• The why and the how of top investor and proxy advisor decisions on management board compensation
  • Investors and proxy advisors have market power but lack transparency
  • The need for a Stewardship Code for investors and proxy advisors as well as a new quality of investor relations dialog

Frankfurt, Germany, December 27, 2017. A joint study by hkp/// group und Ipreo, Say-on-Pay – Which way does the coin flip?, analyzes the ownership structure of DAX index listed companies and decisions taken by the top 30 investors in relation to management board compensation.

According to the study, 40% of shares in DAX companies that are owned by institutional investors are passively managed, i.e. they automatically simulate an index, for example. German institutional shareholders hold only a minority 17% of these shares. ESG criteria (environmental, social and governance) feature more and more heavily in the voting behavior and investment decisions of investors. This background has led to directors' remuneration being viewed particularly critically. In 2017 alone, three of eight say-on-pay votes were rejected. Without anchor investors, more than half of resolutions would have failed.

Proxy advisors, and especially the two market leaders ISS and Glass Lewis, play a key role in say-on-pay voting. Even though most of the major investment houses have their own Governance Departments, almost all use proxy advisor services. The voting behavior of 44% of the top 30 investors is almost identical to the recommendations made by proxy advisors. This influence is considerably greater with smaller investors, since their voting behavior is de facto outsourced to proxy advisors.

There is however, a great lack of transparency in matters relating to voting behavior and outcomes. Very few investors like BlackRock publish detailed guidelines governing their voting behavior. What is needed is a Stewardship Code, a code of conduct giving investors and proxy advisors clear directions on disclosure of their decision-making and voting activities.

“Investors all over the world are paying more attention to corporate governance and corporate social responsibility, the so-called ESG criteria. Passive investors are particularly active in this regard. They often view top-management compensation policies as a powerful lever to exert influence in completely unrelated areas,” explains Andreas Posavac, Managing Director of Ipreo.

Michael H. Kramarsch, Managing Partner of hkp/// group adds: “Investor behavior has become much more unpredictable in relation to management board compensation. Companies can no longer expect that the remuneration policy for their directors will be simply nodded through at an AGM. Rather, they must be prepared that the European Shareholder Rights Directive is making say-on-pay a permanent item on AGM agendas for all companies, instead of being tabled for discussion sporadically on those of just a few. Therefore, companies should engage and communicate proactively with the capital market.”

A selection of study findings
1) Continuing concentration on investor side and passive investments
The worldwide trend to larger and passive investments is reflected in the ownership structures of DAX companies. Ownership is highly concentrated in the hands of the major global institutional investors, who mostly engage in passive investment, in particular BlackRock (around USD 49 billion as a group), Norges Bank (approx. USD 28 billion) and Vanguard (approx. USD 25 billion). German institutional shareholders are clearly underrepresented with a share of about 17% (2017). In addition, the very heterogeneous investor landscape is constantly changing.

2) Management board compensation gaining importance
ESG, and especially directors' remuneration, are becoming increasingly important issues for investors. Both they and proxy advisors have discovered it as a lever to instigate a debate on unrelated issues, such as strategic corporate orientation, ambition, impartiality of the supervisory board etc. It is likely to become even more significant with the advent of the European Shareholder Rights Directive. In future, companies will have to address the issue of directors' remuneration at every Annual General Meeting.

3) Critical look at executive compensation dominates – say-on-pay
Top investors are keeping a critical eye on directors' remuneration in Germany. A trend to negative say-on-pay votes has been observed since 2014. A total of eight DAX companies presented their executive remuneration policies to their shareholders in 2017. Those of Merck, Munich Re and ProSiebenSat.1 Group were rejected. Excluding anchor investors and only looking at the free float, more than half of the latest compensation votes would have been rejected.

4) Proxy advisors determine the mainstream in voting recommendations
Investors rely on the services of proxy advisors to help them evaluate governance aspects. In 2017, 44% of the top 30, and nearly all smaller investors, followed the recommendations of proxy advisors. Thus, the market leaders ISS and Glass Lewis determine the mainstream in voting recommendations. In an average DAX annual general meeting, ISS affects up to five times of the BlackRock Group votes – without owning a single share.

5) Changed decision making processes – lack of transparency
In contrast to smaller investors, the 30 major investment houses in the DAX have established their own ESG teams, which allow them to adequately evaluate key governance issues. They do pay attention to proxy advisor recommendations, but do not necessarily follow them. Moreover, governance experts have different requirements than investors’ investment teams. They address different target audiences (supervisory boards) and come to different conclusions in the end.
Corporate Investor Relation must adapt to this changed investor process landscape. The processes are not always comprehensible for issuers and/or detailed explanation of final voting decisions are only communicated in exceptional cases. This shows that there is a significant lack of transparency.

Implications for regulators and issuers
Based on their analysis, the study authors demand that these substantial transparency deficits are remedied: “We need a Stewardship Code to regulate the behavior of both investors and proxy advisors, and the decision-making processes behind it. Companies simply need more transparency to act professionally in their communications with the capital market. And it is becoming less of just a dialog with the Investment Teams but also additionally an engagement with those who make the decisions in the voting process”, explains Michael H. Kramarsch, Managing Partner at hkp/// group.
 
Andreas Posavac, Managing Director at Ipreo, adds in respect to the companies: “Issuers must be prepared to a modified investor dialog. That involves not only getting in touch with the relevant representatives of investors and proxy advisors at an early stage, but ideally also trying to establish a constant communication. If you only knock on the door shortly before the AGM, you are unlikely to get hold of anyone and will certainly not be able to change people’s minds to your advantage.” In the end, a new quality of investor dialog will have to be achieved.
 
Michael H. Kramarsch, Managing Partner at hkp/// group, also thinks that companies need to present their remuneration reports in a more investor friendly way. “We have to move away from the auditor's perspective, which is currently dominant in Germany, when communicating information about executive pay. Information required by law is mandatory. But that should not stop anyone from presenting meaningful information in an appropriate logical structure and in such a way that it can be understood by anyone.”