Paul Hodgson: Will it be thumbs up or down for Microsoft’s CEO pay at tomorrow’s AGM?

What is there to make of the differing advice from ISS and Glass Lewis?

Microsoft has had a pass grade on its CEO pay practices forever.
Until this year, that is. For the first time since the vote’s introduction, proxy advisor ISS has recommended that shareholders vote against its Say on Pay proposal at the annual meeting tomorrow (December 3). In contrast, rival proxy advisor Glass Lewis has issued the opposite recommendation, indicating that shareholders should consider supporting the pay vote.
To determine the source of this apparent contradictory advice, I spoke to Robert McCormick, Glass Lewis’ Chief Policy Officer and reviewed the firm’s proxy paper. ISS would not comment beyond its proxy report, “in keeping with [its] media policy.”
The source of this controversy is CEO Satya Nadella’s 2014 compensation of, in ISS’ estimation, $91m. In contrast, previous Microsoft CEOs have earned around $1.2m annually. Of course, the prior CEOs were Bill Gates and Steve Ballmer, both very substantial shareholders who received no equity compensation during their entire tenures. Not that being a founder and major shareholder always results in simple and modest compensation. Just look at Larry Ellison at Oracle who, up until this year’s pay reduction, regularly earned $100m or more despite his huge 25% stake.
Nadella, of course, while an employee, is not a major shareholder, and the remuneration committee’s stated purpose was that its initial pay package provide “the opportunity to build significant ownership when the CEO creates sustained long-term value for shareholders.”
What resulted was a $60m one-off equity award with payout opportunities occurring on the 5th, 6th, and 7th anniversaries of the grant date, depending on relative total stockholder return performance against the S&P 500. The proxy statement claims that the annualized value of the one-off award over its seven-year term is $8.45m. Of course, this was not the only pay Nadella earned during the year. He also received an annual base salary of around $900,000, it will be $1.2m in his first full year as CEO, and a bonus of $3.6m, a $13.5m retention award in his role as EVP Cloud and Enterprise award while the company was searching for a CEO following Ballmer’s retirement announcement. Finally, he received another $7m in regular stock awards.As one-off, promotional equity grants go it’s certainly not the largest. Tim Cook’s $376m stock award on his promotion to CEO of Apple was considerably larger and, initially, was not tied to the achievement of performance metrics at all. Shareholder objections led Apple’s board to apply targets retroactively. But then Cook has not received any further grants of equity, while Nadella will receive around $13.2m annually on top of his promotional award, one source of ISS’s disapproval.
Glass Lewis’ report indicates that the company received a D grade in its pay-for-performance model and that Microsoft paid more to its named executive officers, including the CEO, than the median for its peers. Its concerns over the company’s subjective approach to determining incentives are, as it says, “considerably mitigated” by its “reasonable historic compensation practices.”

While it puts the company on a warning that its approach must change, it adds: “the unique context surrounding the previous CEOs and the Company’s generally adequate record of aligning pay with performance have mitigated our concerns to a sufficient degree at this time.”
GL’s Robert McCormick explained this by noting that there was no traditional CEO pay package at Microsoft, which is also hampered by being a lot larger than most of its peers, most of whom pay their CEOs a lot more than, traditionally, Microsoft did. However, he felt that “the structure, vesting and performance aspects of the one-off award looked good. We were a little concerned,” he added, “about the continued need for the retention grants made to Nadella before he was CEO.” And felt that these could have been rescinded in light of his promotion. “Even with these amounts, the pay performance model only gave the company a D grade rather than an F,” he continued. “Even with an F it’s not automatic that we recommend a no vote. It’s less of a determining factor but more of guide. Last year we recommended in favor of 17 per cent of companies with F grades because of other extenuating circumstances.”

“However,” he warned, “while this one-off grant is likely to be supported by shareholders, if there are any other significant additional awards in subsequent years there is likely to be a significant backlash.”

Similarly, ISS’ initial quantitative screen awarded the company a “High Concern” rating, but this would not automatically lead to a recommendation to vote against pay practices as it is followed by a qualitative review. ISS’ key concerns are centered around the fact that a quarter of the special grant can vest for performance at or below approximately the bottom third of the S&P 500, a practice that can hardly be described as “best”. It also objects to continued annual grants despite the size of the special one-off award. In addition, the discretionary nature of performance appraisals for the annual bonus – which for Nadella could amount to up to $10.8m – is questioned, as is the fact that annual equity grants are merely time vesting. These elements, of course, are not new, they have just been thrown into higher relief because of Ballmer’s retirement and Nadella’s promotion.
In a letter to shareholders in advance of next Wednesday’s meeting, Microsoft’s chairman John Thompson called for shareholders to support the Say on Pay proposal without specifically referring to ISS’ recommendation, and assured them that the company will be introducing “metric-based annual incentive pay for all of our executive officers next fiscal year [2016].” Even though ISS specifically notes that the company will be redesigning its incentive plans in 2016, it still recommended a no vote.Some shareholders have already made their voting decisions. For example, the Florida State Board of Administration has voted against the pay package. Tracy Stewart, Senior Corporate Governance Analyst at Florida SBA, said: “We weighed the conversation we had with the company executives against the research analysis of Glass Lewis (recommending for) and ISS (against) and decided that the disconnect between pay levels and targets for performance were too great; the performance threshold was too low and the grants too large. Glass Lewis included a graphic that captured the problem. Microsoft and Oracle are outliers in comparison to their peer group, and that’s not a good thing when you’re talking about pay levels. The SBA had similar concerns with Oracle’s compensation structure.” Other large shareholders were still in communication with Microsoft about the grants and had not made a final decision at the time of writing. For example, neither CalPERS nor PGGM had decided which way to vote.
As is demonstrated above, institutional shareholders do not unquestioningly follow either ISS’ or Glass Lewis’ recommendations, engaging in, typically, their own sophisticated analysis while using the proxy advice to inform their decisions. Nevertheless, recommendations from both ISS and Glass Lewis carry significant sway. When they disagree, as here, the necessity for shareholders also to think for themselves is even greater.

Paul Hodgson is an independent governance analyst.