Executive pay is taking center stage in the governance reform debate, with significant attention given to a proposal to mandate an annual advisory shareholder vote on the executive compensation report, known as “say on pay,” following the example of United Kingdom (U.K.). I have recently completed two studies examining this proposal—the first considers the impact of “say on pay” in the U.K., and the second analyzes the effect of mechanisms currently available to U.S. investors to influence executive pay (i.e. shareholder proposals and vote-no campaigns).
In the first study, co-authored with David Maber of University of Southern California, Say on Pay Votes and CEO Compensation: Evidence from the UK, we perform two sets of tests. First, we examine UK firms’ responses to say on pay votes by analyzing the changes to compensation policies made by firms after facing high voting dissent against their remuneration report. We document that a significant number of these firms removed or modified provisions that investors viewed as “rewards for failure” (e.g., generous severance contracts, low performance hurdles, provisions allowing the retesting of performance conditions)—often in response to institutional investors’ explicit requests—and established a formal process for proactive consultation with their major shareholders going forward. These actions paid off, in that voting dissent at the subsequent annual meeting was substantially lower. We also find evidence of similar actions taken before the vote by a subset of firms that subsequently experienced low voting dissent, suggesting that the threat of a vote induced some firms to revise CEO pay practices ahead of the annual meeting.
Second, we examine the trend in CEO pay and its sensitivity to economic determinants before and after the introduction of say on pay for a large sample of UK firms. We find no evidence of a change in the level and growth rate of CEO pay—after controlling for firm performance, size and other factors. However, we find a significant increase in the sensitivity of CEO pay to poor performance. The increase is most pronounced in (i) firms with high voting dissent, and (ii) firms with an ”excessive” level of CEO pay (relative to the level predicted by its economic determinants) before the adoption of say on pay, regardless of the voting dissent. Interestingly, we do not find a more pronounced increase in firms with higher raw levels of CEO pay. These findings confirm the insights from our small-sample evidence of explicit changes to pay contracts and suggest the following: (i) UK investors used say on pay to push for greater accountability for poor performance; (ii) firms responded to adverse shareholder votes, in spite of their non-binding nature; (iii) (at least some) firms responded to the threat rather than the realization of an adverse vote; (iv) shareholders focused on firms with controversial CEO pay packages (as captured by high voting dissent or excessive CEO pay levels) rather than firms with high (but not abnormal) CEO pay levels.
In the second study Shareholder Activism and CEO Pay, coauthored with Yonca Ertimur of Duke University and Volkan Muslu of the University of Texas at Dallas, we examine a comprehensive sample of 1,332 compensation-related shareholder activism events over the 1997-2007 period (134 vote-no campaigns and 1,198 shareholder proposals). We find that, in targeting firms, activists take both the ”predicted” and ”excess” components of CEO pay into consideration. In other words, activists (particularly institutional investors) appear sophisticated enough to identify excess CEO pay firms, but they also target firms with high (but not abnormal) levels of CEO pay, perhaps to bring greater visibility to their initiatives or because of concerns with social equity. Voting support for compensation-related proposals, in contrast, is higher in firms with excess CEO pay but not in firms with high (but not abnormal) CEO pay, suggesting that shareholder votes reflect a sophisticated understanding of CEO pay figures. Voting patterns depend on the type of shareholder proposal. In particular, proposals aimed at affecting the pay setting process (e.g., proposals requesting shareholder approval of certain compensation items)—which we label Rules of the Game proposals—receive the highest voting support, often resulting in majority votes. Support for proposals aimed at influencing the output of the pay setting process (e.g., proposals to use performance-based vesting conditions in equity grants)—which we label Pay Design proposals—is lower but has been increasing in recent years. Proposals directed at shaping the objective of the pay setting process (e.g., proposals to link executive pay to social criteria or to abolish incentive pay)—labeled Pay Philosophy proposals and mostly filed by individuals and religious funds—have consistently received little support. The rate of implementation for pay-related proposals is generally low (5.3%) but increases substantially for proposals receiving a majority vote (32.2%) most of which are Rules of the Game proposals. With respect to the overall effect on CEO pay, we document a $7.3 million reduction in excess CEO pay for firms targeted by vote-no campaigns, corresponding to a 38% decrease in CEO total pay. As for shareholder proposals, we find evidence of a moderating effect on CEO pay—a $2.3 million reduction—only in firms targeted by Pay Design proposals sponsored by institutional proponents in recent years.
What do these studies tell us about the potential impact of “say on pay” in the U.S.? While drawing policy implications requires caution, a few lessons can be learned. First, there is no indication that special interest groups pushing for radical changes have hijacked shareholder votes in the U.K. or the U.S.—a concern expressed by critics of say on pay. U.S. shareholders have systematically rejected proposals trying to micromanage executive pay and supported those that ask for a say on the pay process. Similarly, U.K. shareholders have shied away from opining on pay levels and focused instead on strengthening the link between pay and performance by imposing certain rules of the game (e.g., no retesting of performance conditions). Second, in both countries, investors use their voting power in a moderate and sophisticated manner, raising their voice only at few firms with controversial pay practices and suspiciously high pay levels. Fears that many firms would face massive chaos and revolts at annual meetings have not materialized. Third, while both in the U.S. and the U.K. boards do listen to shareholder votes, even if advisory, say on pay votes and vote-no campaigns are more effective in getting boards’ attention than shareholder proposals. A say on pay vote against the remuneration report (or votes withheld from a director) greater than 20% usually prompts a firm’s response. In contrast, shareholder proposals have a reasonable (but still low) chance to be implemented only if they win a majority vote. This difference is not surprising. Vote-no campaigns and say on pay directly question directors’ performance and, thus, affect their reputation. In addition, unlike shareholder proposals, they enable shareholders to express their general dissatisfaction with CEO pay rather than with a single problem and do not require an ex ante agreement on the solution. As such, they may force a broad dialogue between investors and boards on all aspects of CEO pay, without putting shareholders in the difficult position to micromanage specific and technically complex aspects of CEO pay through a 500-word “yes or no” proposal. The fourth lesson is that the U.K. experience with say on pay indicates that boards try to prevent an adverse voting outcome through ex ante consultation with institutional investors and that enhanced communication is crucial for boards to “interpret” the say on pay vote.
Overall, these factors suggest that concerns with say on pay may have been exaggerated. Say on pay may be as effective as vote-no campaigns in causing boards to listen and act, and with an added benefit. Specifically, say on pay may allow greater activism by those institutional investors concerned with CEO pay but reluctant to compromise their relation with boards by engaging in vote-no campaigns and voting against the re-election of otherwise valuable directors.
However, a number of caveats are in order, particularly in drawing inferences from the experience of a different country with its own governance environment. First, for say on pay to work investors must have something to say in the first place. In the U.K., institutional investors have developed and agreed upon (and continue to update) a set of guiding principles, or “best practices,” on executive remuneration, complementing the principles in the Combined Code. Under the U.K. “comply or explain” governance model, these best practices provide firms and shareholders with a clear benchmark against which to make assessments of pay practices. In addition, concentrated institutional ownership has led to a relatively high level of engagement which also allows for firm-specific adjustments of these best practices. It is not clear whether institutional investors in the US will take such a proactive role or outsource it to proxy voting services, which may be tempted to adopt “cheap” one-size-fits-all solutions, as cautioned by Jeffrey Gordon of Columbia Law School in a piece in the Harvard Journal on Legislation. In addition, higher concentration and stability of institutional ownership may make communication with boards easier in the U.K. Second, in the U.K. it is generally easier for investors to replace directors, thereby making directors more responsive to shareholder pressure (though the trend toward majority voting and proposed proxy access legislation may make the threat of replacement stronger in the U.S.). In view of these and other caveats, proposals to limit mandatory say on pay to large firms may be a sensible first step (after all, our studies show that most compensation-related activism is focused on the largest firms).
A final word of caution: in the heat of the reform debate, say on pay has often been used in the same sentence as excessive risk-taking to suggest that an advisory shareholder vote would lead to compensation packages that discourage excessive risk-taking. Such a statement is incorrect. Say on pay is a neutral tool that shareholders will use (if they decide to use it) to influence compensation practices in a way consistent with their objectives. The risk-taking profile desired by shareholders may very well differ from the level of risk-taking that regulators may deem optimal for the economy. Similarly, say on pay should not be expected to be a tool to deal with wealth inequality. After all, shareholders have long supported compensation packages that have encouraged risk-taking and resulted in higher compensation levels.