blair, what does executive compensation have to do with this?
Blair Jones: It certainly is not the primary issue that an activist is using as they pursue a company, but it is a hook to engage other investors and also to engage the public at large if it’s a very public fight. The kind of thing they’re looking at is the magnitude of pay. So they would look at the “how much is too much?” question. They might look at certain elements of pay, like retirement or special supplemental retirement benefits, that only executives get. They love to look at pay and performance. Their favorite chart is a pay level that stays steady or even goes up, contrasted against a performance level that’s going down. That’s one of their key areas of focus and interest. They like to look at whether the metrics that they care about are included in the compensation programs, and they also look at say-on-pay votes. And if the company has a pattern of lower say-on-pay votes, it’s often an indication that there may be other governance problems underlying some of the decision-making at the company.
Brossy: Ken, we’ve engaged with activists who are very, very thoughtful about executive pay and have a very reasoned point of view about what the structure of programs ought to look like. But we’ve also been in situations where it felt like stagecraft, and we weren’t sure there was a lot of conviction. Maybe it was more just sort of a point to embarrass or try to curry favor with others. How do you see this fitting in?
Ken Bertsch: Well, I saw both things happen. This is a bit of a campaign—a political campaign—and people use things in campaigns that may make people look bad, which might not always be authentic to what’s going on. On the other hand, I wouldn’t want to overstate that, because I think executive pay does often get to, or is linked to, underlying strategy. Blair talked about discussion of metrics and what makes sense. If the investor has a view on what’s going wrong at the company and the pay strategy fits into that, that’s going to be a useful—and in some ways illuminating—piece of the campaign. So I think it’s both things, and it makes it hard to deal with.
Brossy: So what is your advice for boards?
Bertsch: Number one, be as clear as possible about executive pay. Disclosures have gotten a lot better in recent years, and I think that’s very important. Why are people being paid what they’re paid, and what’s the strategy behind it? How does it link to the company strategy? A lot of the investors who are not activists but [are] potentially voting on activism, that’s what they care about. So you want to be logical about what you’re doing. I think you want to avoid some of the practices that tend to get a lot of criticism. I think, also, you want to listen to the activists, to your shareholders, and try to hear if there is merit in the arguments being made.
Brossy: Blair, when we’ve had boards take activist slates into the board, obviously a very unusual and interesting environment ensues. People who might have been in sort of antagonistic public stand[off]s with each other are now looking to find a constructive way forward, and there may be a variety of points of views or degrees of willingness to have that happen. What should compensation committees do at that stage as they’re taking new members onto the board and potentially onto the compensation committee?
Jones: I think that’s a great question, and one of the most important things is to get a clear articulation of the philosophy of the compensation program. It’s important for the new board members to hear the history of how you got to where you did, but it’s also important for the whole board to talk about where the program is and to either affirm where they are or say there are some things that need to change. They do that as a group where they’re revisiting it. I think that’s job number one.
I think job number two is to … think about the people and the talent. Considering we’re in the situation we’re in, do we have any talent out there that we need to shore up and ask to stay and work with us through the process of taking this company into the next era? That may mean looking at things like severance arrangements so people feel like they have some protection. It may be selective retention or special programs that have new measures related to whatever the objectives of activists’ campaign were.
At the National Association of Corporate Directors’ (NACD’s) Master Class program in Philadelphia June 3-4, nearly 50 experienced directors engaged with corporate leaders on the key elements that will shape the boardroom in the coming decade.
NACD’s Master Class takes place over two days and comprises eight modules presented as panels, keynote speeches, and intensive breakout sessions. Modules are highly interactive and are led by veteran directors, leading business executives, and corporate governance experts. Each Master Class is organized around a specific theme.
In Philadelphia, discussions centered on ensuring effective boardroom dynamics and strengthening the board’s role in strategic planning, cybersecurity, and mitigating global risks. Below are five takeaways that emerged in Philadelphia.
Search out the enemies of effectiveness. Vague expectations, absence of process, inadequate delegation of authority, and individual sabotage can individually or collectively compromise board effectiveness. Independent chairs and lead directors should be attentive to poor board dynamics, which often have root causes that can easily be addressed. Boards can also help counter dysfunction by establishing a foundation of shared principles that will guide the board’s decision-making, agenda-setting, discussion management, and self-assessment.
Analyze the causes of gradual deterioration in performance. Management often rationalizes small performance drops by pointing to macro-economic trends or solvable business execution problems. Boards should consider adopting a forward-looking posture in order to understand the long-term impact of disruptors on business performance. They can do this by engaging with management in frequent discussions about the assumptions that undergird the company’s strategy and the “what-if” events that could invalidate those assumptions.
Think like an activist shareholder. Activists usually know the industry and sometimes even the company better than the board does. To avoid being ambushed by well-informed activists, boards should learn from the consultants and investment banks that serve their company, industry, customers, and competitors. They must also challenge management’s conventional wisdom about the firm’s current performance and future direction.
Clearly delineate the roles of the board and management in developing and executing strategy. Boards can offer more value by engaging “early and often” in the strategy development process, by pressure-testing management assumptions, and by selecting the appropriate metrics to assess strategy success or failure. When seeking a more active role, boards must collaborate with management on defining the boundary between directing strategy and managing it. Addressing this tension over where the lines should be drawn is a critical challenge that will demand ongoing attention from the CEO and the lead director.
Anticipate the consequences of global disruptors. In a hyper-connected global marketplace, economic and political shifts in distant corners of the world can instantaneously impact company performance through supply-chain disruptions, foreign-exchange volatility, and regulatory activism. Boards can increase their understanding of emerging cross-border interdependencies and evaluate whether management is sufficiently agile to respond when conditions change.
For good or ill, activists now are important players in the investor ecology, with increasingly successful records for changing a board’s makeup. At Egon Zehnder, we identified 58 incidents of investor activism against S&P 500 companies over the last two years. Of those, 16 contests involved changes to board composition, urging a “no” vote on the management’s slate of directors or proposing, or threatening to propose, an alternative slate. And of those, only six concluded in favor of management, resulting from the activist slate being withdrawn before a vote or management’s victory in a vote.
It is not surprising, then, that many boards are evaluating their plans for responding to an activist slate this proxy season. Broadly speaking, however, there are really only two possible courses of action a board can take. One path is to accept the reality of activist scrutiny and build it into the nominating committee’s ongoing work. The nominating committee needs to look at the board with an objective eye and identify how its composition might give an activist a foothold, such as directors with conspicuously long tenures or directors whose experience is unaligned with the company’s business and its strategic direction. The nominating committee must then design a director succession plan that identifies, cultivates, and elects candidates with the desired competencies. Doing so is not a guarantee against activist action, but having a carefully chosen board with relevant backgrounds and perspectives deprives activists of a clear weakness to exploit.
Because board seats turn over intermittently and because competition for directors is so high, fully executing this strategy can take several years. In the meantime, an activist investor may well decide to put forth its own slate. When that happens, the nominating committee must shift into high gear. In the 16 activist initiatives involving changes to board composition, the median campaign length was found to be only 77 days—just 11 weeks from the initial announcement to some sort of resolution. And six of those 16 initiatives concluded in less than one month.
Of course, the company could stick with its current slate and hope it receives the necessary votes. But once activists have sown the seeds of doubt in the minds of other investors, events have shown that change is more or less preordained. It is simply a matter of whose change will prevail.
Because time is of the essence when faced with an activist slate, it is incumbent upon boards to watch closely for tremors that might precede such an action. Besieged boards might feel blindsided, but successful activist attacks rarely come out of the blue. Seven of the companies that were subject to investor activism on board composition were the targets of initiatives from more than one group. For example, while Starboard’s Jeff Smith may be the one credited with replacing the Darden board, that upheaval only followed an initial salvo from Barrington Capital Group. Once the board gets the faintest sense that it is the object of activist interest, it needs to move quickly to examine its composition and reshape it as needed.
When the battle is joined, boards must ensure they do two things. First, they must reach beyond their usual networks in identifying new director candidates. Expanded networks are more likely to allow the board to draw upon candidates with a wider range of perspectives and experiences. Furthermore, the wider pool of candidates (and connections to candidates) is essential if a company can hope to quickly assemble a slate that doesn’t look quickly assembled.
Once the company has its nominees, it then must convince the investor community to give its support. Here it is particularly helpful to steal a page from the activist playbook. Activists know that no matter how good their slate may be, their real power lies in their ability to sway a majority of investors to their side. As a result, the best activists are also the best communicators. They make sure that the story they tell is clear and compelling and then tell that story relentlessly. If management has been less than successful, it is because they have been out-maneuvered in the court of investor opinion. Management must make sure that the story they tell about their slate is even more compelling than that put forth in support of the activist candidates, and it must be told with the same energy and clarity.
The bottom line is that nominating committees must build strong director succession plans that result in boards that are clearly relevant for the challenges and opportunities the business is facing. Their only choice is whether to do so preemptively and with the luxury of time or, instead, with their back to the wall and the clock ticking.
George L. Davis co-leads Egon Zehnder’s Global Board Practice and is a trusted advisor across a host of corporate governance matters, with particular focus on leadership succession planning and board effectiveness. Kim Van Der Zon leads the U.S. Board Practice of Egon Zehnder International and has expertise in CEO succession. She has successfully served Fortune 500 clients across a broad spectrum of global companies from financial services and consumer packaged goods to pharmaceuticals and technology.