Say on Pay: Will U.S. Shareholders Give Executives the Thumbs Up on Compensation?Published: December 08, 2010 in Knowledge@Wharton
Top corporate executives of U.S.-listed firms will have a new worry next year: Their pay packages will be scrutinized as never before. Starting in January, shareholders by law will be able to vote regularly to approve or disapprove executive pay packages. What will investors consider before casting their votes? Will they put their foot down if they think a pay check is overly generous or simply rubber stamp what corporate boards put before them? And when they do cast these non-binding votes, how much influence will their views actually have on pay levels and the metrics against which performance is measured?
The so-called "say on pay" advisory shareholder vote was first required by law for U.S. financial institutions receiving bailout funds under the Troubled Asset Relief Program (TARP) in 2008. About 70 other U.S. companies have adopted similar voting voluntarily in recent times. This summer, the Obama administration went a step further with the Dodd-Frank Wall Street Reform and Consumer Protection Act. Starting with annual shareholder meetings taking place after January 21, the Act requires all public companies to conduct say-on-pay votes at least once every three years and ask shareholders to vote on the frequency of those votes every six years. Shareholders will also be asked their views on golden parachute awards after a merger, acquisition or any other type of restructuring. Meanwhile, the country's pension funds and other large institutional investors that will be casting ballots must disclose publicly how they voted and why.
While the general public will be disappointed that the new law won't necessarily put an end to fat-cat pay, it should go some way toward raising the accountability of many executives who have been paid handsomely despite shoddy performance that has harmed, rather than helped, increases in the value of their companies for shareholders. But casting votes that push firms to link pay to performance requires careful analysis by investors, according to experts from Wharton and compensation advisors.
Fat-cat pay has drawn the ire of investors and the general public for years, but their outcry reached a fever pitch after the banking meltdown in 2008. Taxpayers, who were asked to bail out the banks, were particularly infuriated by compensation to Lehman Brothers CEO Richard Fuld in the years before the company filed the largest bankruptcy in U.S. history in September 2008. While Fuld said he received $310 million in compensation over the period between 2000 and 2007 and that he had not sold much of his stock, observers put his pay much higher, to as much as $500 million.
Fuld wasn't alone. The reasons? The sector's excessive cash bonuses, a focus on short-term annual growth measures, and "pay levels that were so high they effectively insured executives against failure" and fueled an aggressive risk-taking culture, according to a new report commissioned by the Council of Institutional Investors (CII), which represents about 130 pension funds. The report found that Wall Street's median compensation levels were between two and three times the levels of the rest of the Fortune 50 during the five years from 2003 to 2007. "The differential was driven for the most part by Wall Street's appetite for larger awards of time-restricted stock," noted the report's author, Paul Hodgson, a senior research associate at the Corporate Library, a corporate governance research outfit.
But experts question whether a mandatory say-on-pay system will help improve the size and structure of pay packages. "The amount of work [institutional investors] can do [to analyze and improve pay packages] is trivial compared to what the board has already done," says Wayne Guay, a Wharton accounting professor who consults on executive compensation plans. "The chance that they'll come up with a flaw in the plan is slim. I'm confident most boards are doing a pretty good job."
According to the CII's report, say-on-pay votes should also be wielded carefully. "A high say-on-pay 'against' vote is a blunt instrument," it stated, adding that there are other, potentially more effective steps investors can take to voice their displeasure with excessive pay. "Shareowners should ensure that if they do vote against compensation, they explain their objections in a letter to the company.... If change is not forthcoming, owners can let the company know that they will vote against the reelection of compensation committee members. As a last step, [they can] consider filing a shareowner resolution seeking improvements in specific pay practices."
Skin in the Game
Despite the intense public scrutiny and frequent criticism of executive pay packages in the media, however, most U.S. shareholders who have been able to cast votes on executive pay have been supportive of company practices. Thus far in 2010, only three companies have failed to receive majority support for their compensation programs, and no company failed to receive majority support for pay programs in 2009, said Towers Watson, a compensation advisory firm, in a recent newsletter. A case in point: Aflac, an insurance firm that was the first company to voluntarily subject its executives' pay packages to a shareholder vote, including $11.96 million to its chief executive, Daniel Amos. More than 93% of the 200 shareholders who voted backed their board.
According to Wharton finance professor Alex Edmans, short-term holders may have different objectives than long-term holders. "Short-term holders usually don't have as much 'skin' in the game," so their focus when analyzing pay packages might be different than long-term investors, he notes.
And regardless of the longevity, evaluation criteria can vary from one shareholder to the next. Michael Useem, a Wharton management professor, says large investors such as Fidelity, Vanguard, BlackRock and T. Rowe Price assign analysts to study the compensation of their holdings, develop broad policies and decide how the organization should vote. Smaller institutional investors are likely to rely on the formulas developed by proxy advisory firms like Glass Lewis or Institutional Shareholder Services (ISS). Their recommendations focus on making sure that executives' pay reflects their performance and that there are not egregious clauses, such as lifetime use of company planes.
An example of ISS's approach can be found in a report posted on its website recommending a vote against the 2008 compensation plan at tax-preparer Jackson Hewitt. Among other things, the ISS did not like awarding stock options based on achieving an earnings-per-share goal for 2009 because the goal was not disclosed. Worse, the goal might have led managers to "encourage franchise openings or acquisitions that are not beneficial for the long term."
As for golden parachutes, Edmans says that even though they are usually frowned upon by the investor community and are not popular among the general public, shareholders should not automatically vote against them. Understandably, shareholders are unhappy when an executive who is asked to leave a company after years of poor performance walks away with a multimillion-dollar retirement plan. But in other cases, without a parachute clause, a CEO might try to scupper a takeover bid, ultimately at a high price to shareholders. "It can be useful to give an incentive to step down and sell the firm," Edmans notes. Under the law, boards can have severance plans approved in advance, without the need for a shareholder vote when the executive departs.
Lifting the Curtain
But "yes" or "no" votes aside, the big benefit of the new law will be the increased transparency as to how executive pay structures are designed, according to Useem, who is also director of Wharton's Center for Leadership and Change Management. Under greater scrutiny, he says, companies will work harder to improve the information about pay in proxy statements and annual reports.
To adhere to the law, Towers Watson says companies will have to disclose how the compensation of the officers named in proxy materials stacks up against company performance -- for example, any change in the value of a firm's shares plus dividends or other metrics, such as total shareholder return (a method used to compare the stocks and shares performance of different companies over time). Also, addressing growing concerns about social inequality, the new rules require companies to state the median of the annual total compensation of all employees (except the CEO), the annual total compensation of the CEO and the ratio between the two. Companies must also say whether they permit employees or board members to engage in hedging against a decrease in the market value of all the company's shares, not just those granted as part of a compensation package.
Alongside greater transparency, "what matters is the structure of pay packages," says Edmans. "I don't think the compensation model is broken or that pay was the cause of the crisis [on Wall Street]." However, he agrees with many experts that it is important for the model "to contain sufficient equity in the form of stock and options to align the executives' interest with shareholders." In addition, executive stock awards "should have long vesting periods," in order to avoid excessive focus on short-term gains, Edmans adds.
Useem favors pay plans that reward executives for outperforming peer groups at other companies. He also likes programs that reward executives for achieving operating metrics, such as boosting market share or growing revenues faster than a benchmark. "Those [compensation tools] are better than stock options," which in effect can reward executives simply because the overall market is performing well, he says.
According to the CII, the average Fortune 50 executive pay package from 2002 through 2007 included 20% cash salary, 22% cash bonus and 58% in equity, including both stock and options. Many compensation experts make the point that investors should approve compensation plans that align executive pay with shareholder returns over time -- preferably over three to five years.
Receiving the thumbs down from investors will not necessarily be the end of the world. "There are emerging opinions that negative vote levels above 15% should be viewed as a signal that shareholder concerns need to be examined or addressed, depending on the circumstances," Towers Watson noted in an October report. "The trend from one vote to the next will also be an important barometer of shareholders' views. For example, a company that goes from 95% favorable in one say-on-pay vote to 80% the following year may have more to worry about than a company that consistently receives 75% shareholder support for its pay programs."
Other countries -- Australia, the Netherlands, South Africa, Norway and Sweden -- that have introduced similar say-on-pay laws in recent years offer insight into what U.S. can expect. Research published in 2009 by Pirc, a London-based corporate governance advisory firm, found that the introduction of a say-on-pay rule in the U.K. in 2002 has led to a higher proportion of executive pay packages at companies being performance-related. Overall remuneration at U.K. companies has risen, the report noted, but directors have faced a high level of opposition on pay in 2009 with four companies losing investor votes.
As the U.K.'s experience proves, the votes by themselves are not likely to lower compensation -- in fact, Guay predicts that the new law will have "no effect whatsoever" on pay levels. And while he believes the voting is a good way to figure out "whether the [pay] process is in good shape or not," he says if regulations make it difficult to pay top executives in line with the value they add to the company, they will go elsewhere. "There are too many other places for these people to get work."
Useem has an additional concern: With boards focused on using pay to incentivize certain behavior, "you may run the risk of focusing them too much on pay and too little on other factors." He says executives need to look at issues that might not fit into a compensation plan but still have important long-term implications for a company, such as preparing for climate change or corporate social responsibility. "An unrelenting focus on pay for performance may ironically undercut the ability of top executives to lead their companies," he notes. "If you want laser-like focus on management pay incentives, you may take the managers' attention away from important long-term objectives."