The Role of Proxy Advisory FirmsThe Role of Proxy Advisory Firmson Executive Compensationon Executive Compensation

STANFORD GRADUATE SCHOOL OF BUSINESSDavid F. Larcker

• Stanford University:

Rock Center for Corporate Governance

GSB Center for Leadership Development and Research

• Guiding Principles:

Our Governance Research Initiatives

• Guiding Principles:

Approach research questions in a neutral and scientific manner

Seek critical feedback

Publish and disseminate the research results

“Get the story straight”

1STANFORD GRADUATE SCHOOL OF BUSINESS

Key Participants

Media

Investors

Legislators

& Regulators

Executive

2STANFORD GRADUATE SCHOOL OF BUSINESS

Boards ofDirectors &Executives

ExecutiveCompensation

Proxy Advisors

• Natural demand for data collection “expert” evaluationservices such as commercial bond rating services,Consumer Reports, and Zagats

• Many critiques of Institutional Shareholder Services (ISS)

Proxy Advisory Industry

• Many critiques of Institutional Shareholder Services (ISS)and Glass Lewis (GL) focused on ownership, data errors,and perceived conflicts related to consulting services

The key question is whether proxy advisory firm votingrecommendations create or destroy shareholder value?

3STANFORD GRADUATE SCHOOL OF BUSINESS

Source of the Recommendations

"Combining the aggregate thinking of ISS’ diverse assetmanagement and asset owner institutional client base

with input from corporate issuers and other experts in thefield, enriched with our own expertise, allows ISS to

implement policy guidelines that strike the right balance

4STANFORD GRADUATE SCHOOL OF BUSINESS

between shareholder interests and business practicality”

Source: http://www.issgovernance.com/policy

Are these recommendations based on any rigorous research?

Has “back-testing” been done to validate the recommendations?

One Source of the SOP Recommendations

5STANFORD GRADUATE SCHOOL OF BUSINESS

Source: ISS 2012-2013 Policy Survey Summary Results

• For example: 1-year and 3-year TSR relative to a broadindustry peer group and corresponding changes in CEO(reported) compensation

• Combined with “problematic” pay practices

Somehow This Translates into Specific Criteria

6

• Combined with “problematic” pay practices

Repricing or replacing underwater options without shareholderapproval and excessive perquisites

Tax gross-ups and new or extended employment agreements thatare considered “improper”

Insufficient performance-based pay

• Along with “analyst judgment”

STANFORD GRADUATE SCHOOL OF BUSINESS

These Recommendations Affect the Vote

Fund Name % with ISS

SEI Investment Management Corp 100%

Grantham, Mayo, Van Otterloo 100%

Evergreen Investment Management 100%

% Voting with ISS when Management and ISS Disagree on SOP

7STANFORD GRADUATE SCHOOL OF BUSINESS

Evergreen Investment Management 100%

Dimensional Fund Advisors 99.4%

Wells Fargo Funds Management 99.3%

Nuveen Asset Management 99.2%

New York Life Investment Management 96.7%

Calvert Group 96.7%

Wisdom Tree Asset Management 94.6%

Proxy Advisor Policies Affect Plan Design

8STANFORD GRADUATE SCHOOL OF BUSINESS

Source: Larcker, McCall, and Tayan, The Influence of Proxy Advisory Firm Voting Recommendationson Say-on-Pay Votes and Executive Compensation Decisions, 2012

Market Reaction to SOP Induced Plan Changes

• Sample:

2,538 companies in the Russell 3000 (FYEs 6/10 to 2/11)

396 “proxy advisor friendly” changes – mostly performance-basedequity, change of control, and severance – prior to first SOP vote

• Results:

Average Negative 0.28% on across all “friendly” changes

9STANFORD GRADUATE SCHOOL OF BUSINESS

Average Negative 0.28% on across all “friendly” changes

Negative 1.9% for Cash LTIPs

Negative 0.21% for performance-based equity

• Changes induced by proxy advisors do not appear toincrease shareholder value

Source: Larcker, McCall, and Ormazabal, The Economic Consequences of Proxy Advisor Say-on-Pay Voting Policies, 2012

Stock Option Exchanges

• Proxy advisors generally recommend against stockoption exchanges if officers and directors are included,are not “value-for-value,” etc.

• Proxy Advisors have a substantive impact on design:

10STANFORD GRADUATE SCHOOL OF BUSINESS

• Proxy Advisors have a substantive impact on design:

“We adjusted our [option exchange] plan design to ensure that it compliedwith ISS requirements. …We were uncertain we would win approval of theplan without an affirmative ISS recommendation. I don’t think it’s likelythat we would have designed the plan in the same way if we weren’ttrying to meet the ISS tests.” (Source: Interview with Thomas H. Blanco, Senior Vice

President and Chief Administrative Officer, Tessera Technologies Inc.)

• Sample: 264 firms that conducted an exchange between2005 and 2009

• Firms that structure their exchange with restrictionsconsistent with proxy advisor guidelines experience

lower stock price performance at the announcement

Stock Option Exchanges

lower stock price performance at the announcement

lower operating performance over time

higher employee turnover over time

• Proxy advisor recommendations on exchange offers donot appear to be value increasing for shareholders

11STANFORD GRADUATE SCHOOL OF BUSINESS

Source: Larcker, McCall, and Ormazabal, Proxy Advisory Firms and Stock Option Repricing, 2012

ISS Stock Option Plan Evaluation

12STANFORD GRADUATE SCHOOL OF BUSINESS

The ISS SVT Criterion is a “Binding Constraint”

Firms clearly movetoward the “threshold”

13

toward the “threshold”

Is this a desirableoutcome?

• Proxy advisory firms have a substantive impact onshareholder vote and the design of executive compensationplans

• We have very little insight into whether the changes

Concluding Remarks

• We have very little insight into whether the changesinduced by proxy advisory firms are beneficial ordetrimental to shareholders

• The results (to date) from the Rock Center researchinitiative on proxy advisors finds that their votingrecommendations do not appear to be value increasing forshareholders

14STANFORD GRADUATE SCHOOL OF BUSINESS

• We welcome the opportunity to conduct joint researchwith proxy advisors and other interested parties in an effortto improve voting recommendations (there are clearintellectual and economic gains to this type of collaboration)

• These studies would feature:

Rigorous empirical research using in-depth knowledge of the

“Next Steps”

Rigorous empirical research using in-depth knowledge of theinstitutional setting

Sophisticated statistical methods (including detailed back-testing)to determine whether the recommendations are likely to increaseor decrease shareholder value

An assessment of whether induced compensation changes aredesirable for shareholders

• We will publish all results for free use by all parties

15STANFORD GRADUATE SCHOOL OF BUSINESS