Shareholders Need a Say on Pay

With executive compensation soaring to unprecedented levels in recent years, the prickly issue of CEO pay has received increasing media and government attention. Now, with the perfect storm of a failing economy, government bailouts, and high unemployment, the topic has hit white-hot status.

One particular tool put forward in reforms is the idea of "say on pay," which gives shareholders a non-binding vote on executive compensation and severance packages. The Obama administration has proposed requiring it in all public companies. And just before its August recess, the U.S. House of Representatives passed a bill granting shareholders a non-binding vote on executive compensation and severance packages. It also maintains that compensation committees should be independent of management.

But given its non-binding status, does say on pay work to control executive compensation?

"Historically, when the government tries to set limits it doesn't work very well."

Say on pay has been a research focus of HBS assistant professor Fabrizio Ferri, who started his career at Stern Stewart & Co specializing in performance measurement and incentive compensation issues. In the paper "Say on Pay Vote and CEO Compensation: Evidence from the UK," Ferri and coauthor David Maber (HBS DBA '09), assistant professor at University of Southern California, analyzed the provision, which has been available to United Kingdom shareholders since 2002.

Although Ferri and Maber found no indication of a change in levels of CEO pay after the adoption of say on pay in the UK, they did discover an increase in the sensitivity of CEO pay to poor performance and a reduction in severance packages. The effect was more pronounced in firms with high voting dissent, but was also observed more generally in organizations with excess CEO pay, suggesting that some companies acted in advance of the annual meeting to avoid a confrontation with shareholders.

These findings suggest that say-on-pay legislation can be a useful tool for shareholders to strengthen the link between CEO pay and performance when it comes to those much-maligned golden parachutes.
Ferri sees say on pay as a tool utilized "quite judiciously" in the past.

"There's no evidence that the process was hijacked by special interests. And it works quite well in terms of favoring more communication and awareness between shareholders and boards." He adds that it forces both entities to grapple with an extremely complex issue.

"To have more say on pay, you need to have something to say in the first place."

One at a time
The political climate has muddied the waters a bit in framing that discussion, says Ferri.

There is the question of how to best align the interests of management and shareholders to incentivize long-term performance. Then there's the larger debate over the government's role in issuing limits on the huge pay discrepancies between a company's highest-ranked employees and those further down the ladder—a discussion that could easily stretch beyond business to the lavishly compensated worlds of professional sports and entertainment. There's also the concern over executive pay at firms that received government bailout money.

"All these issues are converging by chance, but they should be considered separately," says Ferri. "Say on pay is not supposed to solve all these issues. It's simply a tool that shareholders will use as they see fit. It may or may not be used in a way that government believes will be good for society. Shareholders have a different objective function from government in that sense." Ferri points out that when the economy was doing well, for example, shareholders had a healthy appetite for the sort of risk-taking that contributed to the subprime mortgage crisis.

Modeled after the UK law, the legislation before Congress makes some wonder if the legislation's non-binding nature will result in any noticeable effect on executive pay. Others, including Ferri, believe a lighter hand produces better results.

"Historically, when the government tries to set limits it doesn't work very well," he comments. "The flexibility of executive compensation is so enormous that it's always possible to find loopholes. It can even create distorting incentives that make the problem worse."

In 1993, for example, Congress imposed a $1 million cap on CEO salary tax deductibility that then led to an explosion of other perks and forms of compensation, such as stock option grants.

"My sense is that the Obama administration fundamentally believes in the power of markets combined with good government supervision," Ferri says. "While some legislators have been pushing for more socialistic solutions, they worry about intervening too much."

Increased shareholder involvement
Ferri sees the increased interest in executive pay as an objective opportunity to recognize its importance as a complicated business decision with "huge consequences" on the actions taken by management. While there hasn't been much variation on compensation packages in the past, Ferri advocates a more holistic approach that tailors executive pay to a company's individual circumstances.
"I like the notion of say on pay because it encourages institutional shareholders to think and get involved—not only in terms of compensation levels, but in the choice of performance measures consistent with a firm strategy, goal setting, time horizon, etc."

Like all interested observers, Ferri will be watching to see how compensation practices change over time. Despite past periods of outrage, he notes that the situation often reverts to "business as usual," with some cynics asserting that is already the case today. Whatever one's view on executive pay, it seems increasingly clear that the collective involvement of multiple stakeholders will shape whatever praise or blame is to come in the future.

Ferri, on leave as a visiting assistant professor of accounting at NYU's Stern School of Business, sees a number of avenues for future research on executive compensation, including its influence on risk-taking and the effects of regulation and disclosure regimes on pay. With increasing access to data from EU nations, he also foresees the potential for comparative analysis of how different nations handle compensation.

[This article was provided with permission from Harvard Business School Working Knowledge.]