by Cydney Posner
Is executive pay becoming a hot button issue for activist hedge funds? While executive pay has long been under scrutiny from standard-issue corporate governance activists, such as union pension funds, the interest of some hedge fund activists in executive compensation issues has the potential to introduce a more disquieting note to the compensation conversation.
This article by Jeremy Goldstein from the HLS Forum on Corporate Governance and Financial Regulation argues that “activists will not hesitate to use pay as a wedge issue, even if there is nothing wrong with a company’s pay program.” But when pay issues have been identified, compensation can assume greater prominence, and, in some cases, can appear to be the principal concern. The article identifies some considerations regarding executive compensation for companies intent on deterring hedge fund activists as well as for those hoping to avoid unintended consequences in the event of an activist strike.
The author first observes that low levels of support for a company’s say-on-pay proposal could signal that shareholders have identified performance issues at the company and make the company particularly vulnerable to an activist attack “because a failed vote can result in tension between managements and boards.”
[Sidebar: For example, in at least one instance, hedge fund activists expressly cited the precipitous decline in the rate of shareholder approval of the company’s say-on-pay proposal as evidence in support of its slate in the activists’ proxy contest.]
The author suggests that companies “should get ahead of potential activists by (1) understanding how their pay programs diverge from standards of shareholders and proxy advisors, (2) developing a robust, year-round program of shareholder engagement by management and independent directors, and (3) considering appropriate changes to pay and governance structures if advisable. Companies that are the most aggressive at shareholder outreach and develop the best relationships with both the investment and the governance representatives of their major holders will be best able to address an activist attack if it occurs.”
In addition to looking at excessive compensation, the author notes a recent trend among some prominent hedge fund activists to focus on advocating different performance metrics, such as economic profit (i.e. net operating profit minus a capital charge for invested capital) and return on invested capital or equity, rather than revenue-related metrics.
[Sidebar: Hedge fund activists often seek to boost stock prices and return capital to shareholders by advocating stock buybacks, expense cuts and divestitures and other efforts to focus operations through spin-offs and unit sales. Some have argued that advocacy of these preferred alternative performance metrics might be interpreted as efforts to drive achievement of the activists’ own objectives, such as discouraging costly expansion of operations and mere growth of revenue that, for example, might be achieved by acquisition to the detriment of profitability. For example, in one instance, hedge fund activists criticized a company’s compensation program for its poor choice of performance metrics that did not optimally align incentives with “stockholder value enhancement” (translation: stock price increases) and the compensation program’s “lack of accountability for the results of acquisitions and investments,” which the activists contended did not reflect appreciable stock price increases despite years of heavy investment and acquisition activity.]
These recent examples notwithstanding, the author observes that many activists are still creating wedge issues by leveraging reports from proxy advisory firms that simply identify “pay-for-performance disconnects” and other compensation concerns. The author suggests that the “best way for a company to withstand these criticisms is to make sure that its pay programs reward executives for achievement of stated strategic and operational goals and that such goals are consistent with the company’s attempt to achieve sustainable, long-term growth.”
One of the author’s most important recommendations is that companies review the change-in-control provisions in their compensation programs and agreements to assess whether they would be triggered in the event of an attack by a hedge fund activist. In particular, he notes that many change-of-control provisions are not triggered “if an activist takes control of the majority of a board by reason of the settlement of an actual or threatened proxy contest. This can be a critical problem, given the number of activists that have recently attempted to gain control of at least a majority of board seats and given that ISS is increasingly showing support for ‘control’ slates.” In addition, the author suggests that compensation programs be reviewed to ensure proper operation in the light of the prevalence of activists’ tactical demands for dividends, stock buybacks. divestitures through sales and spin-offs and sales of the entire company. Specifically, he recommends that companies consider whether “(1) adjustment provisions of stock plans permit adjustments to awards in the event of both extraordinary dividends and divestitures, (2) all plans are clear as to whether an employee ceasing to be part of the affiliated group of companies in a divestiture will be treated as a terminated employee for purposes of the relevant plans, (3) performance goals still work after extraordinary dividends, the divestiture of a major business and, particularly if there are per share performance metrics, a share buyback, and (4) performance plans are designed in a manner to minimize the effect of such events and related adjustments on the deductibility of compensation under Section 162(m) of the Internal Revenue Code.”
In any event, companies would be well-advised to review these provisions to ensure that they operate as intended on a “clear day,” even prior to an approach by a hedge fund activist, rather than attempting to do so in the midst of an activist siege.