Ten Myths of “Say on Pay”

Posted by David F. Larcker, Stanford Graduate School of Business, on Friday September 28, 2012 at 8:59 am
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Editor’s Note: David Larcker is the James Irvin Miller Professor of Accounting at Stanford University.

In the paper, Ten Myths of “Say on Pay”, my co-authors (Allan McCall, Gaizka Ormazabal, and Brian Tayan) and I review many widely held misconceptions regarding the shareholder voting practice called “say on pay.” “Say on pay” is a prominent issue today, given its unique position at the intersection of executive compensation and shareholder democracy—two topics which themselves are of deep interest to investors, stakeholder, regulators, and the media. Despite this interest, several misconceptions have developed which continue to be commonly accepted. Fortunately, academics have devoted considerable effort studying “say on pay,” shareholder democracy, and executive compensation. As a result, a lengthy empirical record exists against which “say on pay” can be examined. Our intention is to review “say on pay” in light of the scientific evidence so that practitioners have a better understanding of the limits and consequences of granting shareholders the right to vote on executive compensation.

The ten myths of “say on pay” that we examine can be grouped into three general categories. The first category relates to the definition of “say on pay” and the impetus for its adoption in the United States. Despite what many believe, there is no single policy for implementing “say on pay” that is uniformly adopted across countries. Models of “say on pay” vary considerably in terms of whom they address (boards of directors or named executives), their objective (the compensation philosophy or compensation levels), their restrictiveness (binding or advisory), and their catalyst (legal mandate or market-driven pressure). Currently, the academic evidence does not demonstrate which of these approaches is most effective for mitigating compensation related problems, and it is likely to be the case that different mechanisms are more effective for mitigating different problems (e.g., the solution for excessive compensation levels could be different from the solution to poor alignment between pay and performance). Similarly, the evidence is weak that the right to vote on compensation is valuable to shareholders. Academic research demonstrates that markets reacted negatively to the inclusion of “say on pay” in Dodd-Frank, particularly among companies most likely to receive negative votes, perhaps suggesting that negative votes will encourage actions that destroy rather than enhance value.

The second category of myths relates to the impact that “say on pay” has had, and can be expected to have, on the structure and design of compensation contracts. Although proponents of “say on pay” expressed a belief that granting shareholders the right to vote on compensation would reduce pay levels, improve pay for performance, reduce incentive for excessive risk taking, and reduce the incidence of rent-extracting benefits and payments, this has not been the case. To date, fewer than 2 percent of companies in the United States have failed to receive majority approval of their pay plans. Average approval levels across companies are high: approximately 90 percent. Compensation levels have risen in each of the two-years since “say on pay” was adopted. Compensation contracts continue to be heavily weighted toward variable, long-term performance awards whose values correlate well with stock-price and operating performance. And companies continue to offer discretionary bonuses and non-standard perquisites when these judgments are appropriate for their company’s unique strategic or operating requirements. These results are consistent with the existing literature on executive compensation that documents the purpose, desirability, and consequences of specific pay-design features.

The third category of myths relates to the impact that “say on pay” has on shareholder relations. Shareholders delegate authority to a board of directors precisely because shareholders do not and cannot have all the information they need to make informed decisions regarding a company’s strategy and operations. Decisions relating to executive compensation fall into this category. Given the heterogeneity of shareholder groups (in terms of objectives, time horizons, and investment strategies), it is impractical—and indeed impossible—for members of the compensation committee to adjust executive compensation packages to satisfy all shareholders. That said, considerable evidence exists that open dialogue between boards and shareholders mollifies shareholder dissatisfaction, without regard to whether shareholder recommendations on proxy items are adopted. “Say on pay” helps to foster this dialogue. Finally, the practice of “say on pay” increases the influence of third-party proxy advisory firms that provide recommendations to institutional investors on how they should vote items on the annual proxy over corporate policy. Research evidence demonstrates that these recommendations are highly influential. Unfortunately, the research evidence also demonstrates that these recommendations, particularly as they relate to “say on pay”, tend to be value decreasing for shareholders. This poses a dilemma for corporate directors who must consider—and in many cases respond to—the recommendations of proxy advisory firms such as Institutional Shareholder Services and Glass Lewis & Co.

Given the disconnect between the purpose of “say on pay” and its consequences, it is unclear whether a legal requirement to grant shareholders an advisory vote on executive compensation will improve the design of or reduce perceived excesses in executive pay. It would be highly desirable for regulators to carefully study the costs and benefits associated with mandatory “say-on-pay” votes.

The full paper is available for download here.

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