The Dodd-Frank Act has made Say on Pay (SOP), the advisory vote on executive compensation a mandatory practice for publicly-traded companies. This required, but non-binding vote on executive compensation will carry a great deal of weight in 2011, 2012 and 2013, for the majority of U.S. public companies.   

While there were only three companies – Occidental Petroleum, Motorola and KeyCorp – with failed SOP votes in 2010, there is already one company – Jacobs Engineering Co. (54% against) whose SOP and SOP frequency recommendation has gone down to defeat at the hands of shareholders.

Below, we have identified some of the issues compensation committees should give consideration to as they draft their 2011 proxy statements.

The Stakes – Consequences of Failure

The failure to obtain passage of a SOP vote could have potential negative consequences beyond the immediate vote itself. For some companies, the fate of Occidental serves as an example where the defeat of the SOP helped embolden Relational Investors and the California State Teachers’ Retirement System to push for board and senior management changes.

While Laurel Hill expects a greater number of SOP failures in 2011, in part because SOP is mandatory, we do not believe we’ll see hundreds of shareholder rejections as governance advocates focus attention on underperformers and executive compensation outliers. The big question is how many negative recommendations will ISS and Glass Lewis (GL) release and can companies put themselves in a position to overcome the negative spin and have a winning SOP vote for 2011?

Perhaps the best way of approaching next year’s frequency and advisory votes are to view them as a chess match played between your company, your shareholders and the proxy advisory services.

Preparation for the Match

Know Who Is On The Other Side of the Chessboard?

Before making the critical opening moves, issuers need to possess or have access to reliable intelligence on their shareholders – their level of reliance on proxy advisors – and on the potential reaction of the proxy advisory firms on key compensation issues. Issuers will need to rely on their governance advisory/proxy solicitor for counsel and an understanding of which of their investors lean heavily on ISS for voting guidance.

Assess Your Governance First

An assessment of your company’s governance is a necessary compliment to the identification of shareholders and the measurement of proxy advisory influence. Engagement with your shareholders should be a part of your SOP strategy. It is highly advisable that you have a very sound idea as to potential corporate governance flash points that could arise during discussions.

Executive Summaries and Clear Compensation Disclosure and Analysis (CD&A)

Remember your SOP must be sold to shareholders. Preparation entails the development of a sales strategy focusing on rigorousness of the CEO pay evaluation process, clear explanations of how much and what type of pay has been approved; and on the accountability of the board and compensation committee. A strong consensus has developed within the governance community that a well designed executive summary provides investors with important information up front. Remember, investors will be pouring over thousands of proxy statements so laying out key issues and changes will help in selling your program.

End Poor Pay Practices

A strategic option all companies should take advantage of is to end pay practices that ISS and GL have found problematic such as the use of excise tax gross-ups, executive perks; and prepare strong clawback language in advance of SEC rulings (for future disclosure). If a practice cannot be ended, greater efforts will have to be made to explain the need for the gross-up or perk, and why it is essential to the fabric of the compensation program.

Describing the Compensation Committee

The description of board members – especially those on the compensation committee – is of critical importance.  The proxy advisory firms and many shareholders will scrutinize the backgrounds and experience of compensation committee members. Investor confidence in the capabilities of the compensation committee and the robustness of their process could tip the balance in the plan’s favor.

Setting the Tone for the Match

ISS and most shareholders are likely to treat the frequency vote differently than the actual SOP vote, and will not punish companies for recommending a non-annual SOP to shareholders by voting against their SOP. However, we would expect, and have advised clients, that there may be some strong language from proxy advisory firms noting concern on certain pay issues specific to the company as a rationale for the need for an annual vote. Some advocates in the governance community view non-compliance with an annual SOP as a sign of weak compensation practices and an unaccountable board, and they are prepared to subject companies to a higher level of scrutiny.

For a company with a difficult executive compensation program to sell (because of a history of conflict with ISS, GL or shareholders), the risk of pressing investors for a non-annual vote may be a bridge too far. A possible sidestep would be for the board to either not make a recommendation on frequency or to offer shareholders an intermediate step where the board would accept an annual vote only if the preferred frequency option (biennial or triennial) failed to gain a certain percentage of the votes cast (70-75%for example). We don’t necessarily recommend this course of action and it is also not clear whether either method will gain the board the flexibility it seeks. 

The other option for companies with previous compensation conflicts would be to go directly to shareholders with a strong defense of the board’s rationale for recommending a non-annual frequency. However, if these are major concerns, the board should seriously consider recommending an annual SOP vote.

Key points to make: 

1. Use your CD&A’s Executive Summary – The links between the board’s frequency recommendation and the company’s compensation program must be strong.

2. The company must state explicitly its willingness to engage with shareholders on pay and other corporate governance issues in the years when the SOP is not subject to a vote.

3. Note that the board’s recommendation of biennial or triennial vote, if undertaken, should be understood by shareholders, as an indication that the members of the compensation committee stand fully behind the process and philosophy that determined the pay of the CEO and senior management.  In addition, it should also be understood that the board is willing to subject themselves to no-vote recommendations from ISS, GL and potential no-vote campaigns from governance advocates in the years between SOP votes.

The Path to Victory: The Permanent  Engagement Campaign

Receiving a positive SOP vote is the goal and the path to victory lies in the planning and execution of the three key parallel tactics:

1. Demonstrating board and compensation committee commitment to the principle of “pay for performance” while providing accountability to shareholders; 

2. Lessening vulnerability of your company’s executive compensation plan to a negative vote recommendation from proxy advisory and governance rating firms; 

3. Developing and executing a shareholder outreach plan