Commentary by David F. Larcker, James Irvin Miller Professor of Accounting & Director, Stanford GSB Corporate Governance Research Program; and Brian Tayan, Stanford GSB Case Writer, MBA ’03.
RiskMetrics Group (RMG) has a substantial influence on the annual proxy voting process. By some estimates, the company can influence the outcome of a vote by at least 20 percent. This may be all for the better when it comes to informing routine matters such as auditor ratification, or even shareholder-sponsored resolutions whose economic implications may be unclear to the passive shareholder.
What is less clear is whether the firm’s influence is warranted when it comes to the approval of more fundamental issues such as approval of new or expanded equity-based compensation plans. Shareholders do not generally vote on total compensation paid to executives, although companies are starting to allow voting on precatory (non-binding) say-on-pay resolutions. Equity-based compensation plans are a fundamentally different matter because granting equity to employees dilutes the ownership interest of shareholders and a shareholder vote is required. Obviously, shareholders may vote to approve such plans when the cost of dilution is more than offset by the positive effects on stock price that are expected to occur when executives have appropriate incentives.
How much influence does RMG have over the structure of these plans? Interestingly, firms seem to structure their equity-based plans to satisfy a somewhat arbitrary limitation for “burn rate” established by RMG. The burn rate is the ratio of number of options (or option equivalents) granted this year to the number of common shares outstanding. If the limit established by RMG is exceeded, it is very likely that RMG will recommend a vote “against” the proposed equity-based plan.
Take three recent proxies:
- Chesapeake Energy: “In connection with our seeking shareholder approval […], the Board of Directors’ stated intent is to limit the Company’s average annual burn rate […] to not more than 2.62%. […] 2.62% is RiskMetrics’ average allowable burn rate cap over 2009 and 2010 for our industry.”
- United Online: “Both our Board of Directors and the Compensation Committee of our Board commit to our stockholders that for the next three fiscal years […], the ‘burn rate’ will not exceed 6.11% per year on average, which is the average of the 2009 and 2010 ‘burn rate’ limits published by RiskMetrics.”
- Idex: “The Compensation Committee commits to the Company’s shareholders that for fiscal years 2010, 2011 and 2012, it will limit the annual ‘burn rate’ […] to 2.735%, which is the average of the 2009 and the 2010 ‘burn rate’ limit for the Capital Goods segment established by RiskMetrics.”
Companies are restricting their option granting in order to get a positive recommendation from RMG. Do they have any idea whether the limit established by RMG is appropriate for their strategic choice of executive equity incentives?
By limiting their burn rate to satisfy RMG, are companies creating or destroying economic value?