In our paper, Should Shareholders Have a Say on Executive Compensation? Evidence from Say-on-Pay in the United States, which was recently made publicly available on SSRN, we examine the SEC 2011 regulation requiring an advisory (non-binding) shareholder vote on the compensation of the top five highest paid executives – “say-on-pay” (SOP). In July of 2010, Section 951 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) was signed into law requiring all public companies to give their shareholders the opportunity to cast a “non-binding” advisory vote to approve or disapprove the compensation of the 5 highest paid executives at least once every 3-years. The Securities and Exchange Commission (SEC) implemented “say-on-pay” (SOP) in January of 2011, and since then, shareholders in the US have “had their say” on executive compensation packages for two years: 2011 and 2012. To date, the SOP shareholders’ votes overwhelmingly approved the executive compensation proposals by a majority of votes (>than 50 percent) giving broad support to management pay packages (Cotter et al., 2012). Only 1.2 percent of the Russell 3000 failed the SOP proposal in 2011 and 2.5 percent failed in 2012 obtaining less than 50 percent approval. However, around 10 percent of firms received more than 30 percent opposition or “rejection” votes.
Before and during Dodd-Frank’s legislative process, SOP had numerous opponents and proponents, many of which testified in Congress. Opponents of SOP predicted that: 1) shareholder input on pay would diminish the effectiveness of the Board’s role (Kaplan, 2007; Gordon, 2009); 2) shareholders were unable to discern and properly evaluate compensation plans (Gordon, 2009); 3) if say-on-pay were beneficial, then boards could freely adopt it, without the need for legislation; and 4) say-on-pay initiatives had the potential of being divisive or driven by special interests (Kaplan, 2007; Deane, 2007). The opposition to mandatory or regulated SOP was also based on the premise that union pension funds and institutional investor activism could be led by “political agendas” instead of the fund’s benefit and could be at best value neutral or value destroying (see Larcker and Tanyan, 2012; Bainbridge, 2011). The debate and opposition to SOP was fundamentally based on the notion that boards of directors were essentially doing their job by properly aligning their interests to those of shareholders. This board alignment that ensured that managers’ actions were beneficial to shareholders was reflected in properly designed executive compensation contracts that were based in shareholder maximizing incentive structures.
On the other hand, proponents argued that: 1) the results of SOP in UK were positive and that mandatory SOP had a positive impact on corporate governance increasing the sensitivity of pay for performance (Coates, 2009); 2) SOP could enhance transparency, governance and accountability that would in turn lead to greater efficiency and social responsiveness (Bebchuk et al., 2007); 3) shareholders would be able to discern poorly design pay packages and – if needed – would ask for advisory recommendations; and 4) SOP would create a stronger relationship between pay and performance (Bebchuk et. al., 2007; Ferri and Maber, 2012).
The need for shareholders to “have a say” in executive compensation, came from the premise that, at times, boards of directors interests’ were not aligned with those of shareholders and this resulted in excessive executive compensation. Specifically, demands for SOP came after two decades of fraud and financial scandals that resulted in greater global awareness and shareholder activism demanding more transparency and better corporate governance. In particular the option backdating scandals increased concerns about boards’ ability to properly create compensation contracts aligned with shareholders’ interests. Thus, excessive executive compensation was attributed to – among other things – lack of board independence and CEO entrenchment problems that led to board’s interests being aligned with managers rather than with shareholders. Thus, the need for SOP came from the perception that boards were not properly representing the interests of shareholders and that shareholders needed to actively participate in the process of determining executive compensation.
The objective of this paper is to empirically examine the results of SOP in the US during 2011 and 2012. In particular, we examine the efficacy of shareholders’ votes by investigating the characteristics of firms that receive rejection (approval) votes in opposition (favor) of the executive compensation proposals. We test Cai and Walkling’s (2011) predictions and ask whether SOP shareholder votes benefited firms with “questionable compensation practices” and “unfairly hurt good firms”. We also test if institutional investors and shareholder activism played a role in voting results. In particular, we try to examine if shareholders were able to vote rationally by considering firm performance, governance, firm risk, and the appropriateness of executive pay. Additionally, we examine the effect of SOP in the levels of executive compensation by looking at the response of firms that “failed” to receive more than 50 percent approval in 2011. Finally, we investigate if earnings quality affected SOP voting outcomes.
Our sample consists of all firms in the Russell 3000 that voted after SOP became mandatory in 2011 and includes all votes during 2011 and 2012. We find approval (reject) votes are associated with firms that have: better (lower) financial performance, higher (lower) market returns, lower (higher) returns volatility, lower (higher) total compensation, lower (higher) abnormal CEO compensation and better (worse) earnings quality. We also find evidence to suggest that firms that receive a high level of SOP rejection votes subsequently reduce the growth of executive compensation levels.
This study contributes to the literature in two ways. First, it is the first to empirically examine the first two years of SOP votes in the United States. Second, our analysis provides evidence of shareholder efficiency in identifying excessive CEO compensation and poor financial performance, thus lending support to the argument that shareholder voting rights are an effective mechanism of corporate governance that addresses the problem of incomplete contracts and management rent extraction. The first two years of SOP votes in the US show a great degree of shareholder sophistication in recognizing the monitoring and reward tools that need to coexist between owners and firm managers. Furthermore, our results strongly suggest that shareholders are “doing their homework” and are carefully discerning and identifying relevant issues that should be linked to executive compensation. Shareholders are voting down excessive compensation packages of firms with low returns, high return volatility, poor financial performance and low quality accounting.
The full is available for download here.