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Executive pay is important really for two reasons. First, compensation is supported through shareholder money so that every extra dollar of CEO pay is one less dollar for shareholders. Second and more importantly, executive compensation is the incentive structure that guides executive decision making. It drives whether a CEO is focused on building long-term shareholder value or, to the negative, whether he/she engages in short term manipulation of the stock price in order to realize compensation.

It’s really crucial for governance and the long-term sustainability of our investments that executives be compensated appropriately. For example, at Bear Stearns executives were compensated based on a single metric—return on equity. Executives were able to manipulate that metric by taking on leverage. As a result, Bear Stearns was the most highly leveraged financial services company. When the financial crisis hit, that leverage led to the company imploding and shareholders losing all value.

Fred: The Bear Stearns example is interesting. I didn’t realize that its executives were compensated only on that one metric and that one in particular.

Brandon: Only one metric, which gave them the incentive take on excessive risk since it was one way to boost return on equity.

Scott: I think we will see a lot of discussion and engagement between investors and companies in the coming year, especially in the wake of the continued financial crisis. We can expect a continued push from investors for some of the classic reforms, such as board declassification and majority voting. However, we can also expect pushes to open new avenues for director accountability, such as proxy access, and to defend against attacks on established shareholder rights. One recent example of this challenge involves boards unilaterally adopting exclusive forum provisions. In the wake of the Revlon decision in early 2010, boards rashly adopted by-laws designed to restrict rights to select a forum for intrafirm legal disputes. It’s troubling when boards unilaterally remove investor rights established by statutes. Companies shouldn’t curtail rights that otherwise allow shareholders to protect their investment.

Over 80 companies have quietly established exclusive forum provisions over the past year and a half. There will be greater resistance by investors on this issue—more debate on why it is inappropriate for boards to restrict shareholder rights.

Ed: An issue we’re looking at—yet one that may not appear in too many votes this season because of no-action letter challenges at the Securities and Exchange Commission—is auditor independence. Our shareholder proposal calls on corporate boards to establish a policy that mandates audit firm rotation. The overarching issue is auditor independence which has been with us for the past decade prior to Enron, WorldCom and Sarbanes Oxley.

We started to see enhanced disclosure early in the last decade to review potential conflict of interest based on the amount of non-audit work and services provided to companies where the accounting firm was also providing audit services. There has been progress on reducing the level of non-audit fees performed by a company’s audit firm. In 2001 and 2002, it was common to find significant ratios of non-audit services to audit services, ranging as high as 15 or 16 to 1. Typically today, the non-audit services are less than the audit services. The issue now is we have these long-term high dollar relationships for the audit work. By long-term for the typical S&P 500 company, we mean an average term for an audit team working for a given company of over 20 years. For some companies, these fees are literally in the billions of dollars during the term of the engagement period.

Audit rotation may be one legitimate way to solve this problem. Companies have so far successfully challenged it by arguing that selection of the auditor is ordinary business, but that is what they argued years ago when challenging proposals that sought to limit non-audit fees. We successfully got past those challenges and so I believe we’ll successfully get past the new challenges as well. It may not show itself in many votes this season. Hopefully, however, once the issue is freed up from the no-action process it can be used to drive company changes in the area of auditor independence—whether it is mandatory rotation or some other mechanism to enhance independence.

Fred: On auditor rotation, what is the recommended period you would think is a good number of years prior to rotation?

Ed: What the proposals say is seven years. There have been a number of academic studies both pro and con toward mandated rotation. Some argue it could create a poor quality audit in the first few years as institutional knowledge is lost by the last firm and the new firm has to get up to speed. With seven years as the recommended term before rotation, we strike a balance between where you can have institutional knowledge about the company, but at some point there needs to be a change. We’re suggesting a minimum of seven years with a three year wait before the firm that rotated off can be engaged again.

Brandon: To follow up on Ed’s point, audit rotation is really unfinished business of the corporate accounting scandals of Enron and WorldCom. It had been initially proposed for inclusion as a requirement in Sarbanes Oxley, but was diluted to only require audit partner rotation which falls short of providing all the benefits that Ed described.

The other point I make is that the public company accounting oversight board (the PCA) is now considering the question of whether they should go forward and require audit firm rotation. We certainly hope Ed is successful in convincing the SEC that this is a material and appropriate issue for shareholders to consider and vote on.

Ed: What’s been lost on this issue is that the outside audit firm is supposed to work for the investors not for the company. We have a system in this country where for-profit audit firms get hired by companies and then are engaged to conduct the audit, so it’s not a perfect system from the start. If this is the system, we need to make sure that there are protections against threats to auditor independence. This is a much consolidated—very concentrated industry. Literally the big four do 99 percent of the S&P 500 audit engagements—a very concentrated industry.

A firm is hired as the auditor of a company and these relationships last for decades—as long as 60 to 70 years in some cases. Additional features are needed to protect auditor independence and in turn protect investors. Auditor independence may not come up this season because the audit industry does not like this issue and is going to fight it hard. The companies are going to fight on this pretty hard as well.

Louis: For 2012 we are going to take a close look at issues that are outside the proxy statement. One is the SEC rule making process. Very important—we believe the executive compensation disclosure—the median worker-to-CEO-pay ratio—will be a very important metric for us to judge compensation plans going forward.

Taking a broader—more stakeholder—approach in how we view corporations is an attempt to try to integrate annual reporting with trying to move more towards integrated CSR and annual financial reporting at companies. I was just at an ICGN conference this past fall and this topic took up nearly half of a panel debate. As pension investors, this is something we want to be involved in as the discussion moves forward.

In 2012, we also want to see where—by having the integration—we will be better informed in our analysis of how management and the board is doing on a broader scale—an interesting development.

Fred: On the issue about the median worker-to-CEO pay ratio, what kind of arguments do the companies make against that kind of disclosure?

Louis: It’s been viewed by companies as a cost and feasibility argument. With most—at least for the S&P 500 companies—accounting operations and human resources departments are geared towards finding exact cost per man-hour. I have a hard time believing either argument. In my opinion, there is a sane way for median worker-to-CEO pay ratio to be addressed. Whether it is reported annually, bi-annually or quarterly, it is a rule that must get past the SEC process. This disclosure will be very valuable for pension fund investors.

Brandon: There’s going to be a tremendous focus on corporate political contributions disclosure in the wake of the Citizens United decision which held that corporations are persons under the first amendment and therefore can spend unlimited shareholder money on political campaigns and elections. In 2011 there have been a large number of shareholder proposals on this topic seeking enhanced transparency and disclosure.

The Supreme Court has said that it’s the appropriate role for shareholders to monitor management to make sure money is not misappropriated and spent on the pet political causes of the executives rather than in the interest of the shareholders. This is going to be an area of tremendous focus especially given the 2012 elections.

Just to recap our discussion, engagement on issues of corporate accountability, independent boards of directors, good corporate governance and responsible executive compensation are aiming to solve the fact that our companies simply have not been performing.

Our economy has not been working for America. We have record unemployment and continued uncertainty. We suffered ten years of no stock performance. The S&P 500, from 2000 to 2010, went nowhere, in part, I believe directly attributable to the failures of boards of directors and executives to be focused on creating long-term sustainable value.

The decade began with Enron and WorldCom and the corporate accounting crises and is ending with the collapse of Lehman Brothers, Bear Stearns and the Wall Street financial crisis at the end of the decade. We have to remember why this work is so important. It is important because it directly contributes to the creation of value in our portfolio companies which is not just for us as pension fund investors but it’s critical for the health of the economy and for working families as a whole.

Fred: Let’s go on to our next topic—communications between shareholders, boards and CEO’s. How has financial reform shaped engagement between shareholders and companies, if indeed it has?

Louis: The Teamsters has been involved in director engagements for the better part of two decades. During this time, I believe there have been some significant changes in the way our funds as shareholders have been able to engage with corporations. At the same time we can say that some of these relationships are stuck at the same ground zero point as if we were still in 1991—the year we began this program. Many of the companies that were the first to stick their toe into the water and actually engage in the substantive issues—like board independence and executive compensation—talk softly on those issues and are ones progressing in that arena. Others have taken a very negative view toward pension funds getting involved in corporate governance issues whether it has been actively challenging shareholder proposals at the SEC, trying to file lawsuits or working through governance means to limit shareholder power.

These corporations continue to not have meaningful dialogue with our funds as shareholders. There is a progression, but it seems the same companies are progressing. In some cases, companies that have gone through a shareholder fight—whether a battle on their proxy or whether it was a resolution over a board member—got religion from that fight. I think some tension has to be there. There has to some issue that shareholders, the board and management want to engage in to break the ice. The next phase, after a couple of decades of doing this work, is to judge the quality of engagements. Are you tackling issues or are you talking to maintain a relationship?

Ed: Six years ago we started advocating for majority voting. One of the things we did early in the first year of advocacy is we sat down with 15 companies collectively, formed a work group and talked about majority voting. We talked about how you put it in place, what kind of legal implications there were, what other parts of a corporation’s by-laws it might effect, what would happen if somebody didn’t get enough votes, and various other related issues. It was a collective effort both in advocacy and in education. The dialogue also allowed us to anticipate all the “what if’s” so that as companies looked at the issue there was real clarity as to what would happen if they did or did not adopt it.

I can see how this might happen with auditor rotation. We often talk about communication between shareholders, boards and CEOs; however, some of the most productive conversation is among ourselves and company staff. In the case of majority voting, the dialogue was with corporate secretaries and securities attorneys. In the case of auditor rotation, I can already see that it is going to be with CFO’s, controllers and vice presidents of finance—even before you get to the chair of the audit committee. This is because you have got to vent these issues a bit and they have to percolate up. Boards often take their lead from the staff professionals who manage specific issues be it, governance or accounting. A lot of good discussion and decision-making takes place at this level.

With our advocacy on executive compensation or majority voting, talking to a board member can be less than satisfactory. Instead, we often prefer to get to the people within the corporation who can move the issue and give the board technical and strategic answers when they consider a governance or compensation proposition. You have got to have somebody say that the world is not going to end—here is how it will work if we implement. Communication at the sub-board and sub-CEO level can be very valuable and productive.

Fred: That makes sense because you want to get the support, to the extent you can, of the people who are hired by the board to deal with these kinds of issues and that will give the board comfort—as you said—that the world is not going to explode if you engage in some of these things.

Louis: I’m reminded of the time when both of our union funds and several others in the building trades wanted to do something similar. At least start that productive discussion on broad-based common sense issues such as compensation. They had two tracks. One was with the corporate secretary level and the second was a broader outreach to the S&P 500 to see who was game to discuss their company’s compensation philosophies based on discretionary pay, post employment, peer ratios and performance setting metrics. Initially, these were our main issues with compensation. Let the company try to come back to us. In the end, some companies were willing to have deeper conversations. It did not always lead to an agreement but it started the ice breaking on a very tough issue, especially by way of how we laid it out. We were not just criticizing one aspect of the company’s compensation. We really wanted them to open up the books on executive compensation.

Ed: Louis, you raise an interesting point. You almost have to look at the issue. If you look at majority voting and auditor rotation—or let’s say the broader issue of auditor independence—they are simpler issues than executive compensation. There are so many moving parts to executive compensation plans that you could argue are almost distinctive—maybe not unique but distinctive—to the individual companies. Whereas you take issues like majority voting—while we may have a work group with 15 companies—we were essentially engaging the entire business community because majority voting at one company operates the same as every other company. It works the same way. Compensation is an issue where you almost must get down to individual company negotiations. It’s a tougher issue because so many different compensation features and distinctive company plans—solid overall compensation plans—suffer certain shortcomings. As a result, you have to be able to really get down into the weeds through the compensation dialogue.

Louis: The toughest part in any compensation conversation is when you get to the question of when is enough “enough.” That is usually when talks get much more difficult.

Brandon: My general observation is that companies and boards of directors are making an increased effort of outreach to shareholders for dialogue and that should be welcomed by investors. Let’s distinguish between companies that like to engage and talk for the sake of discussion versus those who are prepared to make actual substantive changes in response to shareholder concerns. For example, when we file a resolution for our annual meeting we have the opportunity at most companies to discuss it. Most companies do so, in fact. However, not all of them are willing to try to address concerns beyond simply discussing it and sharing information with us. The real proof will be in terms of shareholder communication—even going beyond communication—to address shareholder concerns substantively in the areas of corporate governance, the independence of the board or executive compensation.

Fred: Is there a company we can name that is talking only for the sake of saying they did it versus a company where you felt like they were receptive to ideas and were willing to genuinely negotiate?

Brandon: Without getting into any specifics on any conversations we’re having right now, there needs to be an incentive or carrot for companies—the carrot and the stick approach in having companies respond to shareholders concerns.

For example, Say-on-Pay votes provided that point of encouragement for companies to reach out to investors and make several changes in response to it. Two examples I would give are Disney and General Electric. On the eve of their shareholder meeting this year, Disney renegotiated employment contracts with executives and reformed executive tax gross ups directly in response to shareholders concerns about that practice. This occurred under the cloud that Disney would have received a high no vote on its Say-on-Pay advisory resolution. General Electric—another leading example—made an eleventh hour change to the formulation of its incentive compensation to try to make it more long-term and linked to sustainable company performance. Again, this occurred directly in response to shareholder concerns that were beginning to percolate on the Say-on-Pay vote at General Electric’s 2011 annual meeting.

Louis: Both majority voting and board independence are issues that could lead to a vote that might go against a director. As a result, they have led to companies starting to seek investor input on the director nomination process.

Ed: Louis’ point is correct. Part of our reason for advocating for majority voting was to get a company to engage. For many companies, there was no consequence for not talking to investors for decades and part of the reason for this is because the elections were not real.

Majority voting has made companies a lot more open to talking to mitigate any issue that could turn into something with a voting consequence in terms of the election—not as a resolution or a narrowly targeted vote on that issue but a broader election issue. With that said, there are still companies that never engage even when they are prompted by a resolution or request for dialogue.

Fred: What does the future hold for equal access to the proxy and the role of private ordering in actions by investors?

Scott: Given the significant rulemaking obligations at the SEC in the near term arising from Dodd Frank, I don’t think we’re likely to see a revised universal proxy access proposal from the SEC in the immediate future. However, given the validity of section 14a-8 proxy access proposals, we can expect to see proxy access resolutions in the upcoming proxy season and beyond. Where these proposals are reasonably constructed and target companies with poor performance and poor record of board oversight, I believe they would likely receive solid support which would, in turn, make a few boards respond—possibly—and also regenerate a discussion about a universal proxy access proposal. The result of that debate, however, remains to be seen.

Brandon: We’re going to see a handful of proxy access resolutions from pension fund investors in 2012 targeting companies that have had clear corporate governance or executive compensation failures and where there is a lot of interest on what formulation these proposals will take. I expect that they will generally track the SEC proposed rule making which had been a three year holding requirement at three percent or some formulation like that. We’re also likely to see a larger number of proposals from individual investors that may have lower thresholds to be put into broader a array of companies which I expect may get lower votes from shareholders. This is a new issue. The proposals are really an indicator of the need for proxy access.

One of our criticisms of “private ordering” is that shareholders who want proxy access may not be able to get it on a company-by-company basis. Companies that have good corporate governance and responsive boards of directors are likely to adopt proxy access for their shareholders whereas those companies where it is most needed—where the boards are most entrenched and where management is the worst performer—are the ones most likely to resist creation of proxy access.

There are a variety of mechanisms—even if the shareholder was to introduce a binding proposal—that can frustrate the will of shareholders—dual class stocks and the like, for example. This is certainly an issue that is not going away anytime soon. We hope and believe that universal proxy access is not a dead issue at the SEC. Given all the other regulatory deadlines, I don’t expect we’ll see revised rulemaking in the near future.

Ed: I don’t think private ordering will have much success. That’s probably why the advocates argue that if you can get a universal solution it would be better. Private ordering does take a lot of time. In the last five years, the Carpenters, Teamsters, Electricians, Sheet Metal Workers and other building trade funds have probably put in 800 majority vote proposals and had about 800 negotiations—give or take—where you had to convince a company. So private ordering on proxy access will be very challenging.

With proxy access you have more moving parts—triggers, thresholds and so forth—that complicate private ordering efforts so private ordering is going to be tough on proxy access. But I would suggest that it would not be time well spent for pension investors anyway. If you’re going to submit it to a problem company, the first thing you want to consider is if all agree that the company is a problem company based on some performance criteria. If so, let’s go after the board in a simpler way. Let’s vote the board out. Let’s start that process. Do they have majority voting? Can we create tension about failed performance short of a short slate contest? I don’t think pension investors fully appreciate the pitfalls of a short slate contest. If you get a pension fund directly involved in a proxy contest, you’re creating potential legal vulnerability.

Finally, let’s take a look at Hewlett Packard. Relational Investors’ Ralph Whitworth just got put on the board because Relational Investors acquired a one percent position. This is the same position they had at Home Depot about five or six years ago when they got a board spot. A one percent holder comes forward with the strategic critique and negotiates behind the scenes for a board seat. There are a couple of things here. Relational Investors gets its big money from pension funds like CalPERS and CalSTRS. So, in essence, a lot of the pension funds are already engaged in board challenges, just a step or two removed.

It’s one or two steps removed and that’s probably the proper way to do it. Put a portion of your portfolio with an activist fund that can go out and assemble a limited portfolio of performance challenged companies, do strategic research, then approach those boards and advocate for some fresh blood on the board. This approach to board challenges for institutional investors should be preferred to creating short slate proxy fights that may be costly to be successful and that come with potential legal vulnerabilities.

At the end of the day for a broad market investor to spend time and energy on a single company or several companies within your portfolio raises this whole cost/benefit issue at the pension fund level. Maybe energy can be better spent on other activities that create the same end of changed boards or better boards.

Brandon: The whole point of proxy access is to empower long-term investors to respond to problem companies where there is an extreme need for the board to be refreshed. Absolutely, Relational Investors and Ralph Whitworth have played a tremendous role in improving values of companies like at Home Depot and—hopefully—HP. However, his appointment under the current process depends on the nominating committee agreeing to put him on the board.

I dispute the argument that proxy access would not facilitate shareholders and pension funds from participating in the director nomination process. You don’t have to run a half-million dollar proxy solicitation campaign where you’ve hired a proxy solicitor and law firms to help prepare the materials. It can be done less expensively—the mailing costs are substantial when you’re in a proxy contest. It’s not just the mailing costs of the proxy material but it’s also the tabulation costs. All of that would have been saved through proxy access as well as giving investors a unified ballot.

One of the problems with existing proxy contests is in many cases shareholders must pick all of the dissidents or all of the management nominees. You can’t pick and choose who you think is the most qualified director from both slates unless one of the parties gives you that option on their proxy card. There are real advantages that proxy access would offer. It would facilitate participation by longer term institutional investors so it’s not just Relational Investors who may have a five to ten year time of horizon for a company but truly long-term investors including pension funds.

Scott: Clearly, with proxy access and other good governance measures such as majority voting there are challenges for investors to enforce and fully make use of the tools. However, having the tools available for potential use sends a signal to the board for better accountability and performance. We—like many other funds—have urged companies to adopt majority voting in the past few years. Some companies have responded that they don’t need majority voting. This is because they never have had a failed election or that majority voting is ineffective if it depends on the Board accepting the director’s resignation. However, we think that the existence of majority voting itself builds in a layer of accountability among directors so that they understand who is electing and re-electing them. It also establishes potential recourse if investors want to vote against a director.

There still are questions on how to fully put teeth into some reforms. As diversified investors with a wide number of portfolio companies we see that some companies have repeatedly failed to deliver performance and have boards that fail to be accountable to shareholders. The question that we as investors need to ask is, “Shouldn’t we have some mechanism by which to propose alternatives and to signal to the board that if there’s not an improvement in performance they might face greater competition for their board seats?”

Ed: If you go back and look at the beginning of the proxy access advocacy process—to the first of several rulemakings of ten years ago—one of the points made was that proxy access was needed because we didn’t have majority voting. We now have majority voting. It’s an imperfect tool because the post election piece isn’t as strong as we would like it to be. But we have majority voting. If somebody gets unelected it’s going to be hard for that director to stay for too long and it’s going to be hard for boards to keep reappointing unelected directors. We really haven’t gotten to that point yet. We have this tool now but we haven’t had the coordinated voting that will translate into large negative votes.

If large investors organize a strong negative vote against a board that is not producing long-term value, those board candidates—whether it’s the entire slate of directors or a class—would create an environment of board receptivity to input from institutional investors about fresh candidates. Those directors would be added in a collegial manner—not in a contest. We in the building trades—I think 25 years ago—put the general president of The International Union of Operating Engineers (IUOE) on the board of directors of American Security Bank here in Washington, DC. At the time, it was the 35th largest bank in the country. We were motivated to do that for several reasons but partially because the bank was acting in this market in a way that was hostile to the interest of our members and financing a lot of work where there were substandard wages and benefits being paid. In addition, we had ownership in that bank through our pension funds. We went to the bank and clearly indicated that we were going to begin to advocate for directors. We were clients of the bank, we were investors of the bank and the bank was undermining the benefits of our members.

Within a month they invited the IUOE general president onto their board of directors. For the next twelve or so years a Trades general president effectively served on the board of American Security Bank. We had a building trades president on a large regional bank board because we used our ownership in a very forceful way to challenge how they were relating to bank stakeholders –not just shareholders—but our members as workers and so forth. A focused effort among institutional investors to challenge a company’s long-term performance can create an environment where you can put fresh blood on a corporate board.

Brandon: I don’t think proxy access is about union funds nominating directors. Frankly, there aren’t enough union pension funds out there to reach the type of threshold the SEC was proposing for ownership. Proxy access is about democratizing the election of directors. It’s not just about giving us a meaningful vote against a board or a director. With the Delaware holdover rule, if the company doesn’t have mandatory resignation of a director that doesn’t get majority vote, that director continues to serve on the board. I think it’s about giving us choice. Why do we only get to choose from a slate of directors hand-picked by the nominating committee? Why can’t we also vote on a short slate of independent directors that have been nominated by large shareholders of these companies? I think that would be a very healthy process for the nomination of directors. It would help make boards less insular and much more responsive to shareholders even though they didn’t face a proxy access candidate.

Fred: From 2011 to 2012, as Say-on-Pay voting helps to reel in excesses in executive compensation, let’s discuss the CEO-to-worker ratio, CEO compensation plans that work best and current practice on the use of golden parachutes.

Brandon: This year was historic in that we had for the first time Say-on-Pay advisory votes on executive compensation required for all large cap companies. A couple of observations on the results of the votes:

Most companies received overwhelming majority support of shareholders in support of their compensation plans. Also, executive compensation with the S&P 500 companies went up last year—23 percent to $11.4 million on average.

So, is Say-on-Pay working? Is it having an effect? Yes, for a couple of reasons.

One that I mentioned previously is that many companies made changes to their executive compensation specifically in anticipation of the Say-on-Pay votes to ensure a high level of shareholder support. Disney and General Electric are two examples. Two, we’ve seen a decline in some of the most egregious abuses of executive compensation. Things like guaranteed bonuses and tax gross-ups are disappearing like a snow man in July—just melting away—and directly attributable to the fact that we have Say-on-Pay voting. Another interesting development in 2011 was that the market voted on annual Say-on-Pay voting. At the beginning of the proxy season most companies were recommending that their shareholders vote for tri-annual Say-on-Pay voting. However, those recommendations were not adopted by the majority of shareholders who did favor annual voting. I believe this indicates that the market as a whole sees value in this process and likes the idea of having an annual vote and accountability.

Ed: If this was historic because of Say-on-Pay then it’s going to go down as historic for a lot of bad reasons. Over the past 15 or so years, there are dozens of companies that made changes to their compensation plans in response to proposals or other forms of shareholder advocacy. It’s important to note that the number of shareholder proposals on executive compensation issues was down dramatically with the advent of Say-on-Pay. What’s falling away is focused advocacy against serious executive compensation problems.

Brandon mentioned at the beginning that companies are going to be targeted that got a lower than 70 percent vote. You don’t need those low votes in order to see issues—such as the acceleration of equity awards—that should be broadly challenged. Nearly every company that won Say-on-Pay votes has accelerated equity provisions in their plans so why shouldn’t they be challenged as well? It is because they got a favorable Say-on-Pay vote by passing a simplistic performance screen by ISS and others. This simplistic screen was put in place simply to make Say-on-Pay voting a manageable process. All Say-on-Pay voting is going to do is reinforce peer practices.

If you stay on the same path as your peers—not doing anything out of bounds, not getting too greedy, even average peer performance—you will get average peer pay with no questions asked. It’s going up and up and up to the extent that a few companies changed some outlier behavior. However, we’re kidding ourselves if we think we’re producing real executive compensation reform. There are many problems with compensation plans, including poor metrics, non-challenging performance targets, excessive equity grants, overly generous severance packages and long-term compensation that is not performance vested. There are so many problems in these plans yet 98 percent of companies will receive a simple Say-on-Pay vote that—in essence—ratifies these practices. We’re going to have this pattern every year of 95 to 98 percent of these companies getting the good housekeeping seal of approval from shareholders when these plans are filled with problematic provisions.

Brandon: I’m the first to agree with Ed. There are fundamental flaws in the way that corporate executives are compensated in this country and I have no illusions that Say-on-Pay votes are a silver bullet. They are—however—another tool for investors to provide feedback to board compensation committees. We did see real changes transpire as a result of these votes but we have to keep in mind that—during the past decade—we have had the worst stock market performance since the Great Depression and yet CEOs have been compensated higher than in any past decade. In 1980, the average CEO made 42 times factory worker pay at a large cap company. By 1990, that had doubled to 85 times. Today, it is 343 times the median worker compensation for companies in the S&P 500, according to AFL-CIO Executive Paywatch website. We are not getting what we’re paying for. We’re paying more for less. This is a fundamental problem with executive compensation and our corporate governance system as a whole.

Executives are enriching themselves at the cost of their shareholders. By the way, they are also being given incentives that encourage them to do inappropriate things—illegal things such as accounting manipulation—and other inappropriate thing from a long-term shareholder perspective including managing quarterly earnings as opposed to investing in the long-term health of the company.

Lewis mentioned CEO- to-worker ratio at the beginning of the roundtable discussion. Let me add why this part of The Dodd Frank Act is so important. CEO pay has a real impact on employee morale and productivity of companies. Lots of academic studies have looked at the issue of wage disparities within organizations and their impact on employee productivity. Executive Paywatch is the most popular part of the AFL-CIO’s website. Workers go online and look at how much their CEO’s are compensated. When you have wide gulf between CEO pay and the next highest officers or between the CEO and the workforce, it reveals whether the company works together as a team or whether the CEO is treated as some sort of superstar who creates all value and where everyone else’s contribution to the organization is therefore given short shrift. This is important.

This disclosure also encourages companies to talk about how they compensate their CEO relative to their other employees and helps refocus compensation committees on the appropriate amount of CEO pay that is in the best interest of their company. Today, too many companies are deferring to the market through peer group benchmarking, targeting the median of what peer companies pay in the amount compensation for the CEO.

This practice is a problem for two reasons. One, many companies consciously target above the median—the 75th percentile. This leads to a ratcheting up effect where each year pay rises because all CEO’s believe they are above average. Two, companies cherry pick their peer group. There’s a flaw in saying that because everyone else is doing it we’re going to do it too—in this instance, to pay our CEO a tremendous amount of compensation and not consider the effect of high levels of CEO pay on the morale of all employees. That is why the CEO-to-worker pay ratio is material to investors. I believe this will have an impact on the overall levels of pay in this country.

Fred: Panelists, how do you deal with the response from companies when they say, “Well, in order to hire a top notch person with top notch skills, you need to compensate him or her competitively”?

Louis: It’s a comment that we’ve heard before. My first response is that your board isn’t looking at developing the position of CEO. As a result, you will now pay for the best from this ratcheting up effect at a very high level—regardless of performance—so that this seems to be outside of the criteria. It is to say that there’s a number attached to that position regardless of quality and it reflects very poorly on the board for not taking it seriously. How a CEO is chosen for the company—whether it is internal development or if there is a committee of the board devoted to keeping an eye on progress of potential candidates—it seems like they’re giving short shrift to the process. It is important for both the company and the owners of the company to lead this process.

Brandon: Steve Jobs was arguably the one CEO that contributed the most value to his company. He was truly a celebrity CEO. He worked for one dollar a year. He did receive other forms of compensation historically, but he took one dollar a year for much of his tenure as a CEO. If Steve Jobs can do it, then I am curious as to why other CEO’s cannot do it. Regarding retaining the CEO, there are other mechanisms in structuring executive compensation that can be used to make sure that there’s an incentive to stay with a company. Their net worth in the company—their equity—should be locked up. That’s the whole point of share retention—to give CEO’s a long-term stake in their companies. So if they leave they’re still required to own their shares in that company and have their net worth tied with it. I am not saying that market levels of compensation are not factors that need to be considered by a compensation committee when deciding the target amount of pay to give to the CEO. I am saying that they are not the only factors. You also have to figure these other factors on employee morale and productivity.

Fred: We deal with this question. I am involved deeply in a case with Bank of America and Merrill Lynch. When BOA took over Merrill in 2008, they agreed to pay top Merrill executives almost $4 billion dollars in bonuses in a quarter where Merrill lost over $20 billion. They’re argument is “Well, we needed to retain these people. Otherwise, we’re not going to have any earnings.” My response is, “Where were they going to go?”

Brandon: Right, they can go anywhere—like to Bear Stearns or Lehman Brothers. It’s more of a long-term issue. The compensation structure of those firms was not set up to encourage retention. There were no lock-up periods or defined benefit pension plans to encourage employee retention. This part of the solution calls for changing the structure of compensation. Frankly, if people are sticking around just for the compensation then there is probably an employee morale problem. In these cases, employees feel their self-worth is being measured solely based on how many zeros they have in their paycheck and there’s a problem with that. The rest of the economy doesn’t run in such a manner. Worker’s wages have been stagnant for the past 30 years yet there are lots of examples of careers like public service, non-profit or the military with effective leadership who are not driven solely by the pursuit of wealth.

Ed: I would argue that our problem with Say-on-Pay is that these votes are reinforcing those negative things. If you look at the Say-on-Pay votes, they are all about peer group benchmarking and driven by false debates. Corporations didn’t like the ISS peer group over the more tailored peer groups. These votes are reinforcing negative practices by saying, if your performance isn’t too far away from what the peer group is doing and your executive compensation isn’t too far from what the peer group is doing, that we’re going to vote for your compensation plan—regardless of whether you have retention requirements or acceleration. It’s reinforcing that system.

Now let’s say that the SEC passes a rule about showing the CEO-to-median worker salary comparison. Is ISS going to now factor this into their voting?

We’ve been doing executive compensation activism for 30 years. It’s not like this is the first look at the issue. That is why we were opposed Say-on-Pay. Focused shareholder activism on serious shortcomings in compensation plans was beginning to work. The pay for performance correlation was strengthening. But a Say-on-Pay vote at thousands of companies is inevitably going to lead to the ratification of many bad plans. Our investment portfolio has 3,600 companies. There are not enough hours in a day to conduct rational analysis of each plan so that you have a thoughtful vote.

Brandon: All of your arguments against Say-on-Pay—in particular the annual vote—are just as applicable towards thoughtful voting on director elections. To genuinely decide whether to withhold a vote from an individual director or to vote against an individual director requires thought and research. You’re right. It’s not going to be a perfect solution. It is one more tool like majority voting to hold boards of directors accountable. It is a tool that is most effectively used against outlier companies. We need additional tools.

Is it going to solve high levels of CEO pay? No. One of the reasons the CEO-to-worker pay ratio disclosure is valuable is because it encourages companies to begin to have that discussion. They have to disclose it to their investors. In addition, companies are well served to put it in context to discussions about their compensation practices for their companies as a whole. One of the most valuable resources of any company is human capital yet there is zero disclosure about how the company attracts and retains its rank-and-file workforce. The SEC only requires companies to state the total number of their employees. Compensation costs are not broken out under the accounting rules for the majority of companies. For this reason there is real value in changing the discussion around compensation and taking the CEO’s out of this bubble they are in right now—where their compensation is set based on a peer group target amount that’s been cherry picked and goes up each year because all CEO’s believe they are above average.

Fred: What about golden parachutes?

Louis: This is one of those areas—whether it’s in the Say-on-Pay discussion or considered part of an individual aspect of executive compensation—where it’s easiest for an investor to pick up. It is the poorest incentive in executive compensation—to attract someone to leave their position. Unfortunately, it’s often used. The words out of a corporate secretary or human resources vice president’s mouth is that, “we use golden parachutes to attract and retain.” It is a very convoluted logic that until this day I’ve never been able to get my mind around. When you look at a compensation plan to pick out the worrisome spots usually the golden parachute is the easiest one to spy. Activism on the issue has gone from trying to give shareholders a Say-on-Pay vote on particular levels of severance compensation down to banning gross ups or accelerated vesting. It’s going to become more and more acute in shareholder analysis. Our pension funds critique these golden parachutes and are seeing a lot more activism even on post life benefits—some plans that go on in perpetuity for generations to CEO relatives that will never add value to the company. You would think there was literally a gun to the head of boards that have signed some of these CEO contracts.

Fred: Is that on the decrease? I remember had a case against Merrill Lynch five to six years ago where after Stan O’Neil presided over Merrill accumulating billions in toxic assets, he left with a huge pay package. Is that still occurring?

Louis: It is without the pension fund investors and other activist investors who are working to shine a light on it. We’ve had discussion back and forth with a company that had one of the worst pre-Enron collapses due to corporate accounting scandals. This was during a merger period once it came to light the company lost somewhere around 75 percent of its value, and each of the CEO’s walked away into a life of luxury. Our activism on getting a shareholder vote on golden parachutes led to a huge vote that they eventually adopted. We then went into discussion again about the post-life benefit and their first reaction was that they were very competitive with what they were paying. How is it a competitive advantage and is it going to excite me—a long-term shareholder—that there’s going to be this waste going on for years and years. The company said, “Lets agree to disagree and we’ll put it up for a vote.” Once again, the shareholders saw a very common sense approach to at least getting the ability to opine on a proxy statement if these post-life benefits would be enacted. The company eventually moved once again. Without the fight the company would not have made a quick decision on these reforms. Once again—like with the other compensation issues—if the other guys have it, expect them to throw it into their compensation plan.

Fred: What role should pension funds play in director elections?

Ed: There are tie-ins to the issues we discussed about the role of pension investors in elections. This includes some of the things we talked about earlier in proxy access and even executive compensation and so forth. We’re talking here about union pension funds—collectively bargaining pension funds—but pension funds generally. The typical pension fund is a broad market investor. It could have a combination of passive and active management.

Going back to something Brandon said at the end on the topic of comparing director elections against executive compensation. It can be a simpler process to use our voting power against boards—simpler in the targeting process and simpler in the voting criteria process than it might be in casting votes on executive compensation. When you look at a board, it is legitimate to say that when we exercise our vote, we should vote against boards that aren’t producing long-term value for the company and its investors. As pension investors, that is what we’re looking for. Is this company going to add value to our portfolio in the long-term because we have long-term obligations?

You can do that type of analysis fairly reasonably. You can look at performance metrics, stock price or some combination of stock price and financial performance metrics. You can look at stock performance relative to peer performance. It is a form of a quantitative analysis that can be done fairly quickly. I would suggest that, in our portfolios every year, there are a significant number of companies where we should be—in a public way—voting against the boards of directors because of failed long-term performance. In most instances, we should not focus on individual director voting based on individual shortcomings, but rather focus on the board’s performance as a group.

The board’s responsibility first and foremost is to ensure that the company has a strategy and has a team of executives that can execute that strategy to grow value. If absolute and relative performance is lacking, then we should vote against boards. This is particularly necessary if under performance is sustained and the board hasn’t changed leadership or re-chartered the company’s course. We ought to be challenging companies and challenging boards by voting against them when long-term performance is lacking. And we ought to be coordinating that voting within the institutional investment community.

Our approach as institutional investors should not include trying to micromanage the companies in our portfolios. If a portfolio company is not performing, let’s start to vote directors out and create a dynamic that produces positive change. I think we are well-positioned to do that.

Brandon: I agree with Ed that voting on director candidates and board slates should be done in a more thoughtful and comprehensive way. It should not just be based on director conflicts of interests or failures of individual committees. It should also look at issues of whether that board is creating value for its investors. A general concern of mine is that our pension funds and investors generally spend an enormous amount of resources on financial analysis, security selection and active management that’s not really about creating value by improving company performance.

Of course collectively we can’t all beat the market. In a sense, pension funds collectively look like one big index fund as a whole yet they are paying for active management. That active management and analysis—I believe—would be better spent on the types of improvements we discussed on today’s roundtable—that is actively engaging in companies to improve their corporate governance, improve the responsiveness of their boards, better tie-in of executive compensation to sustainable long-term performance. A little less time should be spent on picking stocks based on financial analysis that ultimately doesn’t create value over the long-term.

Ed: Most of our portfolios have some combination of passive and active investments. On the active side, we see the turnover because we track it. We track the entire portfolio. You see different managers have different turnovers. We see that reflected in our pension funds. It’s problematic because over time you are not going to beat the market. What we could do to add portfolio value is to take a more passive investing approach combined with a thoughtful approach to activism.

Union pension funds and pension funds generally could put more focused resources and thought behind a set of activism priorities and principles. If we are truly long-term owners, we should invest in being smart owners. The cost benefit analysis says it makes sense to spend a little bit more money on the ownership side. We should have an ownership strategy that first and foremost is focused on board composition. At the end of the day, the ultimate responsibility is with the board and we can in a very clear way come up with some criteria that says, “Is this board succeeding or not?” Then say, “Why isn’t it?” and, “Is change in order?”

A resource allocation away from active investment management and towards thoughtful ownership would be a very good evolution for worker pension funds.

Louis: Some of the discussion among pension fund managers is reflected on huge votes at News Corporation. Regarding the issues with this particular board, the whole board isn’t going to go away but the challenge has gotten the company’s attention. The highest votes were among the Murdoch’s. If you look across at the entire vote, every member of that board got very significant against votes. It is only because of the dual nature stock class that the board isn’t in a crisis with resignations from a number of individual members. I agree with what both Ed and Brandon are saying—the stronger the coordination, the criteria and the critique that pension funds can put together, the greater the impact we can have on director elections.

Brandon: To have an effective board it’s not sufficient to just have qualified and responsive directors. You also need to have independent leadership on that board—directors who are willing to challenge CEO over poor performance and to hold management accountable. That is why having independent board chairs is so important to strengthen leadership. I believe we’re going to see that becoming a continued growing practice in the United States. Other countries like the U.K. are separating the Chair and CEO roles. Here in the U.S., each year the number of companies with a separate chair and CEO increases. About 1/3 of S&P 500 companies have split the chair and CEO. Not all of these have an independent chair. Sometimes the chair is the former CEO which brings its own set of problems and challenges.

Independent board chairs can really strengthen and clarify who’s in charge. Does the CEO work for the shareholders as represented by the board of directors—where you report to the board—or do we have some sort of monarchy in which the CEO both controls the board and runs the company? Running a company is a full time job in and of itself and running a board of directors effectively as a board chair should also be such a responsibility.

Louis: The discussion on board of director election needs to go beyond a company specific discussion between pension funds, investors and companies. It really needs to reflect a “must” in fundamental corporate governance practice—that is to have independent directors serving on boards of public companies.